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New Classical Macroeconomics

Do you regard new classical macroeconomics as a separate school of thought

from monetarism?

I think so. My impression is that monetarism is a school of thought that says

fluctuations in the money supply are the primary cause of fluctuations in

aggregate demand and in aggregate income, whereas new classicism is a

particular theory as to why fluctuations in aggregate demand might matter

through an unanticipated price surprise. This price surprise view proposed by

Lucas is, I think, the next step after monetarism. More recently, new classical

economists have turned their attention to real business cycle theory, which is

the antithesis of monetarism.

Do you think that overall the new classical contributions have had a beneficial

effect on the development of macroeconomics?

Debate is healthy, and the new Keynesian school arose largely in response to

the new classical school. In that sense it is a debate leading to greater truths,

and it has been helpful. Many of the specific contributions, especially real

business cycle theory, are probably not going to survive the test of time. The

literature on the time inconsistency of policy is a contribution that will

survive and has probably been one of the most important contributions to

policy analysis in the past two decades.

How important is the rational expectations hypothesis?

It is important in the sense that it has now become the working hypothesis of

all practising macroeconomists. Economists routinely assume that people are

rational when they make decisions: they maximize utility, they rationally

maximize profits, and so on. It would be peculiar for us to assume that people

are rational except when they come to form expectations and then they act

irrationally. I don’t think the rational expectations hypothesis is important in

the sense of having all the sweeping implications, as was at first believed. At

first people thought that it had all sorts of properties about policy being


Isn’t that more to do with the market-clearing assumption?

Exactly. People have come to realize that it is other assumptions, like the

market-clearing assumption, that are really important and that rational expectations

in itself doesn’t have implications as sweeping as once thought.

You have questioned the argument that the disinflation experience of the early

1980s both in the USA and in Britain provided decisive evidence against the

new classical claim of painless disinflation. Is that because the deflation was


There are two new classical views. The first is the price surprise theory of

Lucas. The second is the real business cycle theory. This second view says

that money anticipated or unanticipated doesn’t matter. My view of that is

that it is completely at variance with the evidence. Larry Ball has a paper that

shows systematically for a large number of countries that whenever you have

a major disinflation it is associated with a period of low output and high

unemployment [see Ball, 1994]. So I think that the evidence is completely

clear on that. The evidence is more favourable to early new classical theory.

You’re right that to a large extent the disinflation was unanticipated even in

the USA, where Volcker said he was going to disinflate. I don’t think people

believed he was going to disinflate as fast as he did. Most measures of

expectations of inflation did not come down until after the recession was well

under way. I am sympathetic to the view that credibility is one determinant of

how costly a disinflation will be.

Keynesianism and the New Keynesians

Do you regard yourself as a Keynesian?

I do, but I’m always nervous about the term because Keynesian can mean

different things to different people, just as different people will read the

General Theory and pull out different elements as being important. People

use the word Keynesian in so many different ways that recently I have

actually tried to avoid using the term at all, on the grounds that it is more

confusing than illuminating. I think of myself as a Keynesian in the sense of

believing that the business cycle represents some sort of market imperfection

on a grand scale. Milton Friedman was also a Keynesian in that sense. My

own views emerged as much from Milton Friedman as they have from John

Maynard Keynes. Some people take the word Keynesian as meaning a belief

in fine-tuning the economy so that the government controls every wiggle of

ups and downs. Other people take it as a belief that deficit spending is not a

bad thing. I don’t subscribe to either of those views. I think that the broad

theme of the General Theory is that the business cycle is something that we

really need to worry about because it is a sign of a market imperfection. In

that way I am a Keynesian, but as I said before, so is Milton Friedman.

Was the breakdown of the Phillips curve fatal for orthodox Keynesianism?

It highlighted the absence of a good theory of aggregate supply. What orthodox

Keynesians had was a pretty good theory of aggregate demand. The

IS–LM model has held up pretty well as a general structure for thinking

about how aggregate demand is determined. The problem is once you’ve got

aggregate demand – a downward-sloping curve in P–Y space – you still need

a good story for the aggregate supply curve. The Phillips curve came out of

nowhere. It is really just an empirical description of what was true in the data

without any particular good theories as to why it should look that way, how it

would change in response to policy, and what might make it unstable. So we

never had a good theory of that, and the breakdown of the Phillips curve

made that very apparent and provided room for the more general critique that

Lucas put forward. The deficiency on the supply side was always a weakness,

but it wasn’t given attention until the Phillips curve broke down.

