What do we know about macroeconomics that Fisher and Wicksell ...

WHAT DO WE KNOW ABOUT MACROECONOMICSTHAT FISHER AND WICKSELL DID NOT

OLIVIER BLANCHARD

This essay argues that the history of macroeconomics during the twentiethcentury can be divided into three epochs Pre-1940 a period of exploration duringwhich all the right ingredients were developed But also a period where confusionreigned because of the lack of an integrated framework From 1940 to 1980 aperiod during which an integrated framework was developedmdashfrom the IS-LM todynamic general equilibrium models But a construction with an Achillesrsquo heel toocasual a treatment of imperfections leading to a crisis in the late 1970s Since1980 a new period of exploration focused on the role of imperfections inmacroeconomics Exploration often feels like confusion But behind it is one of themost productive periods of research in macroeconomics

The editors of the Quarterly Journal of Economics havecommissioned a series of essays on the theme what do we knowabout eld x that Marshall did not In the case of macroeconomicsMarshall is not the right reference But if we replace his namewith those of Wicksell and of Fisher the two dominant gures inthe eld at the start of the twentieth century the answer is veryclear we have learned a lot Indeed progress in macroeconomicsmay well be the success story of twentieth century economics

Such a strong statement will come as a surprise to some Onthe surface the history of macroeconomics in the twentiethcentury appears as a series of battles revolutions and counterrevo-lutions from the Keynesian revolution of the 1930s and 1940s tothe battles between Monetarists and Keynesians of the 1950s and1960s to the Rational Expectations revolution of the 1970s andthe battles between New Keynesians and New Classicals of the1980s These suggest a eld starting anew every twenty years orso often under the pressure of events and with little or nocommon core But this would be the wrong image The right one isof a surprisingly steady accumulation of knowledge The mostoutrageous claims of revolutionaries make the news but areeventually discarded Some of the others get bastardized and thenintegrated The insights become part of the core In this article I

I thank Daron Acemoglu Ben Bernanke Ricardo Caballero Thomas CoolPeter Diamond Rudiger Dornbusch Stanley Fischer Bengt Holmstrom LawrenceKatz David Laibson N Gregory Mankiw David Romer Paul Samuelson AndreiShleifer Robert Solow Justin Wolfers and Michael Woodford for useful commentsand discussions An earlier version was given as the Tinbergen lecture inAmsterdam in October 1999

r 2000 by the President and Fellows of Harvard College and the Massachusetts Institute ofTechnologyThe Quarterly Journal of Economics November 2000

1375

focus on the accumulation of knowledge rather than on therevolutions and counterrevolutions Admittedly this makes forworse history of thought and it surely makes for worse theaterBut it is the best way to answer the question in the title1

Let me state the thesis that underlies this essay I believe thatthe history of macroeconomics during the twentieth century canbe divided into three epochs the third one currently playing2

c Pre-1940 A period of exploration where macroeconomicswas not macroeconomics yet but monetary theory on oneside and business cycle theory on the otherA period duringwhich all the right ingredients and quite a few more weredeveloped But also a period where confusion reignedbecause of the lack of an integrated framework

c From 1940 to 1980 A period of consolidation A periodduring which an integrated framework was developedmdashstarting with the IS-LM all the way to dynamic generalequilibrium modelsmdashand used to clarify the role of shocksand propagation mechanisms in uctuations But a con-struction with an Achillesrsquo heel namely too casual atreatment of imperfections leading to a crisis in the late1970s

c Since 1980 A new period of exploration focused on the roleof imperfections in macroeconomics from the relevance ofnominal wage and price setting to incompleteness ofmarkets to asymmetric information to search and bargain-ing in decentralized markets to increasing returns inproduction Exploration often feels like confusion andconfusion there indeed is But behind it may be one of themost productive periods of research in macroeconomics

Let me develop these themes in turn

I PRE-1940 EXPLORATION

To somebody who reads it today the pre-1940 literature onmacroeconomics feels like an (intellectual) witchrsquos brew many

1 A nice largely parallel review of macroeconomics in the twentieth centurytaking the alternative more historical approach is given by Woodford [1999]

2 For the purpose of this article I shall dene macroeconomicsas the study ofuctuations mundanemdashrecessions and expansionsmdashor sustainedmdashsharp reces-sions long depressions sustained high unemployment I shall exclude both thestudy of growth and of the political economy of macroeconomics Much progresshas been made there as well but covering these two topics would extend the lengthof this essay to unmanageable proportions

QUARTERLY JOURNAL OF ECONOMICS1376

ingredients some of them exotic many insights but also a greatdeal of confusion

The set of issues that would now be called macroeconomicsfell under two largely disconnected headings Monetary Theoryand Business Cycle Theory3

At the center of Monetary Theory was the quantity theorymdashthe theory of how changes in money lead to movements in outputand in prices The focus was both on long-run neutrality and onshort-run nonneutrality The discussion of the short-run effects ofan increase in money on output was not much improved relativeto say the earlier treatments by Hume or by Thornton Somestressed the effects from money to prices and from prices tooutput higher money led to higher prices higher prices lsquolsquoexcitedrsquorsquobusiness and led in turn to higher output Others stressed theeffects from money to output and from output to prices highermoney increased demand and output and the increase in outputin turn led to an increase in prices over time

Business Cycle Theory was not a theory at all but rather acollection of explanations each with its own rich dynamics4 Mostexplanations focused on one factor at a time real factors (weathertechnological innovations) or expectations (optimistic or pessimis-tic rms) or money (banks or the central bank) When favorablethese factors led rms to invest more banks to lend more untilthings turned around typically for endogenous reasons and theboom turned into a slump Even when cast as general equilibriumthe arguments when read today feel incomplete and partialequilibrium in nature it is never clear how and in which marketsoutput and the interest rate are determined

In retrospect one can see the pieces of a macroeconomicmodel slowly falling into place

At the center was the difference emphasized by Wicksell[1898] between the natural rate of interest (the rate of return oncapital) and the money rate of interest (the interest rate onbonds) This would become a crucial key in allowing for the

3 The word lsquolsquomacroeconomicsrsquorsquo does not appear until the 1940s According toJSTOR (the electronic database that includes the articles from most majorjournals since their inception) the rst use of lsquolsquomacro-economicrsquorsquo in the title of anarticle is by De Wolff in 1941 in lsquolsquoIncome elasticity of demand a micro-economicand a macro-economic interpretationrsquorsquo the rst use of lsquolsquomacroeconomicsrsquorsquo in the titleof an article is by Klein [1946] in an article called ttingly lsquolsquoMacroeconomics andthe Theory of Rational Behaviorrsquorsquo

4 The variety and the complexity of these explanations is reected inMitchell [1923] or in the textbook of the time Prosperity and Depression byHaberler [1937]

WHAT DO WE KNOW ABOUT MACROECONOMICS 1377

eventual integration of goods markets (where the natural rate isdetermined) and nancial markets (where the money rate isdetermined) It would also prove to be the key in allowing for theeventual integration of monetary theory (where an increase inmoney decreases the money rate relative to the natural ratetriggering higher investment and higher output for some time)and business cycle theory (in which several factors includingmoney affect either the natural rate or the money rate and thusthe difference between the two)

Where the literature remained confused at least until Keynesand for some time after was how this difference between the tworates translated into movements in output Throughout the 1920sand 1930s the focus was increasingly on the role of the equality ofsaving and investment but the semantic squabbles that domi-nated much of the debate (the distinctions between lsquolsquoex antersquorsquo andlsquolsquoex postrsquorsquo lsquolsquoplannedrsquorsquo and lsquolsquorealizedrsquorsquo saving and investment thediscussion of whether the equality of saving and investment wasan identity or an equilibrium condition) reected a deeper confu-sion It was just not clear how shifts in saving and investmentaffected output

In that context the methodological contributions of theGeneral Theory [1936] made a crucial difference

c Keynes explicitly thought in terms of three markets (thegoods the nancial and the labor markets) and of theimplications of equilibrium in each

c Using the goods market equilibrium condition he showedhow shifts in saving and in investment led to movements inoutput

c Using equilibrium conditions in both the goods and thenancial markets he then showed how various factorsaffected the natural rate of interest (which he called thelsquolsquomarginal efficiency of capitalrsquorsquo) the money rate of interestand output An increase in the marginal efficiency ofcapitalmdashcoming say from more optimistic expectationsabout the futuremdashor a decrease in the money ratemdashcomingfrom expansionary monetary policymdashboth led to an in-crease in output

A quote from Pigoursquos Marshall lectures Keynesrsquos GeneralTheory A Retrospective Viewrsquorsquo [1950] puts it well5 lsquolsquoNobody before

5 Pigoursquos rst assessment of The General Theory in 1936 had been far lesspositive and for understandable reasons Keynes was not kind to Pigou in The


him so far as I know had brought all the relevant factors real andmonetary at once together in a single formal scheme throughwhich their interplay could be coherently investigatedrsquorsquo

The stage was then set for the second epoch of macroeconom-ics a phase of consolidation and enormous progress

II 1940ndash1980 CONSOLIDATION

Macroeconomists often refer to the period from the mid-1940sto the mid-1970s as the golden age of macroeconomics For a goodreason progress was fast and visible

