Twentieth-Century Developments in Macroeconomics: Evolution
or Revolution?
In his survey Blanchard (2000) acknowledges that:
on the surface, this history of macroeconomics in the twentieth century appears as
a series of battles, revolutions, and counterrevolutions, from the Keynesian revolution
of the 1930s and 1940s, to the battles between Monetarists and Keynesians
of the 1950s and 1960s, to the Rational Expectations revolution of the 1970s, and
the battles between New Keynesians and New Classicals of the 1980s.
However, Blanchard argues that viewing progress in macroeconomics in this
way creates the ‘wrong image’ and that instead ‘the right one is of a surprisingly
steady accumulation of knowledge’. In surveying the development of
macroeconomics over the course of the twentieth century he identifies three
epochs, namely:
1. pre-1940, an epoch of exploration;
2. 1940–80, an epoch of consolidation; and
3. post-1980, a new epoch of exploration.
Pre-1940, research into what we now call short-run macroeconomics centred
on the two ‘largely disconnected’ fields of monetary theory and business
cycle theory. In the former case, monetary theory was dominated by the
quantity theory of money and concentrated on issues relating to the shortrun
non-neutrality, and long-run neutrality, of money. In the latter case,
business cycle theory consisted of a ‘collection of explanations, each with
its own rich dynamics’, as evidenced for example by Haberler’s (1937)
survey of pre-Keynesian views contained in his book Prosperity and Depression.
According to Blanchard, the methodological contributions of
Keynes’s (1936) General Theory made a ‘crucial difference’ to integrating
the two fields by pulling together all the relevant factors previously used in
their study. By analysing the interplay between the goods, labour and money
markets, Keynes provided a coherent framework that had been missing in
earlier work.
The epoch 1940–80 Blanchard refers to as a period of consolidation. The
foundation for this prolonged period of consolidation was provided by Keynes’s
(1936) integrated framework and Hicks’s (1937) IS–LM interpretation of the
General Theory. This framework was built upon and extended. Among the
‘steady accumulation of knowledge’ that took place over this period it is
possible to identify a number of examples, which include:
ing the work of James Meade and Richard Stone (1944) in developing a
system of national accounts;
2. the development of, and improvements in, econometric methods (see
Hoover, 1995a, 2001a, 2001b);
3. more detailed modelling of the behavioural relationships of consumption
(for example Modigliani and Brumberg, 1954; Friedman, 1957), investment
(for example Jorgenson, 1963) and the demand for money (for
example Baumol, 1952; Tobin, 1958);
4. the construction of macroeconometric models of the economy, for example
Klein and Goldberger (1955);
5. the incorporation of the expectations-augmented Phillips curve analysis
into macroeconomic models and an examination of the implications for
stabilization policy, for example Friedman (1968a);
6. more careful modelling of how expectations are formed, for example
Cagan (1956); Muth (1961); and
7. an examination of the implications of rational expectations for the analysis
of policy changes, for example Lucas (1976).
This list is far from being exhaustive and merely illustrates a number of
important developments and breakthroughs achieved during this period, some
of which were recognized by the award of the Nobel Memorial Prize in
Economics (see Blaug and Vane, 2003; Vane and Mulhearn, 2004). However,
by the end of the 1970s Blanchard argues that ‘too casual a treatment of
imperfections’ led to a ‘crisis’ in macroeconomics, which initially resulted in
two different routes of enquiry. In the ensuing post-1980 epoch of new
exploration one group of economists labelled new Keynesians (see for example
Gordon, 1990; Mankiw and Romer, 1991) concentrated their attention on
market imperfections in goods, labour and credit markets, and their implications
for macroeconomics. Another group referred to as real business cycle
theorists (see for example Kydland and Prescott, 1982; Long and Plosser,
1983; Prescott, 1986) adopted new classical methodology and assumptions
and initially explored how far equilibrium theorizing could go in explaining
aggregate fluctuations without resorting to monetary shocks and without
introducing imperfections in their analysis.
In contrast, in his survey Woodford (2000) agues that the ‘degree to which
there has been progress over the course of the century is sufficiently far from
transparent’ and that macroeconomics ‘has been famously controversial’.