What would you summarize as being the central propositions of new Keynesian


The central propositions are largely theoretical rather than policy-oriented.

New Keynesians accept the view of the world summarized by the neoclassical

synthesis: the economy can deviate in the short term from its equilibrium

level, and monetary and fiscal policy have important influences on real economic

activity. New Keynesians are saying that the neoclassical synthesis is

not as flawed as Lucas and others have argued. The purpose of the new

Keynesian school has been largely to fix those theoretical problems raised by

Lucas and also to accept Lucas’s argument that we need models supported by

better microeconomic foundations.

So you wouldn’t subscribe to arguments in favour of incomes policies advocated

by Post Keynesians?

No, not at all. When the government gets in the business of setting wages and

prices it is not very good at it. The setting of wages and prices should be left

to free markets.

So you are no Galbraithian?

Absolutely not [laughter].

How important is the theory of imperfect competition to new Keynesian


A large part of new Keynesian economics is trying to explain why firms set

and adjust prices over time in the way that they do. Firms in a perfectly

competitive environment don’t have any choice over what their prices are

going to be. Competitive firms are price takers. If you want to even talk about

firms setting prices you have to talk about firms that have some ability to do

so, and those are firms that have some market power: they are imperfectly

competitive. So I think imperfect competition is central to thinking about

price setting and therefore central to new Keynesian economics.

This is strange, because if you think of the 1930s, you had Keynes and Joan

Robinson at Cambridge. Joan Robinson developed the theory of imperfect

competition and Keynes developed his General Theory. Why did it take so

long to bring these two ideas together?

I don’t think that Keynes was as worried about building his model based on

microfoundations as we are today. Joan Robinson was building the microeconomics

that would later prove to be very useful for addressing the

macroeconomics of Keynes. Keynes, not having read Robert Lucas yet, wasn’t

worried about building the microeconomics of aggregate supply [laughter].

In a sense haven’t the Post Keynesians been ahead of you here? People like

Paul Davidson have for years taken imperfect competition as their microfoundation.

So are the new Keynesians simply catching up on what the Post

Keynesians did a while ago?

They have a broad theme of imperfect competition, but the details are not

very similar. My impression is that the new Keynesian economics is much

more in line with the neoclassical synthesis than with the Post Keynesians.

You will obviously be very familiar with Alan Blinder’s recent surveys. Are

they supporting the new Keynesian views? [See Blinder, 1991.]

Alan is providing a way of judging a variety of different new Keynesian

views. There are a lot of new theories about wage and price rigidities. He is

trying to sort out which is right and wrong using a fairly novel perspective of

asking firms how they set wages and prices. This is terrific work, but what we

are going to learn in the end is still unclear. He is still producing the papers

and we haven’t seen all the results yet. The goal is to provide one way of

deciding which theories we like and which we don’t. It’s a very exciting


An important distinction seems to be made by new Keynesians between real

rigidities and nominal rigidities. Why is it important to make this distinction?

The reason is that a real rigidity, which is a rigidity in a relative price, is not a

reason for monetary non-neutrality. Unions, for example, could set rigid real

wages away from equilibrium. A rigid real wage is not going to provide any

reason to believe that money is not neutral, since it does not create any

nominal lever for money to work on. It would cause unemployment, but not

monetary non-neutrality. To get monetary non-neutrality, which is a central

challenge for macro theorists, you need some nominal rigidity, such as sticky

prices. Having said that, there does seem to be a variety of real rigidities in

the world – unions setting wages above equilibrium levels, for example. The

question is whether nominal and real rigidities interact. One of the big themes

of this literature, mainly due to Larry Ball and David Romer, is that real and

nominal rigidities seem to reinforce each other. The real rigidity is actually

going to make the nominal rigidity much more important than it would be


Critics of the menu cost literature have suggested that this is a small peg on

which to hang an explanation of the business cycle. How can small menu

costs have such large real effects on the macroeconomy? [See Barro, 1989a.]

It is clear that menu costs are quite small. Firms don’t bear huge costs when

they change their prices. Yet it is also clear that recessions are very costly

events. The question is whether these relatively small menu costs can be a

key part of understanding this relatively costly business cycle. This literature

shows that price adjustments by firms have external effects. When a firm

decides to keep prices sticky, this could well be costly for the economy in a

way that is not costly for the firm that is making the decision.

