Snowdon & Vane Modern Macroeconomics

Table 12.1 Some areas of agreement and disagreement in macroeconomics

Rulesv.

discretion

Discretion

Rules

Rules

Rules

Constrained

discretion

Rules

Discretion

Dominant

timeframe

Short

Shortand

long

Long=short

Long=short

Predominantly

short

Shortandlong

Short

Notionof

equilibrium

Stateofrest

probablybelow

full

employment

Marketclearing

atnaturalrate

Marketclearing

atnaturalrate

Marketclearing

atmoving

naturalrate

Consistentwith

involuntary

unemployment

Tendency

towards

Stateofrest

probablybelow

fullemployment

Market

adjustment

Weak

Strong

Very

strong

Very

strong

Slow

Strong

Very

weak

Price/wage

adjustment

Emphasis

onnominal

wage

rigidity

Flexible

Perfectly

flexible

Perfectly

flexible

Emphasis

onprice

rigidities

Flexible

Sticky

Expectations

Adaptive

Adaptive

Rational

Rational

Rational

Reasonable

Reasonable

Dominant

sourceof instability

Fluctuationsin

autonomous

expenditure

Monetary

disturbances

Monetary

disturbances

Supplyshocks

(mainly

technological)

Demandand

supplyshocks

(eclectic)

Monetary

disturbances

Fluctuationsin

autonomous

expenditure

Schoolsin

macroeconomics

OrthodoxKeynesian

Orthodoxmonetarist

Newclassical

Realbusinesscycle

NewKeynesian

Austrian

PostKeynesian

702

Conclusions and reflections

703

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.

12.3Is 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 follows:

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

704	Modern macroeconomics

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).

Conclusions and reflections

705

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

706	Modern macroeconomics

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

Conclusions and reflections

707

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.

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