II1 Establishing a Basic Framework

The IS-LM formalization by Hicks [1937] and Hansen maynot have captured exactly what Keynes had in mind But bydening a list of aggregate markets writing demand and supplyequations for each one and solving for the general equilibrium ittransformed what was now becoming lsquolsquomacroeconomicsrsquorsquo It did notdo this alone Equally impressive in their powerful simplicitywere among others the model developed by Modigliani in 1944with its treatment of the labor market and the role of nominalwage or price rigidities or the model developed by Metzler in1951 with its treatment of expectations wealth effects and thegovernment budget constraint These contributions shared acommon structure the reduction of the economy to three sets ofmarketsmdashgoods nancial and labormdashand a focus on the simulta-neous determination of output the interest rate and the pricelevel This systematic general equilibrium approach to thecharacterization of macroeconomic equilibrium became the stan-dard and reading the literature one is struck by how muchclearer discussions became once this framework had been put inplace

This approach was brought to a new level of rigor in lsquolsquoMoneyInterest and Pricesrsquorsquo by Patinkin [1956] Patinkin painstakinglyderived demand and supply relations from intertemporal optimiz-ing behavior by people and by rms characterized the equilib-rium and in the process laid to rest many of the conceptualconfusions that had plagued earlier discussions It is worth

General Theory But by 1950 time had passed and Pigou clearly felt moregenerous


making amdashnonlimitativemdashlist (if only because some of theseconfusions have a way of coming back in new forms)

c lsquolsquoSayrsquos lawrsquorsquo False In the same way as the supply of anyparticular good did not automatically generate its owndemand (the relative price of the good has to be right) thesupply for all goods taken together did not generate its owndemand either The intertemporal price of goods the realinterest rate also had to be right

c lsquolsquoWalras lawrsquorsquo True As long as each agent took all his or herdecisions under one budget constraint then equilibrium inall markets except one implied equilibrium in the remain-ing one

c The lsquolsquoClassical Dichotomyrsquorsquo between the determination ofthe price level on the one hand and the determination ofrelative prices on the other False lsquolsquoNeutralityrsquorsquo the proposi-tion that changes in money were ultimately reected inproportional changes in the price level leaving relativeprices unaffected was true But this was an equilibriumoutcome not the result of a dichotomous model structure

c lsquolsquoValue Theory versus Monetary Theoryrsquorsquomdashthe issue ofwhether standard methods used in value theory could beused to think about the role and the effects of money in amonetary economy The answer was Yes One could thinkof real money balances as entering either the indirectutility of consumers or the production function of rmsOne could then treat real money balances as one wouldtreat any other good

c lsquolsquoLoanable Funds or Liquidity Preferencersquorsquomdashthe issue ofwhether the interest rate was determined in the goodsmarkets (through the equality of saving and investment)or in the nancial markets (through the equality of thedemand and the supply of money) The answer made clearby the general equilibrium structure of the models was ingeneral both

II2 Back to Dynamics

Keynes himself had focused mostly on comparative staticsSoon after however the focus shifted back to dynamics Little ifany of the old business cycle literature was used and most of thework was done from scratch

Key to these developments was the notion of lsquolsquotemporaryequilibriumrsquorsquo developed by Hicks in Value and Capital [1939] The


approach was to think of the economy as an economy with fewfuture or contingent markets an economy in which people andrms therefore had to make decisions based partly on statevariablesmdashvariables reecting past decisionsmdashand partly on ex-pectations of the future Once current equilibrium conditions wereimposed the current equilibrium depended partly on history andpartly on expectations of the future And given a mechanism forthe formation of expectations one could trace the evolution of theequilibrium through time

Within this framework the next step was to look more closelyat consumption investment and nancial decisions and theirdependence on expectations This was accomplished in a series ofextraordinary contributions by Modigliani and Friedman whoexamined the implications of intertemporal utility maximizationfor consumption and saving by Jorgenson and Tobin who exam-ined the implications of value maximization for investment andby Tobin and a few others who examined the implications ofexpected utility maximization for nancial decisions These devel-opments would warrant more space but they are so well-knownand recognized (in particular by many Nobel prizes) that there isno need to do so here

The natural next step was to introduce rational expectationsThe logic for taking that step was clear If one was to explore theimplications of rational behavior it seemed reasonable to assumethat this extended to the formation of expectations That stephowever took much longer It is hard to tell how much of the delaywas due to technical problemsmdashwhich indeed were substantialmdashand how much to objections to the assumption itself But this waseventually done and by the late 1970s most of the models hadbeen reworked under the assumption of rational expectations6

With the focus on expectations a new battery of small modelsemerged with more of a focus on intertemporal decisions Thecentral model was a remake of a model rst developed by Ramseyin 1928 but now reinterpreted as a temporary equilibrium modelwith innitely lived individuals facing a static production technol-

6 This is where a more historical approach would emphasize that this wasnot a smooth evolution At the time the introduction of rational expectationswas perceived as an attack on the received body of macroeconomics But with thebenet of hindsight it feels much less like a revolution than like a naturalevolution (Some of the other issues raised by the same economists who introducedrational expectations proved more destructive and are at the source of the crisis Idiscuss below)


ogy7 This initial structure was then extended in many directions8Among them were the following

c The introduction of costs of adjustment for capital leadingto a well-dened investment function and a way of think-ing about the role of the term structure of interest rates inachieving the equality of saving and investment

c The introduction of money as a medium of exchange andthe extension of the Baumol-Tobin model of money demandto general equilibrium

c The introduction of some dimensions of heterogeneity forexample allowing for nite lives and extending the overlap-ping-generation model rst developed by Samuelson andDiamond

c The introduction of a leisurelabor choice in addition to theconsumptionsaving decision

c The extension to an economy open both in goods andnancial markets

Initially these models were solved under perfect foresight asimplifying but rather unappealing assumption in a world ofuncertainty and changing information That introducing uncer-tainty was essential was driven home in an article by Hall [1978]who showed that under certain conditions optimizing behaviorimplied that consumption should follow a random walkmdasha resultthat initially came as a shock to those trained to think in terms ofthe life-cycle model Under the leadership of Lucas and Sargent(for example Lucas and Stokey [1989] Lucas [1987] and Sargent[1987]) developments in stochastic dynamic programing togetherwith progress in numerical methods and the development of morepowerful computers were used to characterize behavior underuncertainty This in turn allowed the exploration of a new andimportant set of issues the implications of the absence of somefuture or contingent markets in affecting consumption and invest-ment decisions and in turn the macroeconomic equilibrium

Compared with the rst generation of models (the IS-LMMetzler and Modigliani models) these models in either theirperfect foresight or their stochastic versions were more tightlyspecied less eclectic In their initial incarnation they often

7 Ramsey had thought of his model as purely normative indicating how acentral planner might want to allocate consumption over time

8 The basic Ramsey model and many of these extensions form the core oftodayrsquos graduate textbooks See for example Blanchard and Fischer [1989] orObstfeld and Rogoff [1996]


ignored imperfections that many macroeconomists saw as centralto an explanation of macroeconomic uctuations But they pro-vided a basic set of off-the-shelf structures on which to build andindeed in which to introduce imperfections Getting ahead of mystory this is indeed what has happened since the early 1980s andI shall return to it later

II3 From Models to Data

Starting in the 1940s in macroeconomics as in the rest ofeconomics research was radically transformed by the increasingavailability of data and the development of econometric methodsBut another element specic to macroeconomics played a centralrole the coincidence between the implications of linear dynamicmodels and the time series representation of economic variables

The old business cycle literature had been groping towardnonlinear endogenous cycle models models where the expansioncreated the conditions for the next recession the recession theconditions for the next expansion and so on As early as 1933however Ragnar Frisch had argued that much simpler systemslinear difference systems with shocks could provide a betteraccount of aggregate uctuations In an economy described bysuch systems one could think of uctuations as the result of thecombination of impulsesmdashrandom shocks constantly buffeting theeconomymdashand propagation mechanisms the dynamic effects ofthese shocks implied by the linear system This point wasreinforced by Samuelsonrsquos 1939 analysis of the multiplier accelera-tor which showed how a given shock to spending could generaterich dynamic responses of output The convenience of the ap-proach and its easy mapping to the data quickly led to thedominance of linear models with shocks as the basic approach touctuations and alternative nonlinear approaches largely fadedfrom the scene

These early steps were followed by the specication andestimation of structural models Using the approach to identica-tion developed by Koopmans and others at the Cowles Commis-sion individual equations for consumption investment andmoney demand were estimated and integrated into larger andlarger macroeconometric models culminating on the academicside in models such as the MPS developed by Modigliani andcoauthors in the 1960s and early 1970s

In the late 1970s the focus shifted at least on the academicside to smaller models The feeling was that the immense effort to


construct large structural models had been overambitious thatthe identication conditions used in estimation of individualequations were often dubious and that the equation-by-equationconstruction of econometric models did not in any way insure thatthe reduced form of the estimated model tted the basic character-istics of the data

This was the motivation behind the return to smaller moretransparent structural models whose limited size had the addi-tional advantage of making them solvable under rational expecta-tions It was also the motivation behind the development of a newstatistical tool vector autoregressions or VARsmdashnamely thedirect estimation of the joint stochastic process describing thevariables under consideration VARs were then used in two waysto obtain a set of stylized statistical facts that models had tomatch and to see whether under a minimal set of identicationrestrictions the evidence was consistent with the dynamic effectsof shocks implied by a particular theory or class of theories