Acknowledging that ‘discussions of twentieth-century developments in macroeconomics
make frequent references to revolutions and counter revolutions’
(see for example the titles adopted by Klein, 1947; Clower, 1965; Brunner,
1970; Friedman, 1970c; Johnson, 1971; Tobin, 1981; Begg, 1982; Barro,
1984; Tomlinson, 1984; Booth, 1985; Dimand, 1988; Blaug, 1991b), he
traces the development of macroeconomics in historical perspective. Starting
from Keynes’s (1936) General Theory he tracks progress in macroeconomics
from the Keynesian revolution, the neoclassical synthesis, the Great Inflation
and the crisis in Keynesian economics, monetarism, rational expectations and
the new classical economics, real business cycle theory to a new neoclassical
synthesis. From Woodford’s historical perspective the evolution of economists’
thinking on macroeconomics has been far from smooth.
It should be immediately apparent that the approach we have taken in this
book more closely parallels that taken by Woodford. There is no dissent that
the birth of modern macroeconomics can be traced back to the publication of
Keynes’s (1936) General Theory or that macroeconomics is a ‘quintessentially
twentieth-century development’ (Woodford, 2000). Indeed, Blanchard
(2000) notes that the term ‘macroeconomic’ does not appear in the economics
literature until it formed part of the title of an article by De Wolff which was
published in 1941, while the term ‘macroeconomics’ first appeared in the title
of an article by Klein published in 1946. The central belief which underpinned
the ensuing Keynesian revolution in macroeconomic thought is the
need for stabilization, the view that the authorities can, and therefore should
use discretionary fiscal and monetary policy to stabilize output and employment
at their full employment levels (see Modigliani, 1977). According to
Gerrard (1996), a unifying theme in the evolution of modern macroeconomics
thereafter has been an ‘ever-evolving classical-Keynesian debate’ involving
contributions from various schools of thought that can be differentiated and
classified as being orthodox (the orthodox Keynesian and orthodox monetarist
schools), new (the new classical, real business cycle and new Keynesian
schools) or radical (the Austrian and Post Keynesian schools).
The rise and fall of orthodox Keynesian economics owed a great deal to its
problem-solving effectiveness. It appeared to provide a robust explanation of
a severe empirical problem, namely mass unemployment, which had persisted
long enough not to be easily explained away as a minor anomaly. In
addition it offered an attractive political action programme for the resolution
of the diagnosed problem. Whilst it contained a number of serious conceptual
problems, for example inconsistencies and ambiguities of presentation alongside
more radical elements, these were effectively submerged by the
neoclassical synthesis process. This synthesis of classical and Keynesian
ideas, captured by the IS–LM AD–AS framework, represented the consensus
view before the 1970s and was the standard approach to macroeconomic
analysis both in textbooks and in professional discussion.
The demise of orthodox Keynesianism was in large part the result of its
failure to deal adequately with the major new empirical problem posed by
stagflation in the 1970s. Conceptually much of its ‘heuristic power’ had
‘petered out’ and ‘run dry’ (Leijonhufvud, 1968). As Klamer (1984) conConclusions
and reflections 699
cedes, ‘the 70s were a decade of retreat, defence, and frustration’ for Keynesian
economics. During periods of consensus in macroeconomics divisions among
economists naturally become less intense and less visible in the literature.
The inherent weaknesses and practical failings of both Keynesianism and
economic positivism highlighted in the late 1960s and early 1970s led to the
demise of much of the old orthodoxy without its replacement by any single
dominant new approach. Any continuing ‘submerged’ competition between
rival macroeconomic explanations became more open and pronounced. The
revival of much of the ‘old economics’, in a traditional (Austrian) or new
form (monetarist, new classical and real business cycle approaches), undermined
much of the ‘new economics’ of orthodox Keynesianism, which in
turn encouraged the development of new Keynesian accounts. The more
radical Post Keynesian interpretation of Keynes’s (1936) General Theory
also continues to offer an alternative vision of how the macroeconomic system
operates.
