Macroeconomics for the 21st Century

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Lesson 17-3 Macroeconomics
for the 21st Century
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New Keynesian Economics   New Keynesian economics
is a body of macroeconomic thinking that stresses
the stickiness of prices and the need for
activist stabilization policies through the
manipulation of aggregate demand to keep the
economy operating close to its potential
output.   It incorporates monetarist ideas about
the importance of monetary policy.   It
incorporates new classical ideas about the
importance of aggregate supply, both in the long
and in the short run.   Another new element is
the greater use of microeconomic analysis to
explain macroeconomic phenomena, particularly the
analysis of price and wage stickiness
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The 1980s and 1990s Advances in Macroeconomic
Policy   The Revolution in Monetary Policy   The
monetary revolution began on July 25, 1979, when
Paul Volcker became Chairman of the Board of
Governors of the Federal Reserve System. Volcker
led the Fed to attack inflation strongly through
contractionary monetary policy.   After
continuing high inflation coupled with very high
unemployment rates, the inflation rate began to
fall in 1981.  
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The next revolution began with the appointment of
Alan Greenspan as Chairman of the Fed in the
1990s.   The Fed began to pay attention to lags
in policy and change from expansionary to
contractionary policies even before the solving
of a recessionary gap.
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Fiscal Policy Stepping Back   In 1981, Ronald
Reagan followed policies almost exactly like
Kennedys in 1961 with a tax cut and increased
defense spending, but the rationale was a
supply-side, not Keynesian, argument.   Reagan
said that cutting high marginal tax rates would
encourage work and that reinstating the
investment tax credit would stimulate
investment.   The resultant rising deficits began
to dominate fiscal policy discussions.   Expansion
ary fiscal policy was rejected because of the
national debt even in the recession of
19901991.   Surpluses emerged in 1998 and were
predicted well into the twenty-first century.
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The Rise of New Keynesian Economics   Monetary
Change and Monetarism   The close relationship
between changes in the money supply and
subsequent changes in nominal GDP was broken in
the 1980s and 1990s.   This was one of the
effects of deregulation of banks.   This was
taken as evidence of the instability of velocity
of M2.  
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The New Classical School and Responses to
Policy People did not respond to policies of the
1980s as predicted.   Rational expectations
theory has not explained the publics
responsiveness to monetary policy. Government
deficits did not cause predicted changes in
private savings.  
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A Macroeconomic Consensus?   Surveys of
economists show that the new Keynesian approach
has emerged as the preferred approach to
macroeconomic analysis.   New Keynesianism has
become dominant in the determination of
macroeconomic policy.   It succeeds because it
incorporates elements of the other
approaches.   Gave greater credence to monetary
policy.  
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Accepted microeconomic foundations of maximizing
behavior.   Incorporated changes in aggregate
supply.   Considerable controversy still remains
on which particular policies to use in specific
situations, but a new consensus seems to be
forming.