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12.2 Twentieth-Century Developments in Macroeconomics: Evolution or Revolution?

In his survey Blanchard (2000) acknowledges that:

on the surface, this history of macroeconomics in the twentieth century appears as

a series of battles, revolutions, and counterrevolutions, from the Keynesian revolution

of the 1930s and 1940s, to the battles between Monetarists and Keynesians

of the 1950s and 1960s, to the Rational Expectations revolution of the 1970s, and

the battles between New Keynesians and New Classicals of the 1980s.

However, Blanchard argues that viewing progress in macroeconomics in this

way creates the ‘wrong image’ and that instead ‘the right one is of a surprisingly

steady accumulation of knowledge’. In surveying the development of

macroeconomics over the course of the twentieth century he identifies three

epochs, namely:

1. pre-1940, an epoch of exploration;

2. 1940–80, an epoch of consolidation; and

3. post-1980, a new epoch of exploration.

Pre-1940, research into what we now call short-run macroeconomics centred

on the two ‘largely disconnected’ fields of monetary theory and business

cycle theory. In the former case, monetary theory was dominated by the

quantity theory of money and concentrated on issues relating to the shortrun

non-neutrality, and long-run neutrality, of money. In the latter case,

business cycle theory consisted of a ‘collection of explanations, each with

its own rich dynamics’, as evidenced for example by Haberler’s (1937)

survey of pre-Keynesian views contained in his book Prosperity and Depression.

According to Blanchard, the methodological contributions of

Keynes’s (1936) General Theory made a ‘crucial difference’ to integrating

the two fields by pulling together all the relevant factors previously used in

their study. By analysing the interplay between the goods, labour and money

markets, Keynes provided a coherent framework that had been missing in

earlier work.

The epoch 1940–80 Blanchard refers to as a period of consolidation. The

foundation for this prolonged period of consolidation was provided by Keynes’s

(1936) integrated framework and Hicks’s (1937) IS–LM interpretation of the

General Theory. This framework was built upon and extended. Among the

‘steady accumulation of knowledge’ that took place over this period it is

possible to identify a number of examples, which include:

1. improvements in the availability of economic data, for example followConclusions

and reflections 697

ing the work of James Meade and Richard Stone (1944) in developing a

system of national accounts;

2. the development of, and improvements in, econometric methods (see

Hoover, 1995a, 2001a, 2001b);

3. more detailed modelling of the behavioural relationships of consumption

(for example Modigliani and Brumberg, 1954; Friedman, 1957), investment

(for example Jorgenson, 1963) and the demand for money (for

example Baumol, 1952; Tobin, 1958);

4. the construction of macroeconometric models of the economy, for example

Klein and Goldberger (1955);

5. the incorporation of the expectations-augmented Phillips curve analysis

into macroeconomic models and an examination of the implications for

stabilization policy, for example Friedman (1968a);

6. more careful modelling of how expectations are formed, for example

Cagan (1956); Muth (1961); and

7. an examination of the implications of rational expectations for the analysis

of policy changes, for example Lucas (1976).

This list is far from being exhaustive and merely illustrates a number of

important developments and breakthroughs achieved during this period, some

of which were recognized by the award of the Nobel Memorial Prize in

Economics (see Blaug and Vane, 2003; Vane and Mulhearn, 2004). However,

by the end of the 1970s Blanchard argues that ‘too casual a treatment of

imperfections’ led to a ‘crisis’ in macroeconomics, which initially resulted in

two different routes of enquiry. In the ensuing post-1980 epoch of new

exploration one group of economists labelled new Keynesians (see for example

Gordon, 1990; Mankiw and Romer, 1991) concentrated their attention on

market imperfections in goods, labour and credit markets, and their implications

for macroeconomics. Another group referred to as real business cycle

theorists (see for example Kydland and Prescott, 1982; Long and Plosser,

1983; Prescott, 1986) adopted new classical methodology and assumptions

and initially explored how far equilibrium theorizing could go in explaining

aggregate fluctuations without resorting to monetary shocks and without

introducing imperfections in their analysis.

In contrast, in his survey Woodford (2000) agues that the ‘degree to which

there has been progress over the course of the century is sufficiently far from

transparent’ and that macroeconomics ‘has been famously controversial’.

