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Macroeconomics in disarray.

Macroeconomics in Disarray

N. Gregory Mankiw (1)

The basic questions of macroeconomics are: "What causes output and employment to fluctuate?" and "How should monetary and fiscal policymakers respond to these fluctuations?" As we sit here in the midst of the first recession in about a decade, these questions seem all the more pressing. Yet the sad truth is that we don't have answers to these questions that would command anything like a consensus among macroeconomists. In fact, one can fairly say that academic macroeconomics is in a state of disarray. I'd like to discuss this disarray among my colleagues and me, and the progress - and in some cases perhaps regress - that we've made in the past 20 years in answering these questions.

It was easier being a student of macroeconomics 20 years ago. At that time, there was more agreement among macroeconomists about how the world works. At the textbook level, the accepted model of the economy was the IS-LM model - a theory that unified both Keynesian and monetarist views of the economy. Most economists used a Phillips curve of some sort to explain the adjustment of prices. There was disagreement about whether the trade-off between inflation and unemployment held only in the short run or also in the long run, and how long it took to reach the long run. But these disagreements seem relatively small from today's vantage point.

At the more applied level, this consensus of 20 years ago was embodied in the large-scale macroeconometric models, such as the MPS model and the DRI model. The job of refining these models generated many dissertations. Private and public decisionmakers confidently used the models for forecasting and for evaluating alternative economic policies.

Today, macroeconomists are much less sure of themselves. Graduate courses in macroeconomics, such as the one I teach at Harvard, hardly resemble those taught 20 years ago. The large-scale macroeconometric models are mentioned only occasionally at academic conferences; when they are mentioned, it is often with derision. A graduate student today is unlikely to devote his dissertation to improving the MPS model.

In contrast to this radical change in the way academic macroeconomists have not substantially changed the way they analyze the economy. The textbook IS-LM model, augmented by the Phillips curve, continues to provide the best way to interpret discussions of economic policy in the press and among policymakers. From my own experiences at the Congressional Budget Office and the Council of Economic Advisers, I know that economists in government continue to use the large-scale macroeconometric models for forecasting and policy analysis. The theoretical developments of the past 20 years have had relatively little impact on applied macroeconomics.

Why is there such a great disparity between academic and applied macroeconomics? The view of some academics is that practitioners have simply fallen behind the state of the art, that they continue to use obsolete models because they have not kept up with the quickly advancing field. Yet this self-serving view is suspect, for it violates a fundamental property of economic equilibrium: it assumes that a profit opportunity remains unexploited. If recent developments in macroeconomics were useful for applied work, they would have been adopted. The observation that recent developments have had little impact on applied macroeconomics creates at least the presumption that these developments are of little use to applied economists.

One might be tempted to conclude that, because the macroeconomic research of the past 20 years has had little impact on applied economists, the research has no value. Yet this conclusion also is unwarranted. The past 20 years have been a fertile time for macroeconomics. Recent developments have just not been the sort that can be adopted quickly by applied economists.

A Parable for Macroeconomics

A tale from the history of science is helpful for understanding the current state of macroeconomics. Approximately five centuries ago, Nicholas Copernicus suggested that the sun, rather than the earth, is the center of the planetary system. At the time, he mistakenly thought that the planets followed circular orbits; we now know that these orbits are actually elliptical. Compared to the then prevailing geocentric system of Ptolemy, the original Copernican system was more elegant and, ultimately, it proved more useful. But at the time it was proposed and for many years thereafter, the Copernican system did not work as well as the Ptolemaic system. For predicting the positions of the planets, the Ptolemaic system was superior.

Now imagine yourself, alternatively, as an academic astronomer and as an applied astronomer when Copernicus first published. If you had been an academic astronomer, you would have devoted your research to improving the Copernican system. The Copernican system held out the greater promise for understanding the movements of the planets in a simple and intellectually satisfying way.

