Chapter 1 Homework Nixon declared That Were All Keynesians Now And

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ADDITIONAL ISSUES FOR CLASSROOM DISCUSSION

1. Ask your students which of the ten facts they found most surprising. For

those of us who teach money and banking or macroeconomics, none of

the facts are surprising at all. But, students with little backgrounds in

economics are often quite surprised by many of the ten facts. In giving

speeches as a Federal Reserve economist, I found that fact number 9, that

the Fed can only a”ect inflation in the long run, comes as a surprise to

almost everyone.

2. It may be interesting to talk about fact number 5, “buying stocks is the

best way to increase your wealth—and the worst” now, and then come

back to it when you get to Chapter 7. It seems that almost everyone who

has not looked at the data on stock returns thinks that if only they had

some wealth, they could make a fortune in the stock market. Giving them

a healthy dose of reality is a goal of the book and should be clear in

Chapter 7.

ADDITIONAL TEACHING NOTES

Policy Issue: How Much Should Policymakers Do?

A key question that every policymaker faces is: how much should I do? That

decision influence everyone, because how policymakers answer that

question determines whom citizens vote for and how they perceive

government.

In this textbook, we will look at both sides of the coin, divided between

activist policy, in which the government does a lot, and passive policy, in

which the government does little. In some cases, it will be clear that activist

government policy is wrong. But in others (such as setting up accounting

rules), it is equally clear that government policy actions are valuable.

In 2000, for example, the Securities and Exchange Commission (SEC) passed

a new rule about “fair disclosure.” It stopped the practice that many

companies had engaged in, of telling some people (usually investment

analyst from a large Wall Street 1rm to call the president of a company with

questions, the president would disclose valuable information, and the analyst

would then often write a favorable report on the company. The average

We will spend a lot of time in this textbook discussing monetary policy, and

address the tremendous debate over how activist policy should be.

Keynesian theory in the 1970s suggested that monetary policy could o”set

many disturbances in the economy. But the Great inflation of the 1970s

caused economists to rethink the ability of policymakers to 1ne-tune the

economy. On the other hand, the deep recession of 2008-2009 led to

resurgence of Keynesian policies. If policymakers are to be less activist, how

much should they do? Should they act based on their discretion, keeping in

mind the failures of the past? Chairman Bernanke testi1ed that the Fed

should do its best with the models it has to help the economy. But, some

economists think the Fed should instead eliminate its discretion and follow a

simple rule, such as, “make the money supply grow 5 percent each year.”

Others, such as Mickey Levy of Bank of America Securities, argue that, “The

Fed must avoid being sidetracked from its long-run objectives; in the past,

attempts to over-manage the economy by smoothing short-run #uctuations,

calming financial market turmoil, stabilizing currency #uctuations, or

responding to 1scal policy have been destabilizing.” Levy thinks that most of

the Fed’s actions are counterproductive, doing more harm than good. He

would rather see the Fed focus on its long-run goals and stop engaging in

policy to a”ect the economy in the short run. Levy did admit, however, that

after the financial shock of the fall of 2008, “financial markets have stabilized

and the economy has adjusted, benefiting primarily from the Federal

Reserve’s extraordinary liquidity provisions.”

In research studies on monetary policy, economists have found some support

for that argument. In comparing the performance of di”erent rules for

monetary policy, a number of studies have shown that when the Fed tries to

respond to short-run #uctuations in economic growth, it tends to have worse

overall performance than if it focuses solely on inflation.

Indeed, graduate schools in economics today teach students how

government policy works to manipulate the economy in the short run.

Keynes argued however, that “in the long run, we’re all dead,” and so did not

worry too much about the permanent consequences of the policies he

advocated. That argument was a cop out—we care about our children and

our children’s children, so we care about the long run.

So, what should monetary policymakers do? Should they try to correct

short-run problems, if doing so has adverse long-run consequences? Is there

a way to act in the short-run that will not be detrimental in the long run? As

we will see in Chapters 17 and 18, monetary policy has a big impact on the

short-term growth rate of the economy, but in the long run it can only a”ect

inflation. We will examine the constraints on setting monetary policy, how

the long run and the short run are related, and o”er some advice for making

policy. As usual, there is some truth to both sides of the argument about

activism, but Levy’s cautionary words are worth heeding.

Policy Matters

To convince you that policy matters, let’s look at some examples of recent

events in which major problems were either caused by or strongly a”ected

by policy decisions. These include the Great Depression, the Great inflation

of the 1970s, and Japan’s Depression in the 1990s.

The Great Depression. From 1929 to 1939, the U.S. economy performed

poorly. The number of unemployed workers rose to very high levels, with the

unemployment rate (the number of unemployed workers divided by the

number of people willing and able to work) rising from about 4 percent in

1928 to about 9 percent in 1930, then rising to the range of 20 to 25 percent

thought that the demand for money was declining, but they did not realize

that it did so because the amount of money they were supplying was falling.

Second, the U.S. government pursued a trade policy that was also a major

contributing factor. With the passage of the Smoot-Hawley Tari” Act in 1930,

the United States imposed strong tari”s on imported goods. Not surprisingly,

other countries retaliated. The result was a severe contraction in U.S. trade

with foreign countries, which was another force driving the U.S. economy into

depression.

Third, in response to the depth of the Great Depression, the United States

The Great Depression thus stands as the greatest policy disaster in U.S.

history. The Great Depression only ended when the United States entered

World War II and wartime production brought an economic recovery. Though

there was no clear cause of the depression, errors in monetary policy, trade

policy, and industrial policy definitely contributed to it.

