History of Modern Macroeconomics
Lecture 3.7 New Classicals and New Keynesians
(1970-1985)
Kevin D. Hoover
Department of Economics
Department of Philosophy
Center for the History of Political Economy
Duke University
Economics 882 History of Modern
Macroeconomics (Spring 2013, Module 2)
1
Lucas and Sargent Before the New
Classical Macroeconomics
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Robert E. Lucas, Jr. (1937- )
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Chicago  Berkeley  Chicago (History 
Economic History  Economics)
Keynesian education at Chicago
Early work on investment and labor in Klein’s
microfoundation tradition
First job: Carnegie Tech
Thomas J. Sargent (1943- )
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Berkeley  Harvard
Politically left
Connected to Carnegie-Mellon
16 years at University of Minnesota
Principal subject of Esther-Mirjam Sent’s The
Evolving Rationality of Rational Expectations (working
title: Resisting Sargent)
Economics 882 History of Modern
Macroeconomics (Spring 2013, Module 2)
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Carnegie Tech in the 1950s: Herbert
Simon
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Polymath: economist,
political scientist,
sociologist, psychologist
Cowles Commission:
seminal work on causality
and identification
Intellectual leader of
Carnegie’s Graduate School
of Industrial Administration
Key work on
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Herbert Simon (1916-2001)
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bounded rationality
self-fulfilling expectations
investment
Economics 882 History of Modern
Macroeconomics (Spring 2013, Module 2)
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Carnegie Tech in the 1950s: Two Key
Players – 1
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Franco Modigliani
(1918-2003)
Nobel Laureate
(1985)
Economics 882 History of Modern
Macroeconomics (Spring 2013, Module 2)
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Carnegie Tech in the 1950s: Two Key
Players – 2
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John F. Muth (1930-2005)
Photo? If you Google
Image on John F. Muth you
get photos of
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John Muth (1930-2005)
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Lucas
Sargent
Prescott
Arrow
Simon
Samuelson
Dornbusch
Economics 882 History of Modern
Macroeconomics (Spring 2013, Module 2)
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Carnegie Investment Planning Project
Key Book:
Charles C. Holt, Franco Modigliani, John F.
Muth, and Herbert A. Simon. Planning
Production, Inventories, and Work Force, 1960.
Economics 882 History of Modern
Macroeconomics (Spring 2013, Module 2)
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Muth’s Seminal Papers
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“Rational Expectations and the Theory of Price
Movements” (Econometrica 1961)
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main theory
published second
John F. Muth. “Optimal Properties of Exponentially
Weighted Forecasts” (Journal of the American
Statistical Association 1960)
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key example
refers to later paper in its draft form
Economics 882 History of Modern
Macroeconomics (Spring 2013, Module 2)
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The Rational Expectations Hypothesis
expectations, since they are informed predictions of future events, are
essentially the same as the predictions of the relevant economic theory.
...
The hypothesis can be rephrased a little more precisely as follows: that
expectations of firms (or, more generally, the subjective probability
distribution of outcomes) tend to be distributed, for the same
information set, about the prediction of the theory (or the “objective”
probability distributions of outcomes).
The hypothesis asserts three things: (1) Information is scarce, and the
economic system generally does not waste it. (2) The way expectations
are formed depends specifically on the structure of the relevant system
describing the economy. (3) A “public prediction,” in the sense of
Grunberg and Modigliani, will have no substantial effect on the
operation of the economic system (unless it is based on inside
information). [Muth 1961, p. 316]
Economics 882 History of Modern
Macroeconomics (Spring 2013, Module 2)
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The Cobweb and Rational Expectations
Economics 882 History of Modern
Macroeconomics (Spring 2013, Module 2)
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Lucas and Friedman
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Non-Friedmanian Roots
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Samuelson’s Foundations of Economic Analysis
receptive to Walrasian theory
preference for rigor and formal theory
Debt to Friedman
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preference for radical simplification
natural rate hypothesis/expectations-augmented Phillips
curve: market-clearing explanation of apparent
disequilibrium based in asymmetric information
Economics 882 History of Modern
Macroeconomics (Spring 2013, Module 2)
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Lucas and Rapping: The First New
Classical Papers
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Lucas and Leonard Rapping [1933-1991]:
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“Real Wages, Employment, and Inflation” (JPE 1969)
“Price Expectations and the Phillips Curve” (AER 1969)
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adaptive expectations; mentions does not model rational
expectations
exploitable tradeoff between inflation and unemployment
market clearing with asymmetrical information
surprise-only or Lucas aggregate supply function:
y = (p – pe)
intertemporal substitution of labor
Economics 882 History of Modern
Macroeconomics (Spring 2013, Module 2)
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The Adoption of Rational Expectations
into Macro: Key Lucas Papers
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“Expectations and the Neutrality of Money”
(JET 1972)
“Econometric Testing of the Natural Rate
Hypothesis” (Fed Conference Volume 1972)
“Some International Evidence on OutputInflation Tradeoffs” (AER 1973)
"Econometric Policy Evaluation: A Critique".