Yet if you had been an applied astronomer, you would have continued to use the Ptolemaic system. It would have been foolhardy to navigate your ship by the more promising yet less accurate Copernican system. Given the state of knowledge immediately after Copernicus, a functional separation between academic and applied astronomers was reasonable and, indeed, optimal.

I would like to discuss three recent developments in macroeconomics. My goal is not to proselytize. Rather, it is to show how these developments point the way toward a better understanding of the economy, just as Copernicus's suggestion of the heliocentric system pointed the way toward a better understanding of planetary motion. Yet, just as Copernicus did not see his vision fully realized in his lifetime, we should not expect these recent developments, no matter how promising, to be of great practical use in the near future. In the long run, however, many of these developments - although surely not all of them - will change profoundly the way all economists think about the economy and economic policy.

The Breakdown of the Consensus

Let me begin with a breakdown of the consensus. The consensus in macroeconomics that prevailed until the early 1970s faltered because of two flaws, one empirical and one theoretical. The empirical flaw was that the consensus view could not cope adequately with the rising rates of inflation and unemployment experienced during the 1970s. The theoretical flaw was that the consensus view left a chasm between microeconomic principles and macroeconomic practice that was too great to be intellectually satisfying.

These two flaws came together most dramatically and most profoundly in the famous prediction of Milton Friedman and Edmund Phelps. According to the unadorned Phillips curve, one could achieve and maintain a permanently low level of unemployment merely by tolerating a permanently high level of inflation. Many economists in the 1960s viewed the Phillips curve as a menu of combinations of inflation and unemployment, and they thought policymakers could choose whatever combination they liked. In the late 1960s, when the consensus view was still in its heyday, Friedman and Phelps argued from microeconomic principles that this empirical relationship between inflation and unemployment would break down if policymakers tried to exploit it. They reasoned that the equilibrium, or natural, rate of unemployment should depend on labor supply, labor demand, optimal search times, and other microeconomic considerations, not on money growth and inflation. Maybe the Fed could choose from a menu of inflation and unemployment in the short run, but in the long run all meals come with the same rate of unemployment. Subsequent events proved Friedman and Phelps correct: inflation rose in the 1970s without a permanent reduction in unemployment.

The breakdown of the Phillips curve predicted by Friedman and Phelps - and the remarkable success of this prediction - made macroeconomics ready for Robert Lucas's more comprehensive attack on the consensus view. Lucas contended that many of the empirical relationships that make up the large-scale macroeconometric models were no better founded on microeconomic principles than was the Phillips curve. In particular, the decisions that determine most macroeconomic variables, such as consumption and investment, depend crucially on expectations of the future course of the economy.

Macroeconometric models treated expectations in a cavalier way, most often by resorting to plausible but arbitrary proxies. Lucas pointed out that most policy interventions change the way individuals form expectations about the future. Yet the proxies for expectations used in these models failed to take account of this change in expectation formation. Lucas concluded, therefore, that these models should not be used to evaluate alternative policies. The "Lucas critique" became the rallying cry for those young turks intent on destroying the consensus. During the 1970s, these young turks led a revolution in macroeconomics that was as bloody as any intellectual revolution can be.

Much of the research in macroeconomics during the past 20 years attempts to rebuild in the rubble that this revolution left. Economists have focused renewed and more intensive effort on placing macroeconomics on a firm microeconomic foundation. Very often, the relevance of the research to current economic problems is sacrificed. To macroeconomic practitioners, much of the research must seem esoteric and useless. Indeed, for practical purposes, it is.

To understand the motivation and goals of the research that many academic economists have undertaken in recent years, it is useful to divide developments in macroeconomics into three broad categories.

One large category of research tries to model expectations in a more satisfactory way than was common 20 years ago. More careful attention to the treatment of expectations can often extract new and surprising implications from standard models. The widespread acceptance of the axiom of rational expectations is perhaps the largest single change in macroeconomics in the past two decades.

