CHAPTER 24.

EPILOGUE: THE
STORY OF MACROECONOMICS
I. MOTIVATING QUESTION
How have the core ideas of macroeconomics developed?
Modern macroeconomics starts with Keynes. Since his ​General Theory appeared, there have been a
series of challenges and counter challenges to his basic ideas, as interpreted by Hicks and Hansen. The
Core, as described in this book, is a collection of ideas that have survived these debates and that help to
make sense of the disagreements among economists.

II. WHY THE ANSWER MATTERS

 
Up to this point, the text has avoided describing economic research and ideas in terms of competing
camps. Instead, it has provided a unified model, constructed on the basis of widely held views among
macroeconomists, and emphasized the orderliness of economic research. This chapter provides students
an overview of the tumultuous history of macroeconomic theory. It exposes them to the messier, dynamic
aspect of research, and gives them some appreciation of how quickly economic orthodoxy can and has
changed.

III. KEY TOOLS, CONCEPTS, AND ASSUMPTIONS

1. Tools and Concepts
The chapter introduces some terms associated with the intellectual history of macroeconomics. Such
terms include, among others, the ​neoclassical synthesis​, ​Keynesians​, ​monetarists​, ​new classicals​, and
new Keynesians​.
 
IV. SUMMARY OF THE MATERIAL
1. Keynes and the Great Depression
Few economists during the 1930s could provide a coherent explanation for the depth and breadth of the
Great Depression. Keynes’ ​General Theory delivered an intellectual framework to explain events and
guide policy. Keynes emphasized what we now call aggregate demand. In particular, Keynes stressed the
slow adjustment back to the natural level of output after an adverse demand shock. The ​General Theory
introduced a number of ideas—the multiplier, money demand, and the importance of expectations—that
are fundamental to modern macroeconomics.

2. The Neoclassical Synthesis

By the early 1950s, a consensus had emerged around an interpretation of Keynes’ ideas in the form of the
IS​-​LM model, developed by Hicks and Hansen. This “neoclassical synthesis,” as Samuelson called it,
omitted the role of expectations and wage-price adjustment. During this period, Modigliani and Friedman
developed the theory of consumption, Tobin developed the theory of investment (which was further
developed and tested by Jorgensen), and Tobin also developed the theory of money demand and, more
generally, portfolio selection. These developments were embodied in large macroeconomic models,
pioneered by Klein. At the same time and independently, Solow developed growth theory.
The dissent from the mainstream consensus at this time was represented by monetarists, led by Friedman,
who questioned both that governments wanted to do good and that they actually knew enough to succeed.
The debate between Keynesians and monetarists centered on three issues: monetary versus fiscal policy,
the nature of the Phillips curve, and the role of policy.
 
With respect to monetary versus fiscal policy, monetarists questioned the emphasis of the early
Keynesians on the power of fiscal policy to stabilize output. Instead, monetarists emphasized the power
of monetary policy to destabilize the economy in the absence of a money growth rule to constrain the Fed.
 
With respect to the Phillips curve, many Keynesians believed that the Phillips curve offered a permanent
long-run tradeoff between inflation and unemployment. Friedman and Phelps argued that the tradeoff
would disappear if policymakers tried to exploit it.
 
With respect to the role of policy, Keynesians believed that fiscal and monetary policy could be used to
fine tune macroeconomic performance to avoid fluctuations. Monetarists argued instead that economists
did not know enough to stabilize output and that in any event, policymakers could not be trusted to do the
right thing. Therefore, policymakers should be bound by simple rules.
 
3. The Rational Expectations Critique
The mainstream consensus of the 1960s received two challenges in the 1970s. The first challenge was
empirical. Aggregate demand shocks could not account for stagflation (simultaneous increases in
inflation and unemployment) which arose during the 1970s. The second challenge was intellectual. The
new rational expectations view argued that people form expectations about the future using all available
information, including economic theory and econometric models, rather than solely on the basis of the
past behavior of the variables they are trying to forecast. This idea posed three challenges for Keynesian
macroeconomics.

The first challenge was the so-called Lucas critique. Existing macroeconomic models depicted behavioral
variables dependent on expectations as functions of current and lagged values of other variables in the
model. Under rational expectations, there was no reason to suppose that these historical relationships
would not change if the policy regime changed. Thus, existing models were effectively useless for
analyzing the consequences of changes in policy, which was one of the primary purposes for which these
models were created.

