Revolution and evolution in the macroeconomics of the 20th century

Michael Woodford
Princeton University*

June 1999

The 20th century has witnessed profound progress in economic thought. This has
been associated, among other things, with the progress of economics to a fully
autonomous disciplinary status, which had only begun to be established in the late 19th
century, and with a very substantial improvement in the technical methods employed in
the discipline, both in the development of economic theory and in the statistical analysis
of economic data. Over the past century, the economy has also come to play a more
important role in the world at large. Economic advisors have become more important in
the formulation of government policies and the policies of international organizations such
as the IMF and the World Bank; economic theory has proven to be of practical use in the
design and use of a world of new financial instruments;

Try to catalog, much less evaluate, all the important aspects

Developments in a field so active throughout the century would be a task beyond the scope of a
conference of this length. As a result, I have chosen to discuss a single, albeit important, strand of 20th
century economic thought. This is the field of macroeconomics, the branch of economics that deals with
fluctuations in the general level of business activity, with the determinants of inflation, interest rates and
exchange rates, and with the effects of government policies, such as fiscal policy, monetary policy. and
exchange rate policy, which are considered primarily in relation to their effects on the economy as a
whole.

There are several reasons for the selection of macroeconomics that deserve special attention,
besides the fact that I know it best. First of all, among the applied fields of economics, it occupies a
special place in modern economics curricula. Macroeconomics is also the part of economics that the
general public most often associates with the field. For example, a few years ago, Daniel Bell and Irving
Kristol edited a book titled The Crisis of Economic Theory; 1 *

Prepared for the conference on "Frontiers of Mind in the 21st Century", Library of Congress, Washington, June 14-18, 1999. I would
like to thank Ben Bernanke, Alan Blinder, Michael Bordo, David Laidler, and Julio Rotemberg for their comments on an earlier draft,
and the John Simon Guggenheim Foundation and the Center for Economic Policy Studies at Princeton University, for their support
of the investigation.
1 New York: Basic Books, 1981.

But what the book is about is not general economic theory, but rather the state of
macroeconomics.

Second, macroeconomics is an interesting case because the degree to which there has been progress over the
century is far enough from transparency to make it a suitable topic of conversation. A discussion of the century's progress

1
in general economic theory, with primary emphasis on what is taught in “microeconomic theory” courses, which emphasize
the decisions of individual households and firms, would surely be more appropriate if my goal were to increase the prestige
of my own field among the many distinguished representatives of other disciplines present here. But the story would have
little suspense. For it would not be an oversimplification to present that the field has progressed smoothly and steadily,
developing theories of increasing power and scope within an essentially unchanged explanatory framework, based on the
concepts of optimization of individual behavior and market equilibrium. , which were already central to economic thought in
the previous century. Instead, macroeconomics has been famously controversial, with Bell and Kristol's alarmism going
only slightly further than what is found in the academic literature. Discussions of 20th-century macroeconomic
developments make frequent references to "revolutions" and "counter-revolutions," with Bell and Kristol's alarmism going
only slightly further than what is found in the academic literature. Discussions of 20th-century macroeconomic
developments make frequent references to "revolutions" and "counter-revolutions," with Bell and Kristol's alarmism going
only slightly further than what is found in the academic literature. Debates about the evolution of macroeconomics in the
20th century make frequent references to "revolutions" and "counter-revolutions", 2 and the question of whether there has
been any progress (or what general developments should count as progress) is a topic of further debate. live among
economists than one might believe would be possible in the case of a topic with such canonical status in economics.
Curriculum.

Finally, macroeconomics is an appropriate case to consider on this occasion because it

has been an essentially 20th-century development. The emergence of macroeconomics as a co-
equal second branch of economic theory in the standard curriculum is a novelty of the 20th
century, the result of both intellectual developments (notably the emergence of Keynesian theory)
and a new importance placed on management of the economy in 20th century ideas about the role
of government. Skeptics may question whether it should have an equally prominent role in the
curricula of the next century. I am inclined to believe that this should be the case, but the issue is
worth considering and raises central questions about the nature of both this subfield and
economics in general.

2 See, for example, Lawrence R. Klein, The Keynesian Revolution, New York: Macmillan, 1949; Harry G. Johnson, “The
Keynesian Revolution and the Monetarist Counterrevolution,” American Economic Review 61 (2): 91 – 106 (1971); Mark H.
Willes, "'Rational Expectations' as Counterrevolution," in Bell and Kristol, op. cit.; David K. H. Begg, The Rational
Expectations Revolution in Macroeconomics: Theories and Evidence, Oxford: Philip Allan, 1982.

The birth of macroeconomics

The systematic study of trade fluctuations and stabilization policy is almost entirely a 20th-
century development. During the previous century, the occurrence of repeated "crises" was a
feature of commercial life that was highlighted by several authors, including Karl Marx. But
speculation about the nature of such crises rarely rose to the level of anything that could be called
theory, and it had little effect on the view of market mechanism presented in the major texts on
economic theory.

Monetary economics existed as an identifiable subfield and had even developed at least
2
some important theoretical ideas. These included the quantity theory of money (the proposition
that increases in the money supply lead, at least eventually, to proportional increases in the
general price level) and the dichotomy between "real" and "nominal" variables (the former being
determined, at least in the long term, by purely non-monetary factors). However, discussions about
the conduct of monetary policy had little contact with this theory. 3 Furthermore, monetary policy
was largely seen as a technical issue relating to the way in which the "bank rate" (in British
terminology) was to be managed to avoid a loss of the central bank's gold reserves, in order to
make continuous adhesion possible. to the gold standard; it was not discussed in terms of broader
economic objectives such as the stabilization of economic activity, employment or the general
price level. The main intellectual question related to monetary policy was the choice of a monetary
standard, whether a gold standard, a silver standard, a bimetallic standard, or some other more
exotic proposal was preferable in principle. 4

The first decades of the 20th century saw important advances in the study of trade fluctuations,
with a proliferation of explanations proposed for the regular occurrence of “business cycles.” 5 Perhaps
most importantly, by the 1920s, statistical institutes for the study of business cycles had been founded
in many countries, and business cycle researchers (especially those working with Wesley Mitchell at the
National Bureau of Statistics) of Economic Research in New York) were able to document in detail the
nature of recurrent patterns of comovement among a large number of economic series. 6

3 See, for example, Allan Meltzer, "A History of the Federal Reserve, chapter 2: The Development of Central

Banking Theory and Practice", mimeo, Carnegie-Mellon University, November 1995.

4 For example, the proceedings of the 1904 "Congress of Arts and Sciences" held in conjunction with the St. Louis include
"Money and Credit" as one of the six branches of economics discussed. But the two articles included in that section deal
primarily with the desirability of a gold standard.
5 Gottfried Haberler, Prosperity and Depression, Geneva: League of Nations, 1937, offers a comprehensive review of pre-

Keynesian literature.

6 See Mary S. Morgan, The History of Econometric Ideas, Cambridge: Cambridge University Press, 1990, chapter 2.

Arthur F. Burns and Wesley C. Mitchell, Measuring Business Cycles, New York: National Bureau of Economic Research, 1946, is
the classic summary of early NBER studies.

Business cycle theorists of this period had a wide variety of views, not only about the
origin of such fluctuations, but about what could be done about them. Some, particularly those
influenced by "Austrian" theory, considered the sequence of events characteristic of the "cycle" to
have an inevitable doom, with which it would be unwise, or perhaps impossible, for government
policy to interfere. 7 Others were more optimistic about the possibility of a stabilization policy, 8 but
had very different opinions about the type of policy that would be effective. For example, some
(such as Arthur Pigou and Dennis Robertson at Cambridge) argued that monetary policy would be
ineffective but that varying spending on public works over the cycle would be highly desirable,
while others (such as Ralph Hawtrey, another cycle theorist) of Cambridge) argued exactly the
opposite.

3
 In any case, none of these theories had much effect on public policy before the
1930s. For one thing, the business cycle theories of the 1920s were not yet quantitative
models that could be used to analyze the effects of alternative policies. The statistical
studies of the economic cycle institutes constituted their object of study by highlighting the
similarities between sequences of measurements carried out at different times and
places; But simply documenting these patterns gave little indication of what might happen
differently in the event of government intervention. The theories proposed tended to be
narrative accounts of the sequence of events that unfolded through successive "phases"
of the economic "cycle," tracing an intricate, but purely linear, chain of causality with a
complexity that rivaled a Rube cartoon. Goldberg.

7 The fatalism of this strand of literature is illustrated by the comment of the eminent Harvard business cycle theorist
Joseph Schumpeter, who warned in the early days of the New Deal that "recovery is strong only if it comes of its own
accord. "Merely due to an artificial stimulus it leaves part of the work of the depressions undone and adds, to an undigested
remnant of maladjustment, a new maladjustment." From "Depressions", in DV Brown et al., Eds., The Economics of the
Recovery Program, Cambridge: Harvard University Press, 1934. In Britain, Lionel Robbins's adherence to Austrian theory
led him to oppose public works programs during the Depression, a position he later characterized as "the biggest mistake of
my professional career." From Autobiography of an Economist, London: Macmillan, 1971, p. 154.
8 For example, the prominent Swedish business cycle theorist Gunnar Myrdal was dismissive of the Austrian doctrine and
suggested that “perhaps the whole attitude was ultimately based on a primitive puritanism; Happiness is something bad,
something immoral, which must be accompanied by purifying misery from time to time so that those who have experienced
it can be redeemed; and so it is appropriate, right and natural that after the rebound, with all its sad errors, bad times
come." monetary balance,
London: W. Hodge, 1939 [originally published in Swedish in 1931]. Most members of the Cambridge school, to which Keynes belonged, were
also advocates of the stabilization policy.

