Lesson 17-3 Macroeconomics for the 21 st Century

New Keynesian Economics New Keynesian economics is a body of macroeconomic thinking that stresses the stickiness of prices and the need for activist stabilization policies through the manipulation of aggregate demand to keep the economy operating close to its potential output. It incorporates monetarist ideas about the importance of monetary policy. It incorporates new classical ideas about the importance of aggregate supply, both in the long and in the short run. Another new element is the greater use of microeconomic analysis to explain macroeconomic phenomena, particularly the analysis of price and wage stickiness

The 1980s and 1990s: Advances in Macroeconomic Policy The Revolution in Monetary Policy The monetary revolution began on July 25, 1979, when Paul Volcker became Chairman of the Board of Governors of the Federal Reserve System. Volcker led the Fed to attack inflation strongly through contractionary monetary policy. After continuing high inflation coupled with very high unemployment rates, the inflation rate began to fall in 1981.

The next revolution began with the appointment of Alan Greenspan as Chairman of the Fed in the 1990s. The Fed began to pay attention to lags in policy and change from expansionary to contractionary policies even before the solving of a recessionary gap.

Fiscal Policy: Stepping Back In 1981, Ronald Reagan followed policies almost exactly like Kennedy’s in 1961 with a tax cut and increased defense spending, but the rationale was a supply-side, not Keynesian, argument. Reagan said that cutting high marginal tax rates would encourage work and that reinstating the investment tax credit would stimulate investment. The resultant rising deficits began to dominate fiscal policy discussions. Expansionary fiscal policy was rejected because of the national debt even in the recession of 1990–1991. Surpluses emerged in 1998 and were predicted well into the twenty- first century.

The Rise of New Keynesian Economics Monetary Change and Monetarism The close relationship between changes in the money supply and subsequent changes in nominal GDP was broken in the 1980s and 1990s. This was one of the effects of deregulation of banks. This was taken as evidence of the instability of velocity of M2.

The New Classical School and Responses to Policy People did not respond to policies of the 1980s as predicted. Rational expectations theory has not explained the public’s responsiveness to monetary policy. Government deficits did not cause predicted changes in private savings.

A Macroeconomic Consensus? Surveys of economists show that the new Keynesian approach has emerged as the preferred approach to macroeconomic analysis. New Keynesianism has become dominant in the determination of macroeconomic policy. It succeeds because it incorporates elements of the other approaches. Gave greater credence to monetary policy.

Accepted microeconomic foundations of maximizing behavior. Incorporated changes in aggregate supply. Considerable controversy still remains on which particular policies to use in specific situations, but a new consensus seems to be forming.