Epilogue: The Story of Macroeconomics

© 2003 Prentice Hall Business Publishing© 2003 Prentice Hall Business Publishing Macroeconomics, 3/eMacroeconomics, 3/e Olivier BlanchardOlivier Blanchard

Prepared by:Prepared by:

Fernando Quijano and Yvonn Fernando Quijano and Yvonn QuijanoQuijano

2727C H A P T E RC H A P T E R

Epilogue: The StoryEpilogue: The Storyof Macroeconomicsof Macroeconomics

© 2003 Prentice Hall Business Publishing© 2003 Prentice Hall Business Publishing Macroeconomics, 3/e Macroeconomics, 3/e Olivier BlanchardOlivier Blanchard

Keynes and theKeynes and theGreat DepressionGreat Depression

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The history of modern macroeconomics starts The history of modern macroeconomics starts in 1936, with the publication of Keynes’s in 1936, with the publication of Keynes’s General Theory of Employment, Interest, and General Theory of Employment, Interest, and Money.Money.

The Great Depression was an intellectual failure for the The Great Depression was an intellectual failure for the economists working on economists working on business cycle theorybusiness cycle theory—as —as macroeconomics was then called.macroeconomics was then called.

Keynes emphasized Keynes emphasized effective demandeffective demand, now called , now called aggregate demand. He introduced important concepts aggregate demand. He introduced important concepts such as the multiplier, such as the multiplier, liquidity preferenceliquidity preference (or demand (or demand for money), and animal spirits, or expectations.for money), and animal spirits, or expectations.

Keynes


The Neoclassical SynthesisThe Neoclassical Synthesis27-2

The The neoclassical synthesisneoclassical synthesis refers to a large refers to a large consensus that emerged in the early 1950s, consensus that emerged in the early 1950s, based on the ideas of Keynes and earlier based on the ideas of Keynes and earlier economists.economists.

The neoclassical synthesis was to remain the The neoclassical synthesis was to remain the dominant view for another 20 years. The period dominant view for another 20 years. The period from the early 1940s to the early 1970s was from the early 1940s to the early 1970s was called the golden age of macroeconomics.called the golden age of macroeconomics.


The Neoclassical SynthesisThe Neoclassical Synthesis

The most influential formalization of Keynes’s The most influential formalization of Keynes’s ideas was the ideas was the IS-LMIS-LM model, developed by model, developed by John Hicks and Alvin Hansen in the 1930s John Hicks and Alvin Hansen in the 1930s and early 1940s.and early 1940s.

Discussions became organized around the Discussions became organized around the slopes of the slopes of the ISIS and and LMLM curves. curves.



In the 1950s, Franco Modigliani and In the 1950s, Franco Modigliani and Milton Friedman independently Milton Friedman independently developed the theory of consumption, developed the theory of consumption, and insisted on the importance of and insisted on the importance of expectations.expectations.Modigliani

Tobin

James Tobin developed the theory of James Tobin developed the theory of investment based on the relation investment based on the relation between the present value of profits and between the present value of profits and investment. Dale Jorgenson further investment. Dale Jorgenson further developed and tested the theory.developed and tested the theory.



In 1956, Robert Solow developed the In 1956, Robert Solow developed the growth model—a framework to think growth model—a framework to think about the determinants of growth.about the determinants of growth.

Solow

Klein

Lawrence Klein developed the first Lawrence Klein developed the first U.S. macroeconomic model in the U.S. macroeconomic model in the early 1950s. The model was an early 1950s. The model was an extended IS relation, with 16 extended IS relation, with 16 equations.equations.



Milton Friedman was the intellectual Milton Friedman was the intellectual leader of the monetarists, and the leader of the monetarists, and the father of the theory of consumption.father of the theory of consumption.

He believed that the understanding of He believed that the understanding of the economy remained very limited, the economy remained very limited, and questioned the motives and ability and questioned the motives and ability of governments to improve of governments to improve macroeconomic outcomes.macroeconomic outcomes.

Friedman



In the 1960s, debates between In the 1960s, debates between KeynesiansKeynesians and and monetaristsmonetarists dominated the economic dominated the economic headlines. The debates centered around headlines. The debates centered around three issues:three issues:

1.1. The effectiveness of monetary policy versus The effectiveness of monetary policy versus fiscal policy.fiscal policy.

