chapter:

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>> Macroeconomics: Events
and Ideas

Krugman/Wells

©2009  Worth Publishers 1 of 41

WHAT YOU WILL LEARN IN THIS CHAPTER
 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 discretionary monetary policy
 How challenges led to a revision of Keynesian
ideas and the emergence of new classical
macroeconomics
 The elements of the modern consensus, and the
main remaining disputes
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The Feds Response to the 2001 Recession

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 Classical Macroeconomics
 The first modern school of economic thought.
 Its major developers include Adam Smith, Jean-Baptiste
Say, David Ricardo, Thomas Malthus and John Stuart
Mill.
 Classical macroeconomics asserted that monetary policy
affected only the aggregate price level, not aggregate
output.
 Classical macroeconomics asserted that the short run was
unimportant.
 According to the classical model, prices are flexible, making
the aggregate supply curve vertical even in the short run.

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 Classical Macroeconomics
 As a result, an increase in the money supply leads,
other things equal, to an equal proportional rise in
the aggregate price level, with no effect on
aggregate output.
 Increases in the money supply lead to inflation, and
that’s all.

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 Classical Macroeconomics
 By the 1930s, measurement of business cycles
was a well-established subject, but there was no
widely accepted theory of business cycles.
 In 1920 Wesley Mitchell founded National Bureau
of Economic Research, an independent, nonprofit
organization that to this day has the official role of
declraing the beginnings of recessions and
expansions. The measurement of business cycle
was advanced by 1930.
 The term macroeconomics appears in 1933 by
Norwegian economist Ragnar Frisch.

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►ECONOMICS IN ACTION
When Did the Business Cycle Begin?

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 The Great Depression and the Keynesian
Revolution
 In 1936, Keynes presented his analysis of the
Great Depression—his explanation of what was
wrong with the economy’s alternator—in a book
titled The General Theory of Employment,
Interest, and Money.
 The school of thought that emerged out of the
works of John Maynard Keynes is known as
Keynesian economics.

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Classical versus Keynesian Macroeconomics

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FOR INQUIRING MINDS

The Politics of Keynes

 The term Keynesian economics is sometimes used as a
synonym for leftwing economics.
 Keynes himself was no socialist—and not much of a leftist.
 At the time The General Theory was published, many
intellectuals in Britain believed that the Great Depression
was the final crisis of the capitalist economic system and
that only a government takeover of industry could save the
economy.
 Keynes, in contrast, argued that all the system needed was
a narrow technical fix. In that sense, his ideas were pro-
capitalist and politically conservative.

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FOR INQUIRING MINDS

The Politics of Keynes

 What is true is that the rise of Keynesian economics in the
1940s, 1950s, and 1960s went along with a general
enlargement of the role of government in the economy, and
those who favored a larger role for government tended to be
enthusiastic Keynesians.
 Conversely, a swing of the pendulum back toward free -
market policies in the 1970s and 1980s was accompanied
by a series of challenges to Keynesian ideas, which we
describe later in this chapter.

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 Policy to Fight Recessions
 The main practical consequence of Keynes’s work
was that it legitimized macroeconomic policy
activism—the use of monetary and fiscal policy to
smooth out the business cycle.

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►ECONOMICS IN ACTION
The End of the Great Depression
 The basic message many of the young economists who
adopted Keynes’s ideas in the 1930s took from his work was
that economic recovery requires aggressive fiscal expansion
—deficit spending on a large scale to create jobs.
 And that is what they eventually got, but it wasn’t because
politicians were persuaded.
 Instead, what happened was a very large and expensive
war, World War II.

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►ECONOMICS IN ACTION
Fiscal Policy and the End of the Great Depression

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►ECONOMICS IN ACTION
The End of the Great Depression
 Figure 33-3 shows the U.S. unemployment rate and the
federal budget deficit as a share of GDP from 1930 to 1947.
 As you can see, deficit spending during the 1930s was on a
modest scale.
 In 1940, as the risk of war grew larger, the United States
began a large military buildup, and the budget moved deep
into deficit.
 After the attack on Pearl Harbor on December 7, 1941, the
country began deficit spending on an enormous scale.

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 Challenges to Keynesian Economics
 Monetarism asserted that GDP will grow steadily if
the money supply grows steadily.
 It called for a shift from monetary policy rule to that
of a discretionary monetary policy.
 It argued that GDP would grow steadily if the
money supply grew steadily.
 Monetarism was influential for a time, but was
eventually rejected by many macroeconomists.

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Fiscal Policy with a Fixed Money Supply

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Monetarism
 Milton Friedman (July 31, 1912  – November 16,
2006) ,1976 Nobel laureates in Economics .
 When the central bank changes interest rates or
the money supply based on its assessment of the
state of the economy, it is engaged in
discretionary monetary policy.
 A monetary policy rule is a formula that
determines the central bank’s actions.
 The velocity of money is the ratio of nominal GDP
to the money supply.
 The velocity equation: M × V = P × Y

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 Monetarism
 Monetarists believed that V was stable, so they
believed that if the Federal Reserve kept M on a
steady growth path, nominal GDP would also grow
steadily.
 Rule rather than discretionary.

