A Macroeconomics Reader

Brian Snowdon, Howard Vane

• Publisher: Routledge
• Year: 1997
• ISBN:
  9781134729081
• Edition: 1
• Topic: Business
• Subtopic: Business generale
• Index: Business

A Macroeconomics Reader brings together a collection of key readings in modern macroeconomics. Each article has been carefully chosen to provide the reader with accessible, non-technical, and reflective papers which critically assess important areas and current controversies within modern macroeconomics.The book is divided into six parts, each with

1 The development of modern macroeconomics: A rough guide

Brian Snowdon and Howard R.Vane

Any economics student who graduated from university in the late 1960s and early 1970s, as we both did, would have found macroeconomics a much easier and far less controversial subject to study then than it is today. Since the breakdown of the Keynesian consensus in the early 1970s, macroeconomics has been in a ‘state of disarray’ (Brunner 1989) having witnessed the appearance of a number of conflicting and competing approaches. As a result modern macroeconomics is a rapidly changing diverse subject with a built-in tendency to generate deep divisions. These divisions have led to the formation of schools of thought consisting of economists who share a broad vision of how macroeconomic phenomena are generated. In order to better understand current controversies it is necessary, in our view, to know how macroeconomic thought has developed since Keynes’s General Theory (1936) was published. In this opening chapter we briefly survey some of the important developments in the evolution of macroeconomics since the mid-1930s. Our purpose is not to critically assess in detail the central tenets underlying and policy implications of the main macroeconomic schools of thought, rather it is to provide a background discussion in order to help place the readings that follow in context (for a more detailed survey of competing schools of thought see Phelps 1990; Chrystal and Price 1994; Snowdon et al. 1994).

Although there are significant differences between the various schools of thought, the work of Keynes remains a central point of reference because, as Vercelli (1991) argues, all the schools define themselves in relation to the ideas originally put forward by Keynes in his General Theory, either as a development of some version of his thought or as a restoration of some version of pre-Keynesian classical thought. A unifying theme in the evolution of modern macroeconomics has been an ‘ever-evolving classical Keynesian debate’ (see Gerrard 1996). Although elsewhere (Snowdon et al., 1994) we have identified seven schools of thought which have been influential in the development of macroeconomic analysis since the mid-1930s, each of these schools can be viewed as adhering to one of two basic positions in terms of broad vision. Gregory Mankiw (1989)—reprinted in Part IV—describes these two positions by distinguishing between the classical school and the Keynesian school with respect to their faith in the ‘invisible hand’.

The classical school emphasizes the optimization of private economic actors, the adjustment of relative prices to equate supply and demand, and the efficiency of unfettered markets. The Keynesian school believes that understanding economic fluctuations requires not just studying the intricacies of general equilibrium, but also appreciating the possibility of market failure on a grand scale.

Hence, although it is possible to distinguish between orthodox Keynesians, new Keynesians and post-Keynesians, all three groups are united in the belief that aggregate economic instability represents ‘some sort of market failure on a grand scale’ (Mankiw 1990). In contrast the majority of economists who have been prominent in the monetarist, new classical, real business cycle and Austrian schools have tended to place their faith in market forces as an equilibrating mechanism and question the capacity and desirability of government intervention as a means of achieving the major macroeconomic objectives. Following Gerrard (1996) the seven schools of thought identified above can also be differentiated and classified as orthodox, new or radical. The two ‘orthodox’ schools, ‘IS-LM Keynesianism’ and ‘neoclassical monetarism’, dominated macroeconomic theory in the period up to the mid-1970s. Since then three ‘new’ schools have been highly influential. The new classical, real business cycle and new Keynesian schools place emphasis on issues relating to aggregate supply in contrast to the orthodox schools which focused their research primarily on the factors determining aggregate demand and the consequences of demand-management policies. In particular the new schools share the view that macroeconomic models should be based on solid microeconomic foundations. The ‘radical’ post-Keynesian and Austrian schools are both critical of mainstream analysis whether it be orthodox or new. Since modern macroeconomics has been most influenced by the orthodox and new schools we will confine our discussion here to their contributions (see Davidson 1994 and Chick 1995 for a discussion of post-Keynesian macroeconomics; Garrison 1994 presents the case for the Austrian approach).

In the final section of this opening chapter we briefly review the renaissance of economic growth analysis which since the mid-1980s has moved into the centre stage of macroeconomic research after twenty years of relative neglect. The consequences of economic growth for economic welfare are so important that many prominent macroeconomists who previously concentrated their research efforts on the analysis of business cycles have now turned their attention to theoretical and empirical issues arising out of the burgeoning endogenous growth literature (see Barro and Sala-i-Martin 1995; Mankiw 1995).

