Week 15 · Chapter

Chapter 15 — Macroeconomic Schools & Policy Debates

Principles of Macroeconomics Free sample edition

The module's primary reading · ~40–50 minutes · Objective 8 (analyze the short-run and long-run Phillips curve and the quantity equation of money, and apply open-economy tools — comparative advantage and the gains from trade, the trade balance, exchange rates, and the balance of payments — and weigh the Keynesian and classical / monetarist views of stabilization policy evenhandedly), with Objective 5 (use the aggregate-demand and aggregate-supply model to analyze short-run fluctuations and the business cycle — name which curve shifts, in which direction, and what happens to the price level and real output — and measure recessionary and inflationary gaps), Objective 6 (analyze fiscal policy — government spending, taxes, expansionary and contractionary stances, and automatic stabilizers — apply the spending and tax multipliers, and distinguish the deficit (a flow) from the national debt (a stock)), Objective 7 (explain money, banking, and monetary policy — the functions of money, how fractional-reserve banking creates money and the money multiplier, the Federal Reserve's goals and tools, the money market, and the transmission mechanism from the money supply to interest rates, investment, and aggregate demand), and Objective 1 (apply the tools of macroeconomic modeling — scarcity, opportunity cost, the production possibilities frontier, and the circular-flow model — and distinguish positive statements (what is) from normative statements (what ought to be)) · Read it first this week; the lecture, the slides, the tutorial, the quiz, and the Model Workshop all build on it.

In plain language

Two well-trained economists can look at the same slowdown and give you opposite advice. This week shows why. They share one toolkit, but they read it in two ways, called schools of thought (groups of economists who share a way of reading the evidence and a set of policy instincts). You will build a side-by-side table of the two main schools, learn what both accept, and compute two ratios (one number divided by another and shown as a percent) about government borrowing. Then you will argue one real policy question from both sides without picking a winner.

Why you already care about this

Picture three people reading the same news alert this week: "Economy slowing; output below its potential." A restaurant owner in a small city is deciding whether to hire two more cooks or wait. A nursing student is wondering whether the clinic jobs on offer now will still be open in a year. A retired bus driver is wondering whether the government's growing debt will squeeze the programs he counts on. They are illustrative people, but their questions are real ones.

Now picture two advisers answering them. The first says the government should spend more now, before the slowdown costs more jobs. The second says to hold steady, let wages and prices adjust, and keep the debt from climbing. Both trained on the same diagram you have drawn all term. Both can do the arithmetic. So why do they disagree, and what do they agree on?

That is your question for the last teaching week of the course. You will not get a verdict from this chapter. You will get something more useful: a way to sort every claim you hear into the part evidence can settle and the part that rests on values.

By the end of this chapter you will be able to:

read one recessionary gap the way both schools read it, in billions of dollars and as a percent of potential;
state the Keynesian case and the classical and monetarist case, each at full strength;
build the schools table row by row and explain why rules versus discretion is not fiscal versus monetary;
state the agreed ground plainly: a vertical long-run Phillips curve, sustained inflation as a monetary matter in the long run, and a short run that differs from the long run;
compute the deficit-to-GDP and debt-to-GDP ratios and catch a swapped numerator;
describe inflation targeting factually;
argue a live policy question from both columns, labelling every claim positive or normative.

Carry this line with you: one toolkit, two readings; agree on the arithmetic, argue about the weights.

Where we are

Already covered: Week 1, The Macro Perspective, gave you positive versus normative statements. Week 6, Business Cycles & Short-Run Fluctuations, gave you the output gap. Week 7, Fiscal Policy, gave you the spending multiplier, the deficit, and the debt. Week 11 gave you the transmission chain and the debate over fine-tuning and rules. Week 12 gave you the Phillips curve and the quantity equation.
This week: you put the two main schools of thought side by side, state what both accept, compute the debt and deficit ratios, and argue one live question from both columns.
How they connect: nothing here is a new model. Every number in this chapter is a callback to a dataset you already know, read through two lenses.
Where we're going next: this is the final module. The finals week follows, with the Final Practice Exam and the final, and no new model to learn.

Four earlier ideas carry this chapter. From Week 1, a positive statement says what is and can be tested against evidence, while a normative statement says what ought to be and rests on values. From Week 6, a recessionary gap is actual output below potential output. From Week 7, the spending multiplier is 1 ÷ (1 − MPC), a deficit is a flow, and the debt is a stock. From Week 12, the long-run Phillips curve is vertical at the natural rate of unemployment.

