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Chapter 18: Macroeconomics

Milton Friedman and Anna Schwartz
claimed Great Depression could have been avoided if Fed had acted to prevent the oncoming monetary contraction, as business cycles were historically associated with fluctuations in money supply; proposed NAIRU
National Bureau of Economic Research
independent, nonprofit organization that declares beginnings of recessions and expansions founded in 1920
reasons the official chronology of US business cycles begins 1854
fluctuations in aggregate output in agricultural economies differ from those in business cycles; prices of agricultural goods highly flexible so SRAS curve is close to vertical and demand shocks don’t cause output fluctuations; modern business cycles are largely result of shifts in aggregate demand curve
Keynesian economics
argument that changes in aggregate demand affect affect aggregate output, employment, and prices and that changes in business confidence cause the business cycle; focus on SRAS sloping upward and shifts in AD curve affect all three above factors; well-accepted after WWII
major difference between Keynesian and classical
classical emphasized role of changes in money supply in shifting aggregate demand curve; Keynesian claims other factors especially business confidence are responsible for business cycles
macroeconomic policy activism
use of monetary and fiscal policy to smooth out the business cycle; legitimized by Keynes
Keynesian view of economic recovery
it requires aggressive fiscal expansion, deficit spending on a large scale to create jobs in short-run; proved by economic recovery during WWII; argues monetary policy not effective in depression conditions because of liquidity trap
politics of monetary vs. fiscal policy
fiscal policy necessarily involves political choices about taxes and government spending; monetary policy is more technical issue with central bank cutting everyone’s interest rate at once
asserts that GDP will grow steadily if the money supply grows steadily; believes central bank should target a constant rate of growth of money supply regardless of fluctuations
similarities in Keynesianism and monetarism
short-run matters, short-run changes in aggregate demand affect aggregate output and aggregate prices; policy should have been more expansionary during Great Depression
difference between Keynesianism and monetarism
monetarism believes policymakers’ efforts to smooth out business cycle make things worse because government perceptions about economy often lag; monetarism also believes if central bank refused to change money supply fiscal policy would be much less effective than Keynesians believe bc of crowding out
discretionary monetary policy
changes in the interest rate or the money supply by the central bank to stabilize economy
fiscal policy with a fixed money supply
increase in money demanded due to expansionary fiscal policy drives up interest rate, reducing investment spending and shift of AD, offsetting part of fiscal expansion; multiplier so small it’s irrelevant
monetary policy rule
formula that determines the central bank’s actions with little discretion on the part of individuals; advocated by monetarism
velocity of money
ratio of nominal GDP to money supply; measure of the number of times the average dollar bill in the economy turns over per year between buyers and sellers M(money supply) x V = P (aggregate price level) x Y (GDP)
monetarism on velocity of money
believed it to be stable in short-run and slow-changing in long-run so steady growth in money supply ensures steady growth in spending and GDP; proven wrong with stagflation; 1980s clear that it is erratic
monetarists today
few believe GDP will grow steadily if money supply does, but most economists believe tenet that too much discretionary monetary policy can destabilize economy
problem with Keynesian view of expansionary fiscal policy
initially believed it could be used to achieve full employment on a permanent basis; 1960s realized it caused problems with inflation and trade-off
natural rate hypothesis
because inflation is eventually embedded into expectations, to avoid accelerating inflation over time the unemployment rate must be high enough that the actual inflation rate equals the expected inflation rate
effect of natural rate hypothesis on role of activist monetary policy
limits; task to keep unemployment stable, not low
Friedman-Phelps hypothesis prediction on trade-offs
apparent trade-off between unemployment and inflation would not survive an extended period of rising prices; proven in 1970s
political business cycle
results when politicians use macroeconomic policy to serve political ends; unnecessary instability when politicians pump up economy in election year despite later high inflation of unemployment
Fed and monetarism
late 1970s stopped setting targets for interest rates; since 1982 rejected monetarism and pursued discretionary monetary policy and set target levels again
new classical macroeconomics
