NOTE: In this chapter we will NOT cover the section titled "Keynesian Model of Spending and Output" starting on page 250 and ending on the top of page 256 and we will not cover the section "The Multiplier" starting on page 258 to the top of page 262.

The foundations of the field of microeconomics ("price theory") were largely established in the 1800s and have not changed or evolved much,  since economic laws (supply and demand) are basically irrefutable, mechanical descriptions of the economic universe, similar to the laws that describe the physical universe (law of gravity, law of thermodynamics, etc).

However, the field of macroeconomics IS evolving and changing all the time, as we learn more about the business cycle, economic fluctuations, the role of expectations, the effects of fiscal and monetary policy on the economy, etc.  Economics is a "social science" and therefore economics looks at how people act in the economy.  Once we allow the complexities of human behavior (emotions, self-interest, greed, etc) to affect economic outcomes in the macroeconomy, it makes macroeconomic analysis extremely complex, and theories evolve over time to explain the macroeconomy.  
 
From the time of Adam Smith (1776) until the Great Depression of the 1930s, almost all economists were Classical economists - they believed that the self-correcting mechanisms of a market economy would continually guide the economy toward full output/full employment. Market prices would adjust to restore the economy to full employment.

For example, in a recession or econ contraction, wages, prices and interest rates would fall and would eventually stimulate the economy back to full output. There was little role for government in the classical model and in practice - Fed spending was only 3% of national income.

During the 1930s we experienced the Great Depression, the stock market crash, bank failures, a decade of unemployment averaging about 20% (high of 25% in 1933, see page 351). Great Depression was a worldwide phenomenon.

Debate: Did the self-correcting mechanism of the market economy fail? or Did the fiscal and monetary policies of Congress and the FRS fail?  Congress raised taxes and imposed tariffs (taxes) during a recession, and the FRS contracted the MS by 1/3 - Great Contraction.

Debate continues: Activist, discretionary policy (Keynesian "fine-tuning") vs. Non-activist, Passive policy (Classical).

Traditional, Keynesian approach - Activist approach for policy. Government (fiscal policy) and Federal Reserve (monetary policy) should play an active role in attempting to stabilize the economy by "fine- tuning." Discretionary approach to fine-tuning. Figure out what's wrong and try to fix it. Counter-cyclical approach.

Classical Approach - favors non-interventionist, passive approach for policy, favors policy rules vs. discretionary policies, like balanced budgets, fixed growth rate for MS or inflation targets. Classical economists say that the activist approach will de-stabilize the economy.

Debate centers on:
1) the ability and speed of the economy to self-correct and
2) the ability and speed of policymakers to fine-tune the economy.

The Great Depression challenged the Classical approach and led to a forty year period where the Classical approach lost favor and a new approach emerged, called Keynesian economics, based on a British economist named John Maynard Keynes. Keynes challenged the self-correcting nature of the market economy. Favored active government intervention to stabilize the economy. Led to growth of Big Government. Politicians' favorite economist. See page 248 for a bio on Keynes.

Keynes' views were readily accepted in the 1930s - he developed elegant theories that seemed to explain the Great Depression.
 

Main points of Keynesian Economics:

1. Wages and prices might be inflexible or "sticky," especially downward, and especially in an economy with powerful trade unions and large, powerful corporations. Economy will not necessarily self-correct because wages and prices may NOT fall during a recession (possible explanation for the Great Depression).

2. Prices won't always direct the economy back to full output. According to Keynes, it is changes in output (AD) rather than changes in prices that direct the economy back to equilibrium.

3. Businesses will produce only enough output to satisfy the AD of consumers, businesses, govts and foreigners. If these planned aggregate expenditures are less than full-employment output (Y_F), output will be less than the level of full output. When AD is less than Y_F, there are no automatic forces assuring full employment. Long periods of unemployment may persist.

4. Real output beyond full employment (Y_F) is unattainable, even in the SR.

Keynes' best known book was written in 1936 and it seemed extremely timely and important because he seemed to provide a theory that explained the Great Depression. By the 1950s and 1960s almost the entire profession had adapted Keynesian macroeconomics - it was mainstream. Keynesian economics couldn't explain stagflation.

The strict version of the Keynesian model develops a new macro model - the AE (aggregate expenditure) model. AE is outdated and deficient.

AD/AS Model is preferred because:
1) AE cant explain high unemployment and high inflation. AD/AS can.
2) AD/AS incorporates the effects of expectations. AE doesn't account for expectations.
3. AD/AS shows both LR and SR effects. AE is a short-run model only.