1. Start from one shared picture: the same gap, two readings

Think about two doctors reading the same blood test. They agree on the numbers. They may still disagree on whether to treat now or wait and watch. Economists work the same way.

A school of thought is a group of economists who share a way of reading the evidence and a set of policy instincts; in macroeconomics the two main ones are the Keynesian tradition and the classical and monetarist tradition.

Here is the picture both schools start from. It is the course's illustrative output-gap economy from Week 6 (Dataset D, constructed for this course, not real data).

Worked example — the shared gap. You start where both schools start.

Potential output. Y* = 1,000 billion dollars, where the vertical long-run aggregate supply line stands.
Actual output. Y = 950 billion dollars, where aggregate demand crosses short-run aggregate supply.
The gap in dollars. 1,000 − 950 = 50 billion dollars, a recessionary gap.
The gap as a share of potential. 50 ÷ 1,000 × 100 = 5% of potential.

In words: the economy is producing 50 billion dollars less than it could, a shortfall of 5% of potential, and workers and machines are sitting idle.

Picture the graph. Real output Y runs along the horizontal axis and the price level P runs up the vertical axis. The crossing of aggregate demand and short-run aggregate supply sits to the left of the vertical long-run line. Both schools draw exactly this picture.

Misconception check. Students often assume the two schools disagree because one of them got the numbers wrong. That is tempting, because in a math class a disagreement usually means a mistake. But here both schools compute the same gap of 50 billion dollars, or 5% of potential. They part ways on what happens next: how fast the gap closes on its own, and whether policy should push.

Memory hook: same gap, same arithmetic; the argument starts after the equals sign.

2. Make the Keynesian case: sticky prices and active policy

Think about the restaurant owner. Sales are down, but the menu prices are printed, the lease is signed, and the cooks' wages are set. Nothing about that adjusts overnight. While the owner waits, two cooks who could be working are not.

The Keynesian tradition is the school of thought that stresses sticky prices and wages and aggregate demand as the driver of short-run swings, so an economy can stay stuck in a gap and active policy can help close it.

You met sticky prices and wages in Week 5: prices and wages that are slow to change. On the Keynesian reading, they are slow to fall even in a slump, so short-run aggregate supply does not slide right fast enough to heal the gap. The economy can stay stuck.

Activist policy is a set of deliberate changes in government spending, taxes, or monetary policy, made case by case, with the aim of closing an output gap sooner than the economy would close it on its own.

The Keynesian tradition's preferred lever in a deep slump is fiscal policy, because new government spending puts idle people to work directly.

Worked example — the Keynesian lever in the simple model. Use the shared gap and the course's spending multiplier from Week 7 (Datasets D and E, illustrative).

The multiplier. At an MPC of 0.8, the spending multiplier is 1 ÷ (1 − 0.8) = 5.
The spending needed. A gap of 50 divided by a spending multiplier of 5 is 50 ÷ 5 = 10 billion dollars of new spending.
Check. 5 × 10 = 50 billion dollars, the size of the gap.

In words: in the simple model, 10 billion dollars of new government spending shifts aggregate demand right far enough to close a gap of 50 billion dollars. Your takeaway is the size of the push the Keynesian column asks for.

Caveat: the simple model leaves out taxes, imports, and crowding out, so it is a picture of the logic, not a measurement.

The risk the Keynesian tradition names is a prolonged gap. Every month the gap stays open, people who want work cannot find it, firms leave machines idle, and output that could have been made is lost for good. Skills can fade during a long spell without work, too.

Misconception check. Students often treat the 10 billion dollars as a forecast of what a real spending bill would do. That is tempting, because the arithmetic is so tidy. But the multiplier of 5 is a classroom model, and taxes and imports shrink the real-world multiplier. The model tells you the direction and the logic of the Keynesian case; how big the real effect is remains a question for evidence.

Memory hook: sticky prices, stuck gap; push now, not later.

3. Make the classical and monetarist case: flexible prices, lags, and rules

Now picture the retired bus driver. He has watched the government try to steer the economy before. His worry is not that policy has no effect. It is that the help arrives at the wrong time and leaves a bill behind.