revived the classical view that shifts in the aggregate demand curve affect only the aggregate price level, not aggregate output; challenged SRAS slope with concept of rational expectations; suggested real business cycle theory
real business cycle theory
changes in productivity cause economic fluctuations in the business cycle; pauses in technological progress slow down productivity growth and cause recessions; AS curve is vertical and its shifts cause business cycles, with left shifts causing recessions and right shifts causing recovery; denied that changes in aggregate demand and macroeconomic policy activism have effect on aggregate output
rational expectations
view that individuals and firms make decisions optimally, using all available informations; thus long-term wage contracts reflect future inflation though prices didn’t rise in past; government interventions fails in short and long run; no longer well-accepted
rational expectations model
expected changes in monetary policy have no effect on unemployment and output and only affect price level; attempts to lower unemployment simply result in higher prices
New Keynesian economics
market imperfections can lead to price stickiness for whole economy; reduced practical influence of rational expectations concept
real business cycle theory now
like rational expectations, widely recognized as having made valuable contributions and useful caution against too much emphasis on aggregate demand but fact of upward-sloping AS curve which gives AD potential role in determining aggregate output mean it is no longer accepted on its own
annual rate of total factor productivity growth
estimated by BLS
correlation between total factor productivity and business cycle
result of the effect of business cycle on productivity, not reverse
Great Moderation
relative calm in economy from 1985 to 2007
Great Moderation consensus
apparent consensus; belief in monetary policy as main tool of stabilization, skepticism toward use of fiscal policy, acknowledgment of policy constraints imposed by NAIRU and political business cycle
is expansionary monetary policy helpful in fighting recessions?
see chart for theory answers; now agreed monetary policy is ineffective only in case of liquidity trap
is expansionary fiscal policy effective in fighting recessions?
see chart for theory answers; now agree fiscal and monetary policy can shift AD curve; government should not seek to balance budget; role of budget as an automatic stabilizer helps economy
can monetary and/or fiscal policy reduce unemployment in the long run?
see chart for theory answers; now accept natural rate hypothesis; effective monetary and fiscal policy can limit size of fluctuations of actual unemployment rate around natural rate but can’t be used to keep unemployment below natural rate
should fiscal policy be used in a discretionary way?
see chart for theory answers; many but all now believe it is usually counterproductive because lags mean policies intended to fight slump end up intensifying a boom; gives monetary policy lead role in economic stabilization, fiscal policy in special circumstances like zero bound or liquidity trap; point of contention post-2008
should monetary policy be used in a discretionary way?
see chart for theory answers; most agree under Great Moderation that monetary policy should play main stabilizing role; central bank should be independent, isolated from political pressure and political business cycle; discretionary fiscal policy should be used sparingly because of lags and political business cycle
three main arguments for fiscal stimulus
discretionary fiscal expansion needed because monetary policy could no longer be used with interest rates near zero; crowding out unlikely to be a problem in a depressed economy; argued lag problem less of a concern given likelihood that economy would be depressed for extended period; won out early 2009
two objections against fiscal stimulus
households and firms would see any rise in government spending as a sign that tax burdens would rise in future, leading to a fall in private spending (Ricardian equivalence); spending programs might undermine investors’ faith in government’s ability to pay its debts, leading to an increase in long-term interest rates
expansionary austerity
cutting government spending would increase private sector confidence and lead to a rise in output and employment; popular in Europe
argument that sharp rise in US interest rates due to budget deficits would lead to conventional crowding out
wrong; by 2011 US long-term rates hit record lows despite continuing large deficits
quantitative easing
buying assets other than short-term government debt, notably long-term debt whose interest rate was still significantly above ero
QE2 (quantitative easing 2)
Fed program during Great Recession to buy linger-term debt to drive down longer-term interest rates, which arguably matter more for private spending than short-term rates
interest rate that matters for investment decisions
real interest rate

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