CHAPTE R SLIDES BY S OLINA L INDAHL 6(21) Macroeconomics: The Big Picture FOOD FOR THOUGHT…. SOME GOOD BLOGS AND OTHER SITES TO GET THE JUICES FLOWING: C O P Y R I G H T 2 0 1 5 W O R T H P U B L I S H E R S What you will learn in this chapter ▪ What makes macroeconomics different from microeconomics ▪ What a business cycle is and why policy makers seek to diminish the severity of business cycles ▪ How long-run economic growth determines a country’s standard of living ▪ The meaning of inflation and deflation and why price stability is preferred ▪ The importance of open-economy macroeconomics and how economies interact through trade deficits and trade surpluses To Video To First Active Learning C O P Y R I G H T 2 0 1 5 W O R T H P U B L I S H E R S LEARN BY DOING: DISCUSS With a partner (and without technology), discuss and decide what you think is the (approximate) current annual inflation rate. http://www.bls.gov/ To Next Active Learning C O P Y R I G H T 2 0 1 5 W O R T H P U B L I S H E R S Back to Table of contents LEARN BY DOING: DISCUSS With a partner (and without technology), discuss and decide what you think is the (approximate) current U.S. unemployment rate. http://www.bls.gov/ To Next Active Learning C O P Y R I G H T 2 0 1 5 W O R T H P U B L I S H E R S Back to Table of contents THE ORIGINS OF MACROECONOMICS Hoover’s failure to understand what caused the Great Depression (or how it could be tamed) was common at the time. Microeconomics was well-developed; macroeconomics was not. The effort to understand economic slumps and find ways to prevent them is at the core of macroeconomics. C O P Y R I G H T 2 0 1 5 W O R T H P U B L I S H E R S Back to Table of contents THE BUSINESS LEARN BY DOING: CYCLE APPLICATION VIDEO During the Great Depression, “Hoovervilles” sprang up across America, named after the economically clueless President Herbert Hoover. Back to Table of contents C OPYRIGHT 2015 W ORTH P UBLISHERS The Nature of Macroeconomics Macroeconomic Questions C O P Y R I G H T 2 0 1 5 W O R T H P U B L I S H E R S Back to Table of contents MACROECONOMICS: THE WHOLE IS GREATER THAN THE SUM OF ITS PARTS An example Paradox of thrift: When families and businesses are worried about the possibility of economic hard times, they prepare by cutting their spending. This reduction in spending depresses the economy as consumers spend less and businesses react by laying off workers. As a result, families and businesses may end up worse off than if they hadn’t tried to act responsibly by cutting their spending. C O P Y R I G H T 2 0 1 5 W O R T H P U B L I S H E R S Back to Table of contents MACROECONOMICS: THEORY AND POLICY Pre-1930s conventional wisdom Self-regulating economy: Problems such as unemployment are resolved without government intervention through the working of the invisible hand. Post-1930s conventional wisdom Keynesian economics: Economic slumps are caused by inadequate spending, and they can be mitigated by government intervention. C O P Y R I G H T 2 0 1 5 W O R T H P U B L I S H E R S Back to Table of contents COMPARING THE GREAT RECESSION TO THE GREAT DEPRESSION Measures of economic activity and world industrial production during the Great Depression and the Great Recession C O P Y R I G H T 2 0 1 5 W O R T H P U B L I S H E R S Back to Table of contents MACROECONOMICS “The long run is a misleading guide to current affairs. In the long run we are all dead. Economists set themselves too easy, too useless a task if in tempestuous seasons they can only tell us that when the storm is past the ocean is flat again.” -John Maynard Keynes, A Tract on Monetary Reform (1923) Ch. 3 C O P Y R I G H T 2 0 1 5 W O R T H P U B L I S H E R S Back to Table of contents THE BUSINESS CYCLE Since the 1930s, the U.S. (and most national governments) uses tools to improve the economy. Monetary policy: uses changes in the quantity of money to alter interest rates and