Why classical macroeconomics wasn’t adequate for the problems posed by the Great Depression



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Why classical macroeconomics wasn’t adequate for the problems posed by the Great Depression

  • 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 discretionary monetary policy

  • How challenges led to a revision of Keynesian ideas and the emergence of new classical macroeconomics

  • The elements of the modern consensus, and the main remaining disputes





The first modern school of economic thought.

  • The first modern school of economic thought.

  • Its major developers include Adam Smith, Jean-Baptiste Say, David Ricardo, Thomas Malthus and John Stuart Mill.

  • Classical macroeconomics asserted that monetary policy affected only the aggregate price level, not aggregate output.

  • Classical macroeconomics asserted that the short run was unimportant.

  • According to the classical model, prices are flexible, making the aggregate supply curve vertical even in the short run.



As a result, an increase in the money supply leads, other things equal, to an equal proportional rise in the aggregate price level, with no effect on aggregate output.

  • As a result, an increase in the money supply leads, other things equal, to an equal proportional rise in the aggregate price level, with no effect on aggregate output.

  • Increases in the money supply lead to inflation, and that’s all.



By the 1930s, measurement of business cycles was a well-established subject, but there was no widely accepted theory of business cycles.

  • By the 1930s, measurement of business cycles was a well-established subject, but there was no widely accepted theory of business cycles.

  • In 1920 Wesley Mitchell founded National Bureau of Economic Research, an independent, nonprofit organization that to this day has the official role of declraing the beginnings of recessions and expansions. The measurement of business cycle was advanced by 1930.

  • The term macroeconomics appears in 1933 by Norwegian economist Ragnar Frisch.





In 1936, Keynes presented his analysis of the Great Depression—his explanation of what was wrong with the economy’s alternator—in a book titled The General Theory of Employment, Interest, and Money.

  • In 1936, Keynes presented his analysis of the Great Depression—his explanation of what was wrong with the economy’s alternator—in a book titled The General Theory of Employment, Interest, and Money.

  • The school of thought that emerged out of the works of John Maynard Keynes is known as Keynesian economics.





The Politics of Keynes

  • The Politics of Keynes

  • The term Keynesian economics is sometimes used as a synonym for leftwing economics.

  • Keynes himself was no socialist—and not much of a leftist.

  • At the time The General Theory was published, many intellectuals in Britain believed that the Great Depression was the final crisis of the capitalist economic system and that only a government takeover of industry could save the economy.

  • Keynes, in contrast, argued that all the system needed was a narrow technical fix. In that sense, his ideas were pro-capitalist and politically conservative.



The Politics of Keynes

  • The Politics of Keynes

  • What is true is that the rise of Keynesian economics in the 1940s, 1950s, and 1960s went along with a general enlargement of the role of government in the economy, and those who favored a larger role for government tended to be enthusiastic Keynesians.

  • Conversely, a swing of the pendulum back toward free - market policies in the 1970s and 1980s was accompanied by a series of challenges to Keynesian ideas, which we describe later in this chapter.



The main practical consequence of Keynes’s work was that it legitimized macroeconomic policy activism—the use of monetary and fiscal policy to smooth out the business cycle.

  • The main practical consequence of Keynes’s work was that it legitimized macroeconomic policy activism—the use of monetary and fiscal policy to smooth out the business cycle.



The End of the Great Depression

  • The End of the Great Depression

  • The basic message many of the young economists who adopted Keynes’s ideas in the 1930s took from his work was that economic recovery requires aggressive fiscal expansion—deficit spending on a large scale to create jobs.

  • And that is what they eventually got, but it wasn’t because politicians were persuaded.

  • Instead, what happened was a very large and expensive war, World War II.





The End of the Great Depression

  • The End of the Great Depression

  • Figure 33-3 shows the U.S. unemployment rate and the federal budget deficit as a share of GDP from 1930 to 1947.

  • As you can see, deficit spending during the 1930s was on a modest scale.

  • In 1940, as the risk of war grew larger, the United States began a large military buildup, and the budget moved deep into deficit.

  • After the attack on Pearl Harbor on December 7, 1941, the country began deficit spending on an enormous scale.



Monetarism asserted that GDP will grow steadily if the money supply grows steadily.

  • Monetarism asserted that GDP will grow steadily if the money supply grows steadily.

