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Lesson 17-3
Macroeconomics for the 21st Century
New Keynesian Economics
New Keynesian economics is a body of macroeconomic
thinking that stresses the stickiness of prices and the
need for activist stabilization policies through the
manipulation of aggregate demand to keep the economy
operating close to its potential output.
It incorporates monetarist ideas about the importance of
monetary policy.
It incorporates new classical ideas about the importance
of aggregate supply, both in the long and in the short run.
Another new element is the greater use of microeconomic
analysis to explain macroeconomic phenomena,
particularly the analysis of price and wage stickiness
The 1980s and 1990s: Advances in Macroeconomic
Policy
The Revolution in Monetary Policy
The monetary revolution began on July 25, 1979, when
Paul Volcker became Chairman of the Board of
Governors of the Federal Reserve System.
Volcker led the Fed to attack inflation strongly through
contractionary monetary policy.
After continuing high inflation coupled with very high
unemployment rates, the inflation rate began to fall in
1981.
The next revolution began with the appointment of Alan
Greenspan as Chairman of the Fed in the 1990s.
The Fed began to pay attention to lags in policy and
change from expansionary to contractionary policies
even before the solving of a recessionary gap.
Fiscal Policy: Stepping Back
In 1981, Ronald Reagan followed policies almost exactly like
Kennedy’s in 1961 with a tax cut and increased defense spending,
but the rationale was a supply-side, not Keynesian, argument.
Reagan said that cutting high marginal tax rates would encourage
work and that reinstating the investment tax credit would stimulate
investment.
The resultant rising deficits began to dominate fiscal policy
discussions.
Expansionary fiscal policy was rejected because of the national debt
even in the recession of 1990–1991.
Surpluses emerged in 1998 and were predicted well into the twentyfirst century.
The Rise of New Keynesian Economics
Monetary Change and Monetarism
The close relationship between changes in the
money supply and subsequent
changes in nominal GDP was broken in the
1980s and 1990s.
This was one of the effects of deregulation of
banks.
This was taken as evidence of the instability of
velocity of M2.
The New Classical School and Responses to
Policy
People did not respond to policies of the 1980s
as predicted.
Rational expectations theory has not explained
the public’s responsiveness to monetary policy.
Government deficits did not cause predicted
changes in private savings.
A Macroeconomic Consensus?
Surveys of economists show that the new Keynesian
approach has emerged as the preferred approach to
macroeconomic analysis.
New Keynesianism has become dominant in the
determination of macroeconomic policy.
It succeeds because it incorporates elements of the
other approaches.
Gave greater credence to monetary policy.
Accepted microeconomic foundations of maximizing
behavior.
Incorporated changes in aggregate supply.
Considerable controversy still remains on which
particular policies to use in specific situations, but a
new consensus seems to be forming.