How do efficiency wage and insider–outsider theories fit into new Keynesian


Both of these theories provide a particular explanation for real rigidities, such

as why real wages don’t move to the equilibrium level in labour markets. As I

said before, real rigidities and nominal rigidities can complement each other.

That is, the insider–outsider and efficiency wage explanations for rigid real

wages in some senses complement the menu cost story of rigid prices.

Is the idea of hysteresis crucial to new Keynesian macroeconomics?

Actually I don’t think of it as being crucial. It is an interesting idea that a

recession can have long-lived effects on the economy and leave permanent

scars after the initial cause of the recession has gone. For example, the high

unemployment in Europe in the 1980s persisted far longer than anyone could

explain with standard models. But if this idea turned out to be wrong it would

not bring down our theories. This has been an interesting, but relatively

separate, question.

Do you see the concept of NAIRU, and Friedman’s natural rate, as being the

same idea or are they different?

I have always thought of them as being basically the same. Most new Keynesian

models involve some sort of natural rate; in that sense Milton Friedman has

won the debate. Most new Keynesians believe in the natural rate hypothesis

except for a small group of people working with hysteresis. The natural rate

hypothesis is pretty well entrenched.

What about the concept of full employment? It was difficult to think of doing

macroeconomics 15–20 years ago without the concept of full employment

being central. What do we do about issues like involuntary unemployment?

Lucas suggests that we should abandon this concept, what are your views on

this? (See Lucas, 1978)

I think there is involuntary unemployment. Part of the new Keynesian literature

has come up with models of the labour market to explain why involuntary

unemployment exists, why real wages don’t adjust to equilibrate labour markets.

There is a lot of truth to the efficiency wage theories and the

insider–outsider theories, for example.

Do new Keynesians think of full employment as the natural rate?

I avoid the term full employment because it suggests that the natural rate is in

some sense desirable. I think there is some natural rate which is the long-run

unemployment rate that the economy tends to, that can’t be influenced by

monetary policy in the long run. That doesn’t mean that it is immutable in

response to any policy intervention. There are things that have been done to

the labour market that either increase or decrease the natural rate, things like

the minimum wage, unemployment insurance laws, labour training policies.

There are all sorts of things that the government can do to change the natural

rate. I don’t like calling it full employment because good labour market

policies might well raise employment beyond that level.

How important do you think it is to take into account fairness when you are

looking at the labour market? We are thinking here of the work of George

Akerlof, Janet Yellen and Robert Solow, who have stressed the idea of fairness.

Doesn’t this work suggest that perhaps new Keynesians should start

looking more closely at the psychology and sociology literature? [See Akerlof

and Yellen, 1990; Solow, 1990.]

Some of the papers that they have written have been extremely interesting. I

don’t think there is a lot of compelling evidence yet that we need to abandon

neoclassical assumptions. I’m not doing so yet in my work, but I’m certainly

happy to read the work of others who are doing so [laughter].

In your recent edited volumes of collected papers on new Keynesian economics

you say that ‘new Keynesian macroeconomics could just as easily be

labelled new monetarist economics’. What exactly did you mean? [See Mankiw

and Romer, 1991.]

The challenge raised by the real business cycle school is the question of

whether money is neutral and, if not, why not? Twenty years ago when

Friedman and Tobin were debating, there were some things they agreed on.

They agreed on the proposition that the Federal Reserve was an important

player in the economy, that what it did really mattered. The real business

cycle school has challenged that by writing down models without any real

effects of monetary policy. What the new Keynesian models have tried to do

is establish why money is not neutral, what microeconomic imperfections are

necessary to explain monetary non-neutrality at the macro level. In this sense,

these models are trying to support both traditional Keynesian and monetarist


Would you agree with Stanley Fischer that the views of Friedman, Brunner

and Meltzer are closer to those of Keynesians than they are to equilibrium

business cycle theorists? [See Fischer, 1988.]

Oh yes absolutely. The essence of real business cycle models is the absence

of any role for the Federal Reserve, whereas I think Brunner, Meltzer and

Friedman would agree with Tobin that the Fed is very important. None of

them would ever argue that money is neutral in the way that real business

cycle theorists have.

James Tobin has suggested that good papers in economics contain surprises.

What surprises have new Keynesian papers uncovered? [See Tobin, 1988.]

One of the big surprises is that one can go much further with menu cost

models than people had once thought. A lot of people used to see these

models as a silly way of thinking about price rigidity. What the new literature

is trying to do is to say no, maybe we should take menu cost models seriously.

