The history of modern macroeconomics starts in 1936 with the publication of Keynes’ The General Theory of Employment, Interest and Money as is clear from the opening quotation of Keynes. The timing of the release of the book was one of the reasons for its success.
Before 1936, economists failed to explain the causes of the Great Depression of 1929-33. The General Theory (henceforth GT) offered an interpretation of the depth and length of the Depression and called for government intervention to stabilise the capitalist economy. The GT emphasised effective demand or aggregate demand. Keynes argued that, in the short run, effective demand determines output.
While developing his theory of effective demand, Keynes introduced three important building blocks of modern macroeconomics:
(i) The relation of consumption to income, from which emerges the multiplier mechanism, which explains how shocks to demand can be amplified and lead to larger shifts in output.
(ii) Liquidity preference (the demand for money), which explains how monetary policy can affect interest rates and aggregate demand.
(iii) The importance of expectations in affecting consumption and investment; and the idea that animal spirits (shifts in expectations) are a major factor behind shifts in demand and output.
The GT offered clear policy guidelines which were quite in tune with the times. There was no automatic mechanism for the economy to move from depression to recovery and then to prosperity. During depression it was dangerous to balance the budget.
It would make things worse. Keynes suggested that during depression the government should deliberately incur a deficit in the budget to stimulate the economy. Government expenditure would add to private expenditure in determining aggregate demand and, thus, the volume of aggregate output and the level of employment. In other words, there was need to use discretionary fiscal policy to ensure a high level of employment.
The Neo-Classical Synthesis:
Within a decade or so, the GT had transformed macroeconomics. By the early 1950s, attempts were made to integrate many of Keynes’ ideas with those of classical economists. This integration was called by Paul Samuelson the great neo-classical synthesis, i.e., the synthesis of the classical (monetary) analysis and the Keynesian (income) analysis.
The IS-LM Model:
In 1937, John Hicks formalized the Keynesian ideas by presenting the famous IS-LM model, which was refined and modified by A. H. Hansen (the so-called American Keynes) in the 1940s. The model showed that the commodity market and the money market could be in equilibrium at the same time. So the model was essentially a general equilibrium model. First, expectations played no role. Secondly, the adjustment of prices and wages was completely absent.
Theories of Consumption, Investment and Demand for Money:
On the basis of Keynes’ short run consumption function hypothesis (called absolute income hypothesis) Franco Modigliani and Milton Friedman independently developed two long-term hypotheses of consumption behaviour, viz., the life cycle hypothesis and the permanent income hypothesis.
Both highlighted the importance of expectations in determining current consumption decisions. While Friedman stressed the importance of past incomes in determining current consumption, Modigliani stressed the importance of assets (wealth) in determining current consumption.
Keynes had emphasised the importance of choice between money and bonds. James Tobin extended the model to highlight the importance of choice between money and risky assets in his theory of demand for money entitled ‘liquidity preference as behaviour towards risk’. Thus, Tobin introduced the role of risk and uncertainty in the Keynesian theory of demand for money. In a general sense, Tobin’s theory is essentially one of choice between different assets based on liquidity return and risk.
Tobin also developed the theory of investment based on the relation between the present value of profits and investment. His q-theory relates investment to stock market movements. His theory was further developed and empirically verified by Dale Jorgenson. This is known as the neo-classical theory of investment, in which the key role is played by the rental price of capital.
Along with the work on short-term fluctuations, there was a renewed focus on growth. In 1950, Robert Solow presented a growth model, which provided a framework to identify or trace out the determinants of growth.
He developed the famous growth accounting approach. Solow’s pioneering contribution was followed by an explosion of work on the roles of saving and technological progress in determining long-term growth of a capitalist (market) economy.
Macro Econometric Models:
All these contributions were integrated in larger and larger macroeconomic models by Lawrence Klein in the 1950s. These models were mainly for economy-wide forecasting. Such models were used by Data Resources Inc. and the Wharton Business School (of the University of Pennsylvania).
Keynesians Versus Monetarists:
For all these developments, the followers of Keynes—called Keynesians—were quite optimistic about the future. They thought that by adopting Keynesian principles the policy decisions could be made more effectively, the economy could be fine-tuned, and recessions could be eliminated.
However, Keynesian ideas were rejected by Friedman and other members of the monetarist school. Friedman expressed the view that the understanding of the government policymakers about the economy was not enough to improve macroeconomic outcomes.
The 1960s saw continuous debate between ‘Keynesians’ and ‘monetarists’ on the following three issues:
(i) Monetary Policy Versus Fiscal Policy:
Keynes had emphasised the role of fiscal rather than monetary policy as the key to fighting recessions. Since the IS curve was quite steep, changes in the interest rate had little effect on demand and output. Thus, monetary policy was not much effective. Fiscal policy, which affects demand directly, would surely affect output further.