The classical tradition is the school of thought that stresses flexible prices and wages in the long run and potential output as the economy's anchor, so an economy in a gap tends to correct itself without new policy.
Flexible prices and wages are prices and wages that adjust quickly when demand or costs change, so output returns to potential without a long stay in a gap; whether real prices behave this way is a question for evidence.

On the classical reading, a recessionary gap pushes wages and expected inflation down. Short-run aggregate supply slides right, and output drifts back to potential at a lower price level. You saw this self-correction story in Week 6.

The monetarist tradition is the school of thought, associated with Milton Friedman, that warns monetary policy works with long and variable lags and so favors steady, predictable rules over frequent adjustments.

The classical and monetarist tradition's preferred lever is steady monetary policy that follows a predictable rule. It names two risks. The first is lags: by the time a move is recognized, decided, and felt, the gap may have closed on its own, so the push lands in a healthy economy and opens an inflationary gap instead. The second is crowding out from Week 7: when government borrowing pushes up interest rates, it squeezes private investment, so part of the new spending replaces spending firms would have done anyway.

Worked example — reading the lever through the classical lens. Use the same simple-model spending of 10 billion dollars from section 2 (illustrative).

What the model promises. 5 × 10 = 50 billion dollars of output, if the spending arrives while the gap is still open.
What lags can change. If the gap has already closed by the time the spending lands, the same push moves output past potential, so it opens an inflationary gap.
What crowding out can change. If borrowing raises interest rates, some private investment falls, so the net rise in output is smaller than 50 billion dollars.

In words: the classical and monetarist case accepts the multiplier's logic but warns that timing and crowding out can shrink or reverse the gain.

Misconception check. Students often think the classical tradition says policy never matters. That is tempting, because "the economy corrects itself" sounds like "do nothing." But this tradition accepts that money and spending move output in the short run. Its worry is timing, predictability, and the debt, not whether the chain exists.

Memory hook: flexible prices, self-healing gap; a steady rule, not a scramble.

4. Build the schools table: each column at full weight

You now have both cases. Lay them side by side, row by row. The table below gives each column its strongest version. Neither one is the "real" view with a footnote for the other.

The Keynesian and classical and monetarist traditions compared row by row, each at full strength
Question	Keynesian tradition	Classical and monetarist tradition
How fast do prices and wages adjust?	Slowly; they are sticky, especially downward	Fairly quickly in the long run; they are flexible
Can the economy get stuck in a gap?	Yes, for a long time	It tends to correct itself
Activism or rules?	Activist policy, case by case	Predictable rules announced in advance
Preferred lever	Fiscal policy in a deep slump, with monetary support	Steady monetary policy
Named risk	A prolonged gap: idle workers and lost output	Long and variable lags, and crowding out
View of the deficit and the debt	A deficit in a slump is a tool; the ratio can fall as output recovers	A rising debt ratio crowds out investment and burdens future taxpayers

As you read, take each row as two honest answers to one question. The top row is the root of the rest: if prices are sticky, a gap lasts, and acting looks wise; if prices are flexible, a gap heals, and acting looks risky.

Rules versus discretion is the debate over whether policymakers should follow a policy announced in advance or choose a fresh response to each situation; it applies to fiscal and monetary policy alike.

Worked example — sorting four policies on two questions. For each policy, ask two separate questions: who wields it, and is it a rule or a choice made case by case?

Four illustrative policies sorted by who wields them and whether they follow a rule
Policy	Fiscal or monetary?	Rule or discretion?
Income taxes and unemployment insurance that rise and fall with the economy	Fiscal	Rule: automatic stabilizers need no new law
A new spending bill passed to fight a slump	Fiscal	Discretion
A central bank that announces a steady path for the money supply	Monetary	Rule
A central bank that adjusts policy often to lean against each gap	Monetary	Discretion: fine-tuning

In words: every corner of the table is filled, so the rules question and the fiscal-or-monetary question are two different questions.

Misconception check — two wrong turns. Students often treat sticky versus flexible prices as a political stance, as if your party picks your answer. That is tempting, because the debate shows up in political ads. But how fast prices adjust is an empirical question that evidence can test. Students also mix up rules versus discretion with fiscal versus monetary. The sorting table cures that: an automatic stabilizer is a fiscal rule, and fine-tuning by a central bank is monetary discretion.

Memory hook: who wields it is one question; rule or choice is another.

5. State the agreed ground plainly

Not everything in macroeconomics is up for debate. Some results are settled positive findings that both schools accept. This course states them plainly, with no "on the other hand."

