a brief history of macroeconomics
TRANSCRIPT
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A BRIEF HISTORY OFMACROECONOMICS
JUNE 8, 2011
June 8, 2011 2
THE PHASES OF MACROECONOMICS
The Evolution of Macroeconomics
Three seminal phases of the history of macroeconomicthought/practice
Phase I: Measuring macroeconomic activity (1930s 1950)
Phase II: Keynesian-inspired macroeconometric models (1950 1970s)
Phase III: Dynamic General Equilibrium (DGE) methodology (1980s today)
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June 8, 2011 3
THE BIRTH OF MACROECONOMICS
The Evolution of Macroeconomics: Phase I
Macroeconomics born as a field during and because of the GreatDepression
Idea that government could/should regulate the periodic ups anddowns of the economy rose to prominence
John Maynard Keynes, The Gene r a l Theo r y o f E mp loy men t ,I n te r es t , and Money (1936)
Basic tenet: various rigidities in many markets lead to disequilibriathat can last a long time
Burns and Mitchell, Measur ing Bus iness Cyc les (1946)
First systematic accounting of the co-movement of various aggregates
i.e., GDP, consumption, employment, inflation, unemployment rate, etc
June 8, 2011 4
LONG-RUN GROWTH VS. BUSINESS CYCLES
Macro Fundamentals
Decompose time series into trends and cycles
Two clear patterns
Long-run growth
Frequent and sometimes big short-run fluctuations around long-run
trend
time
Actual GDP (orvirtually any real
economic series)
Long-run trend of GDP
-- a linear trend verysimple; but can also
construct (more nuanced)nonlinear trends (statisticsand econometrics)
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June 8, 2011 5
LONG-RUN GROWTH VS. BUSINESS CYCLES
Macro Fundamentals
Decompose time series into trends and cycles
Two clear patterns
Long-run growth
Frequent and sometimes big short-run fluctuations around long-runtrend
Are the short-run fluctuations tightly related to the long-run trend?
Conventional view in economics has been no But (very) recent work provocatively suggests answer may be yes
Linkage through R&D: R&D typically thought to be a driver of long-rungrowthbut perhaps cyclical fluctuations in R&D themselves haveconsequences for business cycles (much more research needed here)
time
Actual GDP (orvirtually any real
economic series)
Long-run trend of GDP
-- a linear trend very
simple; but can alsoconstruct (more nuanced)nonlinear trends (statisticsand econometrics)
June 8, 2011 6
LONG-RUN GROWTH VS. BUSINESS CYCLES
Macro Fundamentals
Decompose time series into trends and cycles
Two clear patterns
Long-run growth
Frequent and sometimes big short-run fluctuations around long-run
trend
Are the short-run fluctuations tightly related to the long-run trend?
Conventional view in economics has been no
Under the no view, a separation of fields
Studying the trend (economic growth and development)
Studying the fluctuations (macroeconomics)
time
Actual GDP (orvirtually any real
economic series)
Long-run trend of GDP
-- a linear trend verysimple; but can also
construct (more nuanced)nonlinear trends (statisticsand econometrics)
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June 8, 2011 7
BUSINESS CYCLES
Macro Fundamentals
Decompose time series into trends and cycles
time
Actual GDP (orvirtually any real
economic series)
Long-run trend of GDP
-- a linear trend very
simple; but can alsoconstruct (more nuanced)nonlinear trends (statisticsand econometrics)
time0
Highlight the business cycle movements by subtracting trendGDP from actual GDP (i.e., red line minus blue line)
Procedure referred to as detrending macroeconomic data
What explains business cycles?
June 8, 2011 8
PRINCIPLES OF KEYNESIAN MACROECONOMICS
The Evolution of Macroeconomics: Phase I
Basic Tenet: price rigidities/inflexibilities characterize many goodsmarkets and factor markets
Sticky prices
(Many) other rigidities/inflexibilities affect markets functioning aswell
but price (and wage) rigidities the central tenet
More general discussion in Akerlof (2007) essay
Which types ofshocks are the main driver of business cycles?
Policy shocks both monetary policy and fiscal policy
A basis for policy activism: because of high elasticity of private-sector demand to macroeconomic policy, when/ifother (i.e., non-policy) types of shocks affect the economy, monetary and fiscalpolicy can and should step in to mitigate recessions/depressions
Keynes Genera l Theor y just a verbal description of things
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June 8, 2011 9
THE RISE OF MACROECONOMICS
The Evolution of Macroeconomics: Phase II
Macroeconomics born as a field during and because of the GreatDepression
Idea that government could/should regulate the periodic ups anddowns of the economy rose to prominence
John Maynard Keynes, The Gene r a l Theo r y o f E mp loy men t ,I n te r es t , and Money (1936)
Basic tenet: various rigidities in many markets lead to disequilibriathat can last a long time
Burns and Mitchell, Measur ing Bus iness Cyc les (1946)
First systematic accounting of the co-movement of various aggregates
i.e., GDP, consumption, employment, inflation, unemployment rate, etc
How to model (i.e., conceptually/rigorously/mathematicallythink about) business cycles?
