Brief History of Macroeconomic Thought and Policy

Read this chapter to examine macroeconomic attitudes towards economic policies of the three main schools of economic thought: Classical, Keynesian, and Monetarist. Also, learn about modern day interpretations of the main ideas.

3. Macroeconomics for the 21st Century

The New Classical School and Responses to Policy

New classical economics suggests that people should have responded to the fiscal and monetary policies of the 1980s in predictable ways. They did not, and that has created new doubts among economists about the validity of the new classical argument.

The rational expectations hypothesis predicts that if a shift in monetary policy by the Fed is anticipated, it will have no effect on real GDP. The slowing in the rate of growth of the money supply over the period from 1979 to 1982 was surely well known. The Fed announced at the outset what it was going to do, and then did it. It had the full support first of President Carter and then of President Reagan. But the policy plunged the economy into what was then its worst recession since the Great Depression. The experience hardly seemed consistent with new classical logic. New classical economists argued that people may have doubted the Fed would keep its word, but the episode still cast doubt on the rational expectations argument.

The public's response to the huge deficits of the Reagan era also seemed to belie new classical ideas. One new classical argument predicts that people will increase their saving rate in response to an increase in public sector borrowing. The resultant reduction in consumption will cancel the impact of the increase in deficit-financed government expenditures. But the private saving rate in the United States fell during the 1980s. New classical economists contend that standard measures of saving do not fully represent the actual saving rate, but the experience of the 1980s did not seem to support the new classical argument.

The events of the 1980s do not suggest that either monetarist or new classical ideas should be abandoned, but those events certainly raised doubts about relying solely on these approaches. Similarly, doubts about Keynesian economics raised by the events of the 1970s led Keynesians to modify and strengthen their approach.