978-0133780581 Chapter 24 Lecture Note

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Chapter 24. Epilogue: The

Story of Macroeconomics

I. MOTIVATING QUESTION

How have the core ideas of macroeconomics developed?

Modern macroeconomics starts with Keynes. Since his General Theory appeared, there have been a

series of challenges and counter challenges to his basic ideas, as interpreted by Hicks and Hansen. The

Core, as described in this book, is a collection of ideas that have survived these debates and that help to

make sense of the disagreements among economists.

II. WHY THE ANSWER MATTERS

Up to this point, the text has avoided describing economic research and ideas in terms of competing

camps. Instead, it has provided a unified model, constructed on the basis of widely held views among

macroeconomists, and emphasized the orderliness of economic research. This chapter provides students

an overview of the tumultuous history of macroeconomic theory. It exposes them to the messier, dynamic

aspect of research, and gives them some appreciation of how quickly economic orthodoxy can and has

changed.

III. KEY TOOLS, CONCEPTS, AND ASSUMPTIONS

1. Tools and Concepts

The chapter introduces some terms associated with the intellectual history of macroeconomics. Such

terms include, among others, the neoclassical synthesis, Keynesians, monetarists, new classicals, and

new Keynesians.

IV. SUMMARY OF THE MATERIAL

1. Keynes and the Great Depression

Few economists during the 1930s could provide a coherent explanation for the depth and breadth of the

Great Depression. Keynes’ General Theory delivered an intellectual framework to explain events and

guide policy. Keynes emphasized what we now call aggregate demand. In particular, Keynes stressed the

slow adjustment back to the natural level of output after an adverse demand shock. The General Theory

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introduced a number of ideas—the multiplier, money demand, and the importance of expectations—that

are fundamental to modern macroeconomics.

2. The Neoclassical Synthesis

By the early 1950s, a consensus had emerged around an interpretation of Keynes’ ideas in the form of the

IS–LM model, developed by Hicks and Hansen. This “neoclassical synthesis,” as Samuelson called it,

omitted the role of expectations and wage-price adjustment. During this period, Modigliani and Friedman

developed the theory of consumption, Tobin developed the theory of investment (which was further

developed and tested by Jorgensen), and Tobin also developed the theory of money demand and, more

generally, portfolio selection. These developments were embodied in large macroeconomic models,

pioneered by Klein. At the same time and independently, Solow developed growth theory.

The dissent from the mainstream consensus at this time was represented by monetarists, led by Friedman,

who questioned both that governments wanted to do good and that they actually knew enough to succeed.

The debate between Keynesians and monetarists centered on three issues: monetary versus fiscal policy,

the nature of the Phillips curve, and the role of policy.

With respect to monetary versus fiscal policy, monetarists questioned the emphasis

of the early Keynesians on the power of fiscal policy to stabilize output. Instead,

monetarists emphasized the power of monetary policy to destabilize the economy

in the absence of a money growth rule to constrain the Fed.

With respect to the Phillips curve, many Keynesians believed that the Phillips

curve offered a permanent long-run tradeoff between inflation and unemployment.

Friedman and Phelps argued that the tradeoff would disappear if policymakers tried

to exploit it.

With respect to the role of policy, Keynesians believed that fiscal and monetary

policy could be used to fine tune macroeconomic performance to avoid

fluctuations. Monetarists argued instead that economists did not know enough to

stabilize output and that in any event, policymakers could not be trusted to do the

right thing. Therefore, policymakers should be bound by simple rules.

3. The Rational Expectations Critique

The mainstream consensus of the 1960s received two challenges in the 1970s. The first challenge was

empirical. Aggregate demand shocks could not account for stagflation (simultaneous increases in

inflation and unemployment) which arose during the 1970s. The second challenge was intellectual. The

new rational expectations view argued that people form expectations about the future using all available

information, including economic theory and econometric models, rather than solely on the basis of the

past behavior of the variables they are trying to forecast. This idea posed three challenges for Keynesian

macroeconomics.

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The first challenge was the so-called Lucas critique. Existing macroeconomic models depicted behavioral

variables dependent on expectations as functions of current and lagged values of other variables in the

model. Under rational expectations, there was no reason to suppose that these historical relationships

would not change if the policy regime changed. Thus, existing models were effectively useless for

analyzing the consequences of changes in policy, which was one of the primary purposes for which these

models were created.

