1. NEO-KEYNESIANISM Keynesian, Monetarism (Friedman) and Rational Expectations (Sargent)

2. Classical Model Austrian School – von Mises, Hayek ■Markets Will Adjust –Economic Depression – Aggregate Demand Shock ■Aggregate Demand Decreases –Short-run Adjustment – price are sticky ■Decrease in AD -> No Change in AS (prices/wages are sticky downwards) ■Decrease in Real GNP -> Increase in Unemployment –Long-run – prices are flexible ■Labor contracts renegotiated -> input (labor prices) drop -> AS shifts left ■Leads to new Long Run Equilibrium –Lower Prices -> increase in Real Y -> increase in employment (lower U)

3. Keynes Response to Classical Economist ■In the Long-Run we are all dead –Adjustment to Equilibrium takes forever ■Keynes response to the Great Depression –Monetary Stimulus (Increasing the Money Supply) will be ineffective ■Economy is in a liquidity trap –Market Interest Rates are near zero (Zero lower bound or “liquidity trap”) –If you can’t lower interest rates -> can not increase Investment or AD –No Change in Consumption -> Consumers hoard cash during recession –Monetary Policy is weak or ineffective!

4. Keynes Proposal to End the Recession ■Increase Fiscal Stimulus (G) –Increase G to offset decreases in C(Y) and I ■Government increase spending (Congress/Executive branch) –Hires new workers (government employees, contractors) –Build infrastructure (capital) to increase in productivity and long-run GNP ■Multiplier Effect –Increases in Y for Government workers -> increases Consumption Spending –Private Sector: Increases production of new goods, increases hiring –$1 increase in G -> leads to a >$1 Increase in AD ■However, will require the government to increase Budget Deficit as Tax Revenues will be decreasing during a recession (Higher U -> lower Y -> lower T = tY)

5. Fiscal Multipliers Any Evidence That They Exist? ■Fiscal Multipliers in Recessions –Matthew Canzoneriy Fabrice Collardz ■Georgetown University University of Bern –Harris Dellasx Behzad Diba{ ■University of Bern Georgetown University ■January 23, 2015

6. Fiscal Multipliers Any Evidence That They Exist? ■The Great Recession, and the fiscal response to it, has revived interest in the size of fiscal multipliers. ■Standard business cycle models have difficulties generating multipliers greater than one. –And they also cannot produce any significant state-dependence in the size of the multipliers over the business cycle. ■In this paper we show that fiscal multipliers can be strongly state dependent in a countercyclical manner. –In particular, a fiscal expansion during a recession may lead to multiplier values exceeding two, ■while a similar expansion during an economic boom would produce multipliers falling short of unity. ■Our results are consistent with recent empirical work documenting the state contingency of multipliers.

7. Figure 11-7 Demand-Determined Equilibrium Real GDP at Less Than Full Employment - Multiplier > 1 Keynes assumed prices will not fall when aggregate demand falls

8. The breakdown of the Phillips Curve: Multiplier < 1 7 8 This figure shows annual data from 1961 to 1973 on the unemployment rate and on the inflation rate (as measured by the GDP deflator). The Phillips curve of the 1960s breaks down in the early 1970s, just as Friedman and Phelps had predicted. Notice that the points labeled A, B, and C in this figure correspond roughly to the points in Figure 5.

9. Figure 11-9 Real GDP Determination with Fixed versus Flexible Prices - Reconciling the two models

10. So Where Are We Now? ■Current Unemployment at “natural” rate (~5%) ■Low rate of inflation ~2% ■Wage growth starting to increase (<2%) –But still below productivity (~3%) ■GNP (~2%) growth still below long-term growth rate (~3%) ■Should the Fed: –A) increase interest rates? ■Decrease risk of inflation ■Decrease risk of another financial bubble

11. So Where Are We Now? ■Current conditions –Current Unemployment at “natural” rate (~5%) –Low rate of inflation ~2% –Wage growth starting to increase (<2%) ■But still below productivity (~3%) –GNP (~2%) growth still below long-term growth rate (~3%) ■Should the Fed: –B) not change interest rates (historically low, ~ 0%)? ■Raising rates might decrease economic growth –Decrease I, lower AD and hiring, decrease C, raise U ■It would be 1937 All Over Again!