I think the complementarity between real and nominal rigidities is a

surprise. As I mentioned earlier, one of the disappointing features so far of

the new Keynesian literature is that it hasn’t been as empirical as I would

have liked. That is a problem being remedied right now in some research.

Ultimately that is where the literature should go. More empirical work is


Peter Howitt has talked about a Keynesian recovery, Alan Blinder about a

Keynesian restoration; you seem to prefer the term reincarnation. Is there

something important in the different terms used? [See Howitt, 1990; Blinder,

1992b and Mankiw, 1992.]

I chose the term reincarnation because it means rebirth into another body.

While there are many similarities between new and old Keynesian economics,

there are also a lot of differences as well, and I wanted to emphasize that. In

some senses the spirit of Keynes has been brought back, but it doesn’t look like

the old Keynes. In fact Keynes might not recognize the new Keynesians as

Keynesians at all. In general, people might not recognize themselves after they

have been reincarnated. So that is why I used the term reincarnation [laughter].

Would you say that your work is, with respect to Keynes, faithful in spirit, but

critical in detail?

I think that is fair. It tries to go beyond Keynes in a sense of taking

microfoundations more seriously. Alan Blinder wrote a paper ‘Keynes after

Lucas’ and I think that title pretty much describes new Keynesians. It takes

some of Keynes’s ideas seriously, and it also takes some of the critiques of

Lucas seriously as well. [See Blinder, 1986.]

Do you think Keynes would have been a new Keynesian?

I don’t know; I think Keynes was a very unpredictable fellow. I guess he

would see some things in it he would like, and some things in it he wouldn’t.

Real Business Cycle Theory

You’ve recently argued that real business cycle theory has served an important

function in stimulating and provoking scientific debate, but you predict

that the approach will eventually be discarded. What are your main objections

to real business cycle theory? What are the weaknesses, theoretical,

empirical, or both?

My objections are mainly empirical. Theoretically they are very elegant

models, and that is a large part of their appeal. They are very parsimonious

models. But when I look at the real world I see the same things that Milton

Friedman and James Tobin do, which is a very powerful Federal Reserve

board in the USA or the Bank of England in the UK. There is a lot of

evidence across countries that periods of disinflation are periods of low

output and high unemployment. Those effects are completely absent in real

business cycle models. I think the central driving forces for the business cycle

that those models highlight – technology shocks – aren’t very important.

Isn’t the procyclical behaviour of the real wage a strong feature of these

theories? How do new Keynesians explain the movement of real wages over

the business cycle?

The theories do predict procyclical wages. Although I’ve not looked at the

models carefully on this question, my understanding is that they predict very

procyclical, real wages. While it is true that real wages are procyclical, my

reading of the evidence is that they are only mildly procyclical. Therefore,

the fact that these theories predict very procyclical real wages, and the data

show that they are only mildly procyclical, makes it hard to reconcile this

model with the evidence. I think the real wage evidence is not hard to

explain. If you believe in a world where wages and prices are sluggish over

time, the cyclical behaviour of the real wage is really a question of whether

wages or prices are more sluggish. The fact that real wages are roughly

acyclical, maybe slightly procyclical, is some indication to me that wages and

prices are simply equally sticky. This is consistent with Alan Blinder’s evidence,

which says that prices change on average once a year, and we know a

lot of wages change on average once a year. So I think that explanation is

consistent with much of the evidence.

How do we explain procyclical productivity? Some Keynesians seem to suggest

that it is due to labour hoarding.

The procyclical behaviour of productivity is a puzzle for people who don’t

believe in technology shocks. The traditional explanation for why productivity

is procyclical is labour hoarding. In recessions firms keep on workers they

don’t really need so that they can have the workers still available when the

next boom comes, and that tends to give the appearance of procyclical productivity.

These theories make a lot of sense to me. I know I work my

secretary harder when I have more work to be done; therefore her productivity

is procyclical. I know I work harder when there is more work to be done

[laughter]. I think there is a great deal of casual evidence that labour hoarding

and procyclical effort are important.

Macroeconomic Policy

One of the central ideas of Keynesian economics is that an increase in

aggregate demand will stimulate the economy. Under what circumstances do

you think a government should actually stimulate demand?

