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Oct 28, 2013 (3 years and 11 months ago)

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chapter:


33

>>


Krugman/Wells


©2009


Worth Publishers

Macroeconomics: Events
and Ideas

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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


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.


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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


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.

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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.


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.


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.


Real business cycle theory

says that fluctuations
in the rate of growth of total factor productivity
cause the business cycle.


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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

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
macroeconomics

Keynesian
macroeconomics

Monetarism

Modern
consensus

Is expansionary monetary
policy helpful in fighting
recessions?

No

Not very

Yes

Yes, except in
special
circumstances

Is expansionary fiscal policy
effective in fighting
recessions?

No

Yes

No

Yes

Can monetary and/or fiscal
policy reduce unemployment
in the long run?

No

Yes

No

No

Should fiscal policy be used
in a discretionary way?

No

Yes

No

No, except in
special
circumstances

Should monetary policy be
used in a discretionary way?

No

Yes

No

Still in dispute

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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