1. HISTORY AND
ALTERNATIVE
VIEWS OF
MACROECONOMIC
S
MODULE 35

2. CLASSICAL MACROECONOMICS
The term “macroeconomics” was first used in
1933 by the Norwegian economist Ragnar
Frisch.
Before that, however, economists were already
analyzing the behavior of the aggregate price
level and the aggregate output.

3. MONEY AND THE PRICE LEVEL
Before the 1930’s the classical model
dominated economic thinking about the effects
of monetary policy.
According to the classical model, prices are
flexible, making the aggregate supply curve
vertical even in the short run, and any
increases in the money supply lead to inflation.

4. MONEY AND THE PRICE LEVEL
Classical economists probably did realize that
changes in the money supply affected
aggregate output as well as aggregate prices
in the short-run.
However, they regarded these short-run effects
as unimportant, stressing the long run instead.
For this reason, John Maynard Keynes said:
“in the long run, we are all dead.”

5. THE BUSINESS CYCLE
American economist Wesley Mitchell
pioneered the quantitative study of business
cycles, founding in 1920 the National Bureau
of Economic Research, which announces the
beginnings of recessions and expansions.
However, there was no widely accepted theory
of business cycles.

6. THE GREAT DEPRESSION AND THE
KEYNESIAN REVOLUTION
Since there were no clear theories, views of
policy makers were conflicting.
In 1930, John Maynard Keynes used the
metaphor of the economy as a car with a
defective alternator to describe the problems of
the US and British economies.
He said that to get the economy running would
require only a modest repair, not a complete
overhaul.

7. KEYNES´S THEORY
In 1936, Keynes wrote ¨The General Theory of
Employment, Interest, and Money¨
This book reflected two innovations:
1. Keynes emphasized the short-run effects of
shifts in AD on aggregate output, instead of
the long-run determination of the aggregate
price level. He focused the attention of
economists on situations in which the SRAS
curve slopes upward and shifts in the AD
curve affect aggregate output and
employment as well as aggregate prices.

8. CLASSICAL VERSUS KEYNESIAN
MACROECONOMICS

9. KEYNES´S THEORY
2. Classical economists emphasized the role of
changes in the money supply in shifting the
AD curve. Keynes argued that other factors,
especially changes in “animal spirits” are
mainly responsible for business cycles.

10. POLICY TO FIGHT RECESSIONS
The main practical consequence of Keyne´s
work was that it legitimized macroeconomic
policy activism (the use of fiscal and
monetary policy to smooth out the business
cycle)
Today there is a broad consensus about the
useful role that monetary and fiscal policy can
play in fighting recessions.
However, Keynes´s ideas have not been fully
accepted by modern macroeconomists.

11. CHALLENGES TO KEYNESIAN
ECONOMICS
Keynes´s work suggested that monetary policy
wouldn´t be very effective in depression
conditions.
In fact, in the 1930´s interest rates were very
close to 0% (against the zero bound).
The term liquidity trap was first used by the
British economist John Hicks in 1937.
However, many economists continued to
emphasize fiscal policy and downplay
monetary policy.

12. THE REVIVAL OF MONETARY
POLICY
In 1963, Milton Friedmand and Anna Schwartz
published “A Monetary History of the United
States”
In this book, the authors persuaded most
economists that monetary policy should pla a
key role in economic management.
This shifted the burden of managing the
economy away from fiscal policy, which meant
that economic management could be made
mor technical and less political.

13. MONETARISM
Milton Friedman led a movement, called
monetarism, which asserted that GDP will
grow steadily if the money supply grows
steadily.
This is carried out through targeting a constant
growth in the money supply, and maintain that
rate regardless of any fluctuations in the
economy.
Monetarism maintained many Keynesian
ideas, such as that the short run is important,
and tha short run changes in AD affect
aggregate output as well as aggregate prices.

14. MONETARISM
Milton Friedmand also agrued that policy
should have been much more expansionary
during the Great Depression.
However, Monetarists argued that most of the
efforts of policy makers to smooth out the
business cycle actually make things worse,
with concerns about the use of discretionary
fiscal policy, due to lags .
According to economists, discretionary
monetary policy also faces lags, but to a
lesser extent.

15. MONETARISM
Monetarists also point out fiscal policy is less
effective than Keynesians believe.
Friedman pointed out that if the money supply
is held fixed while the government pursues an
expansionary fiscal policy, crowding out will
limit the effect of the fiscal expansion on
aggregate demand.
As a result, the rightward shift of the AD curve
will be smaller than the multiplier analysis
indicates.

16. MONETARISM
However, Friedman didn´t favor activist
monetary policy either, arguing that the
problem of time lags that limit the ability of
discretionary fiscal policy to stabilize the
economy also apply to discretionary monetary
policy.
The solution, he argued, was to follow a
monetary policy rule, which is a formula that
determines its actions and leave relatively little
discretion.

17. THE QUANTITY THEORY OF
MONEY
Underlying the the monetary policy rule was
the Quantity Theory of Money, which relies
on the velocity of money (which is the ratio of
nominal GDP to the money supply) and is the
number of times an average dollar bill in the
economy turns over per year.
This concept gives rise to the velocity
equation:
MxV=PxY
Where M is the money supply, V is velocity, P is
the aggregate price level, and Y is real GDP.

18. THE QUANTITY THEORY OF
MONEY
Monetarists believed that the velocity of money
was stable in the short run and changed only
slowly in the long run.
As a result, steady growth in the money supply
by the central bank would ensure steady
growth in spending, and therefore in GDP.

19. THE QUANTITY THEORY OF
MONEY
Although monetarism strongly influenced
actual monetary policy in the late 1970´s and
early 1980´s, steady growth in the money
supply didn´t ensure steady growth in the
economy, as the velocity of money wasn´t
stable enough for such a simple policy rule to
work.
Traditional monetarists are rare in today´s
macroeconomics, although the concern that
too much discretional monetary policy can
destabilize the economy has become widely
accepted.

