1' THE KEYNESIAN REVOLUTION

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1. THE KEYNESIAN REVOLUTION

• The birth of macroeconomics J.M. Keynes,
  General Theory of Employment, Interest and
  Money, 1936 (towards the end of Depression)
• Keynes was a man of many talents
• - during the First World War he had worked in
  the UK treasury
• - he criticized the harsh reparations imposed on
  Germany, arguing that Germany could not pay for
  the war and would be destabilized by the economic
  burden of the Treaty

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1. THE KEYNESIAN REVOLUTION

• He assembled a group of brilliant economists at
  Cambridge University
• One important message fiscal policy can be used
  to fight recessions in particular when monetary
  policy is ineffective
• In most of Europe, Keynesian ideas are very much
  alive, although their limits are generally well
  recognized
• Keyness theory was not fully workout
• - his book is difficult to read
• - it frequently lacks precision
• - it can be confusing

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1. THE KEYNESIAN REVOLUTION

• European macroeconomists were not particularly
  productive during this period
• Exceptions the Mundell-Fleming model (Marcus
  Fleming (1911-1976), a British economist working
  in the IMF, and Robert Mundell (1932-), inspired
  by the smallness and openness of his native
  Canada and Switzerland)
• An important implication of Keynesian economics
  countries as a whole could be a research subject
• Pre-Keynesian economics was mostly preoccupied
  with sectors and firms, and had little to say
  about questions such as growth or employment
• Aggregate data (GDP, the unemployment rate, the
  CPI) were sporadically collected and very rarely
  the subject of research

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1. THE KEYNESIAN REVOLUTION

• The rise of Keynesian economics started in the
  late 1930s
• The main contributions USA and Great Britain
  (Simon Kuznets (1901-1985), from Columbia
  University and Richard Stone (1913-1991), a
  Keynes student from Cambridge)
• Once data were available and with the
  introduction of the first computers, economists
  started to build large-scale models that mimic
  the economy.
• Despite the subsequent decline of Keynesian
  economics, these models continues to influence
  considerably day-to-day decisions by government,
  banks and businesses

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1. THE KEYNESIAN REVOLUTION

• The neoclassical theory - the Keynesian
  equilibrium is a special case, which occurs when
  prices are sticky
• The next task to explain how prices move, when
  they eventually do
• The missing equation discovered by Phillips
  (1914-1975) at the London School of Economics
• The next question what is the theory behind the
  Phillips curve?
• The curve started to vanish the disappearance of
  the Phillips curve, predicted by Friedman in the
  late 1960s, paved the way for the rise of the
  monetarists.they exposed what was seen as
  fundamental flaws in Keynesian economics

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2. THE MONETARIST REVOLUTION

• By the late 1940s, the Keynesian school was
  strong in the USA, where most of macroeconomic
  research was conducted
• The University of Chicago (Chicago School) led
  against the Keynesians an intellectual attack
• The success of the Chicago School is due to
  MILTON FRIEDMAN extraordinary intellectual
  vigor, leadership charisma, government
  experience, communication skills
• He assembled a group of young economists
  Workshop in Money and Banking
• He devoted much time and effort to popularize his
  ideas

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2. THE MONETARIST REVOLUTION - Friedmans main
ideas

• 1. A strong defender of free markets. He actively
  promoted the view that governments are a threat
  to freedom, and not just in economic matters.
• 2. He confronted Keyness view that fiscal policy
  is a useful tool for macroeconomic stabilization
  and that monetary policy is useless - MONETARIST
• A Monetary History of the United States,
  1867-1960
• - it fundamentally changed the way we look at
  monetary policy
• - at empirical level, it attributes the Great
  Depression to bad monetary policies (Keynes
  blamed procyclical fiscal policies)
• - at theoretical level, it reestablished the
  classic quantity equation MVPY, the
  NEUTRALITY OF MONEY

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2. THE MONETARIST REVOLUTION - Friedmans main
ideas

• 3. A study of consumption patterns in the USA A
  Theory of the Consumption Function (1956)
• - he argued that Keynes consumption function had
  little theoretical foundation and questionable
  empirical validity
• - he put forward the permanent income hypothesis
• - he weakened the significance of the Keynesian
  multiplier and the view that fiscal policy can be
  a tool for output stabilization
• 4. Friedman explained why the Phillips curve
  would vanish as soon as the authorities attempted
  to exploit the output-inflation trade-off

