Schools of Thought in Macroeconomics After Keynes
According to Johnson (1971), ‘by far the most helpful circumstance for the
rapid propagation of a new revolutionary theory is the existence of an established
orthodoxy which is clearly inconsistent with the most salient facts of
reality’. As we have seen, the inability of the classical model to account
adequately for the collapse of output and employment in the 1930s paved the
way for the Keynesian revolution. During the 1950s and 1960s the neoclassical
synthesis became the accepted wisdom for the majority of economists
(see Chapter 3). The work of Nobel Memorial Laureates James Tobin, Lawrence
Klein, Robert Solow, Franco Modigliani, James Meade, John Hicks
and Paul Samuelson dominated the Keynesian school and provided intellectual
support for the view that government intervention in the form of demand
management can significantly improve the performance of the economy. The
‘New Economics’ adopted by the Kennedy administration in 1961 demonstrated
the influence of Keynesian thinking and the 1962 Economic Report of
the President explicitly advocated stabilization policies with the objective of
keeping ‘overall demand in step with the basic production potential of the
economy’.
During the 1970s this Keynesian approach increasingly came under attack
and was subjected to the force of two ‘counter-revolutionary’ approaches,
namely monetarism and new classical macroeconomics. Both of these approaches
are underpinned by the belief that there is no need for activist
stabilization policy. The new classical school in particular supports the view
that the authorities cannot, and therefore should not, attempt to stabilize
fluctuations in output and employment through the use of activist demand
management policies (Lucas, 1981a).
As we shall discuss in Chapter 4, in the orthodox monetarist view there is
no need for activist stabilization policy (except in extreme circumstances)
given the belief that capitalist economies are inherently stable, unless disturbed
by erratic monetary growth. Monetarists hold that when subjected to
some disturbance the economy will return, fairly quickly, to the neighbourhood
of the ‘natural’ level of output and employment. Given this view they
question the need for stabilization policy involving the ‘fine-tuning’ of aggreUnderstanding
gate demand. Even if there were a need, monetarists argue that the authorities
can’t stabilize fluctuations in output and employment due to the problems
associated with stabilization policy. These problems include those posed by
the length of the inside lag associated with fiscal policy, the long and variable
outside time lags associated with monetary policy and uncertainty over what
precise value to attribute to the natural rate of unemployment. In consequence
monetarists argue that the authorities shouldn’t be given discretion to
vary the strength of fiscal and monetary policy as and when they see fit,
fearing that they could do more harm than good. Instead, monetarists advocate
that the monetary authorities should be bound by rules.
With hindsight two publications were particularly influential in cementing
the foundations for the monetarist counter-revolution. First there is Friedman
and Schwartz’s (1963) monumental study, A Monetary History of the United
States, 1867–1960. This influential volume presents persuasive evidence in
support of the monetarist view that changes in the money supply play a
largely independent role in cyclical fluctuations. Second is Friedman’s (1968a)
American Economic Review article on ‘The Role of Monetary Policy’ in
which he put forward the natural rate hypothesis and the view that there is no
long-run trade-off between inflation and unemployment. The influence of
Friedman’s article was greatly enhanced because it anticipated the events of
the 1970s and, in particular, predicted accelerating inflation as a consequence
of the repeated use of expansionary monetary policy geared to over-optimistic
employment targets.
During the 1970s a second counter-revolution took place associated with
new classical macroeconomics. This approach, which cast further doubt on
whether traditional Keynesian aggregate demand management policies can
be used to stabilize the economy, is often seen as synonymous with the work
of one of Friedman’s former University of Chicago students, the 1995 Nobel
Memorial Laureate, Robert E. Lucas Jr. Other leading advocates of the new
classical monetary approach to analysing economic fluctuations during the
1970s include Thomas Sargent, Neil Wallace, Robert Barro, Edward Prescott
and Patrick Minford (see Hoover, 1988; Snowdon et al., 1994).
