Snowdon & Vane Modern Macroeconomics

Personal Information

When we interviewed Milton Friedman [see Snowdon and Vane, 1997b] he commented that he had experienced three reactions to many of his views, to quote: ‘the first reaction is that it’s all a bunch of nonsense, the second reaction is that there is something to it and the third reaction is that it gets embedded in the theory and nobody talks about it anymore’. How well does this parallel with new and controversial ideas you have fought to get accepted?

A little bit. But you know Milton is like Keynes. He goes directly to the public, to the voters, with ideas. The reactions he is talking about are the reactions of non-economists, of politicians, of a huge range of people, to the changes in policies he is advocating. My career hasn’t really taken that form. My influence has been very much more inside the profession and for that matter on a technical subset of the profession. In so far as I have had any influence on the larger world you can’t really identify it because my influence is contained with the influence of many others. How do you tell my influence from Tom Sargent’s influence? Nobody other than professional economists would even have heard of me. No one in the US Congress is going to say ‘I favour Lucas’s policy’. The reply would be, ‘who is Lucas?’! [laughter].

Turning to the award of the Nobel Prize. When we interviewed James Tobin in 1993 and asked him how he felt about being awarded the Prize his reaction was somewhat defensive along the lines that he didn’t ask for it; the Swedish Academy gave it to him. In correspondence we asked Milton Friedman a similar question and he acknowledged that it was extremely rewarding. He also told us that he first learned of the award from a reporter who stuck a microphone in his face when he was in a parking lot in Detroit. We were wondering what importance you attach to having been awarded the Nobel Prize.

Oh, it was a tremendous thing for me. I don’t know what else I can say. I don’t know what Jim could possibly have had in mind. He was certainly pleased when it happened and he certainly merited the award. Reporters will ask you, and this annoys me too after a while, ‘what did you do to deserve this prize?’ They should look up what the Swedish Academy said on the Internet. I don’t want to have to defend it. If that is what Jim meant, then I have been through the same thing and I am just as irritated by it as he is.

What issues or areas are you currently working on?

I’m thinking about monetary policy again, actually. In particular all central banks now want to talk about the interest rate as being the immediate variable they manipulate. I don’t get it and yet their record on controlling inflation is

pretty good. Talking in terms of interest rate targets as opposed to monetary targets seems to me just the wrong way to think about it, but if so, why does it work so well?

Finally, is there any question that you would have liked to have been asked in this interview?

I don’t know [laughter]. Your questions are interesting to me. You guys are economists and it’s a lot more fun being interviewed by an economist than being interviewed by a journalist who is completely ignorant of economics [laughter].

thesis period with the assumption that ‘full employment’ represented equilibrium and that recessions were periods of welfare-reducing disequilibrium implying market failure and the need for stabilization policy. Real business cycle theorists reject this market failure view. While recessions are not desired by economic agents, they represent the aggregate outcome of responses to unavoidable shifts in the constraints that agents face. Given these constraints, agents react optimally and market outcomes displaying aggregate fluctuations are efficient. There is no need for economists to resort to disequilibrium analysis, coordination failure, price stickiness, monetary and financial shocks, and notions such as fundamental uncertainty to explain aggregate instability. Rather, theorists can make use of the basic neoclassical growth model to understand the business cycle once allowance is made for randomness in the rate of technological progress (the neoclassical growth model is discussed in Chapter 11). In this setting, the business cycle emerges as the aggregate outcome of maximizing decisions made by all the agents populating an economy.

