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10/6/2008
1
Macroeconomics:Macroeconomics:IntroductionIntroduction
Vijayamohanan Pillai N.
6 October 2008 Vijayamohan CDS MPhil
The first published use of the term
"macroeconomics" was by the
Norwegian Economist Ragnar Frisch
referring to the Walrasian economy-wide
system of markets
in 1933 in Propagation Problems and
Impulse Problems in Dynamic
Economics. London: Allen & Unwin6 October 2008 Vijayamohan CDS MPhil
6 October 2008 Vijayamohan CDS MPhil
For Marx (1867) classical political
economy begins with
Sir William Petty (1623 – 87)
in the 17th century
and ends with
David Ricardo (1772 – 1823)
Classical Economics
6 October 2008 Vijayamohan CDS MPhil
for Keynes (1936: 3 fn)
the classical school begins with
David Ricardo (1772 – 1823)
and ends with
Arthur Cecil Pigou
(1877 – 1959).
Classical Economics
6 October 2008 Vijayamohan CDS MPhil
1. Labour theory of value:Adam Smith (1723 – 90)
David Ricardo (1772 – 1823)
andKarl Marx (1818 – 83).
Distinction based onTheories of value:
6 October 2008 Vijayamohan CDS MPhil
10/6/2008
2
2. Marginal Utility theory of value:Hermann Heinrich Gossen (1810 – 58);
William Stanley Jevons(1835 – 82)
Carl Menger (1840 – 1921)
Marie Esprit Leon Walras(1834 – 1910)
Alfred Marshall (1842 – 1924)
Distinction based onTheories of value:
6 October 2008 Vijayamohan CDS MPhil
Irving Fisher, Friedrich Hayek,
the Cambridge Marshallians (Pigou,Hawtrey, Robertson and youngKeynes himself)
and the Stockholm School (Myrdal,Lindahl, Ohlin, Lundberg).
6 October 2008 Vijayamohan CDS MPhil
Marginal Utility theory of value:‘Marginalist revolution of 1871-4’:
Neo-Classical Economics
No ‘macroeconomy’ for the neoclassicaleconomists, before the 1920s
The Say's Law, the Quantity Theory,business cycle and growth theory were notpart of neoclassical economics.
Neo-Classicalmacroeconomics
6 October 2008 Vijayamohan CDS MPhil
1920s, the neoclassical theory cameinto contact with business cycletheory.
They were at a loss to explain thepost-World War I economic crisis inEurope.
And the Great Depression that wasinitiated after 1929 also.
Neo-Classicalmacroeconomics
6 October 2008 Vijayamohan CDS MPhil
Neo-Classical macroeconomics
erroneously called
Classical macroeconomics
in text books
thanks to Keynes’ use of the term
‘Classics’
Neo-Classical Macroeconomics ≠ Classical Macroeconomics
6 October 2008 Vijayamohan CDS MPhil
DISPUTES INDISPUTES INMACROECONOMICSMACROECONOMICS
6 October 2008 Vijayamohan CDS MPhil
10/6/2008
3
Disputes In MacroeconomicsDisputes In Macroeconomics
NewNew ClassicalsClassicals SupplySupply--siderssiders New KeynesiansNew Keynesians
Edmund PhelpsRonald ReaganRonald ReaganRobert LucasRobert Lucas
Milton FriedmanMilton FriedmanJohn M. KeynesJohn M. KeynesAlfred MarshallAlfred MarshallNeoNeo--ClassicalsClassicals KeynesiansKeynesians MonetaristsMonetarists
6 October 2008 Vijayamohan CDS MPhil
Hermann Heinrich Gossen (1810 – 58);
William Stanley Jevons(1835 – 82)
Carl Menger (1840 – 1921)
Marie Esprit Leon Walras(1834 – 1910)
Alfred Marshall (1842 – 1924)
In the NeoIn the Neo--Classical IslandClassical Island
6 October 2008 Vijayamohan CDS MPhil
Irving Fisher (1867 – 1947)
Friedrich August von Hayek(1889-1992)
the Cambridge Marshallians
– (Arthur Cecil Pigou,
– Ralph G Hawtrey,
–
In the NeoIn the Neo--Classical IslandClassical Island
6 October 2008 Vijayamohan CDS MPhil
the Cambridge Marshallians
– (Dennis S Robertson andyoung Keynes himself) and
the Stockholm School
– (Gunnar Myrdal, Lindahl, BertilOhlin, Lundberg).
