Macroeconomics in the 20th Century, progress Georgia Bush In the long run we are all dead Economists

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Macroeconomics in the 20th Century,
progress?Georgia BushIn the long run we are
all dead Economists set themselves too easy,
too useless a task if in tempestuous seasons they
can only tell us that when the storm passes the
ocean is flat again.

• Prepared for Rutgers Economics Department Macro
  Study group April 7, 2009

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Outline

• The Great Depression ? Macroeconomics
• Neo-classical-Keynesian Synthesis
• The Great Inflation ? Classical critique
• New-Keynesian rebuttal
• Where are we now
• A Baseline New Keynesian Model
• Progress?

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The Great Depression ? Macroeconomics

• Macroeconomics as a term first appeared in the
  1940s (Lawrence Klein)
  
• Precursors
• Mostly single market models, supply and demand
• 1940s Post Depression
• Key questions pertained to the extreme economic
  environment
  
• In 1933 US unemployment 25, real GDP 31 below
  1929 level
  
• Revolutionary of the day John Maynard Keynes The
  General Theory (1936)
  
• IS-LM model (Hicks, 1937) dynamics of general
  equilibrium made user-friendly
  
• Simplification but highly popular
• Large applied econometrics models (Klein,
  Eckstein, Ando and Modigliani)
  
• By the 1960s, many competing models built for
  policy analysis and forecasting

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Keynesian content and practice

• Keynes innovations simultaneous determination
• de-emphasized business cycle dynamics
• focused on cross-market influences
• determination of a set of key variables
  simultaneously
  
• Stabilization policy required and effective
• Ramifications of Keynesian theory
• For government
• Greater responsibility for macroeconomic
  management
  
• Tools now available to analyze potential effects
  of policy choices
  
• A way to understand extended periods of market
  failure, sticky prices sticky wages
  
• For macroeconomics
• Concept of general equilibrium theory
• Simultaneous-equation modeling in econometrics

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Neo-classical-Keynesian Synthesis

• Key elements of Keynesian theory by the 1960s
• IS curve relating financial conditions and fiscal
  policy to components of GDP
  
• Y C(Y T) I (i expected inflation) G
• LM curve that determines interest rates at the
  price that equilibrates the supply and demand for
  money
  
• M/P L(i,Y)
• Philips curve describing how price level responds
  over time to changes in the output and or
  unemployment
  
• Keynes in the short-run, Classical in the
  long-run
  
• SR Keynesian (prices and wages do not
  instantaneously adjust)
  
• Monetary policy does have real effects
• LR Classical (eventually markets clears)
• Monetary policy ineffectual

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The Great Inflation ? Classical critique

• Keynesian driven public policy coincided with
  rising inflation led to criticism
  
• The Scientists
• Three waves of critique of Keynesian framework
• Monetarism Milton Friedman (and Phelps 1968
  critique)
  
• Philips curve trade-off between inflation and
  unemployment wont hold in long-run (money should
  be neutral in long run).
  
• Cause of empirically observed trade-off
  expectations, ie unanticipated inflation can
  lower employment
  
• Variations in money supply more important than
  fiscal policy (MPC small)
  
• Rational expectations Robert Lucas (1976
  critique)
  
• Large models based on unchanging relationships
  flawed
  
• Exploitable tradeoffs between inflation and
  unemployment will disappear because agents are
  rational, they will change behavior when they
  observe policy
• Monetary policy only has an effect if
  unanticipated (if truly a surprise to people)
  
• Real Business Cycle theory Kydland and Prescott
  (1982)
  
• Random shocks to technology primary driver of
  cycles
  
• Agent maximizes through inter-temporal
  substitution of consumption leisure
  
• Assumed prices adjust instantly to clear markets
• Omitted any role for monetary policy at all

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New-Keynesian rebuttal

• The Engineers
• Three waves of New Keynesians
• General Equilibrium (Barro and Grossman, 1971)
• Tools of general equilibrium to analyze
  situations when markets do not clear
  
• Policy prescription stimulus to demand can have
  multiplier effects thus overcoming detrimental
  cycle of insufficient demand
  
• Rational expectations without market clearing
  (Fischer, 1977)
  
• Response to Lucas critique, desire to model
  empirical inflation dynamics with rational
  actors
  
• Policy prescription systematic monetary policy
  aimed at stabilization can work
  
• Causes of price and wage sticky-ness
• Menu costs changing prices incur costs, tiny
  costs such reprinting menus can deter price
  adjustment and thus lead to aggregate price
  sticky-ness
• efficiency wages firms pay above market wages
  in order to induce efficiency
  
• Monopolistic firms, price-setting power ? markup
  for individual firm rational despite lowering
  aggregate demand
  
• Policy prescription nominal rigidities
  theoretically possible, therefore government
  demand management policy desirable

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New-Keynesian content and practice now

• The New Neoclassical Synthesis
• Uses new science of DSGE theory
• Built on micro-foundations of preferences,
  constraints, optimization
  