There are a couple of questions. First, when should it act? Second, how

should it act? That is, should it use monetary or fiscal policy? On the first

question, one should stimulate aggregate demand when it is too low to

maintain full employment – that is, when you observe very high unemployment

or when there is reason to believe that unemployment is going to rise.

The policy implications of many new Keynesian theories really go back to

the policy implications of the neoclassical synthesis of the 1960s. Some of

the limitations on policy that were then debated are still relevant today. Even

if you accept everything that new Keynesians say about prices being sluggish

and so on, there is still the question of how good the government is at

responding in a timely fashion to the shocks. In that debate, I side to a large

extent with Milton Friedman. The government is very bad at recognizing

shocks in a timely fashion, and when they do respond to shocks they often do

so quite late and counterproductively. So while I see the business cycle as a

sign of market failure, I also think that it is a kind of market failure that a

government is very limited in its ability to fix. If we have a very deep

persistent recession, certainly something along the lines of the Great Depression,

there is room for the government to do something. For the relatively

minor wiggles that we have experienced in the post-war economy, it is not

clear that the government can do much better than it has.

Do you think Keynes was politically naive in thinking that politicians would

be advised by technocrats and take the correct action? We are thinking here

of the public choice literature and the political business cycle literature. Can

we actually trust politicians once they have their hands on the fiscal and

monetary levers to use them in the right way?

I think that this is a serious concern, but there are many ways of fixing that

problem. For example, there is a large literature showing that countries with

more independent central banks have lower inflation on average. With less

independence in the central bank, there is more political pressure and therefore

a greater possibility of following a policy of inflating too much. There are ways

around the political problem, like making independent central banks, which to

some extent are staffed by technocrats. For that reason an independent central

bank would be better at fine-tuning the economy, to the extent we fine-tune it at

all, compared to fiscal policy which is always run by politicians.

You’ve said that the literature on time inconsistency has provided a persuasive

case for a commitment to some sort of rule for monetary policy; do you

also support fiscal rules?

Fiscal rules have to be well crafted. A balanced budget amendment that is too

strict could be a disaster. At certain times, like recessions and wars, it is

appropriate to run budget deficits. So any fiscal rule has to take into account

those special situations where budget deficits are the appropriate policy response.

A fiscal rule by itself wouldn’t be a bad idea, but it has to be well

crafted and so far I haven’t seen one that is.

Isn’t one of the problems with devising rules that if the economy is hit by an

unforeseen shock, then the government has to renege on that rule and take

some discretionary action? It is difficult to think of a rule which really would

be binding?

There are two parts to the question. First, how might you make the rule

binding? Second, do you want to make the rule binding? One way to make

the rule binding is reputational. Many rules are rules just because long tradition

has established them as rules and people don’t want to break the tradition.

Another more legalistic way of imposing rules is by writing them into the

constitution. I think the harder question you raise is do you want to make

rules binding? The question is whether you can write a rule that works well

even in response to unforeseen events. If it becomes too costly to be tied by

the rule, people will stop abiding by it. What we want to do is write down a

rule that will be good in response to normal kinds of shocks. That is, you

don’t know what the shocks are going to be, but you know what kind of

shocks are possible. You’ve got oil shocks, monetary demand shocks and so

on. You write down a rule that is good in response to the kind of shocks you

expect the economy to experience, based on the shocks experienced in the

past. Therefore, unless something completely unforeseeable happens, you

stick by the rule.

Leijonhufvud once argued that the economy can be thought of as travelling

along a corridor. As long as it stays in the corridor, leave it alone, but if it

gets out of the corridor into a severe recession, that is the time for intervention.

Is that what you are saying? [See Leijonhufvud, 1981.]

Well no, because recessions are reasonably foreseeable. Although you don’t

know when a recession is going to occur, you know that one will occur

eventually. A recession is one of the contingencies that you want your rule to

deal with. So I don’t think a recession per se is one of those extraordinary

events that make you want to break the rule. A recession is something you

can plan for in advance. I’m talking about an event that not only can you not

predict when it is going to happen, but you have never even thought that it

might happen. For example, before 1973 people never imagined an OPEC

supply shock. The whole idea of OPEC never even crossed anybody’s mind.

This is the type of situation where you might want to rethink the rule. Now

that we know what OPEC is capable of, we can write down a rule that takes

this into account.

What is the role of fiscal policy in new Keynesian macroeconomics?