However, Friedman challenged this view. His conclusion was that changes in money supply were largely responsible for most of the fluctuations in output. He interpreted the Great Depression as the result of a major mistake in monetary policy, a decrease in the money supply due to bank failures—a decrease that the US Federal Reserve Board could have avoided by increasing the monetary base.
So, the Depression was the result of the adoption of incorrect monetary policy by the US central bank.
Ultimately, on the basis of intense research on the relative effects of fiscal policy and monetary policy, economists reached the consensus that both fiscal policy and monetary policy clearly affected the economy. And, if policymakers cared about not only the level but also the composition of output (GDP), the ideal policy was a judicious mix of the two.
(ii) The Phillips Curve:
Keynes believed that the end of full employment was the beginning of inflation. In other words, ‘full employment’ was the economy’s inflation threshold. True inflation occurs when the full employment boom comes to an end.
This view was rejected by economists as soon as the Phillips curve appeared on the scene. And the Phillips curve showed the trade-off between inflation and unemployment. It established the point that inflation and unemployment could co-exist. And the Phillips curve provided a convenient (and apparently reliable) way of explaining the movement of wages and prices over time.
Many Keynesians believed—on their basis of empirical evidence—that there was a reliable trade-off between inflation and unemployment, even in the long run. Friedman and E. Phelps strongly disagreed.
They argued that the apparent trade-off would quickly disappear if policymakers actually attempted to exploit it—that is, if they tried to achieve low employment by tolerating higher inflation. By the mid-1970s, economists reached the consensus that Friedman and Phelps were absolutely correct in their predictions—there was no long-run trade-off between inflation and unemployment.
(iii) The Role of Policy:
Friedman first argued that economists’ knowledge of the state of the economy is not adequate to stabilise output and policymakers could not be trusted to do the right thing. So, he suggested the use of simple rules, such as steady money growth. In his language.
A steady rate of growth in the money supply will not mean perfect stability even though it would prevent the kind of wide fluctuations that we have experienced from time to time in the past. It is tempting to try to go farther and to use monetary changes to offset other factors making for expansion and contraction.
The available evidence casts grave doubts on the possibility of producing any fine adjustments in economic activity by fine adjustments in monetary policy—at least in the present state of knowledge. There are thus serious limitations to the possibility of a discretionary monetary policy and much danger that such a policy may make matters worse than better.
The Rational Expectations Critique:
By the mid-1970s, most countries were experiencing stagflation, which implies the co-existence of high unemployment and high inflation. This appeared to be a new problem which macroeconomics could not predict. However, after a few years of fruitful research, a convincing explanation was provided on the basis of effects of adverse supply shocks on both prices and output.
At the same time, in the early 1970s, three economists—Robert Lucas, Thomas Sergeant and Robert Barro—led a strong attack against mainstream macroeconomics. In the language of Lucas and Sargent:
Existing Keynesian macroeconomic models cannot provide reliable guidance in the formulation of monetary, fiscal or other types of policy. There is no hope that minor or even major modifications of these models will lead to significant improvements in their reliability.
Although most macroeconomists argue that monetary policy can affect unemployment and output, at least in the short run, new classical macroeconomics, developed by the three economists, emphasised the role of flexible wages and prices in the spirit of the classical approach, but it adds a new feature, called ‘rational expectations’, to explain observations such as the Phillips curve.
The Three Implications of Rational Expectations:
Lucas and Sargent’s main argument was that Keynesian economics had ignored the full implications of the effects of expectations on behaviour. The correct approach was to assume that people formed expectations as rationally as they could on the basis of existing information.
The following three implications of rational expectations are highly damaging to Keynesian macroeconomics:
1. The Lucas Critique:
Prima facie, existing macroeconomic models could not be used to help design policy. The reason is that these models did not incorporate expectations explicitly. All variables were assumed to depend on the current and past values of other variables, including policy variables.
Thus, the standard macroeconomic models just succeeded in capturing the set of relations among economic variables which had existed in the past, under past policies. If these policies were changed, the way people formed expectations would change as well.
This would make estimated relations—and, by implication, simulations generated by using standard macro-econometric models—improper guides to what would happen under these new policies. This critique of macro-econometric models became known as the Lucas critique.
For example, the data up to the early 1970s had suggested a trade-off between unemployment and inflation. As policymakers tried to exploit that trade-off, it disappeared.