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2. THE MONETARIST REVOLUTION - Friedmans main
ideas

• - He restored the importance of expectations (the
  expectations-augmented Phillips curve) and he
  invented the long-run vertical aggregate supply
  schedule
• In general, Europe was slow to recognize the
  power of the monetarists attack and did not
  contribute much to the research effort.
• UK was dominated by Keynesians, until Mrs.
  Thatcher was elected and she brought in Friedman
  as an advisor.
• The Chicago school also contributed much to our
  understanding of the open economies much of
  Mundells work was produced when he was in
  Chicago (the monetary approach to the exchange
  rate)

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3. THE RATIONAL EXPECTATIONS REVOLUTION

• Another attack on Keynesian economics the
  rational expectations revolution
• The expectations-augmented Philips curve of
  Friedman had left an important question
  unanswered what drives expectations?
• Most economists expectations are gradually
  catching up with actually observed inflation
  (adaptive expectations)
• A major step Robert E.Lucas Jr. (Nobel prize
  laureate), a student of Friedman, led the
  rational expectations revolution
• They noted that if the forward-looking component
  dominates and if expectations are not
  systematically biased, the Phillips curve is
  always vertical and systematic policy does not
  work

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3. THE RATIONAL EXPECTATIONS REVOLUTION

• Their conclusion monetary policy only affects
  output and employment if and only if it creates
  inflation surprises
• The RE revolutions message macroeconomic
  policies should not be used on and off with
  complete discretion. Policy should obey rules and
  aim at establishing credibility by sticking to
  these rules.

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4. THE MICROFOUNDATIONS OF MACROECONOMIS

• The RE hypothesis attracted huge interest and
  opened the way for further innovations
• Question if it is appropriate to assume that
  expectations are rational, then why shouldnt all
  other economic decisions be rational as well?
• Researchers at some universities in the USA
  (Chicago, Minnesota, Rochester, Carnegie-Mellon,
  Pennsylvania) established the microeconomic
  foundations of consumption, investment, etc.

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4. THE MICROFOUNDATIONS OF MACROECONOMIS

• However, business cycles remain a fact of life
  that must be explained
• Neoclassical economists created the Real Business
  Cycles (RBC) research programme (Kydland and
  Prescott, Nobel prize in 2004).
• Its aim to show that models with flexible prices
  and fully rational agents can reproduce the key
  features of actual business cycles.
• However, this has not been an empirical success.
  Many of the most important stylized facts remain
  unaccounted for (price stickiness simply appears
  to be a fact)

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4. THE MICROFOUNDATIONS OF MACROECONOMIS

• New Keynesians wanted to show that price
  stickiness is not incompatible with microeconomic
  foundations and full rationality. They produced a
  new synthesis, which fully rests on rational
  behavior but deliver the traditional Keynesian
  results
• The RBC school reached the same conclusion
• In the end, the IS-LM model is alive and well.
  From the policy perspective, the view that fiscal
  and monetary policies can be used as tools for
  output and employment stabilization is now
  generally accepted.
• It is also recognized that the role of
  expectations requires much more prudence and care
  than the traditional Keynesians dared to admit.

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5. GROWTH AND DEVELOPMENT

• One of the most important issues the wealth and
  poverty of nations
• The neoclassical growth model (Robert Solow,
  Nobel prize) has two implications
• 1. Capital is more productive where it is
  scarce
• 2. The key source of sustained growth is
  unexplained technological progress
• Both implications were unsatisfactory..

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5. GROWTH AND DEVELOPMENT

• 1. Robert E. Lucas Jr. - explain why capital does
  not flow from rich to poor countries
• - poor countries are characterized by low capital
  intensity and in theory must have a much higher
  marginal productivity of capital than rich
  countries
• - productivity may be high in theory, but in
  reality is significantly reduced by poor
  institutions that allow corruption, instability
  and war to discourage investment

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5. GROWTH AND DEVELOPMENT

• 2. Technological progress could be treated as
  endogenous - Paul Romer (1955- )
• Education is an investment in human capital, and
  is deterred by poor institutions, like investment
  in physical capital
• Other contributions Robert Barro (1944- ,
  Harvard University), Xavier Sala-i-Martin (1963-
  , Columbia University)
• The result of this research a thorough
  understanding of underdevelopment and of policies
  that try to deal with extreme poverty in many
  parts of the world