What’s Wrong With Modern Macro? Part 2 The Death of Keynesian Economics: The Lucas Critique, Microfoundations, and Rational Expectations

Part 2 in a series of posts on modern macroeconomics. Part 1 covered Keynesian economics, which dominated macroeconomic thinking for around thirty years following World War II. This post will deal with the reasons for the demise of the Keynesian consensus and introduce some of the key components of modern macro.


The Death of Keynesian Economics

Milton Friedman - Wikimedia Commons
Milton Friedman – Wikimedia Commons

Although Keynes had contemporary critics (most notably Hayek, if you haven’t seen the Keynes vs Hayek rap videos, stop reading now and go watch them here and here), these criticisms generally remained outside of the mainstream. However, a more powerful challenger to Keynesian economics arose in the 1950s and 60s: Milton Friedman. Keynesian theory offered policymakers a set of tools that they could use to reduce unemployment. A key empirical and theoretical result was the existence of a “Phillips Curve,” which posited a tradeoff between unemployment and inflation. Keeping unemployment under control simply meant dealing with slightly higher levels of inflation.

Friedman (along with Edmund Phelps), argued that this tradeoff was an illusion. Instead, he developed the Natural Rate Hypothesis. In his own words, the natural rate of unemployment is

the level that would be ground out by the Walrasian system of general equilibrium equations, provided there is embedded in them the actual structural characteristics of the labour and commodity markets, including market imperfections, stochastic variability in demands and supplies, the costs of gathering information about job vacancies, and labor availabilities, the costs of mobility, and so on.
Milton Friedman, “The Role of Monetary Policy,” 1968

If you don’t speak economics, the above essentially means that the rate of unemployment is determined by fundamental economic factors. Governments and central banks cannot do anything to influence this natural rate. Trying to exploit the Phillips curve relationship by increasing inflation would fail because eventually workers would simply factor the inflation into their decisions and restore the previous rate of employment at a higher level of prices. In the long run, printing money could do nothing to improve unemployment.

Friedman’s theories couldn’t have come at a better time. In the 1970s, the United States experienced stagflation, high levels of both inflation and unemployment, an impossibility in the Keynesian models, but easily explained by Friedman’s theory. The first blow to Keynesian economics had been dealt. It would not survive the fight that was still to come.

The Lucas Critique

While Friedman may have provided the first blow, Robert Lucas landed the knockout punch on Keynesian economics. In a 1976 article, Lucas noted that standard economic models of the time assumed people were excessively naive. The rules that were supposed to describe their behavior were invariant to policy changes. Even when they knew about a policy in advance, they were unable to use the information to improve their forecasts, ensuring that those forecasts would be wrong. In Lucas’s words, they made “correctibly incorrect” forecasts.

The Lucas Critique was devastating for the Keynesian modeling paradigm of the time. By estimating the relationships between aggregate variables based on past data, these models could not hope to capture the changes in individual actions that occur when the economy changes. In reality, people form their own theories about the economy (however simple they may be) and use those theories to form expectations about the future. Keynesian models could not allow for this possibility.

Microfoundations

At the heart of the problem with Keynesian models prior to the Lucas critique was their failure to incorporate individual decisions. In microeconomics, economic models almost always begin with a utility maximization problem for an individual or a profit maximization problem for a firm. Keynesian economics attempted to skip these features and jump straight to explaining output, inflation, and other aggregate features of the economy. The Lucas critique demonstrated that this strategy produced some dubious results.

The obvious answer to the Lucas critique was to try to explicitly build up a macroeconomic model from microeconomic fundamentals. Individual consumers and firms returned once again to macroeconomics. Part 3 will explore some specific microfounded models in a bit more detail. But first, I need to explain one other idea that is essential to Lucas’s analysis and to almost all of modern macroeconomics: rational expectations

Rational Expectations

Think about a very simple economic story where a firm has to decide how much of a good to produce before they learn the price (such a model is called a “cobweb model”). Clearly, in order to make this decision a firm needs to form expectations about what the price will be (if they expect a higher price they will want to produce more). In most models before the 1960s, firms were assumed to form these expectations by looking at the past (called adaptive expectations). The problem with this assumption is that it creates predictable forecast errors.

For example, assume that all firms simply believe that today’s price will be the same as yesterday. Then when the price yesterday was high, firms produce a lot, pushing down the price today. Then tomorrow, firms expect a low price so don’t produce very much, which pushes the price back up. A smart businessman would quickly realize that their expectations are always wrong and try to find a new way to predict future prices.

A similar analysis led John Muth to introduce the idea of rational expectations in a 1961 paper. Essentially, Muth argued that if economic theory predicted a difference between expectation and result, the people in the model should be able to do the same. As he describes, “if the prediction of the theory were substantially better than the expectations of the firms, then there would be opportunities for ‘the insider’ to profit from the knowledge.” Since only the best firms would survive, in the end expectations will be “essentially the same as the predictions of the relevant economic theory.”

Lucas took Muth’s idea and applied it to microfounded macroeconomic models. Agents in these new models were aware of the structure of the economy and therefore could not be fooled by policy changes. When a new policy is announced, these agents could anticipate the economic changes that would occur and adjust their own behavior. Microfoundations and rational expectations formed the foundation of a new kind of macroeconomics. Part 3 will discuss the development of Dynamic Stochastic General Equilibrium (DSGE) models, which have dominated macroeconomics for the last 30 years (and then in part 4 I promise I will actually get to what’s wrong with modern macro).

Links 8-21-16

“In the land of the free, where home ownership is a national dream, borrowing to buy a house is a government business for which taxpayers are on the hook.”

“If you think that there has never been a better time to be alive — that humanity has never been safer, healthier, more prosperous or less unequal — then you’re in the minority. But that is what the evidence incontrovertibly shows.”

