1. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 17-1 CHAPTER 17 The Future of Macroeconomics

2. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 17-2 Questions What might the future of macroeconomics bring? How might the macroeconomics taught two decades from now be different from the macroeconomics taught today? What have been the principal changes in the way macroeconomics is taught over the past twenty years?

3. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 17-3 Questions What additional changes took place twenty years before that--from roughly 1960 to roughly 1980? What direction will macroeconomics take if the real business cycle research program is successful? What direction will macroeconomics take if the new Keynesian research program proves successful?

4. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 17-4 Questions How will economists understand the foundations behind the power of monetary policy?

5. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 17-5 The Past of Macroeconomics A 1936 book by John Maynard Keynes shifted economic research and macroeconomic thought into new and different directions –the role of expectations of future profits in determining investment –the volatility of expectations of profits –the power of the government to affect the economy through policy –the multiplier process

6. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 17-6 The Past of Macroeconomics After World War II, more macroeconomic theory was developed –the IS-LM model was created –the relationship between interest rates and the money supply was investigated –the difference between the behavior of the macroeconomy in the flexible-price long run and the fixed-price short run was clarified

7. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 17-7 The Past of Macroeconomics But macroeconomics theory in 1960 was still incomplete –no discussion of the relationship between production and inflation –no detailed model of expectations –the short run was seen as lasting for decades –fiscal policy was emphasized, while the role of monetary policy was downplayed –estimates of the multiplier were much higher than we believe now to be correct

8. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 17-8 The Past of Macroeconomics Between 1960 and 1980, two powerful critiques of the conventional wisdom of macroeconomics occurred –the first was by Milton Friedman the standard models overestimated the government’s ability to control the economy the standard models overestimated the power of fiscal policy and underestimated the power of monetary policy the money supply tells us most of what we need to know about how policy is working there is a natural rate of unemployment

9. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 17-9 The Past of Macroeconomics –the second was by Robert Lucas Keynesian economics fails to think through the importance of expectations systematic changes in economic policy would change the parameters of the consumption and investment functions as well as the location of the Phillips curve

10. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 17-10 The Past of Macroeconomics The late 1980s and 1990s were a time of idea generation and exploration –macroeconomists explored and tested a large number of different ideas and models –the mainstream policy-analytic position of macroeconomists did not shift much

11. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 17-11 The Future of Macroeconomics: Real Business Cycles? Keynesian and monetarist economists believe that there are two key elements to understanding business cycles –the determinants of aggregate demand –the division of changes in nominal aggregate demand into changes in production and changes in prices

12. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 17-12 The Future of Macroeconomics: Real Business Cycles? Real business cycle economists believe that changes in nominal aggregate demand affect output and employment only slightly and have the most impact on prices Real business cycle theory begins with the assumption that the same theory that determines what happens in the long run should be applied to fluctuations in the short run

13. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 17-13 The Future of Macroeconomics: Real Business Cycles? While real business cycle economists believe that prices can be rigid, they believe that this sluggishness of prices is not very relevant –they assume that it is a reasonable first- approximation to suppose that the money supply and the level of potential output determine the price level –the level of potential output is more-or- less equal to actual real GDP

14. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 17-14 The Future of Macroeconomics: Real Business Cycles? Real business cycle economists believe in the classical dichotomy –real variables effectively determine the values of real quantities like real GDP even in the short run –nominal variables determine the values of nominal quantities like the price level

15. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 17-15 The Future of Macroeconomics: Real Business Cycles? Real business cycle theory assumes that the level of output will vary with shocks to the economy –adverse cost shocks lead to a recession as individuals should spend less time working because it is not profitable –favorable cost shocks lead to a boom period because it is advantageous to produce as much as possible

16. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 17-16 Problems of Real Business Cycle Theory Unemployment –real business cycle theory assumes that the total hours worked at any moment is largely determined by how many hours it makes sense for people to work –but when work hours fall, it is not because people have chosen to work shorter shifts and avoid overtime it is because they have become unemployed

17. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 17-17 Problems of Real Business Cycle Theory Technology and Real Business Cycles –according to real business cycle theory, production fluctuates because of the changing value of output and the changing productivity of the economy more is produced when technology rises recessions occur when cost increases make it inefficient to run factories at near capacity –critics claim that cost increases like the 1973 oil price shock are the exception rather than the rule

18. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 17-18 Problems of Real Business Cycle Theory Money and Business Cycles –real business cycle theorists tend to argue that monetary policy has little impact on production and employment fluctuations in the money stock and real interest rates are more reactions to changes already taking place –the Federal Reserve believes that it affects the level of interest rates and that its decisions cause changes in production and employment

19. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 17-19 The Future of Macroeconomics: New Keynesian Economics Since the 1930s, mainstream macroeconomics has attributed the sluggishness of aggregate supply to stickiness in wages and prices Therefore, fluctuations in nominal aggregate demand cause fluctuations in output and employment

20. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 17-20 The Future of Macroeconomics: New Keynesian Economics Where does this stickiness and slow adjustment of wages and prices come from? –menu costs it is costly for businesses to change prices –staggered prices and coordination failures a firm’s best choice for its price may depend on the prices that other firms are charging this means that wages and prices may exhibit inertia

21. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 17-21 Debts and Deficits: Ricardian Equivalence If the government runs a budget deficit, it will make up the deficit by borrowing money now and implicitly committing to raise taxes to repay the debt at some time in the future

22. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 17-22 Debts and Deficits: Ricardian Equivalence Economist Robert Barro argues that consumers will see the budget deficit as an increase in future taxes and cut back on consumption –what matters for the determination of consumption spending this year is not what taxes are levied on you this year, but what all the changes in government policy tell you about stream of taxes this year and in the future

23. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 17-23 Debts and Deficits: Ricardian Equivalence Many economists believe that Ricardian equivalence does not hold for a number of reasons – myopia –liquidity constraints –people are different

24. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 17-24 Consumption and Saving In the early 1900s, the marginal propensity to consume was high –people were liquidity constrained The financial system in the past 50 years has become much more flexible –economic theory would predict that the marginal propensity to consume would decline and the multiplier process would be more or less irrelevant to aggregate demand

25. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 17-25 Consumption and Saving But, consumption falls significantly when the economy goes into recession Why? –one possibility is that consumers are both impatient and risk averse –another possible explanation is that current income is a good proxy for permanent income –another suggestion is for economists to focus on what psychologists have to say about how humans reason

26. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 17-26 Does Monetary Policy Have a Long-Run Future? Economists have tended to assume that monetary policy is powerful and that the reasons for its power are uninteresting The future evolution of the financial system may undermine the sources of influence that monetary policy today possesses

27. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 17-27 Does Monetary Policy Have a Long-Run Future? Forecasting the future of monetary policy will require a deeper knowledge and better models of the sources of central bank power than macroeconomists currently possess

28. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 17-28 Chapter Summary Modern macroeconomics has its origin in the “Keynesian” theories of the Great Depression and post-WWII era Modern macroeconomics was reforged by the monetarists under Milton Friedman in the 1960s and 1970s, and by the rational expectations economists led by Robert Lucas in the 1970s and 1980s

29. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 17-29 Chapter Summary Perhaps the focus on aggregate demand will turn out in the long run to have been a false road –perhaps a better theory of the macroeconomy can be built up out of the theory of real business cycles in the Schumpeterian tradition

30. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 17-30 Chapter Summary Perhaps the future of macroeconomics lies in a more detailed investigation of aggregate supply –perhaps uncovering the reason why prices are sticky will lead to the next wave of progress in macroeconomics

31. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 17-31 Chapter Summary The entire conventional analysis of debts and deficits is under challenge by Robert Barro, who argues that individuals are far-sighted and closely linked, and that they take action to neutralize the effects of many government policies The conventional analysis of consumption--the permanent income hypothesis--is also under challenge by more psychological approaches

32. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 17-32 Chapter Summary The other possible interesting direction in which macroeconomics might evolve involves the future of monetary policy –how will the coming of the “new economy” and the changing institutional framework of transactions and settlements affect the power of monetary policy?