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Macroeconomics in the 20th Century, progress Georgia Bush In the long run we are all dead Economists


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Title: Macroeconomics in the 20th Century, progress Georgia Bush In the long run we are all dead Economists

Macroeconomics in the 20th Century,
progress?Georgia BushIn the long run we are
all dead Economists set themselves too easy,
too useless a task if in tempestuous seasons they
can only tell us that when the storm passes the
ocean is flat again.
  • Prepared for Rutgers Economics Department Macro
    Study group April 7, 2009

  • The Great Depression ? Macroeconomics
  • Neo-classical-Keynesian Synthesis
  • The Great Inflation ? Classical critique
  • New-Keynesian rebuttal
  • Where are we now
  • A Baseline New Keynesian Model
  • Progress?

The Great Depression ? Macroeconomics
  • Macroeconomics as a term first appeared in the
    1940s (Lawrence Klein)
  • Precursors
  • Mostly single market models, supply and demand
  • 1940s Post Depression
  • Key questions pertained to the extreme economic
  • In 1933 US unemployment 25, real GDP 31 below
    1929 level
  • Revolutionary of the day John Maynard Keynes The
    General Theory (1936)
  • IS-LM model (Hicks, 1937) dynamics of general
    equilibrium made user-friendly
  • Simplification but highly popular
  • Large applied econometrics models (Klein,
    Eckstein, Ando and Modigliani)
  • By the 1960s, many competing models built for
    policy analysis and forecasting

Keynesian content and practice
  • Keynes innovations simultaneous determination
  • de-emphasized business cycle dynamics
  • focused on cross-market influences
  • determination of a set of key variables
  • Stabilization policy required and effective
  • Ramifications of Keynesian theory
  • For government
  • Greater responsibility for macroeconomic
  • Tools now available to analyze potential effects
    of policy choices
  • A way to understand extended periods of market
    failure, sticky prices sticky wages
  • For macroeconomics
  • Concept of general equilibrium theory
  • Simultaneous-equation modeling in econometrics

Neo-classical-Keynesian Synthesis
  • Key elements of Keynesian theory by the 1960s
  • IS curve relating financial conditions and fiscal
    policy to components of GDP
  • Y C(Y T) I (i expected inflation) G
  • LM curve that determines interest rates at the
    price that equilibrates the supply and demand for
  • M/P L(i,Y)
  • Philips curve describing how price level responds
    over time to changes in the output and or
  • Keynes in the short-run, Classical in the
  • SR Keynesian (prices and wages do not
    instantaneously adjust)
  • Monetary policy does have real effects
  • LR Classical (eventually markets clears)
  • Monetary policy ineffectual

The Great Inflation ? Classical critique
  • Keynesian driven public policy coincided with
    rising inflation led to criticism
  • The Scientists
  • Three waves of critique of Keynesian framework
  • Monetarism Milton Friedman (and Phelps 1968
  • Philips curve trade-off between inflation and
    unemployment wont hold in long-run (money should
    be neutral in long run).
  • Cause of empirically observed trade-off
    expectations, ie unanticipated inflation can
    lower employment
  • Variations in money supply more important than
    fiscal policy (MPC small)
  • Rational expectations Robert Lucas (1976
  • Large models based on unchanging relationships
  • Exploitable tradeoffs between inflation and
    unemployment will disappear because agents are
    rational, they will change behavior when they
    observe policy
  • Monetary policy only has an effect if
    unanticipated (if truly a surprise to people)
  • Real Business Cycle theory Kydland and Prescott
  • Random shocks to technology primary driver of
  • Agent maximizes through inter-temporal
    substitution of consumption leisure
  • Assumed prices adjust instantly to clear markets
  • Omitted any role for monetary policy at all

New-Keynesian rebuttal
  • The Engineers
  • Three waves of New Keynesians
  • General Equilibrium (Barro and Grossman, 1971)
  • Tools of general equilibrium to analyze
    situations when markets do not clear
  • Policy prescription stimulus to demand can have
    multiplier effects thus overcoming detrimental
    cycle of insufficient demand
  • Rational expectations without market clearing
    (Fischer, 1977)
  • Response to Lucas critique, desire to model
    empirical inflation dynamics with rational
  • Policy prescription systematic monetary policy
    aimed at stabilization can work
  • Causes of price and wage sticky-ness
  • Menu costs changing prices incur costs, tiny
    costs such reprinting menus can deter price
    adjustment and thus lead to aggregate price
  • efficiency wages firms pay above market wages
    in order to induce efficiency
  • Monopolistic firms, price-setting power ? markup
    for individual firm rational despite lowering
    aggregate demand
  • Policy prescription nominal rigidities
    theoretically possible, therefore government
    demand management policy desirable