KEYNESIAN ECONOMICS AND THE KEYNESIAN REVOLUTION

The birth of modern macroeconomics can be traced back to the 1930s, and in particular the publication of John Maynard Keynes’s (1936) General Theory of Employment, Interest and Money. Prior to the 1930s the dominant view, in what we now call macroeconomics, was the classical approach that within capitalist market economies which are subject to periodic shocks the market mechanism would operate quickly and efficiently to restore full employment equilibrium. In such circumstances government intervention to stabilize the economy was believed to be neither necessary nor desirable. However, the experience of the 1920s and 1930s in Britain, and that of all major capitalist market economies during the 1930s, appeared to shatter the classical assumption that full employment was the normal state of affairs. In Britain the rate of unemployment never fell below 10 per cent between 1921 and 1938, and actually exceeded 20 per cent in 1931 and 1932. In the United States unemployment reached a peak of 25 per cent in 1933 and was still almost 10 per cent in 1941. Writing against this background Keynes (1936) put forward a new and revolutionary theory to explain, and provide a remedy for, the then-prevailing persistent and severe unemployment. In doing so Keynes was responding to what undoubtedly was the most significant macroeconomic event of the twentieth century; the Great Depression gave birth to modern macroeconomics.

The causes of the Great Depression are still the subject of considerable dispute and finding a plausible explanation for the global economic collapse during the early 1930s remains the ‘Holy Grail’ of macroeconomics (seeC. D.Romer 1993; Bernanke 1995). In an extensive study of the US experience Gordon and Wilcox (1981) concluded that the cause of the Great Depression can be traced to a series of domestic spending shocks, both monetary and non-monetary. The initial decline in output during the 1929–31 period can be traced to a decline in consumption and residential investment expenditures. After September 1931 the recession was turned into the Great Depression by the perverse actions of the Federal Reserve in letting the money supply decline drastically (see Friedman and Schwartz 1963). Hence the Great Depression resulted from a shift of the aggregate demand curve to the left and the impact of the monetary contraction was transmitted worldwide via the operation of the gold standard (see Eichengreen 1992). The self-equilibrating tendencies of the market failed to come into play and as a result we have the best known example of massive monetary non-neutrality. In the face of enormous unemployment, nominal wages failed to adjust sufficiently to shift the aggregate supply curve so as to restore full employment (Bernanke and Carey 1996). The worldwide decline in aggregate demand as an explanation for the Great Depression has its origin in the work of Keynes, for it was his analysis in the General Theory which turned economists’ attention away from the classical emphasis on supply-side factors. Although economists certainly examined (what we now call) macroeconomic issues prior to the publication of the General Theory, even Pigou argued that Keynes was the first economist to bring together real and monetary factors ‘in a single formal scheme, through which their interplay could be coherently investigated’ (quoted in Solow 1986). The dominance of Keynes in the field of macroeconomics prior to his death in 1946 is clearly illustrated by looking at data on citations for the period 1920–44(see Tables 1.1–1.4). The outstanding feature of these tables is the extent to which Keynes had come to dominate macroeconomics by the mid-1930s.

Table 1.1 Most cited macroeconomists 1920–30

Table 1.2 Most cited macroeconomists 1931-5

Table 1.3 Most cited macroeconomists 1936-9

Table 1.4 Most cited macroeconomists 1940–4

In Solow’s (1986) view, the General Theory ‘has certainly been the most influential work of economics of the 20th century, and Keynes the most important economist’.

A central theme of Keynes’s analysis is the contention that capitalist market economies are inherently unstable and are capable of coming to rest ‘in a chronic condition of sub-normal activity for a considerable period without any marked tendency, either towards recovery or towards complete collapse’ (Keynes 1936:249). This instability was in Keynes’s view predominantly the result of fluctuations in aggregate demand and the Great Depression resulted from a sharp fall in investment expenditure ‘occasioned by a cyclical change in the marginal efficiency of capital’. The resulting unemployment was involuntary and reflected a state of deficient aggregate demand. Given the weak equilibrating powers of the market mechanism in these circumstances the implication of Keynes’s analysis was that fiscal and monetary policy could correct the aggregate instability exhibited by market economies and help stabilize the economy at full employment. Once full employment is restored Keynes accepted that ‘the classical theory comes into its own again’ and Keynes was optimistic that limited government intervention could remedy the shortcomings of the invisible hand (see Keynes 1936:379). Managed capitalism, with a commitment to full employment, was the kind of system Keynes had in mind when in the concluding section of his famous essay The End of Laissez-Faire (1924) he argued that:

For my part I think that capitalism, wisely managed, can probably be made more efficient for attaining economic ends than any alternative yet in sight, but that in itself it is in many ways objectionable. Our problem is to work out a social organisation which shall be as efficient as possible without offending our notions of a satisfactory way or life.

