Start Up: Three Revolutions in Macroeconomic Thought

It is the 1930s. Many people have begun to wonder if the United States will ever escape the Great Depression’s cruel grip. Forecasts that prosperity lies just around the corner take on a hollow ring.

The collapse seems to defy the logic of the dominant economic view—that economies should be able to reach full employment through a process of self-correction. The old ideas of macroeconomics do not seem to work, and it is not clear what new ideas should replace them.

In Britain, Cambridge University economist John Maynard Keynes is struggling with ideas that he thinks will stand the conventional wisdom on its head. He is confident that he has found the key not only to understanding the Great Depression but also to correcting it.

It is the 1960s. Most economists believe that Keynes’s ideas best explain fluctuations in economic activity. The tools Keynes suggested have won widespread acceptance among governments all over the world; the application of expansionary fiscal policy in the United States appears to have been a spectacular success. But economist Milton Friedman of the University of Chicago continues to fight a lonely battle against what has become the Keynesian orthodoxy. He argues that money, not fiscal policy, is what affects aggregate demand. He insists not only that fiscal policy cannot work, but that monetary policy should not be used to move the economy back to its potential output. He counsels a policy of steady money growth, leaving the economy to adjust to long-run equilibrium on its own.

It is 1970. The economy has just taken a startling turn: Real GDP has fallen, but inflation has remained high. A young economist at Carnegie–Mellon University, Robert E. Lucas, Jr., finds this a paradox, one that he thinks cannot be explained by Keynes’s theory. Along with several other economists, he begins work on a radically new approach to macroeconomic thought, one that will challenge Keynes’s view head-on. Lucas and his colleagues suggest a world in which self-correction is swift, rational choices by individuals generally cancel the impact of fiscal and monetary policies, and stabilization efforts are likely to slow economic growth.

John Maynard Keynes, Milton Friedman, and Robert E. Lucas, Jr., each helped to establish a major school of macroeconomic thought. Although their ideas clashed sharply, and although there remains considerable disagreement among economists about a variety of issues, a broad consensus among economists concerning macroeconomic policy began to emerge in the 1980s and 1990s. That consensus has sharply affected macroeconomic policy. And the improved understanding that has grown out of the macroeconomic debate has had dramatic effects on fiscal and on monetary policy.

In this chapter we will examine the macroeconomic developments of five decades: the 1930s, 1960s, 1970s, 1980s, and 1990s. We will use the aggregate demand–aggregate supply model to explain macroeconomic changes during these periods, and we will see how the three major economic schools were affected by these events. We will also see how these schools of thought affected macroeconomic policy. Finally, we will see how the evolution of macroeconomic thought and policy is influencing how economists design policy prescriptions for dealing with the current recession, which many feel has the potential to be the largest since the Great Depression.

In examining the ideas of these schools, we will incorporate concepts such as the potential output and the natural level of employment. While such terms had not been introduced when some of the major schools of thought first emerged, we will use them when they capture the ideas economists were presenting.