4
The "Keynesian revolution"
The Great Depression, of course, had a dramatic effect on thinking about such matters. It
diverted attention from the dynamics of recurring cycles to the pressing problem of what to do in
the face of a severe recession, and made the question of what government measures could
achieve such public works a matter of urgent debate. And the appearance of John Maynard
Keynes General Theory of Employment, Interest and Money 9 had a profound intellectual impact,
essentially creating the subject of macroeconomics as it is now understood. Keynes offered a
theory of depression economics that famously stated that the market mechanism could not be
trusted to recover spontaneously from a recession, and that advocated public spending, preferably
with a deficit in the government budget, to stimulate demand. Most importantly from a scientific
point of view, it presented a framework that could be used to calculate the effects on economic
activity of public spending and taxation of particular amounts, and thus estimate the size of the
intervention required.

The degree to which Keynes's ideas were completely novel is sometimes questioned; 10
and it is certainly true that the aspects of his book that were most novel, and indeed shocking, to
his contemporaries were not the parts that have proven to have the most lasting importance. Many
of the book's important themes, from the slow adjustment of wages as an explanation for the
continuing imbalance to the prescription of spending on public works to increase employment, can
be found in other writings from the period, and even from the previous decade. 11 But Keynes's
genius lies in showing how these pieces fit together.

Furthermore, he illustrated the fruitfulness of a new style of macroeconomic theorizing,

which deemphasized dynamics, to emphasize the simultaneous determination of a set of key
variables (employment, income, interest rates, and prices) relative to each other at a given time.
The obscuring of the dynamics of the business cycle was not an intellectual advance in itself, of
course, 12

9 London: Macmillan, 1936.

10 See, for example, David Laidler, Making the Keynesian Revolution: Studies in the Interwar Literature on Money, the Cycle and
Unemployment, Cambridge: Cambridge University Press, 1999, for a nuanced discussion of this topic.
11 Wage rigidity had been emphasized by Cambridge monetary economists long before the General Theory, beginning with the
work of Alfred and Mary Marshall in the 1870s, and including the work of Marshall, Pigou, and Hawtrey in the 1910s and 1920. See
David Laidler, The Golden Age of Quantity Theory, Princeton: Princeton University Press, 1991, chap. 4. The defense of
countercyclical expenditure on public works as a remedy for unemployment was also common in the Cambridge literature in the
1920s, being adopted by Pigou, Lavington and Robertson; see Laidler, Making the Keynesian Revolution, op. cit., pp. 103-4. For
an example of the views of American economists during the Depression, see Arthur D. Gayer, "Monetary Policy and Public Works",
in Robert M. McIver. et al., Economic Reconstruction: Report of the Columbia University Commission, New York: Columbia
University Press, 1934.
12 Indeed, Keynes's truncated analysis of dynamics and expectations was the feature of the book that was least pleasing to some of his

more sophisticated contemporaries. See, for example, Bertil Ohlin, “Some Notes on the Stockholm

5 and the project of extending Keynesian statics

to a coherent dynamic model has been much of what has kept macroeconomic theorists busy in
the second half of the century. But there is no doubt, in retrospect, that the redirection of attention
was a masterstroke at the time, because of the better understanding it allowed of simultaneous
causal relationships.

Much of what economic analysis meant at the time was the use of the paradigm of the
determination of prices and quantities by supply and demand to explain the determination of some
single price and some corresponding quantity by supply and demand curves. appropriate for a
single market. Thus, wages (and employment) were determined by the supply and demand of
labor; interest rates (and savings) were determined by the supply of savings and the demand for
funds to finance investment; and the general level of prices (and monetary balances) was
determined by the relationships between the supply and demand of money. In any of these cases,
denying that prices clear the market would actually have been equivalent to abandoning the
explanatory paradigm, so economic analysis would have little to say.

But Keynes's analysis showed that if instead the simultaneous determination of all these
prices and quantities were considered at the same time (taking into account that the level of
income implied by a certain level of employment also affects the supply of savings and the
demand for monetary balances, etc.), one could deny the postulate of market clearing at one point
in the system (the labor market), and still put the requirements for equilibrium in the other markets
to good use. 13 Furthermore, conclusions could be drawn about interventions that could affect
employment, say, that went beyond the mere adjustment of factors related to that specific market.
Therefore, although many of Keynes's contemporaries were well aware of the idea that downward
wage rigidity could lead to unemployment, Keynes was not interested in promoting the conclusion
that measures should therefore be taken to reduce the salaries. Considering the interactions
between various markets provided insight into why other types of interventions, such as public
spending, could also be effective and, indeed, why pay cuts would not necessarily be effective.

The result was a powerful engine for the analysis of the effects of any of a variety of disruptive
factors (originating within the economy itself or in government action) on each of several important
variables, in circumstances that allowed the persistence of a sustained situation. period in which

Theory of savings and investment”. Economic Review 47: 53-69, 221-240 (1937), which anticipated important lines
of later development.
13 The system of simultaneous equations is not written in the General theory; Instead, it was left to John R. Hicks writing
them, in his famous comment, “Mr. Keynes and the Classics: A Suggested Interpretation”, Econometrica 5: 147-159
(1937), which became the basis of post-war macroeconomic pedagogy. Keynes's own exposition of his reasoning
regarding the simultaneous determination of the aforementioned variables is largely verbal and quite complex.

6 wages (and possibly prices too) did not fully

adjust. Its availability greatly facilitated the growth of a new attitude towards economic policy, in which
the government accepted a greater degree of responsibility in managing the level of economic activity
and economic advisers provided estimates of the effects of the actions contemplated in particular. 14 It
also provided the impetus for the further development of national income accounting, another critical
20th-century advance in understanding trade fluctuations, through the emphasis placed in Keynes'
system on variations in the various components of national expenditure such as source of short-term
variations in economic activity. . 15

Finally, Keynesian economics provided the conceptual framework within which

simultaneous equation econometric models of the economy could be developed for the purposes
of forecasting and quantitative policy analysis. It is true that the first econometric models of
simultaneous equations, developed by Jan Tinbergen in the 1930s, were mainly inspired by pre-
Keynesian theories of the business cycle, and Keynes himself was quite skeptical of this work. 16
However, major postwar macroeconometric model developers, such as Lawrence Klein and
Franco Modigliani, based the structure of their models directly on the skeleton provided by
Keynes. General theory and later elaborations such as those of Hicks and Modigliani himself.
Furthermore, Tinbergen's models had a recursive structure in which each variable was determined
individually by a combination of exogenous shocks and previous variables, although each
endogenous variable could be affected by the past values of several others; They did not yet
incorporate the simultaneous determination of variables that I have identified as a crucial aspect of
the Keynesian revolution, and which was responsible for the central intellectual problem (the
“identification” problem) related to simultaneous equation econometric models. 17

Thus, the development of Keynesian economics was fundamental to the development of

modern economics as it appeared in the middle of the century. This is not simply because he gave new
importance to the study of business fluctuations, which now had results and a mission of sufficient
importance to make macroeconomics a core subject in the economics curriculum. Keynesian
economics also provided a crucial impetus to the development of two other key mid-century
developments: general equilibrium reasoning in economic theory and simultaneous equation modeling
in econometrics.

14 This new role for economists and economists in the world outside of academia was formalized by institutional
developments such as the Full Employment Act of 1946 in the United States, which committed the federal government to
maintaining full employment and created the President's Council of Economy. Advisors.

15 See, for example, Don Patinkin, "Keynes and Econometrics: On the Interaction between the Macroeconomic

Revolutions of the Interwar Period", Econometrica 44: 1091-1123 (1976).

sixteen See Morgan, op. cit., pp. 121-130.
17 See diagrams of the causal structure of Tinbergen's models in Morgan, op. cit., Chapter 4.
 1
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It may seem strange, in light of disputes over the "microfoundations of macroeconomics" since
the 1960s, which have tended to present Keynesian macroeconomics and general equilibrium theory as
two alternative and apparently incompatible ways of modeling the economy in As a whole, we speak of
Keynesian economics as part of a broader current of general equilibrium reasoning. But the most
important early presentations of general equilibrium theory as a paradigm for economic analysis, such
as that of John R. Hicks Value and
Capital 18 and Paul A. Samuelson's Foundations of Economic Analysis, 19 gave prominence to
Keynesian macroeconomic theory as an important application of general equilibrium analysis.
Furthermore, it turns out that some of the most important critics of general equilibrium analysis in this
period on methodological grounds have also been important critics of Keynesian macroeconomics. 20

The "neoclassical synthesis"

Many of the most important developments in macroeconomics since World War II can be
described as attempts to come to terms with the “Keynesian revolution” just described. The rise of
Keynesian economics created a place for macroeconomics as a second major branch of economic
theory, alongside microeconomic theory (the modern version of the "theory of value" that had
constituted virtually the entire content of economic theory in XIX century). It did so not only by
giving macroeconomics new content and importance, but also by leaving unclear the nature of the
connection between the principles of macroeconomics and the more familiar principles of
microeconomic theory (those of rational individual choice and equilibrium of the market), so that
the pedagogy was made less awkward by treating the two subjects on different days,

At first, the methodological gap was not so extreme; Although Keynes contemplated a failure of
some markets, such as the labor market, for clarification, his analysis nevertheless presumes
equilibrium in a reasonably conventional sense in other markets, and the general theory consists largely
of an analysis of individual decisions and of companies that does not differ in style from the applied
microeconomic analysis of the time. But as macroeconomics became a quantitative subject, with the
development of econometric models as its central objective, connections with the elements of
microeconomic analysis became less important.

