Macroeconomics after Keynes
In the years of Second World War and after in 1950s and 1960s, Keynes-like or Keynesian economic policy became very popular in Western world.
The depression of 1930s had changed the general view of economists and society on the free-market capitalism.
Prior to the depression the general orientation of almost all individuals in western world, except radicals, was against major government interventions in the economy. However, during and after the depression this attitude began to change. Many people felt that if the free market could lead to such economic catastrophes as existed during the depression, than maybe it is time to consider alternative economic systems and policies.
Economists also began to become less confident of neoclassical theory and its policy prescriptions and Keynes's views, which demand that government has to control aggregate demand through monetary, and especially fiscal policies, began to be more and more popular.
During the 1950s and 1960s, Keynesian economic policy became predominant in the western world. In practice, some followers of Keynes proposed that governments should follow a policy of `functional finance'.
Policy of functional finance allowed the government to “drive” the economy, monetary and fiscal policy were portrayed as government's steering wheel. Monetary and fiscal policy should serve to achieve macroeconomic goals of high employment, price stability and high growth. In practice, the prescriptions of the functional finance were the following:
- In times of growing unemployment, government has to increase budget deficit and the money supply
- In times of small unemployment, government has to do the opposite - decrease budget deficit and decrease the money supply.
So the years after the war, 1950s and 1960s can be perceived as the golden age of interventionism in economic policy, western governments did intervene in the economy in many areas to ensure full employment, price stability and high rate of growth.
In general, economists in the two decades after the Second World War began to become less confident of neoclassical theory and its policy prescriptions (laissez faire policy).
Keynes's economic theory and policy, which demand that government has to control aggregate demand through monetary and especially fiscal policies, became central in western macroeconomic thought.
What is more important for the history of Keynes's views, immediately after the publication of General theory, neoclassical economists started to attempt to incorporate Keynesian economics in neoclassical framework.
Attempts to absorb Keynes views and to build one unified macroecnomics started as quickly as in 1937, a year after the publication of General theory. This project of incorporating Keynes theory in neoclassical theory occupied economists for about another two decades, to the mid 1950s.
In this period, a new theoretical approach to macroeconomics appeared, which synthesized neoclassical and Keynesian views. This approach was called neoclassical synthesis, and it constituted the heart of macroeconomics of business cycles after the second world war, up to the 1980s.
Several economists in the framework of the so-called IS-LM model did this synthesis of Keynes's and neoclassical theories.
In the model the downward sloping IS curve represented combinations of interest rates and output for which planned savings (directly related to national income) and planned investment (inversely related to interest rate) were equal.
The upward sloping LM curve represented combinations in which the demand for money (directly related to income and inversely related to interest rate) equalled the fixed supply of money.
The crossing point of the curves determined the level of aggregate demand in the economy. Further, the crossing point between the aggregate demand (the so-called AD curve) and the curve of aggregate supply (AS curve) determined the level of national income and employment in the economy. (This was called as AS-AD model).
This model, ISLM model, was created with the aim of formulating a more general theory than that of Keynes.
In the model economists obtained, as special cases, the traditional neoclassical and the Keynesian model. For example, if you assumed that LM curve is highly inelastic you could obtain neoclassical solution (full employment of resources), while if you assume highly elastic LM curve than Keynesian solution appeared (that fiscal and monetary policy could influence the level of national income and employment and help the economy to recover from depression).
In 1950s, 1960s, at least in textbook presentation, Keynesian and neoclassical came together in general neoclassical-Keynesian model of ISLM analysis. The dispute about macroeconomic problem of business cycles was only about the parameters of the ISLM model.
Economists from different theoretical positions (Keynesians and anti-Keynesians) disagreed only about the values of the parameters of the model, but they agreed that it is the correct representation of the macro side of the economy.
Another important tool of Keynesian economists and proponents of government intervention in the economy was the so-called Phillips curve.
In empirical works in 1950s, William Phillips, found a negative relationship between historical British wage inflation and unemployment. The modified version, with price inflation, implied that governments faced a short-run trade-off between these two variables.
His analysis was interpreted by many Keynesian economists as suggesting that governments could choose the level of unemployment if they accepted a given rate of inflation. This gave another powerful argument for the advocated of interventionism as it suggested that government can control at least one important macroeconomic variable - unemployment at the price of inflation, or inflation at the price of unemployment. In general, it was a strong argument for the active involvement of the state in the economy
But returning to ISLM model.
