Is There a Consensus on Key Macroeconomic Issues?
Our discussion has highlighted some of the major trends in the development
of modern macroeconomics and has inevitably focused on areas of controversy
and disagreement. However, it would be wrong to conclude that there is
no consensus on a number of key macroeconomics issues. In this final section
we summarize six main areas on which there now appears to be widespread
though by no means unanimous agreement, noting that in some instances this
agreement has only been reached after intense debate and controversy. The
present consensus view among macroeconomists can be characterized as
follows:
1. The trend movement of real GDP is primarily driven by supply-side
factors. As such, in the long run, the growth of real GDP depends upon
increases in the supply of factor inputs and improvements in the state of
technology (Solow, 1997). While there are various policies governments
can adopt to influence economic growth – including encouraging education
and training, capital formation, and research and development –
there is continuing debate over what is the best way to increase the
economy’s productive capacity and what role the government can and
should play in encouraging growth. Economists now are also much more
aware of the importance of undertaking research into the deeper determinants
of economic growth and the need for growth theories to account
for the growth experiences of both the Malthusian era and the era of
modern growth.
2. Real GDP fluctuates around a rising long-term trend and short-run
fluctuations in real GDP are primarily caused by aggregate demand
shocks. As we have seen, real business cycle theorists, such as Prescott,
challenge this consensus view, arguing that fluctuations in real GDP
704 Modern macroeconomics
are driven predominantly by persistent supply-side shocks and are
fluctuations in the natural rate of output, not deviations of output from
a smooth deterministic trend. The reason why movements in aggregate
demand can influence real output is linked to the presence of nominal
rigidities. Macroeconomists also debate whether governments cause
instability and what policies they can and should pursue to reduce
short-run fluctuations in economic activity. In attempting to identify
the main cause of cycles emphasis is placed on various sources of
aggregate demand shocks, including fluctuations in autonomous expenditures
(for example Keynesians and Post Keynesians); monetary shocks
(for example monetarists, new classicists and Austrians); and political
distortions to macroeconomic policy (for example political business
cycle theorists). Interestingly, compared with the experience of the
Great Depression, fluctuations in real GDP in the post-Second World
War period have been relatively minor – the main exceptions being the
periods following the two adverse OPEC oil price (supply) shocks and
the period of disinflation in the early 1980s in the USA and Europe. As
Solow (1997) comments, ‘fluctuations around trend are contained within
a moderately narrow corridor’.
3. While the authorities face a short-run trade-off between inflation and
unemployment, in the long run the trade-off disappears. As Blinder (1997a)
argues, the expectations-augmented Phillips curve ‘has worked very well’
and along with ‘Okun’s Law’ represents a ‘sturdy empirical relationship’.
In the short run it is widely accepted that the authorities can reduce
unemployment below the natural rate by engaging in expansionary aggregate
demand policies. Reducing unemployment involves a short-run
trade-off as inflation increases. Alternatively, enacting contractionary
aggregate demand policies which reduce inflation involves a short-run
trade-off as unemployment increases. In the long run, however, there is
no trade-off between inflation and unemployment. A corollary is that in
the long run the authorities can achieve a lower rate of inflation with no
change in the natural rate of unemployment, and that to reduce the
natural rate, which is held to be independent of the level of aggregate
demand, requires microeconomic (aggregate supply management) policies
which improve the structure and functioning of the labour market.
Some new Keynesians would add one important qualification to this
consensus view, namely that in circumstances where the actual rate of
unemployment remains above the natural rate for a prolonged period, the
natural rate (or what new Keynesians would prefer to refer to as NAIRU)
will tend to increase due to hysteresis effects. In other words, some new
Keynesians argue that the natural rate (or NAIRU) can be affected by the
level of aggregate demand (Blanchard, 1997b).
4. In the long run the rate of growth of the money supply determines the
rate of inflation. Friedman has convinced the majority of the profession
and policy makers that sustained inflation is a monetary phenomenon
and that the main aim of monetary policy should be the pursuit of a low
and stable rate of inflation. Indeed, many countries now have a long-run
inflation target with monetary policy directed to keep the growth of
aggregate demand stable in order to create macroeconomic stability.