affect overall spending. Fiscal policy: uses changes in government spending and taxes to affect overall spending. C O P Y R I G H T 2 0 1 5 W O R T H P U B L I S H E R S Back to Table of contents IMAGES OF THE DEPRESSION Back to Table of contents GROWTH INTERRUPTED, 1985–2014 Source: Federal Reserve Bank of St. Louis (Shaded areas are recessions) C O P Y R I G H T 2 0 1 5 W O R T H P U B L I S H E R S Back to Table of contents CHARTING THE BUSINESS CYCLE Recessions (contractions): periods of economic downturn, when output and employment are falling. Expansions (recoveries): periods of economic upturn, when output and employment are rising. Business cycle: the short-run alternation between recessions and expansions. C O P Y R I G H T 2 0 1 5 W O R T H P U B L I S H E R S Back to Table of contents THE BUSINESS CYCLE The point at which the economy turns from expansion to recession is a business-cycle peak. The point at which the economy turns from recession to expansion is a business-cycle trough. C O P Y R I G H T 2 0 1 5 W O R T H P U B L I S H E R S Back to Table of contents THE PAIN OF RECESSION The most important effect of a recession is its effect on the ability of workers to find and hold jobs. C O P Y R I G H T 2 0 1 5 W O R T H P U B L I S H E R S Back to Table of contents TAMING THE BUSINESS CYCLE The business cycle is a main concern of modern policy makers: they try to smooth out the business cycle. They haven’t been completely successful. Source: Bureau of Labor Statistics (Shaded areas are recessions) C O P Y R I G H T 2 0 1 5 W O R T H P U B L I S H E R S Back to Table of contents LEARN BY DOING: APPLICATION VIDEO You might not understand everything mentioned in this epic economist rap battle YET…but you will enjoy it and get a taste for the philosophical debates about stabilization policy within macroeconomics. (6:28 minutes) C O P Y R I G H T 2 0 1 5 W O R T H P U B L I S H E R S Back to Table of contents LEARN BY DOING: PRACTICE QUESTION The use of taxes and government spending to change the overall level of spending in an economy is called: a) monetary policy. b) fiscal policy. c) either monetary or fiscal policy depending upon what is happening to the interest rate. To Next Active Learning C O P Y R I G H T 2 0 1 5 W O R T H P U B L I S H E R S Back to Table of contents LEARN BY DOING: PRACTICE QUESTION Do you think the government is right to begin massive spending programs during deep recessions? a) Yes b) No To Next Active Learning C O P Y R I G H T 2 0 1 5 W O R T H P U B L I S H E R S Back to Table of contents ECONOMICS IN ACTION COMPARING RECESSIONS The 2001 recession was milder than the 2007–2009 one. C O P Y R I G H T 2 0 1 5 W O R T H P U B L I S H E R S Back to Table of contents LONG-RUN ECONOMIC GROWTH Long-run economic growth is the sustained upward trend in the economy’s output over time. Source: W. Michael Cox and Richard Alm, “How Are We Doing?” The American (July/August 2008). http://www.american.com/ archive/2008/july-august-magazine-contents/how-are-we-doing C O P Y R I G H T 2 0 1 5 W O R T H P U B L I S H E R S Back to Table of contents GROWTH, THE LONG VIEW Americans have become able to afford many more material goods over time thanks to long-run economic growth. Sources: Angus Maddison, Statisticson World Population, GDP, and Per Capita GDP, 1– 2008AD,http://www.ggdc.net/MADDISON/oriindex.htm; Bureau of Economic Analysis. C O P Y R I G H T 2 0 1 5 W O R T H P U B L I S H E R S Back to Table of contents GROWTH, THE LONG VIEW Long-run growth is a relatively modern phenomenon. C O P Y R I G H T 2 0 1 5 W O R T H P U B L I S H E R S Back to Table of contents ECONOMICS IN ACTION A TALE OF TWO COUNTRIES Canada and Argentina began the 20th century looking like twins… Political instability and high inflation slowed Argentina down. Now Canada’s standard of living is on par with the U.S., 3x as high as Argentina C O P Y R I G H T 2 