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The Making of Modern
PowerPoint® Slides
by Can Erbil
© 2005 Worth Publishers, all rights reserved
What you will learn in this chapter:
Why classical macroeconomics wasn’t adequate for the
problems posed by the Great Depression
The core ideas of Keynesian economics
How challenges led to a revision of Keynesian ideas
The ideas behind new classical macroeconomics
The elements of the modern consensus, and the main
remaining disputes
The Feds Response to the 2001 Recession
Classical Macroeconomics
Money and the Price Level
Classical macroeconomics asserted that monetary policy
affected only the aggregate price level, not aggregate output, and
that the short run was unimportant.
According to the classical model, prices are flexible, making the
aggregate supply curve vertical even in the short run. As a result,
an increase in the money supply leads, other things equal, to an
equal proportional rise in the aggregate price level, with no effect
on aggregate output.
As a result, increases in the money supply lead to inflation, and
that’s all.
Classical Macroeconomics
The Business Cycle
By the 1930s, measurement of business cycles was a well
established subject, but there was no widely accepted theory of
business cycles.
When Did the Business Cycle Begin?
The Great Depression and the Keynesian
In 1936 Keynes presented his analysis of the Great
Depression—his explanation of what was wrong with the
economy’s alternator—in a book titled The General Theory of
Employment, Interest, and Money.
The school of thought that emerged out of the works of John
Maynard Keynes is known as Keynesian economics.
Classical Versus Keynesian
Policy to Fight Recessions
The main practical consequence of Keynes’s work was that it
legitimized macroeconomic policy activism—the use of
monetary and fiscal policy to smooth out the business cycle.
Fiscal Policy and the End of the Great Depression
The Fisher Effect
Challenges to Keynesian Economics
The Revival of Monetary Policy – Milton Friedman
Monetarism - asserted that GDP will grow steadily if the
money supply grows steadily. It called for a monetary policy rule
as opposed to discretionary monetary policy and argued that GDP
would grow steadily if the money supply grew steadily, was
influential for a time but was eventually rejected by many
Fiscal Policy with a Fixed Money Supply
When the central bank changes interest rates or the money
supply based on its assessment of the state of the economy, it is
engaged in discretionary monetary policy.
A monetary policy rule is a formula that determines the central
bank’s actions.
Recalling the velocity equation: M × V = P × Y 
Monetarists believed that V was stable, so they believed that if the
Federal Reserve kept M on a steady growth path, nominal GDP
would also grow steadily.
The Velocity of Money
Inflation and the Natural Rate of
The natural rate of unemployment is also the non-acceleratinginflation rate of unemployment, or NAIRU.
According to the hypothesis of the NAIRU, inflation eventually
gets built into expectations, so any attempt to keep the
unemployment rate below the natural rat will lead to an everrising inflation rate.
The natural rate hypothesis became almost universally
accepted, limiting the role of macroeconomic policy to stabilizing
the economy, not seeking a permanently lower unemployment
The Political Business Cycle
A political business cycle results when politicians use
macroeconomic policy to serve political ends.
Fears of a political business cycle led to a consensus that
monetary policy should be insulated from politics.
Rational Expectations, Real Business Cycles, and
New Classical Macroeconomics
New classical macroeconomics is an approach to the business
cycle that returns to the classical view that shifts in the aggregate
demand curve affect only the aggregate price level, not aggregate
Rational Expectations
Rational expectations is the view that individuals and firms
make decisions optimally, using all available information.
The idea of rational expectations did serve as a useful caution for
macroeconomists who had become excessively optimistic about
their ability to manage the economy.
Real Business Cycles?
Real business cycle theory says that fluctuations in the rate of
growth of total factor productivity cause the business cycle.
Total Factor Productivity and the
Business Cycle
Real business cycle theory says that fluctuations in the rate of
growth of total factor productivity cause the business cycle.
The Modern Consensus
Five Key Questions About Macroeconomic Policy:
Current Debate
There are continuing debates about the appropriate role of
monetary policy.
Some economists advocate explicit inflation targets, but
others oppose them.
Inflation targeting requires that the central bank try to keep
the inflation rate near a predetermined target rate.
There’s also a debate about whether monetary policy should take
asset prices into account.
The Clean Little Secret of Macroeconomics
The clean little secret of modern macroeconomics is how much
consensus economists have reached over the past 70 years.
The End of Chapter 17
coming attraction:
Chapter 18:
International Trade

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