CHP 18 MACRO

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

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

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)

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

aggregate supply curve is upward sloping.

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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.

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discretionary monetary policy

changes in the interest rate or the money supply to stabilize the economy

Fiscal policy policy makers

Government (e.g. U.S. Congress, Treasury Secretary)

Monetary policy makers

Central Bank (e.g. U.S. Federal Reserve)

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 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 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 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 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

fiscal policy

Fiscal policy is the use of government expenditure and revenue collection to influence the economy.

Fiscal policy tools

Taxes; amount of government spending

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

Monetary policy tools

Interest rates; reserve requirements; currency peg; discount window; quantitative easing; open market operations; signalling

who wrote "the general theory of employment, interest, and money" in 1936?

John Maynard Keynes (many people didn't accept it)

velocity equation

M * V = P * Y M=money supply V=velocity P= aggregate price level Y= real gdp

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.

who is known as the "all time hero of political business cycles"

Richard Nixon

Monetary policy rule

a formula that determines the central banks actions

discretionary fiscal policy

changes in taxes or government spending or both in response to the state of the economy.

total factor productivity

amount of output that can be generated with a given level of factor inputs

monetarism

asserts that gdp will grow steadily if the money supply grows steadily

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

traditional monetarists

believe that gdp will grow steadily if the money supply grows steadily (hard to come by now)

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

fact

Expansionary fiscal policy can create jobs in the short run

fact

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

fact

the great depression could have been avoided if the federal reserve had acted to prevent that monetary contraction

fact

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)

velocity

measure of the number of times the average dollar bill in the economy turns over per year between buyers and sellers

*** ACCORDING TO MONETARISM: -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

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

to avoid the political business cycle......_________

place monetary policy in the hands of the central bank

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.

velocity of money

ratio of nominal gdp to the money supply

great moderation

relatively calm period in the economy from 1985 to 2007

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)

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.

business cycle theorists believe that the source of business are ........

shifts of the aggregate supply curve -recession= slowdown productivity -recovery= pickup in productivity

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

crowding out

the government deficits drive up interest rates and lead to reduced investment spending

Natural rate hypothesis prediction

the tradeoff between unemployment and inflation would not survive an extended period of rising prices.

roeconomic policy activism

the use of monetary and fiscal policy to smooth the business cycle