2.2. The Phillips curve.The Phillips curve.

3.3. The role of policy.The role of policy.



Friedman challenged the view that fiscal policy could Friedman challenged the view that fiscal policy could affect output faster and more reliably than monetary affect output faster and more reliably than monetary policy.policy.

In a 1963 book, A Monetary History of the United In a 1963 book, A Monetary History of the United States, 1867-1960, Friedman and Anna Schwartz States, 1867-1960, Friedman and Anna Schwartz reviewed the history of monetary policy and concluded reviewed the history of monetary policy and concluded that monetary policy was not only very powerful, but that monetary policy was not only very powerful, but that movements in money also explained most of the that movements in money also explained most of the fluctuations in output.fluctuations in output.

They interpreted the Great Depression as the result of They interpreted the Great Depression as the result of major mistake in monetary policy.major mistake in monetary policy.



The Phillips curve had become part of The Phillips curve had become part of the Neoclassical synthesis, but Milton the Neoclassical synthesis, but Milton Friedman and Edmund Phelps argued Friedman and Edmund Phelps argued that the apparent trade-off between that the apparent trade-off between unemployment and inflation would unemployment and inflation would quickly vanish if policy makers actually quickly vanish if policy makers actually tried to exploit it.tried to exploit it.

By the mid 1970s, the consensus was By the mid 1970s, the consensus was that there was no long-run trade off that there was no long-run trade off between inflation and unemployment.between inflation and unemployment.

Phelps



Skeptical that economists knew enough to Skeptical that economists knew enough to stabilize output, and that policy makers could stabilize output, and that policy makers could be trusted to do the right thing, Milton be trusted to do the right thing, Milton Friedman argued for the use of simple rules, Friedman argued for the use of simple rules, such as steady money growth.such as steady money growth.

Friedman believed that political pressures to Friedman believed that political pressures to “do something” in the face of relatively mild “do something” in the face of relatively mild problems may do more harm than good.problems may do more harm than good.


The RationalThe RationalExpectations CritiqueExpectations Critique

They argued that the predictions of Keynesian They argued that the predictions of Keynesian macroeconomics were wildly incorrect, and macroeconomics were wildly incorrect, and based on a doctrine that was fundamentally based on a doctrine that was fundamentally flawed.flawed.

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In the early 1970s, In the early 1970s, Robert Lucas, Thomas Robert Lucas, Thomas Sargent, and Robert Sargent, and Robert Barro led a strong attack Barro led a strong attack against mainstream against mainstream macroeconomics.macroeconomics.

LucasSargent

Barro


The Rational Expectations CritiqueThe Rational Expectations Critique

Robert Lucas argued that macroeconomic Robert Lucas argued that macroeconomic models did not incorporate expectations models did not incorporate expectations explicitly; that the models captured relations explicitly; that the models captured relations as they had held in the past, under past as they had held in the past, under past policies. They were poor guides to what policies. They were poor guides to what would happen under new policies.would happen under new policies.

This critique of macroeconometric models This critique of macroeconometric models became known as the became known as the Lucas CritiqueLucas Critique. .


The Implications ofThe Implications ofRational ExpectationsRational Expectations

Robert Hall showed that if consumers Robert Hall showed that if consumers are very foresighted, then changes in are very foresighted, then changes in consumption should be unpredictable.consumption should be unpredictable.

Consumption will change only when consumers Consumption will change only when consumers learn something new about the future. Since learn something new about the future. Since news about the future cannot be predicted, news about the future cannot be predicted, changes in consumption are highly random. This changes in consumption are highly random. This consumption behavior, known as the consumption behavior, known as the random random walk of consumptionwalk of consumption, has served as a , has served as a benchmark in consumption research ever since.benchmark in consumption research ever since.

Hall



Rudiger Dornbusch developed a model Rudiger Dornbusch developed a model of exchange rates that shows how large of exchange rates that shows how large swings in exchange rates are not the swings in exchange rates are not the result of irrational speculation but, result of irrational speculation but, instead, fully consistent with rationality.instead, fully consistent with rationality.

Dornbusch



Stanley Fischer and John Taylor showed Stanley Fischer and John Taylor showed that the adjustment of prices and wages that the adjustment of prices and wages in response to changes in unemployment in response to changes in unemployment can be slow even under rational can be slow even under rational expectations.expectations.

They pointed to the They pointed to the staggeringstaggering of both of both wage and price decisions, and explained wage and price decisions, and explained how a slow return of output to the natural how a slow return of output to the natural level can be consistent with rational level can be consistent with rational expectations in the labor market.expectations in the labor market.