The constant back and forth between models and data andthe increasing availability of macro and micro data has mademacroeconomics a radically different eld from what it was in1940 Samuelson once remarked that one of his disappointmentswas that econometric evidence had led to less convergence than hehad hoped when the rst econometric steps were taken (inSnowdon and Vane [1999] p 323) It is nevertheless true thatprogress has been nothing short of amazing When Kahn [1931]rst tried to get a sense of the value of the marginal propensity toconsume all he had were a few observations on proxies foraggregate production imports and investment When Modiglianiand Brumberg [1954] tried to assess the empirical t of thelife-cycle hypothesis they could use the time series recently puttogether for the National Income Accounts by Kuznets and othersand a few cross sections on income and saving Today studies ofconsumption have access to long repeated cross sections or evenlong panel data sets (see for example Deaton [1992]) This allowsnot only for much sharper questions about consumption behaviorbut also for a more convincing treatment of identication (throughthe use of lsquolsquonatural experimentsrsquorsquo tracing the effects of changes inthe economic environment affecting some but not all consumers)than was feasible earlier

So far the tone of this essay has been that of a panegyric thedescription of a triumphal march toward truth and wisdom Let


me now turn to the problem that macroeconomics largely ignoredand which led to a major crisis in the late 1970s

II4 The Casual Treatment of Imperfections

From Keynes on there was wide agreement that someimperfections played an essential role in uctuations9 Nominalrigidities along the lines suggested by Keynes and later formal-ized by Modigliani and others played an explicit and central rolein most formalizations They were crucial to explaining why andhow changes in money and other shifts in the demand for goodsaffected output at least in the short run

These nominal rigidities when combined with later develop-ments such as rational expectations proved to have rich andrelevant implications For example in an extension of the Mundell-Fleming model (the version of the IS-LM model for an economyopen in both goods and nancial markets) Dornbusch [1976]showed that the large swings in exchange rates which had beenobserved after the adoption of exible exchange rates in the early1970s and were typically attributed to irrational speculationcould be interpreted instead as the result of arbitrage by specula-tors with rational expectations in an economy with a slowlyadjusting price level The lesson was more general nominalrigidities in some markets led to more volatility in others here inthe foreign exchange market

But as the early models were improved in many dimensionsthe treatment of imperfections remained surprisingly casual Themost obvious example was the treatment of wage adjustment inthe labor market In early models the assumption was typicallythat the nominal wage was xed and that the demand for laborthen determined the outcome Later on these assumptions werereplaced by a Phillips curve specication linking ination tounemployment But there was surprisingly little work on whatexactly lay behind the Phillips curve why and how wages were setthis way and why there was little apparent relation between realwages and the level of employment As a result most macro

9 A semantic clarication following tradition I shall refer to lsquolsquoimperfectionsrsquorsquoas deviations from the standard perfect competition model Admittedly there ismore than just a semantic convention here Why give such status to such an utterlyunrealistic model The answer is because most current research is organized interms of what happens when one relaxes one or more assumptions in that modelThis may change one day But for the time being this approach provides acommon research strategy and makes for easier communication among macroeco-nomic researchers


models developed in the 1960s and 1970s had a schizophrenicfeeling a careful modeling of consumption investment and assetdemand decisions on the one hand and an atheoretical specica-tion of price and wage setting on the other

The only systematic theoretical attempt to explore the impli-cations of nominal rigidities the lsquolsquoxed price equilibriumrsquorsquo ap-proach developed in the 1970s turned out to be a dead end Thiswas for reasons intrinsic to the macroeconomic approach at thetime and so it is worth looking at the episode more closely

The approach was based on the insights of Clower andPatinkin and a systematic treatment was given by Barro andGrossman [1976] The strategy was to assume a competitiveeconomy to allow the vector of prices to differ from the exibleprice equilibrium vector and then to characterize the determina-tion of output under these conditions Equilibrium in each marketwas assumed equal to the minimum of supply and demand Thecomplexity and the richness of the analysis came from the factthat if people or rms were on the short side in one market theythen modied their supply and demand functions in other markets

The results were tantalizing The analysis showed that if theprice vector was such as to yield a state of generalized excesssupply (in both goods and labor markets) the economy behavedvery much as in the Keynesian model Firms constrained in thegoods market employed only as many workers as they needed thedemand for labor was determined by output and was independentof the real wage Workers constrained in the labor market tookemployment and labor income as given in taking consumptiondecisions The economy exhibited a demand multiplier increasesin demand led to more production more income more demandand so on

This was clearly good news for the prevailing view of uctua-tions But the same approach showed that if the price vector wassuch as to yield instead a state of generalized excess demandthings looked very different indeed much more like what one sawin the Soviet Union at the time than in market economies themultiplier was a supply multiplier The inability to buy goods ledpeople to cut down on their labor supply decreasing outputleading to even more rationing in the goods market and so on Anincrease in government spending led to more rationing of consum-ers a decrease in labor supply and a decrease in output

This raised an obvious issue without a theory of why priceswere not right in the rst place the second outcome appeared just


as likely as the rst So why was it that we typically observed therst outcome and not the second The answer clearly required atheory of price setting and so the explicit introduction of pricesetters (so that somebody other than the auctioneer was incharge) But if there were explicit price setters there was then noparticular reason why the market outcome should be equal to theminimum of supply and demand For example if price setterswere monopolistic rms and demand turned out larger than theyexpected then they might well want to satisfy this higher level ofdemand at least as long as their price exceeded marginal cost Soto make progress one had to think hard about market structureand who the price setters were But such focus on marketstructure and on imperfections more generally was altogetherabsent from macroeconomics at the time10

At roughly the same time (circa 1975) this intellectual crisiswas made worse by another development the collapse of tradi-tional conclusions when rational expectations were introduced inotherwise standard Keynesian models Working within the stan-dard model at the time (an IS-LM model plus an expectations-augmented Phillips curve) Sargent [1973] showed that if oneassumed rational expectations of ination the effects of money onoutput lasted only for a brief moment until the relevant informa-tion about money was released So even on its own terms oncerational expectations were introduced the standard model seemedunable to deliver its traditional conclusions (such as for examplelasting effects of money on output)

Thus by the end of the 1970s macroeconomics faced a seriouscrisis The reaction of researchers was to follow two initially verydifferent routes

The rst followed by the lsquolsquoNew Keynesiansrsquorsquo was based on thebelief that the traditional conclusions were indeed largely rightand that what was needed was a deeper look at imperfections andtheir implications for macroeconomics

The second followed by the lsquolsquoNew Classicalsrsquorsquo or lsquolsquoReal Busi-ness Cyclersquorsquo theorists was instead to question the traditionalconclusions and explore how far one could go in explaininguctuations without introducing imperfections [Prescott 1986]

At the time macroeconomics looked (and felt) more dividedthan ever before (the intensity of the debate is well reected in

10 As it was absent from general equilibrium theory leading economistsworking on stability and formalizations of real time tatonnement processes intosimilar dead ends


Lucas and Sargent [1978]) Yet nearly twenty years later the tworoutes have surprisingly converged The methodological contribu-tions of the Real Business Cycle approach namely the develop-ment of stochastic dynamic general equilibrium models haveproved important and have been widely adopted But the initialpropositions that money did not matter that technological shockscould explain uctuations and that imperfections were not neededto explain uctuations have not held up The empirical evidencecontinues to strongly support the notion that monetary policyaffects output And the idea of large high frequency movementsin the aggregate production function remains an implausibleblack box the relation between output and productivity appearsmore likely to reect reverse causality with movements in outputleading to movements in measured total factor productivityrather than the other way around

For those reasons most if not all current models in eitherthe New Keynesian or the New Classical mode (these two labelswill soon join others in the trash bin of history of thought) nowexamine the implications of imperfections be it in labor goods orcredit markets This is the body of work to which I now turn

III POST-1980 I WORKING OUT THE QUANTITY THEORY

In discussing the role of imperfections in macroeconomics itis useful to divide the set of questions into two

c The old Quantity Theory questions Why does money affectoutput What are the origin and the role of nominalrigidities in the process These may be the central ques-tions of macroeconomics not because shifts in money arethe major determinant of uctuations (they are not) butbecause the nonneutrality of money is so obviously at oddswith the predictions of the benchmark exible pricemodel

c The old Business Cycle questions What are the majorshocks that affect output What are their propagationmechanisms What is the role of imperfections in thatcontext

This section focuses on the rst set of questions the next onthe second

Most macroeconomists would I believe agree today on the


following description of what happens in response to an exogenousincrease in nominal money11

c Given the price level an increase in nominal money leadsto an increase in the aggregate demand for goods At givennominal pricesmdashand so at given relative pricesmdashthis trans-lates into an increase in the demand for each good (lsquolsquoPricesrsquorsquois used generically here I do not distinguish betweenwages and prices)

c Increasing marginal costdisutility implies that this in-crease in the demand for each good leads each price setterto want to increase his price relative to others

c If all individual prices were set continuously the attemptby each price setter to increase his price relative to otherswould clearly fail All prices and by implication the pricelevel would rise until the price level had adjusted inproportion to the increase in nominal money demand andoutput were back to their original level and there was nolonger any pressure to increase relative prices This wouldhappen instantaneously Money would be neutral even inthe short run

c Individual prices however are adjusted discretely ratherthan continuously and not all prices are adjusted at thesame time This discrete staggered adjustment of indi-vidual prices leads to a slow adjustment of the averagelevel of pricesmdashthe price level12

c During the process of adjustment of the price level the realmoney stock remains higher and aggregate demand andoutput remain higher than their original value Eventuallythe price level adjusts in proportion to the increase innominal money Demand output and relative prices re-turn to their original value Money is neutral but only inthe long run