The agreed ground is the positive results that both schools of thought accept, such as a vertical long-run Phillips curve and sustained inflation as a monetary matter in the long run, stated plainly rather than argued both ways.

Worked example — the long-run Phillips curve. Use the course's illustrative Phillips curve from Week 12 (Dataset L, constructed for this course, not real data).

The short-run deal. Holding unemployment at 4% buys 6% inflation.
Expectations catch up. Once 6% is expected, the short-run curve shifts up.
Where the economy settles. (u = 5%, π = 6%), back at the natural rate u* = 5%.

In words: policy can buy lower unemployment only for a while; in the long run unemployment returns to the natural rate, and only the higher inflation is left. The long-run Phillips curve is vertical.

Worked example — money and prices in the long run. Use the course's illustrative quantity equation from Week 12 (Dataset M, illustrative).

The rise in money. (550 − 500) ÷ 500 × 100 = 10%.
New spending, with V = 4 and Q = 1,000 fixed. 550 × 4 = 2,200.
New price level. 2,200 ÷ 1,000 = 2.2, up from 2.
The rise in prices. (2.2 − 2) ÷ 2 × 100 = 10%.
The growth form. Inflation ≈ money growth − output growth = 8% − 3% ≈ 5%, an approximation that holds when velocity is stable.

In words: when money grows steadily faster than output, the result in the long run is inflation, not more real goods.

The third agreed result is that the short run and the long run behave differently. In Week 11's illustrative transmission chain, an expansionary move raised real output by 5 × 40 = 200 billion dollars in the short run. In Week 12's separate quantity-equation example, real output stays at Q = 1,000 in the long run when money rises. The two are different illustrative economies, but they make one point: money moves real output in the short run and leaves it alone in the long run.

Misconception check. Students often try to be evenhanded about everything, so they write "some economists think the long-run Phillips curve is vertical." That is tempting, because this week is about two sides. But evenhandedness belongs to contested questions. The vertical long-run curve is agreed ground, and giving it two sides misstates the field.

Memory hook: argue the contested; state the agreed.

6. Compute the ratios both schools share

A government's debt of 1,000 billion dollars sounds enormous on its own. But is it big for this economy? To answer, you compare it to the size of the economy, the same way a lender compares a family's debts to its income.

Use the course's illustrative budget from Week 7 (Dataset F, constructed for this course, not real data). Revenue is 400 billion dollars, spending is 450, the debt at the start of the year is 1,000, and GDP is 1,250.

The deficit-to-GDP ratio is one year's budget deficit divided by that year's GDP, times 100, which measures the year's new borrowing against the size of the economy.
The debt-to-GDP ratio is the national debt at a point in time divided by GDP, times 100, which measures the total the government owes against the size of the economy.

Worked example — the shared ratios. You compute each one from the budget above.

Deficit. Spending − revenue = 450 − 400 = 50 billion dollars for the year, a flow.
Deficit-to-GDP ratio. 50 ÷ 1,250 × 100 = 4% of GDP.
Debt-to-GDP ratio at the start of the year. 1,000 ÷ 1,250 × 100 = 80% of GDP.
Debt at the end of the year. 1,000 + 50 = 1,050 billion dollars, a stock.
Debt-to-GDP ratio at the end of the year. 1,050 ÷ 1,250 × 100 = 84% of GDP.
The change. With GDP held at 1,250, the ratio climbs from 80% to 84%, and 84 − 80 = 4, the same as the deficit ratio.

In words: this year's borrowing equals 4% of the economy's output, and it lifts the total debt from 80% to 84% of a year's output.

Notice step 6. With GDP unchanged, the debt ratio rises by exactly the deficit ratio.

Honesty note: in a real economy GDP also changes from year to year, so the debt ratio can rise by more or less than the deficit ratio. This course holds GDP fixed so you can see the arithmetic cleanly. That is not a coincidence or a school of thought. A deficit adds to the debt; that is arithmetic.

In practice (your tools). In Google Sheets, type the labels revenue, spending, debt at start, and GDP in A2 through A5, and the values 400, 450, 1000, and 1250 in B2 through B5. In B6, type =B3-B2 for the deficit. In B7, type =B6/B5*100 for the deficit ratio, and in B8, type =B4/B5*100 for the starting debt ratio. In B9, type =(B4+B6)/B5*100 for the ending debt ratio. The cells show 50, 4, 80, and 84.

