The Past of Macroeconomics:

The Age of John Maynard Keynes:

Macro-economics as a regulation is to a remarkable extent the creation of John Maynard Keynes.
Keynes’s 1936 book “The General Theory of Employment, Interest and Money” shifted economic research in addition to macroeconomic thought into new and different directions that have led us where we are today.
The General Theory’s amazing impact was in large part a result of the then-ongoing Great Depression.

Keynes’s book accentuate:

a) The role of probable of future profits in determining investment
b) The instability of expectations of future profits
c) The power of the government to distress the economy through fiscal and monetary policy
d) The multiplier process which enlarged the effects of both private-sector shocks and public-sector policies on aggregate demand.

It swept the intellectual field as well as shaped modern macroeconomics.

By a decade or therefore after World War II much of the analytical apparatus used in this textbook was already in place.

a) The IS-LM model was urbanized by economists John Hicks and Alvin Hansen.
Other economists urbanized:

b) He approaches utilized in this textbook to understanding consumption (Milton Friedman and Franco Modigliani)

c) Investment (James Tobin, Dale Jorgenson and many others

d) The relationship between interest rates as well as the money supply (James Tobin once again, along with many others)

e) The difference between the behavior of the macro-economy in the flexible-price long-run and the fixed-price short run (here Franco Modigliani was once more the major contributor).

f) The Solow growth model was build-up by no surprise Robert Solow.

This isn’t to say that the bulk of this textbook stands as it would have been written back in 1960. Macro-economics textbooks in 1960 had next to no discussion of the relationship among production and inflation. They had small discussion of expectations. The short run was observed as lasting for decades and analysis of the long-run flexible-price model was hardly ever included in undergraduate courses. Textbooks in 1960 as well downplayed monetary policy and emphasized fiscal policy- investment was seen as responding little to changes in interest rates and estimates of the multiplier were much higher than we now believe to be correct now or to have been correct then.

The Age of Milton Friedman and Robert Lucas:

Between 1960 as well as 1980 a good deal of the rest of the meat of this textbook was put into place. Powerful analysis of the then-established conventional wisdom of macroeconomics were made first by Milton Friedman and then by Robert Lucas, mutually of whom made their intellectual home at the University of Chicago.

Milton Friedman’s analysis of the then-dominant tradition in macroeconomics had four major parts:

a) The then-standard models very much overestimated the government’s ability to manage and control the economy. Huge uncertainty, long lags and variable effects of policy actions placed extremely tight limits on the ability of the government to smooth out recessions as well as avoid periods of high unemployment.

b) The then-standard models very much overestimated the power of fiscal policy and greatly underestimated the power of monetary policy.

c) The measurement of the funds supply told you most of what you needed to know about how economic policy was working.

d) The thought of that natural rate of unemployment developed by Friedman and Edward Phelps in the second half of the 1960s.

To the degree that macroeconomists in the early 1960s talked about aggregate supply and inflation at all they tended to follow the lead of economists who took the location of the short-run Phillips curve to be fixed. A given degree of unemployment would produce a fixed unchanging rate of inflation with no feedback of past inflation on expected inflation and no shifts in the natural rate of unemployment. Friedman along with Phelps argued that high past inflation would raise expected inflation and that if unemployment were kept below its natural rate then the Phillips curve would shift upward over time generating higher and higher inflation.

The stagflation of the 1970s proved Friedman along with Phelps to be completely correct on their fourth point. In less than a decade the economics occupation shifted to the accelerationist Phillips curve that we use today. Friedman’s first and second points as well became part of the received wisdom. Merely the claim that the money supply was the sole important variable for understanding macroeconomic policy failed to win broad acceptance.

However Milton Friedman’s monetarist critique was only the first half of the successful revisionist challenge to the doctrines of the post-World War II Keynesians. The rational expectations macro-economists— Thomas Sargent, Robert Lucas, Robert Barro and others—argued that Keynesian economics had unsuccessful to think through the importance of expectations.

