Student Notes 13:

1
Rose-Hulman Institute of Technology Department of
Humanities Social Sciences / K. Christ SL 151,
Principles of Economics
Student Notes 13 Macroeconomic Policy History
and an Appraisal
2
Keynes and Keynesianism
I believe myself to be writing a book on economic
theory which will largely revolutionize -- not, I
suppose, at once, but in the course of the next
ten years -- the way the world thinks about
economic problems.
John Maynard Keynes, 1935
The Employment Act of 1946 The Congress hereby
declares that it is the continuing policy and
responsibility of the Federal Government to use
all practicable means consistent with its needs
and obligations and other essential
considerations of national policy to promote
maximum employment, production, and purchasing
power.
What is at stake in our economic decisions today
is not some grand warfare of rival ideologies
which will sweep the country with passion, but
the practical management of a modern economy.
What we need is not labels and clichés but more
basic discussion of the sophisticated and
technical questions involved in keeping a great
economic machinery moving ahead. John F. Kennedy,
1962
Were all Keynesians now. Richard Nixon, 1971
3
Classicalism and New Classicalism
The preservation and expansion of freedom are
today threatened from men of good intentions
and good will who wish to reform us. Impatient
with the slowness of persuasion and example to
achieve the great social changes they envision,
there are anxious to use the power of the state
to achieve their ends and confident of their own
ability to do so Concentrated power is not
rendered harmless by the good intentions of those
who create it..
Milton Friedman, 1962
We who live in free market societies believe that
growth, prosperity and ultimately human
fulfillment, are created from the bottom up, not
the government down. Only when the human spirit
is allowed to invent and create, only when
individuals are given a personal stake in
deciding economic policies and benefiting from
their success -- only then can societies remain
economically alive. Ronald Reagan, 1981
As an advice-giving profession we are in way over
our heads. Robert Lucas, 1980
4
Keynesianism vs. Monetarism
Monetarism is the view that economies are
inherently stable, that the quantity of money has
a major influence on economic activity and the
price level, and that the objectives of monetary
policy are best achieved by targeting the rate of
growth of the money supply. Monetarists
generally express a preference for monetary
policy as a stabilizing tool relative to prices
only, being generally skeptical of attempts to
manage output.
Keynesianism is the view that economies are
inherently unstable, that they may in fact settle
at less-than full employment equilibrium, that
Aggregate Demand is the primary determinant of
output and employment, and that authorities can
intervene in an economy to stabilize it.
Keynesians generally express a preference for
fiscal policy as a stabilizing tool.
Friedman
Lucas
Samuelson
Keynes
5
Fiscal policy Some additional considerations
Timing and lags
q
(1) (2) (3)
Recognition Implementation Effectiveness
Crowding out effects
q
If government debt-financed spending contributes
to rising interest rates, then there may be
detrimental effects on private investment.
Perfect foresight (forward looking behavior)
q
If consumers understand that recessions and booms
are temporary, their consumption spending will
be less sensitive to changes in current income.
(This observation calls into question the
assumption implicit in the typical Keynesian
consumption function).
Central bank accommodation of fiscal policy
q
6
Empirical regularity 1 Okuns law output and
unemployment An empirical relationship between
GDP Growth and Unemployment Rate
DReal GDP 3.18 - 1.90 DUnemployment Rate
1960 - 1998
7
Empirical regularity 2 The Phillips curve
inflation and unemployment
Phillips, A. W., The Relationship Between
Unemployment and the Rate of Change of Money Wage
Rates in the United Kingdom, Economica 25
(November 1958). Samuelson, Paul A., and Robert
M. Solow, "Analytical Aspects of Anti-Inflation
Policy." American Economic Review 502 (1960)
177-94.
5.5
Unemployment Rate
8
The Phillips Curve A Promising Policy Tool
9
Friedman on the Phillips Curve
Phillips analysis of the relation between
unemployment and wage change is deservedly
celebrated as an important and original
contribution. But, unfortunately, it contains a
basic defect the failure to distinguish between
nominal wages and real wages Phillips wrote his
article for a world in which everyone anticipated
that nominal prices would be stable and in which
that anticipation remained unshaken and immutable
whatever happened to actual prices and wages.
Milton Friedman (1912 2006)
the Phillips Curve can be expected to be
reasonably stable and well defined for any period
for which the average rate of change of prices,
and hence the anticipated rate, has been
relatively stable. For such periods, nominal and
real wages move together The higher the average
rate of price change, the higher will tend to be
the level of the curve To state this conclusion
differently, there is always a temporary
trade-off between inflation and unemployment
there is no permanent trade-off. The temporary
trade-off comes not from inflation per se, but
from unanticipated inflation.
The Role of Monetary Policy, American Economic
Review 581 (March 1968), 1 17.
10
The Expectations Augmented Phillips Curve
Friedman, Milton, The Role of Monetary Policy,
American Economic Review 581 (March 1968), 1
17. Phelps, Edmund, "Phillips Curves,
Expectations of Inflation and Optimal
Unemployment over Time, Economica 34 (August
1967).
Inflation
U
Unemployment Rate
11
The Phillips Curve Data Problems
12
Size of Government Sector
Federal
State and Local
13
U.S. Federal Budget Total Outlays
14
U.S. Federal Budget Components of Outlays
Net Interest
Human Resources
National Defense
15
U.S. Federal Budget Surpluses and Deficits
16
U.S. Public Debt
Held by Public
Held by Fed. Govt.
17
Financing of Social Security
Source 2005 Old-Age, Survivor and Disability
Insurance Trustees Report
18
Financing of Social Security
Source 2005 Old-Age, Survivor and Disability
Insurance Trustees Report
19
Financing of Social Security
Source 2005 Old-Age, Survivor and Disability
Insurance Trustees Report
20
Entitlements Social Security and Medicare
Key Demographic Features of the Social Security
Program
21
Different Views on Government Budgets and Public
Debt
Theories of Public Debt
Keynesian (Less-than-full employment)
Classical (Full employment)

• If an economy is in a state of under
  production, expansion of debt could conceivably
  make both current and future generations better
  off.
• Views countercyclical public debt policy as an
  optimal response to the business cycle
  appropriately timed deficits can benefit all.

Ricardian
Neoclassical (Non-Ricardian)

• Debt-financed deficits make households feel
  wealthier in the short run, thereby raising
  current levels of output.
• Public debt competes with private debt for
  available funds, thus driving up interest rates
  and changing the composition of output (lowering
  investment) with deleterious effects for
  long-term growth.
• Debt-financed deficits imply higher future taxes,
  and thereby constitute a burden on future
  generations.

• Debt-financed deficits imply higher future taxes
  with a present value equal to the value of the
  debt.
• Rational agents (behaving according to the
  Permanent Income / Life Cycle model of
  consumption) will adjust current saving plans in
  anticipation of the future taxes.
• Debt-financed deficits will not change households
  perception of wealth, and therefore will not
  precipitate any change in current levels of
  output.