ch27 5e

CHAPTER 27
Epilogue: The Story

of Macroeconomics
CHAPTER 27
Prepared by:
Fernando Quijano and Yvonn Quijano
Epilogue: The Story
of Macroeconomics
Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall Macroeconoics, !"e #li$ier %lanchard
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27-1 Keynes and the Great Depression
+he history o& odern acroeconoics starts
in -9'., /ith the publication o& 0eynes1s
General Theory of Employment, Interest, and
Money.
+he 2reat 3epression /as an intellectual &ailure &or
the econoists /or4ing on business cycle theory5
as acroeconoics /as then called.
0eynes ephasi6ed effective demand, no/ called
aggregate demand.
Keynes
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In the process o& deri$ing e&&ecti$e deand, 0eynes
introduced any o& the building bloc4s o& odern
acroeconoics*
+he relation o& consuption to incoe, and the

ultiplier.
Liquidity preference 7the ter gi$en to the

deand &or oney8.
+he iportance o& e9pectations in a&&ecting

consuption and in$estent: and the idea that
animal spirits are a a;or &actor behind shi&ts in
deand and output.
27-1 Keynes and the Great Depression
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Paul ,auelson /rote the &irst odern econoics
te9tboo4* Economics
+he neoclassical synthesis re&ers to a large
consensus that eerged in the early -9!0s,
based on the ideas o& 0eynes and earlier
econoists.
+he neoclassical synthesis /as to reain the
doinant $ie/ &or another 20 years. +he period &ro
the early -9(0s to the early -9)0s /as called the
golden age o& acroeconoics.
Samuelson
27-2 The eoclassical Synthesis
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+he ost in&luential &orali6ation o& 0eynes1s ideas
/as the IS-LM odel, de$eloped by <ohn Hic4s and
=l$in Hansen in the -9'0s and early -9(0s.
3iscussions becae organi6ed around the slopes o&
the IS and LM cur$es.
Progress on All Fronts
The ISLM Model
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In the -9!0s, >ranco Modigliani and Milton
>riedan independently de$eloped the theory o&
consuption, and insisted on the iportance o&
e9pectations.
Modigliani
Tobin
<aes +obin de$eloped the theory o& in$estent
based on the relation bet/een the present $alue
o& pro&its and in$estent. 3ale <orgenson
&urther de$eloped and tested the theory.
Theories of Consumption !nvestment and Money "emand
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In -9!., ?obert ,olo/ de$eloped the gro/th
odel5a &rae/or4 to thin4 about the
deterinants o& gro/th.
Solo#
It /as &ollo/ed by an e9plosion o& /or4 on the roles sa$ing
and technological progress play in deterining gro/th.
$ro#th Theory
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Klein
Aa/rence 0lein de$eloped the &irst B.,.
acroeconoic odel in the early -9!0s. +he
odel /as an e9tended IS relation, /ith -.
eCuations.
Macroeconometric Models
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Milton >riedan /as the intellectual leader o& the
onetarists, and the &ather o& the theory o&
consuption.
He belie$ed that the understanding o& the econoy
reained $ery liited, and Cuestioned the oti$es
and ability o& go$ernents to ipro$e
acroeconoic outcoes.
Friedman
Keynesians versus Monetarists
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In the -9.0s, debates bet/een Keynesians and
monetarists doinated the econoic headlines. +he
debates centered around three issues*
7-8 the e&&ecti$eness o& onetary policy $ersus &iscal
policy,
728 the Phillips cur$e, and
7'8 the role o& policy.
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>riedan challenged the $ie/ that &iscal policy could a&&ect
output &aster and ore reliably than onetary policy.
In a -9.' boo4, = Monetary History o& the Bnited ,tates,
-@.)D-9.0, >riedan and =nna ,ch/art6 re$ie/ed the
history o& onetary policy and concluded that onetary
policy /as not only $ery po/er&ul, but that o$eents in
oney also e9plained ost o& the &luctuations in output.
+hey interpreted the 2reat 3epression as the result o& a;or
ista4e in onetary policy.
Monetary Policy versus Fiscal Policy
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The Phillips Curve
+he Phillips cur$e had becoe part o& the
Eeoclassical synthesis, but Milton >riedan and
Edund Phelps argued that the apparent tradeDo&&
bet/een uneployent and in&lation /ould Cuic4ly
$anish i& policy a4ers actually tried to e9ploit it.
%y the id -9)0s, the consensus /as that there
/as no longDrun trade o&& bet/een in&lation and
uneployent.
Phelps
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The %ole of Policy
,4eptical that econoists 4ne/ enough to stabili6e
output, and that policy a4ers could be trusted to do the
right thing, Milton >riedan argued &or the use o& siple
rules, such as steady oney gro/th.
>riedan belie$ed that political pressures to Fdo
soethingG in the &ace o& relati$ely ild probles ay
do ore har than good.
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+hey argued that the predictions o& 0eynesian
acroeconoics /ere /ildly incorrect, and based
on a doctrine that /as &undaentally &la/ed.
In the early -9)0s, ?obert
Aucas, +hoas ,argent, and
?obert %arro led a strong attac4
against ainstrea
acroeconoics.
Lucas
Sargent
&arro
27-! The "ational E#pectations $riti%ue
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Aucas and ,argent1s ain arguent /as that
0eynesian econoics had ignored the &ull
iplications o& the e&&ect o& e9pectations on
beha$ior.
+hin4ing o& people as ha$ing rational
expectations had three a;or iplications, all
highly daaging to 0eynesian
acroeconoics.
The Three !mplications of %ational '(pectations
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?obert Aucas argued that acroeconoic
odels did not incorporate e9pectations
e9plicitly: that the odels captured relations as
they had held in the past, under past policies.
+hey /ere poor guides to /hat /ould happen
under ne/ policies.
+his critiCue o& acroeconoetric odels
becae 4no/n as the Lucas Critique.
The Lucas Critique
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In 0eynesian odels, the slo/ return o& output
to the natural le$el o& output cae &ro the
slo/ ad;ustent o& prices and /ages through
the Phillips cur$e echanis.