0 1 5 W O R T H P U B L I S H E R S Back to Table of contents INFLATION AND DEFLATION A rising overall level of prices is inflation. A falling overall level of prices is deflation. The economy has price stability when the overall level of prices changes slowly or not at all. Rising Prices offset most of the rise in average wages. Source: Bureau of Labor Statistics C O P Y R I G H T 2 0 1 5 W O R T H P U B L I S H E R S Back to Table of contents THE CAUSES OF INFLATION AND DEFLATION In the short run, movements in inflation are closely related to the business cycle. When the economy is depressed and jobs are hard to find, inflation tends to fall; when the economy is booming, inflation tends to rise. In the long run, the overall level of prices is mainly determined by changes in the money supply. C O P Y R I G H T 2 0 1 5 W O R T H P U B L I S H E R S Back to Table of contents THE PAIN OF INFLATION AND DEFLATION Both inflation and deflation are problematic. ▪ Inflation discourages people from holding onto cash (because cash loses value if prices are rising). In extreme cases, people stop using cash altogether. ▪ Deflation can cause the reverse problem. Since cash gains value if the price level is falling, holding on to it is more attractive than investing in new factories and other productive assets. This can deepen a recession. C O P Y R I G H T 2 0 1 5 W O R T H P U B L I S H E R S Back to Table of contents ECONOMICS IN ACTION A FAST (FOOD) MEASURE OF INFLATION In 1954 the original McDonald’s sold hamburgers for $0.15 each. In 2013 the same burger sold for $1.00 (6.5x higher) BUT overall consumer prices rose even faster (8.5x) C O P Y R I G H T 2 0 1 5 W O R T H P U B L I S H E R S Back to Table of contents INTERNATIONAL IMBALANCES The United States is an open economy: it trades goods and services with other countries. In 2013, the United States ran a big trade deficit. Trade deficit: the value of goods and services bought from foreigners is more than the value of goods and services sold to them. Trade surplus: the value of goods and services bought from foreigners is less than the value of the goods and services sold to them. C O P Y R I G H T 2 0 1 5 W O R T H P U B L I S H E R S Back to Table of contents WHAT CAUSES TRADE IMBALANCES? In a later chapter we’ll learn the surprising answer: the determinants of the overall balance between exports and imports lie in decisions about savings and investment spending. Countries with high investment spending relative to savings run trade deficits; countries with low investment spending relative to savings run trade surpluses. Source: CIA World Factbook. C O P Y R I G H T 2 0 1 5 W O R T H P U B L I S H E R S Back to Table of contents LEARN BY DOING: PRACTICE QUESTION This year the value of a country’s imports is equal to $1.2 billion, and the value of its exports is equal to $1.3 billion. This country is running a: a) trade surplus. b) trade deficit. C O P Y R I G H T 2 0 1 5 W O R T H P U B L I S H E R S Back to Table of contents ECONOMICS IN ACTION SPAIN’S COSTLY SURPLUS Giving up the Peseta for the Euro (and closer union with Europe) in 1999 had benefits… and costs Did the influx of foreign investment afterward lead to the housing boom (and bust) that brought down Spain? Spain’s Current Account Balance, 1999-2013 C O P Y R I G H T 2 0 1 5 W O R T H P U B L I S H E R S Back to Table of contents LEARN BY DOING: BUSINESS CASE THE DECLINE OF MONTGOMERY WARD (THE IMPORTANCE OF UNDERSTANDING THE MACROECONOMY) 1930’s: Montgomery Ward survived the Depressions by cutting costs and hoarding cash 1940’s: Expecting a similar environment post WWII, they repeated the strategy… and didn’t open a new store until 1959… far too late to stop their decline C O P Y R I G H T 2 0 1 5 W O R T H P U B L I S H E R S Back to Table of contents CHAPTE R SLIDES BY S OLINA L INDAHL 18(33) Crises and Consequences FOOD FOR THOUGHT…. SOME GOOD BLOGS