5. In contrast to the dominant Keynesian view held in the 1950s and early
1960s, it is now widely accepted that governments should not attempt to
‘fine-tune’ their economies in order to keep output and employment
close to, or at, their full employment or natural levels using discretionary
aggregate demand policies. Most economists now accept that the stabilizing
potential of activist discretionary fiscal policy is at best limited
and that the stabilizing role of fiscal policy lies embedded in automatic
stabilizers. Furthermore, there has been a marked change of focus away
from fiscal policy towards monetary policy as the main tool of stabilization
policy. The modern discussion over rules versus discretion involves that
between advocates of flexible Taylor-type rules versus those who favour
rough-tuning. With respect to monetary policy there are few remaining
advocates of Friedman’s hard core monetarist prescription for a k per
cent rule for money growth. The empirical evidence also indicates that in
the short run monetary policy has real effects, so both the ‘classic
Keynesian and vintage RBC view about the cyclical ineffectiveness of
monetary policy has been buried’ (Eichenbaum, 1997).
6. Again, in contrast to the 1950s and 1960s when stabilization was regarded
as a control-theory problem, it is now viewed as a game-theoretic
problem. The insight that the policy regime adopted by the authorities
affects people’s expectations and behaviour is now widely accepted. So
too is the importance given to establishing the credibility of policy and
the design of institutions to conduct credible policy, as evidenced by the
increasing attention given to the issue of central bank independence.
Furthermore, most economists agree that the short-run output/employment
costs of disinflation will be less if policy is credible. While Taylor
(1997b) includes the rational expectations hypothesis in his core of practical
macroeconomics, Solow (1997) remains a sceptic.
To sum up, ‘the good news for policymakers is that there is indeed a core of
usable macroeconomics; the good news for macroeconomic researchers is
that there is a lot of work still to be done’ (Blanchard, 1997b).
As to the future course of macroeconomics, two main pathways immediately
stand out. First, real business cycle models are likely to be integrated
more into the mainstream (Danthine, 1997). Certainly over recent years a
number of real business cycle models have introduced nominal rigidities
which allow for the short-run effects of money on output and employment.
Second, there is likely to be continuing interest shown in new growth theory
and empirics, and especially the now burgeoning research into the deeper
determinants of growth (Temple, 1999; Rodrik, 2003). By providing a better
understanding of the growth process, the renaissance of growth analysis
holds out the prospect of providing insights which may prove invaluable in
helping design policies which could make a significant difference to longterm
growth rates and living standards. In particular, research that integrates
important ideas from economic history, development economics, new political
economy and modern growth theory literature is likely to provide important
new insights into the growth process (see, for example, Galor and Weil, 2000;
Acemoglu and Robinson, 2003).
David Romer (2003) argues that in many cases the adoption of inefficient
policies that reduce welfare has been due to individuals and policy makers
having biased or irrational beliefs (‘misconceptions’) about how the economy
works. This implies that economists need to ensure that those individuals
who are engaged in making important policy decisions are at least aware of
the major research findings of economists. In turn, economists need to appreciate
how strategic interaction among individuals and groups that represent
different interests can distort policy making.
In our broad survey of the development of macroeconomics we have
shown that while the objectives of macroeconomic policy have remained
largely unchanged, there have been significant shifts in policy makers’ views
about how the economy works which in turn have led to major changes in the
conduct of macroeconomic policy. These changes have occurred largely as a
result of improvements in economic understanding driven by the research of
economists. The evolution of thinking on the Phillips curve trade-off between
inflation and unemployment provides an excellent example of how developments
in economic theory and empirical evidence have led to a change in
policy makers’ views concerning the feasibility and sustainability of achieving
low unemployment targets using aggregate demand expansion (see Romer
and Romer, 2002, 2004). Another good example is provided by the decision
in May 1997 to give greater independence to the Bank of England. This move
can be directly traced to the research findings of economists.
However, while there has been progress in macroeconomic analysis, our
existing knowledge will always remain incomplete, for, as Alan Greenspan
(2004) notes:
despite extensive efforts to capture and quantify what we perceive as the key
macroeconomic relationships, our knowledge about many of the important linkages
is far from complete and, in all likelihood, will always remain so. Every
model, no matter how detailed or how well designed, conceptually and empirically,
is a vastly simplified representation of the world that we experience with all
its intricacies on a day-to-day basis.
While it remains to be seen what the next significant development will be
in macroeconomics, it is clear that macroeconomics will continue to change
and progress by a process of evolution and/or revolution. One thing we can
be sure about, with regard to the future direction of macroeconomics, is that
it will continue to surprise us just as much as it has done in the past. As Lucas
commented in our interview with him:
when a macroeconomic consensus is reached on an issue (as it has been, say, on
the monetary sources of inflation), the issue passes off the stage of professional
debate, and we argue about something else. Professional economists are primarily
scholars, not policy managers. Our responsibility is to create new knowledge by
pushing research into new, and hence necessarily controversial, territory. Consensus
can be reached on specific issues, but consensus for a research area as a whole
is equivalent to stagnation, irrelevance and death.
