Macroeconomics: the development of modern methods for policy analysis.

Abstract

Thirty-five years ago, Robert Lucas and Thomas Sargent argued that conventional macroeconomic methods were ‘fatally flawed’. During the last five years, since the financial crisis in the United States and the recession throughout the Western world, the modern macroeconomics that Lucas and Sargent have championed has been roundly criticized, with Paul Krugman (2011) referring to this period of the subject’s development as ‘dark age macroeconomics’. Perhaps partly because of this level of controversy, macroeconomics has been a most exciting part of our discipline throughout this period. After all, it is stimulating to be involved in the initiation of new research agendas. But, while this activity is exciting for researchers in the field, it can be frustrating for students and their instructors. Journal articles by original researchers rarely represent the best pedagogic treatment of a subject, especially when the analysis becomes quite technical. Thus, a fundamental purpose of this book is to bridge the gap between intermediate macro texts and the more advanced analysis of graduate school. But I have two other goals as well – to draw attention to the work of macroeconomists who have been trying to integrate two quite different schools of thought, and to highlight the work that can be, and has been, used to directly address policy debates. Concerning the integration of alternative paradigms, there have been two themes. On the one hand, there is the rigour and explicit micro-foundations provided by the New Classical approach, and, on the other hand, the concern with policy that stems from the Keynesian tradition of focusing on the possibility of market failure. The problem in the 1970s and 1980s was that the Classicals achieved their rigour by excluding market failure, while the Keynesians achieved their intended policy relevance by excluding explicit micro-foundations. So both schools of thought were limited in a fundamental way. This book draws attention to the analyses of macroeconomists who saw the merit in both traditions, and who were, therefore, developing models that could score well on both the criteria for judging model usefulness (consistency with empirical observation and consistency with constrained maximization principles). In many important ways, this drive toward integration has succeeded. Indeed, the integrated approach has acquired a title – the ‘New Neoclassical Synthesis’ – and it now occupies centre stage in the discipline. It is high time that an accessible book should and its use in policy-making circles. With the increasing use of mathematics in graduate school, virtually all undergraduate programmes now offer advanced theory courses, and it has become less appealing to use the same books at both levels. I have found it best to leave PhD students to be served by the excellent books that now exist for them, and to focus this book on the needs of senior undergraduate students and MA students in more applied programmes. With this emphasis, it is appropriate that the book stress policy application, not just the teaching of techniques. The tradition has been to assume that every student who enrols in a course at this level is so motivated that no effort is needed to demonstrate the applicability of the analysis. In contrast to this, I have found that, especially at the senior undergraduate level, each student’s ability to master research methods is still very much dependent on her belief that this analysis is fundamentally ‘relevant’ for the issues that she talks about with non-economists. The book respects this need in every chapter. The New Neoclassical Synthesis permits a consistent comparison of the ‘short-term pain’ and the ‘long-term gain’ that are part of many policy initiatives. Here is a brief introduction to the book’s structure. Chapter 1 provides a concise summary (and extension) of intermediate-level macroeconomics, and it introduces students to both New Classical macroeconomics and Roger Farmer’s (2013b) suggestions for reformulating the treatment of Keynes’s ideas. The chapter ends with the identification of three shortcomings of intermediate-level modelling – the need for more explicit treatment of dynamics, expectations and micro-foundations. The next three chapters cover the analysis that has emerged to address each of these issues. Chapter 2 examines the first Neoclassical Synthesis – a system that involved the Classical model determining full equilibrium, and a Keynesian model of temporarily sticky prices determining the approach to that full equilibrium. Chapter 3 gives extensive discussion of the development of rational expectations, and Chapter 4 provides the dynamic optimization analysis that is necessary for models to have a more thorough micro base. The next three chapters cover models that are not so limited, since they incorporate model-consistent expectations and optimization underpinnings. Chapter 5 covers the first school of thought to stress the desirability of keeping these features central – real business cycle theory. Then, with temporary nominal rigidity added to a simplified New Classical model, Chapters 6 and 7 explain both the methods needed to analyse the New Neoclassical Synthesis, and the success we have had in applying this approach to a set of central policy issues. The book shifts to long-run issues for the final five chapters. Chapters 8 and 9 focus on theory and policy issues concerning the natural unemployment rate, while Chapters 10, 11 and 12 discuss both old and new growth theory. With the chapters on micro-foundations serving as the base for both the short-run and long-run analyses, roughly half of the book is devoted to each of short-run stabilization policy questions and long-run issues that relate to structural unemployment, income distribution and productivity growth. I have tried to maintain the user-friendly exposition that has been appreciated both in my earlier book written for students at this level (Scarth, 2007) and in the several editions of the intermediate macroeconomics text (for Canadian students) that I have co-authored with Greg Mankiw (Mankiw and Scarth, 2011). I give equal treatment to explaining technical details and to exposing the essence of each result and controversy. Using basic mathematics throughout, the book introduces readers to the actual research methods of macroeconomics. But, in addition to explaining methods, it discusses the underlying logic at the intuitive level, and with an eye to both the historical development of the subject and the ability to apply the analysis to ongoing policy debates. Concerning application, some of the highlighted topics are: the Lucas critique of standard methods for evaluating policy, credibility and dynamic consistency issues in policy design, the sustainability of rising debt levels and an evaluation of the austerity versus stimulation debate, the optimal inflation rate, the implications of alternative monetary policies for pursuing price stability (price-level versus inflation-rate targeting, fixed versus flexible exchange rates), how fiscal initiatives can substitute for monetary policy that may be constrained by the zero lower bound on nominal interest rates, tax reform (trickle-down controversies and whether second-best initial conditions can ease the trade-off between efficiency and equity objectives), theories of the natural unemployment rate and the possibility of multiple equilibria, alternative low-income support policies, and globalization (including the alleged threat to the scope for independent macro policy). Also, particular attention is paid to non-renewable resources, the ageing population, happiness economics, progressive expenditure taxes, how New Classical economists calculate ‘wedges’ to diagnose the causes of the recent recession, and why Keynesians stress both stability corridors and multiple equilibria in their approach. Since economics is a learning-by- doing subject, both students and instructors may find it useful to consult the practice questions for each chapter that are available on the publisher’s website: http://goo.gl/mej8LJ. There are now three questions for each chapter, and these will be updated and replaced periodically. In addition, when less technical articles and books appear that evaluate alternative approaches and branches of the literature – writings that are particularly helpful for providing overview and perspective – these references will be added to the recommended general readings section on the website. Comments on both the questions and suggestions for additional readings are most welcome: scarth@mcmaster.ca. I have many debts to acknowledge. First, several instructors during my graduate training had a lasting and important impact on my work (David Laidler, Dick Lipsey, Michael Parkin and Tom Sargent). Second, the published work of, and most helpful discussions with, Peter Howitt, Ben McCallum and Steve Turnovsky have been instrumental in my development and contributions over the years. Third, I have benefited greatly from interaction with some impressive colleagues and graduate students: Roy Bailey, John Burbidge, Buqu Gao, Ben Heijdra, Ron Kneebone, Jean-Paul Lam, Lonnie Magee, Hamza Malik, Thomas Moutos, Tony Myatt, Siyam Rafique and John Smithin. It should, of course, be emphasized that none of these individuals can be held responsible for how I may have filtered their input. As to the production of the book, Alan Sturmer, Alison Hornbeck and Jane Bayliss at Edward Elgar Publishing were most patient, efficient and helpful. But my greatest debt is to my wife, Kathy, whose unfailing love and support have been invaluable. Without this support I would have been unable to work at making the exciting developments in modern macroeconomics more accessible.