A second category of research attempts to explain macroeconomic phenomena using new classical models. These models maintain the assumption that prices continually adjust to equilibrate supply and demand. Twenty years ago, macroeconomists commonly presumed that a nonmarket-clearing theory of some sort was necessary to explain economic fluctuations. Recent research has shown that market-clearing models have much richer implications than was once thought, and they are not so easily dismissed.

A third category of research attempts to reconstruct macroeconomics using new Keynesian models. This last category is most compatible with the consensus view that existed 20 years ago. This research can be viewed as attempting to put textbook Keynesian analysis on a firmer microeconomic foundation.

Expectations and the Case for Policy Rules

Let me start with the widespread acceptance of rational expectations. Economists routinely assume that firms rationally maximize profits, and that consumers rationally maximize utility. It would be an act of schizophrenia not to assume that economic agents act rationally when they form their expectations of the future.

Much of the research in macroeconomics since the breakdown of the consensus has explored the assumption of rational expectations. By itself, the assumption of rational expectations has no empirical implication, just as the assumption of utility maximization has no direct empirical implication. Yet, together with other auxiliary hypotheses, many of which predate the introduction of rational expectations and at the time seemed unobjectionable, the assumption of rational expectations can have profound and startling implications.

Of the many questions that have been reexamined, perhaps the most important is whether public policy should be conducted by rule or by discretion. Various authors have provided new and often persuasive reasons to be skeptical about discretionary policy when the outcome depends on the expectations of private decisionmakers.

The argument against discretion is illustrated most simply in an example involving not economics but politics - specifically, public policy about negotiating with terrorists over the release of hostages. The announced policy of the United States and many other nations is that we will not negotiate over hostages. Such an announcement is intended to deter terrorists: if there is nothing to be gained from kidnapping, rational terrorists won't take hostages. But, in fact, terrorists are rational enough to know that once hostages are taken, the announced policy may have little force, and that the temptation to make some concession to obtain the hostages' release may become overwhelming. The only way to deter truly rational terrorists is somehow to take away the discretion of policymakers and commit them to a rule of never negotiating. If policymakers were truly unable to make concessions, the incentive for terrorists to take hostages would be reduced substantially.

The same problem arises less dramatically in the conduct of monetary policy. Consider the dilemma facing the Federal Reserve. The Fed wants everyone to expect low inflation, so that it will face a favorable trade-off between inflation and unemployment. But an announcement of a policy of low inflation is not credible. Once expectations are formed, the Fed has an incentive to renege on its announcement in order to reduce unemployment. Private economic actors understand the incentive to renege and therefore do not believe the announcement in the first place. Just as president facing a hostage crisis is solely tempted to negotiate their release, a Fed with discretion is sorely tempted to inflate to reduce unemployment. And, just as terrorists discount announced policies of never negotiating, private economic actors discount announced policies of low inflation.

The surprising implication of this analysis is that sometimes policymakers can achieve their own goals better by having their discretion taken away from them. In the case of hostages, there will be fewer hostages taken if governments are bound to follow the seemingly harsh rule of abandoning any hostages that are taken. In the case of monetary policy, there will be lower inflation without higher unemployment if the Fed is committed to a policy of zero inflation.

The issue raised here in the context of hostages and monetary policy is more generally called the time inconsistency of optimal policy. It arises in many other contexts. For example, the government may announce that it will not tax capital in order to encourage accumulation; but once the capital is in place, the government may be tempted to renege on its promise because the taxation of existing capital is nondistortionary. As another example, the government may announce that it will prosecute all tax evaders vigorously; but once the taxes have been evaded, the government may be tempted to declare a "tax amnesty" to collect some extra revenue. As a third example, the government may announce that it will give a temporary monopoly to inventors of new products to encourage innovation; but once a product has been invented, the government may be tempted to revoke the patent to eliminate the distortion of monopoly pricing. In each case, rational agents understand the incentive for the government to renege, and this expectation affects their behavior. And in each case, the solution is to take away the government's discretionary power by binding it to a fixed policy rule.

