Snowdon & Vane Modern Macroeconomics

Modern Macroeconomics

In loving memory of Brian’s parents, Joseph and Margaret Snowdon, and Howard’s father, Philip M. Vane

Modern

Macroeconomics

Its Origins, Development and Current State

Brian Snowdon

Principal Lecturer in Economics in the Newcastle Business

School, Northumbria University, Newcastle upon Tyne, UK

Howard R. Vane

Professor of Economics in the School of Accounting, Finance and Economics, Liverpool John Moores University, Liverpool,

UK

Edward Elgar

Cheltenham, UK • Northampton, MA, USA

© Brian Snowdon, Howard R. Vane 2005

All rights reserved. No part of this publication may be reproduced, stored in a retrieval system or transmitted in any form or by any means, electronic, mechanical or photocopying, recording, or otherwise without the prior permission of the publisher.

Published by

Edward Elgar Publishing Limited

Glensanda House

Montpellier Parade

Cheltenham

Glos GL50 1UA

UK

Edward Elgar Publishing, Inc.

136 West Street

Suite 202

Northampton

Massachusetts 01060

USA

A catalogue record for this book

is available from the British Library

ISBN 1 84376 394 X (cased)

1 84542 208 2 (paperback)

Typeset by Manton Typesetters, Louth, Lincolnshire, UK.

Printed and bound in Great Britain by MPG Books Ltd, Bodmin, Cornwall.

Contents

List of figures		x
List of tables		xiii
Preface		xiv
Acknowledgements		xvii
1	Understanding modern macroeconomics	1
1.1	Macroeconomic issues and ideas	1
1.2	The role of economic theory and controversy	3
1.3	Objectives, instruments and the role of government	7
1.4	The Great Depression	9
1.5	Keynes and the birth of macroeconomics	13
1.6	The rise and fall of the Keynesian consensus	15
1.7	Theoretical schizophrenia and the neoclassical synthesis	21
1.8	Schools of thought in macroeconomics after Keynes	24
1.9	The new political macroeconomics	29
1.10	The renaissance of economic growth research	32
2	Keynes v. the ‘old’ classical model	36
2.1	Introduction	36
2.2	Classical macroeconomics	37
2.3	Employment and output determination	38
2.4	Say’s Law	45
2.5	The quantity theory of money	50
2.6	Keynes’s General Theory	54
2.7	Interpreting the General Theory	57
2.8	Keynes’s main propositions	58
2.9	Keynes’s analysis of the labour market	65
2.10	Keynes’s rejection of Say’s Law	69
2.11	Keynes and the quantity theory of money	69
2.12	Three important interpretations of Keynes	70
2.13	The ‘new’ Keynes scholarship	75
2.14	Causes and consequences of the Great Depression	76
2.15	How to pay for the war	82
2.16	Keynes and international macroeconomics	83

v

vi	Modern macroeconomics
2.17	Keynes’s legacy and the classical revival	85
Interview with Robert Skidelsky		91
3	The orthodox Keynesian school	101
3.1	Introduction	101
3.2	The orthodox Keynesian school	102
3.3	The IS–LM model for a closed economy	102
3.4	Underemployment equilibrium in the Keynesian model	114
3.5	The IS–LM model for an open economy	123
3.6	The Phillips curve and orthodox Keynesian economics	135
3.7	The central propositions of orthodox Keynesian economics	144
Interview with James Tobin		148
4	The orthodox monetarist school	163
4.1	Introduction	163
4.2	The quantity theory of money approach	165
4.3	The expectations-augmented Phillips curve analysis	174

4.4The monetary approach to balance of payments theory and

	exchange rate determination	187
4.5	The orthodox monetarist school and stabilization policy	192
Interview with Milton Friedman		198
5	The new classical school	219
5.1	Introduction	219
5.2	The influence of Robert E. Lucas Jr	220
5.3	The structure of new classical models	223
5.4	Equilibrium business cycle theory	236
5.5	The policy implications of the new classical approach	242
5.6	An assessment	267
Interview with Robert E. Lucas Jr		272
6	The real business cycle school	294

6.1Introduction: the demise of new classical macroeconomics

mark I

294

6.2The transition from monetary to real equilibrium business

	cycle theory	295
6.3	Real business cycle theory in historical perspective	297
6.4	Cycles versus random walks	300
6.5	Supply-side shocks	303
6.6	Business cycles: main features and stylized facts	304
6.7	Real business cycle theory	307
6.8	The structure of a real business cycle model	309

