Schools of Macroeconomic Thought Modules 35 & 36

Classical Theory Prices are flexible Supply curve always vertical Increase in money supply = increase in price level – Real Money Supply (M/P) is constant – Money Neutrality Fiscal and monetary policy have no effect on output – Only lead to inflation

Keynesian Theory Short-run matters – “In the long run we’re all dead” – Prices can be sticky – Aggregate Demand can shift due to sentiment “animal spirits” Monetary policy not very effective – Liquidity trap Fiscal policy effective

Monetarism GDP growth requires growth in money supply Monetary policy better as stabilization policy – Not politicized Monetary policy should follow a target growth rate for money supply – Monetary rule Discretionary policy (fiscal and monetary) is at best ineffective and at worst harmful

Modern Consensus Monetary policy can shift AD and be used to fight recessions – But still acknowledge liquidity trap Governments should not put balancing the budget ahead of the economy – Automatic stabilizers are important While policy can limit swings of unemployment rate, the natural rate will hold in long run

Modern Consensus Discretionary fiscal policy is not normally effective – Monetary policy faster – BUT, in case of liquidity trap may be necessary Monetary policy should take the lead in stabilization policy – Independent of politics – Disagreement on discretionary use