New Classical Macroeconomics

The increased importance of expectations in macroeconomic theory may be the most important development of the past two decades, but it is not the most controversial. Controversy peaks when economists turn to the theory of economic fluctuations. Broadly speaking, there are two schools of thought: new classical and new Keynesian economics. As an example of how much the debate has changed, today monetarists are members of the new Keynesian family. The distance between the new classical and new Keynesian schools is so large that it makes the monetarist-Keynesian debates of the 1960s look like sibling rivalry.

The key difference between new Keynesians and new classicals is how wages and prices adjust. New Keynesians accept the view that was unquestioned 20 years ago: wages and prices adjust slowly over time. New classicals want to rebuild macroeconomics while maintaining the axiom that prices adjust very quickly to clear markets.

Those working in the new classical tradition have recently been emphasizing "real" business cycle theory. This theory proceeds from the assumption that there are large random fluctuations in the rate of technological change. Because these fluctuations in technology lead to fluctuations in relative prices, individuals rationally alter their labor supply and consumption. According to this theory, the business cycle is the natural and efficient response of the economy to changes in the available production technology.

Real business cycle theory contrasts sharply with the consensus view of the 1960s. I will mention briefly three assumptions of these models that would have been considered ridiculous 20 years ago and that remain controversial today.

First, real business cycle theory assumes that the economy experiences large and sudden changes in the available production technology. Many real business cycle models explain recessions as periods of technological regress - that is, declines in society's technological ability. Advocates of this theory point to the procyclical behavior of productivity as evidence that technology shocks are the source of economic fluctuations.

Second, real business cycle theory assumes that fluctuations in employment reflect changes in the amount people want to work. Because employment fluctuates substantially while the determinants of labor supply - the real wage and the real interest rate - vary only slightly, these models require that leisure be highly substitutable over time. This assumption conflicts with the beliefs of many economists that high unemployment in recessions is largely involuntary.

Third, real business cycle theory assumes - and this is the assumption from which the theory derives its name - that monetary policy is irrelevant for economic fluctuations. Before real business cycle theory entered the debate in the early 1980s, almost all macroeconomists agreed on one proposition: money matters. Although there was controversy about whether systematic monetary policy could stabilize the economy, it was universally accepted that bad monetary policy could be destabilizing. Real business cycle theorists have challenged that view using the old Keynesian argument that any correlation of money output arises because the money supply responds to changes in output. They also give little weight to anecdotal evidence on the effects of monetary policy - such as the Volcker disinflation of the early 1980s - that seems to shape the views of many other economists.

New Keynesian Macroeconomics

At the same time that many macroeconomists have been advancing real business cycle theory, many other macroeconomists, including myself, have been attempting to resurrect the old consensus view, with more modern emendations. As I've mentioned, the rubric "new Keynesian" is very broad. We who fall under this term view ourselves as following in the traditions of both John Maynard Keynes and Milton Friedman.

If there is a single theme that unites new Keynesian economists, it is the belief that economic fluctuations reflect not the efficient response of the economy to changes in tastes and technology, but rather some sort of market failure on a grand scale. The market imperfection that recurs most frequently in new Keynesian theories is the failure of wages and prices to adjust instantly to equilibrate supply and demand. Certainly, the short-run sluggishness of wages and prices was the key assumption of the consensus view of the 1960s. And the absence of an adequate theoretical justification for that assumption was one of the fatal flaws that undermined the consensus. Much of new Keynesian research of the 1980s can be viewed as attempting to provide a cogent theoretical foundation for short-run price rigidity.

Let me mention briefly two recent lines of research that attempt to explain the failure of wages and prices to clear markets.