Keynesianism was initially faced by a potent rival, monetarism, which was
better able to explain the empirical anomaly of stagflation in a more consistent
fashion. As we have discussed, in the orthodox monetarist view (and the
new classical approach) there is no need for stabilization policy, the authorities
can’t, and therefore shouldn’t, attempt to stabilize fluctuations in output
and employment through the use of activist aggregate demand management
policies. Monetarism, in turn, experienced a period of progress before being
faced with problems of its own, not least as noted earlier in Chapter 4 the
sharp decline in trend velocity in the 1980s in the USA and elsewhere. The
collapse of a stable demand for money function in the early 1980s was to
seriously undermine monetarism. During the early 1970s a second counterrevolution
took place associated with new classical school which cast further
doubt on whether traditional Keynesian aggregate demand management policies
can be used to stabilize the economy. While new classical macroeconomics
evolved out of the monetarist approach, it in fact provided a sustained challenge
to the monetarist as well as the Keynesian orthodoxies. As we have
seen, the new classical case against discretionary policy activism and in
favour of rules is based on a different set of arguments (most notably the
policy ineffectiveness proposition, the Lucas critique and time inconsistency)
to those advanced by orthodox monetarists.
New classical macroeconomics displayed important conceptual progress
both by nurturing a rational expectations revolution, which was subsequently
widely incorporated into the macroeconomic mainstream, and by highlighting
the role of aggregate supply. However, important criticisms were
increasingly directed at new classical macroeconomics concerning certain
conceptual, empirical and policy deficiencies. Its empirical results have been,
at best, somewhat mixed and inconclusive. Contrary to its early claims, both
700 Modern macroeconomics
unanticipated and anticipated policy changes appear to affect output and
employment, while several economies have experienced real costs of announced
disinflation. New classical macroeconomics has certainly left its
mark, and both real business cycle theory and new Keynesian economics can
be viewed as a response to issues raised by Robert E. Lucas Jr and other
prominent new classicists.
During the 1980s a considerable divide emerged between the flexi-price
competitive equilibrium real business cycle models and the sticky-price new
Keynesian models, where monetary influences are viewed as central to any
explanation of the path of real variables in the short run. In the real business
cycle approach there is no need for stabilization policy. Furthermore, as monetary
factors are irrelevant in explaining such fluctuations, monetary policy
can’t be used to influence output and employment even in the short run. In
these circumstances governments shouldn’t attempt to reduce fluctuations in
output and employment, which are Pareto-efficient responses to shocks to the
production function. In contrast, new Keynesians argue that there is a need for
stabilization policy as capitalist economies are subjected to shocks from both
the demand and supply side of the economy, which cause inefficient fluctuations
in output and employment. Furthermore, since governments can improve macroeconomic
performance, they should pursue stabilization policy. Although there
is no unified view among new Keynesians with respect to the rules versus
discretion debate, new Keynesians do not advocate ‘fine-tuning’ the economy,
but have instead championed the case for ‘rough-tuning’ in response to large
divergences in output and employment from their natural levels. Today the new
Keynesian stance can best be characterized as one which supports the case for
some kind of constrained discretion in the form of an activist rule, along the
lines, for example, of a flexible Taylor-type rule.
As an aside, it is interesting to note that new Keynesian economics could
have been named new monetarist economics (Mankiw and Romer, 1991) in
that it represents a synthesis of certain key foundations of monetarism and
new classical macroeconomics. For example, the new Keynesian school has
absorbed what it regards as valid components of the monetarist and new
classical counter-revolutions, most notably the natural rate hypothesis and the
rational expectations hypothesis. However, responding to the challenge of
new classical macroeconomists, the new Keynesian school has provided rigorous
microfoundations to explain why markets may fail to clear due to wage
and price stickiness. In so doing it has been able to account for involuntary
unemployment as an equilibrium phenomenon and provide a rationale to
justify interventionist policies to stabilize the economy.
Of course the demise of orthodox Keynesianism also permitted the revival
of interest in such non-mainstream accounts as that of the Austrians and the
salvaging of Keynes’s fundamental ideas by the Post Keynesians.
Conclusions and reflections 701
In Chapters 4–9 we examined the nature and extent of disagreement within
macroeconomics resulting from the dismantling of the Keynesian orthodoxy.
