Principles of Macroeconomics, Version 4.

0
Libby Rittenberg, Alan Grant, and Tim Tregarthen
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CHAPTER 17
A Brief History of
Macroeconomic Thought
and Policy
 17.1 Start Up: Three Revolutions in
Macroeconomic Thought

• The Great Depression of the 1930s started economists

thinking about the possibility of the government actively
stabilizing the economy.
• Between the Depression and the 1960s, policymakers
successfully used fiscal policy to steer the economy.
• But in the 1970s those policymakers found themselves
facing both unemployment and inflation. The fiscal
prescription had no recipe to solve those simultaneous
problems.
• Since that time, there have been deep philosophical
debates about the potential for stabilization policy.
 17.2 The Great Depression and
Keynesian Economics

Learning Objectives
1. Explain the basic assumptions of the classical school
of thought that dominated macroeconomic thinking
before the Great Depression and tell why the severity
of the Depression struck a major blow to this view.
2. Compare Keynesian and classical macroeconomic
thought, discussing the Keynesian explanation of
prolonged recessionary and inflationary gaps as well as
the Keynesian approach to correcting these problems.
 17.2. The Great Depression and
Keynesian Economics

• The magnitude of the Depression (1929-1941):

• Longest economic recession, lasted over a decade.
• From peak to trough, real GDP sank 40%, 12 million people out of
work, unemployment rate grew from 3% to 25%.
Figure 17.1: The Depression and the
Recessionary Gap
 17.2 The Classical School and the Great
Depression

classical
economics

• The body of macroeconomic thought

associated primarily with 19th century
British economist David Ricardo that
focused on the long run and on the forces
that determine and produce growth in an
economy’s potential output.
• Acknowledged that this self-correction was long-term,
and that short-term factors could contribute to unnatural
unemployment levels.
• Viewed the Great Depression as ultimately a short-run
aberration and that the economy would right itself in the
long run.
 17.2 Keynesian Economics

Keynesian
Economics
• Changes in aggregate demand can create
gaps between the actual and potential
levels of output, and that such gaps can
continue in the long term.

• Dismissed the long-term self-correction theories as

irrelevant.
• Keynes: “In the long run, we are all dead.”
• Keynesian economists stress the use of fiscal and
monetary policy to close these gaps.
Figure 17.2: Aggregate Demand and
Short-Run Aggregate Supply, 1929–1933
Figure 17.3: World War II Ends the Great
Depression
 Case in Point 17.2 Early Views on Stickiness

• Economists tend to turn to Keynes as the origin of the

sticky wage/sticky price argument.
• But Keynes followed in some distinguished footsteps:
• A century earlier, Henry Thornton argued that a reduction in the
money supply could, because of wage stickiness, produce a
short-run slump in output.
• Half a century before that, David Hume noted that an increase
in the quantity of money would boost output in the short run,
again because of the stickiness of prices.
• Today, most economists recognize that their
characterization of the classical economists as “flexible
price” adherents isn’t as accurate as it could be.
 17.3 Keynesian Economics in the 1960s and 1970s

Learning Objectives
1. Summarize the economic climate in the 1960s and describe the monetary
and fiscal policy responses to those economic challenges.
2. Describe the monetarist school of thought that emerged in the 1960s and
discuss how the experiences of the 1960s and 1970s seemed to be broadly
consistent with it.
3. Describe the new classical school of thought that emerged in the 1970s and
discuss how the experiences of the 1970s seemed to be broadly consistent
with it.
4. Summarize the lessons that economists learned from the economic
experience of the 1970s.
Figure 17.4: The Two Faces of
Expansionary Policy in the 1960s
 17.3 The 1970s: Troubles from the Supply Side

• Nixon inherited a booming economy with inflation at

4.3%.
• Resultant contractionary policy increased
unemployment while keeping price levels high.
Figure 17.5: The Economy Closes an
Inflationary Gap
Figure 17.6: The Energy Supply Shocks
of the 1970s
 17.3 The Monetarist Challenge

• Monetarist school: The body of macroeconomic thought

that holds that changes in the money supply are the
primary cause of changes in nominal GDP.
• Led by Milton Friedman.
Figure 17.7: M2 and Nominal GDP, 1960–1980
 17.3 New Classical Economics: A Focus
on Aggregate Supply

New Classical
Economics
• Macroeconomic analysis built from
analysis of individual maximizing choices
and emphasizing wage and price flexibility.

• Focused on individuals and their decisions.

• Unity of micro- and macroeconomics.
• Focuses on long-run aggregate supply and the economy’s
ability to remain at or near potential output
 New Classical Economics: A Focus on
Aggregate Supply

• Rational expectations hypothesis: individuals form

expectations about the future based on the information
available to them and they act on those expectations.
• Suggests that monetary policy has no effect on real GDP, due to
adjustments in expectations.
• The only monetary policy that works is surprise monetary
policy.
Figure 17.8: Contractionary Monetary
Policy, With and Without Rational
Expectations
 Case in Point 17.3: Tough Medicine Is
Hard to Stomach: Macroeconomic Policy
in the 1960s

• The fiscal policy remedy for an inflationary gap is tough

to stomach.
• Stimulating the economy is more politically popular
than closing an inflationary gap.
• That makes implementing contractionary fiscal policy difficult
and time consuming.
• Monetary policy is likely more flexible.
 17.4 Macroeconomics for the Twenty-first Century

Learning Objectives
1. Discuss how the Fed incorporated a strong inflation
constraint and lags into its policies from the 1980s
onward.
2. Describe the fiscal policies that were undertaken from
the 1980s onwards and their rationales.
3. Discuss the challenges that events from the 1980s
onwards raised for the monetarist and new classical
schools of thought.
4. Summarize the views and policy approaches of the new
Keynesian school of economic thought.
 17.4 Macroeconomics for the 21st Century

New Keynesian
Economics
• Stresses the stickiness of prices and the
need for activist stabilization policies to
keep economy close to potential output.

• Incorporates monetarist ideas on the importance

of monetary policy.
• Incorporates new classical ideas on importance of
aggregate supply and emphasis on microeconomic
analysis.
 17.4 The 1980s and Beyond: Advances in
Macroeconomic Policy

• In 1979, oil prices soared at the same time that

expansionary fiscal policies took effect, resulting in
soaring inflation with no change in GDP.
• Fed’s response was to begin contractionary policy until inflation
was fully under control, then begin expansionary policy.
• In the 1990s, Alan Greenspan’s Fed takes lags into
account as it adjusts monetary policy.
Figure 17.9: The Fed’s Fight Against Inflation
Figure 17.10 M2 and Nominal GDP, 1980–2020
Figure 17.11: M2 Velocity, 1960–2020
 17.4 The Rise of New Keynesian
Economics

• The free-fall of velocity indicated that the link between

money and activity had been broken.
• This ushered in a renewed interest in fiscal policy.
 17.4 The Rise of New Keynesian Economics

• New Keynesianism emerged as the dominant approach.

• To many economists, various macro events of the last
30 years do not seem consistent with either the
monetarist or new classical schools.
• New Keynesian economists have incorporated elements
of those schools into their analyses.
• Recent surveys of economists show more support for
New Keynesianism than for other schools of macro
thought.