CHAPTER 27
CHAPTER27
Epilogue: The Story
of Macroeconomics
Prepared by:
Fernando Quijano and Yvonn Quijano
© 2006 Prentice Hall Business Publishing
Macroeconomics, 4/e
Olivier Blanchard
Chapter 7: Epilogue: The Story of
Macroeconomics
27-1
Keynes and the
Great Depression
The history of modern macroeconomics
starts in 1936, with the publication of
Keynes’s General Theory of Employment,
Interest, and Money.
Keynes
The Great Depression was an intellectual failure
for the economists working on business cycle
theory—as macroeconomics was then called.
Keynes emphasized effective demand, now
called aggregate demand.
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Olivier Blanchard
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Chapter 7: Epilogue: The Story of
Macroeconomics
Keynes and the
Great Depression
In the process of deriving effective demand,
Keynes introduced many of the building blocks
of modern macroeconomics:
 The relation of consumption to income, and
the multiplier.
 Liquidity preference (the term given to the
demand for money)
 The importance of expectations in affecting
consumption and investment; and the idea
that animal spirits are a major factor behind
shifts in demand and output.
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The Neoclassical Synthesis
Paul Samuelson wrote the first modern
economics textbook: Economics
The neoclassical synthesis refers to a
large consensus that emerged in the
early 1950s, based on the ideas of
Keynes and earlier economists.
The neoclassical synthesis was to remain the
dominant view for another 20 years. The period
from the early 1940s to the early 1970s was
called the golden age of macroeconomics.
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Chapter 7: Epilogue: The Story of
Macroeconomics
The IS-LM Model
The most influential formalization of Keynes’s
ideas was the IS-LM model, developed by John
Hicks and Alvin Hansen in the 1930s and early
1940s.
Discussions became organized around the
slopes of the IS and LM curves.
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Chapter 7: Epilogue: The Story of
Macroeconomics
Theories of Consumption,
Investment, and Money Demand
In the 1950s, Franco Modigliani and
Milton Friedman independently
developed the theory of consumption,
and insisted on the importance of
expectations.
Modigliani
James Tobin developed the theory of
investment based on the relation
between the present value of profits and
investment. Dale Jorgenson further
developed and tested the theory.
Tobin
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Chapter 7: Epilogue: The Story of
Macroeconomics
Growth Theory
In 1956, Robert Solow developed the
growth model—a framework to think
about the determinants of growth.
Solow
It was followed by an explosion of work on the
roles saving and technological progress play in
determining growth.
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Chapter 7: Epilogue: The Story of
Macroeconomics
Macroeconometric Models
Lawrence Klein developed the first U.S.
macroeconomic model in the early
1950s. The model was an extended IS
relation, with 16 equations.
Klein
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Chapter 7: Epilogue: The Story of
Macroeconomics
Keynesians Versus Monetarists
Friedman
Milton Friedman was the intellectual
leader of the monetarists, and the father
of the theory of consumption.
He believed that the understanding of
the economy remained very limited, and
questioned the motives and ability of
governments to improve macroeconomic
outcomes.
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Chapter 7: Epilogue: The Story of
Macroeconomics
Keynesians Versus Monetarists
In the 1960s, debates between Keynesians and
monetarists dominated the economic headlines.
The debates centered around three issues: (1)
the effectiveness of monetary policy versus fiscal
policy, (2) the Phillips curve, and (3) the role of
policy.
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Chapter 7: Epilogue: The Story of
Macroeconomics
Monetary Policy Versus Fiscal Policy
Friedman challenged the view that fiscal policy
could affect output faster and more reliably than
monetary policy.
In a 1963 book, A Monetary History of the United
States, 1867-1960, Friedman and Anna Schwartz
reviewed the history of monetary policy and
concluded that monetary policy was not only very
powerful, but that movements in money also
explained most of the fluctuations in output.
They interpreted the Great Depression as the
result of major mistake in monetary policy.
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Chapter 7: Epilogue: The Story of
Macroeconomics
The Phillips Curve
The Phillips curve had become part of the
Neoclassical synthesis, but Milton Friedman
and Edmund Phelps argued that the
apparent trade-off between unemployment
and inflation would quickly vanish if policy
makers actually tried to exploit it.
By the mid 1970s, the consensus was that
there was no long-run trade off between
inflation and unemployment.
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Chapter 7: Epilogue: The Story of
Macroeconomics
The Role of Policy
Skeptical that economists knew enough to
stabilize output, and that policy makers could be
trusted to do the right thing, Milton Friedman
argued for the use of simple rules, such as
steady money growth.
Friedman believed that political pressures to “do
something” in the face of relatively mild problems
may do more harm than good.
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The Rational
Expectations Critique
In the early 1970s, Robert
Lucas, Thomas Sargent,
and Robert Barro led a
strong attack against
mainstream
macroeconomics.
Lucas
Sargent
Barro
They argued that the predictions of Keynesian
macroeconomics were wildly incorrect, and
based on a doctrine that was fundamentally
flawed.
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Chapter 7: Epilogue: The Story of
Macroeconomics
The Three Implications of
Rational Expectations
Lucas and Sargent’s main argument was that
Keynesian economics had ignored the full
implications of the effect of expectations on
behavior. Thinking of people as having rational
expectations had three major implications, all
highly damaging to Keynesian macroeconomics.
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Chapter 7: Epilogue: The Story of
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The Lucas Critique
Robert Lucas argued that macroeconomic
models did not incorporate expectations
explicitly; that the models captured relations as
they had held in the past, under past policies.
They were poor guides to what would happen
under new policies.
This critique of macroeconometric models
became known as the Lucas Critique.