2. Rational Expectations and the Phillips Curve:
According to Lucas, wages responded only to current and past inflation, as also to current unemployment. But once the assumption was made that wage-setters had rational expectations, the adjustment was likely to be much faster. Changes in the money supply, to the extent that they were anticipated, might have no effect on output. Thus, money would have a neutral effect on real variables even in the short run.
Lucas, therefore, argued that only unanticipated changes in the money supply should affect output. Predictable movements in the money supply are unlikely to have any effect on economic activity. In general, if wage setters had rational expectations, shifts in demand were likely to have effects on output for only as long as nominal wages were set—a year or so.
3. Optimal Control Versus Game Theory:
If people and firms had rational expectations, it was incorrect to think of policy as the control of a complicated but passive system. Instead, the correct way to think about a policy is to take it as a game between the policymakers and the economy. The right tool was not optimal control, but game theory. And game theory led to a different version of policy. An obvious example was the issue of time inconsistency.
The Integration of Rational Expectations:
The rational expectations hypothesis quickly gained wide acceptance because it provided a natural benchmark and work started on the unanswered questions raised by Lucas and Sargent. And economists started understanding whether and how actual expectations systematically differ from rational expectations.
First, there was a systematic exploration of the role and implications of rational expectations in goods markets, financial markets and labour markets.
Robert Hall developed a forward-looking theory of consumption function on the basis of rational expectations. He showed that if consumers are very foresighted, then changes in consumption should be unpredictable.
Since changes in consumption is hard to predict, the best forecast of consumption next year would be consumption this year. This consumption behaviour, known as the random walk of consumption, produced ample support to Friedman’s permanent income hypothesis, according to which past incomes do affect consumption.
R. Dornbusch showed that the large swing in exchange rates under flexible exchange rates— which were earlier treated as the result of speculation by irrational investors, were fully consistent with rationality.
His argument is:
(i) Changes in monetary policy can lead to long-lasting changes in nominal interest rates;
(ii) Changes in current and expected nominal interest rates lead, in turn, to large changes in the exchange rate. Dornbusch’s model is known as the overshooting model of exchange rates.
Wage and Price Setting:
S. Fisher and J. Tailor showed that the adjustment of prices and wages in response to changes in unemployment can be slow even under rational expectations.
Fischer and Taylor pointed out an important characteristic of both wage and price-setting, the staggering of wage and price decisions. Actual wage and price decisions are staggered over time. So, we do not find sudden synchronized adjustments of wages and prices to an increase in money supply.
Rather, the adjustment is likely to be slow, with wages and prices gradually adjusting to the new level of money through a process of leapfrogging over time. For this reason, a slow return of output to the natural level of output can be consistent with rational expectations in the labour market.
The Theory of Policy:
One of the notable developments of the 1980s has been the development of a new theory of economic policy and new notions such as ‘credibility’, ‘reputation’ and ‘commitment’ have been introduced. At the same time, there has been a clear shift in focus from ‘what governments should do’ to ‘what governments actually do’. By the end of the 1980s, the basic structure of rational expectations has been extended to explore implications for taking into account the forward-looking behaviour of people and firms.
Current Developments of Post-Keynesian Macroeconomics:
Three current developments since the late 1980s have been:
(i) New Classical Economics and Real Business Cycle Theory:
While criticizing the Keynesian economics, Lucas offered an alternative interpretation of fluctuations. To him, economic fluctuations are largely the effects of shocks in competitive markets with completely flexible wages and prices.
Lucas’ research has been pursued by the new classicists. Edward Prescott and his coworkers developed real business cycle (RBC) models on the basis of the Lucas framework. These models explain equilibrium business cycles since their basic assumption is that output is always at its natural level.
This means that all output fluctuations are movements of the natural level of output, as opposed to movements of output away from the classical benchmark (i.e., the full-employment level). Business cycles are equilibrium-real phenomena, driven largely by productivity shocks. Endogeneity of the money stock accounts for the inflation-or money-output link.
The most fully worked out RBC model is that of Prescott (1982). There is a representative argument, and an infinite horizon intertemporal maximiser. Production inputs are labour, capital and inventories. In the RBC models, intertemporal substitution of labour causes output fluctuations. The economy is hit by imperfectly observed productivity shocks, which are a mixture of permanent and transitory components.
RBC theories suggest that innovations or productivity shocks in one sector can spread to the rest of the economy and cause recessions and booms. In this new classical approach, cycles are caused primarily by shocks to aggregate supply and not by changes in aggregate demand.
According to Prescott, output movements occur solely due to technological progress. With new technology, productivity increases. As a result, output increases. An increase in labour productivity leads to an increase in the wage rate. This induces the workers to put in extra effort. Thus, productivity increases lead to increases in output and employment. This is what is found in the real world.
