This sample Macroeconomic Models Research Paper is published for educational and informational purposes only. Like other free research paper examples, it is not a custom research paper. If you need help writing your assignment, please use our custom writing services and buy a paper on any of the economics research paper topics.
The term macroeconomics refers to study of the behavior of an economy as a whole or as a system; the phenomena explained are (1) the short-run level of economic activity—the levels of national output, income, and employment; (2) the causes of short-run fluctuation in economic activity (business cycles); and (3) the long-run growth rate of an economy. This research paper focuses on the first two aspects of macroeconomics. The models are presented in an approximate chronological order; the research paper’s organizing theme is that modern macro-economic models can be seen as based on one of two competing “visions” of the economy: (1) The economy is seen as stable, with strong market forces pushing it toward an equilibrium level consistent with full employment of labor and capital (as in the classical and new classical models), or (2) it is seen as an unstable system that grows through time in a boom-bust pattern, with its normal state being less than full employment and so less-than-potential output being produced (as in Keynes’s and the Keynesians’ models).
The Beginning: Keynes’s Critique of Classical Economics
Macroeconomics as a distinct field within economics emerged in the late 1930s as a response to John Maynard Keynes’s General Theory of Employment, Interest and Money (1936/1973, referred to subsequently as GT). Keynes contrasted his views on the causes of depressions and persistent involuntary unemployment with those of his predecessors, whom he termed the classical economists. In Keynes’s view, these economists assumed that the normal condition for a market economy is one of capital-accumulation-fueled growth with full employment of labor and capital, and that periods of high unemployment were rare and temporary deviations from the norm. Keynes wrote that this assumption is empirically incorrect because economies frequently experienced prolonged periods of high unemployment and below-potential output (recessions or depressions). He presents his model by developing a critique of three dimensions of the classical theory: (1) Say’s law, (2) the quantity theory of money, and (3) continual clearing of the labor market at “full employment.”
Keynes’s informal model (informal meaning that he did not specify his model with a series of equations or represent it with a set of diagrams but, rather, mainly used verbal exposition) begins by seeing the classical economists as having all held the validity of Say’s law of markets. Say’s law denoted an argument that all income generated by production would be spent on purchasing the national product—either directly, as when workers’ wages or capitalists’ profits are spent on consumption, or indirectly, when capitalists’ savings are borrowed by firms to finance purchases of new capital goods. In modern economic language, we say that the classical economists assumed that the level of aggregate demand (Keynes’s innovative term) for products always equals the cost of producing them, including a return on their capital to the capitalists whose firms produce the products; in other words, aggregate demand is equal to aggregate supply. Because this would mean that firms would always be able to sell any quantity of goods they might produce, they would choose output levels based on their calculations of their profit-maximizing outputs. They would collectively find it profitable to employ as many workers as were willing to sell labor services at the going wage rates; full employment would result: The only unemployed workers would be those unwilling to accept the going wage rate, who were considered to be “voluntarily unemployed.” Keynes rejected this proposition; in his model, aggregate effective demand for the social product was quite likely to be less than the value of what would be produced if all workers willing to work were employed (aggregate demand could be less than aggregate supply at full employment). If the latter occurred, firms would reduce their employment and output levels until they arrived at the levels at which their sales rates equaled their production rates. So aggregate demand determines the level of actual output and employment, and significant and persistent involuntary unemployment can occur. The cause of recessions or depressions is inadequate aggregate demand. How could this occur? Keynes had a simple answer: Although workers’ wage income was generally spent, creating demand for products, profits and interest might very well be saved. And if all of those savings were not borrowed to finance demand for investment goods, aggregate demand could be less than sufficient to employ all those willing to work. Depressions are caused by “too much saving”—too much in comparison with the amount of investment that firms are willing to borrow to finance
Keynes also rejected the validity of another aspect of classical economics: the quantity theory of money (QTM). The QTM argues that the exchange value of a monetary unit is expressed in the average level of prices within the economy (P), and that increases or decreases in the quantity of money (M) in circulation would cause changes in the price level P. Sophisticated versions of the theory were presented using the equation of exchange M x V = P x Y, in which V represents the velocity of circulation of the money stock and Y represents the current (and assumed full-employment level of national product). If V and Y are assumed to be constant, changes in M would lead to directly proportional changes in P. Because the QTM assumed that V and Y were fixed in the short run, changes in the quantity of money (e.g., an increase in M) would not affect the real level of output or employment. So money is “neutral” within the economy: Changes in the money stock will not cause changes in the levels of output or employment.
In Keynes’s model, changes in the quantity of money could cause changes in interest rate levels that could influence aggregate demand for products (especially for investment spending on new capital goods) and thus could influence aggregate production and employment. Money is not generally neutral in Keynes’s model; increases in the money stock would affect only the price level and not output in the special case of the economy already being at the full-employment, full-output level.
Finally, Keynes also rejected the validity of the classical views on the working of the labor market, using Pigou’s model as an example of these views. Pigou and the other neoclassical marginalist theoreticians had argued that if wages were flexible because of competition for employment and employees, the levels of both the money and real wage (the purchasing power of the level of nominal or money wages) would adjust to “clear the market” for labor. They also argued that the equilibrium market-clearing real wage would be equal to the marginal product of labor. Keynes argued that money wages are usually fixed in the short run and that workers cannot bargain over their real wage that would clear the market, because neither they nor their employers can set output prices while bargaining over money wage levels.
Keynes’s Model Represented as a Set of Propositions
Keynes’s theory and model attempt to describe the relationship between the amount of money in circulation, the level of interest rates, and the level of employment (his model, the GT, places financial markets and interest rates at the heart of the macroeconomy).
- High unemployment is caused by insufficient aggregate demand for national product.
- Insufficient aggregate demand is the result of saving in excess of business’ willingness to borrow to finance investment in new capital goods.
- Excessive saving is done by high-income earning households, who receive interest on bonds; it is the result of an “arbitrary and excessive inequality in the distribution of income” (Keynes, 1936/1973, p. 372). Low investment is caused by low profit expectations or high interest rates, or both—both of which discourage business investment in new capital goods.