In the NeoIn the Neo--Classical IslandClassical Island
6 October 2008 Vijayamohan CDS MPhil
• Laissez-faire “Let it be”
• Full employment is the norm.
• Vertical Aggregate Supply Curve
• Stable Aggregate Demand
• Perfect foresight:
No imperfect information
In the NeoIn the Neo--Classical IslandClassical Island
6 October 2008 Vijayamohan CDS MPhil
Real Output Depends Upon…
1. Say’s Law (Jean Baptiste Say
(1767-1832)
2. Flexible Prices and Wages =
Continuous market clearing
In the NeoIn the Neo--Classical IslandClassical Island
6 October 2008 Vijayamohan CDS MPhil
10/6/2008
4
Quantity Theory of Money
a la David Hume (1711-1776):
MV = PY
Velocity of circulation constant
Only transaction demand for money
No speculative demand
In the NeoIn the Neo--Classical IslandClassical Island
6 October 2008 Vijayamohan CDS MPhil
John Maynard Keynes (1883 – 1946)
Keynes’ Circus:
Joan Violet Robinson (1903 – 83)
Richard F. Kahn
Piero Sraffa (1898 – 1983)
Edwin Austin Gossage Robinson
James E. Meade (1907-1995)
In the Keynesian LandIn the Keynesian Land
6 October 2008 Vijayamohan CDS MPhil
Early Post Keynesians
Joan Robinson;
Piero Sraffa;
Nicholas Kaldor (1908 – 86);
Michal Kalecki (1899 – 1970)
In the Keynesian LandIn the Keynesian Land
6 October 2008 Vijayamohan CDS MPhil
Active government policy is needed tostabilize the economy.
“Laissez-Faire” is subject to recessionsand widespread unemployment
AD is Unstable (Investment fluctuates)
Significance of speculative demand formoney
Fiscal policy effective; monetary policynot.
In the Keynesian LandIn the Keynesian Land
6 October 2008 Vijayamohan CDS MPhil
..
Free gifts to every kid inFree gifts to every kid inthe world? Are you athe world? Are you aKeynesian or something?Keynesian or something?
6 October 2008 Vijayamohan CDS MPhil
Neo-Classical – KeynesianSynthesis
Neo-Keynesians
IS – LM Model
John R Hicks (1904 – 1989) at LSE
with
Paul Samuelson (1915 -)
and
Alvin Hansen in America
Hicks (1937) "Mr Keynes and the Classics: A
suggested interpretation", Econometrica6 October 2008 Vijayamohan CDS MPhil
10/6/2008
5
Neo-Keynesians
Franco Modigliani (1918–2003);
James Tobin (1918–2002);
Robert Solow (1924 -)
In the 1950s and 1960s virtually all
macroeconomists except
Milton Friedman (1912 – 2006)6 October 2008 Vijayamohan CDS MPhil
Sticky wages : Modigliani (1940)
Startling result of the IS-LM model:
unable to obtain the Keynesian result of
an "unemployment equilibrium".
Yield the Neoclassical result of "full
employment", with the real balances or
Pigou effect (Don Patinkin 1956).
Neo-Keynesians
6 October 2008 Vijayamohan CDS MPhil
So, in order to generate an
"unemployment equilibrium" as a
solution,
rigid money wages, interest-inelastic
investment demand, income-inelastic
money demand or some other
imperfection added to this system.
