The Future of Macroeconomics Copyright © 2002 by The McGrawHill Companies, Inc. All rights reserved.

No Slide Title CHAPTER 17 The Future of Macroeconomics Questions What might the future of macroeconomics bring? How might the macroeconomics taught two decades from now be different from the macroecon.

CHAPTER 17

The Future of Macroeconomics

• What might the future of

macroeconomics bring?

• How might the macroeconomics

taught two decades from now be

different from the macroeconomics

taught today?

• What have been the principal changes

in the way macroeconomics is taught

over the past twenty years?

• What additional changes took place

twenty years before that from

roughly 1960 to roughly 1980?

• What direction will macroeconomics

take if the real business cycle

research program is successful?

• What direction will macroeconomics

take if the new Keynesian research

• How will economists understand the

foundations behind the power of

monetary policy?

The Past of Macroeconomics

• A 1936 book by John Maynard Keynes

shifted economic research and

macroeconomic thought into new and

different directions

– the role of expectations of future profits in

determining investment – the volatility of expectations of profits

– the power of the government to affect the

The Past of Macroeconomics

• After World War II, more

macroeconomic theory was developed

– the IS-LM model was created

– the relationship between interest rates

and the money supply was investigated – the difference between the behavior of

the macroeconomy in the flexible-price long run and the fixed-price short run was clarified

The Past of Macroeconomics

• But macroeconomics theory in 1960

was still incomplete

– no discussion of the relationship between

production and inflation – no detailed model of expectations

– the short run was seen as lasting for

decades – fiscal policy was emphasized, while the

role of monetary policy was downplayed

The Past of Macroeconomics

• Between 1960 and 1980, two powerful critiques of the conventional wisdom

of macroeconomics occurred

– the first was by Milton Friedman

• the standard models overestimated the government’s ability to control the economy

• the standard models overestimated the power

of fiscal policy and underestimated the power

The Past of Macroeconomics

– the second was by Robert Lucas

• Keynesian economics fails to think through the importance of expectations

• systematic changes in economic policy would change the parameters of the consumption and investment functions as well as the

location of the Phillips curve

The Past of Macroeconomics

• The late 1980s and 1990s were a time

of idea generation and exploration

– macroeconomists explored and tested a

large number of different ideas and models

– the mainstream policy-analytic position of macroeconomists did not shift much

The Future of Macroeconomics:

Real Business Cycles?

• Keynesian and monetarist economists

believe that there are two key

elements to understanding business

cycles

– the determinants of aggregate demand

– the division of changes in nominal

aggregate demand into changes in

The Future of Macroeconomics:

Real Business Cycles?

• Real business cycle economists believe that changes in nominal aggregate

demand affect output and employment only slightly and have the most impact

on prices

• Real business cycle theory begins with

the assumption that the same theory

that determines what happens in the

long run should be applied to

fluctuations in the short run

The Future of Macroeconomics:

Real Business Cycles?

• While real business cycle economists

believe that prices can be rigid, they

believe that this sluggishness of prices

is not very relevant

– they assume that it is a reasonable

first-approximation to suppose that the money supply and the level of potential output

determine the price level

The Future of Macroeconomics:

Real Business Cycles?

• Real business cycle economists

believe in the classical dichotomy

– real variables effectively determine the

values of real quantities like real GDP even in the short run

– nominal variables determine the values of nominal quantities like the price level

The Future of Macroeconomics:

Real Business Cycles?