- Low levels of aggregate demand by the private sector (firms and households) can be offset by high levels of government expenditures (stimulative fiscal policy). Low levels of interest rates can also encourage more investment.
- He argues that the rate of interest should be seen as the price of liquidity (or the price of holding financial wealth as money, as opposed to less liquid financial assets, such as bonds). He termed this the liquidity preference theory of money and interest.
- The level of the rate of interest is explained as determined by the interaction of the supply and demand for money, with the supply controlled by the central bank through monetary policy and the demand determined by the level of transactions and the price level of those transactions, plus financial wealth holders’ expectations regarding the future market price of bonds.
- Another theoretical proposition advanced by Keynes was that if either government expenditures or private investment expenditures increased, total expenditures (aggregated demand) and actual output would increase by a greater amount: He termed this the multiplier effect.
Soon after the publication of his book, professional economists began discussing Keynes’s views in professional journals, most often in the form of book reviews.
Other economists attempted to describe and interpret Keynes with more formal models. The most influential example of this is John R. Hicks’s (1937) IS/LM model, which represented Hicks’s interpretation of Keynes’s theory with a set of equations and a two-dimensional diagram. Hicks argued that Keynes’s theory rested on the validity of his assumption that money wages were fixed in the short run and would not fall if unemployment increased, so Keynes’s model should be seen as valid only in the “special case” of an economy in which some institutional factors prevented wages from being downwardly flexible; ironically, Keynes had not presented a “general theory,” valid for all economies. Hicks later repudiated his evaluation of Keynes’s theory and argued that his model oversimplified Keynes’s theory (Hicks, 1957, 1967).
Other attempts at presenting a formal model of Keynes’s theory were made by Alvin Hansen (1953) and Paul Samuelson (1948). Their model became known as the Hansen-Samuelson Keynesian cross diagram. Given the levels of interest rates, money wages and prices, the parameters of the consumption function—that is, the relationship between personal income and personal consumption expenditures—and planned business investment expenditures, the economy finds a unique equilibrium level of output at the level where aggregated demand equals aggregate production.
By the early 1950s, Keynes’s theory was widely seen as valid by most professional economists (especially among academics). Economists accepting the validity of the Keynesian short-run theory of output determination became known as Keynesians. Their published work focused on how fiscal policy could be used to prevent or end depressions, but they also developed business cycle theory and growth theory consistent with Keynes’s short-run model. Toward the end of the 1950s and in the early 1960s, some of these economists began to argue that Keynes’s theory of depression (inadequate demand causing involuntary unemployment) could be extended to explain price inflation (too much demand at full employment). Logically, there should be a level of unemployment consistent with stable prices and wages, and this was seen as a desirable target for macroeconomic policy. Full employment became defined as the lowest rate of unemployment consistent with wage and price stability. Empirical work attempting to estimate the relationship between wages, prices, and unemployment levels produced evidence of an inverse relationship between unemployment and wage or price inflation, consistent with theory. Because such a relationship is downward sloping if graphed with inflation on the vertical axis and unemployment on the horizontal axis, this curve became a part of the core of Keynesian economics (and named the Phillips curve after W. Phillips, 1958, who conducted one of the earliest econometric estimates of its parameters). Another core belief among the “original Keynesians” was that monetary policy by itself was not usually sufficient to end a severe recession; rather, a fiscal policy stimulus of higher spending by the national government was required. The increases in U.S. gross domestic product (GDP) following increases in expenditure during the 1930s and especially the dramatic increase following large increases in World War II (WWII)-related military expenditures was interpreted by the Keynesians as empirical evidence in support of their central propositions.
However, even as Keynesian economics became dominant in the academy and widely adopted as a guide to macroeconomic policy, widespread opposition to the core theory appeared within academic economics, and Keynesian economics itself divided into several quite different schools of thought, stressing different aspects of Keynes’s somewhat vague and informal model in the GT, including approaches now known as original Keynesians, post-Keynesians, and new Keynesians.
The Evolution of Macroeconomics Since the 1960s
The history of macroeconomics over the last 40 years can be interpreted as a struggle between competing visions of the economy and the proper macroeconomic roles of the state. One vision is exemplified by new classical economics, which sees the economy as essentially stable and tending toward an equilibrium characterized by high employment and an economic growth rate largely determined by the rate of technological change (the natural rate of unemployment and the steady-state rate of growth). Another, contrasting, approach taken by institutionalist and post-Keynesian economics rests on a vision of a very unstable economy, whose growth rate is the result of an open-ended transformational process taking place through economic fluctuations, characterized by excessive unemployment and inequality, and which is often threatened by incoherence and the possibility of breakdown; this approach is called evolutionary Keynesianism here.
The first approach implies a noninterventionist role for the state in the economy; the second argues for a strong interventionist state. A third approach, which acknowledges occasional episodes of instability and a limited role for the state in stabilization and the active promotion of growth, appears in new Keynesian economics and new endogenous growth theory, and appears currently hegemonic within mainstream economics.
New classical economics supports arguments against activist macroeconomic stabilization policy, whereas original Keynesian, new Keynesian, institutionalist, and post-Keynesian economics all support intervention. To a great extent, the debates within macroeconomics reflect a broader and deeper philosophical division between proponents of a radical laissez-faire economic philosophy and those who advocate a strong, interventionist state with wide responsibilities for the common good. The institutionalists and post-Keynesians share a common vision and models that are similar in many respects; their approach is designated evolutionary Keynesianism in what follows. The primary purpose of the rest of this research paper is to delineate the important differences between the new classical (NC), new Keynesian (NK), and evolutionary Keynesian (EK) approaches. This research paper suggests that although new classical economics (NC) dominated the mainstream in the 1970s and 1980s, its influence has declined recently as new Keynesian (NK) economics has become more influential, dominating the postmonetarist “new consensus” among macroeconomists. The research paper also argues that the institutionalist/post-Keynesian approach offers a third framework for economic policy.