(reprinted in Keynes 1972:294)

Keynes objected to mass unemployment which his analysis defined as largely involuntary. In such a situation the economy can be said to be operating in what Tobin (1992) refers to as ‘the Keynesian regime’. Here aggregate economic activity is demand constrained and additional ‘effective’ demand creates its own supply since the economy has the necessary spare capacity during a recession. However, once full employment is restored, the economy operates in the supply constrained classical regime. Here supply creates its own demand. Whereas the classical model recognizes only the supply constrained regime, Keynes and Keynesians believe that the economy is capable, at different times, of being in either regime.

As early as the mid-1950s the consensus which was beginning to emerge in macroeconomics particularly in the USA was labelled the neoclassical synthesis by Samuelson:

In recent years 90 per cent of American economists have stopped being ‘Keynesian economists’ or ‘anti-Keynesian economists’. Instead they have worked towards a synthesis of whatever is valuable in older economics and in modern theories of income determination. The result might be called neoclassical economics and is accepted in its broad outlines by all but about 5 per cent of extreme left-wing and right-wing writers.

(Samuelson 1955:212, emphasis added)

The initial synthesis proceeded along two lines of inquiry. The first studied the long-run movement of output by identifying the determinants of the trend and ignoring fluctuations around the trend. Significant contributions were made during this period to the development of growth theory (see Hahn and Matthews 1964). The second line of inquiry concentrated on the analysis of short-run fluctuations around the trend. At the centre of this analysis lay the Hicks-Hansen IS-LM framework (Hicks 1937; Hansen 1953; Young 1987; Darity and Young 1995). During this period a great deal of macroeconomic research was devoted to refining the four basic building blocks of the IS-LM model, namely the consumption function, the investment function and the demand for, and supply of, money.

During the late 1950s and early 1960s a consensus emerged with respect to the ‘Keynes v. Classics’ debate in which it was generally accepted that at the theoretical level, once the Pigou or wealth effect of falling prices on consumption expenditure is taken into account, then unemployment equilibrium is possible in the Keynesian IS-LM model only where downward money wage rigidity prevents the classical automatic adjustment to full employment. Nevertheless at the practical policy level it was conceded that the process of adjustment via the Pigou effect might be so weak and slow that interventionist policies (notably expansionary fiscal policy) would be required in order to achieve the primary stated objective of full employment (see Snowdon et al. 1994: Chapter 3). With a relatively inelastic IS curve and a relatively elastic LM curve Keynesianism became synonymous with ‘fiscalism’ and policies to fine tune the macroeconomy.

The publication of the results of Bill Phillips’s (1958) statistical investigation into the relationship between the level of unemployment and wage inflation, and Richard Lipsey’s (1960) subsequent theoretical rationale for the curve, proved to be another important development during this period (see Santomero and Seater 1978; Wulwick 1987). The Phillips curve was quickly adopted by orthodox Keynesian economists for three main reasons. First, it provided an explanation of price determination, and inflation, which was missing in the then-prevailing macroeconomic model. Within the IS-LM model the price level is assumed to be fixed at less than full employment with the result that changes in aggregate demand affect only the level of output and employment. Up to full employment money wages are assumed to be fixed and unresponsive to changes in aggregate demand. The Phillips curve allowed the orthodox theory of output and employment determination to be linked to a theory of wage and price inflation (see Lipsey 1978). Second, the Phillips curve appeared to provide rare evidence of a stable relationship between unemployment and inflation that had existed for almost a century. Third, the curve provided an insight into the problem that policymakers face of simultaneously achieving high levels of employment with price stability given the trade-off between wage inflation and unemployment. As such the Phillips curve was interpreted by many orthodox Keynesians as implying a stable long-run trade-off which offered the authorities a menu of possible inflation-unemployment combinations for policy choice (see for example Samuelson and Solow 1960). Up to at...

Table of contents

• COVER PAGE
• TITLE PAGE
• COPYRIGHT PAGE
• PREFACE
• 1: THE DEVELOPMENT OF MODERN MACROECONOMICS: A ROUGH GUIDE
• PART I: KEYNESIAN ECONOMICS AND THE KEYNESIAN REVOLUTION
• PART II: THE MONETARIST COUNTERREVOLUTION
• PART III: THE CHALLENGE OF RATIONAL EXPECTATIONS AND NEW CLASSICAL MACROECONOMICS
• PART IV: THE REAL BUSINESS CYCLE APPROACH TO ECONOMIC FLUCTUATIONS
• PART V: NEW KEYNESIAN ECONOMICS
• PART VI: THE RENAISSANCE OF ECONOMIC GROWTH ANALYSIS