18 Oxford: Clarendon Press, 1939.

19 Cambridge: Harvard University Press, 1947.

20 See, for example, Milton Friedman, "Lange on Price Flexibility and Employment: A Methodological Criticism,"

American Economic Review 36: 613-631 (1946); and "The Marshallian Demand Curve", Journal of Political Economy 57:
463 - 495 (1949). See also E. Roy Weintraub, Microfoundations: The Compatibility of Microeconomics and
Macroeconomics, Cambridge: Cambridge University Press, 1979, chapter 4, for a discussion of the relationship between
the rise of Keynesian macroeconomics and Walrasian general equilibrium theory along similar lines.

and less explicit. Statistical relationships between aggregate economic time series came to take
precedence over theoretical notions such as the incentives provided by prices or the constraints
imposed by budgets, or even the nature of the economic units in which particular decisions were made.
 1
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When it was found that price measurements were not of great help in the regression equations that
sought to explain the evolution of aggregate quantities, prices were no longer emphasized in favor of
relationships that directly relate quantities to other quantities (for example example, explaining
variations in consumption and investment spending by variations in national income). But such
relationships were different in form from those suggested by microeconomic theory, where the response
of individual households and firms to price incentives had always been emphasized. Thus, when
Keynesian macroeconomics reached its full maturity in the 1960s, it was widely agreed that the
apparent inconsistency between the structure of macroeconomic models and the type of economic
theory used in other branches of applied economics posed a fundamental challenge. to coherence. of
the modern economy. This problem was called the need for "microfoundations for macroeconomics." 21

Macroeconomics also seemed at times to present a fundamentally different view of the market
mechanism than that conveyed by mainstream microeconomic theory: a description of the economy as
subject to arbitrary forces and in need of constant management through government policy to keep it in
business. good path, rather than a self-regulatory mechanism that spontaneously leads to efficient
allocation of resources. Keynes's stress in the General Theory on the possibility of market failure and,
indeed, on the idea that unemployed resources could exist as an "equilibrium" state, not spontaneously
eliminated by the market mechanism, contributed in some extent to promote this impression. The stark
contrast he chose to draw between his own system and the previous orthodoxy, which he caricatured
as “classical economics,” did much more. 22

The presentation of Keynesian economics as a radical challenge to conventional

economic theory led some to conclude that, at most, one of the two could be true. Radical
Keynesians, especially in Cambridge, England, hoped that the ideas of the General Theory would
provide the basis for an entirely new economics; At the same time, some traditionalists argued that
Keynesian theory was fundamentally wrong. But the dominant vision, after the end of the
Depression and especially in the United States, was what was called “the neoclassical synthesis.”
The neoclassical synthesis, developed by John R. Hicks and Paul A. Samuelson, among others, in
the first decade after Keynes

21 See, for example, Weintraub, op. cit.

22 As noted above, many themes and recommendations in the General Theory can also be found in the writings of his

contemporaries, and many of them were quite resentful of Keynes' characterization of “classical economics.” See Laidler, Making

the Keynesian Revolution, op. cit., Chap. 11.

 9 wrote, he proposed that both Keynesian theory and
neoclassical general equilibrium theory could be seen as correct, although partial, explanations of economic
reality. It was argued that the conventional theory of general competitive equilibrium correctly explained the
determination of prices and quantities in the long run, once wages and prices had had sufficient time to
adjust to clear markets; Thus, the self-regulatory property of the market system was not denied, but simply
argued that it was sometimes slow enough to profitably allow interventions aimed at accelerating the kind of
adjustment that markets would ideally organize themselves. At the same time, it was argued that the
Keynesian model explained the short-term effects of both shocks to the economy and policy interventions,
before prices and wages had much time to adjust.

The details of how we got from the Keynesian short term to the "classical" long term were
not really resolved. Economists such as Hicks, Samuelson, and Oskar Lange made important
early efforts in developing dynamic versions of the Keynesian model, 23 but in this early work, the
dynamics that were emphasized involved the adjustment of quantities over time in response to
some initial disturbance. , in an environment where wages and prices remained fixed, rather than
the process by which wages and prices would eventually adjust. The integration of short-run
Keynesian analysis with a Walrasian long-run equilibrium model only began to be systematically
addressed in work such as that of Don Patinkin in the 1950s, 24 and the problem remains central
to the current research agenda in macroeconomics. , as discussed below.

However, the “neoclassical synthesis” was not simply a pious profession of faith
that theoretical difficulties would eventually be resolved. His redefinition of the scope of
Keynesian analysis as purely concerned with the period before wages and prices could
adjust offered an important corrective to many of the more extreme views of Keynesian
zealots. For example, one of the most striking aspects of Keynesian doctrine for
traditionalists was Keynes's disparagement of personal savings as a drag on the
economy due to the reduction in aggregate demand for the goods and services
produced. Once it was recognized that conventional neoclassical theory should still apply
in the long run, so that, in the long run, income should depend on productive capacity,
productive capacity should depend on capital formation,

23 Hicks, Value and Capital, op. cit.; Samuelson, op. cit.; Oskar Lange, Price Flexibility and Employment,
Bloomington: Principia Press, 1944.
24 Money, Interest, and Prices: An Integration of Monetary and Value Theory, New York: Harper and Row,
1957.
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Although the “neoclassical synthesis” allowed postwar Keynesians to maintain that there was no
fundamental incompatibility between microeconomic and macroeconomic theory, the perceived
incompleteness of the theoretical foundations of Keynesian economics continued to motivate important
work of criticism and refinement. . The 1950s saw several important analyzes in terms of individual
optimizing behavior of crucial elements of a Keynesian macroeconomic model. Examples of such work
include Franco Modigliani and Milton Friedman's analyzes of the microfoundations of the Keynesian
"consumption function" (which relates consumption spending to household income), or James Tobin's
work on the demand for liquid assets. , to name just a few of the 1950s work later cited by the Nobel
committee. 25

This work was generally presented as a refinement of Keynesian models, rather than as a
fundamental challenge to such models; in fact, such work typically considered only the question of the
appropriate form of a single equation of a Keynesian model, while tacitly accepting the general structure
within which that equation would be used. 26 Thus, although this work drew attention to the importance of
new variables not emphasized by Keynes (for example, income expectations as opposed to current
income, in Friedman's work on the consumption function, or wealth and the variables demographics in
Modigliani), the general impression in this period was one of cumulative progress within a relatively
established paradigm. The theoretical understanding of the individual programs that made up a
Keynesian macroeconomic model and the econometric estimation of quantitative models in this spirit
proceeded to some extent along separate tracks, but while both programs appeared to be progressing
well, there was plenty of ground for faith. that theory and quantitative models would eventually be shown
to be consistent with each other.

The great inflation and the crisis of Keynesian economics

Most of the important new developments since 1960 have been associated, instead, with schools of
thought that have been harshly critical of Keynesian macroeconomics, which at the time was a well-
established orthodoxy. There have been three main waves of such criticism, each often described as another.

25 Franco Modigliani and Richard Brumberg, "Utility Analysis and the Consumption Function: An Interpretation of Cross-Section
Data," in Kenneth K. Kurihara, ed., Post-Keynesian Economics, New Brunswick: Rutgers University Press, 1954; Friedman, A
Theory of the Consumption Function, Princeton: Princeton University Press, 1957; James Tobin, “Liquidity Preference as Risk
Behavior,” Review of Economic Studies 25: 65 – 86 (1957).
26 Of course, whether such work appeared to represent mere refinements or fundamental criticism depended to some extent on one's
attitude toward Keynes. For example, the NBER summary of Friedman's study of the consumption function stated: “It is clear that Friedman
abandons the conception of the consumer as a mechanical link between current income and consumption, a notion that Keynes expounded
in 1936…Friedman goes back to the oldest theory of consumer behavior, in which consumers' plans and decisions are influenced by the
future as well as the present and the past."
 11 “Revolution” or “counterrevolution” in
macroeconomic thought. Each has been clearly anti-Keynesian in the sense that they have
expressed skepticism about the benefits of activist stabilization policy, while consequently
being more optimistic than Keynesian thinking about the self-regulatory capacities of the
market system. The influence of such currents has undoubtedly been greater as a result of a
general trend, in the United States and elsewhere, toward greater skepticism about the role of
government during this period. At the same time, each of these waves of criticism has drawn
much of its intellectual force from the perception that Keynesian macroeconomics was not well
integrated with the main body of economic theory. Each has sought, albeit in somewhat
different ways in each case, to reintegrate macroeconomics with the broader theory of market
functioning.

The increasing harshness of polemics directed against Keynesian economics, especially since the
1970s, was perhaps to some extent a simple reaction to the influence that Keynesian views had achieved in
the 1960s, not only within academia. , but also among politicians. 27 With the apparent triumph of the
Keynesian vision of managing aggregate demand with the help of econometric models as a route to sustained
prosperity, there emerged an obvious sense that the stakes were now higher in intellectual debates about
fundamental solidity of Keynesian ideas. But the sharpness of the debate - and the degree to which even
radical alternatives began to find sympathetic ears - also had a lot to do with the emergence of a serious
public policy problem, which Keynesian policies had not prevented. and were even suspected of having
caused it. This was the sustained increase in the rate of inflation, in the United States as in many of the other
developed economies, that began in the late 1960s and continued until the early 1980s.

The emergence of chronic inflation as an economic problem, after a couple of decades of relatively
stable prices, and shortly after Keynesian ideas about demand management began to be put into practice,
highlighted a critical weakness of the model. somewhat simplified Keynesian that was used in practical policy
analysis. This was their relative neglect of the effects of demand stimulation on the general price level. As
noted above, Keynes's crucial insight in the General Theory had been that it was possible to say many useful
things about the short-run determinants of economic activity by treating wages and prices as given, rather than
adjusting them to clear markets. . But this meant that Keynesian models, in their most basic form, abstracted
from wages

27 In the late 1960s, both Republicans and Democrats in the United States accepted Keynesian views on economic policy, with only minor
qualifications. This became clearer when Richard Nixon, during his 1971 State of the Union address, declared that “by spending as if we
were at full employment, we will help produce full employment,” and in a later interview declared, “I'm a Keynesian now.” . See Herbert
Stein, Presidential Economics, New York: Simon and Schuster, 1985, pp. 172-173.

