Chapter 11 - Keynesian Foundations of Modern Macroeconomics
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
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
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
- 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
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.
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 -
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.