The Rise of New Classical Economics: Monetarism, Rational Expectations, and Real Business Cycle Theory
The brief hegemony of Keynesian economics within academia and policy economics lasted for about 2 decades (perhaps from the late 1940s to around 1970) before being challenged by the new version of classical economics. The 1960s consensus approach to macroeconomics was represented with fixed-price, fixed-wage versions of Samuelson’s (1948) and Hansen’s (1953) Keynesian cross and John Hicks’s (1937) IS/LM macroeconomic models of income and employment, and was based on the assumption of a stable relationship between unemployment and price or wage inflation, represented with a Phillips curve. This approach was often referred to by Paul Samuelson’s term neoclassical-Keynesian synthesis, because its implicit microeconomic foundation was largely a form of the Marshallian price theory that Keynes had used in his GT and that then formed the core of standard neoclassical academic microeconomics, while its macroeconomics was an interpretation of Keynes’s theory of effective demand.
The first generation of Keynesian economists saw national governments as responsible for economic stability, economic growth, and full employment, with the highest short-term priority to be given to full employment. Business cycles were seen as caused by fluctuations in aggregate demand, which could be offset with fiscal policy; monetary policy should be used to support fiscal policy, but monetary policy by itself was generally seen as inadequate to stabilize the economy.
Many economists and historians see Keynesian economics as one of the cornerstones of the post-WWII consensus regarding the proper relationship between the state and the economy, and as an integral component of the argument for a more interventionist role of the state. The new political-economic system that emerged in the 1940s and 1950s in most of the wealthy capitalist nations has been described with many terms including welfare capitalism, managed capitalism, state capitalism, monopoly capitalism, and guided capitalism. The counterrevolution to the Keynesian revolution of the 1940s and 1950s began in the late 1960s with the rise of monetarism, the first component of what was to become NC economics.
Monetarism can be understood as a set of theoretical propositions and policy proposals focused on the macro-economic role of money. The core theoretical propositions are as follows:
- The economy is essentially stable and tends toward an equilibrium at a “natural rate” of unemployment that is consistent with stable wages and prices; this natural rate of employment, the stock of capital, and technology then determine the potential level of national income.
- Disturbances to equilibrium are almost always caused by changes in the money stock or its growth rate.
- If unanticipated, these monetary shocks can result in temporary fluctuations in output and employment, but the economy tends to return to the natural rate quickly as wages, prices, and interest rates adjust. Monetarists argue that anticipated monetary shocks are likely to change only the levels of wages, prices, and interest rates even in the short run. Changes in the money supply are neutral in the long run with respect to the real dimensions of the economy: the levels of output, employment, the composition of output, and the real wage. This proposition is described as the classical dichotomy between the real and nominal or monetary dimensions of the economy, and its refutation was one of the core ideas in Keynes’s GT.
- Inflation and deflation are the result of excessive or insufficient growth rates in the money stock as in the QTM.
A set of ancillary propositions agreed to by most monetarists was consistent with and supported the core distinguishing theoretical principles of their school mentioned previously.
- Most versions of monetarism assumed that fiscal policy could not be used to stabilize an economy or otherwise improve macroeconomic performance; this was described as the “ineffectiveness” of fiscal policy in the literature. Changes in government budgets (deficits) intended to stimulate the economy that were financed by borrowing and bond issue resulted in rising interest rates and “crowded out” private investment. Deficits financed by printing money led to inflation; expenditures financed by taxes lowered private spending commensurately. In any of these scenarios, output composition and the allocation of resources would change, but not the aggregate level of output or employment; surpluses reduced interest rates and stimulated private investment. Because the private sector usually used resources more efficiently than the state sector, expansionary fiscal policy would have detrimental effects; because the economy tended toward the natural rate of employment, countercyclical fiscal policy was unnecessary as well as ineffective.
- The monetarists argue that the normal state of the economy is the natural rate of employment and positive economic growth as described in Robert Solow’s (1956) neoclassical growth theory. A higher saving rate would lead to a higher capital-labor ratio and raise per capita income during a transitional period, but diminishing marginal returns to capital and the free flow of capital and technology across nations implied that growth rates should converge to a “natural rate” of growth determined by technological change.
The key policy proposal advanced by monetarists became known as Friedman’s rule: Central banks should concentrate on keeping the price level constant (or inflation very low) by setting the growth rate of money at the anticipated growth rate in real output plus the estimated change in velocity. In more sophisticated versions, Milton Friedman (1968) acknowledged that some circumstances such as financial crises might warrant a temporary abandonment of monetary growth targets by the central bank, but he argued that such episodes would not occur very often if the central bank were committed to a stable monetary growth regime, which would be consistent with a stable economy. If the chief source of fluctuations in nominal GDP were fluctuations in the money supply, economic fluctuations would largely disappear under such a regime.
Monetarists also advocated flexible exchange rate systems, arguing that they would strengthen the effectiveness of monetary policy and increase its independence by doing away with the necessity to use monetary policy to peg the exchange rate. Keynes and the Keynesians favored interest rate targets, discretionary monetary policy as a supplement to fiscal policy, and fixed exchange rates to reduce uncertainty.
As increasingly formal versions of monetarism were presented, debates centered on how expectations regarding future levels of wages and prices were formed, and how changes in expectations affected the relationship between unemployment, wages, and prices, which the first generation of Keynesians had thought to be fairly stable and described with Phillips curves. Early versions of Phillips curves (Phillips, 1958; Samuelson & Solow, 1960) described a stable inverse relationship between wage or price inflation and unemployment, which would allow policy makers to choose a level of unemployment and inflation. Edmund Phelps (1968) and Friedman (1968) argued that Phillips curves shift over time, implying unanticipated changes in the natural rate, as the economic environment changes; especially important in their view were expectations of future inflation, which were largely determined by the recent past behavior of prices.
If monetary policy caused inflation by pushing unemployment below the natural rate (by “surprising” workers who did not anticipate reductions in their real wage caused by the inflation), the increase in inflation would lead to more inflation as economic actors attempted to regain their real income by raising wages, prices, and interest rates (known as the Gibson paradox and Fisher effect in the literature). Economic actors’ inflationary expectations adapted to the actual rate of inflation as they looked backward into time trying to forecast economic conditions. These related propositions came to be known as the back-ward-looking or adaptive expectations model and were represented with inflation-augmented Phillips curves, which were vertical at the natural rate in the long run, as in the “neutrality of money” story.
