Snowdon & Vane Modern Macroeconomics

rich class of models to be studied and as we get better tools we are going to learn more.

One of the main features of Keynesianism has always been the high priority given by its advocates to the problem of unemployment. Equilibrium business cycle theory seems to treat unemployment as a secondary issue. How do you think about unemployment?

When I think about employment it is easy because you can go out and measure it – you see how many hours people work and how many people work. The problem with unemployment is that it is not a well-defined concept. When I look at the experience of European economies like France and Spain, I see unemployment as something to do with the arrangements that these societies set up. Unemployment, particularly among the young, is a social problem. Lars Ljungqvist and Tom Sargent [1998] are doing some very interesting work on this question and that is something I want to study more.

Given that your work has provided an integrated approach to the theory of growth and fluctuations, should we perhaps abandon the term ‘business cycle’ when we refer to aggregate economic fluctuations?

Business cycles are in large part fluctuations due to variations in how many hours people work. Is that good language or not? I think I’ll leave that for you to decide [laughter]. I’m sympathetic to what your question implies, but I can’t think of any better language right now.

Methodology

You are known as a leading real business cycle theorist. Are you happy with that label?

I tend to see RBC theory more as a methodology – dynamic applied general equilibrium modelling has been a big step forward. Applied analyses that people are doing now are so much better than they used to be. So in so far as I am associated with that, and have helped get that started, I am happy with that label.

Do you regard your work as having resulted in a revolution in macroeconomics?

No – I have just followed the logic of the discipline. There has been no real dramatic change, only an extension, to dynamic economics – it takes time to figure things out and develop new tools. People are always looking for the revolutions – maybe some day some revolution will come along, but I don’t think I’ll sit around and wait for it [laughter].

What role have calibration exercises played in the development of real business cycle models?

I think of the model as something to use to measure something. Given the posed question, we typically want our model economy to match reality on certain dimensions. With a thermometer you want it to register correctly when you put it in ice and in boiling water. In the past economists have tried to find the model and that has held them back. Today people don’t take the data as gospel; they look at how the data are collected. So it has forced people to learn a lot more about government statistics on the economy.

How important was Lucas’s [1980a] paper on ‘Methods and Problems in Business Cycle Theory’ in your development of the calibration approach?

It’s hard to recall exactly – I saw his vision more clearly later on. Back then I kept thinking of trying to find the model, as opposed to thinking of economic theory in terms of a set of instructions for constructing a model to answer a particular question. There never is a right or wrong model – the issue is whether a model is good for the purpose it is being used.

Kevin Hoover [1995b] has suggested that ‘the calibration methodology, to date, lacks any discipline as stern as that imposed by econometric methods’. What happens if you have a Keynesian and a real business cycle model which both perform well? How do you choose between the two?

Well, let’s suppose you work within a Keynesian theoretical framework and it provides guidance to construct models, and you use those models and they work well – that’s success, by definition. There was a vision that neoclassical foundations would eventually be provided for Keynesian models but in the Keynesian programme theory doesn’t provide much discipline in constructing the structure. A lot of the choice of equations came down to an empirical matter – theory was used to restrict these equations, some coefficients being zero. You notice Keynesians talk about equations. Within the applied general equilibrium approach we don’t talk about equations – we always talk about production functions, utility functions or people’s ability and willingness to substitute. We are not trying to follow the physicist in discovering the laws of motion of the economy, unlike Keynesians and monetarists. Keynesian approaches were tried and put to a real test, and to quote Bob Lucas and Tom Sargent [1978], in the 1970s Keynesian macroeconometric models experienced ‘econometric failure on a grand scale’.

To what extent is the question of whether the computational experiment should be regarded as an econometric tool an issue of semantics?

It is pure semantics. Ragnar Frisch wanted to make neoclassical economics quantitative – he talked about quantitative theoretical economics and quanti-

My interest is in the problem of the poor countries, like India. In those countries it is important to let things happen and not protect the status quo. For example, there are some bizarre licensing practices in India. Once things start happening, they can happen pretty fast and there can be rapid development.

