Macroeconomic theory and the global economic recession.

• Author: Hart, Neil
• Position: Report

1. INTRODUCTION

   This paper considers the likelihood of a significant 'redirection' in macroeconomic theory in the shadows of the 'Global Economic Recession' [GER]. Recent commentary on the status of mainstream macroeconomics by the 2007 Nobel Laureate, Paul Krugman, provides an appropriate setting in which to develop a general discussion of the current situation:

   It's hard to believe now, but not long ago economists were congratulating themselves over the success of their field. Those successes--or so they believed--were both theoretical and practical, leading to a golden era for the profession. On the theoretical side, they thought that they had resolved their internal disputes. Thus, in a 2008 paper titled "The State of Macro" (that is, macroeconomics, the study of big-picture issues like recessions), Olivier Blanchard of M.I.T., now the chief economist at the International Monetary Fund, declared that "the state of macro is good." The battles of yesteryear, he said, were over, and there had been a "broad convergence of vision." And in the real world, economists believed they had things under control: the "central problem of depression-prevention has been solved," declared Robert Lucas of the University of Chicago in his 2003 presidential address to the American Economic Association. In 2004, Ben Bernanke, a former Princeton professor who is now the chairman of the Federal Reserve Board, celebrated the Great Moderation in economic performance over the previous two decades, which he attributed in part to improved economic policy making...

   Last year, everything came apart.

   Few economists saw our current crisis coming, but this predictive failure was the least of the field's problems. More important was the profession's blindness to the very possibility of catastrophic failures in a market economy (Krugman 2009: 1).

   The 'convergence of vision' description of 'modern macro' is in one respect misleading, as in terms of theory and methodology, mainstream macroeconomics has become somewhat fragmented over recent years. Two distinct approaches can be isolated, however. Firstly there is the so called 'quantitative dynamic stochastic general equilibrium' [QDSGE] family of models. As is indicated in the title of Lucas and Sargent's (1978) paper, 'After Keynesian Macroeconomics', these models are indicative of an approach which is openly antagonistic towards macroeconomics that even vaguely resembles the Keynesian tradition. On the other hand, the 'new neo-classical synthesis' [NNS] approach attempts to establish a 'consensus' in macroeconomic theory, encompassing both Keynesian and Neo-classical elements. Discussion in this paper focuses most directly on the NNS approach and its capacity to provide a useful guide to macroeconomic policy formulation. The basic structure of the NNS model is summarised in Section 2. Links between NNS theory and the 'policy restraint' principle, widely advocated prior to the GER, are discussed in Section 3. A 'reconstruction' of mainstream macroeconomics predicated on a 'revival of Keynes' economics', as advocated by prominent Nobel Laureates such as Krugman and Akerlof, is contemplated in Section 4. Some observations on the likelihood of a 'redirection' of mainstream macroeconomic theory and policy formulation in the years ahead are presented in the concluding section.

2. THE NNS 'CONSENSUS' MODEL

   The imperative to construct a 'consensus' model, in an attempt to find 'common ground' between 'rival' Keynesian and Neoclassical approaches to macroeconomic theory, has been most enthusiastically pursued by the authors of the popular contemporary textbooks, with the 'erstwhile' Keynesian versus Neoclassical disputes consigned to the earlier stages of the development of 'modern macroeconomics'. The 'consensus' said to exist within macroeconomic theory was initially described within the IS/LM-AD/AS -Philips Curve relation family of models, combining elements of 'Keynesian' demand analysis with 'Neoclassical' visions of 'market clearing' within a family of equilibrium models. While these theoretical models retain their status within the latest of the successive editions of the popular textbooks, the 'consensus' during recent years has most often been discussed formally in the setting of the New Neoclassical Synthesis [NNS] model, and it is the key features of this approach which are outlined in this section.