Misconception check. Students often put the debt where the deficit belongs and report 1,000 ÷ 1,250 × 100 = 80% as the deficit ratio. That is tempting, because both numbers describe borrowing. But 80% is the debt ratio, and it is 80 ÷ 4 = 20 times the true deficit ratio of 4%. Ask the flow-versus-stock question first: a year's borrowing goes on top of the fraction; the total owed goes on top of the other one.

Memory hook: flow over output, stock over output; never swap the tops.

7. Read the ratios through each column

You have one set of numbers: 4%, 80%, and 84%. Both schools accept every one of them. Where they part ways is on how much those numbers should worry you.

The Keynesian reading, at full strength. A deficit in a slump is a tool, not a failure. When output is below potential, borrowing to fund spending puts idle people to work, and crowding out is small because there is spare saving. As output recovers, GDP grows, the denominator of the ratio grows with it, and tax revenue rises. The debt ratio can fall again in the good years.

The classical and monetarist reading, at full strength. A rising debt ratio is a cost even when the spending is well meant. Government borrowing competes with private borrowers, pushes up interest rates, and crowds out the investment that builds future output. A larger debt also leaves a larger interest bill and a larger burden for future taxpayers, who had no vote on the choice made now.

Worked example — what each side would say about one year. Use the ratios from section 6.

The agreed fact. The debt ratio rose from 80% to 84% in one year. Positive, agreed by both.
A Keynesian claim. If the deficit closed a gap, the higher ratio bought jobs that would otherwise have been lost. The jobs part is positive and testable; whether the trade was worth it is normative.
A classical claim. If borrowing raised interest rates, some private investment was crowded out. The size of that effect is positive and disputed; how much weight to give it is normative.

In words: the same rise from 80% to 84% can be read as a fair price for jobs or as a burden on the future, and the choice between those readings is a value judgment.

Misconception check. Students often think the debt ratio itself tells you which school is right. That is tempting, because 84% looks like a verdict. But the ratio is a positive fact that both schools compute the same way. Whether 84% is too high depends on how big crowding out really is, which is a question for evidence, and on how you weigh jobs now against burdens later, which is a question of values.

Memory hook: the ratio is a fact; the worry is a weight.

8. Meet inflation targeting, described factually

Suppose you run a small bakery and you are signing a two-year lease. You want to know how fast prices will rise, because your rent, your flour, and your wages all depend on it. A central bank that tells everyone its plan in advance makes that guess easier.

Inflation targeting is a policy framework in which a central bank announces a numerical goal for the inflation rate and sets its tools to keep inflation near that goal over time.

That is the factual description. The framework has two sides that appeal to the two schools.

What rules supporters value. The goal is announced in advance, so it works like a rule. A believable goal anchors expected inflation, and from Week 12 you know that expected inflation is what shifts the short-run Phillips curve.
What discretion supporters value. The bank aims to keep inflation near the goal over time, not every month. That leaves room to respond to a slump, as long as inflation is expected to return to the goal.

Worked example — reading a central-bank statement. An illustrative central bank says: "Inflation is above our announced goal. We will raise interest rates until we expect it to return to the goal over the next two years."

What is the target? An announced goal for the inflation rate, not for output.
Which tool moves? The interest rate, so this is monetary policy.
Which direction? Higher rates are contractionary: from Week 11, aggregate demand shifts left, so the price level and real output fall.
Rule or discretion? Both: the goal is a rule, and the timing of "over the next two years" leaves judgment.

In words: an inflation target sets the destination in advance, and the central bank still chooses the route.

Misconception check. Students often think a central bank with an inflation target keeps inflation exactly at that number every month. That is tempting, because a "target" sounds like a promise. But the goal is for inflation over time; shocks push it away, and policy pulls it back with the lags you met in Week 11. Whether a given framework strikes the right balance between firmness and flexibility is a judgment, not a fact.

Memory hook: a target names the destination; policy still drives the route.

9. Argue one live question from both columns

Now put everything together on one question that economists argue about in good faith: should a government borrow to close a recessionary gap?

You will not get a verdict here. You will get a method. Write every claim on its own line, say which column it supports, and label it positive or normative. A positive claim can be checked against evidence, even if the evidence is still disputed. A normative claim rests on what you value.

Worked example — the live question, claim by claim. Every number is from the course's illustrative datasets.

