Schools of Macroeconomic Thought

Modules 35 & 36

Classical Theory

• Prices are flexible• Supply curve always vertical• Increase in money supply = increase in price

level– Real Money Supply (M/P) is constant– Money Neutrality

• Fiscal and monetary policy have no effect on output– Only lead to inflation

Keynesian Theory

• Short-run matters– “In the long run we’re all dead”– Prices can be sticky– Aggregate Demand can shift due to sentiment• “animal spirits”

• Monetary policy not very effective– Liquidity trap

• Fiscal policy effective

Monetarism

• GDP growth requires growth in money supply• Monetary policy better as stabilization policy– Not politicized

• Monetary policy should follow a target growth rate for money supply– Monetary rule

• Discretionary policy (fiscal and monetary) is at best ineffective and at worst harmful

Modern Consensus

• Monetary policy can shift AD and be used to fight recessions– But still acknowledge liquidity trap

• Governments should not put balancing the budget ahead of the economy– Automatic stabilizers are important

• While policy can limit swings of unemployment rate, the natural rate will hold in long run

Modern Consensus

• Discretionary fiscal policy is not normally effective– Monetary policy faster– BUT, in case of liquidity trap may be necessary

• Monetary policy should take the lead in stabilization policy– Independent of politics– Disagreement on discretionary use