Chapter 27. 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 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 macroeconomically, 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.
i. 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.
ii. The nature of 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.
iii. 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. They should therefore 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:
i. The 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, such models were effectively useless for analyzing the consequences of changes in policy, which was one of the primary purposes for which they were created.
ii. Rational expectations and 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 unexpected policy changes or demand shocks 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.
iii. Optimal control versus game theory. Under rational expectations, policy formulation affects expectations formed by the private sector. Thus, the policy problem should not be characterized as an optimal control problem, but rather as 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 24) 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 model were two early successes. 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. Current Developments
At present, macroeconomic researchers tend to cluster into three groups: new classicals, new Keynesians, and new growth theorists.
The research agenda of the new classicals consists of an attempt to explain macroeconomic fluctuations as the outcome of shocks to competitive markets with fully flexible wages and prices. These 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, there is strong evidence that money affects 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.
Finally, new growth theory is in the process of reexamining the neoclassical growth model to understand the determinants of productivity growth, as well as the potential role of increasing returns to scale.
5. The Core
Most macroeconomists would agree on the following propositions:
i. In the short run, shifts in aggregate demand affect output.
ii. In the medium run, output returns to its natural level.
iii. In the long run, the evolution of the level of output is determined by capital accumulation and technological progress.
iv. Monetary policy affects output in the short run, but not in the medium or long run. A higher rate of money growth eventually translates one-for-one into a higher rate of inflation.
v. Fiscal policy has short-run, medium-run, and long-run effects on output. Larger deficits tend to increase output in the short run, but to decrease capital accumulation and output in the long run.
Major areas of disagreement concern the length of the short run and the role for policy.
V. Pedagogy
This is the first chapter of the book that recognizes explicitly sources of disagreement among economists. The book has presented a unified model built around a core of widely held beliefs. Implicit in this presentation, and in the concluding comments of the chapter, is the suggestion that future progress will likely arise out of the Core. On the other hand, a reading of the intellectual history described in this chapter suggests that progress may well overturn part of the Core (which part, of course, is unknown) or at least lead to a reinterpretation of some part of the Core. The major developments in macroeconomic theory have been revolutions of a sort, with new syntheses cobbled together afterwards to make sense of competing theories. Students may not want to rule out the possibility that new research will challenge parts of the Core.
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