As we will discuss in Chapter 5, by combining the rational expectations
hypothesis (first put forward by John Muth in the context of microeconomics
in the early 1960s), the assumption that markets continuously clear, and
Friedman’s natural rate hypothesis, Lucas was able to demonstrate in his
1972 Journal of Economic Theory paper on ‘Expectations and the Neutrality
of Money’ how a short-run equilibrium relationship between inflation and
unemployment (Phillips curve) will result if inflation is unanticipated due to
incomplete information.
In line with the monetarist school, new classical economists believe that
the economy is inherently stable, unless disturbed by erratic monetary growth,
and that when subjected to some disturbance will quickly return to its natural
level of output and employment. However, in the new classical approach it is
unanticipated monetary shocks that are the dominant cause of business cycles.
The new classical case against discretionary policy activism, and in
favour of rules, is based on a different set of arguments to those advanced by
monetarists. Three insights in particular underlie the new classical approach.
First, the policy ineffectiveness proposition (Sargent and Wallace, 1975, 1976)
implies that only random or arbitrary monetary policy actions undertaken by
the authorities can have short-run real effects because they cannot be anticipated
by rational economic agents. Given that such actions will only increase
the variation of output and employment around their natural levels, increasing
uncertainty in the economy, the proposition provides an argument against
discretionary policy activism in favour of rules (see Chapter 5, section 5.5.1).
Second, Lucas’s (1976) critique of economic policy evaluation undermines
confidence that traditional Keynesian-style macroeconometric models can be
used to accurately predict the consequences of various policy changes on key
macroeconomic variables (see Chapter 5, section 5.5.6). Third, Kydland and
Prescott’s (1977) analysis of dynamic time inconsistency, which implies that
economic performance can be improved if discretionary powers are taken
away from the authorities, provides another argument in the case for monetary
policy being conducted by rules rather than discretion (see Chapter 5,
section 5.5.3).
Following the demise of the monetary-surprise version of new classical
macroeconomics in the early 1980s a second phase of equilibrium theorizing
was initiated by the seminal contribution of Kydland and Prescott (1982)
which, following Long and Plosser (1983), has come to be referred to as real
business cycle theory. As we shall discuss in Chapter 6, modern equilibrium
business cycle theory starts with the view that ‘growth and fluctuations are
not distinct phenomena to be studied with separate data and analytical tools’
(Cooley and Prescott, 1995). Proponents of this approach view economic
fluctuations as being predominantly caused by persistent real (supply-side)
shocks, rather than unanticipated monetary (demand-side) shocks, to the
economy. The focus of these real shocks involves large random fluctuations
in the rate of technological progress that result in fluctuations in relative
prices to which rational economic agents optimally respond by altering their
supply of labour and consumption. Perhaps the most controversial feature of
this approach is the claim that fluctuations in output and employment are
Pareto-efficient responses to real technology shocks to the aggregate production
function. This implies that observed fluctuations in output are viewed as
fluctuations in the natural rate of output, not deviations of output from a
smooth deterministic trend. As such the government should not attempt to
reduce these fluctuations through stabilization policy, not only because such
Understanding modern macroeconomics 27
attempts are unlikely to achieve their desired objective but also because
reducing instability would reduce welfare (Prescott, 1986).
The real business cycle approach conflicts with both the conventional
Keynesian analysis as well as monetarist and new classical monetary equilibrium
theorizing where equilibrium is identified with a stable trend for the
natural (full employment) growth path. In the Keynesian approach departures
from full employment are viewed as disequilibrium situations where societal
welfare is below potential and government has a role to correct this macroeconomic
market failure using fiscal and monetary policy. In sharp contrast
the ‘bold conjecture’ of real business cycle theorists is that each stage of the
business cycle, boom and slump, is an equilibrium. ‘Slumps represent an
undesired, undesirable, and unavoidable shift in the constraints that people
face; but, given these constraints, markets react efficiently and people succeed
in achieving the best outcomes that circumstances permit … every stage
of the business cycle is a Pareto efficient equilibrium’ (Hartley et al., 1998).
Needless to say, the real business cycle approach has proved to be highly
controversial and has been subjected to a number of criticisms, not least the
problem of identifying negative technological shocks that cause recessions.
In Chapter 6 we shall examine these criticisms and appraise the contribution
that real business cycle theorists have made to modern macroeconomics.
