Epilogue: The Story

of Macroeconomics

CHAPTER 27
CHAPTER27
Prepared by:
Fernando Quijano and Yvonn Quijano

© 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard

 Keynes and the
27-1
Great Depression
Chapter 7: Epilogue: The Story of

The history of modern macroeconomics

starts in 1936, with the publication of
Keynes’s General Theory of Employment,
Interest, and Money.
Keynes
Macroeconomics

The Great Depression was an intellectual failure

for the economists working on business cycle
theory—as macroeconomics was then called.
Keynes emphasized effective demand, now
called aggregate demand.

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 Keynes and the
Great Depression
Chapter 7: Epilogue: The Story of

In the process of deriving effective demand,

Keynes introduced many of the building blocks
of modern macroeconomics:
 The relation of consumption to income, and
the multiplier.
Macroeconomics

 Liquidity preference (the term given to the

demand for money)
 The importance of expectations in affecting
consumption and investment; and the idea
that animal spirits are a major factor behind
shifts in demand and output.

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 27-2 The Neoclassical Synthesis
Chapter 7: Epilogue: The Story of

Paul Samuelson wrote the first modern

economics textbook: Economics

The neoclassical synthesis refers to a

large consensus that emerged in the
Macroeconomics

early 1950s, based on the ideas of

Keynes and earlier economists.
The neoclassical synthesis was to remain the
dominant view for another 20 years. The period
from the early 1940s to the early 1970s was
called the golden age of macroeconomics.

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 The IS-LM Model
Chapter 7: Epilogue: The Story of

The most influential formalization of Keynes’s

ideas was the IS-LM model, developed by John
Hicks and Alvin Hansen in the 1930s and early
1940s.
Discussions became organized around the
Macroeconomics

slopes of the IS and LM curves.

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 Theories of Consumption,
Investment, and Money Demand
Chapter 7: Epilogue: The Story of

In the 1950s, Franco Modigliani and

Milton Friedman independently
developed the theory of consumption,
and insisted on the importance of
expectations.
Macroeconomics

Modigliani

James Tobin developed the theory of

investment based on the relation
between the present value of profits and
investment. Dale Jorgenson further
developed and tested the theory.
Tobin

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 Growth Theory
Chapter 7: Epilogue: The Story of

In 1956, Robert Solow developed the

growth model—a framework to think
about the determinants of growth.
Macroeconomics

Solow

It was followed by an explosion of work on the

roles saving and technological progress play in
determining growth.

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 Macroeconometric Models
Chapter 7: Epilogue: The Story of

Lawrence Klein developed the first U.S.

macroeconomic model in the early
1950s. The model was an extended IS
relation, with 16 equations.
Klein
Macroeconomics

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 Keynesians Versus Monetarists
Chapter 7: Epilogue: The Story of

Milton Friedman was the intellectual

leader of the monetarists, and the father
of the theory of consumption.
He believed that the understanding of
the economy remained very limited, and
Macroeconomics

Friedman
questioned the motives and ability of
governments to improve macroeconomic
outcomes.

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 Keynesians Versus Monetarists
Chapter 7: Epilogue: The Story of

In the 1960s, debates between Keynesians and

monetarists dominated the economic headlines.
The debates centered around three issues: (1)
the effectiveness of monetary policy versus fiscal
policy, (2) the Phillips curve, and (3) the role of
Macroeconomics

policy.

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 Monetary Policy Versus Fiscal Policy
Chapter 7: Epilogue: The Story of

Friedman challenged the view that fiscal policy

could affect output faster and more reliably than
monetary policy.
In a 1963 book, A Monetary History of the United
States, 1867-1960, Friedman and Anna Schwartz
Macroeconomics

reviewed the history of monetary policy and

concluded that monetary policy was not only very
powerful, but that movements in money also
explained most of the fluctuations in output.
They interpreted the Great Depression as the
result of major mistake in monetary policy.

