Econ 314S History of Modern Macroeconomics Lecture 10, Fall 2017 History of Modern Macroeconomics Lecture 10. The Great Moderation (1975-1995) Kevin D. Hoover Department of Economics Department of Philosophy Center for the History of Political Economy Duke University Econ 314S History of Modern Macroeconomics Lecture 10, Fall 2017

Econ 314S History of Modern Macroeconomics Lecture 10, Fall 2017

Econ 314S History of Modern Macroeconomics Lecture 10, Fall 2017

Lucas and Sargent Before the New Classical Macroeconomics Robert E. Lucas, Jr. (1937- ) Chicago  Berkeley  Chicago (History  Economic History  Economics) Keynesian education at Chicago Early work on investment and labor in Klein’s microfoundation tradition First job: Carnegie Tech Thomas J. Sargent (1943- ) Berkeley  Harvard Politically left Connected to Carnegie-Mellon 16 years at University of Minnesota Principal subject of Esther-Mirjam Sent’s The Evolving Rationality of Rational Expectations (working title: Resisting Sargent) Econ 314S History of Modern Macroeconomics Lecture 10, Fall 2017

Carnegie Tech in the 1950s: Herbert Simon Polymath: economist, political scientist, sociologist, psychologist Cowles Commission: seminal work on causality and identification Intellectual leader of Carnegie’s Graduate School of Industrial Administration Key work on bounded rationality self-fulfilling expectations investment Herbert Simon (1916-2001) Econ 314S History of Modern Macroeconomics Lecture 10, Fall 2017

Carnegie Tech in the 1950s: Two Key Players – 1 Franco Modigliani (1918-2003) Nobel Laureate (1985) Econ 314S History of Modern Macroeconomics Lecture 10, Fall 2017

Carnegie Tech in the 1950s: Two Key Players – 2 John F. Muth (1930-2005) Photo? If you Google Image on John F. Muth you get photos of Lucas Sargent Prescott Arrow Simon Samuelson Dornbusch John Muth (1930-2005) Econ 314S History of Modern Macroeconomics Lecture 10, Fall 2017

Carnegie Investment Planning Project Key Book: Charles C. Holt, Franco Modigliani, John F. Muth, and Herbert A. Simon. Planning Production, Inventories, and Work Force, 1960. Econ 314S History of Modern Macroeconomics Lecture 10, Fall 2017

Modeling Expectations A simple expectations model (remember the expectations-augmented Phillips curve): Adaptive expectations (Phillips, Cagan, Friedman): where||< 1. Adaptive expectations implies that current expectations are geometric averages of past prices: Econ 314S History of Modern Macroeconomics Lecture 10, Fall 2017

Adaptive Expectations are Always Wrong Adjustment of expectations to a one-time, unexpected change in X Econ 314S History of Modern Macroeconomics Lecture 10, Fall 2017

Econ 314S History of Modern Macroeconomics Lecture 10, Fall 2017 Muth’s Seminal Papers “Rational Expectations and the Theory of Price Movements” (Econometrica 1961) main theory published second John F. Muth. “Optimal Properties of Exponentially Weighted Forecasts” (Journal of the American Statistical Association 1960) key example refers to later paper in its draft form Econ 314S History of Modern Macroeconomics Lecture 10, Fall 2017

The Rational Expectations Hypothesis expectations, since they are informed predictions of future events, are essentially the same as the predictions of the relevant economic theory. . . . The hypothesis can be rephrased a little more precisely as follows: that expectations of firms (or, more generally, the subjective probability distribution of outcomes) tend to be distributed, for the same information set, about the prediction of the theory (or the “objective” probability distributions of outcomes). The hypothesis asserts three things: (1) Information is scarce, and the economic system generally does not waste it. (2) The way expectations are formed depends specifically on the structure of the relevant system describing the economy. (3) A “public prediction,” in the sense of Grunberg and Modigliani, will have no substantial effect on the operation of the economic system (unless it is based on inside information). [Muth 1961, p. 316] Econ 314S History of Modern Macroeconomics Lecture 10, Fall 2017

The Cobweb and Rational Expectations Econ 314S History of Modern Macroeconomics Lecture 10, Fall 2017

Econ 314S History of Modern Macroeconomics Lecture 10, Fall 2017 Lucas and Friedman Non-Friedmanian Roots Samuelson’s Foundations of Economic Analysis receptive to Walrasian theory preference for rigor and formal theory Debt to Friedman preference for radical simplification natural rate hypothesis/expectations-augmented Phillips curve: market-clearing explanation of apparent disequilibrium based in asymmetric information Econ 314S History of Modern Macroeconomics Lecture 10, Fall 2017

Lucas and Rapping: The First New Classical Papers Lucas and Leonard Rapping [1933-1991]: “Real Wages, Employment, and Inflation” (JPE 1969) “Price Expectations and the Phillips Curve” (AER 1969) adaptive expectations; mentions does not model rational expectations exploitable tradeoff between inflation and unemployment market clearing with asymmetrical information surprise-only or Lucas aggregate supply function: y = (p – pe) intertemporal substitution of labor Econ 314S History of Modern Macroeconomics Lecture 10, Fall 2017