The new classical equilibrium approach to explaining economic fluctuations
has in turn been challenged by a revitalized group of new Keynesian
theorists who prefer to adapt micro to macro theory rather than accept the
new classical approach of adapting macro theory to orthodox neoclassical
market-clearing microfoundations. Important figures here include George
Akerlof, Janet Yellen, Olivier Blanchard, Gregory Mankiw, Edmund Phelps,
David Romer, Joseph Stiglitz and Ben Bernanke (see Gordon, 1989; Mankiw
and Romer, 1991). As we will discuss in Chapter 7, new Keynesian models
have incorporated the rational expectations hypothesis, the assumption that
markets may fail to clear, due to wage and price stickiness, and Friedman’s
natural rate hypothesis. According to proponents of new Keynesian economics
there is a need for stabilization policy as capitalist economies are
subjected to both demand- and supply-side shocks which cause inefficient
fluctuations in output and employment. Not only will capitalist economies
fail to rapidly self-equilibrate, but where the actual rate of unemployment
remains above the natural rate for a prolonged period, the natural rate (or
what new Keynesians prefer to refer to as NAIRU – non-accelerating inflation
rate of unemployment) may well increase due to ‘hysteresis’ effects.
As governments can improve macroeconomic performance, if they are given
discretion to do so, we also explore in Chapter 7 the new Keynesian approach
to monetary policy as set out by Clarida et al. (1999) and Bernanke
et al. (1999).
Finally we can identify two further groups or schools of thought. The Post
Keynesian school is descended from some of Keynes’s more radical contemporaries
and disciples, deriving its inspiration and distinctive approach from
the writings of Joan Robinson, Nicholas Kaldor, Michal Kalecki, George
Shackle and Piero Sraffa. Modern advocates of this approach include Jan
Kregel, Victoria Chick, Hyman Minsky and Paul Davidson, the author of
Chapter 8 which discusses the Post Keynesian school. There is also a school
of thought that has its intellectual roots in the work of Ludwig von Mises and
Nobel Memorial Laureate Friedrich von Hayek which has inspired a distinctly
Austrian approach to economic analysis and in particular to the
explanation of business cycle phenomena. Modern advocates of the Austrian
approach include Israel Kirzner, Karen Vaughn and Roger Garrison, the
author of Chapter 9 which discusses the Austrian school.
To recap, we identify the following schools of thought that have made a
significant contribution to the evolution of twentieth-century macroeconomics:
(i) the orthodox Keynesian school (Chapter 3), (ii) the orthodox monetarist
school (Chapter 4), (iii) the new classical school (Chapter 5), (iv) the real
business cycle school (Chapter 6), (v) the new Keynesian school (Chapter 7),
(vi) the Post Keynesian school (Chapter 8) and (vii) the Austrian school
(Chapter 9). No doubt other economists would choose a different classification,
and some have done so (see Cross, 1982a; Phelps, 1990). For example,
Gerrard (1996) argues that a unifying theme in the evolution of modern
macroeconomics has been an ‘ever-evolving classical Keynesian debate’ involving
contributions from various schools of thought that can be differentiated
and classified as orthodox, new or radical. The two ‘orthodox’ schools, ‘IS–
LM Keynesianism’ and ‘neoclassical monetarism’, dominated macroeconomic
theory in the period up to the mid-1970s. Since then three new schools have
been highly influential. The new classical, real business cycle and new
Keynesian schools place emphasis on issues relating to aggregate supply in
contrast to the orthodox schools which focused their research primarily on
the factors determining aggregate demand and the consequences of demandmanagement
policies. In particular, the new schools share Lucas’s view that
macroeconomic models should be based on solid microeconomic foundations
(Hoover, 1988, 1992). The ‘radical’ schools, both Post Keynesian and Austrian,
are critical of mainstream analysis, whether it be orthodox or new.
