History of all of modern macro (ignoring the last 30 years)

Prof. Delong has a nice summary of the pre-RBC (aka “purist”) macro literature of the 70’s:

The underlying argument went something like this: (i) There is no sense talking about anything like “involuntary unemployment”: markets clear, and at all times people work as much as they want to work and firms produce as much as they want to produce. (ii) Workers work more relative to trend when they think their real wages are high, and firms produce more relative to trend when they think real prices for their products are high. (iii) Workers work less relative to trend when they think their real wages are low, and firms produce less relative to trend when they think real prices for their products are low. (iv) Workers and firms have rational expectations, so if they expect government fiscal or monetary policies to expand (or contract) nominal demand they will expect nominal wages or prices to rise (or fall) accordingly. (v) Thus if a predicted government-driven expansion (or contraction) raises (or lowers) nominal demand and thus their nominal wages or prices, they will understand that their real wages or prices have remained unchanged–and hence will not work more or less, and will not produce more or less. (vi) Only if nominal wages or prices rise (or fall) in an unexpected fashion will workers or firms get confused, and work and produce more (or less) than the trend. (vii) But with rational expectations the only cases in which government policy produces unexpected rises or falls in wages and prices is if the government policy is random. (viii) In which case its effects are random. (ix) And so government policies–not just fiscal but monetary policies too–cannot be stabilizing but only destabilizing. (x) Hence the best of all policies sets a predictable and constant rule for monetary and fiscal policy and does not deviate from it no matter what.

Regarding (i), (ii) and (ii), there’s a growing literature in macro on unemployment. Robert Hall has done a lot of work on this (e.g. note that he uses some psychologist-pleasing behavioral assumptions in wage bargaining). This macro research has done a very healthy thing; it inspired research questions for micro folks (e.g.). The back and forth between macro and micro people on this issue (and the state-based vs. time-based pricing stuff) suggests, at least to me, that macro is far from insular. In fact, I’d say the field is learning real things about the real world. We’re learning practical things that pragmatist might find interesting if they paid attention.

Also, these employment search models — ones where employment doesn’t hinge solely on the labor/leasure trade-off (i.e. doesn’t require unemployment to be equivalent to vacation time) — have recently found themselves studied in the DSGE framework (e.g.) where they’ll quickly find applications in policy making.

All modern macro papers have sticky prices and wages. Recently maligned Nobel prize laureate Robert Lucas has found evidence consistent with sticky prices. In other words, (iv) and (v) may have been the purist view in the 70’s but they don’t reflect the current state of macro.

As to the consequent points (vii to x), modern macro doesn’t deny discretionary policy can have short-term effects, but once the public learns policy makers are using their discretion, they will expect it, policy becomes incredible and it becomes inefficient or ineffective. Policy makers will say one thing but the public will suspect they’re lying. Policy makers will promise to be good and do what’s right in the long run, but the public will suspect they’ll do what’s most expedient. There’s a good discussion of this in the introduction of Micheal Woodford’s textbook.

And have you ever noticed how deficits aren’t counter-cyclical ((Changes in the deficit and GDP growth have had opposite signs only 27% of the time since Eisenhower, if I have my sums right.))? Fiscal policy looks awfully discretionary.

You might interpret the actions of the Fed last year as discretionary, but that entirely depends on what rule (or which rule-making framework) the public thinks the Fed was using. If the public thought the Fed was targeting inflation, then the Fed’s actions may not have looked discretionary at all. If it thought the Fed was doing something because something had to be done, then, yeah, the Fed’s actions looked discretionary. It may be too that last Fall was so unprecidented any action on the part of the Fed would look like it was acting with discretion. On the other hand, if the Fed was seen as acting in its prescribed role as lender of last resort and so it wasn’t acting expediently, its policy credibility may sill be intact. Its hard to tell, but a spontaneous dirty fight between economists — and their political slaves ((Yes, my tongue is firmly planted in cheek)) — about the relative merits of fiscal and monetary policy during that time didn’t do much for the credibility of policy making.