The first emphasizes the sluggish behavior of goods prices. Much effort has been devoted to examining the behavior of monopolistically competitive firms that face small "menu costs" when they change prices. Taken literally, these menu costs are the resources required to post new price lists. More metaphorically and more realistically, these menu costs include the time taken to inform customers, the customer annoyance caused by price changes, and the effort required to even think about a price change.

This line of research is still too new to judge how substantial its impact will be. What is clear now is that one can explain in rigorous microeconomic terms the failure of price-setters to adjust prices quickly enough to prevent recessions. Monopolistically competitive firms do not have much incentive to cut their prices when demand declines. Yet because of the preexisting distortion of monopoly pricing, the benefit to the firm is small. If firms face even a small menu cost, they might maintain their old prices, despite the substantial social loss from this price stickiness.

There has also been growing microeconomic evidence that many firms, in fact, adjust their prices very infrequently. One extreme example is the price of magazines at newsstands. Steve Cecchetti has documented that the prices change every four or five years. In a more comprehensive survey that is still in its preliminary stages, Alan Blinder has found that the median firm in the U.S. economy changes its prices about once a year.

A second line of new Keynesian research is on "efficiency wage" theory, which emphasizes the failure of wages to clear labor markets. According to efficiency wage theory, firms do not reduce wages in the face of persistent unemployment because to do so would reduce productivity. Various reasons have been proposed to explain how wages affect productivity, the most popular of which holds that a high wage improves worker effort. This theory posits that firms cannot monitor their employees' work effort perfectly, and that employees themselves must decide how hard to work. Workers can choose to work hard, or they can choose to shirk and risk getting caught and fired. The higher the wage, the greater is the cost to the worker of getting fired. By paying a higher wage, a firm induces more of its employees not to shirk and thus increases their productivity. If this productivity effect is sufficiently large, the normal competitive forces moving the labor market to the equilibrium of supply and demand are absent.


I began by suggesting that recent developments in macroeconomics are akin to the Copernican revolution in astronomy: immediately they may have little practical value but ultimately they will point the way to a deeper understanding. Perhaps the analogy is too optimistic. Copernicus had a vision of not only what was wrong with the prevailing paradigm, but also of what a new paradigm would look like. In the past decade, macroeconomists have taken only the first step in this process; there remains much disagreement on how to take the second step. It is easier to criticize the state of the art than to improve it.

Yet some developments of the past two decades are now widely accepted. Although some economists still doubt that expectations are rational, the axiom of rational expectations is as firmly established in economic methodology as the axioms that firms maximize profit and households maximize utility. The debate over rules versus discretion continues, but time inconsistency is generally acknowledged to be a problem with discretionary policy. Most fundamentally, almost all macroeconomists agree that basing macroeconomics on firm macroeconomic principles should be higher on the research agenda than it has been in the past.

On the crucial issue of business cycle theory, however, there appears to be little movement toward a new consensus. The "new classicals" and the "new Keynesians" each have made substantial advances within their own paradigms. To explain economic fluctuations, new classical theorists now emphasize technological disturbances, intertemporal substitution of leisure, and real business cycles. New Keynesian theorists now speak of monopolistic competition, menu costs, and efficiency wages. More generally, the classicals continue to believe that the business cycle can be understood within a model of frictionless markets, while the Keynesians believe that market imperfections of various sorts are necessary to explain fluctuations in the economy.

Ultimately, recent developments in macroeconomic theory will be judged by whether they prove to be useful to applied macroeconomists. The passage of time will make efficiency wages, real business cycles, and the other breakthrough of the past decade less novel. The attention of academic researchers surely will turn to other topics. Yet it is likely that some of these recent developments will permanently change the way in which economists of all sorts and discuss economic behavior and economic policy. Twenty years from now we shall know which of these developments has the power to survive the initial debate and to permeate economists' conceptions of how the world works.
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Title Annotation:National Bureau of Economic Research's Annual Research Conference - II
Author:Mankiw, N. Gregory
Publication:NBER Reporter
Date:Jun 22, 1991
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