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16.3: Macroeconomics for the 21st Century

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  • Learning Objectives

    1. Discuss how the Fed incorporated a strong inflation constraint and lags into its policies from the 1980s onwards.
    2. Describe the fiscal policies that were undertaken from the 1980s onwards and their rationales.
    3. Discuss the challenges that events from the 1980s onwards raised for the monetarist and new classical schools of thought.
    4. Summarize the views and policy approaches of the new Keynesian school of economic thought.

    Following the recession that ended in 1982, the last two decades of the 20th century and the early years of the 21st century have sometimes been referred to as the Great Moderation. Yes, there were recessions, but they were fairly mild and short-lived. Prematurely, economists began to pat themselves on the backs for having tamed the business cycle. There was a sense that macroeconomic theory and policy had helped with this improved performance. The ideas associated with macroeconomic theory and policy incorporated elements of Keynesian economics, monetarism, and new classical economics. All three schools of macroeconomic thought contributed to the development of a new school of macroeconomic thought: the new Keynesian school.

    New Keynesian economics is a body of macroeconomic thought 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 and new classical ideas about the importance of aggregate supply, both in the long and in the short run.

    Another “new” element in new Keynesian economic thought is the greater use of microeconomic analysis to explain macroeconomic phenomena, particularly the analysis of price and wage stickiness. We saw in the chapter that introduced the model of aggregate demand and aggregate supply, for example, that sticky prices and wages may be a response to the preferences of consumers and of firms. That idea emerged from research by economists of the new Keynesian school.

    New Keynesian ideas guide macroeconomic policy; they are the basis for the model of aggregate demand and aggregate supply with which we have been working. To see how the new Keynesian school has come to dominate macroeconomic policy, we shall review the major macroeconomic events and policies of the 1980s, 1990s, and early 2000s.

    The 1980s and Beyond: Advances in Macroeconomic Policy

    The exercise of monetary and of fiscal policy has changed dramatically in the last few decades.

    The Revolution in Monetary Policy

    It is fair to say that the monetary policy revolution of the last two decades began on July 25, 1979. On that day, President Jimmy Carter appointed Paul Volcker to be chairman of the Fed’s Board of Governors. Mr. Volcker, with President Carter’s support, charted a new direction for the Fed. The new direction damaged Mr. Carter politically but ultimately produced dramatic gains for the economy.

    Oil prices rose sharply in 1979 as war broke out between Iran and Iraq. Such an increase would, by itself, shift the short-run aggregate supply curve to the left, causing the price level to rise and real GDP to fall. But expansionary fiscal and monetary policies had pushed aggregate demand up at the same time. As a result, real GDP stayed at potential output, while the price level soared. The implicit price deflator jumped 8.1%; the CPI rose 13.5%, the highest inflation rate recorded in the 20th century. Public opinion polls in 1979 consistently showed that most people regarded inflation as the leading problem facing the nation.

    Figure 17.8 The Fed’s Fight Against Inflation

    By 1979, expansionary fiscal and monetary policies had brought the economy to its potential output. Then war between Iran and Iraq caused oil prices to increase, shifting the short-run aggregate supply curve to the left. In the second half of 1979, the Fed launched an aggressive contractionary policy aimed at reducing inflation. The Fed’s action shifted the aggregate demand curve to the left. The result in 1980 was a recession with continued inflation.

    Chairman Volcker charted a monetarist course of fixing the growth rate of the money supply at a rate that would bring inflation down. After the high rates of money growth of the past, the policy was sharply contractionary. Its first effects were to shift the aggregate demand curve to the left. Continued oil price increases produced more leftward shifts in the short-run aggregate supply curve, and the economy suffered a recession in 1980. Inflation remained high. Figure 17.8 “The Fed’s Fight Against Inflation” shows how the combined shifts in aggregate demand and short-run aggregate supply produced a reduction in real GDP and an increase in the price level.

    The Fed stuck to its contractionary guns, and the inflation rate finally began to fall in 1981. But the recession worsened. Unemployment soared, shooting above 10% late in the year. It was, up to that point, the worst recession since the Great Depression. The inflation rate, though, fell sharply in 1982, and the Fed began to shift to a modestly expansionary policy in 1983. But inflation had been licked. Inflation, measured by the implicit price deflator, dropped to a 4.1% rate that year, the lowest since 1967.