Acknowledging that ‘discussions of twentieth-century developments in macroeconomics

make frequent references to revolutions and counter revolutions’

(see for example the titles adopted by Klein, 1947; Clower, 1965; Brunner,

1970; Friedman, 1970c; Johnson, 1971; Tobin, 1981; Begg, 1982; Barro,

1984; Tomlinson, 1984; Booth, 1985; Dimand, 1988; Blaug, 1991b), he

traces the development of macroeconomics in historical perspective. Starting

from Keynes’s (1936) General Theory he tracks progress in macroeconomics

from the Keynesian revolution, the neoclassical synthesis, the Great Inflation

and the crisis in Keynesian economics, monetarism, rational expectations and

the new classical economics, real business cycle theory to a new neoclassical

synthesis. From Woodford’s historical perspective the evolution of economists’

thinking on macroeconomics has been far from smooth.

It should be immediately apparent that the approach we have taken in this

book more closely parallels that taken by Woodford. There is no dissent that

the birth of modern macroeconomics can be traced back to the publication of

Keynes’s (1936) General Theory or that macroeconomics is a ‘quintessentially

twentieth-century development’ (Woodford, 2000). Indeed, Blanchard

(2000) notes that the term ‘macroeconomic’ does not appear in the economics

literature until it formed part of the title of an article by De Wolff which was

published in 1941, while the term ‘macroeconomics’ first appeared in the title

of an article by Klein published in 1946. The central belief which underpinned

the ensuing Keynesian revolution in macroeconomic thought is the

need for stabilization, the view that the authorities can, and therefore should

use discretionary fiscal and monetary policy to stabilize output and employment

at their full employment levels (see Modigliani, 1977). According to

Gerrard (1996), a unifying theme in the evolution of modern macroeconomics

thereafter has been an ‘ever-evolving classical-Keynesian debate’ involving

contributions from various schools of thought that can be differentiated and

classified as being orthodox (the orthodox Keynesian and orthodox monetarist

schools), new (the new classical, real business cycle and new Keynesian

schools) or radical (the Austrian and Post Keynesian schools).

The rise and fall of orthodox Keynesian economics owed a great deal to its

problem-solving effectiveness. It appeared to provide a robust explanation of

a severe empirical problem, namely mass unemployment, which had persisted

long enough not to be easily explained away as a minor anomaly. In

addition it offered an attractive political action programme for the resolution

of the diagnosed problem. Whilst it contained a number of serious conceptual

problems, for example inconsistencies and ambiguities of presentation alongside

more radical elements, these were effectively submerged by the

neoclassical synthesis process. This synthesis of classical and Keynesian

ideas, captured by the IS–LM AD–AS framework, represented the consensus

view before the 1970s and was the standard approach to macroeconomic

analysis both in textbooks and in professional discussion.

The demise of orthodox Keynesianism was in large part the result of its

failure to deal adequately with the major new empirical problem posed by

stagflation in the 1970s. Conceptually much of its ‘heuristic power’ had

‘petered out’ and ‘run dry’ (Leijonhufvud, 1968). As Klamer (1984) conConclusions

cedes, ‘the 70s were a decade of retreat, defence, and frustration’ for Keynesian

economics. During periods of consensus in macroeconomics divisions among

economists naturally become less intense and less visible in the literature.

The inherent weaknesses and practical failings of both Keynesianism and

economic positivism highlighted in the late 1960s and early 1970s led to the

demise of much of the old orthodoxy without its replacement by any single

dominant new approach. Any continuing ‘submerged’ competition between

rival macroeconomic explanations became more open and pronounced. The

revival of much of the ‘old economics’, in a traditional (Austrian) or new

form (monetarist, new classical and real business cycle approaches), undermined

much of the ‘new economics’ of orthodox Keynesianism, which in

turn encouraged the development of new Keynesian accounts. The more

radical Post Keynesian interpretation of Keynes’s (1936) General Theory

also continues to offer an alternative vision of how the macroeconomic system

operates.