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 The Phillips Curve
Chapter 7: Epilogue: The Story of

The Phillips curve had become part of the

Neoclassical synthesis, but Milton Friedman
and Edmund Phelps argued that the
apparent trade-off between unemployment
and inflation would quickly vanish if policy
Macroeconomics

makers actually tried to exploit it.

By the mid 1970s, the consensus was that
there was no long-run trade off between
inflation and unemployment.

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 The Role of Policy
Chapter 7: Epilogue: The Story of

Skeptical that economists knew enough to

stabilize output, and that policy makers could be
trusted to do the right thing, Milton Friedman
argued for the use of simple rules, such as
steady money growth.
Macroeconomics

Friedman believed that political pressures to “do

something” in the face of relatively mild problems
may do more harm than good.

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 The Rational
27-3
Expectations Critique
Chapter 7: Epilogue: The Story of

In the early 1970s, Robert

Lucas, Thomas Sargent,
and Robert Barro led a
strong attack against
mainstream
Lucas macroeconomics.
Macroeconomics

Sargent
Barro

They argued that the predictions of Keynesian

macroeconomics were wildly incorrect, and
based on a doctrine that was fundamentally
flawed.

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 The Three Implications of
Rational Expectations
Chapter 7: Epilogue: The Story of

Lucas and Sargent’s main argument was that

Keynesian economics had ignored the full
implications of the effect of expectations on
behavior. Thinking of people as having rational
expectations had three major implications, all
Macroeconomics

highly damaging to Keynesian macroeconomics.

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 The Lucas Critique
Chapter 7: Epilogue: The Story of

Robert Lucas argued that macroeconomic

models did not incorporate expectations
explicitly; that the models captured relations as
they had held in the past, under past policies.
They were poor guides to what would happen
Macroeconomics

under new policies.

This critique of macroeconometric models
became known as the Lucas Critique.

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 Rational Expectations and the
Phillips Curve
Chapter 7: Epilogue: The Story of

In Keynesian models, the slow return of output to

the natural level of output came from the slow
adjustment of prices and wages through the
Phillips curve mechanism.
Within the logic of the Keynesian models, Lucas
Macroeconomics

therefore argued, only unanticipated changes in

money should affect output.

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 Optimal Control Versus Game Theory
Chapter 7: Epilogue: The Story of

Let’s summarize: When rational expectations

were introduced,

Keynesian models could not be used to

determine policy,
Macroeconomics

Keynesian models could not explain long-lasting

deviations of output from the natural level of
output, and
the theory of policy had to be redesigned, using
the tools of game theory.

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 The Integration of Rational
Expectations
Chapter 7: Epilogue: The Story of

The intellectual atmosphere in macroeconomics

was tense in the early 1970s. But within a few
years, a process of integration (of ideas, not
people) had begun, and it was to dominate the
1970s and the 1980s.
Macroeconomics

Work then started on the challenges raised by

Lucas and Sargent.

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 The Implications of
Rational Expectations
Chapter 7: Epilogue: The Story of

Robert Hall showed that if consumers

are very foresighted, then changes in
consumption should be unpredictable.
Hall

 Consumption will change only when

Macroeconomics

consumers learn something new about the

future. Since news about the future cannot be
predicted, changes in consumption are highly
random. This consumption behavior, known
as the random walk of consumption, has
served as a benchmark in consumption
research ever since.
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 The Implications of
Rational Expectations
Chapter 7: Epilogue: The Story of

Rudiger Dornbusch developed a model

of exchange rates that shows how large
swings in exchange rates are not the
result of irrational speculation but,
Dornbusch instead, fully consistent with rationality.
Macroeconomics

 Dornbusch’s model, known as the

overshooting model of exchange rates, has
become the benchmark in discussions of
exchange-rate movements.