The rational expectations economists presumed that people were doing the best they could to figure out the structure of the economy in which they lived. For the reason that standard Keynesian models did not pay enough attention to expectations, they failed to be familiar with that systematic changes in economic policy would change the parameters of the consumption and investment functions and the location of the Phillips curve. Therefore macroeconomic models that took estimated investment functions, consumption functions and Phillips curves as building blocks would blow up in the face of policy makers.

Once more the critique was incorporated into the mainstream quite rapidly. As MIT economist Olivier Blanchard place it the ‘idea that rational expectations was the right working assumption gained wide acceptance not for the reason that all macoro-economists believe that firms, people and participants always form expectations rationally [but because] rational expectations appear to be natural benchmarks at least until economists have made progress understanding actual expectations.’ In the mid-1980s the intellectual structure of the version of modern macroeconomics presented in this book was largely complete.

As well as since? The late 1980s and 1990s were a time of thought generation and exploration. They saw macroeconomists exploring as well as testing a large number of different ideas and models. It was an age in which the set of probable approaches expanded however in which the mainstream policy-analytic position of macroeconomists did not shift much. If the past is a few guide such a period of exploration and experimentation will eventually be followed by another period of successful critique during which the mainstream of macroeconomics will once more change substantially and rapidly as it did in the 1970s and early 1980s.

What might be the future of macroeconomics bring?

The Future of Macroeconomics: “Real” Business Cycles

One place wherever the future of macro-economic might lie is in the theory of ‘real’ business cycles. The basic premise of this line of thinking is that all the other macroeconomists took a wrong turn a long time ago. It is in excess of half a century since economists turned away from the line of analysis of Joseph Schumpeter and toward that of the monetarists and Keynesians. One possibility is that this was in the long run a mistake

Milton Friedman, John Maynard Keynes, Irving Fisher, Paul Samuelson and all of the economists working in both Keynesian and monetarist traditions believe that there are two key elements to understanding business cycles. First you require understanding the determinants of nominal aggregate demand. Second you require understanding the division of changes in nominal aggregate demand into changes in production (and employment) on the one hand and changes in prices (inflation or deflation) on the other. Therefore Keynesians and monetarists think about the velocity of money the determinants of crowding out, investment spending, the multiplier, the natural rate of unemployment and the rate of expected inflation the Phillips curve and other related topics.

To real business cycle economists in the Schumpeterian practice like Edward Prescott most of this look likes to be a waste of time. There are modify in nominal aggregate demand however their impact falls mostly on prices and only a little in output and employment. To appreciate the roots of real fluctuations—fluctuations in the real economy—you require to follow a different road.

If I thought this line of research truthfully will be the future of macroeconomics I would have written a different book. However there are important points made especially by what I see as the Schumpeterian wing of the real business cycle tradition. Economic growth isn’t smooth. It does precede sector-by-sector. Shifts in investment big backwards-and-forwards moves in the position of the IS curve do occur out of changing beliefs about the current productivity of the economy and the future value of new investment.

The survival of real business cycle theory is a call for all economists to spend more time thinking about the determinants of investment fluctuations- either tying them to changes in productivity and the value of investment or developing useful social-psychological theories of the shifts in animal spirits that cause such large movements in investment over time. My guess is that lots of what is now called real business cycle analysis will be incorporated into mainstream macroeconomics over the next two decades as the theory of growth is integrated with the theory of business cycles and as economists make progress in understanding why investment is thus volatile.

Real Business Cycle Theory:

Real business cycle theorists see roars as generated when rapid technological innovation opens up new industries and new possibilities for investment.  By such moments the stock market will be high the returns to investment large and so investment spending will be high. Real business cycle theorists observe recessions as generated when entrepreneurs conclude that those who came prior to them have been overoptimistic. The socially optimal thing to do isn’t to invest but instead to retrench to cut back on investment spending and scrap capital until it becomes clear where there will be opportunities for profitable large-scale investment.

The Future: New Keynesian Economics

The second probable future for macroeconomics sees the continued development of the mainstream research program as its weaknesses and incoherencies are gradually repaired.