ISLM analysis remained a part of macroeconomic education until 1980s, but in 1990s even in undergraduate textbooks, it was replaced by other approaches. Today the model is old-fashioned and not longer taught in the best undergraduate textbooks, but still remains in some not so up do date.
What were the problems with the ISLM analysis of aggregate demand and employment, that cause economists to finally abandon the model?
First, the model is useless if you want to explain the problem of inflation, which from the 1960s has become very serious economic problem for western economies.
Second, many concepts used in ISLM model, were not formulated in terms of GE model and since the model in the second part of the 20th century became the central model of all economics, ISLM model has lost its appeal with time.
Nonetheless, the model was accepted for several decades, because it was neat, quite simple, it was a unambiguous tool in matters of policy and was easy to present for students - in short it was the best model available.
But as I mentioned before, since 1970s and 1980s many economists argued that we should abandon ISLM model and formulate a macroeconomic model, which would be framed in microeconomic terms, that is a model in which aggregate curves (for money demand, investments, and the like) would be derived from the decisions of particular households.
Thus, starting in the 1970s we saw a reaction against Keynesian economics and the neoclassical synthesis.
The opposition to Keynesian economics and neoclassical synthesis in 1950s and 1960s.
In those decades, the principal opposition to Keynesian macroeconomics and interventionism in economic policy was a current of thought called monetarism.
Monetarism was for many years the chief alternative to mainstream Keynesianism and the Neo-classical Synthesis. The group is closely associated with the University of Chicago where many of its main figures taught or studied. By far the most important figure in monetarism is Milton Friedman, who originated monetarism.
Monetarists are in the tradition of classical and neoclassical economists, using similar assumptions to draw similar conclusions.
The monetarists assumed that in the long run money is neutral, that is that money in the long run does not influence real variables, like real national income or the level of unemployment. The only variable which is affected in the long run by increase in the money supply is the level of prices.
This assumption stood in a direct conflict with a trade off between inflation and unemployment as suggested by Phillips curve.
In the late 1960s monetarists developed models in which they argued that the trade-off between inflation and unemployment is visible only in a very short run.
In other words they argued that monetary policy can affect real output and unemployment only in the short run. In the long run the Phillips curve was vertical at the so-called natural rate of unemployment, which is determined by tastes, technology, resources and institutions. The natural rate of unemployment cannot be influenced by standard Keynesian methods of economic policy, monetary and fiscal policy cannot decrease this natural rate.
The monetarists' models of natural rate of unemployment were powerful arguments against Keynesian economics and interventionism in general.
In matters of economic policy, monetarists advocated that monetary policy should be conducted according to simple and fixed rules. This is evidently against Keynesian proposals. Followers of Keynes thought that monetary policy should be used when needed to stabilize the economy especially in times of depression, that is Keynesians thought that monetary policy could be uses discretionary, if there is a rise in unemployment government can estimate how much it should increase money supply and implement the proper increase.
Monetarists preferred a policy based on fixed rules that target a relatively narrow monetary aggregate (the monetary base or M1) - every year the target should be increased by a fixed percentage, for example we should increase monetary base by 5% every year.
Monetarist' justification for such a policy was complex. It was a partly based on Phillips curve, partly on distrust in econometric modelling (they did not believe that government could estimate how big should be an increase in money supply to counteract the rise in unemployment).
Partly the argument for monetary policy based on fixed rules was based on laissez faire philosophy. Most monetarists believed that in general government should not manipulate people's behaviour, that it would be best if government did not intervene directly in the working of a free market economy.
Monetarists thought that economic policy should be confined to monetary policy, that fiscal or income redistribution policy should be avoided, because it only creates distortions and depressions in the economy. Monetarists were close in their policy prescriptions to classical and neo-classical economists, proponents of laissez-faire policy.
Monetarism influenced, and continues to influence, central banks around the world. Especially important in this respect are the monetarists' notions that monetary policy can effectively target only nominal quantities and therefore ought to target inflation, real variables are not influenced by monetary policy and therefore central banks cannot fight unemployment or falls in the national income.
Moreover, monetarists' views influenced the notions that central banks should be independent of political control and follow transparent rules. These are very popular ideas nowadays around the world, in Poland too.
Beyond this general influence of the working of central banks, strict monetarism as a economic policy was attempted rarely in practice, for example in the US, but only for a brief time between 1979 and 1982 as a response to high and accelerating inflation.
