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12.3 Is There a Consensus on Key Macroeconomic Issues?

Our discussion has highlighted some of the major trends in the development

of modern macroeconomics and has inevitably focused on areas of controversy

and disagreement. However, it would be wrong to conclude that there is

no consensus on a number of key macroeconomics issues. In this final section

we summarize six main areas on which there now appears to be widespread

though by no means unanimous agreement, noting that in some instances this

agreement has only been reached after intense debate and controversy. The

present consensus view among macroeconomists can be characterized as


1. The trend movement of real GDP is primarily driven by supply-side

factors. As such, in the long run, the growth of real GDP depends upon

increases in the supply of factor inputs and improvements in the state of

technology (Solow, 1997). While there are various policies governments

can adopt to influence economic growth – including encouraging education

and training, capital formation, and research and development –

there is continuing debate over what is the best way to increase the

economy’s productive capacity and what role the government can and

should play in encouraging growth. Economists now are also much more

aware of the importance of undertaking research into the deeper determinants

of economic growth and the need for growth theories to account

for the growth experiences of both the Malthusian era and the era of

modern growth.

2. Real GDP fluctuates around a rising long-term trend and short-run

fluctuations in real GDP are primarily caused by aggregate demand

shocks. As we have seen, real business cycle theorists, such as Prescott,

challenge this consensus view, arguing that fluctuations in real GDP

are driven predominantly by persistent supply-side shocks and are

fluctuations in the natural rate of output, not deviations of output from

a smooth deterministic trend. The reason why movements in aggregate

demand can influence real output is linked to the presence of nominal

rigidities. Macroeconomists also debate whether governments cause

instability and what policies they can and should pursue to reduce

short-run fluctuations in economic activity. In attempting to identify

the main cause of cycles emphasis is placed on various sources of

aggregate demand shocks, including fluctuations in autonomous expenditures

(for example Keynesians and Post Keynesians); monetary shocks

(for example monetarists, new classicists and Austrians); and political

distortions to macroeconomic policy (for example political business

cycle theorists). Interestingly, compared with the experience of the

Great Depression, fluctuations in real GDP in the post-Second World

War period have been relatively minor – the main exceptions being the

periods following the two adverse OPEC oil price (supply) shocks and

the period of disinflation in the early 1980s in the USA and Europe. As

Solow (1997) comments, ‘fluctuations around trend are contained within

a moderately narrow corridor’.

3. While the authorities face a short-run trade-off between inflation and

unemployment, in the long run the trade-off disappears. As Blinder (1997a)

argues, the expectations-augmented Phillips curve ‘has worked very well’

and along with ‘Okun’s Law’ represents a ‘sturdy empirical relationship’.

In the short run it is widely accepted that the authorities can reduce

unemployment below the natural rate by engaging in expansionary aggregate

demand policies. Reducing unemployment involves a short-run

trade-off as inflation increases. Alternatively, enacting contractionary

aggregate demand policies which reduce inflation involves a short-run

trade-off as unemployment increases. In the long run, however, there is

no trade-off between inflation and unemployment. A corollary is that in

the long run the authorities can achieve a lower rate of inflation with no

change in the natural rate of unemployment, and that to reduce the

natural rate, which is held to be independent of the level of aggregate

demand, requires microeconomic (aggregate supply management) policies

which improve the structure and functioning of the labour market.

Some new Keynesians would add one important qualification to this

consensus view, namely that in circumstances where the actual rate of

unemployment remains above the natural rate for a prolonged period, the

natural rate (or what new Keynesians would prefer to refer to as NAIRU)

will tend to increase due to hysteresis effects. In other words, some new

Keynesians argue that the natural rate (or NAIRU) can be affected by the

level of aggregate demand (Blanchard, 1997b).

4. In the long run the rate of growth of the money supply determines the

rate of inflation. Friedman has convinced the majority of the profession

and policy makers that sustained inflation is a monetary phenomenon

and that the main aim of monetary policy should be the pursuit of a low

and stable rate of inflation. Indeed, many countries now have a long-run

inflation target with monetary policy directed to keep the growth of

aggregate demand stable in order to create macroeconomic stability.