By the late 1970s, monetarism, the natural rate hypothesis, shifting Phillips curves, and vertical long-run Phillips curves at the natural rate of unemployment appeared in all macroeconomics textbooks and were widely accepted as valid analytic concepts within mainstream economics. Support for the neoclassical-Keynesian synthesis and discretionary countercyclical fiscal policy declined. The Federal Reserve began targeting monetary aggregates in 1970 and increasingly emphasized control over monetary aggregates as its primary intermediate target for policy and low inflation as its primary ultimate objective throughout the 1970s and early 1980s; between 1979 and early 1982, it conducted an inflation-fighting monetarist “experiment,” targeting the growth rate of the monetary base and the monetary aggregates M1 and M2, while allowing interest rates to increase and fluctuate widely. This episode was consistent with the wide support for monetarism within economics and is often cited to indicate the high watermark of monetarist influence among policy makers in the United States.
A parallel development beginning in the early 1970s was the increasing insistence by some economists that Keynesian economics was not based on the proper micro-foundations with respect to assumptions about human behavior. If economic actors are rational and utility maximizing, and markets are complete and efficient, markets should continuously clear—including the market for labor.
Persistent involuntary unemployment seems logically inconsistent with those assumptions, since the labor market should allow utility-maximizing workers and profit-maximizing firms to find each other. Many economists began to reject Keynesian models as unscientific because they ignored these issues and seemed inconsistent with the rational expectations hypothesis.
Combining aspects of monetarism (the quantity theory) and the Walrasian microfoundations critique, Robert E. Lucas Jr. (1972, 1973, 1975, 1976), Thomas Sargent and Neil Wallace (1975), and others argued that if changes in the money stock caused inflation, and if economic actors understood the connection between money and prices— and if they were rational—they would come to anticipate inflation whenever the money stock grew (they would learn from their mistakes and change their behavior). If rational economic actors noticed that the central bank increased the money supply whenever unemployment increased, their “rational” reaction to increasing unemployment and anticipated money supply growth would be to raise wages, prices, and interest rates. Rational economic actors would be forward looking in forming their expectations regarding inflation. If so, monetary policy could not be effective in changing the real dimensions of the economy in even the short run unless the policy changes were unsystematic—irrational policy moves that rational actors would not anticipate, such as raising interest rates in a recession or lowering them in an inflationary boom.
Building on the rational expectations framework, Robert Barro (1974, 1981a, 1981b) argued that rational behavior by forward-looking economic actors would also prevent fiscal policy from stimulating the economy. For example, if the government proposes a tax cut to stimulate consumption and employment, rational consumers and tax payers will anticipate higher taxes (on themselves or their descendants) in the future to repay the increased government debt and will save more to finance those higher anticipated taxes, reducing their current consumption: Aggregate current demand cannot be stimulated with tax cuts. This proposition is known as Ricardian equivalence because Barro claims David Ricardo as an early proponent (although Ricardo himself seems not to have believed in the empirical validity of the proposition; O’Driscoll, 1977). The rational expectations hypothesis thus supports arguments for the irrelevance of both fiscal and monetary stabilization policy. Note that the critical assumptions supporting the ineffectiveness of intervention is that changes in the money supply will lead always to changes in the price level and not cause changes in the real dimensions of the economy (the monetarist quantity theory and neutrality of money hypotheses), and on a more fundamental level, that the economy is stable and tends toward the natural rate of unemployment, which is derived from the market-clearing hypothesis. Rational expectations economists often describe their models as equilibrium economics.
The rational expectations theory began to dominate economics as taught in elite graduate programs in the late 1970s, appearing in textbooks at about the same time. By the early 1980s, its radical argument against the possibility of altering the real dimensions of the economy through monetary or fiscal policy was widely accepted within the profession and became dominant by the end of the decade.
In the late 1970s, versions of the NC theories, business cycles, and inflationary episodes were mainly the result of external shocks to the economy, temporary misperceptions by workers or firms regarding the wages or prices that would clear markets (false trading), or the unintended consequences of well-intentioned but doomed attempts to stabilize the economy, and the latter were most often caused by unanticipated attempts to push the unemployment rate below the natural rate and to raise growth above the longrun trend determined by growth in resources and technological change. The resulting inflation required central banks to tighten monetary policy, forcing the economy into a recession until inflationary expectations were reduced and the economy returned to its equilibrium natural rates of unemployment and growth. The state should leave the economy alone, as in most versions of original classical economics; economic policy should be restricted to providing the proper institutional framework for a capitalist market economy and instructing the central bank to follow Friedman’s rule. This view is a profound rejection of the political economy of Keynes and the early Keynesians, who held that the state can and must improve the performance of the economy through discretionary monetary and fiscal policies.
Real Business Cycle Theory
But to many of those working within the rational expectations-Walrasian model, the “bad monetary policy” story seemed an inadequate explanation for business cycles; real business cycle (RBC) theory emerged in the early 1980s to offer an explanation consistent with both the Walrasian continuous market-clearing approach and the rational expectations theory’s definition of rational behavior. In this theory, economic fluctuations are largely the result of “real” or nonmonetary factors: changes in technology and in preferences by workers for leisure versus goods, or intertemporal substitution. Expansions and high growth rate periods are the result of the introduction of new technology sets, as in Schumpeter’s theory of economic development (and Marx’s as well); recessions occur when the economy readjusts to the diminishing influence of a set of technological changes on investment. Increases in unemployment not caused by technological change are the result of workers’ preferences shifting away from products toward leisure, or rational responses to changes in real wages and interest rates that alter the relative prices of goods and leisure.
Very importantly for present purposes, the RBC models denied any real effects of changes in the money stock on the economy; in fact, in an interesting twist, the money supply was seen as endogenous to the economy: The money stock increased in expansions and declined in contractions, passively reacting to cyclical changes in the demand for loans (as in the endogenous money supply theory advanced by the EK school). The RBC theory is based on a radical version of the classical dichotomy between the real and monetary dimensions of the economy.