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 Inflation and the Natural Rate of Unemployment

 The natural rate of unemployment is also the non-

accelerating-inflation rate of unemployment, or
NAIRU.
 According to the natural rate hypothesis, because
inflation is eventually embedded into expectations,
to avoid accelerating inflation over time the
unemployment rate must be high enough that the
actual inflation rate equals the expected inflation
rate.

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Inflation and the Natural Rate of Unemployment

 The natural rate hypothesis limits the role of

macroeconomic policy in stabilizing the economy.
 The goal is not to seek a permanently lower
unemployment rate, but to keep it stable.
 The natural rate hypothesis became almost
universally accepted.

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 The Political Business Cycle

 A political business cycle results when politicians

use macroeconomic policy to serve political ends.
 Fear of a political business cycle led to a
consensus that monetary policy should be
insulated from politics.

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►ECONOMICS IN ACTION
The Fed’s Flirtation with Monetarism
 In the late 1970s, the Fed adopted a monetary policy rule,
began announcing target ranges for several measures of
the money supply, and stopped setting targets for interest
rates.
 Most people interpreted these changes as a strong move
toward monetarism.
 In 1982, however, the Fed turned its back on monetarism.
 Since 1982 the Fed has pursued a discretionary monetary
policy, which has led to large swings in the money supply.
 Why did the Fed flirt with monetarism, then abandon it?

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►ECONOMICS IN ACTION
The Fed’s Flirtation with Monetarism
 The turn to monetarism largely reflected the events of the
1970s, when a sharp rise in inflation broke the perceived
trade-off between inflation and unemployment and
discredited traditional Keynesianism.
 The turn away from monetarism also reflected events: as
shown Figure 33-5, the velocity of money, which had
followed a smooth trend before 1980, became erratic after
1980.
 This made monetarism seem like less of a good idea.

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►ECONOMICS IN ACTION
The Velocity of Money

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 Rational Expectations, Real Business Cycles, and
New Classical Macroeconomics
 New classical macroeconomics is an approach
to the business cycle.
 New classical macroeconomics emerged as a
school in macroeconomics during the 1970s.
 The most famous New Classical model is that of
Real Business Cycles, developed by Robert Lucas,
Jr.,Finn E. Kydland, and Edward C. Prescott,
building upon the ideas of, among others, John
Muth.
 It returns to the classical view that shifts in the
aggregate demand curve affect only the aggregate
price level, not the aggregate output.
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 Rational Expectations
 Rational expectations is the view that individuals
and firms make decisions optimally, using all
available information.
 This way of modeling expectations was originally
proposed by John F. Muth (1961).
 The idea of rational expectations did serve as a
useful caution for macroeconomists who had
become excessively optimistic about their ability to
manage the economy.

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 Real Business Cycles
 According to new Keynesian economics, market
imperfections can lead to price stickiness for the
economy as a whole.
 New Keynesian macroeconomic analysis usually
assumes that households and firms have rational
New Keynesian analysis usually assumes a
variety of market failures. New Keynesians
assume prices and wages are sticky which means
they do not adjust instantaneously to changes in
economic conditions.
 Real business cycle theory says that
fluctuations in the rate of growth of total factor
productivity cause the business cycle. 28 of 41
FOR INQUIRING MINDS

Supply-Side Economics
 During the 1970s a group of economic writers began
propounding a view of economic policy that came to be
known as “supply-side economics.”
 The core of this view was the belief that reducing tax rates,
and so increasing the incentives to work and invest, would
have a powerful positive effect on the growth rate of
potential output.
 The main reason for this dismissal is lack of evidence.
Almost all economists agree that tax cuts increase
incentives to work and invest, but attempts to estimate these
incentive effects indicate that at current U.S. tax levels they
aren’t nearly strong enough to support the strong claims
made by supply-siders.
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►ECONOMICS IN ACTION
 The term "supply side" economics was first used by
Herbert Stein, a former economic adviser to
President Nixon, in 1976.
 Typical policy recommendations of supply-side
economics are lower marginal tax rates and less
regulation.