6.2The Transition from Monetary to Real Equilibrium Business Cycle Theory

As we have seen in Chapter 5, the dominant new classical theory of the business cycle during the period 1972–82 was the monetary surprise model (MEBCT) initially developed by Lucas (1975, 1977). Since the early 1980s the leading new classical explanation of aggregate instability has focused on real rather than monetary shocks, and after the contribution of Long and Plosser (1983) became known as real (equilibrium) business cycle theory (REBCT). The best-known advocates or contributors to this approach are Edward Prescott of the University of Minnesota, Finn Kydland of CarnegieMellon University, Charles Plosser, John Long and Alan Stockman of the University of Rochester, Robert King of Boston University, Sergio Rebelo of Northwestern University and Robert Barro of Harvard University (see interviews with Robert Barro and Charles Plosser in Snowdon et al. 1994).

In the early 1980s, in response to recognized weaknesses in the MEBCT some new classical theorists sought to provide a rigorous equilibrium account of the business cycle which is both free from the theoretical flaws of earlier new classical models and would, at the same time, be empirically robust. The result has been the development of REBCT, which replaces the impulse mechanism of the earlier models (that is, unanticipated monetary shocks) with supply-side shocks in the form of random changes in technology. The propagation mechanisms of the earlier new classical models are, however, retained and developed. Ironically it was Tobin (1980b) who was one of the first to recognize this unlikely escape route for equilibrium theorists. In

criticizing the monetary misperception stories of Lucas, Tobin noted that the ‘real equilibrium of a full information model could move around, driven by fluctuations in natural endowments, technologies and tastes’ and, if such fluctuations were seriously persistent random processes, the observations generated ‘may look like business cycles’. Meanwhile, around 1980, Kydland and Prescott were working on just such a model and two years after Tobin made his comments Econometrica published Kydland and Prescott’s paper containing their prototype non-monetary equilibrium model.

Before moving on to consider real business cycle theory in more detail, it is interesting to note the reaction to this second phase of equilibrium theorizing of two of the leading pioneers of the new classical mark I approach. In Robert Lucas’s view, Kydland and Prescott have taken macroeconomic modelling ‘into new territory’ (Lucas, 1987). However, Lucas’s initial reaction to REBCT was to suggest that the exclusive focus of such models on real as opposed to monetary considerations was ‘a mistake’ and argued the case for a ‘hybrid’ model as a fruitful way forward. Nevertheless Lucas warmly approved of the methodology adopted by real business cycle theorists who have followed his own earlier recommendation that an understanding of business cycles is best achieved ‘by constructing a model in the most literal sense: a fully articulated artificial economy which behaves through time so as to imitate closely the time series behaviour of actual economies’ (Lucas, 1977). Such artificial economic systems can serve as laboratories ‘in which policies that would be prohibitively expensive to experiment with in actual economies can be tested out at much lower cost’ (Lucas, 1980a). This is exactly what real business cycle theorists established as their research agenda during the 1980s, and Lucas’s (1980a) paper is the reference point for the modern era of equilibrium theorizing. As Williamson (1996) points out, ‘in Lucas one finds a projection for future research methodology which is remarkably close to the real business cycle program’.

By 1996 Lucas admitted that ‘monetary shocks just aren’t that important. That’s the view that I’ve been driven to. There is no question that’s a retreat in my views’ (see Gordon, 2000a, p. 555). Meanwhile Lucas has put forward the view several times that he considers the business cycle to be a relatively ‘minor’ problem, at least at the level experienced since 1945 (Lucas, 1987, 2003). In his view it is far more important to understand the process of economic growth if we are really interested in raising living standards, rather than trying to devise ever more intricate stabilization policies in order to remove the residual amount of business cycle risk (see Lucas, 1988, 1993, 2002, 2003, and Chapter 11).

By the late 1980s Robert Barro (1989a, 1989c) also declared that the emphasis given by new classical economists during the 1970s to explaining the non-neutrality of money was ‘misplaced’ because the ‘new classical

approach does not do very well in accounting for an important role for money in business fluctuations’. By the mid-1980s, Barro regarded the contributions of real business cycle theorists as ‘especially promising’ and representing ‘real progress’ (Barro, 1984). Furthermore, his own work had provided a bridge between the mark I and mark II versions of new classical macroeconomics (see Barro, 1981). In any case the lack of robust empirical success of the earlier models does not invalidate the achievements of the new classical theorists in the 1970s which in Barro’s view led to ‘superior methods of theoretical and empirical analysis’ (Barro, 1984).