Claims on whether a government should borrow to close a recessionary gap, labelled positive or normative
Claim	Kind	Column
In the simple model, 10 billion dollars of new spending closes a gap of 50 billion.	Positive, a model result	Keynesian
A deficit of 50 raises the debt ratio from 80% to 84%.	Positive, arithmetic agreed by both	Both
Sticky prices and wages make a gap last a long time.	Positive, disputed evidence	Keynesian
Lags and crowding out make borrowed spending arrive late and shrink its effect.	Positive, disputed evidence	Classical and monetarist
Shortening a spell of joblessness is worth a higher debt ratio.	Normative	Keynesian
A lower debt burden is worth a slower recovery.	Normative	Classical and monetarist

Read the table from the top, and you will see that the first two rows are not up for debate. The middle two are positive claims that evidence can test, even though economists read that evidence differently. The last two rows are where your values come in, and no diagram can settle them for you.

Misconception check. Students often decide that one school is right and the other is outdated, usually whichever one they heard first. That is tempting, because a single answer feels tidy. But modern macroeconomics draws on both, and both accept the agreed ground. A strong answer states the agreed ground first, gives each side its best case, and labels which parts are positive and which are normative.

Pause and reflect — choose one. Pick either prompt; they count the same.

(a) Write the strongest one-sentence case for borrowing to close the gap, then the strongest one-sentence case against it, and underline the normative part of each.
(b) Name one piece of evidence that would move you toward one column, and explain whether that evidence would settle a positive claim or a normative one.

Memory hook: label every claim; let the reader weigh the values.

10. Look back: the habits you carry into the final

You started this course by asking what "the whole economy" even means. You measured it first: GDP, prices, and jobs. Then you built models: the AD–AS diagram, the money market, the Phillips curve, and trade between two countries. This week you used those models on policy. Four habits carried you the whole way.

Four habits this course built, each with one example from the course's illustrative datasets
Habit	The question it asks	One example from the course
Real versus nominal	Did output grow, or only prices?	Nominal GDP of 1,100 against real GDP of 1,000 gave a deflator of 110
Movement along versus shift of a curve	Did the price level change, or did something else?	Government spending shifted aggregate demand right, from (800, 12) to (900, 13)
Money multiplier versus spending multiplier	Are reserves becoming money, or spending becoming output?	1 ÷ RR = 10 in banking; 1 ÷ (1 − MPC) = 5 in fiscal policy
Positive versus normative	Can evidence settle it, or does it rest on values?	"The debt ratio rose to 84%" versus "the debt ratio is too high"

Worked example — one headline, four habits. An illustrative headline says: "Government doubles spending growth; prices up, debt ratio up, and critics say it is reckless."

Real versus nominal. Before you credit the spending with more output, ask whether real output rose or only prices did.
Movement or shift. New government spending shifts aggregate demand right, so the price level and real output both rise in the short run.
Which multiplier. The spending multiplier sizes the output effect; the money multiplier has no job here.
Positive or normative. "The debt ratio is up" is positive. "It is reckless" is normative.

In words: four questions turn one noisy headline into claims you can check and claims you can weigh.

Misconception check. Students often think the final will ask them to pick the winning school. That is tempting, because this week ends the course on a debate. But the final asks you to compute, read the curves, and sort claims. You will be asked to state each side's case and label it, never to declare a winner.

Memory hook: four habits, one course; real, shift, multiplier, label.