    The Fed’s actions represented a sharp departure from those of the previous two decades. Faced with soaring unemployment, the Fed did not shift to an expansionary policy until inflation was well under control. Inflation continued to edge downward through most of the remaining years of the 20th century and into the new century. The Fed has clearly shifted to a stabilization policy with a strong inflation constraint. It shifts to expansionary policy when the economy has a recessionary gap, but only if it regards inflation as being under control.

    This concern about inflation was evident again when the U.S. economy began to weaken in 2008, and there was initially discussion among the members of the Federal Open Market Committee about whether or not easing would contribute to inflation. At that time, it looked like inflation was becoming a more serious problem, largely due to increases in oil and other commodity prices. Some members of the Fed, including Chairman Bernanke, argued that these price increases were likely to be temporary and the Fed began using expansionary monetary policy early on. By late summer and early fall, inflationary pressures had subsided, and all the members of the FOMC were behind continued expansionary policy. Indeed, at that point, the Fed let it be known that it was willing to do anything in its power to fight the current recession.

    The next major advance in monetary policy came in the 1990s, under Federal Reserve Chairman Alan Greenspan. The Fed had shifted to an expansionary policy as the economy slipped into a recession when Iraq’s invasion of Kuwait in 1990 began the Persian Gulf War and sent oil prices soaring. By early 1994, real GDP was rising, but the economy remained in a recessionary gap. Nevertheless, the Fed announced on February 4, 1994, that it had shifted to a contractionary policy, selling bonds to boost interest rates and to reduce the money supply. While the economy had not reached its potential output, Chairman Greenspan explained that the Fed was concerned that it might push past its potential output within a year. The Fed, for the first time, had explicitly taken the impact lag of monetary policy into account. The issue of lags was also a part of Fed discussions in the 2000s.

    Fiscal Policy: A Resurgence of Interest

    President Ronald Reagan, whose 1980 election victory was aided by a recession that year, introduced a tax cut, combined with increased defense spending, in 1981. While this expansionary fiscal policy was virtually identical to the policy President Kennedy had introduced 20 years earlier, President Reagan rejected Keynesian economics, embracing supply-side arguments instead. He argued that the cut in tax rates, particularly in high marginal rates, would encourage work effort. He reintroduced an investment tax credit, which stimulated investment. With people working harder and firms investing more, he expected long-run aggregate supply to increase more rapidly. His policy, he said, would stimulate economic growth.

    The tax cut and increased defense spending increased the federal deficit. Increased spending for welfare programs and unemployment compensation, both of which were induced by the plunge in real GDP in the early 1980s, contributed to the deficit as well. As deficits continued to rise, they began to dominate discussions of fiscal policy. In 1990, with the economy slipping into a recession, President George H. W. Bush agreed to a tax increase despite an earlier promise not to do so. President Bill Clinton, whose 1992 election resulted largely from the recession of 1990–1991, introduced another tax increase in 1994, with the economy still in a recessionary gap. Both tax increases were designed to curb the rising deficit.

    Congress in the first years of the 1990s rejected the idea of using an expansionary fiscal policy to close a recessionary gap on grounds it would increase the deficit. President Clinton, for example, introduced a stimulus package of increased government investment and tax cuts designed to stimulate private investment in 1993; a Democratic Congress rejected the proposal. The deficit acted like a straitjacket for fiscal policy. The Bush and Clinton tax increases, coupled with spending restraint and increased revenues from economic growth, brought an end to the deficit in 1998.

    Initially, it was expected that the budget surplus would continue well into the new century. But, this picture changed rapidly. President George W. Bush campaigned on a platform of large tax cuts, arguing that less government intervention in the economy would be good for long-term economic growth. His administration saw the enactment of two major pieces of tax-cutting legislation in 2001 and 2003. Coupled with increases in government spending, in part for defense but also for domestic purposes including a Medicare prescription drug benefit, the government budget surpluses gave way to budget deficits. To deal with times of economic weakness during President Bush’s administration, temporary tax cuts were enacted, both in 2001 and again in 2008.

    As the economy continued to weaken in 2008, there was a resurgence of interest in using discretionary increases in government spending, as discussed in the Case in Point, to respond to the recession. Three factors were paramount: (1) the temporary tax cuts had provided only a minor amount of stimulus to the economy, as sizable portions had been used for saving rather than spending, (2) expansionary monetary policy, while useful, had not seemed adequate, and (3) the recession threatening the global economy was larger than those in recent economic history.