Neo-Keynesians
6 October 2008 Vijayamohan CDS MPhil
Hence a "synthesis" of Neoclassicaland Keynesian theory:
Neoclassical conclusions in the "longrun" or in a "perfectly working" IS-LMsystem, but Keynesian conclusions inthe "short-run" or "imperfectlyworking" IS-LM system.
Interpretation of the General Theory asthe economics of disequilibrium.
Neo-Keynesians
6 October 2008 Vijayamohan CDS MPhil
the Phillips Curve (a la Alban W.Phillips 1958; Lipsey, 1960) addedto account for inflation.
The international sectorincorporated into an extended IS-LMsystem known as the Mundell-Fleming model (Robert A Mundell,1962).
Neo-Keynesians
6 October 2008 Vijayamohan CDS MPhil
providing "microfoundations" for thebasic Keynesian relationships:
the consumption function wasformalized as a utility-maximizingproblem by Franco Modigliani
and Richard Brumberg (1953)
Neo-Keynesians
6 October 2008 Vijayamohan CDS MPhil
10/6/2008
6
"microfoundations"
the investment function was derivedfrom profit-maximization by Dale W.Jorgensen (1963) and Robet Eisnerand Robert H. Strotz (1963);
the money demand function derivedfrom utility-maximization by WilliamJ. Baumol (1952) and James Tobin(1956; 1958);
Neo-Keynesians
6 October 2008 Vijayamohan CDS MPhil
"microfoundations"
the transmission mechanism(i.e. the impact of LM on IS) wasexpanded and given more detailedanalysis by Lloyd Metzler(1951), James Tobin (1961 1969) andmany others.
Neo-Keynesians
6 October 2008 Vijayamohan CDS MPhil
For a long time, the Neo-Keynesiansystem was synonymous with the‘Keynesian Revolution’ and washighly influential in both theoretical,applied and policy work.
The post Keynesians were deadopposed to it – ‘KeynesianFundamentalists’
Neo-Keynesians
6 October 2008 Vijayamohan CDS MPhil
Paul Davidson
created the term Post-Keynesian
To separate
the economics of Keynes
From NeoKeynesian economics
Post KeynesiansPost Keynesians
6 October 2008 Vijayamohan CDS MPhil
Post KeynesiansPost Keynesians
The Cambridge Keynesians –Joan Robinson,
Nicholas Kaldor,
Michal Kalecki,
George L.S. Shackle,
Roy Harrod from Oxford
6 October 2008 Vijayamohan CDS MPhil
and their American counterparts –Evsey Domar,
Abba Lerner,
Sidney Weintraub, Paul Davidson,Alfred S. Eichner, Hyman P. Minsky,Alain Barrère, Josef Steindl,Athanasios Asimakopulos,Edward J. Nell
Post KeynesiansPost Keynesians
6 October 2008 Vijayamohan CDS MPhil
10/6/2008
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They did not employ the IS-LM system
but continued on what they perceived to
be the next logical step:
extension of the General Theory into the
longer run, the "dynamic" economy –
dynamic growth and business cycle
models
Post KeynesiansPost Keynesians
6 October 2008 Vijayamohan CDS MPhil
The neo-Keynesian interpretation of theGeneral Theory as the economics ofdisequilibrium in a short-run generalequilibrium model : illegitimate
Joan Robinson called it
‘the bastard Keynesianism’
in 1962 in her review ofHarry Johnson’s Money, Trade andEconomic Growth (1962).
Post KeynesiansPost Keynesians
6 October 2008 Vijayamohan CDS MPhil
The MonetaristsThe Monetarists
Milton Friedman (1912–2006)and Co.
‘Second Chicago School’Nobel prize: 1976
6 October 2008 Vijayamohan CDS MPhil
MonetarismMonetarism
"Monetarism“ coined in 1968 byKarl Brunner
became a powerful intellectual forcein the late 1960s and early 1970s,
In the late 1970s and early 1980schanneled into economic policy.
6 October 2008 Vijayamohan CDS MPhil
MonetarismMonetarism
Monetarism has since given way tothe more mathematically rigorousand "Walrasian"New Classical economics of
Robert E. Lucasin the 1970s and 1980s –the ‘Third Chicago School’.