We are acutely aware of the dangers of categorizing particular economists
in ways which are bound to oversimplify the sophistication and breadth of
their own views. Many economists dislike being labelled or linked to any
specific research programme or school, including some of those economists
listed above. As Hoover (1988) has observed in a similar enterprise, ‘Any
economist is described most fully by a vector of characteristics’ and any
definition will ‘emphasise some elements of this vector, while playing down
related ones’. It is also the case that during the last decade of the twentieth
century, macroeconomics began to evolve into what Goodfriend and King
(1997) have called a ‘New Neoclassical Synthesis’. The central elements of this
new synthesis involve both new classical and new Keynesian elements, namely:
1. the need for macroeconomic models to take into account intertemporal
optimization;
2. the widespread use of the rational expectations hypothesis;
3. recognition of the importance of imperfect competition in goods, labour
and credit markets;
4. incorporating costly price adjustment into macroeconomic models.
Therefore, one important development arising from the vociferous debates of
the 1970s and 1980s is that there is now more of a consensus on what
constitutes a ‘core of practical macroeconomics’ than was the case 25 years
ago (see Blanchard, 1997b, 2000; Blinder, 1997a; Eichenbaum, 1997; Solow,
1997; Taylor, 1997b).
With these caveats in mind we will examine in Chapters 3–9 the competing
schools of macroeconomic thought identified above. We also include interviews
with some of the economists who are generally recognized as being
leading representatives of each group and/or prominent in the development of
macroeconomic analysis in the post-war period. In discussing these various
schools of thought it is important to remember that the work of Keynes
remains the ‘main single point of reference, either positive or negative, for all
the schools of macroeconomics’. Therefore, it is hardly surprising that all the
schools define themselves in relation to the ideas originally put forward by
Keynes in his General Theory, ‘either as a development of some version of
his thought or as a restoration of some version of pre-Keynesian classical
thought’ (Vercelli, 1991, p. 3).
Before considering the central tenets and policy implications of these main
schools of thought we also need to highlight two other important changes that
have taken place in macroeconomics during the final decades of the twentieth
century. First, in section 1.9 we outline the development of what has come to
be known as the new political macroeconomics. The second key change of
emphasis during the last 20 years, reviewed in section 1.10, has been the
renaissance of growth theory and empirics.
According to Johnson (1971), ‘by far the most helpful circumstance for the
rapid propagation of a new revolutionary theory is the existence of an established
orthodoxy which is clearly inconsistent with the most salient facts of
reality’. As we have seen, the inability of the classical model to account
adequately for the collapse of output and employment in the 1930s paved the
way for the Keynesian revolution. During the 1950s and 1960s the neoclassical
synthesis became the accepted wisdom for the majority of economists
(see Chapter 3). The work of Nobel Memorial Laureates James Tobin, Lawrence
Klein, Robert Solow, Franco Modigliani, James Meade, John Hicks
and Paul Samuelson dominated the Keynesian school and provided intellectual
support for the view that government intervention in the form of demand
management can significantly improve the performance of the economy. The
‘New Economics’ adopted by the Kennedy administration in 1961 demonstrated
the influence of Keynesian thinking and the 1962 Economic Report of
the President explicitly advocated stabilization policies with the objective of
keeping ‘overall demand in step with the basic production potential of the
economy’.
During the 1970s this Keynesian approach increasingly came under attack
and was subjected to the force of two ‘counter-revolutionary’ approaches,
namely monetarism and new classical macroeconomics. Both of these approaches
are underpinned by the belief that there is no need for activist
stabilization policy. The new classical school in particular supports the view
that the authorities cannot, and therefore should not, attempt to stabilize
fluctuations in output and employment through the use of activist demand
management policies (Lucas, 1981a).
As we shall discuss in Chapter 4, in the orthodox monetarist view there is
no need for activist stabilization policy (except in extreme circumstances)
given the belief that capitalist economies are inherently stable, unless disturbed
by erratic monetary growth. Monetarists hold that when subjected to
some disturbance the economy will return, fairly quickly, to the neighbourhood
of the ‘natural’ level of output and employment. Given this view they
question the need for stabilization policy involving the ‘fine-tuning’ of aggreUnderstanding
gate demand. Even if there were a need, monetarists argue that the authorities
can’t stabilize fluctuations in output and employment due to the problems
associated with stabilization policy. These problems include those posed by
the length of the inside lag associated with fiscal policy, the long and variable
outside time lags associated with monetary policy and uncertainty over what
precise value to attribute to the natural rate of unemployment. In consequence
monetarists argue that the authorities shouldn’t be given discretion to
vary the strength of fiscal and monetary policy as and when they see fit,
fearing that they could do more harm than good. Instead, monetarists advocate
that the monetary authorities should be bound by rules.