In any case, Professor Delong says, “So when the financial crisis began in the summer of 2007, we Pragmatists largely ignored the Purists, for they seemed to have nothing to say.” There’s been a lot of progress in macro since the Puritan 70’s. The professor has seemed eager to attack finance people and he debated a theorist here in Davis, but as is evidenced by this post he has had limited engagement with modern policy oriented macroeconomics.

And this is all an attempt to change the subject. For standard counter-cyclical policy when given a choice between effective monetary policy and effective fiscal policy, monetary policy wins hands down (and I’ll go out on a limb and say Prof. Delong’s hand would be down too). Monetary policy is faster and, when you consider policy expectations, more efficient. The current debate is over whether or not monetary policy can be effective right now. Are we in a liquidity trap? Is the Fed pushing on strings? Theory says no; monetary policy can be effective when short-term nominal interest rates are zero. What does the evidence say? Well, there hasn’t been very many instances where those interest rates were zero, but monetary forces got us out of the Depression. And so far we’ve managed to stay out of deflationary spiral, so chalk one up for monetary policy at the zero lower bound.

5 thoughts on “History of all of modern macro (ignoring the last 30 years)”

  1. Oh, come on! I can’t believe you’re buying into Delong’s rhetoric and tales of good-versus-evil (“pragmatist” “technocrats” versus “purist” “ideologues”).

    Anyway, why do you believe that a) sticky prices; and b) search unemployment are major/important/defining features of the US economy, given that 1) the median price reset duration is 4 months or so (and yes, I count sales, for obvious reasons) and 2) with search, people are unemployed because they choose to pass job offers in expectation of better ones, so it doesn’t capture the “keynesian” idea that low final goods market demand translates into low labor demand.

    I would speculate that we won’t know what’s the optimal price change frequency (and therefore the degree of price setting inefficiency) until we figure out the major structural sources of inefficiency/deviation from a 2nd Welfare Theorem baseline, which I suspect are not search/matching and monopolistic competition.

    Instead of bitching how great Keynes was and how ignorant people are for not worshiping his awesome Truth, I think people should work out the macro implications of new and promising setups: e.g. I really liked the recent Azariadis paper on capital misallocation due to endogenous borrowing constraints.

    OTOH, I do agree that economists in general have have been total fan-boys for the Fed (Uuu, Bernanke, so dreamy!).

  2. I’m glad to see other macro students aren’t buying Delong’s shtick either. Now we just need to worry about the extensive margin.

    I didn’t say sticky prices and search are important. I said we’re learning a lot about those things by…gasp… testing the theories of that long dead economist.

  3. I am curious, what do you think about the massive amounts of excess reserves the banks are holding?

    Because I agree that in almost all recessions, monetary policy is more effective than fiscal. I am also reluctant to say that monetary policy is ineffective, but given the massive amounts of excess reserves, I don’t really see how it can be otherwise.

    For example, Fed does an open market operation, buys a bond, and the bank gets reserves from it. The bank doesn’t lend it out and keeps it as excess reserves. This should have no effect on the economy right? For me, this is the best evidence the monetary policy would be ineffective. See the fred database at: http://research.stlouisfed.org/fred2/series/EXCRESNS?cid=123 for excess reserves and http://research.stlouisfed.org/fred2/series/BOGAMBNS?cid=124 for money base. They seem to line up, though I should probably run the numbers.

    I have another question: Given that the fed has had a loose monetary policy, do you think that the fed should further increase the money supply? For me, that would be fine, but I don’t think it will have much effect, as it will just go into excess reserves. What is the appropriate amount? The fed has added hundreds of billions of dollars of new money base. How much is enough?

