Modern Macroeconomics

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Modern Macroeconomics

In loving memory of Brians parents, Joseph and Margaret Snowdon, and Howards father, Philip M. Vane

Modern MacroeconomicsIts Origins, Development and Current State

Brian SnowdonPrincipal Lecturer in Economics in the Newcastle Business School, Northumbria University, Newcastle upon Tyne, UK

Howard R. VaneProfessor of Economics in the School of Accounting, Finance and Economics, Liverpool John Moores University, Liverpool, UK

Edward ElgarCheltenham, 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.

ContentsList of gures List of tables Preface Acknowledgements 1 1.1 1.2 1.3 1.4 1.5 1.6 1.7 1.8 1.9 1.10 2 2.1 2.2 2.3 2.4 2.5 2.6 2.7 2.8 2.9 2.10 2.11 2.12 2.13 2.14 2.15 2.16 Understanding modern macroeconomics Macroeconomic issues and ideas The role of economic theory and controversy Objectives, instruments and the role of government The Great Depression Keynes and the birth of macroeconomics The rise and fall of the Keynesian consensus Theoretical schizophrenia and the neoclassical synthesis Schools of thought in macroeconomics after Keynes The new political macroeconomics The renaissance of economic growth research Keynes v. the old classical model Introduction Classical macroeconomics Employment and output determination Says Law The quantity theory of money Keyness General Theory Interpreting the General Theory Keyness main propositions Keyness analysis of the labour market Keyness rejection of Says Law Keynes and the quantity theory of money Three important interpretations of Keynes The new Keynes scholarship Causes and consequences of the Great Depression How to pay for the war Keynes and international macroeconomicsv

x xiii xiv xvii 1 1 3 7 9 13 15 21 24 29 32 36 36 37 38 45 50 54 57 58 65 69 69 70 75 76 82 83

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2.17 Keyness legacy and the classical revival Interview with Robert Skidelsky 3 The orthodox Keynesian school 3.1 Introduction 3.2 The orthodox Keynesian school 3.3 The ISLM model for a closed economy 3.4 Underemployment equilibrium in the Keynesian model 3.5 The ISLM model for an open economy 3.6 The Phillips curve and orthodox Keynesian economics 3.7 The central propositions of orthodox Keynesian economics Interview with James Tobin The orthodox monetarist school Introduction The quantity theory of money approach The expectations-augmented Phillips curve analysis The monetary approach to balance of payments theory and exchange rate determination 4.5 The orthodox monetarist school and stabilization policy Interview with Milton Friedman 5 The new classical school 5.1 Introduction 5.2 The inuence of Robert E. Lucas Jr 5.3 The structure of new classical models 5.4 Equilibrium business cycle theory 5.5 The policy implications of the new classical approach 5.6 An assessment Interview with Robert E. Lucas Jr 6 6.1 6.2 6.3 6.4 6.5 6.6 6.7 6.8 The real business cycle school Introduction: the demise of new classical macroeconomics mark I The transition from monetary to real equilibrium business cycle theory Real business cycle theory in historical perspective Cycles versus random walks Supply-side shocks Business cycles: main features and stylized facts Real business cycle theory The structure of a real business cycle model 4 4.1 4.2 4.3 4.4

85 91 101 101 102 102 114 123 135 144 148 163 163 165 174 187 192 198 219 219 220 223 236 242 267 272 294 294 295 297 300 303 304 307 309

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6.9 Technology shocks 6.10 A real business cycle aggregate demand and supply model 6.11 Calibrating the model 6.12 Real business cycle theory and the neutrality of money 6.13 Measuring technology shocks: the Solow residual 6.14 Real business cycle theory and the stylized facts 6.15 The policy implications of real business cycle theory 6.16 Criticisms of real business cycle theory 6.17 Great Depressions: a real business cycle view 6.18 An assessment Interview with Edward C. Prescott 7 The new Keynesian school 7.1 The fall and rise of Keynesian economics 7.2 A Keynesian resurgence 7.3 New Keynesian economics 7.4 Core propositions and features of new Keynesian economics 7.5 Nominal rigidities 7.6 Dornbuschs overshooting model 7.7 Real rigidities 7.8 New Keynesian business cycle theory 7.9 Hysteresis and the NAIRU 7.10 New Keynesian economics and the stylized facts 7.11 Policy implications 7.12 Keynesian economics without the LM curve 7.13 Criticisms of new Keynesian economics 7.14 An assessment of new Keynesian economics Interview with N. Gregory Mankiw 8 8.1 8.2 8.3 8.4 8.5 8.6 8.7 8.8 8.9 The Post Keynesian school Paul Davidson Introduction The signicance of the principle of effective demand Taxonomy Keyness taxonomic attack on Says Law Can relative price changes induce D2 to ll the gap? Investment spending, liquidity, and the non-neutrality of money axiom What type of an economic system is irrational enough to use money contracts? Information, decisions and uncertainty Classifying decision-making environments