This story feels simple and natural Indeed it is not verydifferent from the account given by the quantity theorists of thenineteenth century What the recent research has done has been

11 Most but not all While other explanations for example based ondistribution (lsquolsquolimited participationrsquorsquo) effects of open market operations have untilnow turned out to be dead ends a number of macroeconomists remain skeptical ofnominal rigidities as the source of the real effects of money

12 An earlier hypothesis for slow adjustment of individual prices developedby Lucas [1973] and based on incomplete information rather than staggering hasbeen largely abandoned It is perceived to rely on implausible assumptions aboutthe structure of information on macroeconomic aggregates


to clarify various parts of the argument and to point to a numberof unresolved issues

III1 Staggering and the Adjustment of the Price Level

A tempting analogy to the proposition that staggered adjust-ment of individual prices leads to a slow price level adjustment isto the movements of a chain gang Unless gang members cancoordinate their movements very precisely the chain gang willrun slowly at best The shorter the length of the chain betweentwo gang members or the larger the number of members in thegang the more slowly it is likely to run

Research on the aggregate implications of specic price rulesand staggering structures has shown that the analogy is typicallyright In most cases discrete adjustment of individual pricesindeed leads to a slow adjustment of the price level13 And themore each desired price depends on other prices the slower theadjustment But this research has also come with a number ofwarnings In a celebrated counterexample to the general proposi-tion Caplin and Spulber [1987] have shown that under someconditions the reverse proposition may in fact hold discreteadjustment of individual prices may still lead to a completelyexible price level14 The conditions under which their conclusionholds are more likely to be satised at high ination and this hasan important implication the effects of money on output are likelyto be shorter the higher the average rate of money growth and theassociated rate of ination

III2 Real and Nominal Rigidities

If individual price changes are staggered the price level willincrease only if at least some individual price setters want toincrease their relative price Once the price level has fullyadjusted to the increase in money and demand and output areback to their original level desired relative prices end up the sameas they were before the increase in money but this is true only inthe end

This observation has one important implication the speed ofadjustment of the price level depends on the elasticity of desired

13 The most inuential model here is surely Taylor [1980] See Taylor [1998]for a recent survey

14 Their result requires two conditions that prices be changed according toan Ss rule and that each desired nominal price be a nondecreasing function oftime Caplin and Leahy [1991] show what happens when only the rst conditionholds Money is then typically nonneutral


relative prices in response to shifts in demand The higher thiselasticity the more each individual price setter will want toincrease his price when he adjusts the faster the price level willincrease and the shorter will be the effects of money on outputResearch suggests that to generate the slow adjustment of theprice level one observes in the data this elasticity must indeed besmall smaller than one would expect if for example the price setby rms reected the increase in marginal cost for rms and thewage reected the increase in the marginal disutility of work forworkers15

This proposition is sometimes stated as follows lsquolsquoReal rigidi-tiesrsquorsquo (a small elasticity of the desired relative price to shifts indemand) are needed to generate substantial lsquolsquonominal rigidityrsquorsquo (aslow adjustment of the price level in response to changes inmoney) The terminology may be infelicitous but the conclusion isan important one and points to an interaction between nominalrigidities and other imperfections If these other imperfections aresuch as to generate real rigidities (a big if) they can help explainthe degree of nominal rigidity we appear to observe in moderneconomies

III3 Demand versus Output

Suppose that the price level responds slowly so an increase inmoney leads to an increase in the demand for goods for some timeIn the absence of further information on the structure in goodsand labor markets there is no warranty that this increase indemand will lead to an increase in output It will do so only ifsuppliers of both labor and goods are willing to supply more Thiswas indeed the main unresolved issue in the xed price equilib-rium approach For increases in demand to translate into in-creases in output the market structure must be such that theprice setters are willing to supply more even at the existing price

There are market structures where this will be the caseSuppose for example that the goods markets is composed ofmonopolistically competitive price setters At the initial equilib-rium monopoly power implies that their price is above theirmarginal cost This implies in turn that even at an unchangedprice they will be willing to satisfy an increase in demand at leastas long as marginal cost remains smaller than the price So under

15 See Blanchard and Fischer [1989 Chapter 8] and Chari Kehoe andMcGrattan [1998] for a recent discussion


this market structure shifts in demand so long as they are not toolarge will lead to an increase in output

For this reason a typical assumption in recent research hasbeen one of monopolistic competition In the goods market theassumption that price setters have some monopoly power and somay be willing to increase output in response to a shift in demandseems indeed reasonable The assumption of monopolistic compe-tition in the labor market is clearly much less appealing and thequestion of whether the same conclusion will derive from morerealistic descriptions of wage setting remains open More gener-ally this points to yet another interaction between nominalrigidities and other imperfections To understand why output andemployment respond to shifts in demand we need a betterunderstanding of the structure of both goods and labor markets

III4 Money as Numeraire and Medium of Exchange

The argument underlying nonneutrality relies on two proper-ties of money money as the medium of exchange and money as thenumeraire

Staggering of individual price changes delivers slow adjust-ment of the average price of goods in terms of the numeraire If inaddition the numeraire is also the medium of exchangemdashwhich itneed not be as a matter of logic but typically ismdashslow adjustmentof the average price of goods in terms of the numeraire means slowadjustment of the average price of goods in terms of the medium ofexchange It is these two features which when combined implythat changes in the stock of nominal money lead to changes in thevalue of the stock of money in terms of goods leading in turn tomovements in the interest rate the demand for goods and output

This coincidence is crucial to the story It suggests thatdelinking the numeraire and the medium of exchange would leadto very different effects of changes in nominal moneymdashand moregenerally of shifts in the demand for goodsmdashon output Put morestrongly it might change the nature of short-run uctuations Theidea of having a numeraire separate from the medium of exchangeis an old idea in macroeconomics an idea explored by IrvingFisher in particular But despite some recent work (for exampleShiller [1999]) we still lack a good understanding of whatmacroeconomic implications and by implication what potentialbenets could come from such a separation

The set of results I have described above is sometimes called


the lsquolsquomenu costsrsquorsquo explanation of the short-run nonneutrality ofmoney16 The expression correctly captures the notion that smallindividual costs of changing prices can have large macroeconomiceffects At the same time the expression may have been a publicrelations disaster It makes the explanation for the effects ofmoney on output look accidental when in fact the effects appear tobe intrinsic to the workings of an economy with decentralizedprice and wage setting In any economy with decentralized priceand wage setting adjustment of the general level of prices interms of the numeraire is likely to be slow relative to a (ctional)economy with an auctioneer

IV POST-1980 II THE ROLE OF OTHER IMPERFECTIONS

Leaving aside nominal rigidities there are three main rea-sons why macroeconomists working on uctuations should careabout imperfections17

c Imperfections lead to very different efficiency and welfarecharacteristics of the equilibrium and thus modify the waywe think about uctuations and the role of policy Forexample think of the question of whether the equilibriumrate of unemployment is too high or too low and itsimplications for macroeconomic policy18

c Imperfections may lead to very different propagation mecha-nisms of shocks For example think of the role of theinteractions of nominal and real rigidities in determiningthe persistence of changes in money on output that Idiscussed in the previous section

c Imperfections may lead to new sources of shocks Forexample think of bank runs which may affect not only thesupply of money but also the functioning of the nancialintermediation system leading to long-lasting effects onoutput

These are the motivations behind the research on imperfec-tions and macroeconomics which has developed in the last twenty

16 See in particular Mankiw [1985] and Akerlof and Yellen [1985]17 The arguments would be even stronger if the focus of this article were

extended to cover growth Much of the recent progress in growth theory has comefrom looking at the role of imperfections and institutions (externalities from RampDand patent laws bankruptcies and bankruptcy laws restrictions to entry by newrms institutions governing corporate governance etc) in growth

18 For example the implications for monetary policy emphasized by Barroand Gordon [1983]


years or so As I indicated in the introduction this phase is stillvery much one of exploration The thousand owers are stillblooming and it is not clear what integrated macroeconomicmodel will emerge if any Let me describe four major lines alongwhich substantial progress has already been made

IV1 Unemployment and the Labor Market

The notion that the labor market was somehow special wasreected in early Keynesian models by the crude assumptionsthat the nominal wage was given and employment was deter-mined by the demand for labor It was reected in the confuseddebates about whether unemployment was involuntary or volun-tary It was reected by the continuing use of an ad hoc formaliza-tion of wage behaviormdashthe Phillips curvemdasheven in theoreticalmodels It was reected by the unease with which the neoclassicalformulation of labor supply developed by Lucas and Rapping[1969] with its focus on intertemporal substitution was receivedby most macroeconomists

