by Thomas
Laubach and Ajay Shah.
Economics is a rich and fascinating subject. But all too often, the
teaching process forces young people in the field to look at the tail
of the elephant, to think about macroeconomics as the game of solving
dynamic models. There is actually much more going on. (On a related
note, you might like to see
that should be read before starting a Ph.D. in economics on
this blog, 18 May 2011).
In this blog post, we walk through the evolution of the key ideas
in historical order, and offer suggestions to interesting readings,
which will help you see the fuller picture. Many of them are on your
reading list, but some are not.
The old paradigm
Nobody tells it better
than The
age of uncertainty by John Kenneth Galbraith.
The old paradigm is now in the dustbin of history. But in order to
comprehend the revolution in macroeconomics, it is rather useful to
start from there. One encounters these arguments from time to time, so
it's worth knowing about the furniture of that mind.
The revolution of modern macroeconomics
The starting point is a speech
: The
role of monetary policy by Milton Friedman, American
Economic Review, 1968, which had enormous influence in
arguing that the mainstream Keynesian paradigm was fatally
flawed, and that it was not going to work as a guide to policy
on a sustained basis. By the early 1970s, the empirical evidence
was showing that Friedman was on the right track, which led to
everything that followed. This speech is arguably the beginning
of modern macroeconomics. At the same time, this was only an
argument conducted in English, and not a model.
The next big milestone was the Lucas
critique: Econometric
policy evaluation: A critique by Robert
Lucas, Carnegie-Rochester Conference Series on Public Policy,
1976. This devastated traditional macroeconomics. In addition, it's
a remarkably elegant idea.
Lucas, Sargent and others mapped out a work program in a series of
non-technical pieces, which were enormously influential. They set a
generation of economists going to build a class of models that were
rooted in the intuition of Friedman, 1968, and were invulnerable to
the Lucas critique. You should
read: Understanding
business cycles by Robert Lucas, Carnegie-Rochester
Conference Series on Public Policy,
1977; After
Keynesian Macroeconomics by Lucas and Sargent, Federal
Reserve Bank of Minneapolis Quarterly Review,
1978; Methods and
problems in business cycle theory by Robert Lucas,
Journal of Money, Credit and Banking, 1980.
As important as the Lucas Critique was
discretion: The inconsistency of optimal plans by Kydland and
Prescott. An accessible set of materials on this work is found in
their
Nobel Prize page.
This work came to fruition in the early 1990s in the form of the
NK-DSGE model with a policy rule. Important tools got developed in a
classical setting (the RBC model), and then Keynesian frictions were
put in, to give the NK-DSGE model. It has many problems, but with
this, the Lucas program did work out. Nice readings on the NK-DSGE
model
are The
science of monetary policy: A new Keynesian perspective in
the JEL by Clarida, Gali, Gertler (1999), and
their Monetary
policy rules and macroeconomic stability: Evidence and some
theory in the QJE in 2000.
The new macroeconomics is nicely showcased in
and the business cycle: Do technology shocks explain aggregate
fluctuations? by Jordi Gali in AER, 1999. This is a wonderful
example of confronting empirics with theory, plus a fundamental (if
highly controversial) contribution in the eternal quest for the
sources of business fluctuations.
On the other side, there is a powerful critique of the
micro-founded approach to
macroeconomics: The
scientific illusion of empirical macroeconomics by Larry
Summers, Scandinavian Journal of Economics, 1992.
By the late 1990s, there was a lot of progress to report. There is
a nice
article: Thirty-Five
Years of Model Building for Monetary Policy Evaluation:
Breakthroughs, Dark Ages, and a Renaissance by John
B. Taylor, Journal of Money, Credit and Banking,
2007. There is the best single book on monetary
policy: Monetary
Policy Strategy by Frederic S. Mishkin, 2007. And, there
are two other nice
articles: A
stable international monetary system emerges: Inflation
targeting is Bretton Woods, reversed by Andrew
K. Rose, Journal of International Money and Finance,
2007,
and How
the World Achieved Consensus on Monetary Policy, by
Marvin Goodfriend, Journal of Economic Perspectives,
2007.
The second stage
Once the basic plan was laid, important work emerged in connected
fields. A critical issue that came to fore was the role of finance
in
macroeconomics. Agency
costs, net worth, and business fluctuations by Bernanke and
Gertler, AER 1989, is the most elegant illustration that financial
structure matters for macroeconomics.
We close this off with a canonical reference about fiscal policy
from a macro perspective. A good recent treatemnt
is Activist
fiscal policy to stabilise economic activity by Auerbach and
Gale, from the 2009 Jackson Hole symposium.
Post-crisis revisionism?
On this, see
policy and financial stability: Is inflation targeting
passe? by Takatoshi Ito, July 2010.
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