The Macroeconomics of Self-Fulfilling Prophecies.

• Author: Chowdhury, Abdur R.

Graduate macroeconomics courses are becoming increasingly technical. Students must learn the tools of dynamic analysis and how to apply these tools to a wide range of macroeconomic models. However, in the contemporary literature only few attempts have been made in this regard. Roger Farmer attempts to fill this gap by providing a comprehensive overview of various approaches to dynamic analysis. Farmer uses general equilibrium theory to relate the ideas that are taught in graduate macroeconomics courses to the foundations of these ideas in the theory of rational choice.

Since the 1970s, macroeconomists have begun to pay much greater attention to the micro foundation of their subject. This change in the way of macro-thinking can be traced to the episode of high inflation and high unemployment in the early 1970s that was inconsistent with orthodox theory. Farmer starts the book with the premise that since macroeconomics deals with the behavior of the economy as a whole, hence the natural foundation for macroeconomics lies in the microeconomic theory of general equilibrium. The author introduces a number of dynamic general equilibrium models each of which maintains the assumption that agents have rational expectations of future prices. He argues that much of the Keynesian resistance to this approach can be attributed to the fact that much of the debate on rational expectations in macroeconomics have taken place in the context of very simple general equilibrium models in which the competitive mechanism functions smoothly. He believes that the use of over-simplistic environments to convey the central message of the rational expectation research agenda has contributed to a widespread misunderstanding of the implications of rational expectations.

The major argument of this book is that one can think of macroeconomics as the study of equilibrium environments in which the welfare theorems relating to Pareto-optimal allocations of resources may break down. The author argues that only under this circumstance it is possible to discuss the role of stabilization policies in a context in which they may serve some purpose.

The author opens the discussion in Chapter 1 with a simple model of an indeterminate equilibrium. Then he gradually expands on the idea that equilibrium theory is a much richer tool for understanding data than one might otherwise think. He argues against the notion that equilibrium models lead to particular normative conclusions. Chapters...