Fischer

Taylor


Current DevelopmentsCurrent Developments

Their Their real business cycle (RBC) modelsreal business cycle (RBC) models assume that output is always at its natural level, assume that output is always at its natural level, and fluctuations are movements of the natural and fluctuations are movements of the natural level of output. These movements are level of output. These movements are fundamentally caused by technological progress.fundamentally caused by technological progress.

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Edward Prescott is the intellectual leader Edward Prescott is the intellectual leader of the of the new classicalsnew classicals—a group of —a group of economists interested in explaining economists interested in explaining fluctuations as the effects of shocks in fluctuations as the effects of shocks in competitive markets with fully flexible competitive markets with fully flexible prices and wages.prices and wages.

Prescott



One line of research focuses on the One line of research focuses on the determination of wages in the labor determination of wages in the labor market. George Akerlof has explored the market. George Akerlof has explored the role of “norms,” or rules that develop in role of “norms,” or rules that develop in any organization to assess what is fair or any organization to assess what is fair or unfair.unfair.

The The new Keynesiansnew Keynesians are a loosely connected are a loosely connected group of researchers working on the implications group of researchers working on the implications of several imperfections in different markets.of several imperfections in different markets.

Akerlof



Yet another direction of research is Yet another direction of research is nominal nominal rigiditiesrigidities in wages and prices. The in wages and prices. The menu costmenu cost explanation of output fluctuations, developed by explanation of output fluctuations, developed by Akerlof and N. Gregory Mankiw, attributes even Akerlof and N. Gregory Mankiw, attributes even small costs of changing prices to the infrequent small costs of changing prices to the infrequent and staggered price adjustment.and staggered price adjustment.

Another line of Another line of new Keynesiannew Keynesian research has research has explored imperfections in credit markets. Ben explored imperfections in credit markets. Ben Bernanke has studied the relation between Bernanke has studied the relation between banks and borrowers and its effects on monetary banks and borrowers and its effects on monetary policy.policy.



New growth theory focuses on the determinants New growth theory focuses on the determinants of technological progress in the long run, and the of technological progress in the long run, and the role of increasing returns to scale.role of increasing returns to scale.

Robert Lucas and Paul Romer have Robert Lucas and Paul Romer have provided a new set of contributions under provided a new set of contributions under the name of the name of new growth theorynew growth theory, which , which take on some of the issues initially raised take on some of the issues initially raised by growth theorists of the 1960s.by growth theorists of the 1960s.

Romer


Common BeliefsCommon Beliefs

Most macroeconomists agree that:Most macroeconomists agree that: In the short run, shifts in aggregate demand affect In the short run, shifts in aggregate demand affect

output.output. In the medium run, output returns to the natural level.In the medium run, output returns to the natural level. In the long run, capital accumulation and the rate of In the long run, capital accumulation and the rate of

technological progress are the main factors that technological progress are the main factors that determine the evolution of the level of output.determine the evolution of the level of output.

Monetary policy affects output in the short run, but Monetary policy affects output in the short run, but not in the medium run or the long run.not in the medium run or the long run.

Fiscal policy has short-run, medium-run, and long-run Fiscal policy has short-run, medium-run, and long-run effects on output.effects on output.

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Common BeliefsCommon Beliefs

Some of the disagreements involve:Some of the disagreements involve: The length of the “short run,” the period of time over The length of the “short run,” the period of time over

which aggregate demand affects output.which aggregate demand affects output. The role of policy. Those who believe that output The role of policy. Those who believe that output

returns quickly to the natural level advocate the use returns quickly to the natural level advocate the use of tight rules on both fiscal and monetary policy. of tight rules on both fiscal and monetary policy. Those who believe that the adjustment is slow prefer Those who believe that the adjustment is slow prefer more flexible stabilization policies.more flexible stabilization policies.


Key TermsKey Terms

business cycle theory,business cycle theory, effective demand,effective demand, liquidity preference,liquidity preference, neoclassical synthesis,neoclassical synthesis, Keynesians,Keynesians, Monetarists,Monetarists, Lucas critique,Lucas critique, random walk of consumption,random walk of consumption,

staggering (of wage and price decisions),

new classicals, real business cycle (RBC) model

s, new Keynesians, nominal rigidities, menu costs, new growth theory,

Epilogue: The Story of Macroeconomics

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