For a long time the basic obstacle was simply how to think ofa market where even in equilibrium there were some unsatisedsellersmdashthere was unemployment The basic answer was given inthe early 1970s in a set of contributions to a volume edited byPhelps [1970] one should think of the labor market as a decentral-ized market in which there were workers looking for jobs andrms looking for workers In such a market there would alwaysbe even in equilibrium both some unemployment and somevacancies

Research started in earnest in the 1980s based on a numberof theoretical contributions to search and bargaining in decentral-ized markets in particular by Diamond [1982] Mortensen [1982]and Pissarides [1985] The conceptual structure that has emergedis known as the ow approach to the labor market19

c The labor market is a decentralized marketAt any point intime because of shifts in the relative demand for goods orchanges in technology or because a rm and a worker nolonger get along a number of employment relations areterminated and a number of new employment relationsare startedThe workers who separate from rms because they quit or

19 For recent surveys see Pissarides [1999] or Mortensen and Pissarides[1998]


are laid off look for new jobs The rms which need to llnew jobs or replace the workers who have left look forworkers At any point in time there are both workerslooking for jobsmdashunemploymentmdashand rms looking forworkersmdashvacancies

c When a worker and a rm meet and conclude that thematch seems right there is typically room for bargainingThe wage is then likely to depend on labor market condi-tions If unemployment is high and vacancies are low therm knows it will be able to nd another worker easily andthe worker knows it will be hard to nd another job This islikely to translate into a low wage If unemployment is lowand vacancies are high the wage will be high

c The level of the wage in turn affects the evolution of bothvacancies and unemployment A high wage means moreterminations less starts and so a decrease in vacanciesand an increase in unemployment Conversely a low wageleads to an increase in vacancies and a decrease in unem-ployment Given these dynamics the economy typicallyconverges to a set of equilibrium values for unemploymentand vacancies One can then think of the natural rate ofunemployment as the value to which the unemploymentrate convergesIt is clear that in such an economy there should be andalways will be some unemployment (and some vacancies)Operating the economy at very low unemployment wouldbe very inefficient But the equilibrium level of unemploy-ment typically has no claim to being the efficient level Theequilibrium level and its relation to the efficient leveldepend on the nature of the process of search and match-ing as well as on the nature of bargaining between workersand rms

One way of assessing progress is to go back to a famous quoteby Friedman [1968] about the natural rate of unemployment

The natural rate of unemployment is the level which would beground out by the Walrasian system of general equilibriumequations provided that there is imbedded in them the actualstructural characteristics of the labor and commodity marketsincluding market imperfections stochastic variability in demandsand supplies the cost of gathering information about job vacanciesand labor availabilities the costs of mobility and so on


What we have done is to go from this quote to a formalframework in which the role of each of these factors (and manyothers) can be understood and then taken to the data20 Today wehave a much better sense of the role and the determinants of jobcreation and job destruction of quits and layoffs of the nature ofthe matching process between rms and workers of the effects oflabor market institutions from unemployment benets to employ-ment protection on unemployment This line of research hasshown for example how higher employment protection leads tolower ows in the labor market but also to longer unemploymentduration Lower ows and longer duration unambiguously changethe nature of unemployment But because in steady stateunemployment is the product of ows times duration togetherthey have an ambiguous effect on the unemployment rate itselfBoth the unambiguous effects on ows and duration are indeedclearly visible when looking across countries with different de-grees of employment protection

Many extensions of this framework have been exploredWhile the basic approach focuses on the implications of thespecicity of the product being transacted (labor services by aparticular worker to a particular rm) and the room for bargain-ing that this creates a number of contributions have focused onother dimensions such as the complexity of the product beingtransacted and the information problems this raises For ex-ample how much effort a worker puts into his job can be hard for arm to monitor If the rm just paid this worker his reservationwage he would not care about being found shirking and beingred One way the rm can induce him not to shirk is by payinghim a wage higher than his reservation wage so as to increase theopportunity cost of being found shirking and being red Thisparticular effect has been the focus of an inuential paper byShapiro and Stiglitz [1984] who have shown that even absentissues of matching the implication would be positive equilibriumunemployment As they have argued in this case equilibriumunemployment plays the role of a (macroeconomic) lsquolsquodisciplinedevicersquorsquo to induce effort on the part of workers

So far however our improved understanding of the determi-nants of the natural rate of unemployment has not translated intoa much better understanding of the dynamic relation betweenwages and labor market conditions In other words we have not

20 For a more detailed assessment see Blanchard and Katz [1997]


made much progress since the Phillips curve In particularcurrent theoretical models appear to imply a stronger and fasteradjustment of wages to labor market conditions than is the case inthe data One reason may be the insufficient attention paid to yetanother dimension of labor transactions namely that they typi-cally are not spot transactions but rather long-term relationsbetween workers and rms Long-term relations often allow forbetter outcomes for reasons emphasized by the theory of repeatedgames For example they may allow the wage to play less of anallocational role and more of a distributional or insurance role21

There may lie one of the keys to explaining observed wagebehavior That rms might want to develop a reputation for goodbehavior and by so doing achieve a more efficient outcome isindeed one of the themes of the research on lsquolsquoefficiency wagesrsquorsquo Butafter much work in the 1980s this direction of research hastapered off without the emergence of a clear picture or anintegrated view22 This is a direction in which more work is clearlyneeded

IV2 Saving Investment and Credit

Issues of nancial intermediation from lsquolsquocredit crunchesrsquorsquo tolsquolsquoliquidity scramblesrsquorsquo gured heavily in the early accounts ofuctuations23 With the introduction of the IS-LM the focusshifted away Issues of nancial intermediation were altogetherabsent from the IS-LM model and most of its descendants Thetreatment of nancial intermediation in larger models was oftenschizophrenic asset markets were typically formalized as competi-tive markets with a set of arbitrage relations determining theterm structure of interest rates and stock prices Among nancialintermediaries typically only banks because of their relevance tothe determination of the money supply were treated explicitlyCredit problems were dealt with implicitly by allowing for thepresence of current cash ow in investment decisions and ofcurrent income in consumption decisions24 One can therefore seerecent research as returning to old themes but with better tools(asymmetric information) and greater clarity

21 See for example Espinosa and Rhee [1989]22 For a survey of work up to 1986 see Katz [1986]23 See for example the 1949 survey by McKean24 A notable exception here is the work by Eckstein and Sinai (summarized

in Eckstein and Sinai [1986] and reected in the DRI model) With its focus onbalance sheets of rms and intermediaries it was surprisingly at odds with thelanguage and the other models of the time But many of its themes have come backinto fashion since


The starting point when thinking about credit must be thephysical separation between borrowers and lenders Lendingmeans giving funds today in anticipation of receiving funds in thefuture Between now and then many things can go wrong Thefunds may not be invested but squandered They may be investedin the wrong project They may be invested but not paid backThis leads potential lenders to put limits on how much they arewilling to lend and to ask borrowers to put some of their ownfunds at risk How much borrowers can borrow therefore dependson how much cash or marketable assets they have to start withand on how much collateral they can put inmdashincluding thecollateral associated with the new project

This fact alone has a number of implications for macroeco-nomic uctuations

c The distribution of income and marketable wealth betweenborrowers and lenders matters very much for investment

c The expected future matters less the past and the presentmdashthrough their effect on the accumulation of marketableassets by rmsmdashmatter more for investment Transitoryshocks to the extent that they affect the amount ofmarketable assets can have lasting effects Higher protstoday lead to a higher cash ow today and thus moreinvestment today and more output in the future a mecha-nism emphasized by Bernanke and Gertler [1989]

c Asset values play a different role than they do in theabsence of credit problems Shocks that affect the value ofmarketable assets can affect investment even when they donot have a direct effect on future protabilitymdasha channelexplored for example by Kiyotaki and Moore [1997]

In such a world the importance of having marketable assetsleads in turn to a demand for marketable or lsquolsquoliquidrsquorsquo assets byconsumers and rms Because consumers nd it hard either toinsure against idiosyncratic income shocks or to borrow againstfuture labor income consumers save as a precaution againstadverse shocks [Carroll 1997 Deaton 1992] Here theoretical andempirical research on saving has made clear that both life-cycleand precautionary motives play an important role in explainingsaving behavior Similar considerations apply to rms Becauserms may need funds to start a new project or to continue with anexisting project they also have a demand for marketable assets ademand for liquidity A new set of general equilibrium questions


arises will the economy provide such marketable assets Can thegovernment for example improve things by issuing such liquidinstruments as T-bills25

In such a world also there is clearly scope for nancialintermediaries to alleviate information and monitoring problemsBut their presence raises a new set of issues To have the rightincentives nancial intermediaries may need to have some oftheir own funds at stake Thus not only the marketable assets ofultimate borrowers but also the marketable assets of intermediar-ies matter Shocks in one part of the economy that decrease thevalue of their marketable assets can force intermediaries toreduce lending to the rest of the economy resulting in a creditcrunch [Holmstrom and Tirole 1997] And to the extent thatnancial intermediaries pool funds from many lenders coordina-tion problems may arise An important contribution along theselines is the clarication by Diamond and Dybvig [1983] of thenature and the necessary conditions for bank runs

Because some of their liabilities are money banks play aspecial role among nancial intermediaries In that light recentresearch has looked at and claried an old question namelywhether monetary policy works only through interest rates (thestandard lsquolsquomoney channelrsquorsquo) or also by affecting the amount ofbank loans and cutting credit to some borrowers who do not haveaccess to other sources of funds (the lsquolsquobank lendingrsquorsquo channel)26