AD/AS model is more flexible, more realistic, helps us understand a broader range of econ issues. It will be used in future chapters.

The strict version of the Keynesian model using the AD/AS model is shown on page 257 and 258, Panel a. The SRAS is horizontal at less than full output, reflecting that prices and wages are inflexible downward when there are idle resources. Wages and prices won't fall below P₁. (Note lower case e indicates that the Keynesian model is short run only).

If AD is at AD₁ (p. 258, Panel a, Polar Assumption of Keynes), the economy is operating at less than full output and there is nothing to automatically get the economy back to full output, since prices and wages won't fall below P₁. If AD increases, output will increase at an UNCHANGED price level (P₁), as idle resources are brought back into the production process.

Once the economy is back at full output, AD₂, further increases in demand will lead to higher prices at full output. Output will not increase beyond Y_F, only prices will (P₂).

A less extreme, maybe more realistic Keynesian model is presented on page 258, Panel b. The SRAS is a little more conventional (prices are slightly flexible) but incorporates some of the insights from the Keynesian model:

1. During a recession (AD₁and e₁), increases in AD (to AD₂) will lead primarily to increases in output (Y₁ to Y_F) and only small price changes (P₁ to P₂).

2. When the economy is operating at full output (e₂), increases in AD will lead primarily to price increases (P₂ to P₃) and only small output increases (Y_F to Y₃).
 

MAJOR INSIGHTS OF KEYNESIAN ECONOMICS -

1. Changes in output, as well as changes in prices play a role in the macroeconomic adjustment process. Classical model emphasizes change in prices, Keynesian model emphasized changes in output. Modern analysis incorporates both.

2. Responsiveness of AS to changes in demand depends on availability of unemployed resources. During a recession, when there are laid off workers and unemployed resources, output will be highly responsive to changes in AD. SRAS curve flat. When econ is at full output, increases in AD will primarily increase prices, not output.

3. Fluctuations in AD are important source of econ instability. Abrupt changes in AD are a potential source of both recession and inflation. "Animal spirits." Government policies (primarily fiscal) should stabilize AD to reduce econ instability, smooth out the bus cycle.
 

EVOLUTION OF MODERN MACROECONOMICS

The Great Depression seemed to present a challenge to the Classical economists and the self-correcting nature of the economy. Keynes' ideas came along at exactly the right time - the economic and political climate was very receptive to a model that explained the Great Depression and presented an alternative view to Classical econ. This view became widely accepted and was considered mainstream for decades.

However, the alternative view is that the Great Depression started as a normal recession and was turned into a Depression by misguided fiscal and monetary policy. Taxes were raised, money supply was cut and trade was cut off.

Important event: Stagflation of the 1970s. Simultaneous high un and high inf. Keynesian model (AE) can not explain stagflation,  led to decreased emphasis on Keynesian view and the AE model.  Also, recessions since the 1930s have been brief and are getting more infrequent.  Over the last 23 years, there have only been 17 months of recession.  Keynesian model better explained prolonged depressions, but it not as useful at explaining the modern economy.  Macroeconomics continues to evolve.

What has emerged in the last several decades is a modern view of macro, a hybrid of Classical and Keynesian.

Short run fluctuations can be explained by a hybrid of Keynesian and classical approaches. Various shocks (unanticipated AD or SRAS shocks) will disrupt full employment. Since prices don't always adjust immediately, there can be adjustments periods of high unemployment or inflation, one or two years. Modern analysis is consistent with Keynesian approach.

However, the LR implications are more consistent with the classical view. We now have Neo-Classical approach. Real wages and real interest rates do fall during a recession. And we don't have prolonged depressions anymore. The last two recessions (1990-91 and 2001 were less than one year). During the last 23 years we have only had about 1.5 years of recession. And real wages and real interest rates did fall in 91-92 recession. Recovery was fairly rapid. Economy is more flexible, resilient, versatile, responsive than before - more resistant to major recessions now.  Classical model seems more consistent with today's high-tech, Information Age economy, moving towards "friction-free capitalism."   

In addition, modern macro incorporates the role of expectations as an important element. Rational expectations revolution of the 1970s and 1980s. People are rational and forward looking, don't act like robots. Don't just respond to the present situation, but consider the future.

We also now emphasize expected vs. unexpected effects, and whether people view changes as permanent or temporary. Modern view now assumes that economic change is more complex than previous models assumed, and incorporates expectations, and distinguishes between temp/permanent and expected/unexpected. Human behavior is complex, so the way the economy operates is complex.....

Classical model has re-emerged as the mainstream macroeconomic model, called New Classical, Neo Classical or Rational Expectations.