• Uses New Keynesian theory of nominal rigidities,
  monopolistic firms
  
• Policy prescription monetary policy has real
  effects in the short run
  
• Key elements of New Keynesian theory now
• IS curve
• Monetary Policy anchor
• Philips curve (augmented price stickyness)
• Ramifications of New Keynesian theory
• For government
• Responsibility for macroeconomic management
  continues
  
• Souped-up tools available to analyze potential
  effects of policy choices
  
• A way to understand extended periods of market
  failure, sticky prices sticky wages in
  framework with rational expectations

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New-Keynesian content and practice now

• Goodfriend and King The New Neoclassical
  Synthesis and the Role of Monetary Policy
  (1997)
  
• Ironically, in spite of the fact that Keynesian
  effects of monetary policy on real activity are
  powerful in NNS models, monetary policy is best
  when it eliminates Keynesian effects entirely.
• Monetary policy has real effects
• Variation in average markup (reciprocal of real
  marginal cost) affect marginal factor returns and
  thus economic activity
  
• Recommend stabilization policy targeting constant
  markup ie inflation near 0
  
• Favor monetary policy even more than the 1960s
  theorists
  
• Expectations central success requires credible
  commitment to low inflation
  
• A Baseline New Keynesian model in brief
• RBC monopolistic competition sticky prices
  IS-monetary policy-New Keynesian Phillips Curve
  (AS)
  
• What follows draws on Professor Jae Won Lees
  lecture notes for Macro II

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Baseline New Keynesian model IS

• Households problem ? IS curve

Subject to
Optimality conditions imposing market clearing
In every period Y C, money demanded is
supplied, all state contingent assets supplied
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Baseline New Keynesian model LM

• Money demand equation ? LM curve
• Use interest rate specification of monetary
  policy to close the model
  
• Interest rate rules such as Taylor rule

If concerned about money dynamics can construct a
money demand function L and model money supply in
several ways assume exogenous process for money s
upply and as a short-cut use quantity equation
MxV PxY use Friedmans rule, maintain constant m
oney supply growth add money to an RBC model by i
ncluding in the utility function (MIU) with the
idea that individuals gain utility from holding
real balances However money demand function not n
ecessary for NK model, no LM
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Baseline New Keynesian model PC (AS)

• Firms problem ? Phillips Curve (Aggregate Supply
  curve)
  
• Monopolistic competition
• allows for a firms optimal relative price
  markup x marginal cost
  
• Price sticky-ness using Calvo model
• price sticky-ness as a random variable a
• in each period a portion of firms (a) experience
  price sticky-ness and cannot change their prices,
  (1 - a) can adjust their prices
  
• strategic complement condition firms that can
  change their prices, wont change them by much
  
• Thus the firm is maximizing with some positive
  probability that it will not be able to adjust
  prices for an extended period of time
  
• Aggregate price dynamics
• A weighted sum of sticky price and adjusted
  price
  

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Baseline New Keynesian model PC (AS)

• Firms problem ? Phillips Curve (Aggregate Supply
  curve)
  

Subject to

Optimality conditions (from which the NK Phillips
Curve is constructed)
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Baseline New Keynesian model PC (AS)

• New Keynesian Phillips Curve (Aggregate Supply
  curve)
  

Result Monetary shocks have persistent real
effects output responds changing by some positiv
e amount (lambda between 0 and 1)
Empirical evidence suggests output takes 40-50
quarters to return to natural level
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Baseline New Keynesian model PC (AS)

• New Keynesian Phillips Curve (Aggregate Supply
  curve)
  

Result Monetary shocks have persistent real
effects lambda between 0 and 1 Com
pared to other models impulse response functions
for a monetary shock
Under flexible prices no effect
Under Neo classical 1 period effect
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Professor Jae Won Lees slide
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Progress? Mankiws view

• Mankiw
• New Keynesian picking up from where they left off
  in 1970s
  
• Wasted energy on showing market failure possible
  and rebutting classical critiques, perhaps Great
  Inflation from measurement error (CB should
  respond more than one to one to inflation)
• Still uncompelling Philips Curve
• models of the 1960s still used by Fed,
• New Keynesian (AND Neo-Classical) little
  influence, not useful
  
• On the other hand,
• neo-classicists shouldnt take credit for Great
  Moderation
  
• low inflation not necessarily due to rules based
  monetary policy and inflation targeting, yes CB
  independence has risen, but this does not equal
  rules based policy (look at US)
• Inflation targeting in practice more like a
  communication framework rather than a rule
  
• Empirical study in 2005 shows inflation targeting
  does not help explain the recent move to low,
  stable inflation. Policy has improved in
  countries with and without targeting

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Progress? Woodfords view

• Woodford
• The dynamics of moving from Short-Run market
  failure to Long-Run market clearing still
  unaddressed and key to future research
  
