A Brief History of Macroeconomics

8/4/2019 A Brief History of Macroeconomics

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A BRIEF HISTORY OFMACROECONOMICS

JUNE 8, 2011

June 8, 2011 2

THE PHASES OF MACROECONOMICS

The Evolution of Macroeconomics

Three seminal phases of the history of macroeconomicthought/practice

Phase I: Measuring macroeconomic activity (1930s 1950)

Phase II: Keynesian-inspired macroeconometric models (1950 1970s)

Phase III: Dynamic General Equilibrium (DGE) methodology (1980s today)


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June 8, 2011 3

THE BIRTH OF MACROECONOMICS

The Evolution of Macroeconomics: Phase I

Macroeconomics born as a field during and because of the GreatDepression

Idea that government could/should regulate the periodic ups anddowns of the economy rose to prominence

John Maynard Keynes, The Gene r a l Theo r y o f E mp loy men t ,I n te r es t , and Money (1936)

Basic tenet: various rigidities in many markets lead to disequilibriathat can last a long time

Burns and Mitchell, Measur ing Bus iness Cyc les (1946)

First systematic accounting of the co-movement of various aggregates

i.e., GDP, consumption, employment, inflation, unemployment rate, etc

June 8, 2011 4

LONG-RUN GROWTH VS. BUSINESS CYCLES

Macro Fundamentals

Decompose time series into trends and cycles

Two clear patterns

Long-run growth

Frequent and sometimes big short-run fluctuations around long-run

trend

time

Actual GDP (orvirtually any real

economic series)

Long-run trend of GDP

-- a linear trend verysimple; but can also

construct (more nuanced)nonlinear trends (statisticsand econometrics)


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June 8, 2011 5


Macro Fundamentals


Two clear patterns

Long-run growth

Frequent and sometimes big short-run fluctuations around long-runtrend

Are the short-run fluctuations tightly related to the long-run trend?

Conventional view in economics has been no But (very) recent work provocatively suggests answer may be yes

Linkage through R&D: R&D typically thought to be a driver of long-rungrowthbut perhaps cyclical fluctuations in R&D themselves haveconsequences for business cycles (much more research needed here)

time


economic series)


-- a linear trend very

simple; but can alsoconstruct (more nuanced)nonlinear trends (statisticsand econometrics)

June 8, 2011 6


Macro Fundamentals


Two clear patterns

Long-run growth

Frequent and sometimes big short-run fluctuations around long-run

trend

Are the short-run fluctuations tightly related to the long-run trend?

Conventional view in economics has been no

Under the no view, a separation of fields

Studying the trend (economic growth and development)

Studying the fluctuations (macroeconomics)

time


economic series)


-- a linear trend verysimple; but can also

construct (more nuanced)nonlinear trends (statisticsand econometrics)


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June 8, 2011 7

BUSINESS CYCLES

Macro Fundamentals


time


economic series)


-- a linear trend very

simple; but can alsoconstruct (more nuanced)nonlinear trends (statisticsand econometrics)

time0

Highlight the business cycle movements by subtracting trendGDP from actual GDP (i.e., red line minus blue line)

Procedure referred to as detrending macroeconomic data

What explains business cycles?

June 8, 2011 8

PRINCIPLES OF KEYNESIAN MACROECONOMICS

The Evolution of Macroeconomics: Phase I

Basic Tenet: price rigidities/inflexibilities characterize many goodsmarkets and factor markets

Sticky prices

(Many) other rigidities/inflexibilities affect markets functioning aswell

but price (and wage) rigidities the central tenet

More general discussion in Akerlof (2007) essay

Which types ofshocks are the main driver of business cycles?

Policy shocks both monetary policy and fiscal policy

A basis for policy activism: because of high elasticity of private-sector demand to macroeconomic policy, when/ifother (i.e., non-policy) types of shocks affect the economy, monetary and fiscalpolicy can and should step in to mitigate recessions/depressions

Keynes Genera l Theor y just a verbal description of things


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June 8, 2011 9

THE RISE OF MACROECONOMICS

The Evolution of Macroeconomics: Phase II








How to model (i.e., conceptually/rigorously/mathematicallythink about) business cycles?

Phase II: The big macroeconometric models

June 8, 2011 10

THE GLORY DAYS OF MACROECONOMICS


Big Keynesian macroeconometric models prominent by the1960s, led by

Kennedys Council of Economic Advisers (Solow, Tobin, Samuelson)

MIT/Penn/Federal Reserve Board

ISLM and AS/AD model (Hicks, 1937) the conceptual core

1 0 2 1 3 2 3

2 3 1 4 3 5 4

136 5987 1 5988 1 3 5989 69

....

...

