Adam Smith: The division of labor
is limited by the extent of the market
Division of labor
Increasing Returns to Scale
...by directing [his] industry in such a manner as its
produce may be of the greatest value, he intends only his
own gain, and he is in this … led by an invisible hand to
promote an end which was no part of his intention.
Laissez -faire
Jean Baptiste Say:
Supply creates its own demand
Thomas Robert Malthus:
Theory of gluts
Knut Wicksell:
“Natural rate”
…cumulative
causation
Irving Fisher:
Debt deflation
depression
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.
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.
The Neoclassical Synthesis
Paul Samuelson wrote the first modern economics
textbook: Economics
Samuelson
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.
The Neoclassical Synthesis
Progress on All Fronts
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.
The Neoclassical Synthesis
Progress on All Fronts
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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The Neoclassical Synthesis
Growth Theory
In 1956, Robert Solow developed the growth
model—a framework to think about the
determinants of growth.
It was followed by an explosion of work on the roles saving
and technological progress play in determining growth.
Solow
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
Keynesians versus Monetarists
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
Friedman
outcomes.
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.
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.
Keynesians versus Monetarists
The Phillips Curve
Phelps
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.
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.
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.
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.
The Lucas Critique
Robert Lucas argued that Keynesian macroeconomic models did not
incorporate expectations explicitly so 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…regime change
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.
Optimal Control versus Game Theory
The theory of policy had to be redesigned, using the tools of game theory.
The Rational Expectations Critique
The Integration of Rational Expectations
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.
The Integration of Rational Expectations
The Implications of Rational Expectations
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
 Dornbusch’s model, known as the overshooting
model of exchange rates, has become the
benchmark in discussions of exchange-rate
movements.
The Rational Expectations Critique
The Integration of Rational Expectations
Wage and Price Setting
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.
Fischer
Taylor
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.
New Classical Economics and Real Business
Cycle Theory
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.
Prescott
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.
New Keynesian Economics
The new Keynesians are a loosely connected group
of researchers working on the implications of several
imperfections in different markets.
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.
Akerlof
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.
Ben Bernanke
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.
N. Gregory Mankiw
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.
Paul Romer
New growth theory focuses on the determinants
of technological progress in the long run, and
the role of increasing returns to scale.
Recent Developments
New Growth Theory
Andrei Shleifer (from Harvard University) has explored
the role of different legal systems in affecting the
organization of the economy, from financial markets to
labor markets, and, through these channels, the
effects of legal systems on growth.
Andrei Shleifer
Daron Acemoglu (from MIT) has explored how to go
from correlations between institutions and growth—
democratic countries are on average richer—to
causality from institutions to growth
Darin Acemoglu
Recent Developments
Dynamic Stochastic General Equilibrium
Woodford, Gali, and a number of co-authors have
developed a model, known as the New-Keynesian
model, that embodies utility and profit maximization,
rational expectations, and nominal rigidities.
Michael Woodford
Interest and Prices
 Inflation targeting
Jordi Gali
This model has proven extremely useful and influential
in the redesign of monetary policy. It has also led to
the development of a class of larger models that build
on its simple structure, but allow for a longer menu of
imperfections and thus must be solved numerically.
These models, which are now used in most central
banks, are known as dynamic stochastic general
equilibrium (DSGE) models.
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.
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.