  • It called for a shift from monetary policy rule to that of a discretionary monetary policy.

  • It argued that GDP would grow steadily if the money supply grew steadily.

  • Monetarism was influential for a time, but was eventually rejected by many macroeconomists.















The Fed’s Flirtation with Monetarism

  • The Fed’s Flirtation with Monetarism

  • In the late 1970s, the Fed adopted a monetary policy rule, began announcing target ranges for several measures of the money supply, and stopped setting targets for interest rates.

  • Most people interpreted these changes as a strong move toward monetarism.

  • In 1982, however, the Fed turned its back on monetarism.

  • Since 1982 the Fed has pursued a discretionary monetary policy, which has led to large swings in the money supply.

  • Why did the Fed flirt with monetarism, then abandon it?



The Fed’s Flirtation with Monetarism

  • The Fed’s Flirtation with Monetarism

  • The turn to monetarism largely reflected the events of the 1970s, when a sharp rise in inflation broke the perceived trade-off between inflation and unemployment and discredited traditional Keynesianism.

  • The turn away from monetarism also reflected events: as shown Figure 33-5, the velocity of money, which had followed a smooth trend before 1980, became erratic after 1980.

  • This made monetarism seem like less of a good idea.











Supply-Side Economics

  • Supply-Side Economics

  • During the 1970s a group of economic writers began propounding a view of economic policy that came to be known as “supply-side economics.”

  • The core of this view was the belief that reducing tax rates, and so increasing the incentives to work and invest, would have a powerful positive effect on the growth rate of potential output.

  • The main reason for this dismissal is lack of evidence. Almost all economists agree that tax cuts increase incentives to work and invest, but attempts to estimate these incentive effects indicate that at current U.S. tax levels they aren’t nearly strong enough to support the strong claims made by supply-siders.



The term "supply side" economics was first used by Herbert Stein, a former economic adviser to President Nixon, in 1976.

  • The term "supply side" economics was first used by Herbert Stein, a former economic adviser to President Nixon, in 1976.

  • Typical policy recommendations of supply-side economics are lower marginal tax rates and less regulation.



Total Factor Productivity and the Business Cycle

  • Total Factor Productivity and the Business Cycle

  • Real business cycle theory argues that fluctuations in the rate of growth of total factor productivity are the principal cause of business cycles.

  • In the early days of real business cycle theory, proponents argued that productivity fluctuations are entirely the result of uneven technological progress. Critics pointed out, however, that in really severe recessions, total factor productivity actually declines.

  • Some economists argue that declining total factor productivity during recessions is a result, not a cause, of economic downturns. It’s now widely accepted that some of the correlation between total factor productivity and the business cycle is the result of the effect of the business cycle on productivity, rather than the reverse.







There are continuing debates about the appropriate role of monetary policy.

  • There are continuing debates about the appropriate role of monetary policy.

  • Some economists advocate explicit inflation targets, but others oppose them.

    • Inflation targeting requires that the central bank try to keep the inflation rate near a predetermined target rate.
  • Economists debate about whether monetary policy should take steps to manage asset prices.

  • Economists debate about what kind of unconventional monetary policy, if any, should be adopted to address a liquidity trap.



The clean little secret of modern macroeconomics is how much consensus economists have reached over the past 70 years.

  • The clean little secret of modern macroeconomics is how much consensus economists have reached over the past 70 years.



After the Bubble

  • After the Bubble

  • During the 1990s, many economists worried that stock prices were irrationally high, and these worries proved justified.

  • In 2001 the plunge in stock prices helped push the United States into recession.

  • The Fed responded with large, rapid interest rate cuts. But should it have tried to burst the stock bubble when it was happening?

  • Although the economy began recovering in late 2001, the recovery was initially weak. Also the Fed had to cut the federal funds rate to only 1%—uncomfortably close to 0%.



After the Bubble

  • After the Bubble

  • In other words, the events of 2001–2003 probably intensified the debate over monetary policy and asset prices, rather than resolving it.

  • The bursting of the housing bubble after 2006 offered another test. The case of the housing bubble also highlighted the problem of identifying bubbles as they inflate.

  • In late 2004, Alan Greenspan, then Fed Chairman, pronounced a “severe distortion” in housing prices “most unlikely.” It seems safe to predict that, in the future, the Fed will be more inclined to take asset prices into account when setting monetary policy.













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