Chapter 28: Epilogue: The Story of Macroeconomics

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Chapter 28 Epilogue The Story of
Macroeconomics

• 28-1 Keynes and the Great Depression
• 28-2 The Neoclassical Synthesis
• 28-3 The Rational Expectations Critique
• 28-4 Current Developments
• 28-5 Common Beliefs

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28-1 Keynes and the Great Depression

• Failure to explain the Depression was a failure
  for classical economics
• Keynes focused on aggregate demand
• He could explain a sustained downturn if people
  were unwilling to spend money to keep the
  circular flow flowing
• Major theoretical innovations
• The multiplier process
• Liquidity preference and interest rates
• Recognized the importance of expectations

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28-2 The Neoclassical Synthesis

• Progress on All Fronts
• Keynesians versus Monetarists

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Progress on All Fronts (Nobel Prize winners are
italicized)

• IS-LM model (Hicks) (Late 1930s)
• Theories of (1950s)
• Consumption (Friedman, Modigliani)
• Investment (Tobin)
• Money demand (Tobin, Cagan)
• Growth theory (Solow)
• Macroeconometrics (Klein)

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Keynesians versus Monetarists (Nobel Prize
winners are italicized)

• Keynes and Keynesians believed in fiscal policy
• Monetary policy didnt exist
• Friedman (60s) argued that most macroeconomic
  events appeared to have monetary causes
• Keynesians adopted the Phillips Curve (60s)
• Friedman and Phelps argued (late 60s) from a
  monetarist perspective that it couldnt be
  exploited

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28-3 The Rational Expectations Critique

• The Three Implications of Rational Expectations
• The Integration of Rational Expectations

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The Three Implications of Rational Expectations
(Nobel Prize winners are italicized)

• The data is not what it seems (70s)
• Lucas critique argued that the way statistics is
  done in other fields cant be extended to
  economics (or business) because people adapt
  their behavior
• Effective policy is unlikely (70s)
• Economies return to their natural level in the
  medium run (Lucas)
• Anticipated policy cant exploit the Phillips
  curve (Sargent, Barro)
• Policy rules are better than discretion (70s)
• Discretion is time-inconsistent (Kydland,
  Prescott)

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The Integration of Rational Expectations

• Implications for volatility (70s)
• Consumption is a random walk (Hall)
• Volatility of flexible exchange rates is
  rational, and we should expect a J-curve
  (Dornbusch)
• Wage and price setting is sluggish (70s)
• Staggered contracts slow change (Taylor)
• Nominal contracts embody old information (Fischer)

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28-4 Current Developments

• New Classical Economics and Real Business Cycle
  Theory
• New Keynesian Economics
• New Growth Theory

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New Classical Economics and Real Business Cycle
Theory

• The work of Lucas, Sargent, and Barro in the
  1970s evolved into real business cycle theory in
  the 1980s
• Kydland and Prescott argued that there are no
  fluctuations from the natural level of output
• Rather, the natural level fluctuates due to
  changes in real variables (like technological
  progress), not nominal ones (like money or
  nominal interest rates)

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New Keynesian Economics

• If people only care about real variables, then
  changing nominal variables shouldnt be costly
• Alternatively, New Keynesians argue that
  nominal rigidities are important
• Mankiw (80s) noted that changing nominal (menu)
  costs is still costly
• Akerlof (80s) noted that many small changes are
  not worth responding too making behavior more
  rigid
• Summers (80s) noted that hysteresis might be an
  important explanation of rigidities

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New Growth Theory

• Romer and Lucas argued that growth is endogenous,
  and comes from two (major) factors
• Learning by doing
• Technological spllovers
• Lucas also convinced macroeconomists that in the
  big picture business cycles are not important,
  growth is

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28-5 Common Beliefs

• There is general agreement that
• Short-run aggregate demand affects output
• Medium-run output tends to its natural level
• Long-run accumulation of capital and technology
  is important
• Monetary policy is useful in the short-run
• Fiscal policy is effective at all horizons, but
  can be detrimental to the accumulation of capital
  in the long-run

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Common Beliefs Contd.

• There is general disagreement about
• How long the short-run is
• Real business cycle theorists would say it is
  almost non-existent
• New Keynesians would say that it might be 20
  years
• Is policy worthwhile?
• If the short-run is very short, then
• Monetary policy isnt worth worrying about
• Fiscal policy is largely detrimental (since
  everything must be medium or long-run)