20. INFLATION AND
THE NATURAL RATE OF
UNEMPLOYMENT
In the 1940´s and 1950´s many Keynesian
economists believed that expansionary fiscal
policy could be used to achieve full
employment on a permanent basis.
In the 1960´s, Edmund Phelps (Columbia
University) and Milton Friedman, working
independently, proposed the concept of the
NRU.

21. INFLATION AND
THE NATURAL RATE OF
UNEMPLOYMENT
According to the natural rate hypothesis, to
avoid accelerating inflation over time, the
unemployment rate must be high enough that
the actual inflation rate equels the expected
rate of inflation.
Attempts to keep the unemployment rate
below the natural rae will lead to ever-rising
inflation rate.
Therefore, the task of government is not to
keep unemployment low, but to keep it stable,
preventing large fluctuations in either direction.

22. INFLATION AND
THE NATURAL RATE OF
UNEMPLOYMENT
The Friedman-Phelps hypothesis predicted
that once inflation was embedded in the
public´s expectation, inflation would continue
even in the face of high unemployment.
This was an accurate prediction that was
proved true in the1970s.

23. INFLATION AND
THE NATURAL RATE OF
UNEMPLOYMENT
This convinced most of the economists that
the natural rate hypothesis was correct, and
became almos universally accepted among
macroeconomists (although some believe that
at very low or negative rates of inflation the
hypothesis doesn´t work).
Traditional monetarism declined in influence as
more evidence accumulated.

24. THE POLITICAL BUSINESS CYCLE
One more challenge to Keynesian economics
focused not on the validity of the economic
analysis but in its political consequences.
Economists believe that activist
macroeconomic policy lends itself to political
manipulation.
The result of this can be unnecessary
instability in the economy, a political
business cycle, caused by the use of
macroeconomic policy to serve political ends.

25. THE POLITICAL BUSINESS CYCLE
One way to avoid a political business cycle is
to place monetary policy in the hands of an
independent central bank.
A political business cycle is also a reason to
limit the use of discretionary fiscal policy to
extreme circumstances.

26. RATIONAL EXPECTATIONS, REAL
BUSINESS CYCLES, AND NEW
CLASSICAL MACROECONOMICS
Classical economists believed tha the SRAS
curve was verical, but Keynes emphasized that
it sloped upwards in the long run.
As a result, demand shocks, shifts in the AD
curve, can cause fluctuations in aggregate
output.

27. RATIONAL EXPECTATIONS, REAL
BUSINESS CYCLES, AND NEW
CLASSICAL MACROECONOMICS
In the 1970´s and 1980´s some economists
developed an approach to the business cycle
known as new classical macroeconomics,
which returned to the classical view that shifts
in the AD curve affect only affect the aggregate
price level and not the aggregate output.

28. RATIONAL EXPECTATIONS, REAL
BUSINESS CYCLES, AND NEW
CLASSICAL MACROECONOMICS
This evolved in two steps:
1. Some economists challenged the traditional
arguments about the slope of the SRAS
based on rational expectations
2. Some economists suggested that changes in
productivity caused economic fluctuations, a
view know as the real business cycle theory.

29. RATIONAL EXPECTATIONS, REAL
BUSINESS CYCLES, AND NEW
CLASSICAL MACROECONOMICS
In 1970, a theory known as rational
expectations had a strong impact on
macroeconomics.
This theory was introduced by John Muth in
1961.
This is a view that individuals and firms make
decisions optimally, using all available
information.
For example in negotiating wage contracts,
workers will incorporate not only expected
rates of inflation and the effects on inflation

30. RATIONAL EXPECTATIONS, REAL
BUSINESS CYCLES, AND NEW
CLASSICAL MACROECONOMICS
Rational expectations can make a major
difference to the effects of government policy.
In the 1970´s, Robert Lucas (University of
Chicago) used this logic to argue that
monetary policy can change the level of
unemployment only if it comes as a surprise to
the public.
So if his analysis is right, monetary policy is
not useful in stabilizing the economy after all,
although many macroeconomists believe that
his conclusions were overstated.

31. RATIONAL EXPECTATIONS, REAL BUSINESS
CYCLES, AND NEW CLASSICAL
MACROECONOMICS
New Keynesian economists (a set of ideas that
became influential in the 1990´s) provides an
explanation at to why the rational expectations
hypothesis doesn´t accurately describe how
the economy behaves.
It argues that market imperfections interact to
make many prices in the economy temporaril
sticky.
Over time, new Keynesian ideas combined
with actual experience have reduced the
practical influence of the rational expectations
concept.

32. REAL BUSINESS CYCLES
Total factor productivity is the amount of output
that can be generated wih a given level of
factor outputs.
Total factor productivity grows over time, but
not smoothly.
The real business cycle theory claims that
fluctuations in the rate of growth of total factor
productivity cause the business cycle.
They believe that the AS curve is vertical, so
they attribute the source of business cycles to
shifts of the AS curve.

33. REAL BUSINESS CYCLES
A recession occurs when a slowdown in
productivity growth shifts the AS curve
leftward, and a recovery occurs when an
increase in productivity growth shifts the AS
curve rightward.
This theory has made valuable contributions to
understanding the economy and serves as a
useful caution against too much emphasis on
aggregate demand.

34. REAL BUSINESS CYCLES
However, many real business cycle theorists
now acknowledge that their models need an
upward-sloping AS curve to fit the economic
data, and that gives AD a potential role in
determining aggregate output.
As seen policy makers stongly believe that
aggregate demand policy has an important
role to play in fighting recessions.