With hindsight two publications were particularly influential in cementing
the foundations for the monetarist counter-revolution. First there is Friedman
and Schwartz’s (1963) monumental study, A Monetary History of the United
States, 1867–1960. This influential volume presents persuasive evidence in
support of the monetarist view that changes in the money supply play a
largely independent role in cyclical fluctuations. Second is Friedman’s (1968a)
American Economic Review article on ‘The Role of Monetary Policy’ in
which he put forward the natural rate hypothesis and the view that there is no
long-run trade-off between inflation and unemployment. The influence of
Friedman’s article was greatly enhanced because it anticipated the events of
the 1970s and, in particular, predicted accelerating inflation as a consequence
of the repeated use of expansionary monetary policy geared to over-optimistic
employment targets.
During the 1970s a second counter-revolution took place associated with
new classical macroeconomics. This approach, which cast further doubt on
whether traditional Keynesian aggregate demand management policies can
be used to stabilize the economy, is often seen as synonymous with the work
of one of Friedman’s former University of Chicago students, the 1995 Nobel
Memorial Laureate, Robert E. Lucas Jr. Other leading advocates of the new
classical monetary approach to analysing economic fluctuations during the
1970s include Thomas Sargent, Neil Wallace, Robert Barro, Edward Prescott
and Patrick Minford (see Hoover, 1988; Snowdon et al., 1994).
As we will discuss in Chapter 5, by combining the rational expectations
hypothesis (first put forward by John Muth in the context of microeconomics
in the early 1960s), the assumption that markets continuously clear, and
Friedman’s natural rate hypothesis, Lucas was able to demonstrate in his
1972 Journal of Economic Theory paper on ‘Expectations and the Neutrality
of Money’ how a short-run equilibrium relationship between inflation and
unemployment (Phillips curve) will result if inflation is unanticipated due to
incomplete information.
In line with the monetarist school, new classical economists believe that
the economy is inherently stable, unless disturbed by erratic monetary growth,
and that when subjected to some disturbance will quickly return to its natural
level of output and employment. However, in the new classical approach it is
unanticipated monetary shocks that are the dominant cause of business cycles.
The new classical case against discretionary policy activism, and in
favour of rules, is based on a different set of arguments to those advanced by
monetarists. Three insights in particular underlie the new classical approach.
First, the policy ineffectiveness proposition (Sargent and Wallace, 1975, 1976)
implies that only random or arbitrary monetary policy actions undertaken by
the authorities can have short-run real effects because they cannot be anticipated
by rational economic agents. Given that such actions will only increase
the variation of output and employment around their natural levels, increasing
uncertainty in the economy, the proposition provides an argument against
discretionary policy activism in favour of rules (see Chapter 5, section 5.5.1).
Second, Lucas’s (1976) critique of economic policy evaluation undermines
confidence that traditional Keynesian-style macroeconometric models can be
used to accurately predict the consequences of various policy changes on key
macroeconomic variables (see Chapter 5, section 5.5.6). Third, Kydland and
Prescott’s (1977) analysis of dynamic time inconsistency, which implies that
economic performance can be improved if discretionary powers are taken
away from the authorities, provides another argument in the case for monetary
policy being conducted by rules rather than discretion (see Chapter 5,
section 5.5.3).