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 Wage and Price Setting
Chapter 7: Epilogue: The Story of

Stanley Fischer and John Taylor showed

that the adjustment of prices and wages
in response to changes in
unemployment can be slow even under
Fischer
rational expectations.
Macroeconomics

They pointed to the staggering of both

wage and price decisions, and explained
how a slow return of output to the natural
level can be consistent with rational
expectations in the labor market.
Taylor

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 The Theory of Policy
Chapter 7: Epilogue: The Story of

In short: By the end of the 1980s, the

challenges raised by the rational-
expectations critique had led to a complete
overhaul of macroeconomics.
Macroeconomics

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 27-4 Current Developments
Chapter 7: Epilogue: The Story of

Since the late 1980s, three groups have

dominated the research headlines: the
new classicals, the new Keynesians, and
the new growth theorists.
Macroeconomics

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 New Classical Economics and Real
Business Cycle Theory
Chapter 7: Epilogue: The Story of

Edward Prescott is the intellectual leader

of the new classicals—a group of
economists interested in explaining
fluctuations as the effects of shocks in
competitive markets with fully flexible
Prescott
prices and wages.
Macroeconomics

Their real business cycle (RBC) models

assume that output is always at its natural level,
and fluctuations are movements of the natural
level of output. These movements are
fundamentally caused by technological progress.

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 New Keynesian Economics
Chapter 7: Epilogue: The Story of

One line of research focuses on the

determination of wages in the labor
market. George Akerlof has explored
the role of “norms,” or rules that develop
in any organization to assess what is fair
Akerlof
or unfair.
Macroeconomics

The new Keynesians are a loosely connected

group of researchers working on the implications
of several imperfections in different markets.

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 New Keynesian Economics
Chapter 7: Epilogue: The Story of

Another line of new Keynesian research

has explored imperfections in credit
markets. Ben Bernanke has studied the
relation between banks and borrowers
and its effects on monetary policy.
Macroeconomics

Yet another direction of research is nominal

rigidities in wages and prices. The menu cost
explanation of output fluctuations, developed by
Akerlof and N. Gregory Mankiw, attributes even
small costs of changing prices to the infrequent
and staggered price adjustment.

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 New Growth Theory
Chapter 7: Epilogue: The Story of

Robert Lucas and Paul Romer have

provided a new set of contributions
under the name of new growth theory,
which take on some of the issues initially
raised by growth theorists of the 1960s.
Romer
Macroeconomics

New growth theory focuses on the determinants

of technological progress in the long run, and the
role of increasing returns to scale.

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 New Growth Theory
Chapter 7: Epilogue: The Story of

One example of some of the advances

economists have made is on the work of
Philippe Aghion and Peter Howitt. They
have developed a theme first explored
by Joseph Schumpeter in the 1930s, the
Macroeconomics

notion that growth is a process of

creative destruction, in which new
products are constantly introduced,
making old ones obsolete.

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 27-5 Common Beliefs
Chapter 7: Epilogue: The Story of

Most macroeconomists agree that:

 In the short run, shifts in aggregate demand
affect output.
 In the medium run, output returns to the natural
level.
 In the long run, capital accumulation and the rate
Macroeconomics

of technological progress are the main factors

that determine the evolution of the level of
output.
 Monetary policy affects output in the short run,
but not in the medium run or the long run.
 Fiscal policy has short-run, medium-run, and
long-run effects on output.
© 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard 30 of 32
 Common Beliefs
Chapter 7: Epilogue: The Story of

Some of the disagreements involve:

 The length of the “short run,” the period of
time over which aggregate demand affects
output.
 The role of policy. Those who believe that
Macroeconomics

output returns quickly to the natural level

advocate the use of tight rules on both fiscal
and monetary policy. Those who believe that
the adjustment is slow prefer more flexible
stabilization policies.

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 Key Terms
Chapter 7: Epilogue: The Story of

 business cycle theory  staggering (of wage and price

decisions)
 effective demand
 new classicals
 liquidity preference
 real business cycle (RBC) models
 neoclassical synthesis
 new Keynesians
 Keynesians
 nominal rigidities
 Monetarists
 menu costs
Macroeconomics

 Lucas critique  new growth theory

 random walk of consumption

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