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

Previously, 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. In this model, other things equal, an increase in the money supply leads to a 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 affected 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 sloped 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, in which, as he said, “we are all dead.”

342

Of course, classical economists were 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, nonprofit organization that to this day has the official role of declaring the beginnings of recessions and expansions. 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, views about how policy makers should respond to a recession were conflicting. Some economists favored 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, the policy-making process was paralyzed by this lack of consensus. In many cases, economists now believe, policy makers took steps in the wrong direction.

Necessity, however, was 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.