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classical* Money and the price level
economists saw short-term effects as unimportant and stressed the long-term effects of monetary policy on the aggregate price level.
By the great depression, the measurement of the business cycle was well advanced but there was no widely accepted theory about why they happened
who wrote “the general theory of employment, interest, and money” in 1936?
John Maynard Keynes (many people didn’t accept it)
Keynesian economics
-emphasized the short-run effects of changes in aggregate demand on aggregate output (rather than long- run)
-other factors, especially business confidence, are mainly responsible for business cycles.

*not accepted until after world war 2

roeconomic policy activism
the use of monetary and fiscal policy to smooth the business cycle
Expansionary fiscal policy can create jobs in the short run
the great depression could have been avoided if the federal reserve had acted to prevent that monetary contraction
asserts that gdp will grow steadily if the money supply grows steadily
discretionary monetary policy
changes in the interest rate or the money supply to stabilize the economy
discretionary fiscal policy
changes in taxes or government spending or both in response to the state of the economy.
Monetary policy
process by which the monetary authority of a country controls the supply of money, often targeting a rate of interest to attain a set of objectives oriented towards the growth and stability of the economy.
fiscal policy
Fiscal policy is the use of government expenditure and revenue collection to influence the economy.
Fiscal policy principle
Manipulating the level of aggregate demand in the economy to achieve economic objectives of price stability, full employment, and economic growth.
Monetary policy principle
Manipulating the supply of money to influence outcomes like economic growth, inflation, exchange rates with other currencies and unemployment.
Fiscal policy policy makers
Government (e.g. U.S. Congress, Treasury Secretary)
Monetary policy makers
Central Bank (e.g. U.S. Federal Reserve)
Fiscal policy tools
Taxes; amount of government spending
Monetary policy tools
Interest rates; reserve requirements; currency peg; discount window; quantitative easing; open market operations; signalling
if the central bank refused to change money supply because of the fluctuations in the economy, fiscal policy would be ……..___
much less effective than keynesians believed
crowding out
the government deficits drive up interest rates and lead to reduced investment spending
if the money supply is held fixed when the government pursues an expansionary fiscal policy, crowding out will occur and limit the effect of the fiscal policy expansion on aggregate demand
fact ( monetarism)
Monetary policy rule
a formula that determines the central banks actions
velocity of money
ratio of nominal gdp to the money supply
measure of the number of times the average dollar bill in the economy turns over per year between buyers and sellers
velocity equation
M * V = P * Y

M=money supply
P= aggregate price level
Y= real gdp

traditional monetarists
believe that gdp will grow steadily if the money supply grows steadily (hard to come by now)
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 is equal to the expected inflation rate (monetarism) *** created by Milton Friedman and Edmund Phelps

Universally accepted among macroeconomists

Natural rate hypothesis prediction
the tradeoff between unemployment and inflation would not survive an extended period of rising prices.
political business cycle
results when politicians use macroeconomic policy to serve political ends (win an election)

-statistical evidence shows that if the economy is growing rapidly and unemployment is low within the last few months of a parties term, that party will be reelected regardless of how the past three years went.
(****** reason to limit discretionary fiscal policy)

who is known as the “all time hero of political business cycles”
Richard Nixon
to avoid the political business cycle……_________
place monetary policy in the hands of the central bank
early keynesianism downplayed the effectiveness of monetary as opossed to fiscal policy, but later macroeconomists realized that monetary policy is effective except in the case of a liquidity trap

-discretionary monetary policy does more harm than good
-monetary policy rule is the best way to stabilize the economy
-velocity of money was stable, so steady growth of the money supply would lead to steady growth of gdp

monetarism fact
new classical macro economics
shifts the aggregate demand curve, affects only the aggregate price level, not output

two steps to new method
1. Rational expectations
2. new business cycle

Rational expectations
(first step of new classical macro economics)
-originally introduced by, JOHN MUTH:
view that individuals and firms make decisions optimally, using all available information
*takes past information and information available about the monetary/ fiscal policy into account
Rational expectations model
-Introduced by, ROBERT LUCA,
expected changes changes in monetary policy to have no effect on unemployment and output, and to only affect the price level.
(admired but many economists believe it to overstated)
New keynesian economics
set of ideas that became influential in the 1990’s
– argues that market imperfections interact to make prices in the economy temporarily sticky
– argues that it’s okay if monopolists set a price level slightly too high because they may lose a few sales, but make it up with profit on each sale.
Real Business Cycle
(second step of new classical macro economics)
**Founded by: Edward Prescott and Finn Kydland
-claims that fluctuations in the growth of total factor productivity cause the business cycle
total factor productivity
amount of output that can be generated with a given level of factor inputs
business cycle theorists believe that the source of business are ……..
shifts of the aggregate supply curve

-recession= slowdown productivity
-recovery= pickup in productivity

new keynesian ideas and events have diminished the acceptance of the rational expectations model, while real business cycle theory has been undermined by its implication that technology regresses during deep recessions.
aggregate supply curve is upward sloping.
great moderation
relatively calm period in the economy from 1985 to 2007
The great moderation consensus
combines a belief in monetary policy as the main tool of stabilization, with skepticism toward the use of fiscal policy, and acknowledgement of the policy constraints imposed by the natural rate of unemployment and the political business cycle
Question 1: Is expansionary monetary policy helpful in fighting recessions?
Classical: no
Keynesian: not very
Monetarism: Yes
Great Moderation consensus: yes, except ineffective only in the case of a liquidity trap
Question 2: Is expansionary fiscal policy effective in fighting recessions?
Classical: no
Keynesian: yes
Monetarism: no
Great moderation consensus: yes

*many macroeconomists now agree that fiscal policy like monetary policy can shift the aggregate demand curve

Question 3: Can monetary and/or fiscal policy reduce unemployment in the long run?
Classical: no
Keynesian: yes
Monetarism: no
Great moderation consensus: no

* almost all macroeconomist now accept the natural rate hypothesis.
* effective monetary and fiscal policy can limit the size of fluctuations of the actual unemployment rate around the natural rate

Question 4: Should fiscal policy be used in a discretionary way?
Classical: no
Keynesian: yes
Monetarism: no
Great moderation census: no except possibly if the economy is in a liquidity trap

* many macroeconomist believe that discretionary fiscal policy is counterproductie

Question 5: Should monetary policy be used in a discretionary way?
Classical: no
Keynesian: yes
Monetarism: no
Great Moderation consensus: still being disputed

* points that most macroeconomists agree on:
-the monetary policy should play the main role in stabilization policy
– the central bank should be independent insulated from political pressures, in order avoid a political business cycle.
– discretionary fiscal policy should be used sparingly, both because of policy lags and because of the risks of a political business cycle

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