Intermediate macroeconomics

Pedro Serodio

July 20, 2016

Theory after history

I Important breakthroughs in macroeconomics tend to followsignificant economic events

I Macroeconomic research will tend to reflect themacroeconomic environment

I From mass unemployment of the 1920s and 1930s to theStagflation of the 1970s

I Financial crisis of the late 2000s

Policy after theory

I Conversely, developments in macroeconomic thinking affectpolicy at the aggregate level and have significantmacroeconomic consequences

I Demand management in 1950s and 1960s (Keynesianframework, IS-LM)

I Monetarist economics of the early 1980s (the resurgence ofthe classical framework)

I Concerns over optimal policy in the 1990s and 2000s and theattempt to constrain decision making to prevent policydictating bad outcomes

Great Depression

I Stock market crash of 1929: after the crash of 1929, thestock market did not recover until well after WWII

Great Depression

I Real GDP collapsed around 26% from peak to trough, andunemployment reached highs of 25%.

Great Depression

I In this environment, a solution to the twin problems ofdeficient aggregate demand along with very highunemployment placed much of the emphasis on short rundemand management.

I A consensus emerged after WWII, a so-called neoclassicalsynthesis, which was an amalgam of the neoclassicalfoundations of microeconomic theory with the aggregatedemand management that permeated Keynesian economics.

I The IS-LM model became the workhorse for macroeconomictheory and policy analysis, with discussion constrained to theeffectiveness of fiscal and monetary policies under differentassumptions.

I Most macroeconomic analysis and policy was circumscribed tothe short run.

Great Depression - aftermath

I The model was augmented with the so-called Phillips curve, a(seemingly) empirical relationship between unemployment andinflation.

I In the short run, the Keynesian view prevailed, but over thelong run markets were assumed to work more or less like theneoclassical, competitive ideal.

I Neoclassical forces shaped phenomena like long run growth,technology and capital accumulation. Crucially, the long runaggregate supply schedule was seen as being unresponsive toshort run macroeconomic fluctuations. In other words,recessions have no impact on the long run productivecapabilities of the economy.

Stagflation and monetarist ressurgence

I The oil shocks of the 1970s set off a period of high inflation:

Stagflation and monetarist ressurgence

I ...and high unemployment:

Stagflation and monetarist ressurgence

I This was in stark contrast with the implications of the simplePhillips curve, which predicted a stable relationship betweenunemployment and inflation.

I Coupled with the seminal book by Friedman & Schwartz onthe monetary policy failures at the onset of the greatdepression, a new consensus emerged around the idea thatmoney was neutral in the long run and that the Phillips curverelationship was incomplete without taking expectations intoconsideration.

Stagflation and monetarist ressurgence

I This led to several important innovations in macroeconomictheory:

1. The expectations augmented Phillips curve2. The accelerationist hypothesis3. Continuous market clearing (economy always in equilibrium!)

and the rational expectations revolution4. The policy ineffectiveness proposition5. Real business cycle theory: random fluctuations amplified by

consumption behaviour of rational agents and the dynamics ofcapital accumulation

New Keynesian mainstream

I Despite its brief success, this revolution primarily took theform of a methodological overhaul of macroeconomics ratherthan an entirely new paradigm.

I Keynesian mechanisms were gradually introduced into themodels and a new consensus emerged, with most ofmacroeconomics now taking seriously both short run marketimperfections as well as the issues of rationality and thedetermination of output in the long run.

New Keynesian mainstream

I Along with the innovations described above, the current suiteof models also includes short run frictions:

I Menu costsI Monopolistic competitionI Nominal wage rigidityI Real wage rigidityI Capital market imperfectionsI Informational asymmetries

I In addition to this, there was a recognition that policy makerswould often deviate from optimal policy, often in a systematicmanner (i.e., inflation bias at central banks). This problem ledto the emergence of the variant of the literature that dealswith optimal policy and optimal rules.

I Many economists believed that discretion can be a problemand that therefore policy makers should be constrained in thekinds of choices they can make.

Policy discretion and rules

I By modelling political actors as rational, self-interestedeconomic agents in a strategic environment, these methodsidentified several important problems with both monetarypolicy (time inconsistency, inflation bias) as well as fiscalpolicy (political business cycles, excessive deficits andsovereign default episodes).

