Modern Macroeconomics In loving memory of Brian’s parents, Joseph and Margaret Snowdon, and Howard’s father, Philip M. Vane Modern Macroeconomics Its Origins, Development and Current State Brian Snowdon Principal Lecturer in Economics in the Newcastle Business School, Northumbria University, Newcastle upon Tyne, UK Howard R. Vane Professor of Economics in the School of Accounting, Finance and Economics, Liverpool John Moores University, Liverpool, UK Edward Elgar Cheltenham, UK • Northampton, MA, USA © Brian Snowdon, Howard R. Vane 2005 All rights reserved. No part of this publication may be reproduced, stored in a retrieval system or transmitted in any form or by any means, electronic, mechanical or photocopying, recording, or otherwise without the prior permission of the publisher. Published by Edward Elgar Publishing Limited Glensanda House Montpellier Parade Cheltenham Glos GL50 1UA UK Edward Elgar Publishing, Inc. 136 West Street Suite 202 Northampton Massachusetts 01060 USA A catalogue record for this book is available from the British Library ISBN 1 84376 394 X (cased) 1 84542 208 2 (paperback) Typeset by Manton Typesetters, Louth, Lincolnshire, UK. Printed and bound in Great Britain by MPG Books Ltd, Bodmin, Cornwall. v Contents List of figures x List of tables xiii Preface xiv Acknowledgements xvii 1 Understanding modern macroeconomics 1 1.1 Macroeconomic issues and ideas 1 1.2 The role of economic theory and controversy 3 1.3 Objectives, instruments and the role of government 7 1.4 The Great Depression 9 1.5 Keynes and the birth of macroeconomics 13 1.6 The rise and fall of the Keynesian consensus 15 1.7 Theoretical schizophrenia and the neoclassical synthesis 21 1.8 Schools of thought in macroeconomics after Keynes 24 1.9 The new political macroeconomics 29 1.10 The renaissance of economic growth research 32 2Keynes v. the ‘old’ classical model 36 2.1 Introduction 36 2.2 Classical macroeconomics 37 2.3 Employment and output determination 38 2.4 Say’s Law 45 2.5 The quantity theory of money 50 2.6 Keynes’s General Theory 54 2.7 Interpreting the General Theory 57 2.8 Keynes’s main propositions 58 2.9 Keynes’s analysis of the labour market 65 2.10 Keynes’s rejection of Say’s Law 69 2.11 Keynes and the quantity theory of money 69 2.12 Three important interpretations of Keynes 70 2.13 The ‘new’ Keynes scholarship 75 2.14 Causes and consequences of the Great Depression 76 2.15 How to pay for the war 82 2.16 Keynes and international macroeconomics 83 2.17 Keynes’s legacy and the classical revival 85 Interview with Robert Skidelsky 91 3 The orthodox Keynesian school 101 3.1 Introduction 101 3.2 The orthodox Keynesian school 102 3.3 The IS–LM model for a closed economy 102 3.4 Underemployment equilibrium in the Keynesian model 114 3.5 The IS–LM model for an open economy 123 3.6 The Phillips curve and orthodox Keynesian economics 135 3.7 The central propositions of orthodox Keynesian economics 144 Interview with James Tobin 148 4 The orthodox monetarist school 163 4.1 Introduction 163 4.2 The quantity theory of money approach 165 4.3 The expectations-augmented Phillips curve analysis 174 4.4 The monetary approach to balance of payments theory and exchange rate determination 187 4.5 The orthodox monetarist school and stabilization policy 192 Interview with Milton Friedman 198 5 The new classical school 219 5.1 Introduction 219 5.2 The influence of Robert E. Lucas Jr 220 5.3 The structure of new classical models 223 5.4 Equilibrium business cycle theory 236 5.5 The policy implications of the new classical approach 242 5.6 An assessment 267 Interview with Robert E. Lucas Jr 272 6 The real business cycle school 294 6.1 Introduction: the demise of new classical macroeconomics mark I 294 6.2 The transition from monetary to real equilibrium business cycle theory 295 6.3 Real business cycle theory in historical perspective 297 6.4 Cycles versus random walks 300 6.5 Supply-side shocks 303 6.6 Business cycles: main features and stylized facts 304 6.7 Real business cycle theory 307 6.8 The structure of a real business cycle model 309 vi Modern macroeconomics Contents vii 6.9 Technology shocks 313 6.10 A real business cycle aggregate demand and supply model 315 6.11 Calibrating the model 320 6.12 Real business cycle theory and the neutrality of money 322 6.13 Measuring technology shocks: the Solow residual 325 6.14 Real business cycle theory and the stylized facts 326 6.15 The policy implications of real business