Over the decades macroeconomists have largely been engaged in emphasizing
their differences rather than their similarities. They have often been more
concerned with differentiating their intellectual products in the academic
arena alongside a willingness to display conflicts over policy advice in the
public arena. In short, there has been a tendency to emphasize uniqueness of
identity, which, in turn, has led to both diversity and labelling.
Table 12.1 highlights some of the important features of the schools of
macroeconomic thought explored in Chapters 3–9 of this book. The mainstream
development of macroeconomics can be read from top to bottom, that
is, from orthodox Keynesian to new Keynesian. The Austrian and Post
Keynesian approaches represent the most important non-mainstream approaches.
Two points should be borne in mind when consulting this table.
First, within each school identified, there are differences of opinion and
emphasis: the table merely characterizes the view most commonly held on
particular issues. Second, as is evident from a close scrutiny of the table,
there is a considerable degree of overlap between the various schools on a
number of issues. This suggests that, in practice, the dividing line between
schools is becoming increasingly blurred on many issues. With the benefit of
hindsight, differences between schools have often been exaggerated. Take,
for example, the debate between Tobin and Friedman concerning the transmission
mechanism of monetary policy. In commenting on the debate Stanley
Fischer (1994) suggests that:
you can read Friedman’s and Tobin’s statement of the transmission mechanism
and you can’t tell who wrote which. The analogy I use is that when I was a kid I
could tell cars apart coming down the road. Then the differences between say a
Chev and a Ford were enormous. Now if you look at an old car I know it’s a 1950s
model but I don’t have any idea whether it’s a Ford or a Chev because they look
practically identical. In that sense the methods and models they used and the
issues they looked at were very similar.
Ten years ago in the concluding chapter to our book A Modern Guide to
Macroeconomics (Snowdon, Vane and Wynarczyk, 1994), we noted that ‘at
the present moment macroeconomics lacks the degree of consensus it once
had under orthodox Keynesianism’ and that ‘while there does not appear to
be any clearly emerging consensus on the horizon we should not be surprised
if a synthesis develops in the future, possibly even from disparate schools’.
According to Marvin Goodfriend and Robert King (1997), the intellectual
currents of recent years are moving modern macroeconomics towards a ‘New
Neoclassical Synthesis’. The new synthesis ‘inherits the spirit of the old in
that it combines Keynesian and classical elements’.
Table 12.1 Some areas of agreement and disagreement in macroeconomics
Schools in Dominant Expectations Price/wage Market Notion of Dominant Rules v.
macroeconomics source of adjustment adjustment equilibrium time frame discretion
instability
Orthodox Keynesian Fluctuations in Adaptive Emphasis Weak State of rest Short Discretion
autonomous on nominal probably below
expenditure wage full
rigidity employment
Orthodox monetarist Monetary Adaptive Flexible Strong Market clearing Short and Rules
disturbances at natural rate long
New classical Monetary Rational Perfectly Very Market clearing Long = short Rules
disturbances flexible strong at natural rate
Real business cycle Supply shocks Rational Perfectly Very Market clearing Long = short Rules
(mainly flexible strong at moving
technological) natural rate
New Keynesian Demand and Rational Emphasis Slow Consistent with Predominantly Constrained
supply shocks on price involuntary short discretion
(eclectic) rigidities unemployment
Austrian Monetary Reasonable Flexible Strong Tendency Short and long Rules
disturbances towards
Post Keynesian Fluctuations in Reasonable Sticky Very State of rest Short Discretion
autonomous weak probably below
expenditure full employment
noting that the key elements in the new synthesis comprise: intertemporal
optimization; rational expectations; imperfect competition in goods, labour
and credit markets; and nominal rigidities and costly price adjustment. In
their analysis Goodfriend and King conclude that the new neoclassical synthesis
suggests several important conclusions about the role of monetary
policy. First, monetary policy has real effects in the short run. Second, there
is little by way of a long-run trade-off between inflation and real activity.
Third, inflation is costly and it is important to eliminate it. Fourth, the
credibility of policy actions has an important impact on monetary policy
outcomes. Goodfriend and King argue that these conclusions point the way to
a rules-based monetary policy framework with inflation targeting acting as
the nominal anchor.
or Revolution?