AND OTHER SITES TO GET THE JUICES FLOWING: C O P Y R I G H T 2 0 1 5 W O R T H P U B L I S H E R S What you will learn in this chapter ▪ Why classical macroeconomics was inadequate 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 why monetarists claim there are limits to the use of discretionary monetary policy ▪ How challenges led to a revision of Keynesian economics and the emergence of the new classical macroeconomics ▪ Why the Great Moderation consensus was challenged by the 2008 financial crisis, leading to fierce debates among economists about the best use of fiscal and monetary policy during challenging economic times To To First Video Active Learning C O P Y R I G H T 2 0 1 5 W O R T H P U B L I S H E R S TWO RECESSIONS, SAME PROBLEM C O P Y R I G H T 2 0 1 5 W O R T H P U B L I S H E R S Back to Table of contents CLASSICAL MACROECONOMICS Ye olde economics: Before the Great Depression “classical” macroeconomics reigned. Main ideas: • The short run was unimportant. • Prices were assumed to be flexible, so the aggregate supply curve was vertical even in the short run. C O P Y R I G H T 2 0 1 5 W O R T H P U B L I S H E R S Back to Table of contents ECONOMICS IN ACTION CLASSICAL MACROECONOMICS By the 1930s, measurement of business cycles was well established, but classical economists had no widely accepted theory of business cycles. Business cycles may have been nonexistent (or small) before 1854. Before then data were not collected and the United States was overwhelmingly rural and agricultural. C O P Y R I G H T 2 0 1 5 W O R T H P U B L I S H E R S Back to Table of contents THE GREAT DEPRESSION AND THE KEYNESIAN REVOLUTION The Great Depression demonstrated that economists cannot safely ignore the short run. The disastrous effects of the international depression helped Adolf Hitler’s rise in Germany. Economists were conflicted in analysis and prognosis. Classical economists advocated waiting it out, but as the depression deepened, this approach was rejected. Some thought capitalism had failed and only a government takeover could end the slump. Some thought the slump could be cured without giving up the basic market economy. John Maynard Keynes compared the problem to a car with a Back to Table of contents defective starter. C O P Y R I G H T 2 0 1 5 W O R T H P U B L I S H E R S KEYNES’S THEORY In 1936, Keynes published The General Theory of Employment, Interest, and Money, one of the most influential books on economics ever written. C O P Y R I G H T 2 0 1 5 W O R T H P U B L I S H E R S Back to Table of contents THE GREAT DEPRESSION AND THE KEYNESIAN REVOLUTION Keynesian economics rests on two main tenets: 1) Changes in aggregate demand affect aggregate output, employment, and prices. 2) Changes in business confidence cause the business cycle. Keynes’s term for business confidence: “animal spirits” C O P Y R I G H T 2 0 1 5 W O R T H P U B L I S H E R S Back to Table of contents LEARN BY DOING: APPLICATION VIDEO Now that you’ve spent time with macroeconomic models, you will enjoy this rap battle between Keynes and Hayek more. (6:28 minutes) To Next Video C O P Y R I G H T 2 0 1 5 W O R T H P U B L I S H E R S Back to Table of contents THE CLASSICAL VS. THE KEYNESIAN VIEW The classical view: Flexible prices and focus on the long run mean a vertical SRAS; shifts in AD affect only aggregate price level. Aggregate price level Aggregate price level SRAS P1 The Keynesian view: Sticky prices and upwardsloping SRAS curve; shifts in AD affect the price level and output. SRAS P1 E1 E1 E2 P2 E2 P2 AD1 AD1 AD2 AD2 C O P Y R I Y1 G H T Real GDP 2 0 1 5 W O R T H P U B L Y2 I S H Y1 E R Real GDP S Back to Table of contents THE POLITICS OF KEYNES Be careful not to confuse Keynes with socialism. Keynes himself was no socialist and not much of a leftist. When The General Theory was published, many intellectuals believed the capitalist system was dying. 