Module 35 history and alternative views of macroeconomics
HISTORY AND ALTERNATIVE VIEWS OFMACROECONOMIC S MODULE 35
CLASSICAL MACROECONOMICSThe term “macroeconomics” was first used in 1933 by the Norwegian economist Ragnar Frisch.Before that, however, economists were already analyzing the behavior of the aggregate price level and the aggregate output.
MONEY AND THE PRICE LEVELBefore the 1930’s the classical model dominated economic thinking about the effects of monetary policy.According to the classical model, prices are flexible, making the aggregate supply curve vertical even in the short run, and any increases in the money supply lead to inflation.
MONEY AND THE PRICE LEVELClassical economists probably did realize that changes in the money supply affected aggregate output as well as aggregate prices in the short-run.However, they regarded these short-run effects as unimportant, stressing the long run instead.For this reason, John Maynard Keynes said: “in the long run, we are all dead.”
THE BUSINESS CYCLEAmerican economist Wesley Mitchell pioneered the quantitative study of business cycles, founding in 1920 the National Bureau of Economic Research, which announces the beginnings of recessions and expansions.However, there was no widely accepted theory of business cycles.
THE GREAT DEPRESSION AND THE KEYNESIAN REVOLUTIONSince there were no clear theories, views of policy makers were conflicting.In 1930, John Maynard Keynes used the metaphor of the economy as a car with a defective alternator to describe the problems of the US and British economies.He said that to get the economy running would require only a modest repair, not a complete overhaul.
KEYNES´S THEORYIn 1936, Keynes wrote ¨The General Theory of Employment, Interest, and Money¨This book reflected two innovations:1. Keynes emphasized the short-run effects of shifts in AD on aggregate output, instead of the long-run determination of the aggregate price level. He focused the attention of economists on situations in which the SRAS curve slopes upward and shifts in the AD curve affect aggregate output and employment as well as aggregate prices.
KEYNES´S THEORY2. Classical economists emphasized the role of changes in the money supply in shifting the AD curve. Keynes argued that other factors, especially changes in “animal spirits” are mainly responsible for business cycles.
POLICY TO FIGHT RECESSIONSThe main practical consequence of Keyne´s work was that it legitimized macroeconomic policy activism (the use of fiscal and monetary policy to smooth out the business cycle)Today there is a broad consensus about the useful role that monetary and fiscal policy can play in fighting recessions.However, Keynes´s ideas have not been fully accepted by modern macroeconomists.
CHALLENGES TO KEYNESIAN ECONOMICSKeynes´s work suggested that monetary policy wouldn´t be very effective in depression conditions.In fact, in the 1930´s interest rates were very close to 0% (against the zero bound).The term liquidity trap was first used by the British economist John Hicks in 1937.However, many economists continued to emphasize fiscal policy and downplay monetary policy.
THE REVIVAL OF MONETARY POLICYIn 1963, Milton Friedmand and Anna Schwartz published “A Monetary History of the United States”In this book, the authors persuaded most economists that monetary policy should pla a key role in economic management.This shifted the burden of managing the economy away from fiscal policy, which meant that economic management could be made mor technical and less political.
MONETARISMMilton Friedman led a movement, called monetarism, which asserted that GDP will grow steadily if the money supply grows steadily.This is carried out through targeting a constant growth in the money supply, and maintain that rate regardless of any fluctuations in the economy.Monetarism maintained many Keynesian ideas, such as that the short run is important, and tha short run changes in AD affect aggregate output as well as aggregate prices.
MONETARISMMilton Friedmand also agrued that policy should have been much more expansionary during the Great Depression.However, Monetarists argued that most of the efforts of policy makers to smooth out the business cycle actually make things worse, with concerns about the use of discretionary fiscal policy, due to lags .According to economists, discretionary monetary policy also faces lags, but to a lesser extent.
MONETARISMMonetarists also point out fiscal policy is less effective than Keynesians believe.Friedman pointed out that if the money supply is held fixed while the government pursues an expansionary fiscal policy, crowding out will limit the effect of the fiscal expansion on aggregate demand.As a result, the rightward shift of the AD curve will be smaller than the multiplier analysis indicates.
MONETARISMHowever, Friedman didn´t favor activist monetary policy either, arguing that the problem of time lags that limit the ability of discretionary fiscal policy to stabilize the economy also apply to discretionary monetary policy.The solution, he argued, was to follow a monetary policy rule, which is a formula that determines its actions and leave relatively little discretion.
THE QUANTITY THEORY OF MONEYUnderlying the the monetary policy rule was the Quantity Theory of Money, which relies on the velocity of money (which is the ratio of nominal GDP to the money supply) and is the number of times an average dollar bill in the economy turns over per year.This concept gives rise to the velocity equation: MxV=PxYWhere M is the money supply, V is velocity, P isthe aggregate price level, and Y is real GDP.
THE QUANTITY THEORY OF MONEYMonetarists believed that the velocity of money was stable in the short run and changed only slowly in the long run.As a result, steady growth in the money supply by the central bank would ensure steady growth in spending, and therefore in GDP.
THE QUANTITY THEORY OF MONEYAlthough monetarism strongly influenced actual monetary policy in the late 1970´s and early 1980´s, steady growth in the money supply didn´t ensure steady growth in the economy, as the velocity of money wasn´t stable enough for such a simple policy rule to work.Traditional monetarists are rare in today´s macroeconomics, although the concern that too much discretional monetary policy can destabilize the economy has become widely accepted.