• Consensus today
• Inter-temporal general equilibrium (LR and SR in
  same model)
  
• Econometrically validated structural models (not
  reduced form)
  
• Model expectations as endogenous
• Real disturbances important source of economic
  fluctuation
  
• Monetary policy effective, especially to control
  inflation
  
• Disagreement
• not enough scientific rigor vs too much
• Policy tools have changed significantly vs have
  not

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Progress? from the horses mouth

• Joseph Schumpeter in on the New Deal quoted in
  Woodfords paper recovery is sound only if it
  does come of itself. For any revival which is
  merely due to artificial stimulus leaves part of
  the work of depressions undone and add, to an
  undigested remnant of maladjustment, new
  maladjustment. (published in 1934)
• Gunnar Myrdal Swedish biz cycle theorist
  perhaps the whole attitude of the Austrian
  school was ultimately based upon a primitive
  puritanism happiness is somehow evil, something
  immoral, which should be accompanied by a
  purifying misery now and then in order that those
  who have experienced it may be redeemed and so
  it is only proper, right and natural that after
  the upswing, with all its sad mistakes, bad times
  should follow. (words originally published in
  Swedish in 1931)
• Quentin Peel, FT commentator yesterday
  Expectations in 2007 and 2008 of a decoupling
  between crisis-hit economies of the west and the
  less exposed emerging markets have vanished. The
  pain is global and the solution had to be too.
• Debate concerning free market and role of
  government intervention I doubt will ever end as
  long as there are governments and individuals (so
  we will always have a job).

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My conclusion Optimistic

• Mankiw contrasts engineers and scientists.
  Unsatisfactory metaphor
  
• scientists mathematicians, physicists, chemists,
  biologists, psychologists, sociologistsspectrum,
  where does social science fit
  
• Content and techniques characterize the
  discipline
  
• Changes LM curve dispensed with, Phillips Curve
  upgraded substantially, IS and PC derived from
  optimizing economic agents
  
• Fertile ground analyzing the behavior of
  individuals to evaluate effectiveness of policy
  
• Examples of psychology in economics
• behavioral finance, systemic risk, asymmetry of
  values or utility (ie risk tolerance, consumer
  choice context specific, (framing, sequence of
  choices ie preferences not transitive), MPC (not
  stable)
• We can continually upgrade the machinery, the
  technology, but this has ramifications for
  consistency. Is it appropriate to use math to
  model humans? Definitely, but always an imperfect
  world.
• Rational expectations revolution picked up on
  this, if we are to ground macro in the behavior
  of optimizing agents (micro-foundations), better
  be sure of what micro assumptions underline the
  behavior of those agents. Appropriate
  simplifications for the purpose at hand (whether
  building theory or evaluating policy)

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References, a very short list

• Empirical evidence of monetary policy effects
• Bernanke, Ben S., and Ilian Mihov (1998),
  "Measuring Monetary Policy," Quarterly Journal of
  Economics 113, 869-902.
  
• Christiano, Lawrence J., Martin Eichenbaum, and
  Charles L. Evans (1999), "Monetary Policy Shocks
  What Have We Learned and To What End?" in Taylor,
  John B., and Michael Woodford, eds., Handbook of
  Macroeconomics, vol. 1A, North-Holland.
• Sims (1980), Macroeconomics and Reality,
  Econometrica 48, no. 1, 1-48.
  
• Sims (1992), Interpreting Macroeconomic Time
  Series Facts The Effects of Monetary Policy,
  European Economic Review 36, 975-1101.
  
• Bills and Klenow (2004), Some Evidence on the
  Importance of Sticky Prices, Journal of
  Political Economy 112, no 5, 947-985.
  
• Theory History
• Woodford, Michael (1999), Revolution and
  Evolution in 20th Century Macroeconomics, and
  Convergence in Macroeconomics Elements of the
  New Synthesis (2008) both from his website.
• Gottfried, Haberler, Prosperity and Depression,
  Geneva League of nations, 1937, provides a
  review of the pre-Keynesian literature.
  
• Hicks, John R. (1937), Mr. Keynes and the
  Classics A suggested Interpretation,
  Econometrica 5 pp. 147-159.
  
• Mankiw, N. Gregory (2006), The Macroeconomist as
  Scientist and Engineer, The Journal of Economic
  Perspectives, Vol. 20, No. 4 (Oct., 2006),
  pp.29-46.
• Goodfriend and King (1997), The New Neoclassical
  Synthesis, NBER Macroeconomics Annual 1997,
  231-282
  
• Books
• Gali, Monetary Policy, Inflation and the Business
  Cycle, Princeton University Press, 2008
  
• Chapter 2 covers the classical model in detail
  and its shortcomings.
  
• Walsh, Monetary Theory and Policy, The MIT Press
  2nd edition, 2003
  
• Chapter 1 gives a nice summary of the empirical
  work on the short run and long-run relationships
  between money, prices and output and the debate
  about causality.