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Chapter 16
Macroeconomics:
What have we learnt?
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Learning objectives
1. What lessons have been learnt from the Great Depression?
2. What lessons have been learnt from the Great Inflation?
3. What challenges remain in the field of economic growth?
4. How would one distinguish a Keynesian economist?
5. In what ways did the monetarist school present a challenge to
Keynesian economics?
6. How do new classical macroeconomists differ from Keynesian
economists and monetarists?
7. For what reason or reasons do new Keynesian
macroeconomists advocate government management of the
economy?
8. According to real business cycle theorists, from where do
business cycle fluctuations in real output originate?
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Chapter organisation
16.1
Lessons from the past
16.2
Schools of thought in macroeconomics
16.3
Some concluding thoughts
Summary
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Great depression
• Four calamitous economic events occurred in the
20th century that contributed to economic knowledge.
• The first was the Great Depression of the 1930s.
Prior to that it was believed that the price system
would adjust so that any deviations of output from
potential were short-lived.
• Keynes explained that, in the short run, economic
activity depends on the level of AD, and that
government has a role to play in influencing AD.
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Great inflation
• The second major economic event of the 20th century
was the Great Inflation of the 1970s and 1980s. This
showed us that, contrary to then-current belief, a high
rate of inflation can co-exist with a high rate of
unemployment.
• Once inflation has occurred in the economy, it can
become entrenched through people building on
inflation through their inflationary expectations.
• The answer to this is credible monetary policy, so
people truly believe not to expect further inflation.
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Unequal growth outcomes
• The third calamitous event is the disparity of growth
outcomes across countries.
• Countries grow at different rates for a variety of
reasons. Understanding of why this is has improved,
but knowing how to improve lagging countries is
another thing.
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The 2008 global financial crisis
• The global financial crisis in 2008 has shown that
demand management policies may still be needed.
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Chapter organisation
16.1
Lessons from the past
16.2
Schools of thought in macroeconomics
16.3
Some concluding thoughts
Summary
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16-8
Keynesian economics
• Keynesians believe the demand side of the economy
is the key to business-cycle fluctuations.
• Investment demand is built on expectations of future
profit. The greatest influence of expectations for the
future is the current situation.
• If the current economic situation is a downturn, it is
difficult for a firm to consider investing. Aggregate
demand will only increase if many firms increase
investment.
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Keynesian economics (cont.)
• This is a co-ordination failure, as without a
co-ordinated plan of a whole range of firms investing,
no firm will feel confident enough to be the first.
• The result is the economy becomes trapped in a selfperpetuating, low investment–low output equilibrium.
• Governments should use fiscal and monetary policies
to maintain a high level of aggregate demand so the
economy remains at potential output.
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Monetarism
• Emerging in the 1960s and early 1970s, monetarists
disagreed with the view that the economy could be
trapped in a self-perpetuating low output –high
unemployment equilibrium.
• They believed that the economy would return to
potential output in the long run after a shift in
aggregate demand.
• They also believed that if there was a recession, it
was most likely due to poor government policy.
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Monetarism (cont.)
• Governments should avoid policies that lead to high
inflation.
• Monetarists believed the cause of the Great
Depression was a contractionary monetary policy
when an expansionary monetary policy was needed.
• Monetarists gained influence as a result of the Great
Inflation of the 1970s that was caused by the oil
shocks. Keynesian policies were not helpful in
economies with both high inflation and high
unemployment.
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New classical macroeconomics
• These economists also believe that the economy will
return to potential output in the long run after a shift in
aggregate demand.
• Workers and firms are said to have rational
expectations, which involves a complete
understanding of the structure of the economy.
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New classical macroeconomics (cont.)
• Therefore workers and firms will organise their affairs
based on an understanding that the economy will be
at potential output, and any change in AD will only
change inflation.
• Therefore they will negotiate nominal prices so that
real wages, employment and output don’t change.
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New Keynesian macroeconomics
• New Keynesians believe that imperfections in
markets—imperfect information, monopoly, trade
unions, etc.— impede the price system to restore
potential GDP after a demand or supply disturbance.
• Therefore there is a role for government policy to try
to improve macroeconomic performance.
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Growth theory and the real business
cycle school
• The real business cycle school believes that business
cycles are not due to fluctuations in AD, but rather to
fluctuations in potential GDP resulting from
technological shocks.
• These events can produce short-run effects that look
like business-cycle effects.
• For example, a reduction in total factor productivity
would decrease the marginal productivity of labour.
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Growth theory and the real business
cycle school (cont.)
• This shifts the labour demand curve to the left and a
lowers the real wage, leading to a fall in employment
and therefore output.
•
What looks like a recession may just be an efficient
response to a productivity decline.
• Economists generally believe such productivity
shocks are a factor in the business cycle, but that AD
changes are still an important part of the explanation
of the business cycle.
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Chapter organisation
16.1
Lessons from the past
16.2
Schools of thought in macroeconomics
16.3
Some concluding thoughts
Summary
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Some concluding thoughts
• Macroeconomics has been informed by historical
events.
• Macroeconomics provides a systematic framework
within which important social trends are analysed.
• Macroeconomics is a strand of theory that is
constantly evolving.
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16-19
Chapter organisation
16.1
Lessons from the past
16.2
Schools of thought in macroeconomics
16.3
Some concluding thoughts
Summary
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PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank
16-20
Summary
• Four major episodes in macroeconomics include the
Great Depression, the Great Inflation, disparity of
growth and the global financial crisis.
• Keynesians and new Keynesians believe that the
economy can be away from potential output for
prolonged periods of time and that this provides
a rationale for government management of
the economy.
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Summary (cont.)
• Monetarists and new classical macroeconomists
believe that the price system will quickly return the
economy to potential output following a shift in the AD
curve.
• Real business cycle theorists look to the economy’s
supply side as the source of business cycle
fluctuations.
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