5. In contrast to the dominant Keynesian view held in the 1950s and early

1960s, it is now widely accepted that governments should not attempt to

‘fine-tune’ their economies in order to keep output and employment

close to, or at, their full employment or natural levels using discretionary

aggregate demand policies. Most economists now accept that the stabilizing

potential of activist discretionary fiscal policy is at best limited

and that the stabilizing role of fiscal policy lies embedded in automatic

stabilizers. Furthermore, there has been a marked change of focus away

from fiscal policy towards monetary policy as the main tool of stabilization

policy. The modern discussion over rules versus discretion involves that

between advocates of flexible Taylor-type rules versus those who favour

rough-tuning. With respect to monetary policy there are few remaining

advocates of Friedman’s hard core monetarist prescription for a k per

cent rule for money growth. The empirical evidence also indicates that in

the short run monetary policy has real effects, so both the ‘classic

Keynesian and vintage RBC view about the cyclical ineffectiveness of

monetary policy has been buried’ (Eichenbaum, 1997).

6. Again, in contrast to the 1950s and 1960s when stabilization was regarded

as a control-theory problem, it is now viewed as a game-theoretic

problem. The insight that the policy regime adopted by the authorities

affects people’s expectations and behaviour is now widely accepted. So

too is the importance given to establishing the credibility of policy and

the design of institutions to conduct credible policy, as evidenced by the

increasing attention given to the issue of central bank independence.

Furthermore, most economists agree that the short-run output/employment

costs of disinflation will be less if policy is credible. While Taylor

(1997b) includes the rational expectations hypothesis in his core of practical

macroeconomics, Solow (1997) remains a sceptic.

To sum up, ‘the good news for policymakers is that there is indeed a core of

usable macroeconomics; the good news for macroeconomic researchers is

that there is a lot of work still to be done’ (Blanchard, 1997b).

As to the future course of macroeconomics, two main pathways immediately

stand out. First, real business cycle models are likely to be integrated

more into the mainstream (Danthine, 1997). Certainly over recent years a

number of real business cycle models have introduced nominal rigidities

which allow for the short-run effects of money on output and employment.

Second, there is likely to be continuing interest shown in new growth theory

and empirics, and especially the now burgeoning research into the deeper

determinants of growth (Temple, 1999; Rodrik, 2003). By providing a better

understanding of the growth process, the renaissance of growth analysis

holds out the prospect of providing insights which may prove invaluable in

helping design policies which could make a significant difference to longterm

growth rates and living standards. In particular, research that integrates

important ideas from economic history, development economics, new political

economy and modern growth theory literature is likely to provide important

new insights into the growth process (see, for example, Galor and Weil, 2000;

Acemoglu and Robinson, 2003).

David Romer (2003) argues that in many cases the adoption of inefficient

policies that reduce welfare has been due to individuals and policy makers

having biased or irrational beliefs (‘misconceptions’) about how the economy

works. This implies that economists need to ensure that those individuals

who are engaged in making important policy decisions are at least aware of

the major research findings of economists. In turn, economists need to appreciate

how strategic interaction among individuals and groups that represent

different interests can distort policy making.

In our broad survey of the development of macroeconomics we have

shown that while the objectives of macroeconomic policy have remained

largely unchanged, there have been significant shifts in policy makers’ views

about how the economy works which in turn have led to major changes in the

conduct of macroeconomic policy. These changes have occurred largely as a

result of improvements in economic understanding driven by the research of

economists. The evolution of thinking on the Phillips curve trade-off between

inflation and unemployment provides an excellent example of how developments

in economic theory and empirical evidence have led to a change in

policy makers’ views concerning the feasibility and sustainability of achieving

low unemployment targets using aggregate demand expansion (see Romer

and Romer, 2002, 2004). Another good example is provided by the decision

in May 1997 to give greater independence to the Bank of England. This move

can be directly traced to the research findings of economists.

However, while there has been progress in macroeconomic analysis, our

existing knowledge will always remain incomplete, for, as Alan Greenspan

(2004) notes:

despite extensive efforts to capture and quantify what we perceive as the key

macroeconomic relationships, our knowledge about many of the important linkages

is far from complete and, in all likelihood, will always remain so. Every

model, no matter how detailed or how well designed, conceptually and empirically,

is a vastly simplified representation of the world that we experience with all

its intricacies on a day-to-day basis.

While it remains to be seen what the next significant development will be

in macroeconomics, it is clear that macroeconomics will continue to change

and progress by a process of evolution and/or revolution. One thing we can

be sure about, with regard to the future direction of macroeconomics, is that

it will continue to surprise us just as much as it has done in the past. As Lucas

commented in our interview with him:

when a macroeconomic consensus is reached on an issue (as it has been, say, on

the monetary sources of inflation), the issue passes off the stage of professional

debate, and we argue about something else. Professional economists are primarily

scholars, not policy managers. Our responsibility is to create new knowledge by

pushing research into new, and hence necessarily controversial, territory. Consensus

can be reached on specific issues, but consensus for a research area as a whole

is equivalent to stagnation, irrelevance and death.