Following the demise of the monetary-surprise version of new classical
macroeconomics in the early 1980s a second phase of equilibrium theorizing
was initiated by the seminal contribution of Kydland and Prescott (1982)
which, following Long and Plosser (1983), has come to be referred to as real
business cycle theory. As we shall discuss in Chapter 6, modern equilibrium
business cycle theory starts with the view that ‘growth and fluctuations are
not distinct phenomena to be studied with separate data and analytical tools’
(Cooley and Prescott, 1995). Proponents of this approach view economic
fluctuations as being predominantly caused by persistent real (supply-side)
shocks, rather than unanticipated monetary (demand-side) shocks, to the
economy. The focus of these real shocks involves large random fluctuations
in the rate of technological progress that result in fluctuations in relative
prices to which rational economic agents optimally respond by altering their
supply of labour and consumption. Perhaps the most controversial feature of
this approach is the claim that fluctuations in output and employment are
Pareto-efficient responses to real technology shocks to the aggregate production
function. This implies that observed fluctuations in output are viewed as
fluctuations in the natural rate of output, not deviations of output from a
smooth deterministic trend. As such the government should not attempt to
reduce these fluctuations through stabilization policy, not only because such
Understanding modern macroeconomics 27
attempts are unlikely to achieve their desired objective but also because
reducing instability would reduce welfare (Prescott, 1986).
The real business cycle approach conflicts with both the conventional
Keynesian analysis as well as monetarist and new classical monetary equilibrium
theorizing where equilibrium is identified with a stable trend for the
natural (full employment) growth path. In the Keynesian approach departures
from full employment are viewed as disequilibrium situations where societal
welfare is below potential and government has a role to correct this macroeconomic
market failure using fiscal and monetary policy. In sharp contrast
the ‘bold conjecture’ of real business cycle theorists is that each stage of the
business cycle, boom and slump, is an equilibrium. ‘Slumps represent an
undesired, undesirable, and unavoidable shift in the constraints that people
face; but, given these constraints, markets react efficiently and people succeed
in achieving the best outcomes that circumstances permit … every stage
of the business cycle is a Pareto efficient equilibrium’ (Hartley et al., 1998).
Needless to say, the real business cycle approach has proved to be highly
controversial and has been subjected to a number of criticisms, not least the
problem of identifying negative technological shocks that cause recessions.
In Chapter 6 we shall examine these criticisms and appraise the contribution
that real business cycle theorists have made to modern macroeconomics.
The new classical equilibrium approach to explaining economic fluctuations
has in turn been challenged by a revitalized group of new Keynesian
theorists who prefer to adapt micro to macro theory rather than accept the
new classical approach of adapting macro theory to orthodox neoclassical
market-clearing microfoundations. Important figures here include George
Akerlof, Janet Yellen, Olivier Blanchard, Gregory Mankiw, Edmund Phelps,
David Romer, Joseph Stiglitz and Ben Bernanke (see Gordon, 1989; Mankiw
and Romer, 1991). As we will discuss in Chapter 7, new Keynesian models
have incorporated the rational expectations hypothesis, the assumption that
markets may fail to clear, due to wage and price stickiness, and Friedman’s
natural rate hypothesis. According to proponents of new Keynesian economics
there is a need for stabilization policy as capitalist economies are
subjected to both demand- and supply-side shocks which cause inefficient
fluctuations in output and employment. Not only will capitalist economies
fail to rapidly self-equilibrate, but where the actual rate of unemployment
remains above the natural rate for a prolonged period, the natural rate (or
what new Keynesians prefer to refer to as NAIRU – non-accelerating inflation
rate of unemployment) may well increase due to ‘hysteresis’ effects.
As governments can improve macroeconomic performance, if they are given
discretion to do so, we also explore in Chapter 7 the new Keynesian approach
to monetary policy as set out by Clarida et al. (1999) and Bernanke
et al. (1999).
Finally we can identify two further groups or schools of thought. The Post
Keynesian school is descended from some of Keynes’s more radical contemporaries
and disciples, deriving its inspiration and distinctive approach from
the writings of Joan Robinson, Nicholas Kaldor, Michal Kalecki, George
Shackle and Piero Sraffa. Modern advocates of this approach include Jan
Kregel, Victoria Chick, Hyman Minsky and Paul Davidson, the author of
Chapter 8 which discusses the Post Keynesian school. There is also a school
of thought that has its intellectual roots in the work of Ludwig von Mises and
Nobel Memorial Laureate Friedrich von Hayek which has inspired a distinctly
Austrian approach to economic analysis and in particular to the
explanation of business cycle phenomena. Modern advocates of the Austrian
approach include Israel Kirzner, Karen Vaughn and Roger Garrison, the
author of Chapter 9 which discusses the Austrian school.