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. C O P Y R I G H T 2 0 1 5 W O R T H P U B L I S H E R S Back to Table of contents LEARN BY DOING: PRACTICE QUESTION Which of the following statements about Keynes’s contributions to economic theory is true? a) In the long run, fluctuations in output are primarily due to fluctuations in AD (aggregate demand). b) In the short run, the aggregate supply curve is upward sloping, and therefore shifts in AD will cause fluctuations in aggregate output. c) Shifts in the aggregate demand curve in the short run are primarily due to changes in the money supply. d) “Animal spirits” primarily affect aggregate supply in the long run. To Next Active Learning C O P Y R I G H T 2 0 1 5 W O R T H P U B L I S H E R S Back to Table of contents POLICY TO FIGHT RECESSIONS The main consequence of Keynes’s work was that it legitimized macroeconomic policy activism. Macroeconomic policy activism: the use of monetary and fiscal policy to smooth out the business cycle. C O P Y R I G H T 2 0 1 5 W O R T H P U B L I S H E R S Back to Table of contents ECONOMICS IN ACTION THE END OF THE GREAT DEPRESSION The basic message young economists took from Keynes in the 1930s was that economic recovery requires aggressive fiscal expansion to create jobs. Policy makers weren’t convinced… …until World War II deficit spending created economic growth. C O P Y R I G H T 2 0 1 5 W O R T H P U B L I S H E R S Back to Table of contents LEARN BY DOING: DISCUSS With a partner, briefly describe the two primary innovations in Keynesian economics. How did Keynes’s work legitimize macroeconomic policy activism? Use the graph to help illustrate your answer, and be sure in your answer to compare the Keynesian viewpoint with the classical viewpoint. To Next Active Learning C O P Y R I G H T 2 0 1 5 W O R T H P U B L I S H E R S Back to Table of contents LEARN BY DOING: PRACTICE QUESTION “Animal spirits” refers to the: a) effect of monetary policy on investment decisions. b) level of confidence businesses have and how that confidence level affects spending decisions by firms and households. c) inappropriate policies enacted by Congress during the political business cycle. d) ability of the government through its spending policies to manage the economy and keep it from recession. To Next Active Learning C O P Y R I G H T 2 0 1 5 W O R T H P U B L I S H E R S Back to Table of contents LEARN BY DOING: PRACTICE QUESTION Keynes argued that: a) the Depression could be eliminated with expansionary monetary policy to reduce the interest rate and raise levels of investment and consumer spending. b) ending the Depression required a focus on spending and the need for government to ensure that the level of spending was adequate. c) the Depression would end with the passage of time; we just all needed to be patient and wait for the economy to move back to long-run equilibrium. d) luckily, during the Depression, the liquidity trap was not an issue, and therefore monetary and fiscal policies would both work to end the Depression. To Next Active Learning C O P Y R I G H T 2 0 1 5 W O R T H P U B L I S H E R S Back to Table of contents LEARN BY DOING: PRACTICE QUESTION The Great Depression: a) reinforced prevailing economic views of the day that only long-run economic performance was important. b) threatened both economic and political stability. c) illustrated that market economies produced consistently at the potential output level. d) Answers (a), (b), and (c) are all correct. e) Answers (b) and (c) are both correct. To Next Active Learning C O P Y R I G H T 2 0 1 5 W O R T H P U B L I S H E R S Back to Table of contents CHALLENGES TO KEYNESIAN ECONOMICS Keynes’s ideas did not go unchallenged, especially his assertion that monetary policy was ineffective during recessions. (Recall the liquidity trap, in which monetary policy is ineffective because the interest rate is down against the