Keynesianism was initially faced by a potent rival, monetarism, which was

better able to explain the empirical anomaly of stagflation in a more consistent

fashion. As we have discussed, in the orthodox monetarist view (and the

new classical approach) there is no need for stabilization policy, the authorities

can’t, and therefore shouldn’t, attempt to stabilize fluctuations in output

and employment through the use of activist aggregate demand management

policies. Monetarism, in turn, experienced a period of progress before being

faced with problems of its own, not least as noted earlier in Chapter 4 the

sharp decline in trend velocity in the 1980s in the USA and elsewhere. The

collapse of a stable demand for money function in the early 1980s was to

seriously undermine monetarism. During the early 1970s a second counterrevolution

took place associated with new classical school which cast further

doubt on whether traditional Keynesian aggregate demand management policies

can be used to stabilize the economy. While new classical macroeconomics

evolved out of the monetarist approach, it in fact provided a sustained challenge

to the monetarist as well as the Keynesian orthodoxies. As we have

seen, the new classical case against discretionary policy activism and in

favour of rules is based on a different set of arguments (most notably the

policy ineffectiveness proposition, the Lucas critique and time inconsistency)

to those advanced by orthodox monetarists.

New classical macroeconomics displayed important conceptual progress

both by nurturing a rational expectations revolution, which was subsequently

widely incorporated into the macroeconomic mainstream, and by highlighting

the role of aggregate supply. However, important criticisms were

increasingly directed at new classical macroeconomics concerning certain

conceptual, empirical and policy deficiencies. Its empirical results have been,

at best, somewhat mixed and inconclusive. Contrary to its early claims, both

unanticipated and anticipated policy changes appear to affect output and

employment, while several economies have experienced real costs of announced

disinflation. New classical macroeconomics has certainly left its

mark, and both real business cycle theory and new Keynesian economics can

be viewed as a response to issues raised by Robert E. Lucas Jr and other

prominent new classicists.

During the 1980s a considerable divide emerged between the flexi-price

competitive equilibrium real business cycle models and the sticky-price new

Keynesian models, where monetary influences are viewed as central to any

explanation of the path of real variables in the short run. In the real business

cycle approach there is no need for stabilization policy. Furthermore, as monetary

factors are irrelevant in explaining such fluctuations, monetary policy

can’t be used to influence output and employment even in the short run. In

these circumstances governments shouldn’t attempt to reduce fluctuations in

output and employment, which are Pareto-efficient responses to shocks to the

production function. In contrast, new Keynesians argue that there is a need for

stabilization policy as capitalist economies are subjected to shocks from both

the demand and supply side of the economy, which cause inefficient fluctuations

in output and employment. Furthermore, since governments can improve macroeconomic

performance, they should pursue stabilization policy. Although there

is no unified view among new Keynesians with respect to the rules versus

discretion debate, new Keynesians do not advocate ‘fine-tuning’ the economy,

but have instead championed the case for ‘rough-tuning’ in response to large

divergences in output and employment from their natural levels. Today the new

Keynesian stance can best be characterized as one which supports the case for

some kind of constrained discretion in the form of an activist rule, along the

lines, for example, of a flexible Taylor-type rule.

As an aside, it is interesting to note that new Keynesian economics could

have been named new monetarist economics (Mankiw and Romer, 1991) in

that it represents a synthesis of certain key foundations of monetarism and

new classical macroeconomics. For example, the new Keynesian school has

absorbed what it regards as valid components of the monetarist and new

classical counter-revolutions, most notably the natural rate hypothesis and the

rational expectations hypothesis. However, responding to the challenge of

new classical macroeconomists, the new Keynesian school has provided rigorous

microfoundations to explain why markets may fail to clear due to wage

and price stickiness. In so doing it has been able to account for involuntary

unemployment as an equilibrium phenomenon and provide a rationale to

justify interventionist policies to stabilize the economy.

Of course the demise of orthodox Keynesianism also permitted the revival

of interest in such non-mainstream accounts as that of the Austrians and the

salvaging of Keynes’s fundamental ideas by the Post Keynesians.

In Chapters 4–9 we examined the nature and extent of disagreement within

macroeconomics resulting from the dismantling of the Keynesian orthodoxy.