Phase II: The big macroeconometric models
June 8, 2011 10
THE GLORY DAYS OF MACROECONOMICS
The Evolution of Macroeconomics: Phase II
Big Keynesian macroeconometric models prominent by the1960s, led by
Kennedys Council of Economic Advisers (Solow, Tobin, Samuelson)
MIT/Penn/Federal Reserve Board
ISLM and AS/AD model (Hicks, 1937) the conceptual core
1 0 2 1 3 2 3
2 3 1 4 3 5 4
136 5987 1 5988 1 3 5989 69
....
...
...
t t t t
t t t t
t t t t
x x x x
x x x x
x x x x
= + + +
= + + +
= + + +
General idea of Keynesian-inspiredmacroeconometric models
Dozens or hundreds ofvariables and equations
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June 8, 2011 11
THE GLORY DAYS OF MACROECONOMICS
The Evolution of Macroeconomics: Phase II
Big Keynesian macroeconometric models prominent by the1960s, led by
Kennedys Council of Economic Advisers (Solow, Tobin, Samuelson)
MIT/Penn/Federal Reserve Board
ISLM and AS/AD model (Hicks, 1937) the conceptual core
Statistical relationships between various macro variables
Basic approach: estimate (econometrically) these equations anduse them for policy advice
In particular: estimate all the alpha coefficients using historical dataand posit that this is h ow the macroeconomy works
An approach to macroeconomic policy-making embodied mostsuccinctly in the view and supposed promise of the Phillips Curve
1 2 3
2 1 4
0 1 2
3 4 5
5987 5988 5136 1 98
3
13 9 69
3
....
...
...
t t t
t t t
t
t
t
tt t
x x x
x x x
x x x x
x
x
= + + +
= + + +
= + + +
Dozens or hundreds ofvariables and equations,some of which describe
how policy affects theeconomy
Say x3 and x13 are policyvariables
Its all about estimating the
alpha terms
General idea of Keynesian-inspiredmacroeconometric models
June 8, 2011 12
THE PHILLIPS CURVE
The Evolution of Macroeconomics: Phase II
A seemingly stable, predictable relationship between an economysinflation rate and unemployment rate
Came to be the centerpiece of the Keynesian macroeconometricagenda
Came to be the centerpiece for policy advice
for fiscal policy (given forceful voice during the Kennedyadministration CEA populated with future Nobel Laureates RobertSolow, James Tobin, Paul SamuelsonJohn Kenneth Galbraith a moremuted enthusiast of this approach to policy formulation)
and eventually for monetary policy (rise of an activist Fed:raising/lowering interest rates to fine tune macroeconomicperformance
unemployment rate
inflationrate
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June 8, 2011 13
THE GLORY DAYS OF MACROECONOMICS
The Evolution of Macroeconomics: Phase II
Big Keynesian macroeconometric models prominent by the1960s, led by
Kennedys Council of Economic Advisers (Solow, Tobin, Samuelson)
MIT/Penn/Federal Reserve Board
ISLM and AS/AD model (Hicks, 1937) the conceptual core
Became widely used for policy-making
General idea of Keynesian-inspiredmacroeconometric models
One of these equations is thePhillips Curve
1 2 3
2 1 4
0 1 2
3 4 5
5987 5988 5136 1 98
3
13 9 69
3
....
...
...
t t t
t t t
t
t
t
tt t
x x x
x x x
x x x x
x
x
= + + +
= + + +
= + + +
Dozens or hundreds ofvariables and equations,some of which describe
how policy affects theeconomy
Say x3 and x13 are policyvariables
June 8, 2011 14
THE FALL OF MACROECONOMICS
The Evolution of Macroeconomics: Phase II
Big Keynesian macroeconometric models prominent by the1960s, led by
Kennedys Council of Economic Advisers (Solow, Tobin, Samuelson)
MIT/Penn/Federal Reserve Board
ISLM and AS/AD model (Hicks, 1937) the conceptual core
Became widely used for policy-making
until they stopped working in the 1970s Amidst a high-inflation environment (U.S. inflation between 15-20% in
second half of 1970s), sparked by OPEC oil embargoes
Lucas Critique (1976): The alphas themselves should be thoughtof / modeled as f unc t i ons of government policy!