6 October 2008 Vijayamohan CDS MPhil
MonetarismMonetarism
“inflation is always and everywhere amonetary phenomenon”
“money is all that matters for changesin nominal income and for short-runchanges in real income”
(Friedman, 1970)
"Quantity Theory" relationship betweenthe money supply and prices
6 October 2008 Vijayamohan CDS MPhil
10/6/2008
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(1) monetarist transmission mechanism:agents dispose of excess money supplyby purchasing goods rather than bonds.
(2) stability of money demand:in practice, the demand for money is astable function of wealth, prices, pricechanges and interest.
Central features of Friedman'sMonetarism
6 October 2008 Vijayamohan CDS MPhil
(3) money-to-income causality:movements in the money supply have beenthe primary cause of business fluctuations;movements in aggregate demand for goodshave relatively little impact.
(4) natural rate of unemployment hypothesis:there exists a unique rate of unemploymentthat is associated with non-acceleratinginflation and that, in the long run, theeconomy will settle at such an unemploymentrate.
Central features of Friedman'sMonetarism
6 October 2008 Vijayamohan CDS MPhil
(5) superiority of monetary policy rules:monetary policy is much more effective thanfiscal policy;
So Central Banks target money aggregatesrather than interest rates;
Following a ‘Constant money growth rule’ is,at least in the long run, better than adiscretionary, counter-cyclical monetarypolicy.
Central features of Friedman'sMonetarism
6 October 2008 Vijayamohan CDS MPhil
Business cycle theory:
Imperfect information:
Adaptive expectation hypothesis
“Fooling Model”
Central features of Friedman'sMonetarism
6 October 2008 Vijayamohan CDS MPhil
From 1960 to 1973, US-Europeaneconomic history well explained byKeynesian economics.
But the 1973 oil shock, by contrast,baffled it;
and the Keynesian economists began torecognize the same basic microeconomictool : the supply/demand diagram.
NewNew ClassicalsClassicals::
6 October 2008 Vijayamohan CDS MPhil
NewNew ClassicalsClassicals
Thus entered the AD – ASdiagram,introduced in the late 1970s (intextbooks)by (Neo/New-)Keynesianeconomists (like Robert Gordon,Edmund Phelps and Alan Blinder).
Could explain 1973 upward supplyshock, causing Stagflation6 October 2008 Vijayamohan CDS MPhil
10/6/2008
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NewNew ClassicalsClassicals
But no policy solution
Keynesian failure
"Monetarist experiments" ofdisinflation in the late 1970s andearly 1980s in several Westerncountries, the US and the UK.
Further disaster
6 October 2008 Vijayamohan CDS MPhil
NewNew ClassicalsClassicals
Thus the advent of New Classicals
A dramatic attack by Robert Lucasand Thomas Sargent at the annualconference of the Federal ReserveBank of Boston in June 1978, onthe very foundation of Keynesianeconomics
"After Keynesian Macroeconomics"6 October 2008 Vijayamohan CDS MPhil
The three basic features of the NewClassical school:
the adoption of the competitivemicrofoundations and imperfectinformation
and the use of rational expectationhypothesis.
NewNew ClassicalsClassicals
6 October 2008 Vijayamohan CDS MPhil
Robert Lucas Wins 1995 Nobel Prize inRobert Lucas Wins 1995 Nobel Prize inEconomicsEconomics
RATIONAL EXPECTATIONS
'For having developedand applied the
hypothesis ofrational expectations,
and thereby havingtransformed
macroeconomicanalysis and
deepened ourunderstanding ofeconomic policy.'6 October 2008 Vijayamohan CDS MPhil
PrizePrize--Winning ForesightWinning Foresightby an Exby an Ex--WifeWifeRobert LucasRobert Lucas, the Nobel prize winner
of $1.1 million dollars$1.1 million dollars, HAD to splitsplit
his money with his exhis money with his ex--wifewife, who sevenseven
years agoyears ago had her divorce lawyer insert
a clause to cover just such a possibility.