However, the RBC approach has been criticised mainly on the ground that technological progress is the result of various diverse innovations, each taking a long time to get transmitted throughout the economy. How this could generate the large short-run fluctuations in output, which are observed in the real world, is not yet transparent.
Likewise, how could recessions occur and output and employment fall due to adverse technology shocks (e.g., a sudden technological change may make a firm’s capital stock obsolete) is beyond anyone’s comprehensive power. Finally, empirical evidence lends considerable support to the view that changes in money supply exert strong influence on output in clear and predictable way.
In spite of all these criticisms, the RBC approach provides an important insight into the theory of fluctuations: all short-run fluctuations in output are not deviations of actual output from its natural level. In short, the new classical approach focused on identifying how much of the fluctuations can be treated as movements in the natural level of output and in the rate of unemployment.
(ii) New Keynesian Economics:
The new classical economists have attempted to explain short-run fluctuations by exploring the nature and implications of the various types of imperfections in different markets. One group of economists have focused on the notion of efficiency wages—the idea that wages, if perceived by workers as being too low, may lead to shirking by workers on the job, to problems of morale within the firm, to difficulties in recruiting or keeping good workers, and so on. Efficiency wages, wages above the market clearing level, are given to prevent the exit of productive workers. However, efficiency wages create real wage rigidity and involuntary unemployment.
Fischer and Taylor have focused on nominal rigidity and have clearly demonstrated that with the staggering of wage or price decisions, output can deviate from its natural level for a long time. In this context, G. Akerloff and N. G. Mankiw have derived a surprising and important result, referred to as the menu cost explanation of output fluctuations.
Each firm is largely indifferent as to when and how often it changes its own price. For example, a retailer may feel that his profit remains more or less unaffected whether he changes his price on a daily or weekly basis.
Therefore, even small costs of changing prices—like the costs involved in printing a new menu—can lead to discrete and staggered price adjustment. This staggering leads to slow adjustment of the average price level and to large aggregate output fluctuations in response to movements in aggregate demand.
This means that decisions that do not matter much at the micro-level (how often to change prices) lead to large aggregate effects (slow price adjustment and shifts in aggregate demand that have a large effect on output).
In short, the focus of New Keynesian approach was on identifying the precise nature of market imperfections and nominal rigidity that give rise to deviations of output from its natural level.
(iii) New Growth Theory:
New growth theory developed by Robert Lucas and Paul Romer addressed two key issues:
(i) The determinants of technological progress; and
(ii) The role of increasing returns to scale, i.e., whether doubling capital and labour can actually cause output to get more than doubled.
The focus of new growth theory was on the effects of research and development on technological progress and the interaction between technological progress and unemployment. Carrying the works of Lucas and Romer a step further, P. Aghion and P. Hewitt have developed a Schumpeterian theme of the 1930s, the notion that growth is a process of creative destruction, in which new products are constantly introduced—making old ones obsolete.
Common Beliefs of Post-Keynesian Macroeconomics:
Macroeconomists agree on certain points and disagree on others. So, we summarise our brief survey of macroeconomics thus:
A. Areas of Agreement:
The basic set of propositions on which most macroeconomists agree are:
(i) Short Run:
In the short run, shifts in aggregate demand affect output. Higher consumer confidence, a larger budget deficit, and further growth of money are all likely to increase output and to reduce cyclical unemployment.
(ii) Medium Run:
In the medium run, output returns to the natural level of output, which depends on the natural rate of unemployment (which, together with the size of the labour force, determines the level of employment), the stock of capital and, of course, the state of technology.
(iii) Long Run:
Output depends on capital accumulation and the rate of technological progress.
(iv) Monetary Policy:
It affects output only in the short run. In the long run, a high rate of money growth only leads to a higher rate of inflation. Thus, money has a neutral effect on the economy.
(v) Fiscal Policy:
If the budget deficit increases, output is likely to increase even in the short run. It has no effect on output in the medium run. It is likely to reduce capital accumulation and output in the long run.
B. Areas of Disagreement:
(i) Length of the ‘Short Run’:
Economists disagree over the duration of the short run during which aggregate demand affects output. At one extreme, RBC theories start from the assumption that output is always at the natural rate level. The ‘short run’ is indeed very short. At the other extreme, the study of slumps and depressions implies a prolongation of the effects of demand.
In other words, the effects of demand may be extremely long-lasting. So, the ‘short run’ may be very long.
(ii) The Role of Policy:
Those who believe that output quickly comes back to its natural rate level are in favour of imposing tight rules on both types of demand management policies— from constant money growth to the requirement of a balanced budget. Those who believe that the adjustment is slow advocate the adoption of more flexible stabilisation policies.