12 and price adjustment, and thus the problem of

inflation was ruled out as a possible consequence of an excessive stimulus of aggregate demand.

Discussions among policymakers were more sophisticated than these simple textbook models, of course, even in the early
1960s. But Keynesian policymakers argued that demand stimulation should not lead to inflation as long as output remained
"below potential," and they devoted considerable effort to constructing quantitative estimates of the economy's potential
output level, as a basis for judgments about the extent to which further demand stimulation would be appropriate. 28 In
retrospect, it now appears that those estimates were systematically overoptimistic for many years, and to a surprising
degree for much of the 1970s. 29 This gave an inflationary bias to policy for most of the period, to the extent that the
economy was perceived to have more slack than actually existed, even as inflation accelerated.

To what extent can this failure be attributed to a flaw in the Keynesian conceptual framework, as
opposed to a simple misinterpretation of current conditions (perhaps honest, perhaps occasionally the result of
political opportunism)? To a large extent, the error in judgment was due to changes in the economy, the
occurrence of which did not invalidate the Keynesian model. For example, the "natural" rate of unemployment,
the rate above which labor market rigidities should not result in inflationary wage demands, is now believed to
have increased significantly in the 1970s relative to what it had been. a couple of decades earlier, as a result,
among other factors, of changes in the demographic composition of the active population. 30 This made
estimates of the degree of overcapacity based on the unemployment rate, simply extrapolating from recent
experience, overly optimistic. At the same time, it is now recognized that the growth rate of labor productivity
declined significantly in the 1970s, for reasons that are still largely mysterious; This also led to a systematic
overestimation of the productive capacity of the economy.

The fact that these quantitative guidelines are unstable over time does not have to invalidate the
basic objectives or the basic conceptual framework behind Keynesian policies. However, it has greatly
tempered the optimism of the 1960s about the extent to which available quantitative models

28 In the USA In the US, the Council of Economic Advisers prepared official estimates of potential output, beginning in 1961 and
ending in 1981. Data on the gap between actual and potential output were part of President Kennedy's first Council presentation to
the Joint Economic Committee on March 6, 1961; The 1962 President's Economic Report provided a comprehensive discussion.
Arthur Okun, "Potential Result: Its Measurement and Meaning", Proceedings of the Economic and Commercial Section,
Washington: American Statistical Association, 1962, explained the methodology. See also Okun, The Political Economy of Prosperity, Washington:
Brookings Institution, 1970, for a review of the principles under which US macroeconomic policy was conducted during the 1960s.
29 See Athanasios Orphanides, “The Quest for Prosperity without Inflation,” unpublished, Federal Reserve Board, May 1999.
30 See, for example, Robert Shimer, “Why is the U.S. Unemployment Rate? USA Is it much lower?" NBER
Macroeconomics Annual 13: 11 - 61 (1998).

1
would allow precise management of aggregate economic
3 performance. This increased the receptiveness of both
economists and policymakers to views that questioned the entire enterprise of attempting to use such models to
carry out stabilization policy. Perhaps most importantly, the fact that the gap between actual and potential output
cannot always be measured well "in real time" strengthened the case for greater attention to long-term price
stability as a policy objective, not because it is the only thing that matters in principle, but because it is easier to
be sure of the extent to which it is being achieved. But such a shift in policy objectives created a demand for
models of the economy that could highlight features that the Keynesian models of the 1960s tended to downplay,
if not abstract entirely.

In particular, a framework was needed to clarify the links between macroeconomic policy and
the eventual changes in the general price level that would arise from it. Attention to this problem soon
pointed out other weaknesses of Keynesian models, such as their neglect of the endogeneity of
expectations and of the determinants of supply costs. Together with the persistent conceptual problem
of the relationship between macroeconomic and microeconomic theory, these themes provided the
fuel for a series of fundamental critiques of Keynesian economics, which have often been described
as "revolutions" or "counter-revolutions" in their own right.

Monetarism

The first of the fundamental criticisms of Keynesian theory was that of the “monetarist”
school, associated in particular with Milton Friedman, Karl Brunner, Allan Meltzer and their students
and collaborators, which rose to prominence in the 1960s. Monetarists criticized Keynesian theory, the
most famous, for its relative neglect of variations in the money supply as a determinant of aggregate
spending in the economy, and as a related point, for its excessive emphasis on other sources of
variations in spending and an exaggerated faith in the usefulness of fiscal policy. 31

The denial of the effectiveness of monetary policy was not a fundamental principle of
Keynesianism. But Keynes had argued that monetary stimulus would have been of little help in getting
out of the Depression, and some of the more dogmatic Keynesians attempted to make this a general
principle, rather than a special circumstance for the Depression period (with rates of interest in
government

31 On the importance of the money supply, probably the fundamental work was Milton Friedman and Anna J. Schwartz, A Monetary
History of the United States 1867-1960, Princeton: Princeton University Press, 1963. On fiscal policy, see Milton Friedman, Capitalism
and Freedom, Chicago: University of Chicago Press, 1962, chapter 5; Leonall C. Anderson and Jerry L. Jordan, "Monetary and Fiscal
Actions: A Test of Their Relative Importance in Economic Stabilization," Review, Federal Reserve Bank of St. Louis, November 1968,
pp. 11-23; and Milton Friedman and Walter W. Heller, Monetary Policy Versus Fiscal Policy: A Dialogue, New York: W. W.
Norton, 1969.

1
4
values already very low and banks reluctant to lend for reasons other than the shortage of bank reserves). A
larger number agreed that monetary policy should affect aggregate demand in principle, but felt that econometric
estimates, which had found little statistical relationship between interest rates and aggregate spending, implied
that the effects were weak and, therefore, less important than factors such as fiscal policy. . Monetarists, in
contrast, started from an insistence that the classical proposition of the neutrality of money had to hold at least in
the long run, meaning that an increase in the money supply would eventually result in a proportional increase in
prices. But this increase in prices would only come about through an increase in the monetary value of added
spending, so changes in the money supply had to increase spending, even if it was difficult to disentangle the
exact mechanism through which this occurred. Monetarists offered their own statistical evidence that changes in
the money supply were associated with changes in the volume of spending and proposed that there was clearer
evidence that money mattered than anything else.

Perhaps more fundamentally, monetarists criticized Keynesian theory for its exclusive emphasis on the
short-term consequences of government policies. As with much pre-Keynesian thought, monetarists instead
gave considerable emphasis to the eventual effects of policies once wages and prices have adjusted to their
equilibrium levels, without denying that the effects were different during a transitional adjustment period. This
emphasis on the long term was based primarily on the argument that economic theory gave clearer answers
about what should eventually happen than about the adjustment process through which it would get there.
Monetarist concern for the long run meant, in particular, that they emphasized the eventual inflationary
consequences of sustained stimulus to aggregate demand, and the inability of government demand
management policies to affect real incomes or employment in any way. that is not transitory (and often
unpredictable). This led to skepticism about "fine-tuning" approaches to demand management and instead
emphasized maintaining a low long-term rate of inflation. 32 As we have discussed, the appeal of such an
emphasis increased enormously in the 1970s, with the perceived failure of demand management policies to
maintain a high level of employment, while inflation accelerated to unacceptable levels.

Related to the monetarist interest in long-term effects, new emphasis was placed on the role of
expectations in a number of crucial structural relationships. Keynes had also recognized the importance of
expectations, in several passages of the General Theory; But in general, his emphasis on the short term forced
him to adopt a mode of analysis in which the public's expectations at a given moment were simply taken for
granted. Monetarist analyses, on the other hand, considered the adjustment of expectations over time as one of
the aspects in

32 See, for example, Milton Friedman, "The Role of Monetary Policy," American Economic Review 58: 1 - 19 (1968).

which economy should eventually adjust to the position of competitive equilibrium described by neoclassical
theory; Therefore, monetarists were among the first to incorporate explicit models of how expectations adjust in
response to experience in macroeconomic analysis. 33

Probably the most important application of this idea was Milton Friedman's prediction, in
his 1967 presidential address to the American Economics Association, of the instability of the
“Phillips curve.” 34 The "Phillips curve" was a more sophisticated version of the notion, mentioned
above, that the inflationary consequences of a given policy depended on the gap between actual

1
5
and "potential" output, which in turn could be inferred from the unemployment rate. Studies of
historical data suggested the existence of a surprisingly stable inverse relationship between the
unemployment rate and the rate of wage and/or price inflation. 35 Keynesian economists of the
1960s interpreted this as a structural relationship that could be relied on to determine the
inflationary impact of alternative policies. By linking real and nominal variables in a way that
allowed their simultaneous determination, this notion represented a major improvement over
simple models that allowed nominal spending to affect prices but not quantities (the "classical"
view), or quantities but not the prices (the "classical" view). basic Keynesian model), or short-term
quantities and long-term prices, without explaining how we went from one to the other (the
“neoclassical synthesis”). It was also an important advance, at least from the point of view of
conceptual clarity, over the simple doctrine that inflation must result from production in excess of
potential,

In one respect, the use of such a model represented a step in the direction advocated by monetarists, in
that the process of price adjustment was no longer ignored; Instead, it was recognized that stimulating demand
to increase employment would always be associated with higher inflation (or at least less deflation). But the
"Phillips curve" also justified a lesser degree of concern that the policies would push output above the economy's
potential, to the extent that the intended consequence of such an excess was simply slightly higher inflation, and
only a temporary inflation, if the output target was subsequently brought online