The tentative answer at this point the credit channel probablyplayed a central role earlier in time especially during the GreatDepression But because of changes in the nancial system itsimportance may now be fading

Research on credit is one of the most active lines of researchtoday in macroeconomics Much progress has already been madeThis is already reected for example in the (ex post) analyses ofthe Asian crisis and in the analysis of the problems of nancialintermediation in Eastern Europe

Let me turn to the two remaining themes I shall be moresuccinct because less progress has been made in the rst casebecause the evidence remains elusive and in the second becausemuch remains to be done

25 See for example Holmstrom and Tirole [1998]26 Bernanke and Gertler [1995] give a general discussion of the way credit

market imperfections can modify the effects of monetary policy on output


IV3 Increasing Returns

The potential relevance of increasing returns to uctuationsis another old theme in macroeconomicsThe argument is straight-forward

c If increasing returns to scale are sufficient to offset theshort-run xity of some factors of production such ascapital short-run marginal cost may be constant or evendecreasing with output Firms may be willing to supplymore goods at roughly the same price leading to longerlasting and larger effects of shifts in aggregate demand onoutput (a version of the interaction between nominal andreal rigidities discussed earlier)

c Indeed if returns are increasing enough the economy mayhave multiple equilibria a low-efficiency low-output equi-librium and a high-efficiency high-output equilibriumMany examples of such multiple equilibria have beenworked out Some have been based on increasing returns inproduction [Kiyotaki 1988] and others on increasing re-turns in exchange [Diamond 1982a]

A related line of research has focused on countercyclicalmarkups (of price over marginal cost) Just like increasingreturns countercyclical markups may explain why rms arewilling to supply more output at roughly the same price Likeincreasing returns countercyclical markups imply that theeconomy may operate more efficiently at higher output in thiscase not because productivity is higher but because distortions(the gap between price and marginal cost) are lower A number ofmodels of markups based on imperfect competition have beendeveloped some indeed predicting countercyclical markups (forexample Rotemberg and Woodford [1991]) others howeverpredicting procyclical markups [Phelps 1992]

Turning to the empirical research gives the same feeling ofambiguity It appears to be true that in response to exogenousshifts in demand rms are willing to supply more at nearly thesame price (for example Shea [1993]) How much is due to atmarginal cost or to countercyclical markups is still unclearCountercyclical markups indeed appear to play a role (for ex-ample Bils [1987]) But the source of such countercyclicality(nominal rigidities lags in the adjustment of prices to costchanges in the desired or in the sustainable markup if the markupis thought to result from a game among oligopolistic rms)remains to be established For the time being the possibility of


multiple equilibria due to either increasing returns or countercy-clical markups remains an intriguing but unproven hypothesis

IV4 Expectations as Driving Forces

This last theme movements in expectations as an importantsource of uctuations is once again an old one It was a dominanttheme of pre-1940 macroeconomics It was a major theme inKeynes and beyond But with the introduction of rationalexpectations in the 1970s expectations became fully endogenousand the theme was lost

To most macroeconomists rational expectations is the rightbenchmark But this only means that the burden of proof is onthose who insist on the presence of deviations from rationalexpectations on their relevance for asset prices and in turn foroutput uctuations This is indeed where a lot of research onlsquolsquobehavioral nancersquorsquo has recently taken place

Research has taken place along two fronts27 The rst haslooked at the way people form expectations A substantial body ofempiricalmdashoften experimentalmdashevidence has documented thatmost people form their expectations in ways which are notconsistent with the economistsrsquo denition of full rationality forexample in ways inconsistent with Bayesrsquo rule Some sequences ofrealizations are more lsquolsquosalientrsquorsquo than others and have more effecton expectations than they should For example there is someevidence that a sequence of positive past returns leads people torevise expectations of future returns more than they should Thisappears potentially relevant in thinking about phenomena suchas fads or bubbles in asset markets

For deviations from rationality by some investors to lead todeviations of asset values from fundamentals another conditionmust be satised there must be only limited arbitrage by theother investors This is the second front on which research hasadvanced The arguments it has made are simple ones First therequired arbitrage is typically not riskless what position do youtake if you believe the stock market is overvalued by x percentSecond professional arbitrageurs do not have unlimited fundsThis opens the same issues as those we discussed earlier whendiscussing credit Asymmetric information implies a limit on how

27 For a review see Shleifer [2000]


much these arbitrageurs can borrow and thus on how much theycan arbitrage incorrect asset prices28

Empirical research has shown that this line of research canaccount for a number of apparent puzzles in asset markets Butother explanations not based on such imperfections may alsoaccount for these facts At this stage the question is far fromsettled At issue is a central question of macroeconomics the roleof expectations of bubbles and fads as driving forces for at leastsome macroeconomic uctuations

V MACRO IN THE (NEAR) FUTURE

Let me briey restate the thread of my argument Relative toWicksell and Fisher macroeconomics today is solidly grounded ina general equilibrium structure Modern models characterize theeconomy as being in temporary equilibrium given the implica-tions of the past and the anticipations of the future They providean interpretation of uctuations as the result of shocks workingtheir way through propagation mechanisms Much of the currentwork is focused on the role of imperfections

What happens next Predicting the evolution of research isvery much like predicting the stock market Like nancial arbi-trage intellectual arbitrage is not perfect but it is close Let menevertheless raise a number of questions and make a few guesses

Which imperfections Part of the reason current researchoften feels confusing comes from the diversity of imperfectionsinvoked in explaining this or that market To caricature but onlyslightly research on labor markets focuses on decentralizationand bargaining research on credit markets focuses on asymmet-ric information research on goods markets on increasing returnsresearch on nancial markets on psychology

To some extent the differences in focus must be right Theproblems involved in spot transactions are different from thoseinvolved in intertemporal ones the problems involved in one-timetransactions are different from those involved in repeated transac-tions and so on Still if for no other than aesthetic reasons onemay hope for an integrated macro model based on only a few

28 One of the small victories of this line of research has been the descriptionof an LTCM-type crisis before it happened In 1997 Shleifer and Vishny arguedthat it was precisely at the time when asset prices deviated most from fundamen-tals that arbitrageurs might be least able to get the external funds they needed toarbitrage and may need to liquidate their positions making things worse This iswhat happened one year later at LTCM


central imperfections (say those that give rise to nominal rigidi-ties and one or two others)

There indeed exists a few attempts to provide such anintegrated view One is by Phelps in lsquolsquoStructural Slumpsrsquorsquo [1994]which is based on implications of asymmetric information in goodsand labor markets Another is by Caballero and Hammour (forexample [1996]) based on the idea that most relations either incredit or in labor markets require some relation-specic invest-ment and therefore open room for holdups ex post These areimportant contributions but I see them more as the prototypecars presented in car shows but never mass produced later theyshow what can be done but they are probably not exactly whatwill be

Policy and welfare One striking implication of recent modelsis how much more complex the welfare implications of policy areTo take one example in a model with monopolistic competition(small) increases in output due to the interaction of money andnominal rigidities improve welfare to a rst order This is becauseinitially marginal cost is below the price and the increase inoutput reduces the wedge between the two Under other distor-tions the effects of output uctuations on efficiency and welfarecan be much more complex For example recent research hasrevisited the question of whether recessions lsquolsquocleansersquorsquo theeconomymdashby eliminating rms that should have been closedanywaymdashor weaken itmdashby destroying perfectly good rms Theanswer so far is both in proportions that depend on the precisenature of imperfections in labor and credit markets This clearlyhas implications for how one views uctuations29

The medium run There has been a traditional conceptualdivision in macroeconomics between the short runmdashthe study ofbusiness cyclesmdashand the long runmdashthe study of growth30 A betterdivision might actually be between the short run the mediumrun and the long run Phenomena such as the long period of highunemployment in Europe in the last 25 years or the behavior ofoutput during the transition in Eastern Europe do not t easilyinto either business cycles or growth They appear to involvedifferent shocks from those generating business cyclemdashchanges inthe pace or the nature of technological progress demographicevolutions or in the case of Eastern Europe dramatic changes in

29 See for example Caballero and Hammour [1999]30 More than the rest of this essay this reects my views rather than some

assessmentof the consensus See for example Blanchard [1997]


institutions They also appear to involve different imperfectionsmdashwith imperfections in labor credit and goods markets rather thannominal rigidities playing the dominant rolemdashthan businesscycles

Research on imperfections has allowed us to make substan-tial progress here Our understanding of the evolution of Euro-pean unemployment for example is still far from good but it ismuch better than it was ten or twenty years ago

Macroeconomics and institutions The presence of imperfec-tions typically leads to the emergence of institutions designedmore or less successfully to correct them Examples range fromantitrust legislation to rules protecting minority shareholders tounemployment insurance Which institutions emerge is clearlyimportant in understanding medium-run evolutions Think of therole of labor market institutions in explaining European unemploy-ment the role of legal structures in explaining the evolution ofoutput in transition economies Institutions also matter for short-run uctuations with different institutions leading to differentshocks and propagation mechanisms across countries For ex-ample a recent paper by Johnson et al [1999] argues that duringthe recent Asian crisis those Asian countries that had theweakest governance institutions (such as poor protection ofminority shareholders) were also those that suffered the largestexchange rate declines Identifying the role of differences ininstitutions in generating differences in macroeconomic short-and medium-run evolutions is likely to be an important topic ofresearch in the future