How do you account for the revival of interest in development economics?

People pushed the paradigm as far as the old tools would allow it to go. Now a new generation has come along and has sought to advance it a little bit further. Exciting theoretical developments as well new data sets are key to the revival of interest. People like Kravis, and more recently Summers and Heston [1991], have done a major service to the profession by providing new data.

General

If you were asked to teach macroeconomics to intermediate undergraduates, how would you go about the task?

Basically I concentrate on the Solow growth model, with factors paid their marginal product and consider the two key decisions: consumption–saving and labour–leisure. In discussing monetary issues I follow some basic simple intertemporal model with people holding assets – Neil Wallace and his students have developed some pretty good material that can be used. The hard thing about teaching macro to undergraduates is that the textbooks are not that good – there is a need for a Paul Samuelson. Samuelson is an artist; he brought undergraduates pretty well up to the level of the state of knowledge in the profession. Now there is a big gap.

Most of your work has involved research which has pushed back the frontiers of knowledge in economics. Have you ever thought about writing a basic principles of economics textbook or an intermediate macro textbook?

Writing this type of book requires a special talent – if I had this talent I would give it some serious thought. I don’t [laughter].

Have you ever been asked to be an economic adviser in Washington?

No [laughter]. I get too excited – you have to be calm and have the right style. You also have to be a good actor as well as being a good economist. So again I’ve never been tempted – maybe if I had the ability I might have been asked.

Are you optimistic about the future of macroeconomics?

Yes – I think a lot of progress has been made and will continue to be made.

What issues or areas are you currently working on?

I always work on a variety of issues in the hope that one will break [laughter]. I’ve recently completed a couple of papers [Parente and Prescott, 1997; Prescott, 1998]. One paper is on economic development for a monograph on barriers to riches – I use game theory to construct an explicit model economy where a particular set of monopoly rights can give rise to large differences in total factor productivity. The other paper is on financial economics, considering why there occurs such a big jump in the value of firms associated with mergers. I also want to look more fully at the issue of the relationship and interaction between monetary and fiscal policy I hinted at earlier.

Blinder (1979), all of whom are ‘Keynesians’, was particularly useful in creating the necessary groundwork which has subsequently allowed the Keynesian model to adapt and evolve in a way that enabled monetarist influences to be absorbed within the existing framework (Mayer, 1997; DeLong, 2000). Moreover, this transition towards a synthesis of ideas did not require any fundamental change in the way economists viewed the economic machine. For example, Gordon (1997) argues that his ‘resolutely Keynesian’ model of inflation, introduced in the mid-1970s and based on inertia, demand and supply shocks, within an expectations-augmented Phillips curve framework, performs very well in explaining the behaviour of output, unemployment and inflation during the ‘Great Inflation’ period. By introducing supply shocks into the Phillips curve framework, Gordon’s ‘triangle’ model proved capable of explaining the positive correlation between inflation and unemployment observed during the 1970s. Meanwhile, debate continues on the relative importance of demand and supply shocks as causes of the ‘Great Inflation’ (see Bernanke et al., 1997; Barsky and Kilian, 2001).

Despite these positive developments within Keynesian economics, by 1978 Lucas and Sargent were contemplating life ‘After Keynesian Macroeconomics’. In their view the Keynesian model could not be patched up. The problems were much more fundamental, and related in particular to: (i) inadequate microfoundations which assume non-market clearing; and (ii) the incorporation in both Keynesian and monetarist models of a hypothesis concerning the formation of expectations which was inconsistent with maximizing behaviour, that is, the use of an adaptive rather than rational expectations hypothesis. In an article entitled ‘The Death of Keynesian Economics: Issues and Ideas’, Lucas (1980b) went so far as to claim that ‘people even take offence if referred to as Keynesians. At research seminars people don’t take Keynesian theorising seriously anymore; the audience starts to whisper and giggle to one another’ (cited in Mankiw, 1992). In a similar vein, Blinder (1988b) has confirmed that ‘by about 1980, it was hard to find an American academic macroeconomist under the age of 40 who professed to be a Keynesian. That was an astonishing intellectual turnabout in less than a decade, an intellectual revolution for sure.’ By this time the USA’s most distinguished ‘old’ Keynesian economist had already posed the question, ‘How Dead is Keynes’? (see Tobin, 1977). When Paul Samuelson was asked whether Keynes was dead he replied, ‘Yes, Keynes is dead; and so are Einstein and Newton’ (see Samuelson, 1988).