33 For example, Friedman's empirical analyzes use explicit quantitative models of income expectations and inflation expectations,
respectively, A Theory of the Consumption Function, op. cit., and Phillip Cagan, "The Monetary Dynamics of Hyperinflation", in Milton
Friedman, ed., Studies in the Quantity Theory of Money, Chicago:
University of Chicago Press, 1956.
34 "The role of monetary policy", op. cit. The same prediction was derived from a more explicit model of endogenous expectation
adjustment in Edmund S. Phelps, "Phillips Curves, Inflation Expectations, and Optimal Unemployment Over Time," Economica 34:
254 - 281 (1967).
35 The relationship was first noted by AW Phillips, "The Relation between Unemployment and the Rate of
Change of Money Wage Rates in the United Kingdom, 1861-1957", Economica 25: 283 - 299 (1958).

sixteen
with potential. It may well seem like the risk is worth taking, even in the face of uncertainty about the economy's
potential. 36

Friedman argued instead that it made sense to consider the statistical "Phillips curve" as an
invariant menu of combinations of unemployment and inflation from which one could choose, since this
would imply that the neutrality of money would not hold. even in the long term. He proposed that the short-
term trade-off between alternative levels of employment and inflation depended on the rate of inflation that
people had reached. expected, and that the apparent stability of that relationship in the historical data only
reflected the relative stability of inflation expectations during a period in which prices had generally
remained fairly stable. However, if expansionary policies achieved constant inflation, inflation expectations
should eventually catch up with the actual inflation rate. changing the employment-inflation trade-off so that
a permanently higher inflation rate would not be associated with higher employment than could have been
obtained under stable prices. In the long run, the unemployment rate could be nothing other than what
Friedman called its “natural rate,” determined by purely real factors of preferences and technology.
Stimulating aggregate demand could instead result in a permanent

increase in inflation, as the price of a purely temporary increase in employment; because once inflation
expectations were allowed to rise, the adverse change in the employment-inflation trade-off would mean that
inflation could not be reduced below the level that people had come to expect without a painful period of
unemployment, even greater than than the natural rate.

The prediction that a period of sustained inflation should result in an adverse change in the
employment-inflation trade-off was spectacularly (although tragically) confirmed by the events of the 1970s,
when the highest inflation of that decade was accompanied by higher inflation, rather than lower, unemployment
rates. Similarly, the disinflation of the 1980s has shown that sustained lower inflation rates result in an apparent
shift of the employment-inflation trade-off in the favorable direction. 37 Therefore, the importance of taking
endogenous expectations into account seems to be confirmed. The episode is also an interesting example of
prediction based on economic factors. theory turning out to have been more reliable than simple extrapolation of
historical correlations. As such, it has provided considerable impetus to work over the past quarter century that
has sought to clarify the theoretical foundations, in terms of individual optimizing behavior, of structural
relationships such as the short-run trade-off between employment and inflation.

36 See, for example, Franco Modigliani, "The Monetarist Controversy or, Should We Forsake Stabilization

Policies?" American Economic Review 67: 1 – 19 (1977).

37 This is in addition to smaller changes in the location of short-term compensation due to changes over time in the natural rate of unemployment itself,

due, for example, to the demographic factors mentioned above.

17
The monetarist critique of early postwar Keynesian views was highly influential and, at least on several
central issues, the monetarist view had become the new orthodoxy by the mid-1970s. The importance of
monetary policy was soon accepted, and today proponents of active stabilization policy almost invariably
consider monetary policy, rather than fiscal policy, as the instrument of choice; because it is widely accepted that
fiscal measures are not suitable for precise "fine-tuning", even if it is not accepted that they have little effect.
Furthermore, the monetarist emphasis on the long-term effects of policies clearly represented an important
complement to Keynesian analyzes of short-term effects. And since the acceleration of inflation in most industrial
countries during the 1970s, few economists or policymakers have doubted that the consequences of
macroeconomic policy for inflation should be a major concern, if not the main criterion. , to judge alternative
policies. Finally, it has become generally accepted that the public's inflation expectations should be expected to
reach the level of inflation actually caused by a given policy, and that this makes it difficult for monetary stimulus
alone to sustain a higher level of inflation. economy. activity or employment for too long.

Thus, at least in these aspects, the “monetarist counterrevolution” has been completely victorious.
However, his victory did not at all mean the disappearance of Keynesian economics. Rather, the Keynesian
models of the 1970s came to incorporate the most important of monetarist insights, thus achieving a new
synthesis. Monetary policy could already be treated as one, if not the only, determinant of aggregate
demand within Hicks' “IS-LM” framework. And the "Phillips curve" could be adapted to be consistent with
the "natural rate hypothesis" simply by postulating a relationship between unemployment and the inflation
rate. in relation to inflation expectations, and add an equation for the endogenous adjustment of
expectations in response to experience. 38

In fact, it is probably in this way that monetarism has had its most lasting impact. More specific
monetarist prescriptions, such as advocating monetary targeting as an approach to monetary policy, have not
fared well in light of experience. Currently, virtually no central banks make significant use of monetary
aggregates as policy guides, although in the US. USA The chairman of the Federal Reserve System is still
required, pro forma, to report twice a year to Congress on the Fed's projections for the growth of the US money
supply, as a vestigial result of the monetarist victory codified in the Humphrey Act. Hawkins from 1978.

In matters of methodology, monetarist writings often seemed to offer a stark contrast to Keynesian work,
recalling in many ways a pre-Keynesian style. Friedman and Schwartz plotted time series side by side and looked at
the relative timing of the "inflection points", using the non-statistical method

38 This system of equations had already been written in the 1967 article by Phelps, cited above.

18 Wesley Mitchell's NBER empirical methodology, instead of

estimating econometric models. Monetarist analysis was typically based on single-equation models rather than
models of simultaneous determination of several variables, and monetarists preferred not to write an explicit
short-run equilibrium model at all. However, these quaint aspects of monetarist methodology did little to impress
younger scholars. 39 Instead, the methodological battle was won by the Keynesians, who were able to embellish
their models in reasonably simple ways to incorporate monetarist ideas - simply by adding additional variables to
be determined simultaneously, and additional dynamic structure when necessary - while retaining the Keynesian
core. , and an essentially Keynesian analysis of the short term. And although the models representing the new
synthesis no longer imply that maintaining continued prosperity must be such a simple matter, they still leave
much room, at least in principle, for managing the economy's short-term response to shocks. shocks through
enlightened monetary policy. policy.

Rational expectations and the "new classical economics"

The second wave of attacks on Keynesian macroeconomics was associated with the introduction into
macroeconomic theory of the concept of "rational expectations", most notably by Robert E. Lucas, Jr., Thomas J.
Sargent and his co-authors in the early 1970s. . These authors emphasized the role of expectations as a crucial
element in many key structural relationships of macroeconomic models, and proposed that expectations be
modeled, not by any specified function of past experience (as in previous monetarist efforts), but by assuming
that people's expectations match at all times what one's economic model implies should happen (at least on
average).

This way of modeling expectations represented a fairly obvious extension (at least in retrospect) to the
context of intertemporal coordination of plans of the concept of equilibrium -- that is, a state in which no one has
any reason to act differently, given A correct understanding of the environment in which they act, as determined
by the collective actions of others, which is fundamental to modern economic theory. The theory of rational
expectations had already found important applications in the 1960s to models of agricultural cycles. 40 and

39 The problem was well identified by Harry Johnson, a relatively neutral observer who wrote during the height of the academic influence of
the monetarists: “The monetarist counter-revolution has served a useful scientific purpose, by challenging and disposing of a great deal of
intellectual nonsense that accumulate after a successful scientific revolution. But its own success is likely to be transitory, precisely because
[among other errors,] it has adopted a methodology that has put it in conflict with long-term trends in the development of the
theme” (Johnson, op. cit., p. 106).
40 The term "rational expectations" was introduced by John F. Muth, “Rational Expectations and the Theory of Price Movements,”
Econometrica 29: 315 – 335 (1961).

19 fluctuations in financial markets. 41 In fact, using this theory

to predict that stock market prices should follow something akin to a "random walk," a prediction that has been
subjected to extensive statistical testing and has had profound consequences for practical stock management.
investments, has perhaps been the most famous insight obtained using this theory. At about the same time that
Lucas introduced the concept into macroeconomic theory, 42 Roy Radner developed a general formulation of an
"equilibrium of plans, prices, and expectations" as an approach to modeling sequential trade within general
equilibrium theory. 43 Therefore, this methodological innovation in macroeconomics had close links with other
developments in economics at the time.

In its macroeconomic application, this view of expectations had radical consequences, at least in
the context of a simple model in which changes in aggregate spending could only affect economic activity
by raising prices relative to what was expected. In this case, the new view implied that No Government
policy should be able to make prices systematically different from what is expected, and therefore
aggregate demand management cannot hope to stabilize the economy's responses to shocks. shocks. 44
Proponents of this view called their theory “New Classical” macroeconomics – proclaiming their anti-
Keynesian intent by embracing the label with which Keynes had caricatured his less radical precursors. 45

More generally, “New Classical” macroeconomics advocated greater attention to providing explicit bases in
terms of individual choice for the structural relationships assumed in macroeconomic models. As noted above, some
attention had been paid, especially in the 1950s, to optimizing the foundations of several key relationships assumed in
Keynesian models. But these theoretical derivations were mainly used to justify the existence of a causal relationship
between certain variables (for example, to explain why “consumption

41 Paul A. Samuelson, “Proof that Correctly Anticipated Prices Fluctuate Randomly,” Review of

industrial management 6: 41 – 49 (1965).