zero bound.) C O P Y R I G H T 2 0 1 5 W O R T H P U B L I S H E R S Back to Table of contents MONETARISM In 1963, Milton Friedman and Anna Schwartz published A Monetary History of the United States, 1867–1960. They argued that business cycles were historically associated with fluctuations in the money supply. In other words, monetary policy mattered, especially in the Great Depression. C O P Y R I G H T 2 0 1 5 W O R T H P U B L I S H E R S Back to Table of contents MONETARISM A provocative idea emerged: The burden of managing the economy could be shifted away from fiscal policy… …and economic management could largely be taken out of the hands of politicians. This could make macroeconomics a more technical, less political issue. C O P Y R I G H T 2 0 1 5 W O R T H P U B L I S H E R S Back to Table of contents MONETARISM Milton Friedman led the monetarism movement, which sought to eliminate macroeconomic policy activism while maintaining the importance of monetary policy. Monetarists asserted that: • attempts to stabilize the economy with fiscal OR monetary policy would make things worse. • GDP would grow steadily if the money supply grew steadily. C O P Y R I G H T 2 0 1 5 W O R T H P U B L I S H E R S Back to Table of contents FISCAL POLICY WITH A FIXED MONEY SUPPLY The increase in aggregate demand from an expansionary fiscal policy is limited when the money supply is fixed… Aggregate price level Interest rate, r SRAS P2 E2 P1 …because the increase in money demand drives up the interest rate, crowding out some investment spending. MS E2 r2 E1 AD2 E1 r1 MD2 AD1 Y1 C O P Y R Y2 I G H MD1 Real GDP T 2 0 1 5 M Quantity of money W O R T H P U B L I S H E R S Back to Table of contents MONETARISM Friedman didn’t favor activist monetary policy either; he favored an autopilot approach. A monetary policy rule is a formula that determines the central bank’s actions. C O P Y R I G H T 2 0 1 5 W O R T H P U B L I S H E R S Back to Table of contents MONETARIST POLICY IDEAS The velocity of money is the ratio of nominal GDP to the money supply, a measure of how many times the average dollar bill is spent each year in the country. The velocity equation: M × V = P × Y Where M is the money supply, V is velocity, P is the aggregate price level, and Y is real GDP. Monetarists believed that V was stable, so if the Fed kept M on a steady growth path, nominal GDP (P × Y) would also grow steadily. C O P Y R I G H T 2 0 1 5 W O R T H P U B L I S H E R S Back to Table of contents THE VELOCITY OF MONEY Monetarism made more sense before 1980. Source: Federal Reserve Bank of St. Louis. C O P Y R I G H T 2 0 1 5 W O R T H P U B L I S H E R S Back to Table of contents ECONOMICS IN ACTION THE FED’S FLIRTATION WITH MONETARISM Paul Volcker, Fed Chairman 1979–1987 In the late 1970s, the Fed used a policy rule: It started announcing target ranges for the money supply and stopped setting targets for interest rates. But since 1982 the Fed has pursued a discretionary monetary policy, which has led to large swings in the money supply. C O P Y R I G H T 2 0 1 5 W O R T H P U B L I S H E R S Back to Table of contents INFLATION AND THE NATURAL RATE OF UNEMPLOYMENT In the 1960s, economists began to worry that expansionary policies could cause inflation problems. 1968: Milton Friedman and Edmund Phelps argued that there is a natural rate of unemployment. Since the government can’t keep unemployment below its natural rate, it should just try to keep it stable. And if inflation gets embedded in the public’s expectations, it will continue even if unemployment is high. C O P Y R I G H T 2 0 1 5 W O R T H P U B L I S H E R S Back to Table of contents INFLATION AND THE NATURAL RATE OF UNEMPLOYMENT The natural rate of unemployment is also the NAIRU (non-accelerating-inflation rate of unemployment). The natural rate hypothesis: because inflation is embedded in expectations, to avoid accelerating inflation over