New-Keynesian content and practice now
  • The New Neoclassical Synthesis
  • Uses new science of DSGE theory
  • Built on micro-foundations of preferences,
    constraints, optimization
  • Uses New Keynesian theory of nominal rigidities,
    monopolistic firms
  • Policy prescription monetary policy has real
    effects in the short run
  • Key elements of New Keynesian theory now
  • IS curve
  • Monetary Policy anchor
  • Philips curve (augmented price stickyness)
  • Ramifications of New Keynesian theory
  • For government
  • Responsibility for macroeconomic management
  • Souped-up tools available to analyze potential
    effects of policy choices
  • A way to understand extended periods of market
    failure, sticky prices sticky wages in
    framework with rational expectations

New-Keynesian content and practice now
  • Goodfriend and King The New Neoclassical
    Synthesis and the Role of Monetary Policy
  • Ironically, in spite of the fact that Keynesian
    effects of monetary policy on real activity are
    powerful in NNS models, monetary policy is best
    when it eliminates Keynesian effects entirely.
  • Monetary policy has real effects
  • Variation in average markup (reciprocal of real
    marginal cost) affect marginal factor returns and
    thus economic activity
  • Recommend stabilization policy targeting constant
    markup ie inflation near 0
  • Favor monetary policy even more than the 1960s
  • Expectations central success requires credible
    commitment to low inflation
  • A Baseline New Keynesian model in brief
  • RBC monopolistic competition sticky prices
    IS-monetary policy-New Keynesian Phillips Curve
  • What follows draws on Professor Jae Won Lees
    lecture notes for Macro II

Baseline New Keynesian model IS
  • Households problem ? IS curve

Subject to
Optimality conditions imposing market clearing
In every period Y C, money demanded is
supplied, all state contingent assets supplied
Baseline New Keynesian model LM
  • Money demand equation ? LM curve
  • Use interest rate specification of monetary
    policy to close the model
  • Interest rate rules such as Taylor rule

If concerned about money dynamics can construct a
money demand function L and model money supply in
several ways assume exogenous process for money s
upply and as a short-cut use quantity equation
MxV PxY use Friedmans rule, maintain constant m
oney supply growth add money to an RBC model by i
ncluding in the utility function (MIU) with the
idea that individuals gain utility from holding
real balances However money demand function not n
ecessary for NK model, no LM
Baseline New Keynesian model PC (AS)
  • Firms problem ? Phillips Curve (Aggregate Supply
  • Monopolistic competition
  • allows for a firms optimal relative price
    markup x marginal cost
  • Price sticky-ness using Calvo model
  • price sticky-ness as a random variable a
  • in each period a portion of firms (a) experience
    price sticky-ness and cannot change their prices,
    (1 - a) can adjust their prices
  • strategic complement condition firms that can
    change their prices, wont change them by much
  • Thus the firm is maximizing with some positive
    probability that it will not be able to adjust
    prices for an extended period of time
  • Aggregate price dynamics
  • A weighted sum of sticky price and adjusted

Baseline New Keynesian model PC (AS)
  • Firms problem ? Phillips Curve (Aggregate Supply

Subject to

Optimality conditions (from which the NK Phillips
Curve is constructed)
Baseline New Keynesian model PC (AS)
  • New Keynesian Phillips Curve (Aggregate Supply

Result Monetary shocks have persistent real
effects output responds changing by some positiv
e amount (lambda between 0 and 1)
Empirical evidence suggests output takes 40-50
quarters to return to natural level
Baseline New Keynesian model PC (AS)
  • New Keynesian Phillips Curve (Aggregate Supply

Result Monetary shocks have persistent real
effects lambda between 0 and 1 Com
pared to other models impulse response functions
for a monetary shock
Under flexible prices no effect
Under Neo classical 1 period effect
Professor Jae Won Lees slide
Progress? Mankiws view
  • Mankiw
  • New Keynesian picking up from where they left off
    in 1970s
  • Wasted energy on showing market failure possible
    and rebutting classical critiques, perhaps Great
    Inflation from measurement error (CB should
    respond more than one to one to inflation)
  • Still uncompelling Philips Curve
  • models of the 1960s still used by Fed,
  • New Keynesian (AND Neo-Classical) little
    influence, not useful
  • On the other hand,
  • neo-classicists shouldnt take credit for Great
  • low inflation not necessarily due to rules based
    monetary policy and inflation targeting, yes CB
    independence has risen, but this does not equal
    rules based policy (look at US)
  • Inflation targeting in practice more like a
    communication framework rather than a rule
  • Empirical study in 2005 shows inflation targeting
    does not help explain the recent move to low,
    stable inflation. Policy has improved in
    countries with and without targeting