7.2A Keynesian Resurgence

Lucas’s obituary of Keynesian economics can now be seen to have been premature because Robert Barro’s ‘bad guys’ have made a comeback (Barro,

1989a). By the mid-1980s Howitt (1986) was commenting on ‘The Keynesian Recovery’, and Blinder was discussing ‘Keynes After Lucas’ (1986) and ‘The Fall and Rise of Keynesian Economics’ (1988b). By the early 1990s Blinder had announced that ‘A Keynesian Restoration is Here’ (1992b), Mankiw (1992) proclaimed that Keynesian economics had been ‘reincarnated’ and Thirlwall (1993) enthusiastically discussed the ‘Keynesian Renaissance’. While in the late 1980s the Keynesian promised land was not yet in sight, Blinder (1988a) believed that ‘we may at long last be emerging from the arid desert and looking over the Jordan’.

In answering his own (1977) question about the ‘death’ of Keynesian economics, Tobin (1987) later provided an unequivocal answer in his essay, ‘The Future of Keynesian Economics’:

One reason Keynesian economics has a future is that rival theories of economic fluctuations do not … I hazard the prediction that neither of the two species of business cycle theory offered by new classical macroeconomics will be regarded as serious and credible explanations of economic fluctuations a few years from now. Whatever cycle theory emerges in a new synthesis will have important Keynesian elements … Yes, Keynesian economics has a future because it is essential to the explanation and understanding of a host of observations and experiences past and present, that alternative macroeconomic approaches do not illuminate.

Tobin (1996) was particularly critical of the ‘elegant fantasies’ of the ‘Robinson Crusoe macroeconomics’ of real business cycle theory because it ignores the coordination question in macroeconomics (see Chapter 6). To economists such as Akerlof, Stiglitz, Tobin and Leijonhufvud, an essential task for macroeconomic theory is to explain in what circumstances the invisible hand does, and does not, efficiently coordinate the economic behaviour of numerous diverse agents. Leijonhufvud (1992) has succinctly summed up this issue:

The co-ordination question, simply stated, is this: Will the market system ‘automatically’ co-ordinate economic activities? Always? Never? Sometimes very well, but sometimes pretty badly? If the latter, under what conditions, and with what institutional structures, will it do well or do badly? I regard these questions as the central and basic ones in macroeconomics.

Certainly the persistence of high unemployment in Europe during the 1980s and 1990s also called into question the plausibility of equilibrium explanations of the business cycle while also providing increasing ‘credibility to Keynesian theory and policy’ (Tobin, 1989; Arestis and Sawyer, 1998).

We have seen in Chapter 5 and 6 how new classical macroeconomists resolved the tension between neoclassical microeconomics and Keynesian

macroeconomics by abandoning the latter. An alternative approach to this problem has been put forward by those economists who feel that the neoclassical synthesis contained some fundamental truths and that, suitably modified, Keynesian economics could once again dominate macroeconomics. The central analytical message of the orthodox Keynesian school comprised the following main propositions (Greenwald and Stiglitz, 1987, 1993a; Tobin, 1996; Lindbeck, 1998):

1.an unregulated market economy will experience ‘prolonged’ periods of excess supply of output and labour in contradiction to ‘Say’s Law’ of markets; that is, in Keynes’s terminology, market economies will exhibit ‘unemployment equilibrium’;

2.aggregate macroeconomic instability (business cycles) are mainly caused by aggregate demand disturbances;

3.‘money matters’ most of the time, although in very deep recessions monetary policy may be ineffective (Blanchard, 1990a; Krugman, 1998);

4.government intervention in the form of stabilization policy has the potential to improve macroeconomic stability and economic welfare.

