A Brief History of Macroeconomic Thought and Policy

A Brief History of Macroeconomic Thought and Policy in the 20 th Century Read Chapter 17 – pages 350 -368

I The Great Depression and Keynesian Economics A) The Classical School and the Great depression. 1) Classical economics is the body of macroeconomics thought associated primarily with nineteenth-century British economist David Ricardo. It emphasized the ability of flexible wages and prices to keep the economy at or near its natural level of employment.

2) The classical school saw the great depression as a short term aberration that would correct itself. Clearly they were wrong. B) Keynesian Economics 1) Keynesian economics asserts that changes in aggregate demand can create gaps between the actual and potential levels of output that can persist. 2) The adjustment process is thwarted because prices tend to be sticky.

3) Keynesian Economics and the Great Depression i) Started with an investment collapse following the excessive build-up during the roaring 20’s. ii) This shifted aggregate demand to the left. iii) Two other factors contributed: a) Stock market collapse created a wealth effect. b) Contractionary fiscal policy. 4) Keynesian solution – Expansionary fiscal policy.

II Keynesian Economics in the 1960’s and 1970’s A) Expansionary Policy in the 1960’s – Two Phases. 1) Correcting a Recessionary Gap in the early 1960’s – Kennedy Tax cuts and expansionary monetary policy. 2) Too much stimulus during the late 1960’s created an inflationary gap. B) The 1970’s: Troubles from the supply side.

C) The Monetarist Challenge 1) The Monetarist school holds that changes in the money supply are the primary cause of changes in nominal GDP. 2) They do not advocate interventionist policy because they believe that lags associated with monetary policy are so long and variable that they are hard to control and can be destabilizing.

D) New Classical Economics: A Focus on Aggregate Supply 1) New classical economics is the approach to macroeconomic analysis built from an analysis of individual maximizing choices. 2) Key assumption behind new classical economics is the assumption of rational expectations. 3) Individuals have rational expectations if their expectations for the future are based on all information available to them and they act on those expectations.

4) One of the implications of classical economics is that policy effects are reduced. E) Lessons from the 1970’s 1) Short run aggregate supply can shift over time. 2) Money matters a lot. 3) Policy stabilization is a delicate process.

III An Emerging Consensus: Macroeconomics for the Twenty-first Century A) Modern economic thinking is for the most part a hybrid of all these views, being neither pure Keynesian, nor pure monetarist, nor pure classical. The New Keynesian economics is a body of macroeconomic thought that stresses the stickiness of prices and need for activist stabilization policies though manipulation of aggregate demand.

B) The 1980’s and 1990’s: Advances in Macroeconomic Policy. 1) The Revolution in Monetary Policy. Fed policy moved to focus on inflation. 2) Fiscal Policy: Stepping back. Focus more on long term goals and in particular aggregate supply growth. Less focus on short term stabilization.