Progress? Woodfords view
  • Woodford
  • The dynamics of moving from Short-Run market
    failure to Long-Run market clearing still
    unaddressed and key to future research
  • Consensus today
  • Inter-temporal general equilibrium (LR and SR in
    same model)
  • Econometrically validated structural models (not
    reduced form)
  • Model expectations as endogenous
  • Real disturbances important source of economic
  • Monetary policy effective, especially to control
  • Disagreement
  • not enough scientific rigor vs too much
  • Policy tools have changed significantly vs have

Progress? from the horses mouth
  • Joseph Schumpeter in on the New Deal quoted in
    Woodfords paper recovery is sound only if it
    does come of itself. For any revival which is
    merely due to artificial stimulus leaves part of
    the work of depressions undone and add, to an
    undigested remnant of maladjustment, new
    maladjustment. (published in 1934)
  • Gunnar Myrdal Swedish biz cycle theorist
    perhaps the whole attitude of the Austrian
    school was ultimately based upon a primitive
    puritanism happiness is somehow evil, something
    immoral, which should be accompanied by a
    purifying misery now and then in order that those
    who have experienced it may be redeemed and so
    it is only proper, right and natural that after
    the upswing, with all its sad mistakes, bad times
    should follow. (words originally published in
    Swedish in 1931)
  • Quentin Peel, FT commentator yesterday
    Expectations in 2007 and 2008 of a decoupling
    between crisis-hit economies of the west and the
    less exposed emerging markets have vanished. The
    pain is global and the solution had to be too.
  • Debate concerning free market and role of
    government intervention I doubt will ever end as
    long as there are governments and individuals (so
    we will always have a job).

My conclusion Optimistic
  • Mankiw contrasts engineers and scientists.
    Unsatisfactory metaphor
  • scientists mathematicians, physicists, chemists,
    biologists, psychologists, sociologistsspectrum,
    where does social science fit
  • Content and techniques characterize the
  • Changes LM curve dispensed with, Phillips Curve
    upgraded substantially, IS and PC derived from
    optimizing economic agents
  • Fertile ground analyzing the behavior of
    individuals to evaluate effectiveness of policy
  • Examples of psychology in economics
  • behavioral finance, systemic risk, asymmetry of
    values or utility (ie risk tolerance, consumer
    choice context specific, (framing, sequence of
    choices ie preferences not transitive), MPC (not
  • We can continually upgrade the machinery, the
    technology, but this has ramifications for
    consistency. Is it appropriate to use math to
    model humans? Definitely, but always an imperfect
  • Rational expectations revolution picked up on
    this, if we are to ground macro in the behavior
    of optimizing agents (micro-foundations), better
    be sure of what micro assumptions underline the
    behavior of those agents. Appropriate
    simplifications for the purpose at hand (whether
    building theory or evaluating policy)

References, a very short list
  • Empirical evidence of monetary policy effects
  • Bernanke, Ben S., and Ilian Mihov (1998),
    "Measuring Monetary Policy," Quarterly Journal of
    Economics 113, 869-902.
  • Christiano, Lawrence J., Martin Eichenbaum, and
    Charles L. Evans (1999), "Monetary Policy Shocks
    What Have We Learned and To What End?" in Taylor,
    John B., and Michael Woodford, eds., Handbook of
    Macroeconomics, vol. 1A, North-Holland.
  • Sims (1980), Macroeconomics and Reality,
    Econometrica 48, no. 1, 1-48.
  • Sims (1992), Interpreting Macroeconomic Time
    Series Facts The Effects of Monetary Policy,
    European Economic Review 36, 975-1101.
  • Bills and Klenow (2004), Some Evidence on the
    Importance of Sticky Prices, Journal of
    Political Economy 112, no 5, 947-985.
  • Theory History
  • Woodford, Michael (1999), Revolution and
    Evolution in 20th Century Macroeconomics, and
    Convergence in Macroeconomics Elements of the
    New Synthesis (2008) both from his website.
  • Gottfried, Haberler, Prosperity and Depression,
    Geneva League of nations, 1937, provides a
    review of the pre-Keynesian literature.
  • Hicks, John R. (1937), Mr. Keynes and the
    Classics A suggested Interpretation,
    Econometrica 5 pp. 147-159.
  • Mankiw, N. Gregory (2006), The Macroeconomist as
    Scientist and Engineer, The Journal of Economic
    Perspectives, Vol. 20, No. 4 (Oct., 2006),
  • Goodfriend and King (1997), The New Neoclassical
    Synthesis, NBER Macroeconomics Annual 1997,
  • Books
  • Gali, Monetary Policy, Inflation and the Business
    Cycle, Princeton University Press, 2008
  • Chapter 2 covers the classical model in detail
    and its shortcomings.
  • Walsh, Monetary Theory and Policy, The MIT Press
    2nd edition, 2003
  • Chapter 1 gives a nice summary of the empirical
    work on the short run and long-run relationships
    between money, prices and output and the debate
    about causality.
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