The experiment collapsed mainly as a result of instability of the demand for money in the face of financial innovation - that is it emerged that you can not easily control any monetary aggregate as the M1 for example, because banking sector introduces new financial products that serve as money for people and firms, and you can not control the money supply.
Monetarists models received a strong boost, strong support in early 1970s, when inflation and unemployment rose simultaneously in most developed countries - this phenomenon was in a direct conflict with the Keynesian Philips curve and much of Keynesian policies and theory lost favour in economics (in 1970s).
Fiscal policy as suggested by Keynesian proved politically to hard too implement, decisions on spending and taxation were made for reasons other that their macroeconomic consequences.
In 1970s, the monetary policy became the only game in town, but the Keynesian models were not suited well to deal with the effects of monetary policy, so there was a movement away from Keynesian economic models for formulating policy.
But at the same time monetarism as the alternative to Keynesian economics also failed, it emerged that it is not possible to control the money supply, and more in 1980s and early 1990s there were important econometric studies published which suggested that money is able to exert a significant the influence on real variables like national income or unemployment - which was a strong argument against monetarists claims.
What is even more important both currents Keynesian economics (or neoclassical syntesis) and monetarism are quite similar on the methodological level. Both approaches showed little interest in developing microfundations of their macrotheories, that is both approaches start with the analysis of the interrelations between aggregate economic notions (like aggregate demand, aggregate investments, national income and the like) and do not build those relationships from the first principles.
That is those models, both Keynesian and monetarist, do not start with the microeconomic analysis of the behaviour of households and firms. Some important economists in the 1970s started to think that the proper macroeconomics should be based on the microeconomic analysis of the behaviour of agents, and this was the important reason for which those Keynesian and monetarist models started to lose popularity and appeal since the 1970s.
In the 1970s, 1980s and 1990s several quite new approaches to the macroeconomic problem of business cycles were created.
From 1970 on, a program called New Classical Macroeconomics has appeared in economics. This program attacked the theoretical foundations of Keynesianism and monetarism.
Leading economist of this approach, Robert Lucas, sought to combine neoclassical or monetarist prescriptions in economic policy with the developing program in general equilibrium foundations of macro theory. That is he wanted to create a macroeconomic model of business cycles, which would be based on GET and which would imply that government does not have to intervene actively in the economy.
Lucas in his model introduced into macroeconomics the concept of rational expectations, developed in economics a little earlier by John Muth.
The rational expectations hypothesis can be formulated in various ways. Lucas preferred to see it in a following way: what people are modelled to expect is what the model itself predicts, so people with rational expectations in the model would still make mistakes, but those mistakes are unpredictable by economists and governments.
He added rational expectations assumption to a monetarist model based on GET and the outcome was that both in the short and the long run, monetary policy did not have an effect on real variables, unemployment for example.
So in Lucas's model, only unexpected changes in money supply can have real effects on income and unemployment. This means that government cannot perform any kind of stabilization policy to prevent economy from the depression or ease the consequences of the depression.
Monetary, and fiscal policies, are useless to policy maker, they do not have any systematic real effects.
So this is strong conclusion from this part of New Classical Macroeconomics, government cannot affect unemployment and real national income. This is the infamous policy ineffectiveness result, which argues that no systematic stabilisation policy, neither fiscal nor monetary, has any real influence on the economy
Only nominal variables, such as inflation, are affected. Policy can only have a real effect if it is unanticipated - but since there is rational expectations assumption, in the model, than the policy would have to be unanticipated for the government and that makes no sense. So according to the proponents of New Classical Macroeconomics, stabilization policy is not effective.
Towards the end of the 1970s confidence in the Lucas's model has diminished or died out, mainly as a result of it being invalidated (or falsified) by econometric studies, and the economists associated with New Classical Macroeconomics approach developed an alternative - the so called real business cycle approach.
Real business cycle theory, as developed in 1980s by Finn Kydland and Edward Prescott, holds that nominal variables, such as the money supply and the price level, do not influence real variables, such as employment and real GNP. Fluctuations in these real factors can only be explained by real changes in the economy.
According to them, the business cycles emerge because of voluntary changes in people's willingness to trade off work and leisure between the present and the future. Those changes are induced by technological shocks - random fluctuations in the productivity level.
Examples of such shocks include innovations, bad weather, imported oil price increase, stricter environmental and safety regulations.