...

t t t t

t t t t

t t t t

x x x x

x x x x

x x x x

= + + +

= + + +

= + + +

General idea of Keynesian-inspiredmacroeconometric models

Dozens or hundreds ofvariables and equations


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June 8, 2011 11







Statistical relationships between various macro variables

Basic approach: estimate (econometrically) these equations anduse them for policy advice

In particular: estimate all the alpha coefficients using historical dataand posit that this is h ow the macroeconomy works

An approach to macroeconomic policy-making embodied mostsuccinctly in the view and supposed promise of the Phillips Curve

1 2 3

2 1 4

0 1 2

3 4 5

5987 5988 5136 1 98

3

13 9 69

3

....

...

...

t t t

t t t

t

t

t

tt t

x x x

x x x

x x x x

x

x

= + + +

= + + +

= + + +

Dozens or hundreds ofvariables and equations,some of which describe

how policy affects theeconomy

Say x3 and x13 are policyvariables

Its all about estimating the

alpha terms


June 8, 2011 12

THE PHILLIPS CURVE


A seemingly stable, predictable relationship between an economysinflation rate and unemployment rate

Came to be the centerpiece of the Keynesian macroeconometricagenda

Came to be the centerpiece for policy advice

for fiscal policy (given forceful voice during the Kennedyadministration CEA populated with future Nobel Laureates RobertSolow, James Tobin, Paul SamuelsonJohn Kenneth Galbraith a moremuted enthusiast of this approach to policy formulation)

and eventually for monetary policy (rise of an activist Fed:raising/lowering interest rates to fine tune macroeconomicperformance

unemployment rate

inflationrate


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June 8, 2011 13







Became widely used for policy-making


One of these equations is thePhillips Curve

1 2 3

2 1 4

0 1 2

3 4 5

5987 5988 5136 1 98

3

13 9 69

3

....

...

...

t t t

t t t

t

t

t

tt t

x x x

x x x

x x x x

x

x

= + + +

= + + +

= + + +

Dozens or hundreds ofvariables and equations,some of which describe

how policy affects theeconomy


June 8, 2011 14

THE FALL OF MACROECONOMICS






Became widely used for policy-making

until they stopped working in the 1970s Amidst a high-inflation environment (U.S. inflation between 15-20% in

second half of 1970s), sparked by OPEC oil embargoes

Lucas Critique (1976): The alphas themselves should be thoughtof / modeled as f unc t i ons of government policy!

1 2 3

2 1 4

0 1 2

3 4 5

5987 5988 5136 1 98

3

13 9 69

3

....

...

...

t t t

t t t

t

t

t

tt t

x x x

x x x

x x x x

x

x

= + + +

= + + +

= + + +

Dozens or hundreds ofvariables and equations,some of which describehow policy affects the

economy



One of these equations is thePhillips Curve


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June 8, 2011 15

THE LUCAS CRITIQUE

The Evolution of Macroeconomics: Between Phase II and Phase III

Crucial inconsistency in Keynesian macroeconometric approach

The estimated coefficients (the alphas) themselves may change ifpolicy (monetary and/or fiscal) changes!

In which case the macroeconometric approach cannot usefully givepolicy advice unless one knows/makes assumptions about how thealphas themselves depend on policy

Discovered in the 1970s amidst world-wide macroeconomicturbulence caused (seemingly) by the two oil crises

The usual Phillips relation stopped working even as policy-makerstried harder than ever to exploit it

Led to breakdown of existing macroeconomic theory and opened thedoor for a complete re-thinking of the basic tenets of macroeconomics

Keynesian macroeconometric models are n o t e co n o m i c m o d e l s

Merely a statistical description of historical events Economics: the study of how incentives influence behavior of

individuals/market participants

A damning criticism of the entire macroeconomics profession

This problemwas alwayspresent, butdidnt revealitself until the1970s

June 8, 2011 16

THE FALL OF MACROECONOMICS

The Evolution of Macroeconomics: Phase III








How to model (i.e., conceptually/rigorously/mathematicallythink about) business cycles?

Phase II: The big macroeconometric models

Death knell spelled by the devastating Lucas Critique

Phase III: Microeconomic foundations and DGE modeling


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June 8, 2011 17

THE REBIRTH OF MACROECONOMICS


Kydland and Prescott (1982), Long and Plosser (1983)

A dynamic general equilibrium (DGE) view of business cycles

A real business cycle (RBC)

TFP shocks the driving force, not policy shocks

Business cycles are efficient and natural

so macroeconomic policy aimed at stabilizing cycles is

unimportant/misguided

An economic theory, not a statistical theory

Building blocks

Consumer preferences

Production technology

Interactions through markets (goods, labor, and financial markets)

The alphas are functions of policy variables (if policy variablespresent in the model)

thus immune to Lucas Critique

June 8, 2011 18

PRINCIPLES OF RBC MACROECONOMICS


Basic Tenets

Markets operate (nearly) perfectly competitively

Price rigidities/inflexibilities are n ot very important conceptual breakfrom Keynesian principles

Model the economic interactions, not merely the statisticalrelationships methodological break from Keynesian principles


TFP shocks (not policy another conceptual break from Keynesianism)