Our discussion has highlighted some of the major trends in the development
of modern macroeconomics and has inevitably focused on areas of controversy
and disagreement. However, it would be wrong to conclude that there is
no consensus on a number of key macroeconomics issues. In this final section
we summarize six main areas on which there now appears to be widespread
though by no means unanimous agreement, noting that in some instances this
agreement has only been reached after intense debate and controversy. The
present consensus view among macroeconomists can be characterized as
follows:
1. The trend movement of real GDP is primarily driven by supply-side
factors. As such, in the long run, the growth of real GDP depends upon
increases in the supply of factor inputs and improvements in the state of
technology (Solow, 1997). While there are various policies governments
can adopt to influence economic growth – including encouraging education
and training, capital formation, and research and development –
there is continuing debate over what is the best way to increase the
economy’s productive capacity and what role the government can and
should play in encouraging growth. Economists now are also much more
aware of the importance of undertaking research into the deeper determinants
of economic growth and the need for growth theories to account
for the growth experiences of both the Malthusian era and the era of
modern growth.
2. Real GDP fluctuates around a rising long-term trend and short-run
fluctuations in real GDP are primarily caused by aggregate demand
shocks. As we have seen, real business cycle theorists, such as Prescott,
challenge this consensus view, arguing that fluctuations in real GDP
704 Modern macroeconomics
are driven predominantly by persistent supply-side shocks and are
fluctuations in the natural rate of output, not deviations of output from
a smooth deterministic trend. The reason why movements in aggregate
demand can influence real output is linked to the presence of nominal
rigidities. Macroeconomists also debate whether governments cause
instability and what policies they can and should pursue to reduce
short-run fluctuations in economic activity. In attempting to identify
the main cause of cycles emphasis is placed on various sources of
aggregate demand shocks, including fluctuations in autonomous expenditures
(for example Keynesians and Post Keynesians); monetary shocks
(for example monetarists, new classicists and Austrians); and political
distortions to macroeconomic policy (for example political business
cycle theorists). Interestingly, compared with the experience of the
Great Depression, fluctuations in real GDP in the post-Second World
War period have been relatively minor – the main exceptions being the
periods following the two adverse OPEC oil price (supply) shocks and
the period of disinflation in the early 1980s in the USA and Europe. As
Solow (1997) comments, ‘fluctuations around trend are contained within
a moderately narrow corridor’.
3. While the authorities face a short-run trade-off between inflation and
unemployment, in the long run the trade-off disappears. As Blinder (1997a)
argues, the expectations-augmented Phillips curve ‘has worked very well’
and along with ‘Okun’s Law’ represents a ‘sturdy empirical relationship’.
In the short run it is widely accepted that the authorities can reduce
unemployment below the natural rate by engaging in expansionary aggregate
demand policies. Reducing unemployment involves a short-run
trade-off as inflation increases. Alternatively, enacting contractionary
aggregate demand policies which reduce inflation involves a short-run
trade-off as unemployment increases. In the long run, however, there is
no trade-off between inflation and unemployment. A corollary is that in
the long run the authorities can achieve a lower rate of inflation with no
change in the natural rate of unemployment, and that to reduce the
natural rate, which is held to be independent of the level of aggregate
demand, requires microeconomic (aggregate supply management) policies
which improve the structure and functioning of the labour market.
Some new Keynesians would add one important qualification to this
consensus view, namely that in circumstances where the actual rate of
unemployment remains above the natural rate for a prolonged period, the
natural rate (or what new Keynesians would prefer to refer to as NAIRU)
will tend to increase due to hysteresis effects. In other words, some new
Keynesians argue that the natural rate (or NAIRU) can be affected by the
level of aggregate demand (Blanchard, 1997b).
4. In the long run the rate of growth of the money supply determines the
rate of inflation. Friedman has convinced the majority of the profession
and policy makers that sustained inflation is a monetary phenomenon
and that the main aim of monetary policy should be the pursuit of a low
and stable rate of inflation. Indeed, many countries now have a long-run
inflation target with monetary policy directed to keep the growth of
aggregate demand stable in order to create macroeconomic stability.