42 "Expectations and the neutrality of money", Journal of Economic Theory 4: 103 - 123 (1972). 43 Roy Radner, "Equilibrium
existence of plans, prices, and price expectations in a sequence of
markets", Econometrica 40: 289 - 303 (1972).
44 This "irrelevant policy proposal" was announced in Thomas J. Sargent and Neil Wallace, “‘Rational’ Expectations, the Optimal
Monetary Instrument, and the Optimal Money Supply Rule,” Journal of Political Economy 83: 241 – 254 (1975). The “New Classical”
challenge to Keynesian orthodoxy was most aggressively advanced in Lucas and Sargent, “After Keynesian Macroeconomics,” in
After the Phillips Curve: Persistence of High Inflation and High Unemployment, Boston: Reserve Bank Boston Federal, 1978.
45 Keynes had admitted that “post-war economists rarely, in fact, manage to maintain this [classical] view consistently; because his thinking
today is too impregnated with the contrary tendency and with facts of experience too obviously incompatible with his previous point of view.
But,” he maintained, “they have not drawn sufficiently far-reaching consequences; and they have not revised their fundamental theory."
Keynes, op. cit., p. 20. Chicago economist Frank H. Knight, by contrast, denounced Keynes's references to the existence of "classical
economics" as "the kind of caricatures typically presented as straw men for attack purposes in controversial writings." From "Unemployment
and Mr. Keynes's Revolution in Economic Theory", Canadian Journal of Economics and Political Science 3: 100-123 (1937).

20 function” should include financial wealth as an

argument, and not just current disposable income), rather than deriving the dynamic relationship
specification that would actually be estimated in an econometric model. Lucas and Sargent called instead
for models in which all aspects of the model equations were derived from consistent foundations in terms of
behavioral optimization. This naturally required an emphasis on dynamic optimization, which made
expectations crucial, and made it natural to assume that the model was also internally consistent in the
sense of postulating forecasts by agents within the model who agreed with what the model I would predict
myself.

The new style of modeling – illustrated in particular by Lucas's celebrated, though highly stylized,
business cycle model – essentially imported into macroeconomics the rigorous and tightly structured modeling
style of modern intertemporal general equilibrium theory. One feature of standard general equilibrium models
that was quite contrary to the spirit of Keynesian macroeconomics was the assumption of perfectly competitive,
instantly clearing markets. “New Classical” macroeconomists also enthusiastically adopted this feature of general
equilibrium models and argued that the effects on economic activity that were observed as a result of monetary
instability should be attributed to imperfect information about the aggregate state of the economy by part of the
producers. and not because wages or prices do not immediately adjust to clear markets. In this respect, their
models shared the monetarist emphasis on the consequences of an eventual price adjustment, but they brought
this adjustment even further to the foreground by stating that

Only incomplete information prevented it from happening immediately.

In addition to its critique of Keynesian theory, “New Classical” macroeconomics also challenged the empirical
foundations of the macroeconometric models used by Keynesians for quantitative policy evaluation. In another seminal
paper, 46 Lucas argued that such models failed to identify truly "structural" economic relationships, that is, relationships
that could be expected to remain unchanged despite a change in the way economic policy is conducted, due to the
How people's behavior depends on their expectations regarding economic policy. future evolution of inflation, income,
interest rates, etc.

Keynesian macroeconometricians recognized that the current and lagged variables appearing in their
estimated equations often appeared in whole, or at least in part, as proxies for people's forecasts of future values of
those or other variables, whose forecasts, without However, they were not directly observed. As long as forecasts
could be trusted to evolve as mechanical functions of current and past variables that were observed by the
econometrician, it mattered little.

46 "Econometric Policy Evaluation: A Critique," Carnegie-Rochester Lecture Series on Public Policy 1: 19 – 46 (1976).

21 whether the observed variables entered the equations as

substitutes for expectations or whether they had a genuine causal effect on the behavior itself. However, the
theory of "rational expectations" implied that the way expectations vary with other observed variables should
change whenever the patterns of correlation between those variables and the predicted quantities change, as
they should if the systematic component of government policy.

That this will happen, at least eventually, is reasonably clear in principle. The 1970s experience with the
instability of econometric “Phillips curves” made it plausible that such changes could occur quickly enough to be
important even for medium-term policy analysis. Lucas charged that conventional policy simulation exercises were
fundamentally flawed in this regard, suggesting in particular that the apparent possibility of significantly improved
economic performance through "fine-tuning" depended on erroneous inferences of this kind.

Like monetarism, the critique of the “New Classic” has had a profound effect on macroeconomic practice, although
this is perhaps clearer in the case of academic work than in the type of economic analysis carried out within the policy-making
institutions. The recognition that economic behavior has a prospective character, and therefore that the effects of government
policy on expectations are fundamental to its effects in general, is fundamental to current ways of thinking about monetary and
fiscal policy. For example, it is now widely accepted in discussions about central banking, both within banks and in academia,
that the way that policy is perceived by the public should be a fundamental concern for central bankers. 47

The “New Classic” literature has also had important consequences for the way policymakers think about the
trade-off between employment and inflation.
It is now widely accepted that it would be a mistake to try to exploit the short-term compensation of the
"Phillips curve", without recognizing that the reputation of doing so will soon cause the public's inflation
expectations to change, in a way that removing the apparent benefits achieved by the policy. To a large
extent, this point had been made without the theory of "rational expectations", as we have discussed above.
But the “New Classic” literature identified an additional pitfall, showing how discretionary optimization by a
central bank seeking to exploit such compensation leads to a suboptimal outcome (specifically, a bias toward
too much inflation) even when the central bank correctly

includes the determination of the expectations of the private sector.

This is because the central bank, in choosing the optimal degree to exploit compensation at a
given time, would rationally ignore the effect of its

47 See Alan S. Blinder, Central Banking in Theory and Practice, Cambridge: MIT Press, 1998, chap. 3, sec. 4, for a comparison of academics'

and central bankers' understanding of the role of central bank “credibility.”

22
decision then on the inflation expectations of the private sector in the past, which are at this point a simple historical
fact. However, the private sector, if it has rational expectations, expects the central bank to act the way it does, and the
expectation of inflationary behavior shifts the short-term trade-off in an adverse direction. A better outcome could be
achieved if the central bank could decide to resist the temptation to inflate, although past expectations are simply a
given. ex post; For if he could make his commitment credible to the private sector, inflation expectations would be
lower, allowing a lower inflation rate to be consistent with unemployment at the natural rate. 48

This theoretical analysis of the possibility of a failure in coordination between the private sector
and the government has seemed to many to help explain the trap in which politicians found themselves in
the 1970s. The model implies that avoiding the trap is not simply a matter of striving to never let inflation
begin, as one would conclude if inflation expectations were simply a mechanical function of past inflation. It
implies that it is important not to give the impression that policymakers are willing to exploit the private
sector's expectations of low inflation by choosing to stimulate the economy, taking advantage of a
temporary opportunity to obtain high levels of employment without much inflation ( although higher than
people expected).

In practice, this has meant that central bankers have come to see the importance of emphasizing their commitment to
controlling inflation as the primary objective of monetary policy, regardless of the existence of a short-term trade-off
between inflation and activity. economical. 49 Indeed, in the 1990s, several central banks have been willing to accept
responsibility for achieving explicit inflation targets. 50

The assumption of “rational expectations” as a modeling device is also now completely orthodox. And
macroeconomic models with explicit bases in intertemporal optimality behavior are now generally accepted as ideal, at
least in principle, although models used in central banks and elsewhere for practical policy analysis must generally
compromise the ideal to some extent. spot. However, this does not mean that the specific “New Classical” model of the
business cycle, or its nihilistic implications for the possibility of a stabilization policy, are now generally accepted. For
Lucas's original model of the business cycle also turned out to be successful in explaining why trade fluctuations
should not be a big problem; Under plausible assumptions about the speed with which information circulates in a
modern economy, the model could not explain

48 The classic source for this analysis is Finn E. Kydland and Edward C. Prescott, “Rules Instead of Discretion: The Inconsistency of
Optimal Plans,” Journal of Political Economy 85: 437 – 491 (1977). 49 See Blinder, op. cit., Chap. 2 seconds. 4. Blinder offers himself as an
example of at least one central banker whose

approach to his task was consciously affected by the theoretical analysis of inflationary bias in discretionary policymaking (p. 43).

50 See Ben S. Bernanke, Thomas Laubach, Frederic S. Mishkin and Adam S. Posen, Inflation Targeting: Lessons from International

Experience, Princeton: Princeton University Press, 1999.

23 why monetary shocks should have significant effects (and,

above all, any persistent effects) at all. But this meant that it could not explain the nature of the fluctuations observed in
business activity. And more specifically, it could not explain the effects of specifically monetary shocks that
sophisticated recent studies continue to find, carefully controlling for the possible reverse causality from economic
activity to the money supply. 51

Instead, it has been shown that it is possible to incorporate rational expectations – and indeed
intertemporal optimizing behavior – into models of nominal wage and price rigidity. 52 The “neo-Keynesian”
models obtained in this way remain recognizably Keynesian in that they allow for prolonged deviations of
economic activity from its optimal level as a consequence of instability in aggregate spending. And they still
allow, in principle, a skillfully conducted active stabilization policy to improve on what would occur under an
arbitrarily chosen passive rule, although the policy recommendations they produce are very different as a result
of taking rational expectations into account. These models, developed since the late 1970s, have been much
more successful than earlier "New Classical" models in accounting for the statistical properties of real economic
time series, and estimated versions of such models are used now for policy analysis in several countries. central
banks. 53

Theory of the real business cycle

The third and most recent wave of attacks on Keynesian macroeconomics has been the “real business
cycle theory” developed in the 1980s by Finn Kydland, Edward Prescott, Charles Plosser, and their students and
collaborators. 54 This theory represented a radical departure from most previous speculation about trade
fluctuations, including that of most pre-Keynesian business cycle theorists, in that it proposed that business
cycles did not indicate any failure of the market mechanism. (whether inherent or due

51 For a recent survey, see Lawrence J. Christiano, Martin Eichenbaum and Charles L. Evans, "Monetary

Policy Shocks: What have Learned and to What End?" in John B. Taylor and Michael Woodford, eds., Handbook of Macroeconomics,
Amsterdam: North-Holland, forthcoming.
52 For a review of this literature, see John B. Taylor, "Staggered Price and Wage Setting in
Macroeconomics", in Taylor and Woodford, op. cit.
53 For example, on the role of rational expectations and intertemporal optimization in the US model currently used by the Federal Reserve
Board, see Flint Brayton, Andrew Levin, Ralph Tryon, and John Williams, “The Evolution of Macro Models at the Federal Reserve Board,
"Carnegie-Rochester Lecture Series on Public Policy 47: 43 - 81 (1997); and Flint Brayton, Eileen Mauskopf, David Reifschneider, Peter
Tinsley, and John Williams, "The Role of Expectations in the FRB/US Macroeconomic Model", Federal Reserve Bulletin 83 (4): 227 - 245
(1997). For an example of policy analysis using the model, see John C. Williams, “Simple Rules for Monetary Policy,” Finance and Economics
Discussion Series no. 1999-12,
Federal Reserve Board, February 1999.
54 Classic references include Kydland and Prescott, "Time to Build and Aggregate Fluctuations,"
Econometrica 50: 1345 - 1370 (1982); and John Long and Charles Plosser, “Real Business Cycles,” Journal of Political
Economy 91: 39 – 69 (1983). For a comprehensive review of the current state of the literature, see Robert G. King and Sergio
Rebelo, "ResuscATING Real Business Cycles," in Taylor and Woodford, op. cit.