How to measure TFP? As a residual, using Cobb-Douglasproduction function

1output ( , )t t t t t t t A f k n A k n

= =

Whats left overafter accounting for what we can account for


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June 8, 2011 19



Basic Tenets

Markets operate (nearly) perfectly competitively

Price rigidities/inflexibilities are n ot very important conceptual breakfrom Keynesian principles

Model the economic interactions, not merely the statisticalrelationships methodological break from Keynesian principles


TFP shocks (not policy another conceptual break from Keynesianism)

How to measure TFP? As a residual, using Cobb-Douglasproduction function

1output ( , )t t t t t t t A f k n A k n

= =

Whats left overafter accounting for what we can account for

1.1161617.62010

1.2161619.22009

1.291614.420081.091612.02007

TFPLaborCapitalOutputPeriod

Suppose alpha =

0.5 for simplicity

(U.S. economy:alpha 0.30)

Productivity improved between 2007 and 2008

Productivity stagnated between 2008 and 2009

Productivity declined between 2009 and 2010

EXAMPLE

June 8, 2011 20



Shocks to TFP are persistent

Once A t rises unexpectedly, TFP tends to stay elevated for multipleperiods

Example: IfA2000 > A1999, then A2001 is likely to be higher than A1999 aswell, but not as large as A2000

A slowly-dampening time-profile of TFP

RBC view

Persistent TFP shocks the driver of business cycles

NOT policy shocks

time

The periodof theshock

Gradual return to steady-state

steady-state TFP

Detrended TFPseries (i.e., actualTFP displayslong-run growth)

Over two-thirds ofbusiness-cyclefluctuations driven byTFP shocks


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June 8, 2011 21

RBC MECHANISM: AN EXAMPLE


Positive TFP shock occurs (i.e., TFPrises)

Effect on labor market: rise in A t risein MP Nt shift in labor demand

Effect on capital demand: rise in A trise in A t+1 (because shocks arepersistent) rise in MPKt+1 shift incapital demand

labor

real

wage

D

rise in A

inv

r

investment demandfunction

rise in A

June 8, 2011 22

RBC MECHANISM: AN EXAMPLE


Positive TFP shock occurs (i.e., TFPrises)

Effect on labor market: rise in A t risein MP Nt shift in labor demand

Effect on capital demand: rise in A trise in A t+1 (because shocks arepersistent) rise in MPKt+1 shift incapital demand

labor

realwage

D

rise in A

inv

r

investment demandfunction

rise in A

S

S

Superimposing the supply sides of thelabor and capital markets:

1. Investment (one of the componentsof GDP) rises

2. EQUILIBRIUM quantity of labor

rises

3. Hence total output (i.e., GDP) rises(because both A t and nt rise)

TFP shocks lead to fluctuations in GDP

What is TFP? Could be

1. Literally technology (better

computers, etc.)

2. Better-educated workers3. More open international trade

4. Financial market conditions

5.


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June 8, 2011 23

UNDERSTANDING EQUILIBRIUM

Macro Fundamentals

Prices coordinate activity of suppliers and demanders (whether P,w, or r; basic idea same in any market)

Macro markets (suppose no taxes anywhere for simplicity)

D

S

equilibrium price

( , )

( , )

l t tt

c t t

u c lw

u c l=

1

'( )1

'( )

tt

t

u cr

u c += +

Consumption-leisureoptimality condition

Consumption-savingsoptimality condition

CONSUMERS

June 8, 2011 24


Macro Fundamentals



D

S

equilibrium price

( ( , ))t t t n t t

w mpn A f k n= =

( ( , ))t t t k t t

r mpk A f k n= =

Optimal labor demand

Optimal investmentdemand

FIRMS


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June 8, 2011 25


Macro Fundamentals



Prices anonymously coordinate activity of suppliers and demanders

Invisible hand described by Adam Smith (Wea l th o f N a t i ons , 1776)

D

S

equilibrium price

( , )

( , )

l t tt

c t t

u c lmpn

u c l=

1

'( )1

'( )

tt

t

u cmpk

u c += +

EQUILIBRIUM IN THE LABOR MARKET

EQUILIBRIUM IN THE CAPITAL MARKET

June 8, 2011 26

WHERE IS MACROECONOMICS TODAY?

The Evolution of Macroeconomics: Next?

Keynesian Macroeconomics

Ideology: Price rigidities/sticky prices

Policy stance: policy (fiscal and monetary) of crucial importance formacroeconomic performance

Methodology: econometric/statistical modeling

RBC Macroeconomics

Ideology: Prices are not rigid or sticky

Policy stance: policy (neither fiscal nor monetary) not very importantfor macroeconomic performance

Methodology: dynamic general equilibrium modeling

New Keynesian Macroeconomics

Ideology: Price rigidities/sticky prices Policy stance: policy (fiscal and monetary) of crucial importance for

macroeconomic performance

Methodology: dynamic general equilibrium modeling

A central issue in macroeconomics: monetary neutrality?

Does monetary policy have long-lasting effects on rea l economy?

The enduring imprint of the RBC revolution

Empirical evidence still EXTREMELY mixedon this

A Brief History of Macroeconomics

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