The Great In(ation of the 1970s. In the United States in the 1960s,

Keynesian economic theory (which we will discuss in Chapter 12) was used

by government policymakers, who were able to successfully 1ne-tune the

economy—or so it appeared. In the early 1970s, President Richard Nixon

declared that “we’re all Keynesians now” and leading economists thought

that there might never again be an economic recession because

policymakers could control the economy with great precision. Suddenly,

however, the economy went into a tailspin at the same time that inflation

was rising. The rise in both unemployment and inflation was impossible,

according to the dominant Keynesian theory of the era. And there was worse

to come throughout the 1970s. Two major oil-price shocks caused major

restructuring in the economy, leading many firms to change the way they

produced goods. inflation jumped from about 2 percent in the first half of the

1960s to nearly 10 percent in the second half of the 1970s and early 1980s.

This was the largest sustained increase in the inflation rate in U.S. history,

thus deserving the name Great inflation.

why did the Fed allow inflation to become so high, when inflation is the only

major economic variable that the Fed can in#uence in the long run? Why was

the Fed so complacent? The Fed itself believed the current state-of-the-art

economic theory, which was the Keynesian view that recessions could be

o”set by increasing the growth rate of money in circulation. The Fed tried to

combat the recessions of the late 1960s, mid 1970s, and early 1980s with

faster and faster money growth. But because people’s expectations of

inflation changed in response, the Fed’s policies were ine”ective at

increasing economic growth and instead simply fueled inflation. So, the

blame might instead be placed on incorrect economic theory, rather than on

the Federal Reserve itself. Of course, had the Fed reduced the growth rate of

money, the Great inflation would not have occurred, but the recessions in the

1960s, 1970s, and 1980s would likely have been deeper and longer, for

which the Fed would have taken the blame.

Japan’s Depression in the 1990s. Japan’s experience in the 1990s

represents yet another policy failure. It is also a shocking event, given

Japan’s history. In the 1980s, Japan’s economy appeared close to overtaking

the U.S. economy as the dominant force in the world. But there were

deep-rooted problems under the surface. Corporations were heavily involved

in the banking business, to the point where many investments were made

without being questioned by the 1nanciers. The government was entangled

in private industry and did everything it could to prevent business firms from

failing. Financial markets were poorly developed, in part because the

accounting rules were not as clear as in the United States. These elements

did not hold Japan back in the 1980s, as its pace of economic growth

increased sharply. Japan, after all, did many things right, especially in

organizing production in the manufacturing industry—techniques that were

copied throughout the world. But, with cozy lending practices, a poorly

Japan went bust in the 1990s. The downturn began when monetary

policymakers tried to take some air out of the bubble in real-estate prices by

tightening monetary policy. People began to realize that corporate profits

were based on rising land values, not pro1table production. As the Japanese

stock market fell, and land prices fell, investors learned that the economy

lacked a strong financial framework. Over the following decade, the Japanese

government tried to prop up the economy using traditional methods, but

never understood the fundamental problems in the economy. Japan’s

economy remained in a depression for over a decade, thanks in large part to

a failure of policy.

The Importance of Economic Theory

Good economic policy requires good economic theory. There is nothing worse

than well-meaning, intelligent, but uninformed people making policy

decisions. Without a framework for understanding how policy works and what

its consequences are, a policymaker is adrift. Economic theory is valuable

because it gives the policymaker options within a rigorous foundation.

Economists may not have all the answers, but they know when the answers

are wrong, and that knowledge can prevent policy errors.

For example, as we will see in Chapter 18, monetary policymakers often set

policy by choosing a short-term real interest rate. (You will recall that the real

interest rate is the nominal interest rate minus the expected inflation rate.)

Economists think that the di”erence between the level of this short-term real

interest rate and its long-run equilibrium level can be used as a measure of

the impact of monetary policy on the economy in the short run. The higher

the real interest rate is relative to its long-run equilibrium value, the tighter is

monetary policy. But what is the level of this real interest rate in long-run

that the economy has changed in signiticant ways. In particular, economic

growth was much more rapid in the 1950s and 1960s than it was in the

1970s, 1980s, and early 1990s. Economic theory tells us that when economic

growth is faster, the equilibrium real interest rate is higher. So, policymakers,

trying to think about the equilibrium real interest rate, need to understand

that the real interest rate was higher in the 1950s and 1960s than it was in

the 1970s, 1980s, and early 1990s. Because, the late 1990s brought

economic growth back up to the levels it achieved in the earlier period, the

equilibrium real interest rate also likely rose in that period. Thus,

REFERENCES

The Great Depression

Cole, Harold L., and Lee E. Ohanian. “The Great Depression in the United

States from a Neoclassical Perspective,” Federal Reserve Bank of Minneapolis

Quarterly Review (Winter 1999), pp. 2–24.

Friedman, Milton, and Anna J. Schwartz. A Monetary History of the United

States, 1867–1960

(Princeton, N.J.: Princeton University Press, 1963).

Prescott, Edward C. “Some Observations on the Great Depression,” Federal

Reserve Bank of

Minneapolis Quarterly Review (Winter 1999), pp. 25–31.

The Great In(ation of the 1970s

Japan’s Depression in the 1990s

Krugman, Paul. “Time on the Cross: Can Fiscal Stimulus Save Japan?”

Roubini, Nouriel. “Japan’s Economic Crisis,” November 12, 1996.

The Economist. “Japan’s Economic Plight: Fallen Idol.” June 20th, 1998, pp.

21-23.

How Much Should Policymakers Do?