313 315 320 322 325 326 330 332 336 338 344 357 357 358 361 363 366 376 378 396 401 408 409 423 428 431 433 451 451 453 454 455 457 459 461 463 464

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8.10 8.11 9 9.1 9.2 9.3 9.4 9.5 9.6 9.7 9.8 9.9 9.10 9.11 9.12 9.13 10 10.1 10.2 10.3 10.4 10.5 10.6 10.7 10.8 10.9 10.10 10.11 10.12 10.13 10.14 10.15 10.16 10.17 10.18

Keynesian uncertainty, money and explicit money contracts Conclusions The Austrian school Roger W. Garrison The Mengerian vision The intertemporal structure of capital Saving and economic growth The savinginvestment nexus The market for loanable funds Full employment and the production possibilities frontier The capital-based macroeconomic framework Saving-induced capital restructuring Keyness paradox of thrift revisited The Austrian theory of the business cycle A Keynesian downturn in the Austrian framework Ination and deation in the Austrian theory Policy and reform The new political macroeconomics Introduction: political distortions and macroeconomic performance Political inuences on policy choice The role of government Politicians and stabilization policy Alternative approaches to the political business cycle: an overview The Nordhaus opportunistic model The Hibbs partisan model The decline and renaissance of opportunistic and partisan models Rational political business cycles Rational partisan theory Opportunistic and partisan behaviour: a synthesis Politics, time inconsistency, credibility and reputation Policy implications of politico-economic models: an independent central bank? The political economy of debt and decits Political and economic instability: are they related? The political economy of economic growth Political barriers to economic growth The size of nations

468 472 474 474 475 479 482 489 492 496 498 501 503 509 513 515 517 517 518 521 523 525 526 532 535 537 538 545 546 549 554 555 556 562 564

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10.19 Conclusion Interview with Alberto Alesina 11 11.1 11.2 11.3 11.4 11.5 11.6 11.7 11.8 11.9 11.10 11.11 11.12 11.13 11.14 11.15 11.16 11.17 11.18 11.19 11.20 11.21 11.22 The renaissance of economic growth research Introduction The Great Divergence In praise of economic history Back to the long run Why is economic growth so important? Modern economic growth in historical perspective The stylized facts of growth Proximate v. fundamental sources of growth The HarrodDomar model The Solow neoclassical growth model Accounting for the sources of economic growth The convergence debate Beyond the Solow model Endogenous growth: constant returns to capital accumulation Endogenous growth: the economics of ideas An augmented Solow model: a neoclassical revival? Focusing on the fundamental causes of growth Institutions and economic growth Trade and economic growth Geography and growth Growth in history: in search of a unied theory The ideal conditions for growth and development: rediscovering old truths Interview with Robert M. Solow Interview with Paul M. Romer 12 12.1 12.2 12.3 Conclusions and reections Introduction Twentieth-century developments in macroeconomics: evolution or revolution? Is there a consensus on key macroeconomic issues?

565 567 579 579 580 584 585 589 593 595 596 598 602 612 614 622 625 627 632 633 635 647 652 654 657 660 673 695 695 696 703 708 791 803

Bibliography Author index Subject index

Figures1.1 1.2 2.1 2.2 2.3 2.4 2.5 2.6 2.7 3.1 3.2 3.3 3.4 3.5 3.6 3.7 3.8 3.9 3.10 3.11 3.12 3.13 3.14 3.15 3.16 3.17 Unemployment in the US and UK economies over the course of the twentieth century Ination in the US and UK economies over the course of the twentieth century The aggregate production function (a) and the marginal product of labour (b) Output and employment determination in the classical model The classical interest rate mechanism and Says Law The determination of the price level in the classical model The determination of output and employment Keynes and involuntary unemployment Aggregate demand failure in the US economy, 192933 Demand for speculative balances The generalized ISLM model Expansionary scal policy Expansionary monetary policy The government budget constr