1 2 3
2 1 4
0 1 2
3 4 5
5987 5988 5136 1 98
3
13 9 69
3
....
...
...
t t t
t t t
t
t
t
tt t
x x x
x x x
x x x x
x
x
= + + +
= + + +
= + + +
Dozens or hundreds ofvariables and equations,some of which describehow policy affects the
economy
Say x3 and x13 are policyvariables
General idea of Keynesian-inspiredmacroeconometric models
One of these equations is thePhillips Curve
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June 8, 2011 15
THE LUCAS CRITIQUE
The Evolution of Macroeconomics: Between Phase II and Phase III
Crucial inconsistency in Keynesian macroeconometric approach
The estimated coefficients (the alphas) themselves may change ifpolicy (monetary and/or fiscal) changes!
In which case the macroeconometric approach cannot usefully givepolicy advice unless one knows/makes assumptions about how thealphas themselves depend on policy
Discovered in the 1970s amidst world-wide macroeconomicturbulence caused (seemingly) by the two oil crises
The usual Phillips relation stopped working even as policy-makerstried harder than ever to exploit it
Led to breakdown of existing macroeconomic theory and opened thedoor for a complete re-thinking of the basic tenets of macroeconomics
Keynesian macroeconometric models are n o t e co n o m i c m o d e l s
Merely a statistical description of historical events Economics: the study of how incentives influence behavior of
individuals/market participants
A damning criticism of the entire macroeconomics profession
This problemwas alwayspresent, butdidnt revealitself until the1970s
June 8, 2011 16
THE FALL OF MACROECONOMICS
The Evolution of Macroeconomics: Phase III
Macroeconomics born as a field during and because of the GreatDepression
Idea that government could/should regulate the periodic ups anddowns of the economy rose to prominence
John Maynard Keynes, The Gene r a l Theo r y o f E mp loy men t ,I n te r es t , and Money (1936)
Basic tenet: various rigidities in many markets lead to disequilibriathat can last a long time
Burns and Mitchell, Measur ing Bus iness Cyc les (1946)
First systematic accounting of the co-movement of various aggregates
i.e., GDP, consumption, employment, inflation, unemployment rate, etc
How to model (i.e., conceptually/rigorously/mathematicallythink about) business cycles?
Phase II: The big macroeconometric models
Death knell spelled by the devastating Lucas Critique
Phase III: Microeconomic foundations and DGE modeling
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June 8, 2011 17
THE REBIRTH OF MACROECONOMICS
The Evolution of Macroeconomics: Phase III
Kydland and Prescott (1982), Long and Plosser (1983)
A dynamic general equilibrium (DGE) view of business cycles
A real business cycle (RBC)
TFP shocks the driving force, not policy shocks
Business cycles are efficient and natural
so macroeconomic policy aimed at stabilizing cycles is
unimportant/misguided
An economic theory, not a statistical theory
Building blocks
Consumer preferences
Production technology
Interactions through markets (goods, labor, and financial markets)
The alphas are functions of policy variables (if policy variablespresent in the model)
thus immune to Lucas Critique
June 8, 2011 18
PRINCIPLES OF RBC MACROECONOMICS
The Evolution of Macroeconomics: Phase III
Basic Tenets
Markets operate (nearly) perfectly competitively
Price rigidities/inflexibilities are n ot very important conceptual breakfrom Keynesian principles
Model the economic interactions, not merely the statisticalrelationships methodological break from Keynesian principles
Which types ofshocks are the main driver of business cycles?
TFP shocks (not policy another conceptual break from Keynesianism)
How to measure TFP? As a residual, using Cobb-Douglasproduction function
1output ( , )t t t t t t t A f k n A k n
= =
Whats left overafter accounting for what we can account for
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June 8, 2011 19
PRINCIPLES OF RBC MACROECONOMICS
The Evolution of Macroeconomics: Phase III
Basic Tenets
Markets operate (nearly) perfectly competitively
Price rigidities/inflexibilities are n ot very important conceptual breakfrom Keynesian principles
Model the economic interactions, not merely the statisticalrelationships methodological break from Keynesian principles
Which types ofshocks are the main driver of business cycles?