• Real business cycle theory assumes

that the level of output will vary with

shocks to the economy

– adverse cost shocks lead to a recession

as individuals should spend less time working because it is not profitable

– favorable cost shocks lead to a boom

Problems of Real Business

Cycle Theory

• Unemployment

– real business cycle theory assumes that

the total hours worked at any moment is largely determined by how many hours it makes sense for people to work

– but when work hours fall, it is not

because people have chosen to work shorter shifts and avoid overtime

• it is because they have become unemployed

Problems of Real Business

Cycle Theory

• Technology and Real Business Cycles

– according to real business cycle theory,

production fluctuates because of the changing value of output and the changing productivity of the economy

• more is produced when technology rises

• recessions occur when cost increases make it inefficient to run factories at near capacity

– critics claim that cost increases like the 1973

Problems of Real Business

Cycle Theory

• Money and Business Cycles

– real business cycle theorists tend to argue

that monetary policy has little impact on production and employment

• fluctuations in the money stock and real interest rates are more reactions to changes already

taking place

– the Federal Reserve believes that it affects

the level of interest rates and that its decisions cause changes in production and employment

The Future of Macroeconomics:

New Keynesian Economics

• Since the 1930s, mainstream

macroeconomics has attributed the

sluggishness of aggregate supply to

stickiness in wages and prices

• Therefore, fluctuations in nominal

aggregate demand cause fluctuations

in output and employment

The Future of Macroeconomics:

New Keynesian Economics

• Where does this stickiness and slow

adjustment of wages and prices come

from?

– menu costs

• it is costly for businesses to change prices

– staggered prices and coordination failures

• a firm’s best choice for its price may depend on the prices that other firms are charging

• this means that wages and prices may exhibit

inertia

Debts and Deficits:

Ricardian Equivalence

• If the government runs a budget

deficit, it will make up the deficit by

borrowing money now and implicitly

committing to raise taxes to repay the debt at some time in the future

Debts and Deficits:

Ricardian Equivalence

• Economist Robert Barro argues that

consumers will see the budget deficit as

an increase in future taxes and cut back

on consumption

– what matters for the determination of

consumption spending this year is not what taxes are levied on you this year, but what all the changes in government policy tell you about stream of taxes this year and in the future

Debts and Deficits:

Ricardian Equivalence

• Many economists believe that

Ricardian equivalence does not hold

for a number of reasons

– myopia

– liquidity constraints

– people are different

Consumption and Saving

• In the early 1900s, the marginal

propensity to consume was high

– people were liquidity constrained

• The financial system in the past 50

years has become much more flexible

– economic theory would predict that the

marginal propensity to consume would decline and the multiplier process would

be more or less irrelevant to aggregate demand

Consumption and Saving

• But, consumption falls significantly

when the economy goes into recession

• Why?

– one possibility is that consumers are both

impatient and risk averse – another possible explanation is that

current income is a good proxy for permanent income

– another suggestion is for economists to

focus on what psychologists have to say

Does Monetary Policy Have a

Long-Run Future?

• Economists have tended to assume

that monetary policy is powerful and

that the reasons for its power are

uninteresting

• The future evolution of the financial

system may undermine the sources of influence that monetary policy today

possesses

Does Monetary Policy Have a

Long-Run Future?

• Forecasting the future of monetary

policy will require a deeper knowledge and better models of the sources of

central bank power than

macroeconomists currently possess

Chapter Summary

• Modern macroeconomics has its origin

in the “Keynesian” theories of the

Great Depression and post-WWII era

• Modern macroeconomics was reforged

by the monetarists under Milton

Friedman in the 1960s and 1970s, and

by the rational expectations

economists led by Robert Lucas in the 1970s and 1980s

Chapter Summary

• Perhaps the focus on aggregate

demand will turn out in the long run to have been a false road

– perhaps a better theory of the

macroeconomy can be built up out of the theory of real business cycles in the

Schumpeterian tradition

Chapter Summary

• Perhaps the future of macroeconomics lies in a more detailed investigation of aggregate supply

– perhaps uncovering the reason why

prices are sticky will lead to the next wave of progress in macroeconomics

Chapter Summary

• The entire conventional analysis of

debts and deficits is under challenge by Robert Barro, who argues that

individuals are far-sighted and closely

linked, and that they take action to

neutralize the effects of many

government policies

• The conventional analysis of

consumption the permanent income

Chapter Summary

• The other possible interesting

direction in which macroeconomics

might evolve involves the future of

monetary policy

– how will the coming of the “new

economy” and the changing institutional framework of transactions and

settlements affect the power of monetary policy?