Keynesandthe

GreatDepressionThehistoryofmodernmacroeconomicsstartsin1936,withthepublicationofKeynes’sGeneralTheoryofEmployment,Interest,andMoney.TheGreatDepressionwasanintellectualfailurefortheeconomistsworkingonbusinesscycletheory—asmacroeconomicswasthencalled.Keynesemphasizedeffectivedemand,nowcalledaggregatedemand.Keynes27-12Keynesandthe

GreatDepressionIntheprocessofderivingeffectivedemand,Keynesintroducedmanyofthebuildingblocksofmodernmacroeconomics:Therelationofconsumptiontoincome,andthemultiplier.Liquiditypreference(thetermgiventothedemandformoney)Theimportanceofexpectationsinaffectingconsumptionandinvestment;andtheideathatanimalspiritsareamajorfactorbehindshiftsindemandandoutput.3

TheNeoclassicalSynthesisPaulSamuelsonwrotethefirstmoderneconomicstextbook:Economics27-2Theneoclassicalsynthesisreferstoalargeconsensusthatemergedintheearly1950s,basedontheideasofKeynesandearliereconomists.Theneoclassicalsynthesiswastoremainthedominantviewforanother20years.Theperiodfromtheearly1940stotheearly1970swascalledthegoldenageofmacroeconomics.4TheIS-LMModelThemostinfluentialformalizationofKeynes’sideaswastheIS-LMmodel,developedbyJohnHicksandAlvinHanseninthe1930sandearly1940s.DiscussionsbecameorganizedaroundtheslopesoftheISandLMcurves.5TheoriesofConsumption,Investment,andMoneyDemandInthe1950s,FrancoModiglianiandMiltonFriedmanindependentlydevelopedthetheoryofconsumption,andinsistedontheimportanceofexpectations.ModiglianiTobinJamesTobindevelopedthetheoryofinvestmentbasedontherelationbetweenthepresentvalueofprofitsandinvestment.DaleJorgensonfurtherdevelopedandtestedthetheory.6GrowthTheoryIn1956,RobertSolowdevelopedthegrowthmodel—aframeworktothinkaboutthedeterminantsofgrowth.SolowItwasfollowedbyanexplosionofworkontherolessavingandtechnologicalprogressplayindetermininggrowth.7MacroeconometricModelsKleinLawrenceKleindevelopedthefirstU.S.macroeconomicmodelintheearly1950s.ThemodelwasanextendedISrelation,with16equations.8KeynesiansVersusMonetaristsMiltonFriedmanwastheintellectualleaderofthemonetarists,andthefatherofthetheoryofconsumption.Hebelievedthattheunderstandingoftheeconomyremainedverylimited,andquestionedthemotivesandabilityofgovernmentstoimprovemacroeconomicoutcomes.Friedman9KeynesiansVersusMonetaristsInthe1960s,debatesbetweenKeynesiansandmonetaristsdominatedtheeconomicheadlines.Thedebatescenteredaroundthreeissues:(1)theeffectivenessofmonetarypolicyversusfiscalpolicy,(2)thePhillipscurve,and(3)theroleofpolicy.10MonetaryPolicyVersusFiscalPolicyFriedmanchallengedtheviewthatfiscalpolicycouldaffectoutputfasterandmorereliablythanmonetarypolicy.Ina1963book,AMonetaryHistoryoftheUnitedStates,1867-1960,FriedmanandAnnaSchwartzreviewedthehistoryofmonetarypolicyandconcludedthatmonetarypolicywasnotonlyverypowerful,butthatmovementsinmoneyalsoexplainedmostofthefluctuationsinoutput.TheyinterpretedtheGreatDepressionastheresultofmajormistakeinmonetarypolicy.11ThePhillipsCurveThePhillipscurvehadbecomepartoftheNeoclassicalsynthesis,butMiltonFriedmanandEdmundPhelpsarguedthattheapparenttrade-offbetweenunemploymentandinflationwouldquicklyvanishifpolicymakersactuallytriedtoexploitit.Bythemid1970s,theconsensuswasthattherewasnolong-runtradeoffbetweeninflationandunemployment.12TheRoleofPolicySkepticalthateconomistsknewenoughtostabilizeoutput,andthatpolicymakerscouldbetrustedtodotherightthing,MiltonFriedmanarguedfortheuseofsimplerules,suchassteadymoneygrowth.Friedmanbelievedthatpoliticalpressuresto“dosomething”inthefaceofrelativelymildproblemsmaydomoreharmthangood.13TheRational

ExpectationsCritiqueTheyarguedthatthepredictionsofKeynesianmacroeconomicswerewildlyincorrect,andbasedonadoctrinethatwasfundamentallyflawed.Intheearly1970s,RobertLucas,ThomasSargent,andRobertBarroledastrongattackagainstmainstreammacroeconomics.LucasSargentBarro27-314TheThreeImplicationsof

RationalExpectationsLucasandSargent’smainargumentwasthatKeynesianeconomicshadignoredthefullimplicationsoftheeffectofexpectationsonbehavior.Thinkingofpeopleashavingrationalexpectationshadthreemajorimplications,allhighlydamagingtoKeynesianmacroeconomics.15TheLucasCritiqueRobertLucasarguedthatmacroeconomicmodelsdidnotincorporateexpectationsexplicitly;thatthemodelscapturedrelationsastheyhadheldinthepast,underpastpolicies.Theywerepoorguidestowhatwouldhappenundernewpolicies.ThiscritiqueofmacroeconometricmodelsbecameknownastheLucasCritique.16RationalExpectationsandthe

