18.1 Classical Macroeconomics

The term macroeconomics appears to have been coined in 1933 by the Norwegian economist Ragnar Frisch. The date, during the worst year of the Great Depression, is no accident. Still, there were economists analyzing what we now consider macroeconomic issues—the behaviour of the aggregate price level and aggregate output—before then.

Money and the Price Level

In Chapter 16, we described the classical model of the price level. According to the classical model, prices are flexible, making the aggregate supply curve vertical even in the short run.1 In this model, an increase in the money supply leads, other things equal, to an equal proportional rise in the aggregate price level, with no effect on aggregate output. As a result, increases in the money supply lead to inflation, and that’s all. Before the 1930s, the classical model of the price level dominated economic thinking about the effects of monetary policy.

Did classical economists really believe that changes in the money supply affected only aggregate prices, without any effect on aggregate output? Probably not. Historians of economic thought argue that before 1930 most economists were aware that changes in the money supply affect aggregate output as well as aggregate prices in the short run—or, to use modern terms, they were aware that the short-run aggregate supply curve slopes upward. But they regarded such short-run effects as unimportant, stressing the long run instead. It was this attitude that led John Maynard Keynes to scoff at the focus on the long run, about which he said the “long run is a misleading guide to current affairs. In the long run we are all dead.”

The Business Cycle

Classical economists were, of course, also aware that the economy did not grow smoothly. The American economist Wesley Mitchell pioneered the quantitative study of business cycles. In 1920 he founded the National Bureau of Economic Research, an independent, non-profit organization that to this day has the official role of declaring the beginnings of recessions and expansions in the United States. Thanks to Mitchell’s work, the measurement of business cycles was well advanced by 1930. But there was no widely accepted theory of business cycles.

In the absence of any clear theory, conflicts arose among policy-makers on how to respond to a recession. Some economists favoured expansionary monetary and fiscal policies to fight a recession. Others believed that such policies would worsen the slump or merely postpone the inevitable. For example, in 1934 Harvard’s Joseph Schumpeter, now famous for his early recognition of the importance of technological change, warned that any attempt to alleviate the Great Depression with expansionary monetary policy “would, in the end, lead to a collapse worse than the one it was called in to remedy.” When the Great Depression hit, policy was paralyzed by this lack of consensus. In many cases, economists now believe, policy moved in the wrong direction.

Necessity was, however, the mother of invention. As we’ll explain next, the Great Depression provided a strong incentive for economists to develop theories that could serve as a guide to policy—and economists responded.

WHEN DID THE BUSINESS CYCLE BEGIN?

The modern business cycle probably originated in Britain—home of the Industrial Revolution—which was already a largely industrial and urban society by 1820. The British recession of 1846–1847 had a particularly modern feel: it followed a bout of “irrational exuberance” in which firms spent heavily on an exciting new technology—railways—and then realized they had overdone it.

But when did Canada have its first business cycle? Unfortunately, we can’t know for sure. There are two reasons for this. The first reason is that the further back in time we go, the less economic data are available. We have GDP data only from 1926 and output by industry from 1919. The other is that business cycles, in the modern sense, depend upon having a predominantly industrial society. We know that Canada had an overwhelmingly rural, agricultural economy throughout most of the 1800s. But by 1919—the first year for which we have data—industrial activities were already 1.5 times more important than agriculture. So we can’t say precisely when Canada became sufficiently industrialized to experience a modern business cycle. Figure 18-1 shows the estimates of the changing percentages of GDP coming from agriculture and from manufacturing and mining over the period from 1919 to 1969. The figure shows that the importance of agriculture in national output declined, while manufacturing continued to gain in economic importance in these 50 years.

Figure18-1The Changing Character of the Canadian Economy Source: Historical Statistics of Canada.

But why does the modern business cycle depend on having a predominantly industrialized society? Fluctuations in aggregate output in agricultural economies are very different from the business cycles we know today. That’s because the prices of agricultural goods tend to be highly flexible. As a result, the short-run aggregate supply curve of a mainly agricultural economy is probably close to vertical, so demand shocks don’t cause output fluctuations—they cause price fluctuations (volatility). Instead, fluctuations on the farm are driven mainly by weather, making shifts of the short-run aggregate supply curve the primary source of output and employment fluctuations. In contrast, with the modern business cycle fluctuations in output and employment are largely the result of shifts in the aggregate demand curve.

Quick Review

  • Classical macroeconomists focused on the long-run effects of monetary policy on the aggregate price level, ignoring any short-run effects on aggregate output.

  • By the time of the Great Depression, the measurement of business cycles was well advanced, but there was no widely accepted theory about why they happened.

Check Your Understanding 18-1

CHECK YOUR UNDERSTANDING 18-1

Question 18.1

When Ben Bernanke, in his tribute to Milton Friedman, said that “Regarding the Great Depression … we did it,” he was referring to the fact that the U.S. Federal Reserve at the time did not pursue expansionary monetary policy. Why would a classical economist have thought that action by the Federal Reserve would not have made a difference in the length or depth of the Great Depression?

A classical economist would have said that although expansionary monetary policy would probably have some effect in the short run, the short run was unimportant. Instead, a classical economist would have stressed the long run, claiming expansionary monetary policy would result only in an increase in the aggregate price level without affecting aggregate output.