Two Ways of Viewing Aggregate Supply Econ 314S History of Modern Macroeconomics Lecture 10, Fall 2017

The Adoption of Rational Expectations into Macro: Key Lucas Papers “Expectations and the Neutrality of Money” (JET 1972) “Econometric Testing of the Natural Rate Hypothesis” (Fed Conference Volume 1972) “Some International Evidence on Output-Inflation Tradeoffs” (AER 1973) "Econometric Policy Evaluation: A Critique". (Carnegie-Rochester Conference Series on Public Policy 1976) Econ 314S History of Modern Macroeconomics Lecture 10, Fall 2017

“Expectations and the Neutrality of Money” (JET 1972) Lucas and Rapping paper in Phelps, editor. Microeconomic Foundations of Employment and Inflation Theory. Phelps’s “island model” Signal extraction Stylized, but rigorous, model of the “surprise-only” aggregate supply function The ephemeral Phillips curve More cited than used Econ 314S History of Modern Macroeconomics Lecture 10, Fall 2017

“Some International Evidence on Output-Inflation Tradeoffs” (AER 1973) Empirical test of JET 1972 paper Cross-country analysis Implication of signal extraction: Phillips curve (aka: Lucas supply function) steeper in high variance of inflation environment Confirmed, but contested in the literature Econ 314S History of Modern Macroeconomics Lecture 10, Fall 2017

Aggregate Supply and Noise Econ 314S History of Modern Macroeconomics Lecture 10, Fall 2017

Econ 314S History of Modern Macroeconomics Lecture 10, Fall 2017 “Econometric Testing of the Natural Rate Hypothesis” (Fed Conference Volume 1972) Friedman’s not really a natural rate model regression tests the wrong test of the natural rate hypothesis (cf. Muth 1960) correct test: overidentifying cross-equation restrictions (early example of solution methods for rational expectations models characterizes policy by a fixed rule  proto-policy invariance critique Econ 314S History of Modern Macroeconomics Lecture 10, Fall 2017

Econ 314S History of Modern Macroeconomics Lecture 10, Fall 2017 “Econometric Policy Evaluation: A Critique” (Carnegie-Rochester Conference Series on Public Policy 1976) Pivotal macroeconomics paper of the second half of the 20th century Foreshadowed by Tinbergen, Simon, Marschak, et al. (Cowles Commission) Novelty: rational expectations as source of invariance Critique of Tinbergen’s policy framework: targets and instruments = engineering paradigm can’t neglect rational action or economists inside the game Solution model tastes and technology  GE microfoundations essential doing Cowles right Econ 314S History of Modern Macroeconomics Lecture 10, Fall 2017

Econ 314S History of Modern Macroeconomics Lecture 10, Fall 2017 Sargent Independent introduction of rational expectations real interest rates hyperinflation Phillips curve Integration of rational expectations to time-series econometrics (Christopher Sims (Nobel Prize 2011) a colleague at Minnesota) More empirically oriented than Lucas Econ 314S History of Modern Macroeconomics Lecture 10, Fall 2017

Sargent and Wallace: Policy Ineffectiveness – 1 Neil Wallace (1938- ) Chicago Ph.D under Friedman Faculty of University of Minnesota “Rational Expectations, the Optimal Monetary Policy and the Optimal Money Supply Rule (JPE 1975) “Rational Expectations and the Theory of Economic Policy” (JME 1976) Econ 314S History of Modern Macroeconomics Lecture 10, Fall 2017

Sargent and Wallace: Policy Ineffectiveness – 2 IS-LM model = no microfoundations with Lucas aggregate supply function = classical dichotomy and continuously clearing markets + rational expectations = no short-run deviations of expectations from reality except randomly  Policy Ineffectiveness = pure AD policies affect output only randomly + Fixed M rules  price level control + Interest-rate rules or feedback rules  indeterminancy Startling, suits conservative rhetoric Econ 314S History of Modern Macroeconomics Lecture 10, Fall 2017

Key Tenets of the New Classical Macroeconomics Real economic decisions based on real, not nominal (i.e., monetary) factors = classical dichotomy Agents, to the limits of their information, are successful optimizers = market clearing conditional on information Agents make no systematic errors in evaluating their economic environments = rational expectations hypothesis Econ 314S History of Modern Macroeconomics Lecture 10, Fall 2017

Consolidation of the New Classical School Sargent’s graduate textbook: Macroeconomic Theory 1979 Lucas and Sargent, editors. Rational Expectations and Econometric Practice 1981 aggregative macro/not microfoundational emphasis on systems or GE implications of rational expectations emphasis on econometrics Econ 314S History of Modern Macroeconomics Lecture 10, Fall 2017

