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Module 35 History and Alternative Views of Macroeconomics. John Maynard Keynes & Milton Friedman. Module 35 Essential Questions. Why was classical macroeconomics inadequate for the problems posed by the Great Depression?
John Maynard Keynes & Milton Friedman
Legitimized macroeconomic policy activism—the use of monetary and fiscal policy to smooth out the business cycle.
1930: division on the issue of government intervention into the economy…
2012: division on the issue of government intervention into the economy….
Wide economic consensus exists that the government should intervene in the economy & those policies can be useful & beneficial. The division today is to what degree does the government intervene?
University of Chicago Economist, Milton Friedman
In the latter half of the 20th century, economists continued to develop and modify versions of classical and Keynesian economic models. 2 parts:
A. Rational Expectations
Rational expectations (1970s) : concept with powerful impact on macroeconomics
Rational expectations (John Muth in 1961) is the view that individuals and firms make decisions optimally, using all available information.
What is the implication of this assumption for economic policy?
Original version of the natural rate hypothesis: a government attempt to trade off higher inflation for lower unemployment would work in the short run but would eventually fail because higher inflation would get built into expectations.
New Keynesians: market imperfections lead to price stickiness and inflation is not always quick to rise, even if expectations are for higher prices.
B. Real Business Cycles
Past economic thinking circa 1980s: slowdowns in productivity growth (usually attributed to pauses in technological progress), are the main cause of recessions.
Real business cycle theory: (AS is vertical) fluctuations in the rate of growth of total factor productivity cause the business cycle & business cycles to shifts of the aggregate supply curve. (deemphasizing AD)
A recession: slowdown in productivity growth: shifts the AS leftward.
A recovery: pickup in productivity growth: shifts the AS rightward.
RBC theory: recognized as making valuable contributions understanding the economy & it deemphasized aggregate demand
Today: RBC theorists - AS is upward sloping and that this gives AD potential role in determining aggregate output as well as AS
The Modern Macroeconomic Consensus
Insert your caption here!
5 Key Questions About Macroeconomic Policy
A. Is Expansionary Monetary Policy Helpful in Fighting Recessions?
Classical economics really didn’t believe that monetary policy would reverse a recession. Keynesians thought it could have limited effectiveness.
B. Is Expansionary Fiscal Policy Effective in Fighting Recessions?
C. Can Monetary and/or Fiscal Policy Reduce Unemployment in the Long Run?
D. Should Fiscal Policy Be Used in a Discretionary Way?
Classical macroeconomists didn’t think that monetary policy should be used to fight recessions; Keynesian economists didn’t oppose discretionary monetary policy, but they were skeptical about its effectiveness. Monetarists argued that discretionary monetary policy was doing more harm than good.
Today there is a broad consensus among macroeconomists on these points:
Point 1: Monetary policy should play the main role in stabilization policy.
Point 2: The central bank should be independent, insulated from political pressures, in order to avoid a political business cycle.
Point 3: Discretionary fiscal policy should be used sparingly, both because of policy lags and because of the risks of a political business cycle.
1. Central Bank Targets:
Announced specified inflation targets. - prepares the public for how the central bank will deal with the issue of inflation if it gets out of line with the target. The Fed doesn’t announce a target rate of inflation, but it is consistent with a target of about 2%.
2. Asset Prices
Should the Fed be pro-actively influencing the stock market, real estate market or any asset market?
For example, if the Fed thought the stock market was at an unsustainably high level, should the Fed intervene and try to slow down investors? Some people don’t want the Fed to intervene in any market. However, if the stock market bubble bursts, the damage can be very painful, so maybe the Fed should prevent that from happening? What is your opinion?
3. Unconventional Monetary Policies
Desperate times call for desperate measures!!!
The financial system collapse of 2008: the Fed lent big $$$ to a variety of financial institutions that were not member banks, buying asset backed mortgages, buying short term business debts…