The emerging new version of classical theory that attacked the previous Keynesian consensus began with an argument that only changes in the money stock could influence the economy (early monetarism); moved to the position that money mattered but only in the short run (the inflation-enhanced Phillips curve version of monetarism); then adopted the rational expectations position that only unanticipated, unsystematic, irrational monetary policy (“bad policy”) could have even short-run effects; and then finally proposed that money did not matter at all with respect to causation in the short-run or long-run behavior of the economy in the RBC models.
The NC theory presented a view of the economy consistent with the original classical story at least in its popularized form within modern economics literature: Capitalism is self-adjusting and stable; competitive markets lead to the most desirable state of affairs; the normal state is high employment with economic growth at the highest rate possible, given time and leisure-goods preferences and the exogenously determined rate of technological change. The only policy role for the state consistent with this vision is providing the necessary institutional structure; otherwise, laissez-faire and free market fundamentalism are advised. By the late 1980s, NC dominated academic economics in the United States in the elite graduate programs and in textbooks, and was widely taught to undergraduates as well.
Opposition to the New Classical Theory
Two strong currents questioning the validity and challenging the hegemony of NC macroeconomics developed even as NC emerged: the new Keynesians and the institutionalist/post-Keynesians or evolutionary Keynesians (EK). The new Keynesians operate within the mainstream, teaching at elite universities and publishing in the profession’s highly ranked journals; many of them (e.g., Ben Bernanke, Alan Blinder, Stanley Fischer, Gregory Mankiw, Joseph Stiglitz, Lawrence Summers, John Taylor, and Janet Yellen) have held important policymaking positions in institutions such as the Federal Reserve, World Bank, Council of Economic Advisors, U.S. Treasury, and the International Monetary Fund.
Meanwhile, outside of the inner circle of mainstream economics, a radical critique of both NC and NK based on a different vision of the economy, a different set of assumptions about human behavior and economic reality, and perhaps a different set of social values and priorities was developed by the EK school.
New Keynesian Macroeconomics
NKE emerged in the late 1970s and early 1980s in reaction to the criticism of consensus IS/LM Keynesianism mounted by the NC school; their emphasis was on explaining the causes of business cycles. The new Keynesians retained Keynes’s insistence that economic fluctuations can be caused by aggregate demand changes and that aggregate demand fluctuations could be caused by factors other than monetary shocks, and they retained the early consensus Keynesian approach that held that wages and prices were downwardly inflexible in the short run and that recessions could be seen as the result of “coordination failures” and “quantity adjustments” to demand or supply shocks. They retained the Keynesian view that recessions were inherent in capitalism, undesirable, socially expensive, and preventable with correct policy. But many of them accepted the NC microfoundations argument that assuming rational utility-maximizing behavior by economic actors and some version of rational expectations was necessary and useful for economic analysis.
Although some NK economists have advocated the use of countercyclical fiscal policy in severe recessions or when the threat of deflation appears (Stiglitz, 2002; comments by Auerbach, Blinder, and Feldstein in Federal Reserve Bank of Kansas City, 2002), most of them have argued that monetary policy is more efficient and generally sufficient to stabilize the economy. And although they advocate interventionist monetary policy to stabilize the economy (money is not neutral in the short run), they generally express a preference for monetary policy rules as opposed to discretion (Taylor, 1999, 2000). “Rules” means setting targets for policy (the rate of inflation, or more often minimizing the gap between actual and potential GDP, defined as the level of GDP consistent with the lowest sustainable level of unemployment without accelerating price inflation—the nonaccelerating rate of inflation [NAIRU]) and designing a policy reaction function in which the central bank would increase or decrease interest rates by a given amount if GDP exceeds or falls below potential. Most of the new Keynesians see the money supply as endogenous in the sense of its growth rate being the interaction of demand for credit and the central bank-determined level of short-term interest rates, and see money as neutral in the long run with respect to its influence over the growth path of the economy (DeLong, 2000; Parkin, 2000; Taylor, 2000).
Their primary focus and contribution with respect to understanding business cycles has been to demonstrate that (a) inflexible wages and prices could lead to quantity adjustments that were destabilizing (recessions could be understood as systemic coordination failures of the economy’s markets because markets do not always quickly find prices that “clear”) and that (b) rigid, sticky, or slowly adjusting prices and wages could be seen as the result of rational responses by economic actors within the actual institutions of capitalist economies. Much of their research focused on the latter point; they found plausible explanations for sticky wages and prices, which challenged both the NC argument that markets clear quickly (or would in a more nearly perfect world) and the NC claim that the Walrasian equilibrium approach was useful as a description of reality. NK has been described as disequlibrium economics, in that it explains why economies are usually not in equilibrium at the natural rate of unemployment and the potential level of output.
Inflexible wages and prices are explained by institutional factors such as monopolistic competition, menu costs, lengthy contracts, efficiency wage theory, wage and price staggering, markup pricing, bureaucratic inertia, and marketing strategy. Other NK lines of attack on NC involved skepticism regarding aspects of rational expectations, importantly including the assumption of inexpensive and complete information; the NC assumption that workers, managers, and owners actually think and behave like the NC economists’ models would have them; and propositions built on rational expectations, such as the Ricardian equivalence story.
In summation, the new Keynesians argue that capitalism is often unstable due to the persistence of both demand and supply shocks, and to the ways in which the market system adjusts to such shocks. They also believe that it is both desirable and necessary to use interventionist policy to stabilize the economy; these positions put them in the Keynesian camp and in clear opposition to the views of the NC school. Their preference for monetary policy over fiscal policy—(a) because they think monetary policy is usually effective, (b) because they think that automatic stabilizers are more effective than discretionary policy due to the relatively small estimates for multipliers and the long time lags for fiscal policy, and (c) because of the political problems that make timely changes in fiscal policy difficult—and for policy rules over discretion differentiates them from the original Keynesians as well as the post-Keynesians.
The views of the new Keynesians appear to be currently hegemonic within mainstream academic macroeconomics in the United States and United Kingdom from the perspectives of who has been selected for policy advice by the Federal Reserve, the Bank of England, and recent governments in both countries; whose macroeconomics texts are most widely adopted and whose theoretical views are dominant in classrooms; and whose policy views are adhered to by the Federal Reserve.