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Chapter 7: Epilogue: The Story of
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Rational Expectations and the
Phillips Curve
In Keynesian models, the slow return of output to
the natural level of output came from the slow
adjustment of prices and wages through the
Phillips curve mechanism.
Within the logic of the Keynesian models, Lucas
therefore argued, only unanticipated changes in
money should affect output.
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Chapter 7: Epilogue: The Story of
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Optimal Control Versus Game Theory
Let’s summarize: When rational expectations
were introduced,
Keynesian models could not be used to
determine policy,
Keynesian models could not explain long-lasting
deviations of output from the natural level of
output, and
the theory of policy had to be redesigned, using
the tools of game theory.
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Chapter 7: Epilogue: The Story of
Macroeconomics
The Integration of Rational
Expectations
The intellectual atmosphere in macroeconomics
was tense in the early 1970s. But within a few
years, a process of integration (of ideas, not
people) had begun, and it was to dominate the
1970s and the 1980s.
Work then started on the challenges raised by
Lucas and Sargent.
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Chapter 7: Epilogue: The Story of
Macroeconomics
The Implications of
Rational Expectations
Robert Hall showed that if consumers
are very foresighted, then changes in
consumption should be unpredictable.
Hall
 Consumption will change only when
consumers learn something new about the
future. Since news about the future cannot be
predicted, changes in consumption are highly
random. This consumption behavior, known
as the random walk of consumption, has
served as a benchmark in consumption
research ever since.
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Chapter 7: Epilogue: The Story of
Macroeconomics
The Implications of
Rational Expectations
Dornbusch
Rudiger Dornbusch developed a model
of exchange rates that shows how large
swings in exchange rates are not the
result of irrational speculation but,
instead, fully consistent with rationality.
 Dornbusch’s model, known as the
overshooting model of exchange rates, has
become the benchmark in discussions of
exchange-rate movements.
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Chapter 7: Epilogue: The Story of
Macroeconomics
Wage and Price Setting
Fischer
Stanley Fischer and John Taylor showed
that the adjustment of prices and wages
in response to changes in
unemployment can be slow even under
rational expectations.
They pointed to the staggering of both
wage and price decisions, and explained
how a slow return of output to the natural
level can be consistent with rational
expectations in the labor market.
Taylor
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The Theory of Policy
In short: By the end of the 1980s, the
challenges raised by the rationalexpectations critique had led to a complete
overhaul of macroeconomics.
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Current Developments
Since the late 1980s, three groups have
dominated the research headlines: the
new classicals, the new Keynesians, and
the new growth theorists.
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Chapter 7: Epilogue: The Story of
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New Classical Economics and Real
Business Cycle Theory
Prescott
Edward Prescott is the intellectual leader
of the new classicals—a group of
economists interested in explaining
fluctuations as the effects of shocks in
competitive markets with fully flexible
prices and wages.
Their real business cycle (RBC) models
assume that output is always at its natural level,
and fluctuations are movements of the natural
level of output. These movements are
fundamentally caused by technological progress.
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Chapter 7: Epilogue: The Story of
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New Keynesian Economics
Akerlof
One line of research focuses on the
determination of wages in the labor
market. George Akerlof has explored
the role of “norms,” or rules that develop
in any organization to assess what is fair
or unfair.
The new Keynesians are a loosely connected
group of researchers working on the implications
of several imperfections in different markets.
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Chapter 7: Epilogue: The Story of
Macroeconomics
New Keynesian Economics
Another line of new Keynesian research
has explored imperfections in credit
markets. Ben Bernanke has studied the
relation between banks and borrowers
and its effects on monetary policy.
Yet another direction of research is nominal
rigidities in wages and prices. The menu cost
explanation of output fluctuations, developed by
Akerlof and N. Gregory Mankiw, attributes even
small costs of changing prices to the infrequent
and staggered price adjustment.
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Chapter 7: Epilogue: The Story of
Macroeconomics
New Growth Theory
Robert Lucas and Paul Romer have
provided a new set of contributions
under the name of new growth theory,
which take on some of the issues initially
raised by growth theorists of the 1960s.
Romer
New growth theory focuses on the determinants
of technological progress in the long run, and the
role of increasing returns to scale.
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Chapter 7: Epilogue: The Story of
Macroeconomics
New Growth Theory
One example of some of the advances
economists have made is on the work of
Philippe Aghion and Peter Howitt. They
have developed a theme first explored
by Joseph Schumpeter in the 1930s, the
notion that growth is a process of
creative destruction, in which new
products are constantly introduced,
making old ones obsolete.
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Macroeconomics
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Common Beliefs
Most macroeconomists agree that:
 In the short run, shifts in aggregate demand
affect output.
 In the medium run, output returns to the natural
level.
 In the long run, capital accumulation and the rate
of technological progress are the main factors
that determine the evolution of the level of
output.
 Monetary policy affects output in the short run,
but not in the medium run or the long run.
 Fiscal policy has short-run, medium-run, and
long-run effects on output.
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Chapter 7: Epilogue: The Story of
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Common Beliefs
Some of the disagreements involve:
 The length of the “short run,” the period of
time over which aggregate demand affects
output.
 The role of policy. Those who believe that
output returns quickly to the natural level
advocate the use of tight rules on both fiscal
and monetary policy. Those who believe that
the adjustment is slow prefer more flexible
stabilization policies.
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Chapter 7: Epilogue: The Story of
Macroeconomics
Key Terms








business cycle theory
effective demand
liquidity preference
neoclassical synthesis
Keynesians
Monetarists
Lucas critique
random walk of consumption
© 2006 Prentice Hall Business Publishing
 staggering (of wage and price
decisions)
 new classicals
 real business cycle (RBC) models
 new Keynesians
 nominal rigidities
 menu costs
 new growth theory
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