Competing Views in Macroeconomic Theory

Competing Views in Macroeconomic Theory ● ● ● ● Until the Great Depression, there was no distinction between macroeconomics and microeconomics. Economics was the study of resources and markets, and economists assumed that labor markets function like most competitive markets. However, the prolonged unemployment of the 1930s challenged economists' views about how markets correct themselves and reach a new equilibrium. John Maynard Keynes challenged several common economic assumptions and provided a possible explanation for how the Great Depression started and why it was lasting so long. His theories set the stage for macroeconomics as a field of economics that analyzes the importance of spending, money, and economic policies. Although later economists have challenged these theories, Keynes's models are key to understanding modern macroeconomics and economic policy. animal spirits: Unpredictable human emotions that can lead to panics or market crashes. money illusion: The idea that people focus only on the nominal value of their wealth, not the real value (adjusting for inflation). sticky wages: A situation where wages do not adjust in the short run. If wages are sticky downward, workers are reluctant to accept a decrease in their wages, creating a flat labor supply curve at the current wage ● ● ● ● ● ● ● ● In explaining the cause and length of the Great Depression, Keynes challenged common assumptions about markets, firms, and labor. Classical economic theory would have predicted that a lower equilibrium wage rate would fix the unemployment caused by a decrease in labor demand. Keynes highlighted new ideas, such as animal spirits, sticky wages, and money illusion, to explain why unemployment may not fix itself quickly. Keynes believed that increased government spending could help the economy recover from the Great Depression. This argument seemed to validate the many government spending programs that, coupled with increased spending during World War II, are credited with pulling the U.S. economy out of the Great Depression. As a result, Keynesian macroeconomics became a dominant theory about how economies work and the role the government can play in stabilizing economic output. The field of medicine has undergone massive changes in the last few centuries as scientists have developed better tools for understanding the human body and our environment. We have a better understanding of why people get sick and how we can treat or prevent illnesses. Similarly, the field of macroeconomics has evolved over the last several decades. We have better economic data, and the tools we use to analyze data have also improved. As new events conflict with and challenge established theories, we rethink our approach and refine our models. In this section, we examine a few of these revisions to the Keynesian approach and how they affect our understanding of the есопопу marginal propensity to consume (MPC): The fraction of each additional dollar of income that is spent on consumption. adaptive expectations: The idea that people slowly incorporate new information into the decisions they make, adapting to changes they observe in the economy. stagflation: When an economy simultaneously experiences both rising unemployment (a stagnating economy) and rising prices (inflation). Phillips curve: The downward-sloping line that represents the negative, or inverse, relationship between the rate of inflation and the unemployment rate in the short run. unemployment rate: The percentage of workers in the labor force who are unemployed; a good indicator of the economy's overall health. inflation rate: The percentage change in the overall price of goods and services in the economy from one time period to another. ● ● ● ● ● Over the last century, economists have developed more realistic theories, collected better data, and employed better tools to analyze the economy, with the goal of helping policy makers make better decisions. The Keynesian model of aggregate expenditures helped economists explain why the Great Depression lasted so long and what the government might do to fix the economy. After World War II several significant advances were made in the field. Friedman made important contributions with his explanations of permanent income, adaptive expectations, and the importance of the money supply. Postwar economic events, mainly the stagflation of the 1970s, showed economists that Keynesian theory did not perfectly describe the economy and that newer and better approaches were necessary. The 1980s gave rise to many new insights in economics. New theories and increased computational ability expanded economists' use of statistical methods to analyze data. The rational expectations revolution helped make macroeconomics both more realistic and more complicated, in some cases replacing one simple model with several morecomplicated, dynamic, and interrelated models. rational expectations: The idea that people assess all the information available to them, immediately update their expectations, and change their behaviors as needed. New Classical: Economic models that assume perfectly competitive markets and rapid adjustments to a new economic equilibrium when a market is subjected to a shock. New Keynesian: Economic models that assume monopolistically competitive markets and sticky prices and wages, which make the economy take longer to reach a new equilibrium when it is subjected to a shock. ● ● ● The rational expectations revolution embarked on a mission to bring increased realism and complexity to economic models. Rational expectations imply that people quickly process new information and adapt their expectations fully. General-equilibrium analysis incorporates multiple different markets (labor, money, goods, and so on) into one dynamic, sophisticated model of the economy, showing how a change in one variable, such as an increase in labor supply, will ripple throughout the economy into different markets. New Classical models hold that markets are perfectly competitive and quick to respond and adjust to any change. New Keynesian models assume monopolistically competitive markets and some stickiness in wages and prices, which means that it can take awhile for an economy to reach a new equilibrium. mainstream view: An economic school of thought that emphasizes volatility in investment spending as the primary cause of changes in aggregate demand and therefore the level of output in the economy. monetarist view: An economic school of thought that emphasizes the importance of the money supply and therefore monetary policy in determining the level of output in an economy. real business cycle theory: An economic school of thought that emphasizes the importance of technological innovation and resource availability in determining aggregate supply and therefore the level of output in an economy. self-correction view: An economic school of thought emphasizing that the best policy response to macroeconomic instability is to let the economy return to equilibrium, or self-correct, without outside interference. ● ● ● ● ● Several different schools of macroeconomic thought attempt to explain what determines output, inflation, interest rates, and many other important macroeconomic variables. The mainstream, monetarist, real business cycle, and self-correction theories differ mainly on whether shocks, government policies, or central bank policies affect aggregate demand or aggregate supply and on how best to intervene to fix an ailing economy. The aggregate demand and supply model can be integrated into all four of these views. While most economists agree that they would prefer business cycle fluctuations to be small, they often disagree about how to achieve that outcome. New Keynesian economists believe that markets are imperfect and that wages and prices are often sticky. Thus, if the government does not intervene during a shock to the economy, it may take a long time for the economy to adjust back to a long-run equilibrium. In contrast, New Classical economists believe that markets are quick to adjust, so there's no reason for the government to get involved, and government action could actually make things worse. In addition to making different assumptions about how the economy works, economists often have different goals and priorities. ○ For example, some care more about the national debt, while others focus on income inequality or the environmental effects of growth. Because we all have different priorities, there's no one right answer to the question of what the government should do. In this section, you'll gain a better understanding of how different schools of economic thought approach stabilization policy. business cycle: The short-term fluctuations experienced in the economy due to changes in levels of economic activity. stabilization policy: A policy, or set of policies, enacted by a government to minimize business cycle fluctuations and avoid excessive unemployment or inflation. New Classical: Economic models that assume perfectly competitive markets and rapid adjustments to a new economic equilibrium when an economy is subjected to a shock. New Keynesian: Economic models that assume monopolistically competitive markets and sticky prices and wages, which make the economy take longer to reach a new equilibrium when it is subjected to a shock. ● ● Every modern economy uses stabilization policy to reduce the severity of business cycle fluctuations. Which policy is helpful, and which may be detrimental, depends on one's assumptions about the economy and one's goals or priorities. Every economic policy has its costs and benefits, so there is usually no clear-cut "right" answer on complex issues. New Classical economists typically favor using less stabilization policy, while New Keynesian economists typically favor using a more active stabilization policy.