    Also, I think the monetary policy/fiscal policy dichotomy is a false one. There is not real choice between the two in the sense that you can have both a loose monetary and fiscal policy at the same time. I think there should be loose monetary policy, as do you, as does Brad de Long. I don’t see a large call for monetary tightening (though there are some extreme inflation hawks who seem kind of nutty imo). So the correct question (which you have also asked) is whether fiscal policy is the correct policy. But I don’t get why the discussion is still about monetary policy- it has been extremely loose, and rightfully so.

    That being said, if you want 1 trillion dollars in added monetary base, I support you 100%

    [sorry, your comment got caught in the spam filter]

  4. If you follow Scott Sumner, you have to ask if money is really loose right now. I think his argument is that because the Fed is paying interest on reserves its no wonder reserves are high. This policy is contractionary because money is being shoved in reserve and its not getting “out there”.

    I don’t know enough about banks, but an alternative take on this policy is that its addressing the real problem. The real shock that precipitated this mess was to the banking sector… Bank’s balance sheets looked crappy all of a sudden and they were reluctant to lend. Reserves make their balance sheets look better. So the reserves policy undid the real shock.

    This theory has a number of testable implications like was there a contraction in demand or supply of credit last Fall.

    Regarding the policy trade-off… I meant to look into this more. Shooting from the hip, suppose the real problem is bank balance sheets. Fiscal policy causes expectations of inflation to rise (which is good), but it doesn’t fix the real problem. The Fed needs to fix the real problem and because it has an inflation target, it has to worry about that too. There’s also a risk that inflation expectations become unanchored, that Fed inflation policy will become incredible.

    The other strand of thought here is that fiscal policy is practically ineffective. In theory it might work even if we forget about the timing issues, but the politics of it are a mess. Its hard to argue the type of spending done in the current policy makes sense. At the same time, its not hard, given the institutions involved, to see why we got such a bad fiscal policy. Believers in fiscal policy should be thinking of ways to fix the administration of it. Maybe an independent fiscal authority with a precisely defined policy instrument (e.g. stimulus checks and a consumption tax) and mandate (e.g. keep consumptions spending smooth)?

  5. I do follow sumner somewhat, and I agree completely that paying interest on reserves was a huge blunder. However, I don’t think that excess reserves would be zero even with no payment of interest on reserves, as there were significant excess reserves during the 1930s: http://eh.net/graphics/encyclopedia/Steindl.GD.Recovery_files/image008.gif

    However, the policy has been loose, i.e. expanding monetary base, but if the multiplier is falling off a cliff, M1 and M2 won’t expand much. That being said, M2 has expanded somewhat, though not as much as it should have. http://research.stlouisfed.org/fred2/series/M2

    I think this discussion is relevant to the idea of a liquidity trap (though I’m not implying that you accept its existence, as I know many don’t accept it, like sumner). It seems to me like the equivalence between bonds and cash at zero interest rates is not really relevent. One could have equivalence, the fed buys bonds which are equivalent to cash, banks lend out the cash, -> monetary policy is effective. The main issue is that there is nothing that the banks want to lend to, or at least they prefer the liquidity of excess reserves to any investment they could make now. This does not need any “animal spirits” type argument either, as good investments may be difficult to find (or difficult to screen out, a la bernanke gertler gilchrist). But the end result is the same, diminished credit availability and liquidity trap.

    I’ll post on fiscal policy in the more current post, since this one is a few days old. I disagree that fiscal policy is inflationary, as in this environment with significant slack, output can increase with little increase in inflation.

    As for the political implementation, I agree with your argument, which goes back to Friedman, that fiscal policy is more difficult to implement than monetary. But in this case, I think the timing issue is less relevant, as the downturn will be longlasting, especially if it is a jobless recovery. As to its contents, I see the fiscal stimulus as much more than “half full”, but this is about the guts of the proposal, not the general theory of fiscal stimulus.

    I don’t know about an independent fiscal authority, as fiscal stimulus will (hopefully) not be needed for a long time if ever. I think that’s one thing that’s important to point out, that I don’t like having to use fiscal stimulus. I would much prefer a world where all the crises can be dealt with monetary policy. Alas…

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