Since those shocks are random, unpredictable, than government cannot predict them and there is no role for government in fighting business cycles. Therefore, the best policy, according to real business cycles theorists is laissez faire policy.
Real business cycles theory is still popular among macroeconomists, but in 1990s, there were several econometric studies published, which suggested that random technological shocks are not frequent enough and not deep enough to explain the fluctuations in the production and unemployment levels. So the theory is not well supported by the empirical evidence.
So much on the New Classical Macroecnomics.
Since 1980s, in reaction to the development of New Classical Macroeconomics in economics appeared a current called new Keynesian Macroeconomics.
Economists who created this current argued that in the face of the developments in new classical macroeconomics, new foundations for Keynesian-like macroeconomics are needed, and moreover, that those new foundations actually can be formulated.
New Keynesian macroeconomists has accepted the use of rational expectations assumption in macroeconomics, but they argue that there is nothing contradictory between Keynesian economics and rational expectations.
They built several different models in which there is an assumption of rational expectations, but monetary and fiscal policy still plays some role in stabilization of the economy.
For example, there is a class of models belonging to New Keynesian macroeconomics, which suggests that there is a place for active government policy in the management of aggregate demand, if
real wages and prices in the economy are sticky (do not change or change slowly in reaction in changes in demand or supply).
There are dozens of new Keynesian models explaining stickiness in prices and wages, and many completely different models which focus on different reasons for Keynesian like policy even in presence of rational expectations assumption.
We do not have time to discuss these models. Most of new Keynesian works is highly abstract and theoretical, starting with abstract game theoretic models. For the most part those models have not filtered down to introductory or even intermediate textbooks on macroeconomics, but probably in the end, they will.
The problem with New Keynesian Macroeconomics is that, new Keynesians have never offered a systematic vision or a comprehensive model of the economy similar to that of the New Classical Macroeconomics. So, this approach is less general and convincing than the approach of new classical theory.
The revival of theoretical interest in Keynesian economics that we observe since 1980s does not mean that what were known as Keynesian economic policy, have regained its power in practice
Since 1970s, many Keynesian economists argued that monetary and fiscal policy were politically useless to utilize and that politics, not sound economic principles, determined the size of the budget deficits and the growth of money supply. Even Keynesians were disappointed with the original Keynesian-like economic policy. So today's economic policy in the western world in the field of stabilization of the economy is much more limited than in the golden age of Keynesianism (that is the decades of 1950s and 1960s).
Those developments in macroeconomics since 1980s, that is the rise of New Classical Macroeconomics, real business cycle theory and new Keynesian economics are still quite new, so it is too soon to attempt to provide a sensible history of macroeconomics in the past two decades.
It is a fact that in today's macroeconomics we observe the battle of the schools - those close to neoclassical approach like new classical macroeconomics and real business cycles theory, and those close to original Keynesianism like new Keynesian macroeconomics. The most evident difference between those schools is in the matters of economic policy, the former argue that there is no role for government in preventing or fighting business cycles, while the latter argues the opposite, that there are some useful means of fiscal and monetary policy to counteract economic fluctuations.
Still we can draw some important conclusions about the state of macroeconomics in the beginning of the 21st century.
The insistence, first made in 1970s by new classical macroeconomics, that macroeconomic theory should have microfoundations (should be based on some kind of microeconomic theory), has been adopted by almost all mainstream macroeconomists.
Another important feature of modern macroeconomics is that all schools, new Classicals, new Keynesians and even heterodox macroeconomists, use the same empirical methods to validate their results. All macroeconomists use for example structural VAR models. In addition, the empirical method of the so-called calibration, which abandons econometric estimation in favour of specific simulations, although controversial, is in a quite widespread use in modern macroeconomics.
So at least in terms of methods used in empirical inquiry, we have consent among macroeconomists.
On macroeconomic policy, there is now general agreement that monetary policy can have important, systematic real effects in the short run. It was established in serious empirical studies.
But there remains disagreement over whether the economy is sufficiently self-adjusting in the short run that active government management should be abandoned or not.
Finally, perhaps the 1990s were in the Western world less prone to economic fluctuations and more prosperous than the 1970s and 1980s, macroeconomists have turned their attention from the problem of business cycles to the macroeconomics of economic growth, and especially to the role of technical change and social and political institutions in the growth process.