Key terms

school of thought — A group of economists who share a way of reading the evidence and a set of policy instincts; in macroeconomics the two main ones are the Keynesian tradition and the classical and monetarist tradition. (first used: 1. Start from one shared picture: the same gap, two readings)
Keynesian tradition — The school of thought that stresses sticky prices and wages and aggregate demand as the driver of short-run swings, so an economy can stay stuck in a gap and active policy can help close it. (first used: 2. Make the Keynesian case: sticky prices and active policy)
activist policy — Deliberate changes in government spending, taxes, or monetary policy, made case by case, with the aim of closing an output gap sooner than the economy would close it on its own. (first used: 2. Make the Keynesian case: sticky prices and active policy)
classical tradition — The school of thought that stresses flexible prices and wages in the long run and potential output as the economy's anchor, so an economy in a gap tends to correct itself without new policy. (first used: 3. Make the classical and monetarist case: flexible prices, lags, and rules)
flexible prices and wages — Prices and wages that adjust quickly when demand or costs change, so output returns to potential without a long stay in a gap; whether real prices behave this way is a question for evidence. (first used: 3. Make the classical and monetarist case: flexible prices, lags, and rules)
monetarist tradition — The school of thought, associated with Milton Friedman, that warns monetary policy works with long and variable lags and so favors steady, predictable rules over frequent adjustments. (first used: 3. Make the classical and monetarist case: flexible prices, lags, and rules)
rules versus discretion — The debate over whether policymakers should follow a policy announced in advance or choose a fresh response to each situation; it applies to fiscal and monetary policy alike. (first used: 4. Build the schools table: each column at full weight)
agreed ground — The positive results that both schools of thought accept, such as a vertical long-run Phillips curve and sustained inflation as a monetary matter in the long run, stated plainly rather than argued both ways. (first used: 5. State the agreed ground plainly)
deficit-to-GDP ratio — One year's budget deficit divided by that year's GDP, times 100, which measures the year's new borrowing against the size of the economy. (first used: 6. Compute the ratios both schools share)
debt-to-GDP ratio — The national debt at a point in time divided by GDP, times 100, which measures the total the government owes against the size of the economy. (first used: 6. Compute the ratios both schools share)
inflation targeting — A policy framework in which a central bank announces a numerical goal for the inflation rate and sets its tools to keep inflation near that goal over time. (first used: 8. Meet inflation targeting, described factually)

Summary

Both schools read the same gap the same way; they disagree about what happens next.
The Keynesian tradition: sticky prices, a gap that can last, activist policy, fiscal policy first.
The classical and monetarist tradition: flexible prices, a self-correcting gap, rules, steady money.
Rules versus discretion is a separate question from fiscal versus monetary.
Agreed ground: a vertical long-run Phillips curve, inflation as a monetary matter in the long run, and a short run that differs from the long run.
Deficit-to-GDP puts the year's flow over output; debt-to-GDP puts the stock over output.
Inflation targeting announces a goal for inflation and steers toward it over time.
On any live question, label each claim positive or normative and leave the values to the reader.

Check your understanding

Work these before looking at the answers — they are ungraded, and the answers (with reasoning) are at the bottom of the page.

An illustrative island economy (not real data) collects revenue of 180 billion dollars, spends 210 billion, starts the year with a debt of 750 billion, and has a GDP of 1,500 billion. Find the deficit, the deficit-to-GDP ratio, and the debt-to-GDP ratio at the start and the end of the year.
A classmate computes the island's deficit ratio as 750 ÷ 1,500 × 100 = 50%. Explain the error and say what the 50% really measures.
Sort each policy by who wields it and by rule or discretion. (a) A city-level sales tax that falls automatically when spending falls. (b) A central bank that cuts interest rates at a surprise meeting after a weak jobs report.
Label each claim positive or normative, and say which school it supports: (a) "Wages in a slump fall slowly enough that a gap can last for years." (b) "Future taxpayers should not have to pay for the current recovery."

Answers (worked reasoning — read after attempting)

The deficit is 210 − 180 = 30 billion dollars for the year. The deficit-to-GDP ratio is 30 ÷ 1,500 × 100 = 2%. The debt-to-GDP ratio at the start is 750 ÷ 1,500 × 100 = 50%. The debt at the end is 750 + 30 = 780 billion dollars, so the ratio at the end is 780 ÷ 1,500 × 100 = 52%. With GDP unchanged, the debt ratio rose by exactly the deficit ratio, from 50% to 52%.
The classmate put the debt, a stock, on top of the fraction where the deficit, a flow, belongs. The 50% is the debt-to-GDP ratio at the start of the year. The deficit ratio is 2%, so the classmate's answer is 50 ÷ 2 = 25 times too large.
(a) is fiscal, because a tax is the government's tool. It is also a rule, because it moves with the economy with no new decision, like an automatic stabilizer. (b) is monetary, because the central bank moved its interest rate. It is discretion, because the bank chose a fresh response to new data.
(a) is positive, because evidence on how fast wages fall could confirm or refute it. It supports the Keynesian column. (b) is normative, because it says what ought to happen and rests on a value about fairness across generations. It supports the classical and monetarist column.

Next up in this module: the Readings & Resources page, the lecture tutorial, the practice set, and the quiz — and next week the Final Practice Exam and the final test your four habits, not a new model.

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