The three main new classical achievements identified by Barro (1989a) are

(i) the application of equilibrium modelling to macroeconomic analysis, (ii) the adoption and promotion of the rational expectations hypothesis, and (iii) the application of game theory to policy making and evaluation. The first two contributions satisfy the objectives of building macro models on choicetheoretic microfoundations, as well as providing an analytical framework which can better withstand the Lucas (1976) critique. The third area relating to dynamic games has drawn out the importance in policy analysis of the roles of commitment, credibility and reputation as well as clarifying the distinction between rules and discretion. The insights gained relating to the time inconsistency of policy have now been applied to a wide variety of areas other than the conduct of monetary policy. Although Barro remains enthusiastic about real business cycle theory, he, like Lucas, began to redirect his research work in the late 1980s primarily towards issues related to economic growth (see Barro, 1991, 1997; Barro and Sala-i-Martin, 1995).

For detailed surveys of the evolution and development of REBCT, the reader is referred to Walsh (1986), Rush (1987), Kim (1988), Plosser (1989), Mullineux and Dickinson (1992), McCallum (1992), Danthine and Donaldson (1993), Stadler (1994), Williamson (1996), Ryan and Mullineux (1997), Snowdon and Vane (1997a), Hartley et al. (1998), Arnold (2002), and Kehoe and Prescott (2002).

6.3Real Business Cycle Theory in Historical Perspective

Real business cycle theory, as developed by its modern proponents, is built on the assumption that there are large random fluctuations in the rate of technological progress. These supply-side shocks to the production function generate fluctuations in aggregate output and employment as rational individuals respond to the altered structure of relative prices by changing their labour supply and consumption decisions. While this development is in large part a response to the demise of the earlier monetary misperception models and Lucas’s call to construct ‘artificial economies’, it also represents a general revival of interest in the supply side of the macro equation.

The idea that business cycles might be driven by real rather than monetary forces is certainly not an entirely new idea. The real business cycle models inspired by Kydland and Prescott’s (1982) seminal paper belong to a long line of analysis which was prominent in the literature before Keynes’s (1936) General Theory (see Haberler, 1963, for a superb survey of the interwar business cycle literature). Whereas some economists such as Ralph Hawtrey held to the extreme monetary interpretation of the business cycle, the work of others, in particular Dennis Robertson, Joseph Schumpeter and Knut Wicksell, emphasized real forces as the engine behind business fluctuations (see Deutscher, 1990; Goodhart and Presley, 1991; T. Caporale, 1993). While the work of Robertson was not as dismissive of monetary forces as modern real business cycle theory, according to Goodhart and Presley there is a great deal of similarity between the emphasis given by Robertson to technological change and the recent work of the equilibrium theorists. Technological change also played a pivotal role in Joseph Schumpeter’s analysis of the short-run instability and long-run dynamics of capitalist development. Since the introduction of new technology influences the long-run growth of productivity as well as causing short-run disequilibrating effects, Schumpeter, like modern real business cycle theorists, viewed cycles and growth as inseparably interrelated (see Schumpeter, 1939). Caporale (1993) argues that Knut Wicksell was also an early expositor of real business cycle theory. Caporale shows that Wicksell attributed ‘trade cycles to real causes independent of movements in commodity prices’. To Wicksell the main cause of the trade cycle is a supplyside shock that raises the natural rate of interest above the loan rate of interest. This is equivalent to a reduction in the loan rate of interest since the banking system will typically fail to adjust the loan rate immediately to reflect the new natural rate. Loan market disequilibrium acting as a propagation mechanism leads to endogenous money creation by the banking system in response to entrepreneurs’ demand for loans to finance investment. The investment boom, by distorting the time structure of production, thereby creates inflationary pressures. Eventually the money rate of interest catches up with the natural rate and the boom comes to an end. While this story had a major influence on later Swedish and Austrian monetary theories of the trade cycle, Caporale highlights how the Wicksell trade cycle story begins with a real shock to the marginal product of capital. Wicksell’s real shocks plus endogenous money account of the trade cycle is therefore remarkably similar to the modern versions of REBCT provided by, for example, King and Plosser (1984); see below, section 6.12.

