1. Center for the History of Political Economy Summer School June 2014 1 History of Modern Macroeconomics Lecture 3.4. The Empirical Microfoundations of Macroeconomics (1945-1970) Kevin D. Hoover Department of Economics Department of Philosophy Center for the History of Political Economy Duke University

2. Center for the History of Political Economy Summer School June 2014 2 Two Macroeconomic Traditions of the 1930s – 1 Frisch/Tinbergen:  micro/macro distinction  macro dominates micro  problem of aggregation ignored  supported econometrics  engineering attitude  socialist/central planner

3. Center for the History of Political Economy Summer School June 2014 3 Two Macroeconomic Traditions of the 1930s – 2 Keynes:  micro/macro distinction (not in those words)  micro at root; macro emergent  problem of aggregation does not arise  hostile to econometrics  medical attitude Aside: “ If economists could manage to get themselves thought of as humble, competent people on a level with dentists, that would be splendid. ” John Maynard Keynes (1931) liberal/saving markets from their own fallabilities

4. Center for the History of Political Economy Summer School June 2014 4 Wartime Planning and Controls

5. Center for the History of Political Economy Summer School June 2014 5 Wartime Planners Milton Friedman (1912-2006)John Kenneth Galbraith (1908-2006)

6. Center for the History of Political Economy Summer School June 2014 6 Economists and the War “ The other thing that was so important in the ’ fifties and ’ sixties was operations research. The World War II generation brought a whole bunch of smart guys, like Abraham Wald and Friedman,... I mean everybody into Washington to work on the war effort, and economists thought of all kinds of great stuff... I guess that ’ s what we always claim. We invented the convoy system... we basically won the war singlehandedly. “ Robert E. Lucas, Jr.

7. Center for the History of Political Economy Summer School June 2014 7 Keynes Mostly Lost. What Survived Consilience of Keynes ’ s ontology with the national income and product accounts Interventionist attitude The Neoclassical Synthesis :  Already in Keynes: classical is special case of the general theory  Picked up by Klein ( The Keynesian Revolution )  Samuelson: implicit in 1 st edition of Economics (1948); term coined in 3 rd edition (1955)

8. Center for the History of Political Economy Summer School June 2014 8 The New Empirical Macroeconomics Walrasian:  general equilibrium  individual optimization (microfoundations) IS-LM Keynesian Aggregation  practice demands  must be eliminable in theory  work towards maximum disaggregation Lawrence Klein (1920- 1930 )

9. Center for the History of Political Economy Summer School June 2014 9 IS-LM-AS Sets the Agenda for Macroeconmetric Models

10. Center for the History of Political Economy Summer School June 2014 10 Hydraulic Keynesianism: The Phillips Machine or Moniac

11. Center for the History of Political Economy Summer School June 2014 11 Phillips Machine: Schematic

12. Center for the History of Political Economy Summer School June 2014 12 Phillips Machine: Details

13. Center for the History of Political Economy Summer School June 2014 13 Phillips Machine in Punch

14. Center for the History of Political Economy Summer School June 2014 14 IS-LM-AS Sets the Agenda for Macroeconmetric Models

15. Center for the History of Political Economy Summer School June 2014 15 Microfoundations : Transactions Demand for Money (Baumol) – 1

16. Center for the History of Political Economy Summer School June 2014 16 Microfoundations : Transactions Demand for Money (Baumol) – 2

17. Center for the History of Political Economy Summer School June 2014 17 Microfoundations : Transactions Demand for Money (Baumol) – 3 Implications:  Income-elasticity of money demand = ½  Interest-elasticity of money demand = –½ Compare to the Traditional Quantity Equation:  Income-elasticity of money demand = 1  Interest-elasticity of money demand = undetermined (possibly zero)

18. Center for the History of Political Economy Summer School June 2014 18 Microfoundations of the Various “ Keynesian ” Functions Transaction Demand for Money : Baumol (1952) Speculative Demand for Money : Tobin (1958) Consumption Function : Duesenberry (1949); Modigliani and Brumberg (1952); Friedman (1945; 1955) Investment : Jorgensen (1966) Production Function : (Franklin Fisher 1969) Labor Supply : Lucas and Rapping (1969)

19. Center for the History of Political Economy Summer School June 2014 19 Klein ’ s Modeling Agenda In contrast with the parsimonious view of natural simplicity, I believe that economic life is enormously complicated and that the successful model will try to build in as much of the complicated interrelationships as possible. That is why I want to work with large econometric models and a great deal of computer power. Instead of the rule of parsimony, I prefer the following rule: the largest possible system that can be managed and that can explain the main economic magnitudes as well as the parsimonious system is the better system to develop and use. [Klein 1992]

20. Center for the History of Political Economy Summer School June 2014 20 An Opposing Current the focus should be on the analysis of parts of the economy in the hope that we can find bits of order here and there and gradually combine these bits into a systematic picture of the whole [1951] A hypothesis is important if it ‘ explains ” much by little, that is, if it abstracts the common and crucial elements from the mass of complex and detailed circumstances surrounding the phenomena to be explained and permits valid predictions on the basis of them alone. [Friedman 1953, p. 14] We curtsy to Marshall, but we walk with Walras [1949] Milton Friedman (1912-2006)

21. Center for the History of Political Economy Summer School June 2014 21 Genealogy of Klein ’ s Macroeconometric Models

22. Center for the History of Political Economy Summer School June 2014 22 Complexity of Klein ’ s Models ModelNumber of Equations Klein Model I (1950) 6 Klein Model II (1950) 3 Klein Model III (1950)12 Klein-Goldberger (1955)25 Brookings-early (1959)about 200 Brookings-late (1972)about 400

23. Center for the History of Political Economy Summer School June 2014 23 Brookings Model (1965)

24. Center for the History of Political Economy Summer School June 2014 24 Phillips Machine: Schematic

25. Center for the History of Political Economy Summer School June 2014 25 The IS-LM Core of a Large-scale Macroeconometric Model Source: Green et al. “ The IS-LM Cores of Three Econometric Models, ” in Lawrence Klein (editor) Comparative Performance of U.S. Econometric Models, p. 104.

26. Center for the History of Political Economy Summer School June 2014 26 Computing Power as a Limitation on Economic Modeling Burroughs Adding Machines in Veterans Bureau Computing Section Eniac: The First American Digital Computer Before World War IIAfter World War II

27. Center for the History of Political Economy Summer School June 2014 27 Thanks  The End