To a large extent new Keynesian economics has been about the theory of

aggregate supply and why it is that prices adjust slowly. It has been relatively

neutral on the question of what determines aggregate demand, in particular

whether monetary or fiscal levers are most useful. As I mentioned a moment

ago, I am sceptical personally about the usefulness of fiscal policy in finetuning

the economy because, at least in the USA, the Congress acts very

slowly. Even as we are doing this interview [18 February 1993] the Congress

is debating a fiscal stimulus, even though the recovery has been going on for

about a year now. By the time this fiscal stimulus actually has an effect on the

economy, my guess is that we will be pretty close to the natural rate again.

This is a perfect example of how the lags can be very long in fiscal policy.

Monetary policy is a more useful tool for stabilizing aggregate demand.

Do budget deficits matter?

I think they matter a lot. The way they matter is not for short-run macroeconomic

reasons but for long-run reasons – reasons that are best described not

by Keynesian models but by growth models. The evidence as I see it is that

large budget deficits reduce national saving. And the lesson from growth

theory and growth experience across countries is that low saving leads to low

growth. That is a big problem for the USA today.

If you were advising President Clinton about macroeconomic policy for the

next three or four years, what would be the kinds of policies you feel are


My reaction to President Clinton’s speech [17 February 1993] is that I don’t

think we need the fiscal stimulus that he is proposing. Recovery is already on

its way. It wasn’t a very deep recession to start off with, so I’m not terribly

shocked that there is a mild recovery. It will take the fiscal stimulus a while to

get people employed. I am happy that he is worried about the budget deficit,

as low national saving is an important macro problem in the long term in the

USA. Yet I am disappointed that he is putting so much emphasis on tax

increases rather than spending cuts. That is really a view not so much about

macroeconomics as about the size of government. I am also disappointed that

he is giving no attention to the low rate of private saving in the USA. I would

recommend tax reforms to remove the present disincentives toward saving.

So I give him a mixed review.

Current and Future Progress in Macroeconomics

Much research in the 1980s, your own included, was directed at providing

more rigorous microeconomic foundations for the central elements of

Keynesian economics. Taking an overview of the last decade, how successful

do you think that research has been in providing a more substantial

microfoundation for Keynesian economics?

It has been successful at the theoretical level in the sense that one can now

say that Keynesian economics, the economics of wage and price rigidities, is

well founded on microeconomic models. There are now several microeconomic

models that people can pull off the shelf. The theoretical challenge of Lucas

and his followers has been met. It is less clear whether this line of research is

going to be successful as an empirical matter. That is, to what extent does it

yield new insights to help understand actual economic fluctuations? Does it

give us new ways to look at data and policies? The jury is still out on that

one. There is a small empirical literature, but I can probably count the

number of empirical papers on the fingers of two hands. I hope it is a growth

area, but so far the literature has not been as empirically orientated as I would


Do you think there is some truth to the view that at the moment we have too

many theories?

Yes, I have a lot of sympathy with that view. There is too big a premium for

coming up with clever theories in the profession. Yet I don’t know of any way

to solve this problem. Obviously I believe the things I believe, and I can’t tell

people that they should believe what I believe, just because there are too

many theories [laughter]. It would be nice if macroeconomists reached a

consensus and they could do more work on details and less work on creating

brand new theories of the business cycle. Until we reach a consensus, there is

no way to enforce that by fiat.

Do you see any signs of an emerging consensus in macroeconomics?

That is a good question. I change my mind on that a lot, depending on what

conference I go to [laughter]. There are certainly groups within the profession

that are agreeing with each other. There is much agreement among new

Keynesian people like Olivier Blanchard, Larry Ball, David Romer, George

Akerlof, Alan Blinder and so on. Whether we as a group are coming to

agreement with some of the real business cycle group is hard to say. I’m

delighted that some of the people who previously worked closely with the

real business cycle models are now trying to incorporate monetary effects

into those models. That provides a hope that somewhere down the line the

new Keynesian models and the real business cycle models are going to merge

to some grand synthesis that incorporates the strengths of both approaches.

That hasn’t happened yet; that is just a hope.

Additional Questions Answered by Correspondence: February/March


When we last talked with you in February 1993 you were somewhat hopeful

that ‘somewhere down the line the new Keynesian models and the real business

cycle models are going to merge to some grand synthesis that incorporates

the strengths of both approaches’. Have developments in macroeconomic

research during the last five years moved in the direction of more consensus,

as you had hoped?