The clauseclause in the settlement reads: “Wife shall receive 50%“Wife shall receive 50%of any Nobel Prize if it occurs within seven years.”of any Nobel Prize if it occurs within seven years.”
Lucas said, “A deal is a deal. It’s hard to be unpleasant after“A deal is a deal. It’s hard to be unpleasant aftera prize like that.”a prize like that.”
Rita LucasRita Lucas had more than just foresightforesight; she had luckluck.If the announcement, which came on Oct. 10Oct. 10, had comeafterafter Oct. 31Oct. 31, she would have gotten nothinggotten nothing.
**Rita LucasRita Lucas knew who had won in the pastwon in the past and she was thinkingthinking
in a rational mannerin a rational manner on who she expectedexpected to winto win in the futurefuture.
8 University of Chicago professors have won8 University of Chicago professors have won and he was the55thth in the last 6 yearsin the last 6 years.6 October 2008 Vijayamohan CDS MPhil
NewNew ClassicalsClassicals
2004 Nobel Memorial Prize:Finn Kydland and Edward Prescott:
“For their contributions to dynamicmacroeconomics:
the time consistency of economicpolicy, and
the driving forces behind businesscycles.” Real business cycle theory6 October 2008 Vijayamohan CDS MPhil
10/6/2008
10
NewNew ClassicalsClassicals::the ‘Third Chicago School’the ‘Third Chicago School’
Robert Lucas ()
Thomas Sargent
Robert Barro
Edward Prescott
Finn Kydland
6 October 2008 Vijayamohan CDS MPhil
developed during the 1980s as aresponse to New Classical theory
New Keynesians investigate whatthey believe to be the essentialaspect of Keynes’s theory:
the existence of price and wagerigidities.
New Keynesian TheoryNew Keynesian Theory
6 October 2008 Vijayamohan CDS MPhil
New KeynesiansNew Keynesians
the New Classicalrational expectations +the natural rate hypothesis +the assumption of continuous marketclearing
Policy Ineffectiveness proposition (PIP):
anticipated monetary policy changeshave no effect on output andemployment even in the short run.
6 October 2008 Vijayamohan CDS MPhil
Stanley Fischer (1977) and EdmundPhelps and John Taylor (1977):
nominal demand disturbances arecapable of producing real effects inmodels incorporating rationalexpectations,
if the New Classical assumption ofcontinuous market clearing isabandoned;
And in such models systematicmonetary policy can help stabilize theeconomy.
New KeynesiansNew Keynesians
6 October 2008 Vijayamohan CDS MPhil
Non-market clearing model:
Market imperfections: Imperfectcompetition; coordination failures;credit restrictions
Nominal wage and price rigidity
Rational Expectation Hypothesis
Microfoundations
Optimization: Firms – profits;workers – utility
New KeynesiansNew Keynesians
6 October 2008 Vijayamohan CDS MPhil
In explaining business cyclefluctuations new Keynesians emphasizenominal price rigidities over nominalwage rigidity.
This is in sharp contrast to
Keynes,
the Neo-Keynesianism of Modigliani
and the neoclassical synthesis,
which emphasize nominal wagerigidities.
New KeynesiansNew Keynesians
6 October 2008 Vijayamohan CDS MPhil
10/6/2008
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The economy is stable butstable butpotentially unstablepotentially unstable
[supply shockssupply shocks or booms andbusts impact investmentinvestment].
Many prices/wages are inflexibleprices/wages are inflexibledownwarddownward,
particularly wages
[contractscontracts and efficiencyefficiencywageswages].
New KeynesiansNew Keynesians
6 October 2008 Vijayamohan CDS MPhil
Velocity is unstableVelocity is unstable
[directdirect with the interest rateinterest rate andiinnvveerrssee with the mmoonneey sy suuppppllyy]
InflationInflation can be caused by excess MSexcess MS,
but it may also be caused by
“investment booms”“investment booms”, or
“adverse supply shocks.”“adverse supply shocks.”