PhillipsCurveInKeynesianmodels,theslowreturnofoutputtothenaturallevelofoutputcamefromtheslowadjustmentofpricesandwagesthroughthePhillipscurvemechanism.WithinthelogicoftheKeynesianmodels,Lucasthereforeargued,onlyunanticipatedchangesinmoneyshouldaffectoutput.17OptimalControlVersusGameTheoryLet’ssummarize:Whenrationalexpectationswereintroduced,Keynesianmodelscouldnotbeusedtodeterminepolicy,Keynesianmodelscouldnotexplainlong-lastingdeviationsofoutputfromthenaturallevelofoutput,andthetheoryofpolicyhadtoberedesigned,usingthetoolsofgametheory.18TheIntegrationofRationalExpectationsTheintellectualatmosphereinmacroeconomicswastenseintheearly1970s.Butwithinafewyears,aprocessofintegration(ofideas,notpeople)hadbegun,anditwastodominatethe1970sandthe1980s.WorkthenstartedonthechallengesraisedbyLucasandSargent.19TheImplicationsof

RationalExpectationsRobertHallshowedthatifconsumersareveryforesighted,thenchangesinconsumptionshouldbeunpredictable.Consumptionwillchangeonlywhenconsumerslearnsomethingnewaboutthefuture.Sincenewsaboutthefuturecannotbepredicted,changesinconsumptionarehighlyrandom.Thisconsumptionbehavior,knownastherandomwalkofconsumption,hasservedasabenchmarkinconsumptionresearcheversince.Hall20TheImplicationsof

RationalExpectationsRudigerDornbuschdevelopedamodelofexchangeratesthatshowshowlargeswingsinexchangeratesarenottheresultofirrationalspeculationbut,instead,fullyconsistentwithrationality.DornbuschDornbusch’smodel,knownastheovershootingmodelofexchangerates,hasbecomethebenchmarkindiscussionsofexchange-ratemovements.21WageandPriceSettingStanleyFischerandJohnTaylorshowedthattheadjustmentofpricesandwagesinresponsetochangesinunemploymentcanbeslowevenunderrationalexpectations.Theypointedtothestaggeringofbothwageandpricedecisions,andexplainedhowaslowreturnofoutputtothenaturallevelcanbeconsistentwithrationalexpectationsinthelabormarket.FischerTaylor22TheTheoryofPolicyInshort:Bytheendofthe1980s,thechallengesraisedbytherational-expectationscritiquehadledtoacompleteoverhaulofmacroeconomics.23CurrentDevelopmentsSincethelate1980s,threegroupshavedominatedtheresearchheadlines:thenewclassicals,thenewKeynesians,andthenewgrowththeorists.27-424NewClassicalEconomicsandRealBusinessCycleTheoryTheirrealbusinesscycle(RBC)modelsassumethatoutputisalwaysatitsnaturallevel,andfluctuationsaremovementsofthenaturallevelofoutput.Thesemovementsarefundamentallycausedbytechnologicalprogress.EdwardPrescottistheintellectualleaderofthenewclassicals—agroupofeconomistsinterestedinexplainingfluctuationsastheeffectsofshocksincompetitivemarketswithfullyflexiblepricesandwages.Prescott25NewKeynesianEconomicsOnelineofresearchfocusesonthedeterminationofwagesinthelabormarket.GeorgeAkerlofhasexploredtheroleof“norms,”orrulesthatdevelopinanyorganizationtoassesswhatisfairorunfair.ThenewKeynesiansarealooselyconnectedgroupofresearchersworkingontheimplicationsofseveralimperfectionsindifferentmarkets.Akerlof26NewKeynesianEconomicsYetanotherdirectionofresearchisnominalrigiditiesinwagesandprices.Themenucostexplanationofoutputfluctuations,developedbyAkerlofandN.GregoryMankiw,attributesevensmallcostsofchangingpricestotheinfrequentandstaggeredpriceadjustment.AnotherlineofnewKeynesianresearchhasexploredimperfectionsincreditmarkets.BenBernankehasstudiedtherelationbetweenbanksandborrowersanditseffectsonmonetarypolicy.27NewGrowthTheoryNewgrowththeoryfocusesonthedeterminantsoftechnologicalprogressinthelongrun,andtheroleofincreasingreturnstoscale.RobertLucasandPaulRomerhaveprovidedanewsetofcontributionsunderthenameofnewgrowththeory,whichtakeonsomeoftheissuesinitiallyraisedbygrowththeoristsofthe1960s.Romer28NewGrowthTheoryOneexampleofsomeoftheadvanceseconomistshavemadeisontheworkofPhilippeAghionandPeterHowitt.TheyhavedevelopedathemefirstexploredbyJosephSchumpeterinthe1930s,thenotionthatgrowthisaprocessofcreativedestruction,inwhichnewproductsareconstantlyintroduced,makingoldonesobsolete.29CommonBeliefsMostmacroeconomistsagreethat:Intheshortrun,shiftsinaggregatedemanda