In his survey Blanchard (2000) acknowledges that:
on the surface, this history of macroeconomics in the twentieth century appears as
a series of battles, revolutions, and counterrevolutions, from the Keynesian revolution
of the 1930s and 1940s, to the battles between Monetarists and Keynesians
of the 1950s and 1960s, to the Rational Expectations revolution of the 1970s, and
the battles between New Keynesians and New Classicals of the 1980s.
However, Blanchard argues that viewing progress in macroeconomics in this
way creates the ‘wrong image’ and that instead ‘the right one is of a surprisingly
steady accumulation of knowledge’. In surveying the development of
macroeconomics over the course of the twentieth century he identifies three
epochs, namely:
1. pre-1940, an epoch of exploration;
2. 1940–80, an epoch of consolidation; and
3. post-1980, a new epoch of exploration.
Pre-1940, research into what we now call short-run macroeconomics centred
on the two ‘largely disconnected’ fields of monetary theory and business
cycle theory. In the former case, monetary theory was dominated by the
quantity theory of money and concentrated on issues relating to the shortrun
non-neutrality, and long-run neutrality, of money. In the latter case,
business cycle theory consisted of a ‘collection of explanations, each with
its own rich dynamics’, as evidenced for example by Haberler’s (1937)
survey of pre-Keynesian views contained in his book Prosperity and Depression.
According to Blanchard, the methodological contributions of
Keynes’s (1936) General Theory made a ‘crucial difference’ to integrating
the two fields by pulling together all the relevant factors previously used in
their study. By analysing the interplay between the goods, labour and money
markets, Keynes provided a coherent framework that had been missing in
earlier work.
The epoch 1940–80 Blanchard refers to as a period of consolidation. The
foundation for this prolonged period of consolidation was provided by Keynes’s
(1936) integrated framework and Hicks’s (1937) IS–LM interpretation of the
General Theory. This framework was built upon and extended. Among the
‘steady accumulation of knowledge’ that took place over this period it is
possible to identify a number of examples, which include:
ing the work of James Meade and Richard Stone (1944) in developing a
system of national accounts;
2. the development of, and improvements in, econometric methods (see
Hoover, 1995a, 2001a, 2001b);
3. more detailed modelling of the behavioural relationships of consumption
(for example Modigliani and Brumberg, 1954; Friedman, 1957), investment
(for example Jorgenson, 1963) and the demand for money (for
example Baumol, 1952; Tobin, 1958);
4. the construction of macroeconometric models of the economy, for example
Klein and Goldberger (1955);
5. the incorporation of the expectations-augmented Phillips curve analysis
into macroeconomic models and an examination of the implications for
stabilization policy, for example Friedman (1968a);
6. more careful modelling of how expectations are formed, for example
Cagan (1956); Muth (1961); and
7. an examination of the implications of rational expectations for the analysis
of policy changes, for example Lucas (1976).
This list is far from being exhaustive and merely illustrates a number of
important developments and breakthroughs achieved during this period, some
of which were recognized by the award of the Nobel Memorial Prize in
Economics (see Blaug and Vane, 2003; Vane and Mulhearn, 2004). However,
by the end of the 1970s Blanchard argues that ‘too casual a treatment of
imperfections’ led to a ‘crisis’ in macroeconomics, which initially resulted in
two different routes of enquiry. In the ensuing post-1980 epoch of new
exploration one group of economists labelled new Keynesians (see for example
Gordon, 1990; Mankiw and Romer, 1991) concentrated their attention on
market imperfections in goods, labour and credit markets, and their implications
for macroeconomics. Another group referred to as real business cycle
theorists (see for example Kydland and Prescott, 1982; Long and Plosser,
1983; Prescott, 1986) adopted new classical methodology and assumptions
and initially explored how far equilibrium theorizing could go in explaining
aggregate fluctuations without resorting to monetary shocks and without
introducing imperfections in their analysis.
In contrast, in his survey Woodford (2000) agues that the ‘degree to which
there has been progress over the course of the century is sufficiently far from
transparent’ and that macroeconomics ‘has been famously controversial’.