24 to government meddling), but in reality they were an

efficient response to exogenous variations over time in production opportunities. It also differed in not giving any
importance to monetary or financial factors, nor to any nominal variable, in the explanation of commercial
fluctuations (hence the reference to “real” economic cycles). 55 In fact, real business cycle models imply that
monetary policy has no effect on the economy, for better or worse; Therefore, they proposed that the "classical
dichotomy" of 19th-century monetary theory holds even in the short run. 56

The attention these proposals have received is not only due to the premium placed on originality in
academic life. Around 1980 it had been realized that Lucas's proposal to reconcile a view of business cycles due
to monetary instability with rational expectations, individual optimization and instantaneous market clearing
depended on assumptions that were clearly implausible. Therefore, if one wanted to adhere to Lucas's
methodological constraints (in their strong form, including the rejection of non-market-compensating models as
lacking motivation in terms of individual rationality) and still explain trade fluctuations , it was necessary to find
another source. for them.
Furthermore, the "technological shocks" hypothesis, although unconventional, offered a simple explanation
for well-established business cycle phenomena that had long tested the ingenuity of business cycle theorists who
sought to explain them under the assumption that the technological possibilities only changed. slowly. These included
the fact that real wages do not move countercyclically (i.e., they decrease when economic activity is high) and the fact
that productivity measures are strongly procyclical (i.e., they increase with economic activity). Finally, the economic
effects of the two major OPEC "oil shocks" of the 1970s made economists more receptive to the hypothesis of real
shocks to production costs as a major source of economic instability (even if the RBC models were not really about oil
shocks, 57

The real business cycle literature also offered a new methodology, both for theoretical analysis and
empirical testing. It showed how complete

55 However, there were some precursors to such an analysis, for example, Dennis Robertson, A Study of Industrial Fluctuation, London: King
and Son, 1915. Robertson not only attributed a primary causal role to variations in technical progress, but argued that at least some of the
resulting variations in economic activity represented “appropriate fluctuations.” His 1915 work also completely ignored monetary factors,
although this was not entirely true in his more mature exposition of his theory. Banking policy and price level, London:
Macmillan, 1926.
56 The correlations between changes in the money supply and the business cycle emphasized by monetarists were explained, at least by some real

business cycle theorists, as due to reverse causality, reviving an argument that Keynesians had once made against the evidence. monetarist. See, for

example, Robert G. King and Charles I. Plosser, “Money, Credit and Prices in a Real Business Cycle Economy,” American Economic Review 74: 363 –

380 (1984). As noted above, most recent literature rejects this interpretation.

57 These events also led to increased attention to real shocks and supply factors among other macroeconomists during the 1980s; see, for example,

Michael Bruno and Jeffrey Sachs, Economics of World Stagflation, Cambridge: Harvard University Press, 1985.

25
Business cycle models could be constructed using the intertemporal general equilibrium methodology that Lucas
had advocated, but which only a few of the “New Classic” papers of the 1970s had been able to apply. More
importantly, it showed how such models could be made. quantitative,

emphasize the assignment of realistic numerical parameter values and the calculation of
numerical solutions to the model equations, rather than being content with merely qualitative
conclusions derived from more general assumptions.
Lucas's "equilibrium business cycle models" had really only been parables; They cannot be considered
literal descriptions of an economy, even taking into account the type of idealization that all models of reality
imply. Thus, for example, in Lucas's 1972 classical business cycle model, the economy is made up of successive
"generations" of agents, each of whom participates in the economy during two successive "periods", which could
be interpreted as follows ( if you think about the life cycle being represented) like each one of them for decades.
But in the model, a "period" is also the time between when you get the money from a sale and the first
opportunity the recipient has to spend it (so it should be very short), it is the reciprocal. of "The velocity of money"
(i.e. the period of time during which the value of the national product is equal to the money supply, or a couple of
months), and is the period of time it takes for a change in supply monetary to be public knowledge (perhaps a
month). Given this, it is difficult to evaluate the model's "quantitative" prediction that business cycles should last
only "one period." The predicted changes in business activity are probably too short-lived to match the evidence,
but it is difficult to say exactly. how short lived the model says they are.

Real business cycle models are instead quantitative models, which should be taken seriously as literal
representations of the economy, even if many details are abstracted. The literature emphasizes numerical
predictions of models, when parameter values are assigned based on the measurement of relevant aspects of a
real economy. This "calibration" procedure relies on other sources of information about realistic parameter
values, rather than simply asking what parameter values would give rise to the best predictions regarding the
character of cyclical fluctuations. 58
Indeed, one of the great advantages of the approach is the fact that, exactly because the structural
relationships of the model are derived from the foundations in terms of individual behavior, the structural
parameters have a meaning apart from their role in predicting certain types of behavior. short-term responses to
shocks. Hence other sources of information about the structure of the economy. can be used to judge whether
the parameters are realistic or not. How conscientiously have the real company addressed these questions of
microeconomic realism

58 This methodological aspect of the CBR literature is highlighted in Robert G. King, "Quantitative Theory and Econometrics,"

Economic Quarterly, Federal Reserve Bank of Richmond, 81: 53-105 (1995).

 26 cycle theorists in practice is a topic of debate; 59 but the
attempt is undoubtedly a step forward. Given the complexity of the simultaneous interactions that are
necessarily involved in macroeconomic models, and the paucity of true "natural experiments" in
macroeconomics (because the entire economy is involved in the phenomena one wishes to understand),
the discipline imposed on the business cycle is Modeling through a requirement of microeconomic realism
is essential. Here, if nowhere else in economics, the positivist insistence that a theory should be judged
only by the success of its predictions, and not by the realism of the model's assumptions, seems unwise.
Finally, the RBC literature has emphasized tests of the ability of models to explain not only the qualitative
characteristics of the observed trade fluctuations, but the statistical properties of the observed aggregate time series, in
particular the relative volatilities and the degree of co-movement between several aggregated series. While statistical
descriptions of the data have been emphasized, the methods used to compare them with model predictions have been
quite informal, compared to the canons of assessing model adequacy within the earlier Keynesian macroeconometric
tradition. The rejection of traditional econometric methods by the early CBR literature has surely been exaggerated; A
consideration of the way in which sampling error affects the degree of confidence that can be placed in any putative
rejection of a model's predictions, for example, should be a critical part of any serious evaluation of the model.
However, more informal types of model evaluation are appropriate for the early stages in successful theory
development, and the vigor with which this literature has pursued investigation of the ways in which alterations to
model structure affect a battery of quantitative predictions should be applauded.

It may be too early to make a conclusive judgment on the final impact of this work. However, it seems
likely that many of the methodological innovations in the CBR literature will have a lasting effect. They have
already been widely adopted in analyzes that depart from the substantive assumptions of real business cycle
theory by introducing market imperfections of various types (with the implication that equilibrium fluctuations in
economic activity and employment can be significantly greater). suboptimal), and assuming other important
sources of disturbances in the economy (or, in some cases, even showing how fluctuations in economic activity
can occur spontaneously). 60
The RBC literature has probably also had an important effect in directing greater attention to modeling
the determinants of supply decisions, a topic that is surely of considerable importance for
macroeconomic dynamics in all countries.

59 See, for example, Lawrence J. Summers, "Some Skeptical Observations on Real Business Cycle Theory," Quarterly Review, Federal

Reserve Bank of Minneapolis, Fall 1986, pp. 22-27; and Martin Browning, Lars Peter Hansen and James J. Heckman, “Micro Data

and General EquilibriumModels,” in Taylor and Woodford, op. cit.

60 Several early examples are provided in the chapters by Thomas F. Cooley, ed., Frontiers of Business Cycle Research, Princeton: Princeton

University Press, 1995; and in Pierre-Yves Henin, ed., Advances in Business Cycle Research, Berlin: Springer-Verlag, 1995.

27 shortest race. Keynesian models of the 1940s and 1950s

often ignored the supply side entirely (assuming that supply would be perfectly elastic in response to any
variation in demand that might occur), but many of the most important developments since then have involved
repositioning the determinants of aggregate supply. in the image. 61 Both the monetarist and the new classical
schools brought with them important improvements in the analysis of aggregate supply. But both were still
primarily concerned with how price changes (and inflationary expectations) related to transitory outflows from the
country. actual quantity supplied of the quantity that the economy would ideally supply if wages and prices were
flexible and expectations were met; the latter, the ideal supply (the "potential output" of the economy) still tended
not to be modeled, but simply taken as a given. This was possible because these authors still accepted the
Keynesian assumption that trade fluctuations were mainly due to deviations of actual output from the economy's
potential.
 Real business cycle theory, on the other hand, due to its radical assumption that real output is always
exactly equal to potential, has devoted considerable resources to modeling the determinants of variations in
potential output. Whether or not one accepts the view that there are no major deviations from potential, a better
understanding of the determinants of potential output is an important advance. There is a widespread consensus
that many of the important political problems of our time, such as the persistently high levels of unemployment in
Western Europe, have more to do with the real determinants of potential output than with any shortfall in nominal
spending, even if the potential production models needed to understand them involve market failures not allowed
for in first-generation RBC models. 62

A new neoclassical synthesis?