Surely the area of modern macro-economic that is in least satisfactory shape is the area of aggregate supply. Why do changes in ostensible aggregate demand show up as changes in the level of production and employment as well as not just as changes in the level of prices?

Because at least the 1930s the mainstream of macroeconomics has attributed the sluggishness of aggregate supply the fact that the Phillips curve has a slope and isn’t vertical—to stickiness in wages and prices. Therefore fluctuations in the nominal level of aggregate demand cause fluctuations in output and employment. However where does this stickiness and slow adjustment of wages and prices come from? Given that business cycles emerge to be as unpleasant and costly to society as a whole that by now a way should have been found to greatly reduce the harmful macroeconomic consequences of price stickiness.

Therefore a direction that might be the future of macroeconomics is that of deep investigation into the sources of sluggish wage and price adjustment and of aggregate supply. This research program has got the name of New Keynesian Economics.

New Keynesian Theories:

Why do changes in nominal aggregate demand show up as changes in the level of production and employment, and not just as changes in the level of prices?

The mainstream of macro-economic has attributed this to stickiness in wages and prices. However where does this stickiness come from? One possibility is that little costs of changing prices on the part of individual firms have large effects for the reason that a price adjustment or a failure to adjust prices on the part of one firm affects other firms through aggregate demand externalities. One more possibility is that prices and wages are sticky because agents in the economy don’t all make long-run decisions at the same time.

Debts and Deficits, Consumption and Saving:

The standard view of debts as well as deficits has been subject to a powerful challenge a challenge which may become a significant part of the future of economics and whether it is successful or not is likely to change the way we think about how the government’s budget affects the economy. This alternative outlook of the long run (and of the short run too) effects of debts and deficits is called Ricardian subsequent to David Ricardo (who does not seem to have held it) and that must be called Barrovian after its most effective and powerful advocate Harvard macroeconomist Robert Barro.

Robert Barro’s View:

Think of it this way- The government is in wisdom our agent. It purchases things for us (government purchases) and it collects money from us to pay for the things it buys on our behalf. The duty it collects from us is called taxes. Occasionally the government collects as much from us as it buys on our behalf- then the government budget is balanced. Occasionally the government collects less from us than it spends on our behalf- then the government budget is in deficit as well as the government makes up the deficit by borrowing money now and implicitly committing to raise taxes to repay the debt (interest and principal) at some time in the future).

Presume that the government spends an extra $1000 on your behalf and at the same time raises your taxes by $1000. For the reason that your after-tax income has gone down by $1000 you cut back on consumption spending. Now presume that the government spends an extra $1000 on your behalf but doesn’t raise taxes—instead it borrows the $1000 for one year as well as announces that it is going to raise taxes next year to repay the debt.

What is the difference among these two situations? In one case the government has composed an extra $1000 in taxes from you this year. In the other case the government has announced that it will collect an extra $1000 in taxes from you next year. In either case you are inferior. In the initial case you cut back on your consumption. Must not you cut back on your consumption in the second case too set aside a reserve to pay the extra taxes next year and invest it perhaps in the bonds that the government has issued? Subsequent to all the effect of the government policy on your personal private wealth is identical in the two cases.

Robert Barro would utter yes. He would utter that what matters for the determination of consumption spending isn’t what taxes are levied on you this year however what all of the changes in government policy tell you about the value of the total stream of taxes this year next year and on into the future. Government policy therefore ought to affect consumption only to the extent that it tells you about how much the government is going to spend and thus what will be the total lifetime tax bill levied on your wealth.

Counterarguments:

Several economists point out that the theoretical elegance of Barro’s view is broken by a number of different considerations.

Myopia: Perhaps people aren’t far-sighted enough to fully work out what an increased deficit in the present implies for their future taxes.

Liquidity constraints: Barro’s argument implicitly presumes that it is easy for people to borrow and lend. If a good several people can’t borrow and lend—would wish to spend more if merely they could borrow it on reasonable terms—then you would expect consumers to react to tax cuts by rising consumption spending even if they knew full well that the government was going to recapture those tax cuts with tax increases later.