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►ECONOMICS IN ACTION
Total Factor Productivity and the Business Cycle
 Real business cycle theory argues that fluctuations in the rate
of growth of total factor productivity are the principal cause of
business cycles.
 In the early days of real business cycle theory, proponents
argued that productivity fluctuations are entirely the result of
uneven technological progress. Critics pointed out, however,
that in really severe recessions, total factor productivity
actually declines.
 Some economists argue that declining total factor productivity
during recessions is a result, not a cause, of economic
downturns. It’s now widely accepted that some of the
correlation between total factor productivity and the business
cycle is the result of the effect of the business cycle on
productivity, rather than the reverse.
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►ECONOMICS IN ACTION
Total Factor Productivity and the Business Cycle

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 Five Key Questions About Macroeconomic Policy

Classical Keynesian Modern

Monetarism
macroeconomics macroeconomics consensus

Is expansionary monetary Yes, except in

policy helpful in fighting No Not very Yes special
recessions? circumstances
Is expansionary fiscal policy
effective in fighting No Yes No Yes
recessions?
Can monetary and/or fiscal
policy reduce unemployment No Yes No No
in the long run?
No, except in
Should fiscal policy be used
No Yes No special
in a discretionary way?
circumstances
Should monetary policy be
No Yes No Still in dispute
used in a discretionary way?

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 Current Debate
 There are continuing debates about the appropriate
role of monetary policy.
 Some economists advocate explicit inflation
targets, but others oppose them.
 Inflation targeting requires that the central bank try to
keep the inflation rate near a predetermined target rate.
 Economists debate about whether monetary policy
should take steps to manage asset prices.
 Economists debate about what kind of
unconventional monetary policy, if any, should be
adopted to address a liquidity trap.

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 The Clean Little Secret of Macroeconomics
 The clean little secret of modern macroeconomics
is how much consensus economists have reached
over the past 70 years.

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►ECONOMICS IN ACTION
After the Bubble
 During the 1990s, many economists worried that stock
prices were irrationally high, and these worries proved
justified.
 In 2001 the plunge in stock prices helped push the United
States into recession.
 The Fed responded with large, rapid interest rate cuts. But
should it have tried to burst the stock bubble when it was
happening?
 Although the economy began recovering in late 2001, the
recovery was initially weak. Also the Fed had to cut the
federal funds rate to only 1%—uncomfortably close to 0%.

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►ECONOMICS IN ACTION
After the Bubble
 In other words, the events of 2001–2003 probably
intensified the debate over monetary policy and asset
prices, rather than resolving it.
 The bursting of the housing bubble after 2006 offered
another test. The case of the housing bubble also
highlighted the problem of identifying bubbles as they
inflate.
 In late 2004, Alan Greenspan, then Fed Chairman,
pronounced a “severe distortion” in housing prices “most
unlikely.” It seems safe to predict that, in the future, the Fed
will be more inclined to take asset prices into account when
setting monetary policy.

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SUMMARY

1. Classical macroeconomics asserted that monetary policy

affected only the aggregate price level, not aggregate output,
and that the short run was unimportant. By the 1930s,
measurement of business cycles was a well-established
subject, but there was no widely accepted theory of business
cycles.
2. Keynesian economics attributed the business cycle to
shifts of the aggregate demand curve, often the result of
changes in business confidence. Keynesian economics also
offered a rationale for macroeconomic policy activism.

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SUMMARY

3. In the decades that followed Keynes’s work, economists

came to agree that monetary policy as well as fiscal policy is
effective under certain conditions. Monetarism, a doctrine that
called for a monetary policy rule as opposed to
discretionary monetary policy, and which argued—based on
a belief that the velocity of money was stable—that GDP
would grow steadily if the money supply grew steadily, was
influential for a time but was eventually rejected by many
macroeconomists.
4. The natural rate hypothesis became almost universally
accepted, limiting the role of macroeconomic policy to
stabilizing the economy rather than seeking a permanently
lower unemployment rate. Fears of a political business cycle
led to a consensus that monetary policy should be insulated
from politics.
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SUMMARY

5. Rational expectations suggests that even in the short run

there might not be a trade-off between inflation and
unemployment because expected inflation would change
immediately in the face of expected changes in policy. Real
business cycle theory claims that changes in the rate of
growth of total factor productivity are the main cause of
business cycles. Both of these versions of new classical
macroeconomics received wide attention and respect, but
policy makers and many economists haven’t accepted the
conclusion that monetary and fiscal policy are ineffective in
changing aggregate output.
6. New Keynesian economics argues that market
imperfections can lead to price stickiness, so that changes in
aggregate demand have effects on aggregate output after all.

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SUMMARY

7. The modern consensus is that monetary and fiscal policy

are both effective in the short run but that neither can reduce
the unemployment rate in the long run. Discretionary fiscal
policy is considered generally unadvisable, except in special
circumstances.
8. There are continuing debates about the appropriate role of
monetary policy. Some economists advocate the explicit use of
an inflation target, but others oppose it. There’s also a debate
about whether monetary policy should take steps to manage
asset prices and what kind of unconventional monetary policy,
if any, should be adopted to address a liquidity trap.

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 The End of Chapter 33

coming attraction:
Chapter 34:
Open-Economy Macroeconomics

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