Transcript Module History and Alternative Views of

Pump Primer:
• Define Keynesian Economics.
Module 35
History and
Alternative Views of
Macroeconomics
John Maynard Keynes & Milton Friedman
KRUGMAN'S
MACROECONOMICS for AP*
Margaret Ray and David Anderson
Biblical Integration:
• As Christians we need to be prudent
and foresee problems before they
arise (Prov. 22:3) History sheds a
great deal of light on what can
happen in an economic, and it is for
that reason why we need to understand where we as a nation went
wrong. In order to prevent a repeat
of history.
What you will learn
in this Module:
• Why classical macroeconomics wasn’t
adequate for the problems posed by the
Great Depression
• How Keynes and the experience of the
Great Depression legitimized
macroeconomic policy activism
• What monetarism is and its views about
the limits of monetary policy
• How challenges led to a revision of
Keynesian ideas and the emergence of
the new classical macroeconomics
Classical Macroeconomics:
Money and the Price Level
According to the classical model:
Prices are flexible.
The aggregate supply curve is vertical
even in the short run.
An increase in the money supply leads,
other things equal, to a proportional rise
in the aggregate price level.
An increase in the money supply does
not increase aggregate output.
Key result is that increases in the
money supply lead to inflation, and
that’s all. Really?
Classical Macroeconomics:
Money and the Price Level
Before 1930, most economists were aware
that changes in the money supply affect
aggregate output as well as aggregate
prices in the short run. They were aware
that the short–run aggregate supply curve
slopes upward. But, they regarded such
short-run effects as unimportant, stressing
the long run instead.
Classical Macroeconomics: The
Business Cycle
•There was no consensus theory
of how business cycles worked.
However, many economists
believed the economy would
self-adjust to long-run
•equilibrium. They assumed that
any downturn in the economy
was only temporary. Active
policy was not needed to
alleviate a recession.
Classical Macroeconomics: The
Business Cycle
• The failure of economic theory to predict, or
fix, the Great Depression led many to rethink
the way in which the business cycle moved,
and the role of government policy in the
economy.
Keynes’s Theory
• In 1936 John Maynard Keynes presents his
explanation of what was wrong with the
economy during the Great Depression in a
book titled The General Theory of
Employment, Interest, and Money.
Keynesian economics mainly reflected two
innovations:
Keynes’s Theory
1. Short-run shifts in aggregate demand do affect
aggregate output and the price level because
there is an upward sloping aggregate supply
curve. Rather than minor and temporary shifts,
these short-run shifts are important.
2. The AD curve can shift because of several
factors including “animal spirits” or business
confidence, and that these were the main
cause of business cycles..
Keynes’s Theory
Classical economists emphasized the role of
changes in the money supply in shifting
the aggregate demand curve, paying little
attention to other factors.
Keynes’s Theory
Classical
Theory
Keynesian
Theory
Challenges to Keynesian Economics:
The Revival of Monetary Policy
The main practical consequence of Keynes’s work
was that it legitimized macroeconomic policy
activism—the use of monetary and fiscal policy is to
smooth out the business cycle.
In the 1930s, economists were divided on the issue
of government policy that would affect the business
cycle.
Today there is broad consensus that active
monetary and/or fiscal policy can play useful roles.
The debate today is the degree to which policies
should be taken.
Challenges to Keynesian
Economics: Monetarism
Over the years, economists became much
more aware of the limits to macroeconomic
policy activism.
Different theories, or “schools of thought”,
were presented and have continued to evolve
to shape economic policy.
Challenges to Keynesian
Economics: Monetarism
A. The Revival of Monetary
Policy
Monetary policy began to gain
traction after WWII.
Milton Friedman and Anna
Schwartz (1963) published: A
Monetary History of the United
States, 1867–1960 .
University of Chicago
Economist, Milton Friedman
They showed that business cycles
had historically been associated
with fluctuations in the money
supply.
Challenges to Keynesian
Economics: Monetarism
In particular, the money supply fell sharply during the
onset of the Great Depression.
They persuaded most economists that monetary
policy should play a key role in economic
management.
The revival of interest in monetary policy was
significant because it suggested that the burden of
managing the economy could be shifted away from
fiscal policy—meaning that economic management
could largely be taken out of the hands of politicians.
Challenges to Keynesian
Economics: Monetarism
The revival of interest in monetary policy was
significant because it suggested that the burden
of managing the economy could be shifted away
from fiscal policy—meaning that economic
management could largely be taken out of the
hands of politicians.
• What taxes, and for whom, should be cut?
• What programs should receive more
government spending?
A central bank, insulated from political pressures,
should be able to conduct monetary policy more
effectively than fiscal policy.
Challenges to Keynesian
Economics: Monetarism
B. Monetarism
Milton Friedman led a movement that sought to
eliminate macroeconomic policy activism while
maintaining the importance of monetary policy.
Monetarism asserted that GDP will grow steadily if
the money supply grows steadily.