New Economic Growth Theory
Another interesting aspect of mainstream economics is the development of new neoclassical approaches to economic growth that go beyond the Solow growth models and lend support to arguments for government intervention in the economy. Solovian growth models are based on neoclassical and NC assumptions such as perfect competition (and continuous market clearing), diminishing marginal returns to capital, the free flow of information and technological change, and equilibrium between aggregate demand and aggregate supply (so that the economy is assumed to be always at full employment). In these models, diminishing returns to capital lead to the counterintuitive deduction that high rates of investment will have no effect on economic growth over the long run; conditional convergence should be obtained, in which countries with similar savings and population growth rates should converge to the same level of per capita national income and to the same rate of growth (the stationary state), while countries with different characteristics would end up with different per capita income levels but the same growth rate. The common growth rate would be determined by the exogenous rate of technological change under the assumption that technology and knowledge are mobile across countries (Solow, 1956); this leaves almost no role for the state in promoting economic growth.
The new economic growth theories (NEG) broaden the definition of capital to include knowledge (human capital) and also incorporate the spillover effects of investment in both human and fixed capital and the effects of increasing returns to scale. Under these conditions, countries with higher rates of savings and investment could have permanently higher rates of technological progress and economic growth. Because the growth rates of technological progress and output are influenced by the rate of investment, which is determined within these models, this approach is often termed endogenous growth theory.
For present purposes, the importance of the NEG models is that they present another reason for state intervention in the economy: The state can encourage economic growth (a) through its investment in human capital (education, research, and development) and in infrastructure (Aschauer, 1989), (b) by developing appropriate institutions (competitive markets, well-regulated financial systems, stable money), and (c) through policies that encourage saving and investment by the private sector.
A radical critique of original IS/LM Keynesianism, NCE— especially its monetarist core—and new Keynesianism as well has been developed by institutionalist and post-Keynesian economists, whose separate views on macroeconomics have been merging since the late 1970s. Following the much admired Joan Robinson, the first generation of economists who referred to themselves as post-Keynesians such as Paul Davidson (1978) used derogatory terms such as bastard Keynesianism, IS/LM Keynesianism, and textbook Keynesianism to refer to what they saw as a much attenuated and misleading version of the master’s views that had been developed in the 1940s and 1950s by the first generation of Keynesians. They argued that IS/LM Keynesianism ignores Keynes’s stress on uncertainty and disequilibrium; it is another form of general equilibrium theory, describing a tendency toward equilibrium that does not exist in the real world (or in Keynes’s theory).
These economists attempted to go beyond Keynes’s work (post-Keynesian) by building on what they saw as Keynes’s correct ideas and insights while rejecting what they found inadequate in his work. Included in the latter category are his GT assumption of a central bank-determined exogenous money supply (although Keynes apparently held to an endogenous theory of money in his other works), his Marshallian price theory, and the lack of a theory of economic growth. The post-Keynesian project is to construct a realistic model of modern capitalism that would be useful in designing policy to encourage full employment, stability, growth, and less inequality. A strong emphasis on finding practical solutions to economic policy problems is found throughout the work of this group, which has also been a hallmark of American institutionalism. Many of the early post-Keynesians were (and some still are) sympathetic to some versions of democratic socialism; most advocate some form of incomes policy; and all advocate a powerful, interventionist state whose economic policies should give highest priority to encouraging full employment, economic growth, and less inequality—the goals proposed by Keynes in the final chapter of his GT.
The core propositions of post-Keynesian economics (the first two form their “pre-analytic vision,” in Schumpeter’s [1954, pp. 41-42] term) include the following:
- The recognition of fundamental or absolute uncertainty as radically different from statistical or probabilistic risk; fundamental uncertainly does not allow us to make precise calculations of risk. Keynes observed that many of the most important economic decisions—such as whether to invest in fixed capital, purchase a bond, or hold money—are made in situations in which the information necessary to evaluate risk probabilistically will always be absent. The post-Keynesians’ understanding of uncertainty is related to their stress on the importance of historical time and the irreversibility of many important decisions, and is antithetical to the NC approach to knowledge and uncertainly.
- The economy is inherently unstable because of uncertainty and the instability of expectations, especially expectations regarding profit from investment and the future prices of assets. The classical and NC’s equilibrating mechanism of flexible prices is weak (prices are not very flexible downward), and it would actually increase instability if prices could somehow be made more flexible with institutional change, because falling prices in a recession would depress profit expectations and investment. Full employment is less likely than widespread unemployment. Financial speculation and financial instability are inherent in the structure of modern financial institutions and financial markets, and can be the cause of instability in the “real” economy. Society needs to impose stabilizing constraints on the economy, including institutions that stabilize prices, wages, and interest rates. Most important, a large government sector whose expenditure can quickly increase in slumps is necessary to prevent downward instability (Minsky, 1982); small state sectors reduce stability.
- Economic growth, economic fluctuations, and income distribution are dialectically related and mutually reinforcing: Inequality enhances instability; instability (especially recessions) reduces investment and growth, while recessions and low growth increase inequality. This centrality of demand in post-Keynesian theory leads to the proposition of demand-led growth: The long-run growth path of the economy is determined by its short-run behavior.
- Economies are best understood as “complex systems” that are “self-organizing” and exhibit “emerging properties” (see Moore, 1999, for a clear statement of this proposition and its implications; it is related to the institutionalist economists’ insistence that society’s institutions evolve through time, so that theory must be institutionally specific to be useful).
- Moving to another core proposition on a lower level of abstraction, the entry point into macroeconomics for the EK school is a “monetary theory of production” (Keynes, 1936/1973). Money is created (by banks) to finance an increase in production, which requires more fixed and circulating capital. Money is necessary for production to take place because production takes time and because money is the social institution that transfers and stores purchasing power over time. Because of the existence of money, interruptions in the circular flow of income and expenditure can take place (by holding wealth in the form of money), which are unlikely in a barter economy.
