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CHAPTER 17
The Future of Macroeconomics
17-1
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Questions
• What might the future of
macroeconomics bring?
• How might the macroeconomics
taught two decades from now be
different from the macroeconomics
taught today?
• What have been the principal changes
in the way macroeconomics is taught
over the past twenty years?
17-2
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Questions
• What additional changes took place
twenty years before that--from
roughly 1960 to roughly 1980?
• What direction will macroeconomics
take if the real business cycle
research program is successful?
• What direction will macroeconomics
take if the new Keynesian research
program proves successful?
17-3
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Questions
• How will economists understand the
foundations behind the power of
monetary policy?
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Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
The Past of Macroeconomics
• A 1936 book by John Maynard Keynes
shifted economic research and
macroeconomic thought into new and
different directions
– the role of expectations of future profits
in determining investment
– the volatility of expectations of profits
– the power of the government to affect
the economy through policy
– the multiplier process
17-5
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
The Past of Macroeconomics
• After World War II, more
macroeconomic theory was developed
– the IS-LM model was created
– the relationship between interest rates
and the money supply was investigated
– the difference between the behavior of
the macroeconomy in the flexible-price
long run and the fixed-price short run
was clarified
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Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
The Past of Macroeconomics
• But macroeconomics theory in 1960
was still incomplete
– no discussion of the relationship between
production and inflation
– no detailed model of expectations
– the short run was seen as lasting for
decades
– fiscal policy was emphasized, while the
role of monetary policy was downplayed
– estimates of the multiplier were much
higher than we believe now to be correct
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Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
The Past of Macroeconomics
• Between 1960 and 1980, two
powerful critiques of the conventional
wisdom of macroeconomics occurred
– the first was by Milton Friedman
• the standard models overestimated the
government’s ability to control the economy
• the standard models overestimated the power
of fiscal policy and underestimated the power
of monetary policy
• the money supply tells us most of what we
need to know about how policy is working
• there is a natural rate of unemployment
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Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
The Past of Macroeconomics
– the second was by Robert Lucas
• Keynesian economics fails to think through
the importance of expectations
• systematic changes in economic policy would
change the parameters of the consumption
and investment functions as well as the
location of the Phillips curve
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Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
The Past of Macroeconomics
• The late 1980s and 1990s were a time
of idea generation and exploration
– macroeconomists explored and tested a
large number of different ideas and
models
– the mainstream policy-analytic position of
macroeconomists did not shift much
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Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
The Future of Macroeconomics:
Real Business Cycles?
• Keynesian and monetarist economists
believe that there are two key
elements to understanding business
cycles
– the determinants of aggregate demand
– the division of changes in nominal
aggregate demand into changes in
production and changes in prices
17-11
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
The Future of Macroeconomics:
Real Business Cycles?
• Real business cycle economists
believe that changes in nominal
aggregate demand affect output and
employment only slightly and have
the most impact on prices
• Real business cycle theory begins with
the assumption that the same theory
that determines what happens in the
long run should be applied to
fluctuations in the short run
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Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
The Future of Macroeconomics:
Real Business Cycles?
• While real business cycle economists
believe that prices can be rigid, they
believe that this sluggishness of prices
is not very relevant
– they assume that it is a reasonable firstapproximation to suppose that the money
supply and the level of potential output
determine the price level
– the level of potential output is more-orless equal to actual real GDP
17-13
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
The Future of Macroeconomics:
Real Business Cycles?
• Real business cycle economists
believe in the classical dichotomy
– real variables effectively determine the
values of real quantities like real GDP
even in the short run
– nominal variables determine the values of
nominal quantities like the price level
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Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
The Future of Macroeconomics:
Real Business Cycles?