Hithin the logic o& the 0eynesian odels,
Aucas there&ore argued, only unanticipated
changes in money should a&&ect output.
%ational '(pectations and the Phillips Curve
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Aet1s suari6e* Hhen rational e9pectations /ere
introduced,
0eynesian odels could not be used to deterine
policy:
0eynesian odels could not e9plain longDlasting
de$iations o& output &ro the natural le$el o&
output:
the theory o& policy had to be redesigned, using the
tools o& gae theory.
)ptimal Control versus $ame Theory
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+he intellectual atosphere in acroeconoics /as
tense in the early -9)0s. %ut /ithin a &e/ years, a
process o& integration 7o& ideas, not people, because
tepers reained high8 had begun, and it /as to
doinate the -9)0s and the -9@0s.
Hor4 then started on the challenges raised by Aucas
and ,argent.
The !ntegration of %ational '(pectations
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The !mplications of %ational '(pectations
?obert Hall sho/ed that i& consuers are $ery
&oresighted, then changes in consuption should
be unpredictable.
Consuption /ill change only /hen consuers

learn soething ne/ about the &uture. ,ince ne/s
about the &uture cannot be predicted, changes in
consuption are highly rando. +his consuption
beha$ior, 4no/n as the random #al* of
consumption, has ser$ed as a benchar4 in
consuption research e$er since.
+all
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The !mplications of %ational '(pectations
?udiger 3ornbusch de$eloped a odel o& e9change
rates that sho/s ho/ large s/ings in e9change rates
are not the result o& irrational speculation but, instead,
&ully consistent /ith rationality.
3ornbusch1s odel, 4no/n as the overshooting