Even for issues related to short-term stabilization policy,

Understanding how economic shocks and potential policy interventions affect both supply and demand allows for
a more sophisticated analysis of what government policy can hope to achieve.
Indeed, the 1990s have seen the development of what has been called a "new neoclassical synthesis",
uniting important elements of real business.

61 The rhetorical banner under which the “supply-side economists” of the Reagan administration marched had at least a superficial connection to
important intellectual developments. However, the resurgence of emphasis on the supply side among academic macroeconomists has had little to do
with the belief that tax cuts are a painless route to prosperity. In fact, it has had more to do with a sober acceptance of limits to the extent that

Sustained prosperity can be achieved with a simple reorganization of financial rights. 62 See, for example, Richard Layard, Stephen Nickell
and Richard Jackman, Unemployment: Performance
Macroeconomics and the Labor Market, Oxford: Oxford University Press, 1991; Assar Lindbeck, Unemployment and
Macroeconomics, Cambridge: MIT Press, 1993; and Edmund S. Phelps, Structural Depressions: The Modern Equilibrium Theory of
Unemployment, Interest, and Assets, Cambridge: Harvard University Press, 1994.

28
Like the neoclassical synthesis
cycle theory with other elements of the “new Keynesian” models of the 1980s. 63

of Hicks, Samuelson and Patinkin, the new literature seeks to close the methodological gap
between microeconomics and macroeconomics, using the tools of general equilibrium theory to
model Keynesian ideas. Today, this means using intertemporal general equilibrium analysis to
model the full dynamics of the macroeconomy, as is done in modern theories of financial
markets, industry structure, etc., rather than simply using a static general equilibrium model to
describe the long run. -Execution position towards which the economy must tend asymptotically.
In practice, this means that the methodology of the new synthesis is largely that of the real
business cycle literature, although price and wage rigidities are taken into account,
The new synthesis also proposes giving "Keynesian" and "classical" knowledge their due by assigning each a
different role within a complete model. The division of labor is no longer one in which Keynesian theory explains the
short run while general equilibrium theory explains the long run. Rather, the factors emphasized in real business cycle
theory explain the evolution over time of potential output, while transitory deviations potentially result from delays in the
adjustment of wages and prices. Furthermore, the price and wage adjustment process is explicitly modeled, so that
even in the short-term analysis, changes in prices and wages can be taken into account, as can variations in potential
output.
In such models, real shocks can play an important role as the ultimate source of short-term variations in
economic activity, contrary to monetarist and New Classical models alike, which attributed trade fluctuations primarily
to erratic monetary policy. As noted above, recent econometric studies on the effects of monetary policy shocks tend to
attribute only a small fraction of the overall variability in economic activity to this source, so it may make sense to
emphasize real shocks instead. place, as RBC models do. But in the case of the new synthesis models, this no longer
means that the fluctuations in economic activity that occur are necessarily desirable, nor that monetary policy is
irrelevant. Due to delays in price and wage adjustment, the consequences of real shocks are often ineffective, and their
degree of inefficiency depends on the monetary policy response. As a result, active monetary policy has a role in
mitigating the distortions that would otherwise result from wages and prices not adjusting sufficiently in response to
these real shocks.

It therefore seems likely that, as in the case of alleged

previous "counterrevolutions", the final impact of CBR literature will not be the
establishment of a fundamentally new vision of phenomena
macroeconomics, but an adjustment of emphasis and an increase in methodological

63 See, for example, Marvin Goodfriend and Robert G. King, "The New Neoclassical Synthesis and the Role of Monetary Policy,"

NBER Macroeconomics Annual 12: 231 - 283 (1997).

29 sophistication, with a relatively continuous dominant tradition.

Because the new synthesis shares important elements with Keynesian economics and, indeed, with the Cambridge
neoclassical tradition from which Keynes's ideas were developed. These include an emphasis on the inefficiency of
short-term responses to economic shocks and on the role of wage and price rigidities as a source of such inefficient
responses. It also shares with postwar Keynesianism the aspiration to construct models of the economy that can be
matched with the detailed properties of economic time series and used for the quantitative analysis of alternative
policies. 64 This includes a return to the use of optimal control methods to calculate optimal stabilization policies, once
these methods have been appropriately modified to take into account the prospective elements in the correctly
specified structural relationships of a model based on behavioral optimization. from the private sector. Sixty-five

There is probably little point in insisting on the specifically Keynesian character of the emerging
theoretical synthesis. 66 As Robert Lucas has noted, it is a sign of a successful scientific revolution that one
does not see physicists still referring to themselves as "Einstein physicists" at the end of the century. And
with regard to many of the most debated topics among professed Keynesians and anti-Keynesians of some
decades ago, such as the usefulness for macroeconomics of the paradigm of individual optimization and
equilibrium analysis, the relative effectiveness of fiscal policy and monetary, or the question of whether
demand stimulation has consequences for inflation under circumstances of less than full employment:
modern literature sides with the critics of Keynesianism. Perhaps more pertinent would be the observation
that the zeal to completely reverse Keynesian economics and start anew has been a frequent source of
strident manifestos that have been no more helpful to ultimate progress in the scientific understanding of
aggregate fluctuations than Keynesian excesses. . fundamentalism in the middle of the century. As in the
case of

64 See, for example, Robert G. King and Mark W. Watson, "Money, Prices, Interest Rates and the Business Cycle,"

Review of Economics and Statistics 78: 35 – 53 (1996); Julio J. Rotemberg and Michael Woodford, “An Optimization-Based
Econometric Framework for the Evaluation of Monetary Policy,” NBER Macroeconomics Annual 12: 297 – 346 (1997); and Peter N.
Ireland, “A Small, Structural, Quarterly Model for Monetary Policy Evaluation,” Carnegie-Rochester Lecture Series on Public Policy 47:
83 – 108 (1997).

sixty-five See, for example, Michael Woodford, “Optimal Monetary Policy Inertia,” NBER working paper, forthcoming.

1999.
66 Miles Kimball has called the new style of model “neomonetarist,” and Robert G. King and Alexander L. Wolman have also emphasized the
kinship between the new synthesis models and some aspects of the monetarist models of the 1960s. Kimball, “The Quantitative Analysis of the
Basic Neomonetarist Model,” Journal of Money, Credit, and Banking 27: 1241-1277 (1995); King and Wolman, "Inflation Targeting in a St.
Louis Model of the 21st Century", Review, Federal Reserve Bank of St. Louis, 78: 83-107 (1996). The main sense in which the models are
monetarist is that they present deviations from the level of potential output determined by real factors as purely transitory, and pay attention to
the adjustment of prices and inflation expectations as the process through which real output adjusts. towards potential. On the other hand, they
do not have to imply a special importance for the money supply, either as a determinant of aggregate spending or as the appropriate
instrument of monetary policy. See, for example, Rotemberg and Woodford, op. cit.

30
Keynesian Revolution, the true meaning of fundamental advances later in the century has not always been best
understood by the most ardent advocates of revolutionary change.
Finally, it is worth reflecting on the prospects for resolution in the new century of the
schism between the “micro” and “macro” branches of economics, which has so characterized the
pedagogy of recent decades.
In principle, the grounds for subject reunification appear to be largely established. Macroeconomics no longer
claims that the study of aggregate phenomena requires a different methodology; In contrast, modern
macroeconomic models are intertemporal general equilibrium models, derived from the same foundations of
optimizing behavior by households and businesses that are used in other branches of the economy.
Furthermore, the objectives of stabilization policy can now be discussed in terms, that is, the attempt to mitigate
quantifiable efficiency losses resulting from identifiable distortions of the market mechanism, that correspond to
those used for policy evaluation by the microeconomists.

At the same time, when it comes to the sociology of the discipline, the division between
microeconomists and macroeconomists has probably become more acute in recent decades, despite
methodological convergence. The main reason for this is probably the increasing specialization of economic
research, as in other fields. As recently as the 1960s, it was still quite common for leading economists to
contribute to the analysis of both microeconomic and macroeconomic issues and to feel qualified to teach both
types of courses. This has become quite uncommon. Furthermore, branches of various specializations within
economics that deal with microeconomic and macroeconomic issues have come to have less frequent contact
with each other. In the Princeton doctoral program, the former field of specialization in “international economics”
has only recently been divided into two distinct fields (“international trade” and “international finance”),
corresponding to the microeconomic and macroeconomic aspects of international economics. . It can now be
clearly identified that applied econometricians study econometric issues that arise in empirical microeconomics
or that arise in empirical macroeconomics, but not both. In other specializations, such as labor economics,
development economics, and public finance, a similar division has not developed primarily because, in many
American departments, the macroeconomic aspects of these fields have been quietly removed from the tailored
curriculum. that these specializations have been incorporated. be dominated by microeconomists.
It is not clear that anything can be done about this, as increasing specialization appears to be a
reality at our research universities. However, the trend has unattractive consequences, among which the
atrophy of fields of study such as development macroeconomics and “macrolabor” stands out, which would
still seem to be crucial fields from the point of view of their importance for the improvement of policies.
public. The disappearance of these

31 fields as topics of academic research has been

unfortunate, both because it means less academic attention to these policy issues and because it has
reduced the richness of the body of institutional knowledge that general macroeconomists can draw on. It
would be desirable that the emergence of a methodological consensus in macroeconomics would make
possible, in the new century, a resurgence of the links between general macroeconomics and these more
specialized fields of research.
32