INFLATION AND THE NATURAL RATE OF UNEMPLOYMENTIn the 1940´s and 1950´s many Keynesian economists believed that expansionary fiscal policy could be used to achieve full employment on a permanent basis.In the 1960´s, Edmund Phelps (Columbia University) and Milton Friedman, working independently, proposed the concept of the NRU.
INFLATION AND THE NATURAL RATE OF UNEMPLOYMENTAccording to the natural rate hypothesis, to avoid accelerating inflation over time, the unemployment rate must be high enough that the actual inflation rate equels the expected rate of inflation.Attempts to keep the unemployment rate below the natural rae will lead to ever-rising inflation rate.Therefore, the task of government is not to keep unemployment low, but to keep it stable, preventing large fluctuations in either direction.
INFLATION AND THE NATURAL RATE OF UNEMPLOYMENTThe Friedman-Phelps hypothesis predicted that once inflation was embedded in the public´s expectation, inflation would continue even in the face of high unemployment.This was an accurate prediction that was proved true in the1970s.
INFLATION AND THE NATURAL RATE OF UNEMPLOYMENTThis convinced most of the economists that the natural rate hypothesis was correct, and became almos universally accepted among macroeconomists (although some believe that at very low or negative rates of inflation the hypothesis doesn´t work).Traditional monetarism declined in influence as more evidence accumulated.
THE POLITICAL BUSINESS CYCLEOne more challenge to Keynesian economics focused not on the validity of the economic analysis but in its political consequences.Economists believe that activist macroeconomic policy lends itself to political manipulation.The result of this can be unnecessary instability in the economy, a political business cycle, caused by the use of macroeconomic policy to serve political ends.
THE POLITICAL BUSINESS CYCLEOne way to avoid a political business cycle is to place monetary policy in the hands of an independent central bank.A political business cycle is also a reason to limit the use of discretionary fiscal policy to extreme circumstances.
RATIONAL EXPECTATIONS, REAL BUSINESS CYCLES, AND NEW CLASSICAL MACROECONOMICSClassical economists believed tha the SRAS curve was verical, but Keynes emphasized that it sloped upwards in the long run.As a result, demand shocks, shifts in the AD curve, can cause fluctuations in aggregate output.
RATIONAL EXPECTATIONS, REAL BUSINESS CYCLES, AND NEW CLASSICAL MACROECONOMICSIn the 1970´s and 1980´s some economists developed an approach to the business cycle known as new classical macroeconomics, which returned to the classical view that shifts in the AD curve affect only affect the aggregate price level and not the aggregate output.
RATIONAL EXPECTATIONS, REAL BUSINESS CYCLES, AND NEW CLASSICAL MACROECONOMICSThis evolved in two steps:1. Some economists challenged the traditional arguments about the slope of the SRAS based on rational expectations2. Some economists suggested that changes in productivity caused economic fluctuations, a view know as the real business cycle theory.
RATIONAL EXPECTATIONS, REAL BUSINESS CYCLES, AND NEW CLASSICAL MACROECONOMICSIn 1970, a theory known as rational expectations had a strong impact on macroeconomics.This theory was introduced by John Muth in 1961.This is a view that individuals and firms make decisions optimally, using all available information.For example in negotiating wage contracts, workers will incorporate not only expected rates of inflation and the effects on inflation
RATIONAL EXPECTATIONS, REAL BUSINESS CYCLES, AND NEW CLASSICAL MACROECONOMICSRational expectations can make a major difference to the effects of government policy.In the 1970´s, Robert Lucas (University of Chicago) used this logic to argue that monetary policy can change the level of unemployment only if it comes as a surprise to the public.So if his analysis is right, monetary policy is not useful in stabilizing the economy after all, although many macroeconomists believe that his conclusions were overstated.
RATIONAL EXPECTATIONS, REAL BUSINESS CYCLES, AND NEW CLASSICAL MACROECONOMICSNew Keynesian economists (a set of ideas that became influential in the 1990´s) provides an explanation at to why the rational expectations hypothesis doesn´t accurately describe how the economy behaves.It argues that market imperfections interact to make many prices in the economy temporaril sticky.Over time, new Keynesian ideas combined with actual experience have reduced the practical influence of the rational expectations concept.
REAL BUSINESS CYCLESTotal factor productivity is the amount of output that can be generated wih a given level of factor outputs.Total factor productivity grows over time, but not smoothly.The real business cycle theory claims that fluctuations in the rate of growth of total factor productivity cause the business cycle.They believe that the AS curve is vertical, so they attribute the source of business cycles to shifts of the AS curve.
REAL BUSINESS CYCLESA recession occurs when a slowdown in productivity growth shifts the AS curve leftward, and a recovery occurs when an increase in productivity growth shifts the AS curve rightward.This theory has made valuable contributions to understanding the economy and serves as a useful caution against too much emphasis on aggregate demand.
REAL BUSINESS CYCLESHowever, many real business cycle theorists now acknowledge that their models need an upward-sloping AS curve to fit the economic data, and that gives AD a potential role in determining aggregate output.As seen policy makers stongly believe that aggregate demand policy has an important role to play in fighting recessions.