To some extent, yes. Increasingly, there are economists (such as Bob King,

Julio Rotemberg and Mike Woodford) trying to integrate the insights of the

new Keynesian and real business cycle literatures. Not surprisingly, this

raises a host of difficult technical issues. We have long known that dynamic

sticky price models are hard to solve except in some special cases. But some

progress has been made.

Your new Principles of Economics textbook [Mankiw, 1997] has generated a

great deal of interest and comment. For example, in his Wall Street Journal

review of your book [October 1997] Mark Skousen interprets your overall

message to be that ‘classical economics is now the “general theory” and

Keynesian economics to be the “special” case’. Skousen also writes that

‘virtually the entire book is devoted to classical economics leaving the

Keynesian model as an afterthought in the end chapters’. Is this an accurate

view of the balance of the book and your own current position?

I have been delighted about the response to my new textbook. Some of the

commentary, such as the Skousen op-ed piece in the Wall Street Journal

exaggerated what my book does, and the Journal published a letter I wrote

responding to that article. In the book, I try to present a balance between

Keynesian and classical ideas. The Keynesian analysis is developed over

three full chapters, which explain and apply the model of aggregate demand

and aggregate supply. That is perhaps less coverage than in many traditional

texts, but in no sense is Keynesian economics treated as a mere ‘afterthought’.

I begin with classical ideas – including long-run growth, the quantity

theory of money and so on – but by the end of the book the student is fully

acquainted with the importance and role of Keynesian theory.

In our previous interview you commented that the ‘natural rate hypothesis is

pretty well entrenched’ and that ‘most new Keynesians believe in the natural

rate hypothesis’. How do you account for the remarkably low combination of

inflation and unemployment currently being experienced in the US economy?

It seems increasingly clear that the natural rate of unemployment has fallen in

the USA. At one level, that is not terribly shocking, since in principle there is

no reason to think the natural rate must be constant. Various changes in the

labour market can alter the natural rate. But I have not yet seen a good

explanation of the decline, which is somewhat troubling. Some people might

react by rejecting the whole natural rate framework, but I am not ready to do

so. In part, I remain committed to the natural rate model because I have not

seen a good alternative to it.

Your research interests in recent years have been more focused on economic

growth than the short-run issues of aggregate fluctuations. Unlike Paul Romer

and other endogenous growth theorists, you provide a spirited defence of a

modified Solow model in your [1995] ‘Growth of Nations’ paper. What is

your assessment of the progress that has been made in this burgeoning

research area?

The growth literature has been a very positive development for the economics

profession. After all, long-run growth is at least as important for human

welfare as the business cycle, so it’s great that the issue is being studied

seriously again. In my new principles textbook, as well as in my intermediate

macro text, I introduce the topic of long-run growth quite early. This is in

large part a reflection of the research trend started by Paul Romer and others.

On the question of what progress has been made, I remain somewhat

ambivalent. There are now many theoretical models of growth and more

empirical studies than we have data points. Yet it is hard to find important

questions that we can now answer with confidence that we couldn’t answer

before. Adam Smith once said that ‘little else is requisite to carry a state to

the highest degree of opulence from the lowest barbarism, but peace, easy

taxes, and tolerable administration of justice’. That still seems like the best

policy advice. In that sense, we haven’t made much progress in 200 years. On

the other hand, perhaps we better understand why Smith’s instincts were right

ones, and that is progress.

What are the main differences between your view of technological progress

and Paul Romer’s?

I don’t disagree with Paul Romer about technological progress. It comes

mainly from the creation of ideas that are largely but not completely public

goods. Both of us would agree that this explains why most nations are richer

than they were a century ago.

Where Romer and I seem to disagree is whether this old insight is important

for understanding cross-country differences. I have argued that much of

the international variation in living standards can be explained by the differences

in the quantities of human and physical capital. As I understand Paul

Romer’s view, he is sceptical of this possibility. He argues that differences in

knowledge across countries are important; in essence, he claims that different

countries have access to different sets of blueprints. One problem in testing

these two theories is that physical capital and human capital (schooling) can

be measured and evaluated, which is what I tried to do in my [1992] Quarterly

Journal of Economics paper with David Romer and David Weil, while

the ‘ideas’ that Paul Romer emphasizes are harder to measure. I am sure that

there is some truth in both the ‘capital view’ and the ‘ideas view’ and that

other things – trade policy, property rights and so on – matter as well. The

relative importance of these different factors is ultimately an empirical question

that is very hard to answer conclusively.