Acknowledging that ‘discussions of twentieth-century developments in macroeconomics
make frequent references to revolutions and counter revolutions’
(see for example the titles adopted by Klein, 1947; Clower, 1965; Brunner,
1970; Friedman, 1970c; Johnson, 1971; Tobin, 1981; Begg, 1982; Barro,
1984; Tomlinson, 1984; Booth, 1985; Dimand, 1988; Blaug, 1991b), he
traces the development of macroeconomics in historical perspective. Starting
from Keynes’s (1936) General Theory he tracks progress in macroeconomics
from the Keynesian revolution, the neoclassical synthesis, the Great Inflation
and the crisis in Keynesian economics, monetarism, rational expectations and
the new classical economics, real business cycle theory to a new neoclassical
synthesis. From Woodford’s historical perspective the evolution of economists’
thinking on macroeconomics has been far from smooth.
It should be immediately apparent that the approach we have taken in this
book more closely parallels that taken by Woodford. There is no dissent that
the birth of modern macroeconomics can be traced back to the publication of
Keynes’s (1936) General Theory or that macroeconomics is a ‘quintessentially
twentieth-century development’ (Woodford, 2000). Indeed, Blanchard
(2000) notes that the term ‘macroeconomic’ does not appear in the economics
literature until it formed part of the title of an article by De Wolff which was
published in 1941, while the term ‘macroeconomics’ first appeared in the title
of an article by Klein published in 1946. The central belief which underpinned
the ensuing Keynesian revolution in macroeconomic thought is the
need for stabilization, the view that the authorities can, and therefore should
use discretionary fiscal and monetary policy to stabilize output and employment
at their full employment levels (see Modigliani, 1977). According to
Gerrard (1996), a unifying theme in the evolution of modern macroeconomics
thereafter has been an ‘ever-evolving classical-Keynesian debate’ involving
contributions from various schools of thought that can be differentiated and
classified as being orthodox (the orthodox Keynesian and orthodox monetarist
schools), new (the new classical, real business cycle and new Keynesian
schools) or radical (the Austrian and Post Keynesian schools).
The rise and fall of orthodox Keynesian economics owed a great deal to its
problem-solving effectiveness. It appeared to provide a robust explanation of
a severe empirical problem, namely mass unemployment, which had persisted
long enough not to be easily explained away as a minor anomaly. In
addition it offered an attractive political action programme for the resolution
of the diagnosed problem. Whilst it contained a number of serious conceptual
problems, for example inconsistencies and ambiguities of presentation alongside
more radical elements, these were effectively submerged by the
neoclassical synthesis process. This synthesis of classical and Keynesian
ideas, captured by the IS–LM AD–AS framework, represented the consensus
view before the 1970s and was the standard approach to macroeconomic
analysis both in textbooks and in professional discussion.
The demise of orthodox Keynesianism was in large part the result of its
failure to deal adequately with the major new empirical problem posed by
stagflation in the 1970s. Conceptually much of its ‘heuristic power’ had
‘petered out’ and ‘run dry’ (Leijonhufvud, 1968). As Klamer (1984) conConclusions
and reflections 699
cedes, ‘the 70s were a decade of retreat, defence, and frustration’ for Keynesian
economics. During periods of consensus in macroeconomics divisions among
economists naturally become less intense and less visible in the literature.
The inherent weaknesses and practical failings of both Keynesianism and
economic positivism highlighted in the late 1960s and early 1970s led to the
demise of much of the old orthodoxy without its replacement by any single
dominant new approach. Any continuing ‘submerged’ competition between
rival macroeconomic explanations became more open and pronounced. The
revival of much of the ‘old economics’, in a traditional (Austrian) or new
form (monetarist, new classical and real business cycle approaches), undermined
much of the ‘new economics’ of orthodox Keynesianism, which in
turn encouraged the development of new Keynesian accounts. The more
radical Post Keynesian interpretation of Keynes’s (1936) General Theory
also continues to offer an alternative vision of how the macroeconomic system
operates.