(Carnegie-Rochester Conference Series on Public
Policy 1976)
Economics 882 History of Modern
Macroeconomics (Spring 2013, Module 2)
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“Expectations and the Neutrality of
Money” (JET 1972)
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Lucas and Rapping paper in Phelps, editor.
Microeconomic Foundations of Employment and
Inflation Theory.
Phelps’s “island model”
Signal extraction
Stylized, but rigorous, model of the
“surprise-only” aggregate supply function
The ephemeral Phillips curve
More cited than used
Economics 882 History of Modern
Macroeconomics (Spring 2013, Module 2)
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“Some International Evidence on OutputInflation Tradeoffs” (AER 1973)
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Empirical test of JET 1972 paper
Cross-country analysis
Implication of signal extraction: Phillips
curve (aka: Lucas supply function) steeper in
high variance of inflation environment
Confirmed, but contested in the literature
Economics 882 History of Modern
Macroeconomics (Spring 2013, Module 2)
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“Econometric Testing of the Natural Rate
Hypothesis” (Fed Conference Volume
1972)
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Friedman’s not really a natural rate model
regression tests the wrong test of the natural
rate hypothesis (cf. Muth 1960)
correct test: overidentifying cross-equation
restrictions (early example of solution
methods for rational expectations models
characterizes policy by a fixed rule  protopolicy invariance critique
Economics 882 History of Modern
Macroeconomics (Spring 2013, Module 2)
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“Econometric Policy Evaluation: A Critique” (CarnegieRochester Conference Series on Public Policy 1976)
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Pivotal macroeconomics paper of the second half of the 20th
century
Foreshadowed by Tinbergen, Simon, Marschak, et al. (Cowles
Commission)
Novelty: rational expectations as source of invariance
Critique of Tinbergen’s policy framework:
 targets and instruments = engineering paradigm
 can’t neglect rational action or economists inside the game
Solution
 model tastes and technology  GE microfoundations essential
 doing Cowles right
Economics 882 History of Modern
Macroeconomics (Spring 2013, Module 2)
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Sargent
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Independent introduction of rational
expectations
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real interest rates
hyperinflation
Phillips curve
Integration of rational expectations to timeseries econometrics (Sims a colleague at
Minnesota)
More empirically oriented than Lucas
Economics 882 History of Modern
Macroeconomics (Spring 2013, Module 2)
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Sargent and Wallace: Policy
Ineffectiveness – 1
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Neil Wallace (1938- )
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Chicago Ph.D under Friedman
Faculty of University of Minnesota
“Rational Expectations, the Optimal
Monetary Policy and the Optimal Money
Supply Rule (JPE 1975)
“Rational Expectations and the Theory of
Economic Policy” (JME 1976)
Economics 882 History of Modern
Macroeconomics (Spring 2013, Module 2)
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Sargent and Wallace: Policy
Ineffectiveness – 2
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IS-LM model with Lucas aggregate supply
function + rational expectations
Pure AD policies affect output only
randomly (note: nominal not real policies in
question)
Fixed M rules  price level control
Interest-rate rules or feedback rules 
indeterminancy
Startling, suits conservative rhetoric
Economics 882 History of Modern
Macroeconomics (Spring 2013, Module 2)
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Consolidation of the New Classical School
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Sargent’s graduate textbook: Macroeconomic
Theory 1979
Lucas and Sargent, editors. Rational
Expectations and Econometric Practice 1981
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aggregative macro/not microfoundational
emphasis on systems or GE implications of
rational expectations
emphasis on econometrics
Economics 882 History of Modern
Macroeconomics (Spring 2013, Module 2)
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The Manifestos
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Lucas and Sargent “After Keynesian
Macroeconomics” (Minneapolis Fed Quarterly Review
1979)
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framed as attack on Keynes despite
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Keynesian roots
earlier critical targets Klein and Tinbergen
Sargent “Beyond Demand and Supply Curves in
Macroeconomics” (AER 1982)