Following the publication of Keynes’s (1936) General Theory, models of the business cycle were constructed which emphasized the interaction of the multiplier–accelerator mechanism (Samuelson, 1939; Hicks, 1950; Trigg, 2002). These models were also ‘real’ in that they viewed fluctuations as being

driven by real aggregate demand, mainly unstable investment expenditures, with monetary factors downgraded and supply-side phenomena providing the constraints which give rise to business cycle turning points (see Laidler, 1992a). Whatever their merits, multiplier–accelerator models ceased to be a focus of active research by the early 1960s. To a large extent this reflected the impact of the Keynesian revolution, which shifted the focus of macroeconomic analysis away from business cycle phenomena to the development of methods and policies which could improve macroeconomic performance. Such was the confidence of some economists that the business cycle was no longer a major problem that by 1969 some were even considering the question: ‘Is the Business Cycle Obsolete?’ (Bronfenbrenner, 1969). Similar conjectures about ‘The End of the Business Cycle’ appeared during the late 1990s, often framed in terms of discussions of the ‘new economy’; see, for example, Weber (1997). We have already seen that during the 1970s and 1980s the business cycle returned with a vengeance (relative to the norm for instability post 1945) and how dissatisfaction with Keynesian models led to monetarist and new classical counter-revolutions.

The most recent developments in business cycle research inspired by equilibrium theorists during the 1980s have proved to be a challenge to all the earlier models relying on aggregate demand fluctuations as the main source of instability. Hence real business cycle theory is not only a competitor to the ‘old’ Keynesian macroeconomics of the neoclassical synthesis period but also represents a serious challenge to all monetarist and early MEBCT new classical models.

In addition to the above influences, the transition from monetary to real theories of the business cycle was further stimulated by two other important developments. First, the supply shocks associated with the two OPEC oil price increases during the 1970s made macroeconomists more aware of the importance of supply-side factors in explaining macroeconomic instability (Blinder, 1979). These events, together with the apparent failure of the demand-oriented Keynesian model to account adequately for rising unemployment accompanied by accelerating inflation, forced all macroeconomists to devote increasing research effort to the construction of macroeconomic theories where the supply side has coherent microfoundations (see Chapter 7). Second, the seminal work of Nelson and Plosser (1982) suggested that real shocks may be far more important than monetary shocks in explaining the path of aggregate output over time. Nelson and Plosser argue that the evidence is consistent with the proposition that output follows a path, which could best be described as a ‘random walk’.

Before examining the contribution of Nelson and Plosser in more detail it is important to note that the desire of both Keynesian and new classical economists to build better microfoundations for the supply side of their

models should not be confused with the emergence during the late 1970s and 1980s of a distinctive ‘supply-side school’ of economists, particularly in the USA during the presidency of Ronald Reagan. Writing in the mid-1980s, Feldstein distinguished between ‘traditional supply-siders’ and the ‘new sup- ply-side economics’ (Feldstein, 1986). Traditional supply-siders base their analysis on mainstream neoclassical economic analysis and emphasize the efficiency of markets, the importance of incentives for economic growth, and the possibility of government failure. A large consensus of economists would subscribe to this form of supply-side economics, including Keynesians, monetarists and new classicists (see Friedman, 1968a; Tobin, 1987; Lucas, 1990a). In contrast, the new supply-siders, such as Arthur Laffer, Jude Wanniski and President Reagan himself, made ‘extravagant claims’ relating to the impact of tax cuts and deregulation on the rate of economic growth. While supplysiders claimed that the incentive effects of the Reagan tax cuts were responsible for the US recovery after 1982, Tobin (1987) argued that Reagan’s policies amounted to ‘Keynesian medicine, demand tonics masquerading as supplyside nostrums, serendipitously administered by anti-Keynesian doctors’. For discussions of ‘Reaganomics’ and the influence of ‘new supply-siders’ during the 1980s see Samuelson (1984); Blanchard (1986); Feldstein (1986); Levacic (1988); Modigliani (1988b); Roberts (1989); and Minford (1991).