Keynesianism was initially faced by a potent rival, monetarism, which was
better able to explain the empirical anomaly of stagflation in a more consistent
fashion. As we have discussed, in the orthodox monetarist view (and the
new classical approach) there is no need for stabilization policy, the authorities
can’t, and therefore shouldn’t, attempt to stabilize fluctuations in output
and employment through the use of activist aggregate demand management
policies. Monetarism, in turn, experienced a period of progress before being
faced with problems of its own, not least as noted earlier in Chapter 4 the
sharp decline in trend velocity in the 1980s in the USA and elsewhere. The
collapse of a stable demand for money function in the early 1980s was to
seriously undermine monetarism. During the early 1970s a second counterrevolution
took place associated with new classical school which cast further
doubt on whether traditional Keynesian aggregate demand management policies
can be used to stabilize the economy. While new classical macroeconomics
evolved out of the monetarist approach, it in fact provided a sustained challenge
to the monetarist as well as the Keynesian orthodoxies. As we have
seen, the new classical case against discretionary policy activism and in
favour of rules is based on a different set of arguments (most notably the
policy ineffectiveness proposition, the Lucas critique and time inconsistency)
to those advanced by orthodox monetarists.
New classical macroeconomics displayed important conceptual progress
both by nurturing a rational expectations revolution, which was subsequently
widely incorporated into the macroeconomic mainstream, and by highlighting
the role of aggregate supply. However, important criticisms were
increasingly directed at new classical macroeconomics concerning certain
conceptual, empirical and policy deficiencies. Its empirical results have been,
at best, somewhat mixed and inconclusive. Contrary to its early claims, both
700 Modern macroeconomics
unanticipated and anticipated policy changes appear to affect output and
employment, while several economies have experienced real costs of announced
disinflation. New classical macroeconomics has certainly left its
mark, and both real business cycle theory and new Keynesian economics can
be viewed as a response to issues raised by Robert E. Lucas Jr and other
prominent new classicists.
During the 1980s a considerable divide emerged between the flexi-price
competitive equilibrium real business cycle models and the sticky-price new
Keynesian models, where monetary influences are viewed as central to any
explanation of the path of real variables in the short run. In the real business
cycle approach there is no need for stabilization policy. Furthermore, as monetary
factors are irrelevant in explaining such fluctuations, monetary policy
can’t be used to influence output and employment even in the short run. In
these circumstances governments shouldn’t attempt to reduce fluctuations in
output and employment, which are Pareto-efficient responses to shocks to the
production function. In contrast, new Keynesians argue that there is a need for
stabilization policy as capitalist economies are subjected to shocks from both
the demand and supply side of the economy, which cause inefficient fluctuations
in output and employment. Furthermore, since governments can improve macroeconomic
performance, they should pursue stabilization policy. Although there
is no unified view among new Keynesians with respect to the rules versus
discretion debate, new Keynesians do not advocate ‘fine-tuning’ the economy,
but have instead championed the case for ‘rough-tuning’ in response to large
divergences in output and employment from their natural levels. Today the new
Keynesian stance can best be characterized as one which supports the case for
some kind of constrained discretion in the form of an activist rule, along the
lines, for example, of a flexible Taylor-type rule.
As an aside, it is interesting to note that new Keynesian economics could
have been named new monetarist economics (Mankiw and Romer, 1991) in
that it represents a synthesis of certain key foundations of monetarism and
new classical macroeconomics. For example, the new Keynesian school has
absorbed what it regards as valid components of the monetarist and new
classical counter-revolutions, most notably the natural rate hypothesis and the
rational expectations hypothesis. However, responding to the challenge of
new classical macroeconomists, the new Keynesian school has provided rigorous
microfoundations to explain why markets may fail to clear due to wage
and price stickiness. In so doing it has been able to account for involuntary
unemployment as an equilibrium phenomenon and provide a rationale to
justify interventionist policies to stabilize the economy.
Of course the demise of orthodox Keynesianism also permitted the revival
of interest in such non-mainstream accounts as that of the Austrians and the
salvaging of Keynes’s fundamental ideas by the Post Keynesians.
Conclusions and reflections 701
In Chapters 4–9 we examined the nature and extent of disagreement within
macroeconomics resulting from the dismantling of the Keynesian orthodoxy.
