Transcript Module 35/36 PPT

Learning Target:
• I will assess how macroeconomic thinking has
changed throughout history
Classical Economics: 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!?  Keynes: “in the long run, we are all dead”
The Business Cycle (?)
 Wesley Mitchell (Bureau of Economic Research)
 There was no consensus theory of how business cycles
worked!
 Many economists believed the economy would selfadjust to long-run equilibrium, they assumed that any
downturn in the economy was only temporary!
 Active policy was not needed to alleviate a recession.
 And then . . . THE GREAT DEPRESSION! (neither
predicted or fixable by classical economic theory)
Great Depression an Keynesian
Revolution
 (1936) John Maynard Keynes: The General Theory of
Employment, Interest, and Money
 Two innovations.
1.
2.
Short run shifts in AD do affect aggregate output and the PL
because there is an upward sloping AS curve; rather than
minor and temporary shifts, these short-run shifts are
important!
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 (classical economists
emphasized the role of changes in the money supply in
shifting the aggregate demand curve, paying little attention
to other factors)
Classical Versus Keynesian
Macroeconomics
Classical View: SRAS is vertical; Keynesian View: SRAS curve is upward sloping.
Conclusion: Shifts in AD can increase output (in the short run); justifies use of
Monetary and Fiscal policy to bring economy into LR Equilibrium (Yfe).
Results of Keynes’ work
 Legitimized macroeconomic policy activism—the use
of monetary and fiscal policy to smooth out the
business cycle (WE CAN DO SOMETHING!)
 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:
The Revival of Monetary Policy
 Keynes had downplayed effectiveness of Monetary Policy
 Milton Friedman and Anna Schwartz (1963) published: A
Monetary History of the United States, 1867–1960
 Showed that business cycles had historically been associated
with fluctuations in the money supply.
 Money supply fell sharply during the onset of the Great Depression!
 Persuaded most economists that monetary policy should play a
key role in economic management.
 Suggested that the burden of managing the economy could be
shifted away from fiscal policy (economic management could
largely be taken out of the hands of politicians!)
 A central bank, insulated from political pressures, should be able
to conduct monetary policy more effectively than fiscal policy!
Monetarism
 Monetarism: GDP will grow steadily if money supply grows
steadily
 Discretionary Policies – bad! (creates instability)
 Crowding Out (AD movements “crowd out” private
investment spending through changes in the interest rate
 Monetary Policy Rule: formula that determines central
banks actions (i.e grow MS by 3% annually)
 Quantity Theory of Money, MV = PY
 Velocity of Money: ratio of GDP to money supply/number of
times the average dollar bill is spent
 If we assume that V is constant then a slow increase in M
will increase PY or nominal GDP; however during 1980s
erratic Velocity undermined Monetarism
Inflation and the Natural Rate of
Unemployment
 Friedman and Phelps suggested NAIRU
 Natural Rate Hypothesis: to avoid accelerating
inflation over time, unemployment must be high
enough that actual inflation = expected inflation
 Thus there is a limit to Discretionary Policy
 Stagflation of 1970s proof of Hypothesis!
 Natural Rate empirical tested and widely accepted;
influence of monetarism declined.
Challenges to Keynes: The Political
Business Cycle
 Researchers have found statistical correlation between
upcoming political elections and expansionary fiscal policy.
 In months leading up to an election, government either
cuts taxes or announces new spending programs; policies
put more money in the pockets of voters and also tend to
lower the unemployment rate.
 Eventual cost is inflation, but by then the election is over
and inflation can be addressed at a later date!
 Result: more justification for putting economic policy in
the hands of a central bank that is free of political
influence (go Monetarism!)
Challenges to Keynes: Real Business Cycles,
and New Classical Macroeconomics
 New Classical Economics: return to classical view that shifts in
the AD affect only the PL
 Rational Expectations (John Muth, 1961): individuals and firms
make decisions optimally, using all available information.
 Implication:
 If government trades off higher inflation for lower unemployment .
..
 Then the public will understand this, and expected inflation will
immediately rise (no sticky wages/sticky prices)
 But this doesn’t accurately describe how the economy behaves!
 New Keynesian economics: price stickiness does exist in the
economy and that inflation is not always quick to rise, even if
expectations are for higher prices.
Challenges to Keynes: Real Business Cycles,
and New Classical Macroeconomics
 (1980s) economists argued that slowdowns in productivity growth
(which they attributed to pauses in technological progress) are the
main cause of recessions.
 Real business cycle theory claims that fluctuations in the rate of
growth of total factor productivity cause the business cycle.
 RBC believes AS curve is vertical and shifts in AS cause the business
cycle
 Recession: occurs when there is a slowdown in productivity growth (AS
curve shifts left).
 Recovery: occurs when there is a pickup in productivity growth (AS
curve shifts right).
 RBC has made valuable contributions to our understanding of the
economy; caution against too much emphasis on aggregate demand.
 RBC acknowledges that models need an upward sloping AS to fit the
economic data (AD then has role in determining output)
Should Monetary Policy Be Used in
a Discretionary Way?
 Monetary Policy should play a central role in





stabilization policy.
Central bank should be Independent of political
influence
Discretionary fiscal used sparingly (b/c of lags and to
avoid political influence)
Central Bank Inflation Targets
Should Fed support Asset Prices? (Maybe)
Unconventional Monetary Policies (2008 Crisis)
The Great Recession!
Arguments for Fiscal Policy Stimulus:
The Great Recession!
Arguments against Fiscal Policy Stimulus: