Module History and Alternative Views of Macroeconomics

1. 35 John Maynard Keynes & Milton Friedman ModuleHistory andAlternative Views ofMacroeconomics • KRUGMAN'S • MACROECONOMICS for AP* Margaret Ray and David Anderson

2. What you will learnin thisModule: • 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

3. Classical Macroeconomics: Money and the Price Level • %∆ M = % ∆ PL • Short-Run Effects Unimportant • Focus is on the Long-Run (before 1930s) • Keynes - “ (in the long run) we are all dead.”

4. Classical Macroeconomics: The Business Cycle • The Business Cycle (measurement yes but no theory of business cycles) Series of short-run cycles….. • Lack of consensus • Necessity is the mother of invention (Great Depression spurred LOTS of theories) The Great Depression demonstrated that economists could not ignore the SR.

5. Keynes’s Theory • The General Theory (Keynes, 1936) one of the most influential economic books ever written • Classical View (next page graph) • Keynesian View (next page graph) • “Animal Spirits” (Keynes argued “AnSp” were mainly responsible for business cycles---today it’s called business confidence)

6. Keynes’s Theory Classical Theory Keynesian Theory Keynesian AS curve normally drawn as straight line…. Important difference: SRAS is vertical (CT) so a shift in AD changes PL but not output. In Keynesian view, a shift affects both PL and output.

7. The main practical consequence of Keynes’s work was that it legitimized macroeconomic political activism---the use of fiscal and monetary policy to smooth out the business cycle.

8. Challenges to Keynesian Economics: The Revival of Monetary Policy • A Monetary History of the United States, 1867 - 1960 • Great Depression caused by Fed contracting the money supply • Business cycles caused by fluctuations in the money supply. • Monetary policy is important - less political (economics policy can be taken out of the hands of politicians) University of Chicago Economist, Milton Friedman

9. Challenges to Keynesian Economics: Monetarism • Monetarism: idea that GDP will grow steadily if the MS grows steadily. • Discretionary Fiscal Policies – bad because of “lags”—policies may actually feed a boom • Crowding Out: if MS is held fixed while the government pursues an expansionary fiscal policy, crowding out will limit the effect of the fiscal expansion on AD. • Monetary Policy Rule: formula that determines actions of FED and leaves little discretion.

10. Challenges to Keynesian Economics: Monetarism • Quantity Theory of Money, MV = PY: relies on velocity of money (stable in SR, slow growth in LR) ---this means that steady growth in MS = steady growth in spending = steady growth in GDP • Velocity of Money: measure of the number of times the average dollar is spent per year. • Erratic Velocity undermines Monetarism: steady through the 1870s, erratic starting in 1980s

11. Challenges to Keynesian Economics: Inflation and the Natural Rate of Unemployment • Natural Rate Hypothesis (NAIRU): because inflation is embedded into expectations, the unemployment rate must be high enough that actual inflation must be high enough that it meets expected inflation.

12. Challenges to Keynesian Economics: Inflation and the Natural Rate of Unemployment • Limit to Discretionary Policy: Friedman-Phelps Hypothesis (NAIRU) predicted that the apparent tradeoff between inflation and unemployment would not survive a period of extended period of rising prices. • Stagflation of 1970s proof of Hypothesis • Natural Rate widely accepted

13. Challenges to Keynesian Economics: The Political Business Cycle • Consequences of Keynes on Politics: lends itself to political manipulation • Election Day Economics: misery index predicts which party will get into office based on economy in months preceding the election • Political Business Cycle: caused by use of macroeconomic policy to serve political ends….pay the price with infl or unemp to get reelected. The need for central bank independence • The need for central bank independence President Obama and Senator McCain

14. Rational Expectations, Real Business Cycles, and New Classical Macroeconomics • New Classical Macroeconomics: (1970s/1980s) returned to view that shifts in AD curve only affects AggPL, not AggOP. • Rational Expectations Theory: view that individuals and firms make decisions optimally, using all available information • New Keynesian Economics: even small costs to changing prices can lead to substantial price stickiness and make the economy behave in Keynesian fashion • Real Business Cycle Theory: fluctuations in rate of growth of total factor productivity cause the business cycle.

15. ModuleThe ModernMacroeconomicConsensus 36 • KRUGMAN’SMACROECONOMICS for AP* Margaret Ray and David Anderson

16. What you will learnin thisModule: • The elements of the modern macroeconomic consensus • The main remaining disputes

17. The Modern Consensus

18. Should Monetary Policy Be Used in a Discretionary Way? • Main role in stabilization policy • Independent central bank • Discretionary fiscal - sparingly • Central Bank Targets • Asset Prices • Unconventional Monetary Policies