1. THE MODERN
MACROECONOMIC
CONSENSUS
MODULE 36

2.  There is now broad consensus about
crucial macroeconomic issues.
 We’ll look at how macroeconomists have
changed their answers to five key
questions about macroeconomic policy.
FIVE KEY QUESTIONS ABOUT
MACROECONOMIC POLICY

3.  Nearly all macroeconomists now agree
that monetary policy can be used to shift
the AD curve and reduce economic
instability.
 It is generally agreed today that monetary
policy is ineffective only in the case of a
liquidity trap.
IS EXPANSIONARY MONETARY POLICY
HELPFUL IN FIGHTING RECESSIONS?

4.  Almost all macroeconomists now accept
the natural rate hypothesis and agree on
the limitations of monetary and fiscal
policy.
 They believe that effective monetary and
fiscal policy can limit the size of
fluctuations of the unemployment rate
around the natural rate but can’t keep the
unemployment below the natural rate.
IS EXPANSIONARY FISCAL POLICY
INEFFECTIVE IN FIGHTING RECESSIONS?

5.  Most macroeconomists believe that tax
cuts and spending increases are
somewhat effective in increasing AD.
 Many (but not all), macroeconomists
believe that discretionary fiscal policy is
usually counterproductive: the lags in
adjusting fiscal policy cause policies to
end up intensifying a boom.
SHOULD FISCAL POLICY BE USED IN A
DISCRETIONARY WAY? (1)

6.  Therefore, the macroeconomic consensus
gives monetary policy the lead role in
economic stabilization.
 Discretionary fiscal policy plays the
leading role only in special circumstances
when monetary policy is ineffective (such
as when the economy is in a liquidity
trap)
SHOULD FISCAL POLICY BE USED IN A
DISCRETIONARY WAY? (2)

7.  Monetary policy should play the main role
in stabilization policy.
 The central bank should be independent,
insulated from political pressures, in order
to avoid a political business cycle.
 Discretionary fiscal policy should be used
sparingly, both because of policy lags and
because of the riskes of a political
business cycle.
SHOULD MONETARY POLICY BE USED
IN A DISCRETIONARY WAY?

8.  It’s often not clear what the Fed is trying
to achieve.
 This absence of specific guidelines gives
the central bank flexibility in coping with
economic events.
 Chairs of the Fed have tended to stay in
office a long time, acquiring personal
credibility that reassures the public that
the central bank’s power will be used well.
THE ROLE OF CENTRAL BANKS (1)

9.  Central banks in other countries have
adopted formal guidelines, such as
inflation targeting.
 Inflation targeting is advocated by many
macroeconomists, but others believe that
such a rule can limit the ability of a
central bank to respond to economic
events.
 The Fed doesn’t have an explicit inflation
target, although it is widely believed to
want an inflation rate of about 2%.
THE ROLE OF CENTRAL BANKS (2)

10.  In the 1990s many economists warned
that the US stock market was artificially
inflated.
 In 2000, the stock market fell, taking the
economy with it.
 Americans whose assets fell in value, felt
poorer and cut back on their spending,
pushing the economy into a recession.
ASSET PRICES (1)

11.  A few years later, the same thing
happened in the housing market.
 As home prices climbed above levels that
were justified by the incomes of home
buyers and the cost of renting instead of
buying.
 This bubble popped in 2006, leading to a
financial crisis, and pushing the economy
into another recession.
ASSET PRICES (2)

12.  These events drew attention to the debate
over monetary policy.
 Should the central bank restrict its
concernes to inflation and possibly
unemployment, or should it also try to
prevent extreme movements in asset
prices, such as the average price of stocks
or the average price of houses?
ASSET PRICES (3)

13.  One view is that the central bank should
not raise interest rates to curb stock
prices or housing prices if overall
consumer price inflation remains low.
 If an overvalued stock market eventually
falls and depresses AD, the central bank
can deal with that by cutting interest
rates.
 However, the alternative view warns that
after a bubble bursts, it may be difficult
for monetary and fiscal policy to offset the
effects on AD.
ASSET PRICES (4)

14.  Although the Fed normally conducts
monetary policy through open-market
operations, in 2008, when faced with the
severe problems in the financial markets, it
vastly expanded its operations.
 The Fed lent huge sums to a wide variety of
financial institutions, and began large-scale
purchases of private assets, including
commercial paper (short-term business
debts) and assets backed by home
mortgages.
UNCONVENTIONAL MONETARY
POLICIES (1)

15.  However, these actions were controversial.
 Supporters of these moves argued that
extraordinary action was necessary to deal
with the financial crisis and cope with the
liquidity trap the economy had fallen into.
 The opponents questioned the effectiveness
of the moves and whether the Fed was taking
on dangerous risks. The Fed appeared to not
have any other alternative because it was up
against the zero bound.
UNCONVENTIONAL MONETARY
POLICIES (2)

16.  The debates of macroeconomists must be
kept in perspective.
 There will always be debates about
appropriate policies.
 But the striking thing about current debates
is how modest the differences among
macroeconomists really are.
 The clean little secret of modern
macroeconomics is how much consensus
economists have reached in the past 70
years.
THE CLEAN LITTLE SECRET OF
MACROECONOMICS

17. CLASSICAL KEYNESIAN MONETARISM MODERN
MACRO- MACRO- CONSENSUS
ECONOMISTS ECONOMISTS
Is expansionary
monetary policy helpful No Not Yes Yes, except in
in fighting recessions? very special
circumstances
Is expansionary fiscal
policy effective in No Yes No Yes
fighting recessions?
Can monetary and/or
fiscal policy reduce No Yes No No
unemployment in the
long run?
Should fiscal policy be
used in a discretionary NO Yes No No, except in
way? special
circumstances
Should monetary policy
be used in a NO Yes No Still in dispute
discretionary way?