cycle theory 330 6.16 Criticisms of real business cycle theory 332 6.17 Great Depressions: a real business cycle view 336 6.18 An assessment 338 Interview with Edward C. Prescott 344 7 The new Keynesian school 357 7.1 The fall and rise of Keynesian economics 357 7.2 A Keynesian resurgence 358 7.3 New Keynesian economics 361 7.4 Core propositions and features of new Keynesian economics 363 7.5 Nominal rigidities 366 7.6 Dornbusch’s overshooting model 376 7.7 Real rigidities 378 7.8 New Keynesian business cycle theory 396 7.9 Hysteresis and the NAIRU 401 7.10 New Keynesian economics and the stylized facts 408 7.11 Policy implications 409 7.12 Keynesian economics without the LM curve 423 7.13 Criticisms of new Keynesian economics 428 7.14 An assessment of new Keynesian economics 431 Interview with N. Gregory Mankiw 433 8 The Post Keynesian school 451 Paul Davidson 8.1 Introduction 451 8.2 The significance of the principle of effective demand 453 8.3 Taxonomy 454 8.4 Keynes’s taxonomic attack on Say’s Law 455 8.5 Can relative price changes induce D 2 to fill the gap? 457 8.6 Investment spending, liquidity, and the non-neutrality of money axiom 459 8.7 What type of an economic system is ‘irrational’ enough to use money contracts? 461 8.8 Information, decisions and uncertainty 463 8.9 Classifying decision-making environments 464 8.10 Keynesian uncertainty, money and explicit money contracts 468 8.11 Conclusions 472 9 The Austrian school 474 Roger W. Garrison 9.1 The Mengerian vision 474 9.2 The intertemporal structure of capital 475 9.3 Saving and economic growth 479 9.4 The saving–investment nexus 482 9.5 The market for loanable funds 489 9.6 Full employment and the production possibilities frontier 492 9.7 The capital-based macroeconomic framework 496 9.8 Saving-induced capital restructuring 498 9.9 Keynes’s paradox of thrift revisited 501 9.10 The Austrian theory of the business cycle 503 9.11 A Keynesian downturn in the Austrian framework 509 9.12 Inflation and deflation in the Austrian theory 513 9.13 Policy and reform 515 10 The new political macroeconomics 517 10.1 Introduction: political distortions and macroeconomic performance 517 10.2 Political influences on policy choice 518 10.3 The role of government 521 10.4 Politicians and stabilization policy 523 10.5 Alternative approaches to the ‘political business cycle’: an overview 525 10.6 The Nordhaus opportunistic model 526 10.7 The Hibbs partisan model 532 10.8 The decline and renaissance of opportunistic and partisan models 535 10.9 Rational political business cycles 537 10.10 Rational partisan theory 538 10.11 Opportunistic and partisan behaviour: a synthesis 545 10.12 Politics, time inconsistency, credibility and reputation 546 10.13 Policy implications of politico-economic models: an independent central bank? 549 10.14 The political economy of debt and deficits 554 10.15 Political and economic instability: are they related? 555 10.16 The political economy of economic growth 556 10.17 Political barriers to economic growth 562 10.18 The size of nations 564 viii Modern macroeconomics Contents ix 10.19 Conclusion 565 Interview with Alberto Alesina 567 11 The renaissance of economic growth research 579 11.1 Introduction 579 11.2 The ‘Great Divergence’ 580 11.3 In praise of economic history 584 11.4 Back to the long run 585 11.5 Why is economic growth so important? 589 11.6 Modern economic growth in historical perspective 593 11.7 The stylized facts of growth 595 11.8 Proximate v. fundamental sources of growth 596 11.9 The Harrod–Domar model 598 11.10 The Solow neoclassical growth model 602 11.11 Accounting for the sources of economic growth 612 11.12 The convergence debate 614 11.13 Beyond the Solow model 622 11.14 Endogenous growth: constant returns to capital accumulation 625 11.15 Endogenous growth: the economics of ideas 627 11.16 An augmented Solow model: a neoclassical revival? 632 11.17 Focusing on the fundamental causes of growth 633 11.18 Institutions and economic growth 635 11.19 Trade and economic growth 647 11.20 Geography and growth 652 11.21 Growth in history: in search of a unified theory 654 11.22 The ideal conditions for growth and development: rediscovering old truths 657 Interview with Robert M. Solow 660 Interview with Paul M. Romer 673 12 Conclusions and reflections 695 12.1 Introduction 695 12.2 Twentieth-century developments in macroeconomics: evolution or revolution? 696 12.3 Is there a consensus on key macroeconomic issues? 