To recap, we identify the following schools of thought that have made a
significant contribution to the evolution of twentieth-century macroeconomics:
(i) the orthodox Keynesian school (Chapter 3), (ii) the orthodox monetarist
school (Chapter 4), (iii) the new classical school (Chapter 5), (iv) the real
business cycle school (Chapter 6), (v) the new Keynesian school (Chapter 7),
(vi) the Post Keynesian school (Chapter 8) and (vii) the Austrian school
(Chapter 9). No doubt other economists would choose a different classification,
and some have done so (see Cross, 1982a; Phelps, 1990). For example,
Gerrard (1996) argues that a unifying theme in the evolution of modern
macroeconomics has been an ‘ever-evolving classical Keynesian debate’ involving
contributions from various schools of thought that can be differentiated
and classified as orthodox, new or radical. The two ‘orthodox’ schools, ‘IS–
LM Keynesianism’ and ‘neoclassical monetarism’, dominated macroeconomic
theory in the period up to the mid-1970s. Since then three new schools have
been highly influential. The new classical, real business cycle and new
Keynesian schools place emphasis on issues relating to aggregate supply in
contrast to the orthodox schools which focused their research primarily on
the factors determining aggregate demand and the consequences of demandmanagement
policies. In particular, the new schools share Lucas’s view that
macroeconomic models should be based on solid microeconomic foundations
(Hoover, 1988, 1992). The ‘radical’ schools, both Post Keynesian and Austrian,
are critical of mainstream analysis, whether it be orthodox or new.
We are acutely aware of the dangers of categorizing particular economists
in ways which are bound to oversimplify the sophistication and breadth of
their own views. Many economists dislike being labelled or linked to any
specific research programme or school, including some of those economists
listed above. As Hoover (1988) has observed in a similar enterprise, ‘Any
economist is described most fully by a vector of characteristics’ and any
definition will ‘emphasise some elements of this vector, while playing down
related ones’. It is also the case that during the last decade of the twentieth
century, macroeconomics began to evolve into what Goodfriend and King
(1997) have called a ‘New Neoclassical Synthesis’. The central elements of this
new synthesis involve both new classical and new Keynesian elements, namely:
1. the need for macroeconomic models to take into account intertemporal
optimization;
2. the widespread use of the rational expectations hypothesis;
3. recognition of the importance of imperfect competition in goods, labour
and credit markets;
4. incorporating costly price adjustment into macroeconomic models.
Therefore, one important development arising from the vociferous debates of
the 1970s and 1980s is that there is now more of a consensus on what
constitutes a ‘core of practical macroeconomics’ than was the case 25 years
ago (see Blanchard, 1997b, 2000; Blinder, 1997a; Eichenbaum, 1997; Solow,
1997; Taylor, 1997b).
With these caveats in mind we will examine in Chapters 3–9 the competing
schools of macroeconomic thought identified above. We also include interviews
with some of the economists who are generally recognized as being
leading representatives of each group and/or prominent in the development of
macroeconomic analysis in the post-war period. In discussing these various
schools of thought it is important to remember that the work of Keynes
remains the ‘main single point of reference, either positive or negative, for all
the schools of macroeconomics’. Therefore, it is hardly surprising that all the
schools define themselves in relation to the ideas originally put forward by
Keynes in his General Theory, ‘either as a development of some version of
his thought or as a restoration of some version of pre-Keynesian classical
thought’ (Vercelli, 1991, p. 3).
Before considering the central tenets and policy implications of these main
schools of thought we also need to highlight two other important changes that
have taken place in macroeconomics during the final decades of the twentieth
century. First, in section 1.9 we outline the development of what has come to
be known as the new political macroeconomics. The second key change of
emphasis during the last 20 years, reviewed in section 1.10, has been the
renaissance of growth theory and empirics.
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