5. In contrast to the dominant Keynesian view held in the 1950s and early
1960s, it is now widely accepted that governments should not attempt to
‘fine-tune’ their economies in order to keep output and employment
close to, or at, their full employment or natural levels using discretionary
aggregate demand policies. Most economists now accept that the stabilizing
potential of activist discretionary fiscal policy is at best limited
and that the stabilizing role of fiscal policy lies embedded in automatic
stabilizers. Furthermore, there has been a marked change of focus away
from fiscal policy towards monetary policy as the main tool of stabilization
policy. The modern discussion over rules versus discretion involves that
between advocates of flexible Taylor-type rules versus those who favour
rough-tuning. With respect to monetary policy there are few remaining
advocates of Friedman’s hard core monetarist prescription for a k per
cent rule for money growth. The empirical evidence also indicates that in
the short run monetary policy has real effects, so both the ‘classic
Keynesian and vintage RBC view about the cyclical ineffectiveness of
monetary policy has been buried’ (Eichenbaum, 1997).
6. Again, in contrast to the 1950s and 1960s when stabilization was regarded
as a control-theory problem, it is now viewed as a game-theoretic
problem. The insight that the policy regime adopted by the authorities
affects people’s expectations and behaviour is now widely accepted. So
too is the importance given to establishing the credibility of policy and
the design of institutions to conduct credible policy, as evidenced by the
increasing attention given to the issue of central bank independence.
Furthermore, most economists agree that the short-run output/employment
costs of disinflation will be less if policy is credible. While Taylor
(1997b) includes the rational expectations hypothesis in his core of practical
macroeconomics, Solow (1997) remains a sceptic.
To sum up, ‘the good news for policymakers is that there is indeed a core of
usable macroeconomics; the good news for macroeconomic researchers is
that there is a lot of work still to be done’ (Blanchard, 1997b).
As to the future course of macroeconomics, two main pathways immediately
stand out. First, real business cycle models are likely to be integrated
more into the mainstream (Danthine, 1997). Certainly over recent years a
number of real business cycle models have introduced nominal rigidities
which allow for the short-run effects of money on output and employment.
Second, there is likely to be continuing interest shown in new growth theory
and empirics, and especially the now burgeoning research into the deeper
determinants of growth (Temple, 1999; Rodrik, 2003). By providing a better
understanding of the growth process, the renaissance of growth analysis
holds out the prospect of providing insights which may prove invaluable in
helping design policies which could make a significant difference to longterm
growth rates and living standards. In particular, research that integrates
important ideas from economic history, development economics, new political
economy and modern growth theory literature is likely to provide important
new insights into the growth process (see, for example, Galor and Weil, 2000;
Acemoglu and Robinson, 2003).
David Romer (2003) argues that in many cases the adoption of inefficient
policies that reduce welfare has been due to individuals and policy makers
having biased or irrational beliefs (‘misconceptions’) about how the economy
works. This implies that economists need to ensure that those individuals
who are engaged in making important policy decisions are at least aware of
the major research findings of economists. In turn, economists need to appreciate
how strategic interaction among individuals and groups that represent
different interests can distort policy making.
In our broad survey of the development of macroeconomics we have
shown that while the objectives of macroeconomic policy have remained
largely unchanged, there have been significant shifts in policy makers’ views
about how the economy works which in turn have led to major changes in the
conduct of macroeconomic policy. These changes have occurred largely as a
result of improvements in economic understanding driven by the research of
economists. The evolution of thinking on the Phillips curve trade-off between
inflation and unemployment provides an excellent example of how developments
in economic theory and empirical evidence have led to a change in
policy makers’ views concerning the feasibility and sustainability of achieving
low unemployment targets using aggregate demand expansion (see Romer
and Romer, 2002, 2004). Another good example is provided by the decision
in May 1997 to give greater independence to the Bank of England. This move
can be directly traced to the research findings of economists.
However, while there has been progress in macroeconomic analysis, our
existing knowledge will always remain incomplete, for, as Alan Greenspan
(2004) notes:
despite extensive efforts to capture and quantify what we perceive as the key
macroeconomic relationships, our knowledge about many of the important linkages
is far from complete and, in all likelihood, will always remain so. Every
model, no matter how detailed or how well designed, conceptually and empirically,
is a vastly simplified representation of the world that we experience with all
its intricacies on a day-to-day basis.
While it remains to be seen what the next significant development will be
in macroeconomics, it is clear that macroeconomics will continue to change
and progress by a process of evolution and/or revolution. One thing we can
be sure about, with regard to the future direction of macroeconomics, is that
it will continue to surprise us just as much as it has done in the past. As Lucas
commented in our interview with him:
when a macroeconomic consensus is reached on an issue (as it has been, say, on
the monetary sources of inflation), the issue passes off the stage of professional
debate, and we argue about something else. Professional economists are primarily
scholars, not policy managers. Our responsibility is to create new knowledge by
pushing research into new, and hence necessarily controversial, territory. Consensus
can be reached on specific issues, but consensus for a research area as a whole
is equivalent to stagnation, irrelevance and death.
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