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optimizing microfoundations with rational expectations
ignores earlier microfoundational programs
Economics 882 History of Modern
Macroeconomics (Spring 2013, Module 2)
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The Euthanasia of Macroeconomics
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If these developments succeed, the term
“macroeconomics” will simply disappear from
use, and the modifer “micro” will become
superfluous. We will simply speak, as did Smith,
Ricardo, Marshall, and Walras, of economic
theory. [Lucas Models of Business Cycles 1987]
The inversion of Klein’s program:
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data first (analogical consistency with theory)
theory first (analogical consistency with data)
Economics 882 History of Modern
Macroeconomics (Spring 2013, Module 2)
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The Problem of Business Cycles
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The empirical failure of the monetary shocks
approach
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no difference between anticipated and
unanticipated money
no reaction to data revisions
unaccountable serial correlations
Ad hoc solutions
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lagged dependent variables without a rationale
Economics 882 History of Modern
Macroeconomics (Spring 2013, Module 2)
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Lucas: A Positive Program for Business
Cycles
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Continuous market-clearing, dynamic equilibrium
 against Keynes’s involuntary unemployment
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“involuntary unemployment is not a fact or a phenomenon which
it is the task of the theorist to explain. It is, on the contrary, a
theoretical construct which Keynes . . . hope[d] would be helpful
in discovering a correct explanation for a genuine phenomenon:
large-scale fluctuations in measured, total unemployment. Is it
the task of modern theoretical economics to ‘explain’ the
theoretical constructs of our predecessors, whether or not they
have proved fruitful?”
Business cycle phenomena:
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not objects, but patterns of covariation
picked up by Kydland and Prescott
surprising respect for Burns and Mitchell
Economics 882 History of Modern
Macroeconomics (Spring 2013, Module 2)
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The Simulacrum Account of Models
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j
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j
pattern prediction vs. forecasting
testing rules vs. conditional forecasts
Turing and Adelman tests
Economics 882 History of Modern
Macroeconomics (Spring 2013, Module 2)
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The Transition to the Real Business Cycle
Model
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Lucas’s 1975 Business Cycle Model
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growth, capital, and the propagation mechanism
the last gasp of the monetary surprises
alternative rationales for money
Kydland and Prescott, “Time to Build and
Aggregate Fluctuations”
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technology shocks
the absence of monetary shocks
the irrelevance of time-to-build
Economics 882 History of Modern
Macroeconomics (Spring 2013, Module 2)
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The Rise of the Representative Agent
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The neoclassical growth model
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Solow
optimal growth in the 1960s
the planning roots of the “representative agent”
Ignoring aggregation
Economics 882 History of Modern
Macroeconomics (Spring 2013, Module 2)
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New Keynesian Macroeconomics
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Rational expectations is not the issue
Failures of new classical models to account
for business cycles 
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imperfections – e.g., menu costs  cost stickiness
perfectionist accounts – e.g., coordination failure,
multiple equilibrium, or sunspot models
Room for policy
Saltwater/Freshwater
Off the boil
Economics 882 History of Modern
Macroeconomics (Spring 2013, Module 2)
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Much Left Out
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Truncation of history post-1982
Growth theory
Macro labor theory
Finance
Macroeconometrics in the VAR tradition
Monetary policy modeling
and more . . .
Economics 882 History of Modern
Macroeconomics (Spring 2013, Module 2)
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Thanks

The End
Economics 882 History of Modern
Macroeconomics (Spring 2013, Module 2)
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