• Real business cycle theory assumes
that the level of output will vary with
shocks to the economy
– adverse cost shocks lead to a recession
as individuals should spend less time
working because it is not profitable
– favorable cost shocks lead to a boom
period because it is advantageous to
produce as much as possible
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Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Problems of Real Business
Cycle Theory
• Unemployment
– real business cycle theory assumes that
the total hours worked at any moment is
largely determined by how many hours it
makes sense for people to work
– but when work hours fall, it is not
because people have chosen to work
shorter shifts and avoid overtime
• it is because they have become unemployed
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Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Problems of Real Business
Cycle Theory
• Technology and Real Business Cycles
– according to real business cycle theory,
production fluctuates because of the
changing value of output and the
changing productivity of the economy
• more is produced when technology rises
• recessions occur when cost increases make it
inefficient to run factories at near capacity
– critics claim that cost increases like the
1973 oil price shock are the exception
rather than the rule
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Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Problems of Real Business
Cycle Theory
• Money and Business Cycles
– real business cycle theorists tend to
argue that monetary policy has little
impact on production and employment
• fluctuations in the money stock and real
interest rates are more reactions to changes
already taking place
– the Federal Reserve believes that it
affects the level of interest rates and that
its decisions cause changes in production
and employment
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Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
The Future of Macroeconomics:
New Keynesian Economics
• Since the 1930s, mainstream
macroeconomics has attributed the
sluggishness of aggregate supply to
stickiness in wages and prices
• Therefore, fluctuations in nominal
aggregate demand cause fluctuations
in output and employment
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Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
The Future of Macroeconomics:
New Keynesian Economics
• Where does this stickiness and slow
adjustment of wages and prices come
from?
– menu costs
• it is costly for businesses to change prices
– staggered prices and coordination failures
• a firm’s best choice for its price may depend
on the prices that other firms are charging
• this means that wages and prices may exhibit
inertia
17-20
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Debts and Deficits:
Ricardian Equivalence
• If the government runs a budget
deficit, it will make up the deficit by
borrowing money now and implicitly
committing to raise taxes to repay the
debt at some time in the future
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Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Debts and Deficits:
Ricardian Equivalence
• Economist Robert Barro argues that
consumers will see the budget deficit
as an increase in future taxes and cut
back on consumption
– what matters for the determination of
consumption spending this year is not
what taxes are levied on you this year,
but what all the changes in government
policy tell you about stream of taxes this
year and in the future
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Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Debts and Deficits:
Ricardian Equivalence
• Many economists believe that
Ricardian equivalence does not hold
for a number of reasons
– myopia
– liquidity constraints
– people are different
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Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Consumption and Saving
• In the early 1900s, the marginal
propensity to consume was high
– people were liquidity constrained
• The financial system in the past 50
years has become much more flexible
– economic theory would predict that the
marginal propensity to consume would
decline and the multiplier process would
be more or less irrelevant to aggregate
demand
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Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Consumption and Saving
• But, consumption falls significantly
when the economy goes into
recession
• Why?
– one possibility is that consumers are both
impatient and risk averse
– another possible explanation is that
current income is a good proxy for
permanent income
– another suggestion is for economists to
focus on what psychologists have to say
about how humans reason
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Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Does Monetary Policy Have a
Long-Run Future?
• Economists have tended to assume
that monetary policy is powerful and
that the reasons for its power are
uninteresting
• The future evolution of the financial
system may undermine the sources of
influence that monetary policy today
possesses
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Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Does Monetary Policy Have a
Long-Run Future?
• Forecasting the future of monetary
policy will require a deeper knowledge
and better models of the sources of
central bank power than
macroeconomists currently possess
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Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Chapter Summary
• Modern macroeconomics has its origin
in the “Keynesian” theories of the
Great Depression and post-WWII era
• Modern macroeconomics was reforged
by the monetarists under Milton
Friedman in the 1960s and 1970s,
and by the rational expectations
economists led by Robert Lucas in the
1970s and 1980s
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Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Chapter Summary
• Perhaps the focus on aggregate
demand will turn out in the long run
to have been a false road
– perhaps a better theory of the
macroeconomy can be built up out of the
theory of real business cycles in the
Schumpeterian tradition
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Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Chapter Summary
• Perhaps the future of macroeconomics
lies in a more detailed investigation of
aggregate supply
– perhaps uncovering the reason why
prices are sticky will lead to the next
wave of progress in macroeconomics
17-30
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Chapter Summary
• The entire conventional analysis of
debts and deficits is under challenge
by Robert Barro, who argues that
individuals are far-sighted and closely
linked, and that they take action to
neutralize the effects of many
government policies
• The conventional analysis of
consumption--the permanent income
hypothesis--is also under challenge by
more psychological approaches
17-31
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Chapter Summary
• The other possible interesting
direction in which macroeconomics
might evolve involves the future of
monetary policy
– how will the coming of the “new
economy” and the changing institutional
framework of transactions and
settlements affect the power of monetary
policy?
17-32
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.