Today questions of economic growth are the most important to macroeconomists and the debate or the battle of the new Classicals and the new Keynesians on the problem of business cycles is somewhat of secondary importance.
In the modern research program on economic growth so far, there are no similar divisions between alternative schools of thought similar to those that plagued the macroeconomics of business cycles.
The modern analysis of growth started in 1950s. In this decade, Robert Solow developed a model of growth, called later Solow's model as a response to the Harrod-Domar standard model of growth from 1930s, 1940s.
Harrod-Domar model of growth argued that growth was something very unique and that unless the economy was very lucky, it would likely fall into a depression (the economy was unstable according to H-D's model). The model was very unrealistic (it assumed for example a fixed capital to labor ratio through time), but still it was the best available model of growth before 1950s.
Solow's model challenged the conclusion of Harrod-Domar's model by eliminating the unrealistic assumption of a fixed capital to labor ratio. Solow's model showed that the economy would always come back to a balanced growth path - so that long run depressions are not possible.
The economy was stable, not unstable according to Solow's model. The Solow's growth model, also called the neoclassical model of growth, focused completely on supply, demand played no role in determining output. In this sense, it was an extension of classical model of growth, where the only force determining the output was also the supply.
In 1960s and 1970s, mainstream economists tried to develop Solow's model further to explain why growth rates among countries differed, but in general, they did not succeed.
In early 1990s, a new class of growth models where developed and Solow's model was supplemented with the so-called endogenous growth theory.
In endogenous growth theory, technological change was not considered something that occurred outside the economic model (as it was in a Solow's model, where technological change was not modelled).
Technological progress in this research program is considered to be a natural result of investment in research and development, it is modelled inside the model, it is endogenous, hence the name endogenous growth theory. The theory also allowed increasing returns to be analyzed in models. The result of models with increasing returns is continual growth and no eventual movement to the stationary state (where the rate of growth is zero) - as it was in the Solow's model.
The stationary state is not inevitable in endogenous growth theory.
These developments brought mainstream macroeconomics back into the optimist vision of classical economics, where the potential for growth was unlimited.
So today's macroeconomics is, for the most part, the theory of economic growth, and the problems of business cycles are considered to be uninteresting to many economists.
Theory of growth occupies the major part of intermediate and advanced textbooks on macroeconomics.
In recent endogenous theories of growth, not only technological progress is modelled, but also the effects of other various factors of growth are considered (for example the effect of social and political institutions).
It is a very popular and promising research program in modern economics.
A summary about modern macroeconomics.
The history of macroeconomics has been marked by changing interest in growth, business cycles and inflation. While Adam Smith was primarly interested in the question of economic growth, later classical economists focused their analysis on the distribution of income and saw the economy as in the end being driven to a stationary state, where there is no economic growth.
Classical economists also saw prices as being primarily determined by the quantity theory of money, and they thought that money do not have any influence on real economic variables.
They saw the economy as essentially self-correcting, with little need for government intervention.
Keynes's general Theory marked a significant change in the focus of economics from neoclassical insistence on microeconomic questions of resource allocation to macroeconomic question of business cycles. Keynes offered a new theoretical framework to explain the forces determining the level of economic activity, especially in the short run.
He not only found capitalism inherently unstable, but also concluded that the usual outcome of the automatic working of the market was to produce equilibrium at less than full employment of resources. For Keynes the reason for this was a failure in the process of investment spending of businessmen.
A great deal of literature followed that extended and improved original Keynes's statement. Keynesian concepts were formulated in a mathematical language and empirically tested.
The revolution in economic theory was followed shortly by a policy revolution as the major industrialized countries began programs and constructed agencies designed to foster full employment. All theory and practice of macroeconomics has changed.
Keynesian ideas were incorporated into mainstream macroeconomics, and ISLM model became the dominant macroeconomic model in 1950s and later.
In late 1970s, the ISLM model was found to be unsatisfactory for economic research as it was unable to explain inflation. The model could not be constructed on microeconomic basis, and this contributed to its demise.
From 1980s several new theoretical approaches to macroeconomics were develop and no single approach is accepted by all economists, there are proponents of new classical macroeconomics, advocates of new Keynesian macro, followers of real business cycle theory, and, what is most important, leading macroeconomists are interested rather in the questions of growth than in the problem of business cycles, which inspired Keynes.
Today's macroeconomics is a field of pluralism and scholars are carrying on a wide range of research programs addressing many different economic questions.
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