According to the EK school, the NC’s axiom of reals (also held to a lesser extent by the NK school as well)—the dichotomy between the monetary and real dimensions of the economy—is misleading; capitalism must be understood as a monetary economy, in which the circuit of money is as important as the physical flow of production and circulation of goods and services. Macroeconomics must begin with an analysis of money—its nature, origin, and functions; money is never neutral with respect to the real economy. The level of interest rates (the price of liquidity and the cost of credit) is a key price within the economy, because it influences both the willingness and the ability of entrepreneurs to invest in real capital and of financial capitalists to hold nonmonetary financial assets such as stocks and bonds.
- The levels of prices, wages, and interest rates should be understood as the result of distributional struggles that are determined by social institutions and complex processes, as opposed to their determination by the quantity theory of money as advanced by NC. Rather than determining the level of wages and prices, the quantity of money in circulation is seen as the result of changes in the level of wages and prices, reversing the quantity theory’s direction of causality. In EK economics, changes in the level of wages lead to a change in the prices of goods, because firms practice markup pricing: Prices are marked up over—primarily—labor costs of production, and estimates of average rather than marginal cost at normal output levels are used to set prices. Changes in the price level (inflation) leads ceteris paribus to an increase in the demand for working capital (credit), which banks accommodate. As more loans are made, the money supply increases (Moore, 1988).
- The endogenous money supply theory argues that anything that increases the demand for bank credit will increase the money supply; commercial banks must accommodate most of any increase in business or consumer loan demand, because most loans are made under predetermined lines of credit (Moore, 1988).
- Finally, although EK economists see the level of interest rates as important in influencing aggregate demand—especially business investment—their empirical work argues that spending and real output may not be very sensitive to interest rates in recessions, so that other demand-stimulating policies are necessary (Arestis & Sawyer, 2002a, 2002b; European Central Bank, 2002). Those same studies provide evidence that interest rate changes are not very effective in reducing price inflation either.
Post-Keynesians and New Keynesians
Although the EK and NK economists agree on aspects of macroeconomics (e.g., the endogeneity of the money supply and the need for interventionist demand management), they disagree on many important points.
- EK economists see the economy as very unstable, requiring constraints stronger than discretionary monetary policy; new Keynesians assume strong equilibrating processes in the long run, pushing the economy toward equilibrium at a socially optimal natural rate of employment and the potential level of output.
- EK economics follows Keynes (and Kalecki) in arguing that savings does not finance investment as in the old classical, neoclassical, NC, and NK models. Rather, investment is determined by profit expectations and the rate of interest, and it is financed by bank credit (and the growth in the money supply). The level of investment coupled with the variables that determine the Keynesian multiplier then determines the level of national income. National income moves toward the level that generates enough savings to equal the exogenously determined level of investment: Investment determines savings, rather than savings determining investment.
This insight has powerful implications for many aspects of policy: Most NC and NK economists argue for policies (such as low marginal rates of taxation, high real interest
rates, shrinking government, reducing the generosity of public pension systems) that should encourage higher net national savings (savings net of government budget deficits and depreciation), because in their models, this would lead to higher private investment. From the EK perspective, this is wrongheaded: Government spending— especially public investment—can increase productivity, private profits, and profit expectations, thus encouraging private investment (“crowding in” rather than “crowding out”). And the level of savings has little influence over either interest rates or investment, because interest rates are primarily determined by monetary policy and liquidity preference. In fact, ceteris paribus, a higher saving rate might depress investment and economic growth because it would lead to a lower level of consumption and aggregate demand growth.
- EK economists put a higher priority on full employment than on price stability and argue that the level of unemployment necessary to keep effective downward pressure on wages and prices entails unacceptable social costs. NK economists put a higher priority on low inflation than on full employment. EK economists are skeptical of our ability to reliably estimate the level of unemployment consistent with price and wage stability—the natural rate of unemployment or the NAIRU, which determines the potential level of national income in the NK model—and use that as a target for stabilization policy. There is no natural rate of unemployment in the sense of a strong attractor that the economy tends toward.
EK economists argue that the important goals of full employment and both wage and price stability can be reached only by developing institutions that socially control wages, prices, and the distribution of income across the social classes (the wage-profit ratio), and that link aggregate wage and profit increases to productivity gains.
In contrast, new Keynesians argue that the NAIRU can be reliably estimated (although the range of estimates is seen by some as quite wide) and the estimates used as a target for stabilization policy; NK economists are willing to tolerate whatever levels of unemployment are necessary for price stability, disagreeing with the EK view that “non-traditional” forms of intervention such as incomes policy can be effective.
- EK economists agree with both Keynes and Kalecki that the distribution of income is important for business cycles and growth; they are interested in both the functional or class distribution between labor and capital and the personal or size distribution across individuals, households, and families. One argument that Keynes and post-Keynesians make is that changes in the distribution of income can influence the composition and levels of aggregate demand (more profits means more investment, higher wages means more consumption). From this perspective, less inequality is preferred because it will stimulate production and employment in the short run and thus stimulate investment and economic growth in the long run; lower interest rates both reduce inequality and stimulate investment (Keynes, 1936/1973; Niggle, 1998, surveys and assesses some recent literature discussing the relationship between inequality and growth).
Followers of Kalecki observe that a declining wage share should be expected to reduce aggregate demand, capacity utilization, and investment, and thus reduce both employment and economic growth. Proper macroeconomic policy implies paying attention to income distribution. Again, new Keynesians do not pay much attention to these issues.
- EK emphasizes a demand-led approach to growth theory, in contrast to the NC supply-side approach, which new Keynesians and new (endogenous) economic growth theories also stress.
- Many EK economists advocate fixed exchange rate systems constructed around an international financial institution that could issue liquid financial assets as needed by deficit countries (Davidson, 1994); most new Keynesians, such as Joseph Stiglitz (2002), accept flexible exchange rates with some important and influential exceptions.
- EK economists favor financial market regulations and see unregulated financial markets as dangerous (Isenberg, 2000; Minsky, 1982, 1986); most new Keynesians are not concerned with financial market deregulation.
In the 1970s and 1980s, NC economists developed and mainstream economics assimilated a set of propositions, models, and theories that argued against both the need for and the efficiency of Keynesian forms of state intervention in the economy to promote full employment, stability, equality, and economic growth. Aspects of this economic philosophy—NC, monetarism, RBC theory, supply-side economics, and public choice theory—offered theoretical support for neoliberalism and have been very influential both within economics and within the domains of policy and politics.
