SUMMARY

  1. Classical macroeconomics asserted that monetary policy affected only the aggregate price level, not aggregate output, and that the short run was unimportant. By the 1930s, measurement of business cycles was a well-established subject, but there was no widely accepted theory of business cycles.

  2. Keynesian economics attributed the business cycle to shifts of the aggregate demand curve, often the result of changes in business confidence. Keynesian economics also offered a rationale for macroeconomic policy activism.

  3. In the decades that followed Keynes’s work, economists came to agree that monetary policy as well as fiscal policy is effective under certain conditions. Monetarism, a doctrine that called for a monetary policy rule as opposed to discretionary monetary policy and that argued—based on a belief that the velocity of money was stable—that GDP would grow steadily if the money supply grew steadily, was influential for a time but was eventually rejected by many macroeconomists.

  4. The natural rate hypothesis became almost universally accepted, limiting the role of macroeconomic policy to stabilizing the economy rather than seeking a permanently lower unemployment rate. Fears of a political business cycle led to a consensus that monetary policy should be insulated from politics.

  5. Rational expectations claims that individuals and firms make decisions using all available information. According to the rational expectations model of the economy, only unexpected changes in monetary policy affect aggregate output and employment; expected changes merely alter the price level. Real business cycle theory claims that changes in the rate of growth of total factor productivity are the main cause of business cycles. Both of these versions of new classical macroeconomics received wide attention and respect, but policy makers and many economists haven’t accepted the conclusion that monetary and fiscal policy are ineffective in changing aggregate output.

  6. New Keynesian economics argues that market imperfections can lead to price stickiness, so that changes in aggregate demand have effects on aggregate output after all.

  7. The Great Moderation from 1985 to 2007 generated the Great Moderation consensus: belief in monetary policy as the main tool of stabilization; skepticism toward use of fiscal policy, except possibly in exceptional circumstances such as a liquidity trap; and acknowledgement of the policy constraints imposed by the natural rate of unemployment and the political business cycle. But the Great Moderation consensus was challenged by the post-2008 crisis events, as monetary policy lost its effectiveness in the midst of a liquidity trap. As a result, many advocated the use of fiscal policy to address the deep recession.

  8. In 2009, a number of governments, including the United States, used fiscal stimulus to support their deeply depressed economies in the face of a liquidity trap. The use of fiscal policy remained highly controversial. In the United States, it failed to significantly reduce unemployment, with critics citing that as proof of its general ineffectiveness, while supporters argued the size of the stimulus was too small. Yet the crowding out predicted by its critics failed to occur.

  9. Monetary policy was also hotly debated in the wake of the Great Recession, as the Fed pursued “quantitative easing” and other unconventional monetary policies to address the liquidity trap. Critics claimed the Fed was doing too much and would sacrifice its hard-won credibility as an inflation fighter. Others countered that the Fed was doing too little, yet others claimed the Fed’s actions would have little impact. Some proposed the Fed adopt a higher inflation target to push the real interest rate down.