Thursday, November 14, 2013

The War Within The Economics Profession

Keynesian economics, which focused on restoring demand during downturns in the business cycle, was never popular with conservatives because it justified government intervention into the market economy.  Conservatives did not want government's to run budget deficits to boost aggregate demand when it was below the level needed for full-employment.  Conservative economists, centered around the University of Chicago, developed an alternative view of the macro economy that implicitly ruled out the need for governments to intervene in the market economy.  Milton Friedman's monetarism, followed by rational expectations theory, suggested that government intervention to restore aggregate demand was either unnecessary or that it would make things worse.  For example, rational expectations theory assumed that rational agents would respond to any change in government policy by taking actions which would reverse the intended effect of the policy.

The Chicago approach to macro economics eventually became more popular within academia, but New Keynsian models, which assumed a classical micro foundation with rational agents, but also assumed that price were sticky, and may not adjust the economy in the short term,  have been used by economists at central banks to develop policy proposals.  They assume that monetary policy is the preferred vehicle for moderating the business cycle in the short term with one exception.  When interest rates are at the zero lower bound as they are today, fiscal policy can have a more powerful effect on aggregate demand and reduce unemployment.

The battle between conservatives and New Keynesian's is still going on.  Paul Krugman is not happy with the way in which the battle is being waged by conservatives.  He argues that they control the academic journals and that they ignore evidence when they criticize those who argue for the use of fiscal policy in the kind of recession that we have today.

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