I These theoretical breakthroughs led to the gradualindependence of central banks and the introduction of severalbinding agreements between nations (stability and growthpact, fiscal compact) as well as budget rules for domesticconsumption.

I These reflect the increased realisation that in certainenvironments, constraining the choices of political actors canhave welfare maximising outcomes.

New challenges... or old debates?

I The great recession of 2007-08 has had a lasting impact onboth the economic performance of almost every economy inthe world and on many contemporary debates overmacroeconomic policy.

Source: NIESR

A slow recovery: Productivity

Components of productivity measures.png

Source: ONS

A slow recovery: Inequality

A slow recovery: Wages

A slow recovery: Employment

Source: CityAM

A slow recovery: Unemployment, UK

Source: ONS

A slow recovery: Employment, US

A slow recovery: Beveridge Curve, UK

Source:Smith (2012)

A slow recovery: Beveridge Curve, US

Where next?

I The slow pace of the recovery since the onset of the crisis hasbeen a feature of the performance of the world economy and,especially, of a large number of industrialised nations.

I The crisis and recovery have been the subjects of renewedattentions by the economics mainstream and current researchis prying into a large number of these topics.

Where next?

I Despite the flexible consensus in the mainstream, which takesmodels with perfectly competitive markets and rationalexpectations and introduces relevant frictions to match severalkey business cycle statistics, several points of disagreementremain, and these are far more pronounced in schools ofthought that reject the underlying assumptions of mainstreammodels (Post-Keynesian and Austrian economics are twoprominent examples). We briefly discuss these disagreements:

1. The flexibility of prices and wages2. The flexibility of aggregate supply3. The role of expectations in the working of the market4. The significance of government budget deficits

The flexibility of prices and wages

I There is substantial disagreement among economists over thedegree of price and wage flexibility. An influential number ofeconomists, primarily associated with the classical view andreal business cycle theory, maintain that fluctuations can beattributed to real shocks. They argue these real shocks areamplified by equilibrium adjustment processes (which areefficient) and therefore that fluctuations in realmacroeconomic aggregates is not driven by the failure ofmarkets to clear. At the other end, other economists suggestthat prices and wages are extremely inflexible and may neverconverge to their long run equilibria under certain conditions.

The flexibility of aggregate supply

I Under the assumption that all prices (including wages) adjustvery quickly, many economists argue therefore that in the longrun, aggregate supply is determined exclusively by theproductive potential of the economy and that this potential isnot affected by short run fluctuations. Under the real businesscycle view, the economy always returns to a stable long runequilibrium regardless, which implies that the aggregatesupply schedule is completely independent from short runequilibria. On the other hand, many economists argue that aphenomenon known as hysteresis is present, whereby there issignificant persistence in macroeconomic variables, to theextent that the path of, for example, unemploymentdetermines its long run equilibrium.

The role of expectations in the working of the market

I The vast majority of mainstream macroeconomic modelsselect equilibria based on the assumption of rationalexpectations. This assumption means that the agents in themodel are aware of the structure of the economy (they knowthe true model of the world) and can therefore correctlypredict, on average, realisations of macroeconomic variables.This assumption has been highly criticised in the aftermath ofthe great recession and some models now attempt to modelthe process of expectation formation explicitly, allowing agentsto learn the true model of the economy or make mistakes inforecasting. Previous versions of models like the IS-LM with aPhillips curve, often made the assumption that expectationswere naive, which implied that agents made systematic errorswhen forecasting macroeconomic conditions.

The significance of government budget deficits

I Finally, a contentious debate has emerged in the aftermath ofthe great recession, where concerns over deficient aggregatedemand were met with opposing concerns over sovereign debtsustainability. Economists who argue there are marketfrictions which prevent the economy from quickly attaining anefficient equilibrium often make the argument that aggregatedemand management, in the form of government spending,can accelerate the process of convergence to the long runequilibrium or, in some extreme instances, prevent theeconomy from being dragged into a recessionary/deflationaryspiral. Other economists believe that output is primarilydriven by supply factors, given that markets clear andequilibrium allocations are efficient, and therefore worry thatexcessive spending will have a negligible impact on economicactivity but will instead contribute towards making public debtunsustainable.