While ‘new’ Keynesian economists would agree with these ‘old’ Keynesian propositions, we shall see that the new Keynesian models are very different in many aspects from their distant (1960s) cousins. While new Keynesians disagree with the new classical explanations of instability, they do share two new classical methodological premises. First, macroeconomic theories require solid microeconomic foundations. Second, macroeconomic models are best constructed within a general equilibrium framework. However, as Greenwald and Stiglitz (1993a) point out, real business cycle theorists adopt microfoundations that describe a world of perfect information, perfect competition, zero transactions costs, and the existence of a complete set of markets. Problems associated with asymmetric information, heterogeneous agents and imperfect and incomplete markets are assumed away. The essence of the new Keynesian approach is to recognize the importance of a whole variety of realworld imperfections (Stiglitz, 2000; 2002). By rebuilding the microfoundations of Keynesian economics utilizing the findings of modern microeconomic theory, new Keynesian theorists have established a research programme aimed at rectifying the theoretical flaws which permeated the supply side of the ‘old’ Keynesian model (see Snowdon and Vane, 1995). Because the typical market economy is riddled with numerous imperfections, aggregate supply does respond to changes in aggregate demand.

For a detailed and critical discussion of the new Keynesian literature, we refer the reader to McCallum (1986); Greenwald and Stiglitz (1987, 1993a); Rotemberg (1987); Fischer (1988); Barro (1989a); Blanchard (1990a); Gordon

(1990); Phelps (1990); Colander et al. (1992); Hargreaves-Heap (1992, 2002); Stiglitz (1992); King (1993); D. Romer (1993); Tobin (1993); Davidson (1994); Dixon (1997); Snowdon and Vane (1997a); Lindbeck (1998). Most of the important papers are collected in the twin volumes edited by Mankiw and Romer (1991), who also provide an excellent tour of the early literature in their introductory survey.

7.3New Keynesian Economics

Although the term ‘new Keynesian’ was first used by Parkin and Bade in 1982 in their textbook on modern macroeconomics (1982b), it is clear that this line of thought had been conceived in the 1970s during the first phase of the new classical revolution. The burgeoning new Keynesian literature since then has been primarily concerned with the ‘search for rigorous and convincing models of wage and/or price stickiness based on maximising behaviour and rational expectations’ (Gordon, 1990). New Keynesian economics developed in response to the perceived theoretical crisis within Keynesian economics which had been exposed by Lucas during the 1970s. The paramount task facing Keynesian theorists is to remedy the theoretical flaws and inconsistencies in the old Keynesian model. Therefore, new Keynesian theorists aim to construct a coherent theory of aggregate supply where wage and price rigidities can be rationalized.

Both the old and new versions of classical economics assume continuous market clearing and in such a world the economy can never be constrained by a lack of effective demand. To many economists the hallmark of Keynesian economics is the absence of continuous market clearing. In both the old (neoclassical synthesis) and new versions of Keynesian models the failure of prices to change quickly enough to clear markets implies that demand and supply shocks will lead to substantial real effects on an economy’s output and employment. In a Keynesian world, deviations of output and employment from their equilibrium values can be substantial and prolonged, and are certainly interpreted as damaging to economic welfare. As Gordon (1993) points out, ‘the appeal of Keynesian economics stems from the evident unhappiness of workers and firms during recessions and depressions. Workers and firms do not act as if they were making a voluntary choice to cut production and hours worked.’ New Keynesians argue that a theory of the business cycle based on the failure of markets to clear is more realistic than the new classical or real business cycle alternatives. The essential difference between the old and new versions of Keynesian economics is that the models associated with the neoclassical synthesis tended to assume nominal rigidities, while the attraction of the new Keynesian approach is that it attempts to provide acceptable microfoundations to explain the phenomena of wage and price stickiness.