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Chapter 18
Conclusion:
Where We Stand
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Evolution of Ideas and Events
• Events and ideas evolve together
– Historical events can be analyzed applying ideas
from macroeconomic theories
– Conversely, the outcome of historical events often
challenge theorists and overturn theories, leading
to the evolution of new theories
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The Reaction of Ideas to Events,
1923-47
• Prior to the Great Depression, the dominant idea in
macroeconomics was the old classical approach based on
the quantity theory of money
– The 1923-29 period seemed consistent with this approach
• The Great Depression changed everything in the 1930s
– The self-correcting properties of the private economy no longer
operated
• Unemployment soared to 25%, and remained high (above 10%)
until in 1940
– The Keynesian revolution focused on stimulative fiscal policy
(since interest rates were near zero so monetary policy was not
an option), and the recovery following higher defence spending
in 1941-42 supported this view
• After WWII, price controls were lifted and inflation soared
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Figure 18-1 Key Macroeconomic
Variables, 1923–47 (1 of 2)
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Figure 18-1 Key Macroeconomic
Variables, 1923–47 (2 of 2)
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The Reaction of Ideas to Events,
1950s
• The economy in the 1950s looks much better in retrospect.
– The 1950-53 period was dominated by effects from the Korean War.
– A mild recession in 1953-54 was caused by a cut in government
spending, but easy money moderated the effects on output.
– 1956-57 showed the short-term Phillips Curve trade-off between
inflation and low unemployment.
– The Fed allowed interest rates to rise, and that brought the 1957-58
recession, following by a brief recovery and then another recession in
1960-61.
• Keynesian ideas continued to hold sway though the 1950s.
– Fiscal policy via tax hikes to moderate inflation and tax cuts to fight
recessions was the primary tool to stabilize output.
– Variations in government military spending ironically led to some
instability, but that spending was determined by political forces.
• The main shift in ideas was the Phillips Curve in 1958 in response to
prices that did not fall during recessions.
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The Reaction of Ideas to Events,
1960s
• The longest economic expansion occurred
between 1961-69.
– The early period is attributed to easy money.
– Income tax cuts in 1964-65 and Vietnam War
spending led to a huge fiscal stimulus for the
second half of the expansion.
• Intellectual Revolutions of the 1960s
– Walter Heller’s fiscal activism
– Milton Friedman’s monetarism
– The natural rate hypothesis
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Figure 18-2 Key Macroeconomic
Variables, 1948–69 (1 of 2)
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Figure 18-2 Key Macroeconomic
Variables, 1948–69 (2 of 2)
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The Reaction of Ideas to Events,
1971-82
• The economy seemed to get worse after 1970 with
a sharp increase in food and oil prices in 1973-75.
– Fiscal policy was out of favor, but a fiscal stimulus helped
end the 1974-75 recession.
– Monetary policy played a passive role in 1975-79.
– In October, 1979 the Fed changed its policy and adopted a
policy close to a monetarist rule.
• This lead to interest rate volatility in 1979-82.
• Major ideas of the 1970s
– The Lucas model
– The supply-shock analysis of inflation adjustment
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The Reaction of Ideas to Events,
1982-91
• Everything seemed to improve in the rest of the 1980s.
– Both inflation and unemployment fell.
– The Reagan-era tax cuts of 1981-83 led to 15 years of natural
employment deficits.
– In 1982, the Fed abandoned monetarism and seemed to follow a
Taylor Rule, responding to both inflation and the output ratio.
• New ideas of the 1980s and early 1990s
– RBC theories gained more acceptance against the 1973-82
background
– Debate over the twin deficits began in the 1990s about the longterm impact of fiscal policy.
– The use of monetary aggregates (like M1) was discredited by the
Fed.
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The Reaction of Ideas to Events,
1991-2007
• The 1990s expansion was unusual for several reasons:
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Employment grew so slowly it was called “the jobless recover.”
Inflation decelerated during the expansion.
Productivity growth revived after 1995.
Monetary policy seemed to deviate from the Taylor Rule.
• New Ideas and Puzzles from the 1991-2007 period
– Why did productivity growth revive?
– Why was inflation so low in the late 1990s?
• One possibility is that the natural rate of unemployment may change
regularly or be time-varying (TV-NAIRU)
– The ECB adopted an inflation target for monetary policy.
– Short-term fiscal stabilization policy was revived after 2001
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Figure 18-3 Key Macroeconomic
Variables, 1970–2010 (1 of 2)
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Figure 18-3 Key Macroeconomic
Variables, 1970–2010 (2 of 2)
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Effect of the Global Economic Crisis
on Ideas
• RBC models (based on continuous market clearing)
were seriously questioned
– Persistent U was consistent with Keynesian models
• Reminded economists that bubbles leave a
“hangover” of excess supply and excess debt
– Financial crises impede economic recovery
• Conclusion: The Global Economic Crisis can be
explained as an aggregate demand shock
emanating from the financial sector
– Both IS/LM and AD-SAS models can explain the crisis
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The Reaction of Ideas to World
Events
• Between the 1930s and mid-1960s, the U.S. was
virtually a closed economy.
• After WWII, the U.S. entered a fixed exchange rate
system with the rest of the world known as the
Bretton Woods system.
– In the 1960s, the U.S. “exported” its inflation.
• In 1973, the Bretton Woods system was abandoned
for a flexible exchange rate system.
– Countries gained the use of monetary policy, but the
volatility of exchange rates disrupted export markets.
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The Reaction of Ideas to World
Events
• In the 1991-2007 period, international economics in
the U.S. was dominated by questions of
competitiveness with Asia and the desirability of
free trade.
– What should a country with a large trade deficit do?
• Allow a depreciation of its currency
• Enact protectionist measures
• Reduce the government budget deficit
– Will Asian central banks be willing to continue propping up
the dollar in order to keep their currencies from
appreciating
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Unsettled Issues and Debates
• Most important puzzle of 2011-12: How can monetary and fiscal
policy be combined to combat the hangover from the housing bubble
and financial crisis?
• How can poor countries achieve economic growth?
• Why does productivity growth ebb and flow?
• Why did the natural rate of unemployment fall?
• Should we go for zero inflation?
• Inflation targeting vs. the Taylor rule
• What explains differences among countries?
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Why did productivity growth accelerate in the U.S. after 2001 while it
slowed in the EU?
Why do individuals in Italy and France save so much?
Why is unemployment so high in France, but decline recently in
Germany?
Why do some countries like Argentina and Brazil suffer and then recover
from periods of hyperinflation, while others with similar policies do not?
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