Module

History and
Alternative Views of
Macroeconomics


KRUGMAN'S
MACROECONOMICS for AP*
35
Margaret Ray and David Anderson
John Maynard Keynes & Milton Friedman
What you will learn
in this Module:
Why classical macroeconomics wasnt
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
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.
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.
Keyness 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 its called
business confidence)
Keyness Theory
Classical Theory Keynesian Theory
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.
Keynesian
AS curve
normally
drawn as
straight
line.
The main practical
consequence of Keyness
work was that it legitimized
macroeconomic political
activism---the use of fiscal
and monetary policy to
smooth out the business
cycle.
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
Challenges to Keynesian
Economics: Monetarism
Monetarism: idea that GDP will grow steadily if the
MS grows steadily.
Discretionary Fiscal Policies bad because of
lagspolicies 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.
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


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.

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


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
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.
Module
The Modern
Macroeconomic
Consensus


KRUGMANS MACROECONOMICS for
AP*
36
Margaret Ray and David Anderson
What you will learn
in this Module:
The elements of the modern
macroeconomic consensus
The main remaining disputes
The Modern Consensus
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