KW_Macro_Ch_17_Sec_03_Challenges_to_Keynesian_Economics -...

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>> The Making of Modern Macroeconomics Section 3: Challenges to Keynesian Economics chapter 17 Keynes’s ideas fundamentally changed the way economists think about business cycles. They did not, however, go unquestioned. In the decades that followed the pub- lication of The General Theory, Keynesian economics faced a series of challenges. As a result, the consensus of macroeconomists retreated somewhat from the strong ver- sion of Keynesianism that prevailed in the 1950s. In particular, economists became much more aware of the limits to macroeconomic policy activism. The Revival of Monetary Policy Keynes’s General Theory suggested that monetary policy wouldn’t be very effective in depression conditions. Many modern macroeconomists agree: in Chapter 16 we intro- duced the concept of a liquidity trap, a situation in which monetary policy is ineffec- tive because the nominal interest rate is down against the zero bound. In the 1930s, when Keynes wrote, interest rates were, in fact, very close to 0%. (The term liquidity trap was first introduced by the British economist John Hicks in a 1937 paper, “Mr. Keynes and The Classics: A Suggested Simplification,” that summarized Keynes’s ideas.)
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2 CHAPTER 17 SECTION 3: CHALLENGES TO KEYNESIAN ECONOMICS But even after the era of near-0% interest rates came to an end after World War II, many economists continued to emphasize fiscal policy and downplay the useful- ness of monetary policy. Eventually, however, macroeconomists reassessed the impor- tance of monetary policy. A key milestone in this reassessment was the 1963 publication of A Monetary History of the United States, 1867–1960 by Milton Friedman, of the University of Chicago, and Anna Schwartz of the National Bureau of Economic Research. Friedman and Schwartz showed that business cycles had his- torically been associated with fluctuations in the money supply. In particular, the money supply fell sharply during the onset of the Great Depression. Friedman and Schwartz persuaded many, though not all, economists that the Great Depression could have been avoided if the Federal Reserve had acted to prevent that monetary contraction. They persuaded most economists that monetary policy should play a key role in economic management. The revival of interest in monetary policy was significant because it suggested that the burden of managing the economy could be shifted away from fiscal policy—mean- ing that economic management could largely be taken out of the hands of politicians. Fiscal policy, which must involve changing tax rates or government spending, neces- sarily involves political choices. If the government tries to stimulate the economy by cutting taxes, it must decide whose taxes will be cut. If it tries to stimulate the econo- my with government spending, it must decide what to spend the money on. Monetary policy, in contrast, does not involve such choices: when the central bank
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This note was uploaded on 04/10/2008 for the course ECONOMICS 103 taught by Professor Sheflin during the Spring '08 term at Rutgers.

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KW_Macro_Ch_17_Sec_03_Challenges_to_Keynesian_Economics -...

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