Keynesian economists rejected many aspects of the neoliberal program based on their competing NK theoretical stance. EK economists present a more radical critique of NC and offer a very different perspective on the economy. In the past decade, new Keynesian and new growth theory economics have become more influential within the mainstream. This phenomenon, coupled with the persistence of economic problems that seem intrinsic to unregulated global capitalism—such as stagnation, increasing unemployment and inequality, and recurrent financial crises—opens up the possibility for EK economics to be seriously considered by mainstream economists, because it offers coherent explanations for those problems along with plausible solutions to them.
- Arestis, R., & Sawyer, M. (2002a). The Bank of England macro-economic model: Its nature and implications. Journal of Post Keynesian Economics, 24(4), 529-546.
- Arestis, R., & Sawyer, M. (2002b). Can monetary policy affect the real economy? (Working Paper No. 355). Annandaleon-Hudson, NY: Levy Economics Institute. Available from http://www.levy.org/download.aspx?file=wp355.pdf&pub id=111
- Aschauer, D. (1989). Is public expenditure productive? Journal of Monetary Economics, 23(2), 177-200.
- Barro, R. (1974). Are government bonds net wealth? Journal of Political Economy, 82(6), 1095-1117.
- Barro, R. (1981a). Output effects of government purchases. Journal of Political Economy, 89(6), 1086-1121.
- Barro, R. (1981b). Public debt and taxes. In Money, expectations and business cycles. New York: Academic Press.
- Davidson, P. (1978). Money and the real world (2nd ed.). New York: Macmillan.
- Davidson, P. (1994). Post Keynesian macroeconomic theory. Aldershot, UK: Edward Elgar.
- DeLong, B. (2000). The triumph of monetarism? Journal of Economic Perspectives, 14(1), 83-94.
- European Central Bank. (2002, October). Recent findings on monetary transmission in the Euro area. Monthly Bulletin, pp. 44-55.
- Federal Reserve Bank of Kansas City. (2002). Symposium: Rethinking stabilization policy. Available from http://www.kansascityfed.org/PUBLICAT/SYMPOS/2002/sym02prg.htm
- Friedman, M. (1968). The role of monetary policy. American Economic Review, 58, 1-17.
- Hansen, A. (1953). A guide to Keynes. New York: McGraw-Hill.
- Hicks, J. (1937). Mr. Keynes and the classics: A suggested interpretation. Econometrica, 5(2), 144-159.
- Hicks, J. (1957). The “classics” again. Economic Journal, 67, 278-289.
- Hicks, J. (1967). Monetary theory and history: An attempt at perspective. In Critical essays in monetary theory (pp. 155-173). Oxford, UK: Clarendon Press.
- Isenberg, D. (2000). The political economy of financial reform: The origins of the U.S. deregulation of the 1980s and 1990s. In R. Pollin (Ed.), Capitalism, socialism, and radical political economy (pp. 245-269). Northampton, MA: Edward Elgar.
- Keynes, J. (1973). The collected writings of John Maynard Keynes: Vol. 7. The general theory of employment, interest and money. New York: Macmillan. (Original work published 1936)
- Lucas, R. E., Jr. (1972). Expectations and the neutrality of money. Journal of Economic Theory, 4, 103-124.
- Lucas, R. E., Jr. (1973). Some international evidence on output inflation tradeoffs. American Economic Review, 63(3), 326-334.
- Lucas, R. E., Jr. (1975). An equilibrium model of the business cycle. Journal of Political Economy, 83(6), 1113-1144.
- Lucas, R. E., Jr. (1976). Economic policy evaluation: A critique. In K. Brunner & A. Meltzer (Eds.), The Phillips curve and labor markets (Carnegie-Rochester Conference Series on Public Policy No. 1, pp. 19-46). New York: Elsevier North-Holland.
- Minsky, H. (1982). Can “it” happen again? Essays on instability and finance. Armonk, NY: M. E. Sharpe.
- Minsky, H. (1986). Stabilizing an unstable economy. New Haven, CT: Yale University Press.
- Moore, B. (1988). Horizontalists and verticalists: The macroeconomics of credit money. New York: Cambridge University Press.
- Moore, B. (1999). Economics and complexity. In M. Setterfield (Ed.), Growth, employment and inflation: Essays in honor of John Cornwall (pp. 41-66). New York: St. Martins.
- Niggle, C. (1998). Equality, democracy, institutions and growth. Journal of Economic Issues, 32(3), 523-530.
- O’Driscoll, G. (1977). The Ricardian nonequivalence theorem. Journal of Political Economy, 85(2), 207-210.
- Parkin, M. (2000). The principles of macroeconomics at the millennium. American Economic Review, 90(2), 85-89.
- Phelps, E. (1968). Money-wage dynamics and labor-market equilibrium. Journal of Political Economy, 76(S4), 678-711.
- Phillips, A. W. (1958). The relationship between unemployment and the rate of change of money wage rates in the United Kingdom, 1861-1957. Economica, 25, 283-299.
- Samuelson, P. (1948). Economics. New York: McGraw-Hill.
- Samuelson, P., & Solow, R. (1960). Analytical aspects of anti-inflation policy. American Economic Review, 50(2), 177-194.
- Sargent, T., & Wallace, N. (1975). Rational expectations, the optimal monetary instrument, and the optimal money supply rule. Journal of Political Economy, 83(2), 241-255.
- Schumpeter, J. (1954). History of economic analysis. New York: Oxford University Press.
- Solow, R. (1956). A contribution to the theory of economic growth. Quarterly Journal of Economics, 70(1), 65-94.
- Stiglitz, J. (2002). Globalization and its discontents. New York: W. W. Norton.
- Taylor, J. (Ed.). (1999). Monetary policy rules. Chicago: University of Chicago Press.
- Taylor, J. (2000). Teaching modern macroeconomics at the principles level. American Economic Review, 90(2), 90-94.
Free research papers are not written to satisfy your specific instructions. You can use our professional writing services to buy a custom research paper on any topic and get your high quality paper at affordable price.