The second challenge arose from the incorporation of rational expectations into the Phillips curve. In
existing Keynesian models, output returned slowly to its natural level after a shock because wages and
prices adjusted slowly through the Phillips curve mechanism. Lucas pointed out that slow adjustment
arose from backward-looking inflation expectations assumed in the models. Introducing rational
expectations into Keynesian models implied that only policy or demand shocks that were unexpected
should affect output. Moreover, deviations of output from its natural level would last only as long as
existing nominal wage contracts that had failed to anticipate the shock.

The third challenge concerned the implications of game theory for policymaking. Under rational
expectations, policy formulation affected expectations formed by the private sector. Thus, the policy
problem was not an optimal control problem, but rather a strategic game between policymakers and the
private sector. Game theory led to different implications for policy. For example, the time inconsistency
problem (discussed in Chapter 21) implied that discretion on the part of benevolent policymakers could
lead to worse outcomes than rules.
 
In sum, rational expectations implied that Keynesian models could not be used to evaluate potential
policy measures, that Keynesian models could not explain long-lasting deviations of output from its
natural level, and that the theory of policy needed to be redesigned, using the tools of game theory.

Rational expectations quickly became the accepted working assumption in macroeconomics, and theories
of economic behavior in goods, financial, and labor markets began to be reevaluated in light of this
modification. Hall’s random walk of consumption result and the Dornbusch overshooting of exchange
rates model were two early successes. In addition, Fischer and Taylor showed that the staggering of wage
and price decisions could imply long lasting deviations of output from its natural level even under rational
expectations. This finding resolved one of the issues raised by the rational expectations critique. Finally,
research on policy games led to a new emphasis on (and more rigorous thinking about) credibility and
commitment on the part of policymakers.

4. Developments in Macroeconomics Up to the 2009 Crisis

Since the late 1980s, macroeconomic researchers have tended to cluster into three groups: new classicals,
new Keynesians, and new growth theorists.

The research agenda of the new classical theorists consists of an attempt to explain macroeconomic
fluctuations as the outcome of shocks to competitive markets with fully flexible wages and prices. These
so-called real business cycle models assume that output is always at its natural level, and interpret
fluctuations as arising from movements in the natural level, triggered by technological changes. The
problem with this view is that the nature of technological progress does not seem consistent with the types
of output fluctuations typically associated with business cycles. Moreover, although in real business
cycle models the money supply is irrelevant to output, there is strong evidence that changes in money
affect output.

New Keynesians essentially accept the synthesis that has emerged in response to the rational expectations
critique, and their research agenda consists of exploring the implications of market imperfections for
macroeconomic behavior. Research covers areas such as efficiency wages, imperfections in credit
markets, and sources of nominal rigidities.
 
New growth theorists have been reexamining the neoclassical growth model to understand the potential
role of increasing returns to scale and the determinants of technological progress. Research has also
examined the role of specific institutions in fostering or inhibiting growth.

Although there was contention among the three research camps in the 1980s and 1990s, a synthesis of
sorts has emerged. The synthesis builds on the methodology of the new classical theorists, recognizes the
potential importance of changes in the pace of technological progress as emphasized by the new classical
theorists and the new growth theorists, and allows for the market imperfections that characterize the
research of the New Keynesians. Although there is no agreement on a single model, or an accepted list of
market imperfections, there is a basic framework that organizes much macroeconomic research.

5. First Lessons for Macroeconomics after the Crisis

There is no question that the crisis reflects a major intellectual failure on the part of macroeconomics. The
failure is in not realizing that such a large crisis ​could happen​, that the characteristics of the economy
were such that a relatively small shock, in this case the decrease in housing prices, could lead to a major
financial and macroeconomic world crisis.
In general, the many components of a systematic understanding of the financial system were not
integrated into many macroeconomic models prior to the crisis. The exceptions were works by:

● Doug Diamond and Philip Dybvig in the 1980s had clarified the nature of bank runs (which we
examined in Chapter 6).
● Bengt Holmstrom and Jean Tirole showed that liquidity issues were endemic to a modern
economy.
● Andrei Shleifer, called “The Limits of Arbitrage” showed that, after a decline in an asset price
below its fundamental value, investors might not be able to take advantage of the arbitrage
opportunity; indeed they themselves may be forced to sell the asset, leading to a further decline in
the price and a further deviation from fundamentals.
● Behavioral economists (for example, Richard Thaler, from Chicago) pointed to the way in which
individuals differ from the rational individual model typically used in economics, and drew
implications for financial markets.

In conclusion, the consensus from the lessons learned from the crisis is that respect to small shocks and
normal fluctuations, the adjustment process works; but that, in response to large, exceptional shocks, the
normal adjustment process may fail, the room for policy may be limited, and it may take a long time for
the economy to repair itself.