odel o& e9change rates, has becoe the
benchar4 in discussions o& e9changeDrate
o$eents.
"ornbusch
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,age and Price Setting
Fischer
Taylor
,tanley >ischer and <ohn +aylor sho/ed that the
ad;ustent o& prices and /ages in response to
changes in uneployent can be slo/ even under
rational expectations.
+hey pointed to the staggering o& both /age and
price decisions, and e9plained ho/ a slo/ return o&
output to the natural le$el can be consistent /ith
rational e9pectations in the labor ar4et.
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The Theory of Policy
In short* %y the end o& the -9@0s, the challenges
raised by the rationalDe9pectations critiCue had led
to a coplete o$erhaul o& acroeconoics.
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27-& "ecent De'elopments
,ince the late -9@0s, three groups ha$e
doinated the research headlines* the ne/
classicals, the ne/ 0eynesians, and the ne/
gro/th theorists.
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-e# Classical 'conomics and %eal &usiness Cycle Theory
+heir real business cycle .%&C/ models assue
that output is al/ays at its natural le$el, and
&luctuations are o$eents o& the natural le$el o&
output. +hese o$eents are &undaentally
caused by technological progress.
Ed/ard Prescott is the intellectual leader o& the
ne# classicals5a group o& econoists
interested in e9plaining &luctuations as the
e&&ects o& shoc4s in copetiti$e ar4ets /ith &ully
&le9ible prices and /ages.
Prescott
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-e# Keynesian 'conomics
#ne line o& research &ocuses on the
deterination o& /ages in the labor ar4et.
2eorge =4erlo& has e9plored the role o&
Fnors,G or rules that de$elop in any
organi6ation to assess /hat is &air or un&air.
+he ne# Keynesians are a loosely connected group
o& researchers /or4ing on the iplications o& se$eral
iper&ections in di&&erent ar4ets.
A*erlof
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-e# Keynesian 'conomics
Iet another direction o& research is nominal rigidities in
/ages and prices. +he menu cost e9planation o& output
&luctuations, de$eloped by =4erlo& and E. 2regory Man4i/,
attributes e$en sall costs o& changing prices to the
in&reCuent and staggered price ad;ustent.
=nother line o& ne/ 0eynesian research has
e9plored iper&ections in credit ar4ets. %en
%ernan4e has studied the relation bet/een
ban4s and borro/ers and its e&&ects on onetary
policy.
&en &ernan*e
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Ee/ gro/th theory &ocuses on the deterinants o&
technological progress in the long run, and the role
o& increasing returns to scale.
?obert Aucas and Paul ?oer ha$e pro$ided a
ne/ set o& contributions under the nae o& ne#
gro#th theory, /hich ta4e on soe o& the
issues initially raised by gro/th theorists o& the
-9.0s.
%omer
-e# $ro#th Theory
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-e# $ro#th Theory
#ne e9aple o& soe o& the ad$ances
econoists ha$e ade is on the /or4 o& Philippe
=ghion and Peter Ho/itt. +hey ha$e de$eloped a
thee &irst e9plored by <oseph ,chupeter in
the -9'0s, the notion that gro/th is a process o&
creative destruction, in /hich ne/ products are
constantly introduced, a4ing old ones obsolete.
Aghion
+o#itt
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-e# $ro#th Theory
=ndrei ,hlei&er 7&ro Har$ard Bni$ersity8 has e9plored
the role o& di&&erent legal systes in a&&ecting the
organi6ation o& the econoy, &ro &inancial ar4ets to
labor ar4ets, and, through these channels, the
e&&ects o& legal systes on gro/th.
3aron =ceoglu 7&ro MI+8 has e9plored ho/ to go
&ro correlations bet/een institutions and gro/th5
deocratic countries are on a$erage richer5to
causality &ro institutions to gro/th
Shleifer
Acemoglu
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-e# $ro#th Theory
Hood&ord, 2ali, and a nuber o& coDauthors ha$e
de$eloped a odel, 4no/n as the -e#0Keynesian
model, that ebodies utility and pro&it a9ii6ation,
rational e9pectations, and noinal rigidities.
+his odel has pro$en e9treely use&ul and in&luential
in the redesign o& onetary policy. It has also led to
the de$elopent o& a class o& larger odels that build
on its siple structure, but allo/ &or a longer enu o&
iper&ections and thus ust be sol$ed nuerically.
+hese odels, /hich are no/ used in ost central
ban4s, are 4no/n as dynamic stochastic general
equilibrium ."S$'/ models.
,oodford
$ali
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Most acroeconoists agree that*
In the short run, shi&ts in aggregate deand a&&ect output.
In the ediu run, output returns to the natural le$el.
In the long run, capital accuulation and the rate o&

technological progress are the ain &actors that deterine
the e$olution o& the le$el o& output.
Monetary policy a&&ects output in the short run, but not in

the ediu run or the long run.
>iscal policy has shortDrun, ediuDrun, and longDrun

e&&ects on output.
27-( $ommon )eliefs
'' o& '(
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,oe o& the disagreeents in$ol$e*
+he length o& the Fshort run,G the period o& tie o$er /hich
aggregate deand a&&ects output.
+he role o& policy. +hose /ho belie$e that output returns
Cuic4ly to the natural le$el ad$ocate the use o& tight rules
on both &iscal and onetary policy. +hose /ho belie$e that
the ad;ustent is slo/ pre&er ore &le9ible stabili6ation
policies.
27-( $ommon )eliefs
'( o& '(
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*

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Key Terms
business cycle theory
effective demand
liquidity preference
neoclassical synthesis
Keynesians
Monetarists
Lucas critique
random #al* of consumption
staggering .of #age and price

decisions/
ne# classicals
real business cycle .%&C/ models
ne# Keynesians
nominal rigidities
menu cost
ne# gro#th theory
-e#0Keynesian model
"S$' models .dynamic

stochastic general equilibrium
models/

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CHAPTER 27

Epilogue: The Story

+he relation o& consuption to incoe, and the

Liquidity preference 7the ter gi$en to the

+he iportance o& e9pectations in a&&ecting

Consuption /ill change only /hen consuers

3ornbusch1s odel, 4no/n as the overshooting

In the short run, shi&ts in aggregate deand a&&ect output.

In the ediu run, output returns to the natural le$el.

In the long run, capital accuulation and the rate o&

Monetary policy a&&ects output in the short run, but not in

>iscal policy has shortDrun, ediuDrun, and longDrun

business cycle theory

random #al* of consumption

staggering .of #age and price

real business cycle .%&C/ models

ne# gro#th theory

"S$' models .dynamic

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