	Contents	vii
6.9	Technology shocks	313
6.10	A real business cycle aggregate demand and supply model	315
6.11	Calibrating the model	320
6.12	Real business cycle theory and the neutrality of money	322
6.13	Measuring technology shocks: the Solow residual	325
6.14	Real business cycle theory and the stylized facts	326
6.15	The policy implications of real business cycle theory	330
6.16	Criticisms of real business cycle theory	332
6.17	Great Depressions: a real business cycle view	336
6.18	An assessment	338
Interview with Edward C. Prescott		344
7	The new Keynesian school	357
7.1	The fall and rise of Keynesian economics	357
7.2	A Keynesian resurgence	358
7.3	New Keynesian economics	361
7.4	Core propositions and features of new Keynesian economics	363
7.5	Nominal rigidities	366
7.6	Dornbusch’s overshooting model	376
7.7	Real rigidities	378
7.8	New Keynesian business cycle theory	396
7.9	Hysteresis and the NAIRU	401
7.10	New Keynesian economics and the stylized facts	408
7.11	Policy implications	409
7.12	Keynesian economics without the LM curve	423
7.13	Criticisms of new Keynesian economics	428
7.14	An assessment of new Keynesian economics	431
Interview with N. Gregory Mankiw		433
8	The Post Keynesian school	451
	Paul Davidson
8.1	Introduction	451
8.2	The significance of the principle of effective demand	453
8.3	Taxonomy	454
8.4	Keynes’s taxonomic attack on Say’s Law	455
8.5	Can relative price changes induce D2 to fill the gap?	457

8.6Investment spending, liquidity, and the non-neutrality of

money axiom

459

8.7What type of an economic system is ‘irrational’ enough to use

	money contracts?	461
8.8	Information, decisions and uncertainty	463
8.9	Classifying decision-making environments	464

viii	Modern macroeconomics
8.10	Keynesian uncertainty, money and explicit money contracts	468
8.11	Conclusions	472
9	The Austrian school	474
	Roger W. Garrison
9.1	The Mengerian vision	474
9.2	The intertemporal structure of capital	475
9.3	Saving and economic growth	479
9.4	The saving–investment nexus	482
9.5	The market for loanable funds	489
9.6	Full employment and the production possibilities frontier	492
9.7	The capital-based macroeconomic framework	496
9.8	Saving-induced capital restructuring	498
9.9	Keynes’s paradox of thrift revisited	501
9.10	The Austrian theory of the business cycle	503
9.11	A Keynesian downturn in the Austrian framework	509
9.12	Inflation and deflation in the Austrian theory	513
9.13	Policy and reform	515
10	The new political macroeconomics	517

10.1Introduction: political distortions and macroeconomic

	performance	517
10.2	Political influences on policy choice	518
10.3	The role of government	521
10.4	Politicians and stabilization policy	523

10.5Alternative approaches to the ‘political business cycle’: an

	overview	525
10.6	The Nordhaus opportunistic model	526
10.7	The Hibbs partisan model	532

10.8The decline and renaissance of opportunistic and partisan

	models	535
10.9	Rational political business cycles	537
10.10	Rational partisan theory	538
10.11	Opportunistic and partisan behaviour: a synthesis	545
10.12	Politics, time inconsistency, credibility and reputation	546

10.13Policy implications of politico-economic models: an

	independent central bank?	549
10.14	The political economy of debt and deficits	554
10.15	Political and economic instability: are they related?	555
10.16	The political economy of economic growth	556
10.17	Political barriers to economic growth	562
10.18	The size of nations	564

	Contents	ix
10.19	Conclusion	565
Interview with Alberto Alesina		567
11	The renaissance of economic growth research	579
11.1	Introduction	579
11.2	The ‘Great Divergence’	580
11.3	In praise of economic history	584
11.4	Back to the long run	585
11.5	Why is economic growth so important?	589
11.6	Modern economic growth in historical perspective	593
11.7	The stylized facts of growth	595
11.8	Proximate v. fundamental sources of growth	596
11.9	The Harrod–Domar model	598
11.10	The Solow neoclassical growth model	602
11.11	Accounting for the sources of economic growth	612
11.12	The convergence debate	614
11.13	Beyond the Solow model	622
11.14	Endogenous growth: constant returns to capital accumulation	625
11.15	Endogenous growth: the economics of ideas	627
11.16	An augmented Solow model: a neoclassical revival?	632
11.17	Focusing on the fundamental causes of growth	633
11.18	Institutions and economic growth	635
11.19	Trade and economic growth	647
11.20	Geography and growth	652
11.21	Growth in history: in search of a unified theory	654

11.22The ideal conditions for growth and development:

	rediscovering old truths	657
Interview with Robert M. Solow		660
Interview with Paul M. Romer		673
12	Conclusions and reflections	695
12.1	Introduction	695

12.2Twentieth-century developments in macroeconomics:

	evolution or revolution?	696
12.3	Is there a consensus on key macroeconomic issues?	703
Bibliography		708
Author index		791
Subject index		803