"If you owe the bank a billion dollars…"
Liveblogging World War II: June 16, 1942

Three Tests of Macroeconomic Theory

Paul Krugman:

Still A Phantom Menace: The policy response to financial crisis has, in effect, given us a great natural experiment in macroeconomics — an experiment that can and should be viewed as a test of two views of the economy. One view — which includes both freshwater macro and much of what Austrians say — is in effect classical macro as Keynes described it, in which the economy is always constrained by supply. The other is a more or less Keynesian view in which a depressed economy is constrained by demand, not supply.

These two views had strong implications on three fronts. One was interest rates: would large budget deficits drive rates up, as a classical view implied, or would they do no such thing under depression conditions? A second was the effects of austerity (which has been much larger than the weak efforts at stimulus, and therefore provides the real test); would austerity policies release resources to the private sector, as per the classical view, or lead to economic contraction? Finally, a third implication involved inflation: would large increases in the monetary base produce soaring inflation, again as classicists of all kinds claimed, or do no such thing under depression conditions?

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