Current debates In the early 1980s macroeconomic researchseemed divided into two camps with sharp ideological andmethodological differences Real business cycle theorists arguedthat uctuations could be explained by a fully competitive modelwith technological shocks New Keynesians argued that imperfec-tions were of the essence Real business cycle theorists used fullyspecied general equilibrium models based on equilibrium andoptimization under uncertainty New Keynesians used smallmodels capturing what they saw as the essence of their argu-ments without the paraphernalia of fully specied models

Today the ideological divide is gone Not in the sense thatunderlying ideological differences are gone but in the sense thattrying to organize recent contributions along ideological lineswould not work well As I argued earlier most macroeconomicresearch today focuses on the macroeconomic implications of some


imperfection or another At the frontier of macroeconomic re-search the eld is surprisingly a-ideological

The methodological divide is narrower than it was but it isstill present Can macroeconomists use small models such as theIS-LM model or the Taylor modelmdashthe model of aggregate de-mand and supply with wage staggering developed by John TaylorOr should they use only fully specied dynamic general equilib-rium models now that such models can be solved numerically31

Put in these terms it is obvious that this is an incorrectly frameddebate Intuition is often obtained by playing with small modelsLarge explicit models then allow for further checking and ren-ing Small models then allow conveying of the essence of theargument to others At this stage I believe that small models areindeed underused and undertaught32 Small back-of-the enve-lope models are much too useful to disappear and I expect thatmethodological divide will also fade away

One way to end is to ask of how much use was macroeconomicresearch in understanding for example and helping resolve theAsian crisis of the late 1990s

Macroeconomists did not predict either the time place orscope of the crisis Previous exchange rate crises had involvedeither scal misbehavior (as in Latin America) or steady realappreciation and large current account decits (as in Mexico)Neither scal policy nor given the very high rate of investmentthe current account position of Asian countries seemed particu-larly worrisome at the time33

So when the crisis started macroeconomic mistakes (such asscal tightening the right recommendation in previous crises butnot in this one) were made But fairly quickly the nature of thecrisis was better understood and the mistakes were correctedAnd most of the tools needed were there to analyze events andhelp the design of policy from micro-based models of bank runs tomodels of nancial intermediation to variations on the Mundell-Fleming model allowing for example for an effect of foreign-

31 This debate is about models used in research not about the appliedeconometric models used for forecasting or policy

32 Paul Krugman recently wondered how many macroeconomists stillbelieve in the IS-LM model The answer is probably that most do but many ofthem probably do not know it well enough to tell

33 A notable exception here is the work of Calvo (for example Calvo [1998])who before the crisis took place emphasized the potential for maturity mismatch(short-term foreign debt long-term domestic loans) to generate an exchange ratecrisis even absent scal or current account decits


currency-denominated debt on the balance sheet and in turn onthe behavior of rms and banks

Since then a large amount of further research has takenplace leading to a better understanding of the role of nancialintermediation in exchange rate crises Based on this researchproposals for better prudential regulation of nancial institu-tions for restrictions on some forms of capital ows for aredenition of the role of the IMF are being discussed A passinggrade for macroeconomics Given the complexity of the issues Ithink so But it is for the reader to judge

MASSACHUSETTS INSTITUTE OF TECHNOLOGY AND

NATIONAL BUREAU OF ECONOMIC RESEARCH

REFERENCES

Akerlof George and Janet Yellen lsquolsquoA Near-Rational Model of the Business Cyclewith Wage and Price Inertiarsquorsquo Quarterly Journal of Economics C (1985)823ndash838

Barro Robert and David Gordon lsquolsquoA Positive Theory of Monetary Policy in aNatural Rate Modelrsquorsquo Journal of Political Economy XC (1983) 589ndash610

Barro Robert and Herschel Grossman Money Employment and Ination(Cambridge UK Cambridge University Press 1976)

Bernanke Ben and Mark Gertler lsquolsquoAgency Costs Net Worth and BusinessFluctuationsrsquorsquo American Economic Review LXXIX (1989) 14ndash31

Bernanke Ben and Mark Gertler lsquolsquoInside the Black Box The Credit Channel ofMonetary Policy Transmissionrsquorsquo Journal of Economic Perspectives IX (1995)27ndash48

Bils Mark lsquolsquoThe Cyclical Behavior of Marginal Cost and Pricersquorsquo AmericanEconomic Review XXVII (1987) 838ndash855

Blanchard Olivier lsquolsquoThe Medium Runrsquorsquo Brookings Papers on Economic Activity 2(1997) 89ndash158

Blanchard Olivier and Stanley Fischer Lectures on Macroeconomics (CambridgeMA MIT Press 1989)

Blanchard Olivier and Lawrence Katz lsquolsquoWhat we Know and Do not Know aboutthe Natural rate of Unemploymentrsquorsquo Journal of Economic Perspectives XI(1997) 51ndash72

Caballero Ricardo and Mohamad Hammour lsquolsquoThe lsquoFundamental Transformationrsquoin Macroeconomicsrsquorsquo American Economic Review LXXXVI (1996) 181ndash186

Caballero Ricardo and Mohamad Hammour lsquolsquoThe Cost of Recessions Revisited AReverse-LiquidationistViewrsquorsquo mimeo MIT 1999

Calvo Guillermo lsquolsquoVarieties of Capital Market Crises in G Calvo and M Kingeds The Debt Burden and its Consequences for Monetary Policy Macmillan(London 1998)

Caplin Andrew and John Leahy lsquolsquoState-Dependent Pricing and the Dynamics ofMoney and Outputrsquorsquo Quarterly Journal of Economics CVI (1991) 683ndash708

Caplin Andrew and Dan Spulber lsquolsquoMenu Costs and the Neutrality of MoneyrsquorsquoQuarterly Journal of Economics CII (1987) 703ndash726

Carroll Christopher lsquolsquoBuffer-Stock Saving and the Life CyclePermanent IncomeHypothesisrsquorsquo Quarterly Journal of Economics CXII (1997) 1ndash56

Chari V V Patrick Kehoe and Ellen McGrattan lsquolsquoSticky Price Models of theBusiness Cycle Can the Contract Multiplier Solve the Persistence ProblemrsquorsquoFRB of Minneapolis staff paper No 217 1998

De Wolff Piet lsquolsquoIncome Elasticity of Demand a Micro-Economic and a Macro-economic Interpretationrsquorsquo Economic Journal LI (1941) 140ndash145


Deaton Angus Understanding Consumption (Oxford Oxford University Press1992)

Diamond Douglas and Philip Dybvig lsquolsquoBank Runs Deposit Insurance andLiquidityrsquorsquo Journal of Political Economy XCI (1983) 401ndash419

Diamond Peter lsquolsquoAggregate Demand Management in Search Equilibriumrsquorsquo Jour-nal of Political Economy XC (1982a) 881ndash894 lsquolsquoWage Determination and Efficiency in Search Equilibriumrsquorsquo Review ofEconomic Studies XCIX (1982b) 217ndash227

Dornbusch Rudiger lsquolsquoExpectations and Exchange Rate Dynamicsrsquorsquo Journal ofPolitical Economy LXXXIV (1976) 1161ndash1176

Eckstein Otto and Allen Sinai lsquolsquoThe Mechanisms of the Business Cycle in thePostwar Erarsquorsquo in The American Business Cycle Continuity and Change RGordon ed (Chicago NBER and the University of Chicago Press 1986) pp39ndash122

Espinosa Maria and Changyong Rhee lsquolsquoEfficient Wage Bargaining as a RepeatedGamersquorsquo Quarterly Journal of Economics CIV (1989) 565ndash588

Fisher Irving The Purchasing Power of Money (New York Macmillan 1911)Friedman Milton lsquolsquoThe Role of Monetary Policyrsquorsquo American Economic Review

LVIII (1968) 1ndash21Frisch Ragnar lsquolsquoPropagation Problemsand Impulse Problems in Dynamic Econom-

icsrsquorsquo in Readings in Business Cycles (New York Irwin 1965 rst published in1933) pp 155ndash185

Haberler Gottfried Prosperity and Depression A Theoretical Analysis of CyclicalMovements (Geneva League of Nations 1937)

Hall Robert lsquolsquoStochastic Implications of the Life-Cycle Permanent Income Hy-pothesis Theory and Evidencersquorsquo Journal of Political Economy LXXXVI(1978) 971ndash987

Hicks John lsquolsquoMr Keynes and the ClassicsA Suggested Interpretationrsquorsquo Economet-rica V (1937) 147ndash159 Value and Capital (Oxford Oxford University Press 1939)

Holmstrom Bengt and Jean Tirole lsquolsquoFinancial Intermediation Loanable Fundsand the Real Sectorrsquorsquo Quarterly Journal of Economics CXII (1997) 663ndash692

Holmstrom Bengt and Jean Tirole lsquolsquoPrivate and Public Supply of LiquidityrsquorsquoJournal of Political Economy CVI (1998) 1ndash40

