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Module 35
History and
Alternative Views of
John Maynard Keynes & Milton Friedman
Margaret Ray and David Anderson
What you will learn
in this Module:
• 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 monetary policy
• How challenges led to a revision of
Keynesian ideas and the emergence of
the new classical macroeconomics
Classical Macroeconomics:
Money and the Price Level
•%∆ M = % ∆ PL
•Short-Run Effects
•Focus is on the
Long-Run (before 1930s)
•Keynes - “ (in the long
run) we are all dead.”
Classical Macroeconomics: The
Business Cycle
•The Business Cycle
(measurement yes but
no theory of business
cycles) Series of shortrun cycles…..
•Lack of consensus
•Necessity is the
mother of invention
The Great Depression demonstrated that
economists could not ignore the SR.
(Great Depression spurred
LOTS of theories)
Keynes’s Theory
•The General Theory
(Keynes, 1936) one of the
most influential economic
books ever written
•Classical View (next page
•Keynesian View (next page
•“Animal Spirits” (Keynes
argued “AnSp” were mainly responsible
for business cycles---today it’s called
business confidence)
Keynes’s Theory
Classical Theory
Keynesian Theory
AS curve
drawn as
Important difference: SRAS is vertical (CT) so a shift in AD changes PL but
not output. In Keynesian view, a shift affects both PL and output.
The main practical
consequence of Keynes’s
work was that it legitimized
macroeconomic political
activism---the use of fiscal
and monetary policy to
smooth out the business
Challenges to Keynesian Economics:
The Revival of Monetary Policy
•A Monetary History of the United States,
1867 - 1960
•Great Depression caused by Fed
contracting the money supply
•Business cycles caused by fluctuations
in the money supply.
University of Chicago
Economist, Milton Friedman
•Monetary policy is important - less
political (economics policy can be taken
out of the hands of politicians)
Challenges to Keynesian
Economics: Monetarism
•Monetarism: idea that GDP will grow steadily if the
MS grows steadily.
•Discretionary Fiscal Policies – bad because of
“lags”—policies may actually feed a boom
•Crowding Out: if MS is held fixed while the
government pursues an expansionary fiscal policy,
crowding out will limit the effect of the fiscal
expansion on AD.
•Monetary Policy Rule: formula that determines
actions of FED and leaves little discretion.
Challenges to Keynesian
Economics: Monetarism
•Quantity Theory of Money, MV = PY: relies on
velocity of money (stable in SR, slow growth in LR) --this means that steady growth in MS = steady
growth in spending = steady growth in GDP
•Velocity of Money: measure of the number of times
the average dollar is spent per year.
•Erratic Velocity undermines Monetarism: steady
through the 1870s, erratic starting in 1980s
Challenges to Keynesian Economics: Inflation
and the Natural Rate of Unemployment
•Natural Rate Hypothesis
(NAIRU): because inflation is
embedded into expectations,
the unemployment rate must
be high enough that actual
inflation must be high enough
that it meets expected inflation.
Challenges to Keynesian Economics: Inflation
and the Natural Rate of Unemployment
•Limit to Discretionary Policy:
Friedman-Phelps Hypothesis
(NAIRU) predicted that the
apparent tradeoff between inflation
and unemployment would not
survive a period of extended period
of rising prices.
•Stagflation of 1970s proof of
•Natural Rate widely accepted
Challenges to Keynesian Economics:
The Political Business Cycle
•Consequences of Keynes on Politics:
lends itself to political manipulation
•Election Day Economics: misery index
predicts which party will get into office based on
economy in months preceding the election
•Political Business Cycle: caused by use
President Obama and Senator McCain
of macroeconomic policy to serve political
ends….pay the price with infl or unemp to get
reelected. The need for central bank
•The need for central bank independence
Rational Expectations, Real Business
Cycles, and New Classical Macroeconomics
• New Classical Macroeconomics:
(1970s/1980s) returned to view that shifts in
AD curve only affects AggPL, not AggOP.
• Rational Expectations Theory:
view that individuals and firms make decisions
optimally, using all available information
• New Keynesian Economics: even
small costs to changing prices can lead to
substantial price stickiness and make the
economy behave in Keynesian fashion
• Real Business Cycle Theory:
fluctuations in rate of growth of total factor
productivity cause the business cycle.
Module 36
The Modern
Margaret Ray and David Anderson
What you will learn
in this Module:
• The elements of the modern
macroeconomic consensus
• The main remaining disputes
The Modern Consensus
Should Monetary Policy Be Used in a
Discretionary Way?
•Main role in stabilization policy
•Independent central bank
•Discretionary fiscal - sparingly
•Central Bank Targets
•Asset Prices
•Unconventional Monetary Policies