Noah Smith criticizes heterodox macro

And then addresses some of the responses

The Solution to High Rents: Build More Houses. Who would have thought?

What’s Wrong With Modern Macro? Part 1 Before Modern Macro - Keynesian Economics

Part 1 in a series of posts on modern macroeconomics. This post focuses on Keynesian economics in order to set the stage for my explanation of modern macro, which will begin in part 2. 


John Maynard Keynes – Wikimedia Commons

If you’ve never taken a macroeconomics class, you almost certainly have no idea what macroeconomists do. Even if you have an undergraduate degree in economics, your odds of understanding modern macro probably don’t improve much (they didn’t for me at least. I had no idea what I was getting into when I entered grad school). The gap between what is taught in undergraduate macroeconomics classes and the research that is actually done by professional macroeconomists is perhaps larger than in any other field. Therefore, for those of you who made the excellent choice not to subject yourself to the horrors of a first year graduate macroeconomics sequence, I will attempt to explain in plain English (as much as possible), what modern macro is and why I think it could be better.

But before getting to modern macro itself, it is important to understand what came before. Keep in mind throughout these posts that the pretense of knowledge is quite strong here. For a much better exposition that is still somewhat readable for anyone with a basic economic background, Michael De Vroey has a comprehensive book on the history of macroeconomics. I’m working through it now and it’s very good. I highly recommend it to anyone who is interested in what I say in this series of posts.

Keynesian Economics

Although Keynes was not the first to think about business cycles, unemployment, and other macroeconomic topics, it wouldn’t be too much of an exaggeration to say that macroeconomics as a field didn’t truly appear until Keynes published his General Theory in 1936. I admit I have not read the original book (but it’s on my list). My summary here will therefore be based on my undergraduate macro courses, which I think capture the spirit (but probably not the nuance) of Keynes.

Keynesian economics begins by breaking aggregate spending (GDP) into four pieces. Private spending consists of consumption (spending by households on goods and services) and investment (spending by firms on capital). Government spending on goods and services makes up the rest of domestic spending. Finally, net exports (exports minus imports) is added to account for foreign expenditures. In a Keynesian equilibrium, spending is equal to income. Consumption is assumed to be a fraction of total income, which means that any increase in spending (like an increase in government spending) will cause an increase in consumption as well.

An important implication of this setup is that increases in spending increase total income by more than the initial increase (called the multiplier effect). Assume that the government decides to build a new road that costs $1 million. This increase in expenditure immediately increases GDP by $1 million, but it also adds $1 million to the income of the people involved in building the road. Let’s say that all of these people spend 3/4 of their income and save the rest. Then consumption also increases by $750,000, which then becomes other people’s incomes, adding another $562,500, and the process continues. Some algebra shows that the initial increase of $1 million leads to an increase in GDP of $4 million. Similar results occur if the initial change came from investment or changes in taxes.

The multiplier effect also works in the other direction. If businesses start to feel pessimistic about the future, they might cut back on investment. Their beliefs then become self-fulfilling as the reduction in investment causes a reduction in consumption and aggregate spending. Although the productive resources in the economy have not changed, output falls and some of these resources become underutilized. A recession occurs not because of a change in economic fundamentals, but because people’s perceptions changed for some unknown reason – Keynes’s famous “animal spirits.” Through this mechanism, workers may not be able to find a job even if they would be willing to work at the prevailing wage rate, a phenomenon known as involuntary unemployment. In most theories prior to Keynes, involuntary unemployment was impossible because the wage rate would simply adjust to clear the market.

Keynes’s theory also opened the door for government intervention in the economy. If investment falls and causes unemployment, the government can replace the lost spending by increasing its own expenditure. By increasing spending during recessions and decreasing it during booms, the government can theoretically smooth the business cycle.

IS-LM

The above description is Keynes at its most basic. I haven’t said anything about monetary policy or interest rates yet, but both of these were essential to Keynes’s analysis. Unfortunately, although The General Theory was a monumental achievement for its time and probably the most rigorous analysis of the economy that had been written, it is not exactly the most readable or even coherent theory. To capture Keynes’s ideas in a more tractable framework, J.R. Hicks and other economists developed the IS-LM model.

I don’t want to give a full derivation of the IS-LM model here, but the basic idea is to model the relationship between interest rates and income. The IS (Investment-Savings) curve plots all of the points where the goods market is in equilibrium. Here we assume that investment depends negatively on interest rates (if interest rates are high, firms would rather put their money in a bank then invest in new projects). A higher interest rate then lowers investment and decreases total income through the same multiplier effect outlined above. Therefore we end up with a negative relationship between interest rates and income.

The LM (Liquidity Preference-Money) curve plots all of the points where the money market is in equilibrium. Here we assume that the money supply is fixed. Money demand depends negatively on interest rates (since a higher interest rate means you would rather keep money in the bank than in your wallet) and positively on income (more cash is needed to buy stuff). Together these imply that a higher level of income results in a lower interest rate required to clear the money market. An equilibrium in the IS-LM model comes when both the money market and the goods market are in equilibrium (the point where the two lines cross).

The above probably doesn’t make much sense if you haven’t seen it before. All you really need to know is that an increase in government spending or investment shifts the IS curve right, which increases both income and interest rates. If the central bank increases the money supply, the LM curve shifts right, increasing income and decreasing interest rates. Policymakers then have two powerful options to combat economic downturns.

In the decades following Keynes and Hicks, the IS-LM model grew to include hundreds or thousands of equations that economists attempted to estimate econometrically, but the basic features remained in place. However, in the 1970s, the Keynesian model came under attack due to both empirical and theoretical failures. Part 2 will deal with these failures and the attempts to solve them.