TFP shocks (not policy another conceptual break from Keynesianism)
How to measure TFP? As a residual, using Cobb-Douglasproduction function
1output ( , )t t t t t t t A f k n A k n
= =
Whats left overafter accounting for what we can account for
1.1161617.62010
1.2161619.22009
1.291614.420081.091612.02007
TFPLaborCapitalOutputPeriod
Suppose alpha =
0.5 for simplicity
(U.S. economy:alpha 0.30)
Productivity improved between 2007 and 2008
Productivity stagnated between 2008 and 2009
Productivity declined between 2009 and 2010
EXAMPLE
June 8, 2011 20
PRINCIPLES OF RBC MACROECONOMICS
The Evolution of Macroeconomics: Phase III
Shocks to TFP are persistent
Once A t rises unexpectedly, TFP tends to stay elevated for multipleperiods
Example: IfA2000 > A1999, then A2001 is likely to be higher than A1999 aswell, but not as large as A2000
A slowly-dampening time-profile of TFP
RBC view
Persistent TFP shocks the driver of business cycles
NOT policy shocks
time
The periodof theshock
Gradual return to steady-state
steady-state TFP
Detrended TFPseries (i.e., actualTFP displayslong-run growth)
Over two-thirds ofbusiness-cyclefluctuations driven byTFP shocks
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June 8, 2011 21
RBC MECHANISM: AN EXAMPLE
The Evolution of Macroeconomics: Phase III
Positive TFP shock occurs (i.e., TFPrises)
Effect on labor market: rise in A t risein MP Nt shift in labor demand
Effect on capital demand: rise in A trise in A t+1 (because shocks arepersistent) rise in MPKt+1 shift incapital demand
labor
real
wage
D
rise in A
inv
r
investment demandfunction
rise in A
June 8, 2011 22
RBC MECHANISM: AN EXAMPLE
The Evolution of Macroeconomics: Phase III
Positive TFP shock occurs (i.e., TFPrises)
Effect on labor market: rise in A t risein MP Nt shift in labor demand
Effect on capital demand: rise in A trise in A t+1 (because shocks arepersistent) rise in MPKt+1 shift incapital demand
labor
realwage
D
rise in A
inv
r
investment demandfunction
rise in A
S
S
Superimposing the supply sides of thelabor and capital markets:
1. Investment (one of the componentsof GDP) rises
2. EQUILIBRIUM quantity of labor
rises
3. Hence total output (i.e., GDP) rises(because both A t and nt rise)
TFP shocks lead to fluctuations in GDP
What is TFP? Could be
1. Literally technology (better
computers, etc.)
2. Better-educated workers3. More open international trade
4. Financial market conditions
5.
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June 8, 2011 23
UNDERSTANDING EQUILIBRIUM
Macro Fundamentals
Prices coordinate activity of suppliers and demanders (whether P,w, or r; basic idea same in any market)
Macro markets (suppose no taxes anywhere for simplicity)
D
S
equilibrium price
( , )
( , )
l t tt
c t t
u c lw
u c l=
1
'( )1
'( )
tt
t
u cr
u c += +
Consumption-leisureoptimality condition
Consumption-savingsoptimality condition
CONSUMERS
June 8, 2011 24
UNDERSTANDING EQUILIBRIUM
Macro Fundamentals
Prices coordinate activity of suppliers and demanders (whether P,w, or r; basic idea same in any market)
Macro markets (suppose no taxes anywhere for simplicity)
D
S
equilibrium price
( ( , ))t t t n t t
w mpn A f k n= =
( ( , ))t t t k t t
r mpk A f k n= =
Optimal labor demand
Optimal investmentdemand
FIRMS
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June 8, 2011 25
UNDERSTANDING EQUILIBRIUM
Macro Fundamentals
Prices coordinate activity of suppliers and demanders (whether P,w, or r; basic idea same in any market)
Macro markets (suppose no taxes anywhere for simplicity)
Prices anonymously coordinate activity of suppliers and demanders
Invisible hand described by Adam Smith (Wea l th o f N a t i ons , 1776)
D
S
equilibrium price
( , )
( , )
l t tt
c t t
u c lmpn
u c l=
1
'( )1
'( )
tt
t
u cmpk
u c += +
EQUILIBRIUM IN THE LABOR MARKET
EQUILIBRIUM IN THE CAPITAL MARKET
June 8, 2011 26
WHERE IS MACROECONOMICS TODAY?
The Evolution of Macroeconomics: Next?
Keynesian Macroeconomics
Ideology: Price rigidities/sticky prices
Policy stance: policy (fiscal and monetary) of crucial importance formacroeconomic performance
Methodology: econometric/statistical modeling
RBC Macroeconomics
Ideology: Prices are not rigid or sticky
Policy stance: policy (neither fiscal nor monetary) not very importantfor macroeconomic performance
Methodology: dynamic general equilibrium modeling
New Keynesian Macroeconomics
Ideology: Price rigidities/sticky prices Policy stance: policy (fiscal and monetary) of crucial importance for
macroeconomic performance
Methodology: dynamic general equilibrium modeling
A central issue in macroeconomics: monetary neutrality?
Does monetary policy have long-lasting effects on rea l economy?
The enduring imprint of the RBC revolution
Empirical evidence still EXTREMELY mixedon this