1. Econ 314S History of Modern Macroeconomics Lecture 10, Fall 2017
History of Modern Macroeconomics Lecture 10. The Great Moderation ( ) 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

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

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

4. Lucas and Sargent Before the New Classical Macroeconomics
Robert E. Lucas, Jr. ( )
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 ( )
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

5. 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 ( )
Econ 314S History of Modern Macroeconomics Lecture 10, Fall 2017

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

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

8. 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

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

10. 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

11. 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

12. 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

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

14. 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

15. Lucas and Rapping: The First New Classical Papers
Lucas and Leonard Rapping [ ]:
“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

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

17. 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

18. “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

19. “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

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

21. 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

22. 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

23. 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

24. Sargent and Wallace: Policy Ineffectiveness – 1
Neil Wallace ( )
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

25. 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

26. 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

27. 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

28. 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

29. 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

30. 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

31. 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

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

33. 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

34. 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

35. 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

36. 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

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

38. 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

39. 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

40. 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 crisis: DSGE + financial frictions
An end to the Saltwater/Freshwater split?
Econ 314S History of Modern Macroeconomics Lecture 10, Fall 2017

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