Johnson Simon Peter Boone Alasdair Breach and Eric Friedman lsquolsquoCorporateGovernance in the Asian Financial Crisis 1997ndash1998rsquorsquo mimeo MassachusettsInstitute of Technology January 1999

Kahn R F lsquolsquoThe Relation of Home Investment to Unemploymentrsquorsquo EconomicJournal XLI (1931) 173ndash198

Katz Lawrence lsquolsquoEfficiency Wage TheoriesA Partial Evaluationrsquorsquo NBER Macroeco-nomics Annual (Cambridge MIT Press 1986) pp 235ndash276

Keynes John M The General Theory of Employment Interest and Money (NewYork Harcourt 1964 rst published 1936)

Kiyotaki Nobuhiro lsquolsquoMultiple Expectational Equilibria under Monopolistic Com-petitionrsquorsquo Quarterly Journal of Economics CII (1988) 695ndash714

Kiyotaki Nobuhiroand John Moore lsquolsquoCredit Cyclesrsquorsquo Journal of Political EconomyCV (1997) 211ndash248

Klein Lawrence lsquolsquoMacroeconomics and the Theory of Rational Behaviorrsquorsquo Econo-metrica XIV (1946) 93ndash108

Lucas Robert E lsquolsquoSome International Evidence on the Output-Ination Trade-offrsquorsquo American Economic Review LXIII (1973) 326ndash334 Models of Business Cycles (Oxford Basil Blackwell 1987)

Lucas Robert and Leonard Rapping lsquolsquoReal Wages Employment and InationrsquorsquoJournal of Political Economy LXXVII (1969) 721ndash754

Lucas Robert and Thomas Sargent lsquolsquoAfter Keynesian Economicsrsquorsquo in After thePhillips Curve Persistence of High Ination and High Unemployment (Bos-ton MA Federal Reserve Bank of Boston 1978)

Lucas Robert and Nancy Stokey Recursive Methods in Economic Dynamics(Cambridge MA Harvard University Press 1989)

Mankiw N Gregory lsquolsquoSmall Menu Costs and Large Business Cycles A Macroeco-nomic Modelrsquorsquo Quarterly Journal of Economics C (1985) 529ndash539

McKean Roland lsquolsquoLiquidity and a National Balance Sheetrsquorsquo Journal of PoliticalEconomy LVII (1949) 506ndash522


Metzler Lloyd lsquolsquoWealth Saving and the Rate of Interestrsquorsquo Journal of PoliticalEconomy LIX (1951) 93ndash116

Mitchell Wesley Business Cycles and Unemployment (New York National Bureauof Economic Research and McGraw-Hill 1923)

Modigliani Franco lsquolsquoLiquidity Preference and the Theory of Interest and MoneyrsquorsquoEconometrica XII (1944) 45ndash88

Modigliani Franco and Richard Brumberg lsquolsquoUtility Analysis and the Consump-tion Function An Interpretation of Cross-Section Datarsquorsquo in Post KeynesianEconomics K Kurihara ed (New Jersey Rutgers University Press 1954)pp 388ndash436

Mortensen Dale lsquolsquoThe Matching Process as a NoncooperativeBargaining GamersquorsquoThe Economics of Information and Uncertainty J J McCall ed (ChicagoUniversity of Chicago Press 1982) pp 233ndash254

Mortensen Dale and Christopher Pissarides lsquolsquoJob Reallocation EmploymentFluctuations and Unemploymentrsquorsquo Chapter 18 in Handbook of Macroeconom-ics John Taylor and Michael Woodford eds (Amsterdam Elsevier Science BV) pp 1171ndash1228

Obstfeld Maurice and Kenneth Rogoff Foundations of International Macroeconom-ics (Cambridge MA MIT Press 1996)

Patinkin Don Money Interest and Prices An Integration of Monetary and ValueTheory (New York Harper and Row 1965) rst edition 1956

PhelpsEdmund Microeconomic Foundations of Employment and Ination Theory(New York W W Norton 1970) lsquolsquoCustomer Demand and Equilibrium Unemployment in a Working Model ofthe Incentive-Wage Customer-Market EconomyrsquorsquoQuarterly Journal of Econom-ics CVII (1992) 1003ndash1033 Structural Slumps The Modern Equilibrium Theory of UnemploymentInterest and Assets (Cambridge MA Harvard University Press 1994)

PigouA C lsquolsquoReview of The General Theory of Employment Interest and Money byJ M Keynesrsquorsquo Economica III (1936) 115ndash132 Keynesrsquo General Theory A Retrospective View (London Macmillan 1950)

Pissarides Christopher lsquolsquoShort-Run Equilibrium Dynamics of UnemploymentVacancies and Real Wagesrsquorsquo American Economic Review LXXV (1985)676ndash690 Equilibrium Unemployment Theory second edition (Cambridge MIT Press2000)

Prescott Edward lsquolsquoTheory Ahead of Business Cycle Measurementrsquorsquo QuarterlyReview Minneapolis Fed (1986) 9ndash22

Ramsey Frank lsquolsquoA Mathematical Theory of Savingrsquorsquo Economic Journal XXXVIII(1928) 543ndash559

Rotemberg Julio and Michael Woodford lsquolsquoMarkups and the Business CyclersquorsquoNBER Macroeconomics Annual Olivier Blanchard and Stanley Fischer eds(Cambridge MIT Press 1991) pp 63ndash128

Samuelson Paul lsquolsquoInteractions between the MultiplierAnalysis and the Principleof Accelerationrsquorsquo Review of Economic Statistics XXI (1939) 75ndash78

Sargent Thomas lsquolsquoRational Expectations the Real Rate of Interest and theNatural Rate of Unemploymentrsquorsquo Brookings Papers on Economic Activity 2(1973) 429ndash472 Dynamic Macroeconomic Theory (Cambridge Harvard University Press1987)

Shapiro Carl and Joseph Stiglitz lsquolsquoEquilibrium Unemployment as a DisciplineDevicersquorsquo American Economic Review LXXIV (1984) 433ndash444

Shea John lsquolsquoDo Supply Curves Slope uprsquorsquo Quarterly Journal of Economics CVIII(1993) 1ndash32

Shiller Robert lsquolsquoDesigning Indexed Units of Accountrsquorsquo NBER Working Paper No7160 1999

Shleifer Andrei Inefficient Markets An Introduction to Behavioral FinanceClarendon Lecture Series (Oxford Oxford University Press 2000)

Shleifer Andrei and Robert Vishny lsquolsquoThe limits of Arbitragersquorsquo Journal of FinanceLIII (1997) 35ndash55

Snowdon Brian and Howard Vane Conversations with Leading EconomistsInterpreting Modern Macroeconomics (Cheltenham UK Edward Elgar 1999)


Taylor John lsquolsquoAggregate Dynamics and Staggered Contractsrsquorsquo Journal of PoliticalEconomy LXXXVIII (1980) 1ndash24 lsquolsquoStaggered Price and Wage Setting in Macroeconomicsrsquorsquo Chapter 15 inHandbook of Macroeconomics John Taylor and Michael Woodford eds(Amsterdam Elsevier B V 1999) pp 1009ndash1050

Wicksell Knut Interest and Prices (London Macmillan 1898) rst published inGerman in 1898

Woodford Michael lsquolsquoRevolutionand Evolution in Twentieth-Century Macroeconom-icsrsquorsquo mimeo 1999


focus on the accumulation of knowledge rather than on therevolutions and counterrevolutions Admittedly this makes forworse history of thought and it surely makes for worse theaterBut it is the best way to answer the question in the title1

Let me state the thesis that underlies this essay I believe thatthe history of macroeconomics during the twentieth century canbe divided into three epochs the third one currently playing2

c Pre-1940 A period of exploration where macroeconomicswas not macroeconomics yet but monetary theory on oneside and business cycle theory on the otherA period duringwhich all the right ingredients and quite a few more weredeveloped But also a period where confusion reignedbecause of the lack of an integrated framework

c From 1940 to 1980 A period of consolidation A periodduring which an integrated framework was developedmdashstarting with the IS-LM all the way to dynamic generalequilibrium modelsmdashand used to clarify the role of shocksand propagation mechanisms in uctuations But a con-struction with an Achillesrsquo heel namely too casual atreatment of imperfections leading to a crisis in the late1970s

c Since 1980 A new period of exploration focused on the roleof imperfections in macroeconomics from the relevance ofnominal wage and price setting to incompleteness ofmarkets to asymmetric information to search and bargain-ing in decentralized markets to increasing returns inproduction Exploration often feels like confusion andconfusion there indeed is But behind it may be one of themost productive periods of research in macroeconomics

Let me develop these themes in turn

I PRE-1940 EXPLORATION

To somebody who reads it today the pre-1940 literature onmacroeconomics feels like an (intellectual) witchrsquos brew many

1 A nice largely parallel review of macroeconomics in the twentieth centurytaking the alternative more historical approach is given by Woodford [1999]

2 For the purpose of this article I shall dene macroeconomicsas the study ofuctuations mundanemdashrecessions and expansionsmdashor sustainedmdashsharp reces-sions long depressions sustained high unemployment I shall exclude both thestudy of growth and of the political economy of macroeconomics Much progresshas been made there as well but covering these two topics would extend the lengthof this essay to unmanageable proportions














































































































































































































































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What do we know about macroeconomics that Fisher and Wicksell ...

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