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7.1 The Fall and Rise of Keynesian Economics

Dennis Robertson, one of Keynes’s most articulate critics, once wrote that

‘high brow opinion is like the hunted hare; if you stand in the same place, or

nearly the same place, it can be relied upon to come around to you in a circle’

(Robertson, 1956). Good examples that illustrate Robertson’s observation

have been provided by the revival of both classical and Keynesian ideas in

their ‘new’ guise. In Chapters 5 and 6 we have seen how classical ideas have

been given new form through the technically impressive and imaginative

contributions inspired, in particular, by Robert Lucas and Edward Prescott. In

this chapter we survey how Keynesian economics has also undergone a

‘renaissance’ during the last 20 years.

We have seen in the previous chapters how the orthodox Keynesian model

associated with the neoclassical synthesis came under attack during the 1970s.

It soon became apparent to the Keynesian mainstream that the new classical

critique represented a much more powerful and potentially damaging challenge

than the one launched by the monetarists, which was of longer standing.

Although orthodox monetarism presented itself as an alternative to the standard

Keynesian model, it did not constitute a radical theoretical challenge to it

(see Laidler, 1986). While Lucas’s new classical monetary theory of aggregate

instability had its roots in Friedman’s monetarism, the new classical real

business cycle school represents a challenge to Keynesianism, monetarism

and Lucas’s monetary explanations of the business cycle. The poor performance

of Keynesian wage and price adjustment equations, during the ‘Great

Inflation’ of the 1970s, based on the idea of a stable Phillips curve, made it

imperative for Keynesians to modify their models so as to take into account

both the influence of inflationary expectations and the impact of supply

shocks. This was duly done and once the Phillips curve was suitably modified,

it performed ‘remarkably well’ (Blinder, 1986; Snowdon, 2001a). The

important work of Gordon (1972, 1975), Phelps (1968, 1972, 1978) and

Blinder (1979), all of whom are ‘Keynesians’, was particularly useful in

creating the necessary groundwork which has subsequently allowed the

Keynesian model to adapt and evolve in a way that enabled monetarist

influences to be absorbed within the existing framework (Mayer, 1997;

DeLong, 2000). Moreover, this transition towards a synthesis of ideas did not

require any fundamental change in the way economists viewed the economic

machine. For example, Gordon (1997) argues that his ‘resolutely Keynesian’

model of inflation, introduced in the mid-1970s and based on inertia, demand

and supply shocks, within an expectations-augmented Phillips curve framework,

performs very well in explaining the behaviour of output, unemployment

and inflation during the ‘Great Inflation’ period. By introducing supply shocks

into the Phillips curve framework, Gordon’s ‘triangle’ model proved capable

of explaining the positive correlation between inflation and unemployment

observed during the 1970s. Meanwhile, debate continues on the relative

importance of demand and supply shocks as causes of the ‘Great Inflation’

(see Bernanke et al., 1997; Barsky and Kilian, 2001).

Despite these positive developments within Keynesian economics, by 1978

Lucas and Sargent were contemplating life ‘After Keynesian Macroeconomics’.

In their view the Keynesian model could not be patched up. The problems

were much more fundamental, and related in particular to: (i) inadequate

microfoundations which assume non-market clearing; and (ii) the incorporation

in both Keynesian and monetarist models of a hypothesis concerning the

formation of expectations which was inconsistent with maximizing behaviour,

that is, the use of an adaptive rather than rational expectations hypothesis.

In an article entitled ‘The Death of Keynesian Economics: Issues and Ideas’,

Lucas (1980b) went so far as to claim that ‘people even take offence if

referred to as Keynesians. At research seminars people don’t take Keynesian

theorising seriously anymore; the audience starts to whisper and giggle to

one another’ (cited in Mankiw, 1992). In a similar vein, Blinder (1988b) has

confirmed that ‘by about 1980, it was hard to find an American academic

macroeconomist under the age of 40 who professed to be a Keynesian. That

was an astonishing intellectual turnabout in less than a decade, an intellectual

revolution for sure.’ By this time the USA’s most distinguished ‘old’ Keynesian

economist had already posed the question, ‘How Dead is Keynes’? (see

Tobin, 1977). When Paul Samuelson was asked whether Keynes was dead he

replied, ‘Yes, Keynes is dead; and so are Einstein and Newton’ (see Samuelson,