The second challenge arose from the incorporation of rational expectations into the

Phillips curve. In existing Keynesian models, output returned slowly to its natural

level after a shock because wages and prices adjusted slowly through the Phillips

curve mechanism. Lucas pointed out that slow adjustment arose from

backward-looking inflation expectations assumed in the models. Introducing

rational expectations into Keynesian models implied that only policy or demand

shocks that were unexpected should affect output. Moreover, deviations of output

from its natural level would last only as long as existing nominal wage contracts

that had failed to anticipate the shock.

The third challenge concerned the implications of game theory for policymaking.

Under rational expectations, policy formulation affected expectations formed by

the private sector. Thus, the policy problem was not an optimal control problem,

but rather a strategic game between policymakers and the private sector. Game

theory led to different implications for policy. For example, the time inconsistency

problem (discussed in Chapter 21) implied that discretion on the part of benevolent

policymakers could lead to worse outcomes than rules.

In sum, rational expectations implied that Keynesian models could not be used to evaluate potential

policy measures, that Keynesian models could not explain long-lasting deviations of output from its

natural level, and that the theory of policy needed to be redesigned, using the tools of game theory.

Rational expectations quickly became the accepted working assumption in macroeconomics, and theories

of economic behavior in goods, financial, and labor markets began to be reevaluated in light of this

modification. Hall’s random walk of consumption result and the Dornbusch overshooting of exchange

rates model were two early successes. In addition, Fischer and Taylor showed that the staggering of wage

and price decisions could imply long lasting deviations of output from its natural level even under rational

expectations. This finding resolved one of the issues raised by the rational expectations critique. Finally,

research on policy games led to a new emphasis on (and more rigorous thinking about) credibility and

commitment on the part of policymakers.

4. Developments in Macroeconomics Up to the 2009 Crisis

Since the late 1980s, macroeconomic researchers have tended to cluster into three groups: new classicals,

new Keynesians, and new growth theorists.

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The research agenda of the new classical theorists consists of an attempt to explain macroeconomic

fluctuations as the outcome of shocks to competitive markets with fully flexible wages and prices. These

so-called real business cycle models assume that output is always at its natural level, and interpret

fluctuations as arising from movements in the natural level, triggered by technological changes. The

problem with this view is that the nature of technological progress does not seem consistent with the types

of output fluctuations typically associated with business cycles. Moreover, although in real business

cycle models the money supply is irrelevant to output, there is strong evidence that changes in money

affect output.

New Keynesians essentially accept the synthesis that has emerged in response to the rational expectations

critique, and their research agenda consists of exploring the implications of market imperfections for

macroeconomic behavior. Research covers areas such as efficiency wages, imperfections in credit

markets, and sources of nominal rigidities.

New growth theorists have been reexamining the neoclassical growth model to understand the potential

role of increasing returns to scale and the determinants of technological progress. Research has also

examined the role of specific institutions in fostering or inhibiting growth.

Although there was contention among the three research camps in the 1980s and 1990s, a synthesis of

sorts has emerged. The synthesis builds on the methodology of the new classical theorists, recognizes the

potential importance of changes in the pace of technological progress as emphasized by the new classical

theorists and the new growth theorists, and allows for the market imperfections that characterize the

research of the New Keynesians. Although there is no agreement on a single model, or an accepted list of

market imperfections, there is a basic framework that organizes much macroeconomic research.

5. First Lessons for Macroeconomics after the Crisis

There is no question that the crisis reflects a major intellectual failure on the part of macroeconomics. The

failure is in not realizing that such a large crisis could happen, that the characteristics of the economy

were such that a relatively small shock, in this case the decrease in housing prices, could lead to a major

financial and macroeconomic world crisis.

In general, the many components of a systematic understanding of the financial system were not

integrated into many macroeconomic models prior to the crisis. The exceptions were works by:

Doug Diamond and Philip Dybvig in the 1980s had clarified the nature of bank runs (which we

examined in Chapter 6).

Bengt Holmstrom and Jean Tirole showed that liquidity issues were endemic to a modern

economy.

Andrei Shleifer, called “The Limits of Arbitrage” showed that, after a decline in an asset price

below its fundamental value, investors might not be able to take advantage of the arbitrage

opportunity; indeed they themselves may be forced to sell the asset, leading to a further decline in

the price and a further deviation from fundamentals.

Behavioral economists (for example, Richard Thaler, from Chicago) pointed to the way in which

individuals differ from the rational individual model typically used in economics, and drew

implications for financial markets.

In conclusion, the consensus from the lessons learned from the crisis is that respect to small shocks and

normal fluctuations, the adjustment process works; but that, in response to large, exceptional

shocks, the normal adjustment process may fail, the room for policy may be limited, and it may take a

long time for the economy to repair itself.

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