The Fed targets the interest ratetargets the interest rate ininthe SRthe SR
but monitors the MSmonitors the MS in the LRin the LR.
New KeynesiansNew Keynesians
6 October 2008 Vijayamohan CDS MPhil
New KeynesiansNew Keynesians
Edmund Phelps
Nobel prize in 2006:
"for his analysis of intertemporal
tradeoffs in macroeconomic policy
6 October 2008 Vijayamohan CDS MPhil
SupplySupply--SideSide EconomicsEconomics
6 October 2008 Vijayamohan CDS MPhil
MundellMundell
Robert Mundell created modernsupply-side economics in a singleparagraph at the end of a monographpublished in 1971, then neverpursued his idea in print.
1999 Nobel prize “for his analysis of monetary andfiscal policy under different exchange rate regimes
and his analysis of optimum currency areas”.
6 October 2008 Vijayamohan CDS MPhil
Arthur LafferArthur Laffer
works with Mundell from 1969.
Calls Mundell “a genius.”
Whereas Mundell deliberately avoids thelimelight, Laffer wants fame. Uses his contacts atChicago and Stanford to become PresidentNixon’s Chief Economist.
Mundell visits Laffer in Washington. Lafferintroduces Mundell to George Schultz who playsa key role in the Reagan Administration.
The stage is set for ReagonomicsReagonomics.
1974, Laffer draws a curve on a napkin.
6 October 2008 Vijayamohan CDS MPhil
10/6/2008
12
Laffer CurveLaffer Curve
TaxRevenue
Marginal Tax Rate0%
100%tmax thigh
45
6 October 2008 Vijayamohan CDS MPhil
Wall Street JournalWall Street Journal ConnectionConnection
Jude Wanniski (WSJ reporter) reportson the ideas of Mundell and Laffer in aseries of articles beginning in 1974.
Coins ‘Laffer curve’.
March 1976, conference in Virginia:
Herb Stein refers to “supply-side fiscalism”.
Later this becomes “supply-side economics.
1978, Wanniski writes a book called
The Way the World Works.
6 October 2008 Vijayamohan CDS MPhil
ReagonomicsReagonomics in practicein practice
When Ronald Reagan ran forpresident in 1980, he promised to cuttaxes in what seemed, at the time, amagical way.
Tax revenue would go up, not down,he said, as the economy boomed inresponse to lower rates.
6 October 2008 Vijayamohan CDS MPhil
Since then supply-side economics hasbecome a central tenet of Republicanpolitical and economic thinking.
That’s despite the fact that the bigsupply-side tax cuts of the 1980s andthe 2000s did not work out asadvertised, as even most supportersacknowledge
ReagonomicsReagonomics in practicein practice
6 October 2008 Vijayamohan CDS MPhil
In the 1980s, during the initial era ofsupply-side tax cuts, per capitarevenue from personal income taxes,adjusted for inflation, rose anaverage of just 0.7 percent annuallythroughout the Reagan presidency,according to the White House Officeof Management and Budget.
ReagonomicsReagonomics in practicein practice
6 October 2008 Vijayamohan CDS MPhil
That was far below what turned outto be an average annual increase of6.5 percent in the eight years of theClinton administration, when taxrates at the high end of the incomeladder were raised.
ReagonomicsReagonomics in practicein practice
6 October 2008 Vijayamohan CDS MPhil
10/6/2008
13
Since 2001, the annual per capitarevenue from income taxes fell1 percent under President Bush eventhough tax collections picked upsharply starting in 2005.
The budget surplus Mr. Bushinherited turned into a deficit.
ReagonomicsReagonomics in practicein practice
6 October 2008 Vijayamohan CDS MPhil 6 October 2008 Vijayamohan CDS MPhil
NextNext
NationalNationalIncomeIncome
AccountingAccounting
6 October 2008 Vijayamohan CDS MPhil