time the unemployment rate must be high enough that the actual inflation rate equals the expected inflation rate. C O P Y R I G H T 2 0 1 5 W O R T H P U B L I S H E R S Back to Table of contents THE POLITICAL BUSINESS CYCLE A final challenge to Keynes: What if politicians use Keynesian theory as an excuse to pump up the economy during election years to appeal to voters? A political business cycle: political use of macroeconomic policy to serve political ends. Nixon, “King of the political business cycle” campaigns, 1972 C O P Y R I G H T 2 0 1 5 W O R T H P U B L I S H E R S Back to Table of contents RATIONAL EXPECTATIONS, REAL BUSINESS CYCLES, AND NEW CLASSICAL MACROECONOMICS In the 1970s and 1980s, some economists argued that aggregate demand didn’t matter as much as Keynes believed. New classical macroeconomics evolved in two steps: • rational expectations theory • real business cycle theory C O P Y R I G H T 2 0 1 5 W O R T H P U B L I S H E R S Back to Table of contents RATIONAL EXPECTATIONS New classical macroeconomics returns to the classical view that shifts in the aggregate demand curve affect only the aggregate price level, not the aggregate output. In the 1970s “rational expectations” came into favor. Rational expectations: the view that individuals and firms make decisions optimally, using all available information. Expansionary policies will have no effect if the markets adjust wages now in anticipation of future inflation. C O P Y R I G H T 2 0 1 5 W O R T H P U B L I S H E R S Back to Table of contents NEW KEYNESIAN CRITIQUE In the 1990s, new Keynesian economics became influential and criticized rational expectations. New Keynesians argue that market imperfections interact to make many prices in the economy temporarily sticky. Rational expectations theory has become less influential, but it did serve as a useful caution for those who were too optimistic about their ability to manage the economy. C O P Y R I G H T 2 0 1 5 W O R T H P U B L I S H E R S Back to Table of contents REAL BUSINESS CYCLES In the 1980s some economists argued that recessions are caused by slowdowns in technology (and productivity) growth. Real business cycle theory: the idea that fluctuations in the rate of growth of total factor productivity cause the business cycle. Proponents saw no role for policy activism, since they believed the aggregate supply curve was vertical. C O P Y R I G H T 2 0 1 5 W O R T H P U B L I S H E R S Back to Table of contents SUPPLY-SIDE ECONOMICS In the 1970s, the idea that reducing tax rates would increase the incentives to work and invest became popular. This encouraged politicians like Ronald Reagan to cut taxes without cutting spending, since economic growth would theoretically offset any effect of budget deficits. C O P Y R I G H T 2 0 1 5 W O R T H P U B L I S H E R S Back to Table of contents WHAT’S WRONG WITH SUPPLY-SIDE ECONOMICS? Economic researchers mainly dismiss supply-side claims, not because the logic isn’t sound but because at current U.S. tax rates the incentives don’t seem to be strong enough. The Congressional Budget Office and others show no sign of an acceleration in growth after the Reagan tax cuts were implemented. C O P Y R I G H T 2 0 1 5 W O R T H P U B L I S H E R S Back to Table of contents ECONOMICS IN ACTION THE 1970’S IN REVERSE If the theory of the Natural Rate of Unemployment argues that sustained low unemployment leads to accelerating inflation… shouldn’t the opposite be true? The Great Recession tested this idea. Although the U.S. had lower inflation, it never entered the deflation predicted by the model. The old-fashioned Keynesian view that unemployment can be permanently reduced gained ground after 2008 C O P Y R I G H T 2 0 1 5 W O R T H P U B L I S H E R S Back to Table of contents CONSENSUS AND CONFLICT IN MODERN MACROECONOMICS After the stormy 1970s and the first half of the 1980s, things settled down. The