Over the decades macroeconomists have largely been engaged in emphasizing

their differences rather than their similarities. They have often been more

concerned with differentiating their intellectual products in the academic

arena alongside a willingness to display conflicts over policy advice in the

public arena. In short, there has been a tendency to emphasize uniqueness of

identity, which, in turn, has led to both diversity and labelling.

Table 12.1 highlights some of the important features of the schools of

macroeconomic thought explored in Chapters 3–9 of this book. The mainstream

development of macroeconomics can be read from top to bottom, that

is, from orthodox Keynesian to new Keynesian. The Austrian and Post

Keynesian approaches represent the most important non-mainstream approaches.

Two points should be borne in mind when consulting this table.

First, within each school identified, there are differences of opinion and

emphasis: the table merely characterizes the view most commonly held on

particular issues. Second, as is evident from a close scrutiny of the table,

there is a considerable degree of overlap between the various schools on a

number of issues. This suggests that, in practice, the dividing line between

schools is becoming increasingly blurred on many issues. With the benefit of

hindsight, differences between schools have often been exaggerated. Take,

for example, the debate between Tobin and Friedman concerning the transmission

mechanism of monetary policy. In commenting on the debate Stanley

Fischer (1994) suggests that:

you can read Friedman’s and Tobin’s statement of the transmission mechanism

and you can’t tell who wrote which. The analogy I use is that when I was a kid I

could tell cars apart coming down the road. Then the differences between say a

Chev and a Ford were enormous. Now if you look at an old car I know it’s a 1950s

model but I don’t have any idea whether it’s a Ford or a Chev because they look

practically identical. In that sense the methods and models they used and the

issues they looked at were very similar.

Ten years ago in the concluding chapter to our book A Modern Guide to

Macroeconomics (Snowdon, Vane and Wynarczyk, 1994), we noted that ‘at

the present moment macroeconomics lacks the degree of consensus it once

had under orthodox Keynesianism’ and that ‘while there does not appear to

be any clearly emerging consensus on the horizon we should not be surprised

if a synthesis develops in the future, possibly even from disparate schools’.

According to Marvin Goodfriend and Robert King (1997), the intellectual

currents of recent years are moving modern macroeconomics towards a ‘New

Neoclassical Synthesis’. The new synthesis ‘inherits the spirit of the old in

that it combines Keynesian and classical elements’. This can be seen by

Table 12.1 Some areas of agreement and disagreement in macroeconomics

Schools in Dominant Expectations Price/wage Market Notion of Dominant Rules v.

macroeconomics source of adjustment adjustment equilibrium time frame discretion

instability

Orthodox Keynesian Fluctuations in Adaptive Emphasis Weak State of rest Short Discretion

autonomous on nominal probably below

expenditure wage full

rigidity employment

Orthodox monetarist Monetary Adaptive Flexible Strong Market clearing Short and Rules

disturbances at natural rate long

New classical Monetary Rational Perfectly Very Market clearing Long = short Rules

disturbances flexible strong at natural rate

Real business cycle Supply shocks Rational Perfectly Very Market clearing Long = short Rules

(mainly flexible strong at moving

technological) natural rate

New Keynesian Demand and Rational Emphasis Slow Consistent with Predominantly Constrained

supply shocks on price involuntary short discretion

(eclectic) rigidities unemployment

Austrian Monetary Reasonable Flexible Strong Tendency Short and long Rules

disturbances towards

Post Keynesian Fluctuations in Reasonable Sticky Very State of rest Short Discretion

autonomous weak probably below

expenditure full employment

noting that the key elements in the new synthesis comprise: intertemporal

optimization; rational expectations; imperfect competition in goods, labour

and credit markets; and nominal rigidities and costly price adjustment. In

their analysis Goodfriend and King conclude that the new neoclassical synthesis

suggests several important conclusions about the role of monetary

policy. First, monetary policy has real effects in the short run. Second, there

is little by way of a long-run trade-off between inflation and real activity.

Third, inflation is costly and it is important to eliminate it. Fourth, the

credibility of policy actions has an important impact on monetary policy

outcomes. Goodfriend and King argue that these conclusions point the way to

a rules-based monetary policy framework with inflation targeting acting as

the nominal anchor.