703 Bibliography 708 Author index 791 Subject index 803 [...]... of the Modern Guide to Macroeconomics involving amendments to each chapter, as well as updating the data and references However, as the project unfolded we decided that the Modern Guide to Macroeconomics required an extensive rewrite, not only involving major amendments to each chapter, but also requiring the addition of two new chapters surveying the burgeoning literature on the ‘new political macroeconomics ... and needs, in line with the Modern Guide to Macroeconomics the book follows a structured direction tracing the origins and development of modern macroeconomics in historical perspective In a book of this nature it is obviously impossible to cover every area We have therefore aimed to highlight what we consider to have been the major issues that emerged following the birth of macroeconomics in the 1930s... (%): the two Koreas Some areas of agreement and disagreement in macroeconomics xiii 12 18 18 19 20 78 85 86 86 87 87 221 260 306 402 428 526 534 543 547 559 581 583 590 639 640 702 Preface Over the last ten years we have collaborated in co-writing and/or editing five books on macroeconomics The first of this series of books, A Modern Guide to Macroeconomics: An Introduction to Competing Schools of Thought,... in 1994, while our most recent joint venture, An Encyclopedia of Macroeconomics, was published by Edward Elgar in 2002 During the course of co-writing and editing the Encyclopedia of Macroeconomics a number of eminent economists, who contributed to the project, asked if we had any plans to write a second edition of the Modern Guide to Macroeconomics, a book which has received widespread critical acclaim... area), rather than the single chapter approach used in the Modern Guide to Macroeconomics Furthermore, to reflect important developments that have taken place in macroeconomics over the final decades of the twentieth century we have introduced two entirely new chapters In Chapter 10 we consider what has come to be known as the ‘new political macroeconomics , while in Chapter 11 we discuss the renaissance... research into the area of ‘economic growth’ It is hoped that these changes will be welcomed by reviewers and readers alike In line with the Modern Guide to Macroeconomics, to help bring the subject matter alive and capture the imagination of the reader, we have xvi Modern macroeconomics included at the end of certain chapters interviews with world-renowned scholars who are experts in their field of study... prolonged research effort often involving Understanding modern macroeconomics 5 intense controversy and an ever-increasing data bank of experience As Blanchard (1997a) points out: Macroeconomics is not an exact science but an applied one where ideas, theories, and models are constantly evaluated against the facts, and often modified or rejected … Macroeconomics is thus the result of a sustained process... accumulation of new knowledge and progress in macroeconomics We would therefore endorse Mill’s plea for continued dialogue (in this case within macroeconomics) between the alternative frameworks and suggest that all economists have something to learn from each other The macroeconomic problems that economists address and endeavour to solve are often shared 6 Modern macroeconomics That there is a wide variety... (Chapter 7), the Post Keynesian school (Chapter 8) and the Austrian school (Chapter 9) Readers familiar with a Modern Guide to Macroeconomics will recognize our chosen approach, namely to discuss the central tenets underlying, and the policy implications of, these main competing schools of thought in macroeconomics as they evolved in historical perspective In doing so we have taken the opportunity to include... the leading figure in the development of new classical macroeconomics) ; Edward Prescott (widely acknowledged as a leading advocate of the real business cycle approach to economic fluctuations); Greg Mankiw (a leading exponent of the new Keynesian school of macroeconomics) ; Alberto Alesina (a leading contributor to the literature on the new political macroeconomics) ; and Robert Solow (the 1987 Nobel Memorial . Modern Macroeconomics In loving memory of Brian’s parents, Joseph and Margaret Snowdon, and Howard’s father, Philip M. Vane Modern Macroeconomics. in line with the Modern Guide to Macroeconomics the book follows a structured direction tracing the origins and development of modern macroeconomics in