   The NNS model in part reflects a 'consensus' that emerged from a symposium at the 1997 Annual Meeting of the American Economic Association, where prominent macroeconomists Blanchard, Blinder, Eichenbaum, Solow and Taylor were asked to consider if there is a core of practical macroeconomics that could be used to underpin macroeconomic policy. As portrayed by Taylor (2000: 90), the 'consensus' elements that form the foundations of NNS model are as follows. It is maintained that the 'long run real growth trend' or 'potential GDP' can be 'understood' using the Solow type growth model 'extended to make "technology" explicitly endogenous' (i.e. 'New Growth' Theory?). Expectations regarding inflation and future policy decisions are endogenous, and 'quantitatively significant'. There is no 'long-run trade off' between inflation and unemployment, implying that monetary policy is neutral in the 'long-run'. However, in the short-run, due largely to price and wage 'stickiness', an inflation- unemployment trade-off is likely to be present and money is non-neutral. In this sense, it is sometimes suggested that the proposed synthesis combines a 'New Keynesian' style demand determined short-run with a 'Neoclassical' supply determined 'long-run'. The 'New Keynesian' component is of interest, given that this approach was developed largely as a result of criticisms of the New Classical principles that have formed the theoretical foundations of the QDSGE models. While allowing for 'price-stickiness' flowing largely from risk-adverse behaviour where information is incomplete and asymmetric, New Keynesian models generally retained the assumption of rational expectations and optimising behaviour popularised by their New Classical foes in the battle for 'micro foundations'.

   The final area of consensus related to monetary policy decisions, which were seen as rules, or reaction functions, in which the short-term nominal interest rate (the instrument of policy) is adjusted in reaction to economic events (Taylor 2000: 90). It should be noted that this equation is based on observation of procedures currently adopted by central banks, and does not necessarily imply that these rules are optimal elements of a macroeconomic policy package. Significantly, the inclusion of monetary policy reaction functions signalled the demise of LM functions, with the latter seen to be inconsistent with the realities of monetary policy based on interest rate setting instruments (as opposed to monetary aggregates).

   The key components of the NNS model can be summarised in the following functional relationships:

   [y.sub.t] = [a.sub.0] + [a.sub.1][y.sub.t-1] + [a.sub.2][y.sup.e] - [a.sub.3]([i.sub.t] - [[p.sup.e.sub.t+1]) + [u.sub.1] (1)

   [p.sub.t] = [b.sub.1][y.sub.t] + [b.sub.2][p.sub.t-1] + [[b.sub.3][p.sup.e.sub.t+1] + [u.sub.2] (2)

   [i.sub.t] = [R.sup.*] + [p.sup.e.sub.t+1] + [c.sub.1][y.sub.t-1] + [c.sub.2]([p.sub.t-1] - [p.sup.T]) + [c.sub.0] (3)

   where y is the output gap (actual less full capacity output); p = inflation; i = nominal rate of interest; [R.sup.*] = 'equilibrium' real rate of interest (consistent with y = 0?); [p.sup.T] = target rate of inflation, e superscripts indicate expected values.

   Equation (i) is the aggregate demand relationship, showing the output gap as a function of past and expected future output gaps, the real rate of interest and 'demand shocks' ([a.sub.0]). Equation (2) is a generic Phillips Curve relationship (with [b.sub.2]+[b.sub.3] = i), while equation (3) is the monetary policy reaction function of the type referred to in the above quote from Taylor. This policy reaction function explicitly incorporates interest rates as the policy instrument, with the control of inflationary pressures perceived to be the major policy target. In these functional relationships, money supply is in effect a residual outcome, having no causal feedback effects on the economy.

   In terms of its application to practical policy issues, most discussion within the NNS has been focused on the monetary policy reaction function, or 'Taylor Rule', with policy directed towards changes in official (nominal) interest rates used to offset inflationary pressures which surface whenever real output exceeds (or approaches) full capacity output (y>0). The effectiveness of monetary policy in influencing real variables depends on the sensitivity of expenditures to variations in (real) interest rates. The role and nature of fiscal policy has by contrast been largely neglected. In terms of the functional relationships outlined above, the impact of fiscal policy on the economy has to be interpreted as being transmitted initially through the a0 ('shift') variable in equation (1). Significantly, expansionary fiscal policy can be seen to add to current demand, thereby reducing the gap between full capacity and current output levels. In this setting, expansionary fiscal policy would only fuel inflationary pressures in the economy and place upward pressure on interest rates if the accompanying increases in demand pushed the economy beyond full capacity output...