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Copyright©2002byTheMcGraw-HillCompanies,Inc.Allrightsreserved.17-1CHAPTER17TheFutureofMacroeconomicsCopyright©2002byTheMcGraw-HillCompanies,Inc.Allrightsreserved.17-2Questions•Whatmightthefutureofmacroeconomicsbring?•Howmightthemacroeconomicstaughttwodecadesfromnowbedifferentfromthemacroeconomicstaughttoday?•Whathavebeentheprincipalchangesinthewaymacroeconomicsistaughtoverthepasttwentyyears?Copyright©2002byTheMcGraw-HillCompanies,Inc.Allrightsreserved.17-3Questions•Whatadditionalchangestookplacetwentyyearsbeforethat--fromroughly1960toroughly1980?•Whatdirectionwillmacroeconomicstakeiftherealbusinesscycleresearchprogramissuccessful?•WhatdirectionwillmacroeconomicstakeifthenewKeynesianresearchprogramprovessuccessful?Copyright©2002byTheMcGraw-HillCompanies,Inc.Allrightsreserved.17-4Questions•Howwilleconomistsunderstandthefoundationsbehindthepowerofmonetarypolicy?Copyright©2002byTheMcGraw-HillCompanies,Inc.Allrightsreserved.17-5ThePastofMacroeconomics•A1936bookbyJohnMaynardKeynesshiftedeconomicresearchandmacroeconomicthoughtintonewanddifferentdirections–theroleofexpectationsoffutureprofitsindetermininginvestment–thevolatilityofexpectationsofprofits–thepowerofthegovernmenttoaffecttheeconomythroughpolicy–themultiplierprocessCopyright©2002byTheMcGraw-HillCompanies,Inc.Allrightsreserved.17-6ThePastofMacroeconomics•AfterWorldWarII,moremacroeconomictheorywasdeveloped–theIS-LMmodelwascreated–therelationshipbetweeninterestratesandthemoneysupplywasinvestigated–thedifferencebetweenthebehaviorofthemacroeconomyintheflexible-pricelongrunandthefixed-priceshortrunwasclarifiedCopyright©2002byTheMcGraw-HillCompanies,Inc.Allrightsreserved.17-7ThePastofMacroeconomics•Butmacroeconomicstheoryin1960wasstillincomplete–nodiscussionoftherelationshipbetweenproductionandinflation–nodetailedmodelofexpectations–theshortrunwasseenaslastingfordecades–fiscalpolicywasemphasized,whiletheroleofmonetarypolicywasdownplayed–estimatesofthemultiplierweremuchhigherthanwebelievenowtobecorrectCopyright©2002byTheMcGraw-HillCompanies,Inc.Allrightsreserved.17-8ThePastofMacroeconomics•Between1960and1980,twopowerfulcritiquesoftheconventionalwisdomofmacroeconomicsoccurred–thefirstwasbyMiltonFriedman•thestandardmodelsoverestimatedthegovernment’sabilitytocontroltheeconomy•thestandardmodelsoverestimatedthepoweroffiscalpolicyandunderestimatedthepowerofmonetarypolicy•themoneysupplytellsusmostofwhatweneedtoknowabouthowpolicyisworking•thereisanaturalrateofunemploymentCopyright©2002byTheMcGraw-HillCompanies,Inc.Allrightsreserved.17-9ThePastofMacroeconomics–thesecondwasbyRobertLucas•Keynesianeconomicsfailstothinkthroughtheimportanceofexpectations•systematicchangesineconomicpolicywouldchangetheparametersoftheconsumptionandinvestmentfunctionsaswellasthelocationofthePhillipscurveCopyright©2002byTheMcGraw-HillCompanies,Inc.Allrightsreserved.17-10ThePastofMacroeconomics•Thelate1980sand1990swereatimeofideagenerationandexploration–macroeconomistsexploredandtestedalargenumberofdifferentideasandmodels–themainstreampolicy-analyticpositionofmacroeconomistsdidnotshiftmuchCopyright©2002byTheMcGraw-HillCompanies,Inc.Allrightsreserved.17-11TheFutureofMacroeconomics:RealBusinessCycles?•Keynesianandmonetaristeconomistsbelievethattherearetwokeyelementstounderstandingbusinesscycles–thedeterminantsofaggregatedemand–thedivisionofchangesinnominalaggregatedemandintochangesinproductionandchangesinpricesCopyright©2002byTheMcGraw-HillCompanies,Inc.Allrightsreserved.17-12TheFutureofMacroeconomics:RealBusinessCycles?•Realbusinesscycleeconomistsbelievethatchangesinnominalaggregatedemandaffectoutputandemploymentonlyslightlyandhavethemostimpactonprices•RealbusinesscycletheorybeginswiththeassumptionthatthesametheorythatdetermineswhathappensinthelongrunshouldbeappliedtofluctuationsintheshortrunCopyright©2002byTheMcGraw-HillCompanies,Inc.Allrightsreserved.17-13TheFutureofMacroeconomics:RealBusinessCycles?•Whilerealbusinesscycleeconomistsbelievethatpricescanberigid,theybelievethatthissluggishnessofpricesisnotveryrelevant–theyassumethatitisareasonablefirst-approximationtosupposethatthemoneysupplyandthelevelofpotentialoutputdeterminethepricelevel–thelevelofpotentialoutputismore-or-lessequaltoactualrealGDPCopyright©2002byTheMcGraw-HillCompanies,Inc.Allrightsreserved.17-14TheFutureofMacroeconomics:RealBusinessCycles?•Realbusinesscycleeconomistsbelieveintheclassicaldichotomy–realvariableseffectivelydeterminethevaluesofrealquantitieslikerealGDPevenintheshortrun–nominalvariablesdeterminethevaluesofnominalquantitieslikethepricelevelCopyright©2002byTheMcGraw-HillCompanies,Inc.Allrightsreserved.17-15TheFutureofMacroeconomics:RealBusinessCycles?•Realbusinesscycletheoryassumesthatthelevelofoutputwillvarywithshockstotheeconomy–adversecostshocksleadtoarecessionasindividualsshouldspendlesstimeworkingbecauseitisnotprofitable–favorablecostshocksleadtoaboomperiodbecauseitisadvantageoustoproduceasmuchaspossibleCopyright©2002byTheMcGraw-HillCompanies,Inc.Allrightsreserved.17-16ProblemsofRealBusinessCycleTheory•Unemployment