Over the decades macroeconomists have largely been engaged in emphasizing
their differences rather than their similarities. They have often been more
concerned with differentiating their intellectual products in the academic
arena alongside a willingness to display conflicts over policy advice in the
public arena. In short, there has been a tendency to emphasize uniqueness of
identity, which, in turn, has led to both diversity and labelling.
Table 12.1 highlights some of the important features of the schools of
macroeconomic thought explored in Chapters 3–9 of this book. The mainstream
development of macroeconomics can be read from top to bottom, that
is, from orthodox Keynesian to new Keynesian. The Austrian and Post
Keynesian approaches represent the most important non-mainstream approaches.
Two points should be borne in mind when consulting this table.
First, within each school identified, there are differences of opinion and
emphasis: the table merely characterizes the view most commonly held on
particular issues. Second, as is evident from a close scrutiny of the table,
there is a considerable degree of overlap between the various schools on a
number of issues. This suggests that, in practice, the dividing line between
schools is becoming increasingly blurred on many issues. With the benefit of
hindsight, differences between schools have often been exaggerated. Take,
for example, the debate between Tobin and Friedman concerning the transmission
mechanism of monetary policy. In commenting on the debate Stanley
Fischer (1994) suggests that:
you can read Friedman’s and Tobin’s statement of the transmission mechanism
and you can’t tell who wrote which. The analogy I use is that when I was a kid I
could tell cars apart coming down the road. Then the differences between say a
Chev and a Ford were enormous. Now if you look at an old car I know it’s a 1950s
model but I don’t have any idea whether it’s a Ford or a Chev because they look
practically identical. In that sense the methods and models they used and the
issues they looked at were very similar.
Ten years ago in the concluding chapter to our book A Modern Guide to
Macroeconomics (Snowdon, Vane and Wynarczyk, 1994), we noted that ‘at
the present moment macroeconomics lacks the degree of consensus it once
had under orthodox Keynesianism’ and that ‘while there does not appear to
be any clearly emerging consensus on the horizon we should not be surprised
if a synthesis develops in the future, possibly even from disparate schools’.
According to Marvin Goodfriend and Robert King (1997), the intellectual
currents of recent years are moving modern macroeconomics towards a ‘New
Neoclassical Synthesis’. The new synthesis ‘inherits the spirit of the old in
that it combines Keynesian and classical elements’.
Table 12.1 Some areas of agreement and disagreement in macroeconomics
Schools in Dominant Expectations Price/wage Market Notion of Dominant Rules v.
macroeconomics source of adjustment adjustment equilibrium time frame discretion
instability
Orthodox Keynesian Fluctuations in Adaptive Emphasis Weak State of rest Short Discretion
autonomous on nominal probably below
expenditure wage full
rigidity employment
Orthodox monetarist Monetary Adaptive Flexible Strong Market clearing Short and Rules
disturbances at natural rate long
New classical Monetary Rational Perfectly Very Market clearing Long = short Rules
disturbances flexible strong at natural rate
Real business cycle Supply shocks Rational Perfectly Very Market clearing Long = short Rules
(mainly flexible strong at moving
technological) natural rate
New Keynesian Demand and Rational Emphasis Slow Consistent with Predominantly Constrained
supply shocks on price involuntary short discretion
(eclectic) rigidities unemployment
Austrian Monetary Reasonable Flexible Strong Tendency Short and long Rules
disturbances towards
Post Keynesian Fluctuations in Reasonable Sticky Very State of rest Short Discretion
autonomous weak probably below
expenditure full employment
noting that the key elements in the new synthesis comprise: intertemporal
optimization; rational expectations; imperfect competition in goods, labour
and credit markets; and nominal rigidities and costly price adjustment. In
their analysis Goodfriend and King conclude that the new neoclassical synthesis
suggests several important conclusions about the role of monetary
policy. First, monetary policy has real effects in the short run. Second, there
is little by way of a long-run trade-off between inflation and real activity.
Third, inflation is costly and it is important to eliminate it. Fourth, the
credibility of policy actions has an important impact on monetary policy
outcomes. Goodfriend and King argue that these conclusions point the way to
a rules-based monetary policy framework with inflation targeting acting as
the nominal anchor.
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