Econ 314S History of Modern Macroeconomics Lecture 10, Fall 2017 The Manifestos Lucas and Sargent “After Keynesian Macroeconomics” (Minneapolis Fed Quarterly Review 1979) framed as attack on Keynes despite Keynesian roots earlier critical targets Klein and Tinbergen Sargent “Beyond Demand and Supply Curves in Macroeconomics” (AER 1982) optimizing microfoundations with rational expectations ignores earlier microfoundational programs Econ 314S History of Modern Macroeconomics Lecture 10, Fall 2017

The Euthanasia of Macroeconomics If these developments succeed, the term “macroeconomics” will simply disappear from use, and the modifer “micro” will become superfluous. We will simply speak, as did Smith, Ricardo, Marshall, and Walras, of economic theory. [Lucas Models of Business Cycles 1987] The inversion of Klein’s program: Klein: data first (analogical consistency with theory) Lucas: theory first (analogical consistency with data) Econ 314S History of Modern Macroeconomics Lecture 10, Fall 2017

The Problem of Business Cycles The empirical failure of the monetary shocks approach no difference between anticipated and unanticipated money no reaction to data revisions unaccountable serial correlations Ad hoc solutions lagged dependent variables without a rationale Econ 314S History of Modern Macroeconomics Lecture 10, Fall 2017

Lucas: A Positive Program for Business Cycles Continuous market-clearing, dynamic equilibrium  against Keynes’s involuntary unemployment “involuntary unemployment is not a fact or a phenomenon which it is the task of the theorist to explain. It is, on the contrary, a theoretical construct which Keynes . . . hope[d] would be helpful in discovering a correct explanation for a genuine phenomenon: large-scale fluctuations in measured, total unemployment. Is it the task of modern theoretical economics to ‘explain’ the theoretical constructs of our predecessors, whether or not they have proved fruitful?” Business cycle phenomena: not objects, but patterns of covariation picked up by Kydland and Prescott surprising respect for Burns and Mitchell Econ 314S History of Modern Macroeconomics Lecture 10, Fall 2017

The Simulacrum Account of Models j pattern prediction vs. forecasting testing rules vs. conditional forecasts Turing and Adelman tests Econ 314S History of Modern Macroeconomics Lecture 10, Fall 2017

The Transition to the Real Business Cycle Model Lucas’s 1975 Business Cycle Model growth, capital, and the propagation mechanism the last gasp of the monetary surprises alternative rationales for money Kydland and Prescott, “Time to Build and Aggregate Fluctuations” technology shocks the absence of monetary shocks the irrelevance of time-to-build Econ 314S History of Modern Macroeconomics Lecture 10, Fall 2017

The Rise of the Representative Agent The neoclassical growth model Solow optimal growth in the 1960s the planning roots of the “representative agent” Ignoring aggregation Econ 314S History of Modern Macroeconomics Lecture 10, Fall 2017

New Keynesian Macroeconomics Immediate objections to the policy ineffectiveness proposition: John Taylor Stanley Fischer overlapping labor contracts Rational expectations is not the issue Central Issues: apparent effectiveness of monetary policy = e.g., Friedman & Schwartz the problem of business cycles Econ 314S History of Modern Macroeconomics Lecture 10, Fall 2017

Econ 314S History of Modern Macroeconomics Lecture 10, Fall 2017 Sources of “Friction” New Keynesians = “imperfectionists” concede the ideal model to New Classicals Slow price adjustment implies policy effectiveness provides basis for cycles Sources: menu costs efficiency wages fixed contracts Econ 314S History of Modern Macroeconomics Lecture 10, Fall 2017

“Perfectionist” New Keynesians Sunspot Models Multiple equilibrium models Econ 314S History of Modern Macroeconomics Lecture 10, Fall 2017

The Saltwater and Freshwater Schools New Classicals = Freshwater: near lakes (Universities of Chicago, Minnesota, and Rochester New Keynesians = Saltwater: near oceans (Universities of California, Berkeley, Harvard, MIT Econ 314S History of Modern Macroeconomics Lecture 10, Fall 2017

Econ 314S History of Modern Macroeconomics Lecture 10, Fall 2017 Two Victories New Classicals won the methodological battle representative-agent microfoundations imperfectionist models major defeat for the Klein program New Keynesians won the empirical battle price stickiness widely accepted needed to explain business cycles supports policy effectiveness Econ 314S History of Modern Macroeconomics Lecture 10, Fall 2017

The New Neoclassical Synthesis The Dynamic Stochastic General Equilibrium Model (DSGE) intertemporal optimization rational expectations representative agent microfoundations “frictions” as necessary e.g., reaction to 2007-2009 crisis: DSGE + financial frictions An end to the Saltwater/Freshwater split? Econ 314S History of Modern Macroeconomics Lecture 10, Fall 2017

Econ 314S History of Modern Macroeconomics Lecture 10, Fall 2017 Thanks  The End Econ 314S History of Modern Macroeconomics Lecture 10, Fall 2017