Georgia Bush Macroeconomics in the 20th Century, progress? draft: Apr 18, 2023 1

Macroeconomics in the 20th Century, progress?Georgia Bush

“In 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

Georgia Bush Macroeconomics in the 20th Century, progress? draft: Apr 18, 2023 2

Outline:

• 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?

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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 environment:

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

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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 simultaneously:

• Stabilization policy required and effective

• Ramifications of Keynesian theory:

For government

– Greater responsibility for macroeconomic management

– 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

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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 money:

• M/P = L(i,Y)

– Philips curve describing how price level responds over time to changes in the output and or unemployment

• Keynes in the short-run, Classical in the long-run

– SR: Keynesian (prices and wages do not instantaneously adjust)

• Monetary policy does have real effects

– LR: Classical (eventually markets clears):

• Monetary policy ineffectual

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The Great Inflation → Classical critique

• Keynesian driven public policy coincided with rising inflation led to criticismThe “Scientists”Three waves of critique of Keynesian framework• Monetarism: Milton Friedman (and Phelps 1968 critique)

– 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 critique)

– Large models based on unchanging relationships flawed – 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 (1982)– Random shocks to technology primary driver of cycles – Agent maximizes through inter-temporal substitution of consumption & leisure– Assumed prices adjust instantly to clear markets– Omitted any role for monetary policy at all

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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 actors

– 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 sticky-ness

– “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

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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 continues– 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

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New-Keynesian content and practice now

• Goodfriend and King “The New Neoclassical Synthesis and the Role of Monetary Policy” (1997):

“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 theorists– 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 (AS)

– What follows draws on Professor Jae Won Lee’s lecture notes for Macro II:

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Baseline New Keynesian model: IS

• Household’s problem → IS curve

Subject to

Optimality conditions imposing market clearing:In every period Y = C, money demanded is supplied, all state contingent assets supplied

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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 supply and as a short-cut use quantity equation MxV= PxY

• use Friedman’s rule, maintain constant money supply growth

• add money to an RBC model by including in the utility function (MIU) with the idea that individuals gain utility from holding real balances

• However money demand function not necessary for NK model, no LM

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Baseline New Keynesian model: PC (AS)

• Firm’s problem → Phillips Curve (Aggregate Supply curve)

– Monopolistic competition

• allows for a firm’s optimal relative price = markup x marginal cost

– Price sticky-ness using Calvo model

• price sticky-ness as a random variable α

• in each period a portion of firms (α) experience price sticky-ness and cannot change their prices, (1 - α) 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 price

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Baseline New Keynesian model: PC (AS)

• Firm’s problem → Phillips Curve (Aggregate Supply curve)

Subject to

Optimality conditions (from which the NK Phillips Curve is constructed)

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Baseline New Keynesian model: PC (AS)

• New Keynesian Phillips Curve (Aggregate Supply curve)

Result: Monetary shocks have persistent real effects • output responds changing by some positive amount (lambda between 0 and 1)

• Empirical evidence suggests output takes 40-50 quarters to return to “natural” level

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Baseline New Keynesian model: PC (AS)

• New Keynesian Phillips Curve (Aggregate Supply curve)

– Result: Monetary shocks have persistent real effects • lambda between 0 and 1

Compared to other models impulse response functions for a monetary shock:

Under flexible prices = no effect: Under Neo classical = 1 period effect:

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Professor Jae Won Lee’s slide:

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Progress? Mankiw’s 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-classicist’s shouldn’t take credit for Great Moderation:

– 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

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Progress? Woodford’s 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 fluctuation

• Monetary policy effective, especially to control inflation

• Disagreement:

• not enough scientific rigor vs too much

• Policy tools have changed significantly vs have not

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Progress? from the horses’ mouth

• Joseph Schumpeter in on the New Deal quoted in Woodford’s 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).

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My conclusion: Optimistic

• Mankiw contrasts engineers and scientists. Unsatisfactory metaphor – scientists: mathematicians, physicists, chemists, biologists, psychologists, sociologists…

spectrum, where does social science fit • Content and techniques characterize the discipline

• 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 stable)

• 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 world.

• 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)

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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), pp.29-46.• Goodfriend and King (1997), “The New Neoclassical Synthesis,” NBER Macroeconomics Annual 1997, 231-282

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.Both Walsh and Gali cover the New Keynesian models characterized by dynamic general equilibrium, monopolistic competition and nominal rigidities (sometimes prices, sometime wages). Walsh has several chapters on policy in particular if you are interested in discretion verse commitment in monetary policy.

• Blanchard and Fischer, Lectures on Macroeconomics, The MIT press, 1989, and Romer, David, Advanced Macroeconomics, McGraw-Hill Irwin; 3rd edition, 2006 for IS-LM discussion.