great moderation: the period from 1985 to 2007, when the U.S. economy had relatively small fluctuations and low inflation. The great moderation consensus combines a belief in monetary policy as the main tool of stabilization with skepticism about the use of fiscal policy and an acknowledgment of the policy constraints imposed by the natural rate of unemployment and the political business cycle. C O P Y R I G H T 2 0 1 5 W O R T H P U B L I S H E R S Back to Table of contents FIVE KEY QUESTIONS ABOUT MACROECONOMIC POLICY But the Great Recession shattered the consensus. C O P Y R I G H T 2 0 1 5 W O R T H P U B L I S H E R S Back to Table of contents LEARN BY DOING: APPLICATION VIDEO They’re back: Keynes vs. Hayek, “The Fight of the Century,” round 2. Is fiscal policy stabilizing or destabilizing? Has the Great Recession proved either man right? Click here or below. (10:10 minutes) C O P Y R I G H T 2 0 1 5 W O R T H P U B L I S H E R S Back to Table of contents CRISIS AND AFTERMATH The debate over fiscal policy in 2009 Supporters of fiscal stimulus argued: 1. Fiscal policy was needed, since interest rates were near zero. 2. Crowding out was unlikely to be a problem in a depressed economy. 3. Because the recession was likely to be a long one, lags in fiscal policy didn’t matter much. C O P Y R I G H T 2 0 1 5 W O R T H P U B L I S H E R S Back to Table of contents CRISIS AND AFTERMATH The debate over fiscal policy in 2009 Opponents of fiscal stimulus argued: 1. New government spending would be ineffective, since people would increase their savings (and cut their spending) in anticipation of higher taxes in the future (Ricardian equivalence argument). 2. Spending programs might undermine investors’ faith in the government’s ability to repay its debts, leading to an increase in long-term interest rates despite loose monetary policy. C O P Y R I G H T 2 0 1 5 W O R T H P U B L I S H E R S Back to Table of contents CRISIS AND AFTERMATH By 2010, many economists argued that the best solution was to cut government spending, which they hoped would increase confidence and growth. This “expansionary austerity” was especially popular in Europe. Time to tighten the belt? C O P Y R I G H T 2 0 1 5 W O R T H P U B L I S H E R S Back to Table of contents CRISIS AND AFTERMATH Who’s right? Both sides claim that the continued slump supports their arguments. Supporters of stimulus say it helped but wasn’t big enough. Opponents of stimulus say it didn’t work, but austerity programs in Britain and elsewhere seem to have deepened the slump. In any case, interest rates have not risen, as some insisted would happen. C O P Y R I G H T 2 0 1 5 W O R T H P U B L I S H E R S Back to Table of contents CRISIS AND AFTERMATH The debate over monetary policy In 2008–2010, the Fed got creative in trying to stimulate the economy by buying longerterm government bonds. This QE (“quantitative easing”) was controversial. • Some thought it would be hard to undo. • Some thought it would be ineffective. • Some thought the Fed should increase its inflation target instead so that we wouldn’t be so close to the zero bound on interest rates. C O P Y R I G H T 2 0 1 5 W O R T H P U B L I S H E R S Back to Table of contents ECONOMICS IN ACTION LATS OF LUCK Is Latvia’s relative postcrisis success due to its austerity policies? Or is it the natural “catch-up” growth of a relatively poor nation? Is it even a success if GDP hasn’t returned to pre-crisis levels? C O P Y R I G H T 2 0 1 5 W O R T H P U B L I S H E R S Back to Table of contents LEARN BY DOING: PRACTICE QUESTION If the economy is in a recession and the president invites three economists—A Keynesian, a monetarist, and a new classical—to offer explanation and policy options, what would each say in two sentences or less? C O P Y R I G H T 2 0 1 5 W O R T H P U B L I S H E R S Back to Table of contents
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