People are different: I am the beneficiary from enlarged spending this year however the extra taxes that the government will exact two decades therefore may well not be paid by me but by someone who isn’t even in the labor force today.

However are any of these or all of them together really enough to make us confident that changes in the timing of taxes (holding government spending patterns constant) will have a big effect on overall consumption? Even if Barro’s challenge to the conventional wisdom is ineffective it will only become clear that it is unsuccessful when we have a much better understanding of how and why people divide their income among consumption and saving.

Consumption and Saving:

In the early part of the twentieth century it was comparatively easy to justify a relatively high marginal propensity to consume. The majority households had little if any savings. Most households found themselves not capable to borrow. Therefore they were liquidity constrained- they wished to spend more today however could not find anyone to lend them the liquid wealth to enable them to do so. Therefore one would expect a boost to income today to generate a large rise in consumption spending. Add to this the actuality that buying consumer durables is in a sense as valid a way of saving for the future as putting money in the bank and a high marginal propensity to consume and a strong multiplier process seemed easy to understand.

The past fifty years nevertheless have seen steady and large increases in the flexibility of the financial system. Few Americans today are with no the ability to borrow to increase current consumption must they so wish. Those Americans who are convincingly liquidity constrained today receive a very small portion of total income and a small portion of increases in total income. Therefore economists’ theories would predict that the marginal propensity to consume would have dropped far by today and that the multiplier process would be more or less irrelevant to aggregate demand. Nonetheless consumption still declines significantly when the economy goes into recession.

This consumption puzzle is one more substantial hole in today’s current macroeconomic knowledge. Several economists are trying to close it. Several like Johns Hopkins macroeconomist Chris Carroll dispute that the typical consumer is both impatient and strongly risk averse. Risk aversion formulate him or her unwilling to borrow. Edginess makes him or her eager to spend increases in income. Therefore the fact that improvements in financial flexibility signifies that consumers could borrow doesn’t mean that they will. Other economists focus on the perseverance of income changes and say that current income is a good proxy for permanent income as well as hence should be a strong determinant of consumption. Still others guide by Chicago economist Richard Thaler argue that it is time for economists to throw the simple-minded psychological theory of utility maximization overboard and to take gravely what psychologists have to say about how humans reason.

It is indistinct how this hole in macroeconomists’ understanding will be resolved. It is clear nevertheless that whatever answer is reached to the puzzles regarding consumption and saving will as well have a powerful impact on the debate over debts and deficits as well.

Does Monetary Policy Have a Long-Run Future?

When the Federal Reserve utilizes open market operations to affect interest rates it does so for the reason that its purchases or sales of Treasury Bills raise or lower the supply of bank reserves in the economy and so make it easier or harder for businesses to borrow money. However total commercial bank reserves in the U.S. amount to less than half a percent of GDP. A usual open market operation is a few billion dollars.

In the perspective of an economy in which annual GDP is more than $11 trillion and in which total wealth is something like $40 trillion how is it that a swap of one government promise to pay (a Treasury Bill) for another (a dollar bill) can cause big changes in the cost of borrowing money and ultimately in the level and composition of economic activity?

This question hasn’t been asked often enough in the past hundred years. Economists have tended to presume that monetary policy is powerful and that the reasons for its power are relatively uninteresting. They have by and large unobserved the fact that to shift from an extremely tight monetary policy in which long-run nominal GDP growth is zero as well as a loose one in which long-run nominal GDP growth is ten percent per year requires that the Federal Reserve increase purchases of Treasury Bills by an average of merely some $20 million a day.

Monetary policy is positively powerful. However in at least one of the potential futures of macroeconomics the reasons for its power become very interesting indeed. For it is at least probable that the future evolution of the financial system might undermine the sources of influence that monetary policy today possesses.

The reasons that financial policy has power today that economists usually bring forward rest on what Harvard macroeconomist Benjamin Friedman calls politely a series of ... familiar fictions- [like that] households as well as firms need currency to purchase goods... nonbank financial institutions [cannot] create credit... [and] so on.

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