The monetarist policy prescription was to have the
central bank target a constant rate of growth of
the money supply, such as 3% per year, and
maintain that target regardless of any fluctuations
in the economy.
Challenges to Keynesian
Economics: Monetarism
By creating a kind of “monetary rule” the
central bank would avoid the political perils
of fiscal policy and the effect of large
government spending crowding out
investment spending.
How would this crowding-out happen?
Challenges to Keynesian
Economics: Monetarism
Draw these graphs in the space provided as the
instructor describes the chain of events.
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•
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Suppose government spending
increases.
In the AD/AS model, AD shifts to the right.
The price level rises, as well as the real GDP.
In the money market, higher prices cause an
increase in money demand.
The interest rate begins to rise.
Higher interest rates reduce private investment,
which decreases AD.
Thus the final effect of expansionary fiscal policy
is
weakened because private investment is
crowded-out.
Challenges to Keynesian
Economics: Monetarism
Challenges to Keynesian
Economics: Monetarism
The Quantity Theory of Money emerges to
justify the slow steady growth of the money
supply.
MV = PY
If we assume that V, the velocity of money, is
constant then a slow increase in M will
increase PY or nominal GDP.
In the 1980s, V becomes more unpredictable
and the effectiveness of the Monetarism
policies slides.
Challenges to Keynesian Economics: Inflation
and the Natural Rate of Unemployment
Not all economists were convinced
that monetarism was the way to go.
In 1968, Milton Friedman and
Edmund Phelps of Columbia
University, working independently,
proposed the concept of the
natural rate of unemployment.
In Module 34, we saw that the
natural rate of unemployment is
also the non-accelerating
inflation rate of unemployment,
or NAIRU.
Challenges to Keynesian Economics: Inflation
and the Natural Rate of Unemployment
(Note: The Phillips curve is a good review of how higher
inflation becomes embedded into expectations. In order to
avoid accelerating inflation over time, the unemployment rate
must be high enough so that actual inflation equals the
expected inflation rate.)
The important result is that if the unemployment
rate is kept below the NAIRU, inflation will start
to rise.
The natural rate hypothesis was validated with
experimental testing and the influence of
monetarism declined.
Challenges to Keynesian Economics:
The Political Business Cycle
Researchers have found statistical correlation between
upcoming political elections and expansionary fiscal policy.
This means that, in months leading up to an election,
government either cuts taxes or announces new spending
programs. These policies put more money in the pockets of
voters and also tend to lower the unemployment rate. The
eventual cost is inflation, but by then the election is over and
inflation can be addressed at a later date.
This is even more justification for putting economic policy in the
hands of a central bank that is free of political influence.
Rational Expectations, Real Business
Cycles, and New Classical Macroeconomics
Macroeconomics
• In the latter half of the 20th century,
economists continued to develop and
modify versions of classical and
Keynesian economic models.
Rational Expectations, Real Business
Cycles, and New Classical Macroeconomics
A. Rational Expectations
• In the 1970s a concept known as rational expectations
had a powerful impact on macroeconomics.
• Rational expectations (John Muth in 1961) is the view that
individuals and firms make decisions optimally, using all
available information.
• What is the implication of this assumption for economic
policy?
• According to the original version of the natural rate
hypothesis, a governments attempt to trade off higher
inflation for lower unemployment would work in the short
run but would eventually fail because higher inflation would
get built into expectations.
Rational Expectations, Real Business
Cycles, and New Classical Macroeconomics
• According to rational expectations, we should
remove the word eventually: if it’s clear that the
government intends to trade off higher inflation for
lower unemployment, the public will understand
this, and expected inflation will immediately rise.
• Most macroeconomists accept a notion of the New
Keynesians that price stickiness does exist in the
economy and that inflation is not always quick to
rise, even if expectations are for higher prices.
Rational Expectations, Real Business
Cycles, and New Classical Macroeconomics
B. Real Business Cycles
• In the 1980s a number of
economists argued that
slowdowns in productivity
growth, which they attributed
to pauses in technological
progress, are the main cause
of recessions.
Rational Expectations, Real Business
Cycles, and New Classical Macroeconomics
• Real business cycle theory claims that fluctuations
in the rate of growth of total factor productivity cause
the business cycle.
• Believing that the aggregate supply curve is vertical,
real business cycle theorists attribute the source of
business cycles to shifts of the aggregate supply
curve.
• A recession occurs when a slowdown in productivity
growth shifts the aggregate supply curve leftward.
• A recovery occurs when a pickup in productivity
growth shifts the aggregate supply curve rightward.
Rational Expectations, Real Business
Cycles, and New Classical Macroeconomics
• RBC theory is widely recognized as having made
valuable contributions to our understanding of the
economy, and it serves as a useful caution against
too much emphasis on aggregate demand.
• But many RBC theorists themselves now
acknowledge that their models need an upward –
sloping aggregate supply curve to fit the economic
data—and that this gives aggregate demand a
potential role in determining aggregate output. And
as we have seen, policy makers strongly believe
that aggregate demand policy has an important
role to play in fighting recessions.