6.4Cycles versus Random Walks

During the 1970s, with the rebirth of interest in business cycle research, economists became more involved with the statistical properties of economic time series. One of the main problems in this work is to separate trend from cycle. The conventional approach has been to imagine that the economy evolves along a path reflecting an underlying trend rate of growth described by Solow’s neoclassical model (Solow, 1956). This approach assumes that the long-run trend component of GNP is smooth, with short-run fluctuations about trend being primarily determined by demand shocks. This conventional wisdom was accepted by Keynesian, monetarist and new classical economists alike until the early 1980s. The demand-shock models of all three groups interpret output deviations from trend as temporary. If business cycles are temporary events, then recessions create no long-run adverse effects on GDP. However, whereas Keynesians feel that such deviations could be severe and prolonged and therefore justify the need for corrective action, monetarists, and especially new classical economists, reject the need for activist stabilization policy, having greater faith in the equilibrating power of market forces and rules-based monetary policy.

In 1982, Nelson and Plosser published an important paper which challenged this conventional wisdom. Their research into macroeconomic time

series led them to conclude that ‘macroeconomic models that focus on monetary disturbances as a source of purely transitory fluctuations may never be successful in explaining a large fraction of output variation and that stochastic variation due to real factors is an essential element of any model of macroeconomic fluctuations’. If real factors are behind aggregate fluctuations, then business cycles should not be viewed as temporary events. Recessions may well have permanent effects on GDP. The much-discussed ‘productivity slowdown’ after 1973 represents one such example (see Fischer et al., 1988). Abel and Bernanke (2001) note that GDP in the USA remained below the levels consistent with the 1947–73 trend throughout the 1980s and 1990s. In an analysis of the UK economy in the interwar period Solomou (1996) finds that the shock of the First World War, and further shocks in the immediate post-war period, had a permanent effect on the path of equilibrium output.

Nelson and Plosser reached their important conclusion because in their research into US data they were unable to reject the hypothesis that GNP follows a random walk. How does this conclusion differ from the conventional approach? The view that reversible cyclical fluctuations can account for most of the short-term movements of real GNP can be represented by equation (6.1):

where t represents time, g and b are constants and z represents random shocks which have a zero mean. In equation (6.1) gt represents the underlying average growth rate of GNP which describes the deterministic trend. Suppose there is some shock to zt that causes output to rise above trend at time t. We assume that the shock lasts one period only. Since Yt depends on Yt–1, the shock will be transmitted forward in time, generating serial correlation. But since in the traditional approach 0 < b < 1, the impact of the shock on output will eventually die out and output will return to its trend rate of growth. In this case output is said to be ‘trend-reverting’ or ‘trend-stationary’ (see Blanchard and Fischer, 1989).

The impact of a shock on the path of income in the trend-stationary case is illustrated in Figure 6.1, where we assume an expansionary monetary shock occurs at time t1. Notice that Y eventually reverts to its trend path and therefore this case is consistent with the natural rate hypothesis, which states that deviations from the natural level of output caused by unanticipated monetary shocks will be temporary.

In contrast to the above, Nelson and Plosser argue that most of the changes in GNP that we observe are permanent, in that there is no tendency for output to revert to its former trend following a shock. In this case GNP is said to