Evolution of Macroeconomic Theory: An Overview

"For economists, history not only represents the material against which to test theories and hypotheses, it also gives clues to the future."

Introduction

Now that we know where we are going, how do we get there?  We are not going to take the traditional approach where the divisions (chapters) are based on topics or policies - chapters on unemployment, inflation, monetary policy, and fiscal policy.  We are going to take a historical approach that emphasizes the evolution of macroeconomic theory.  Rather than looking at macroeconomics as a stagnant set of established theories, we will look at how macroeconomic theory evolved, how 'contemporary wisdom' was rooted in the performance of the economy and how the economy's performance was affected by policies grounded in the prevailing wisdom.  You can think of it as 'just-in-time' theory.  The economic theory will be introduced at just the time where it is needed, at the time where the economics profession 'discovered' the theory that allowed it to understand the problems of the time and to propose policies to improve the situation.  In this sense we will be following the lead taken by Robert Heilbroner who, in his book The Worldly Philosophers, described how the views of the important economic theorists were rooted in the times in which they were writing. 

The story and the storyteller

As you begin your reading of the story of macroeconomics, you should realize the story you hear / see will depend very much on the story teller's view of the world.  In the United States most economic policy debates generally take place between two groups known as Liberals and Conservatives and you should review the discussion of these two ideological perspectives. The shortened version is conservatives believe a good government is a small government that simply sets the "rules" to govern the competition.  Liberals, meanwhile, share with the conservatives a strong faith in the market, but believe there are advantages to be gained by devising policies to offset some of the structural flaws of the system.

As we move forward we will see there is clearly a parallel between economic theory, economic policy, and economic performance.  Economic policies will be grounded in the prevailing economic theories and there will be little pressure to unseat these theories or policies as long as the economy is performing adequately.  It is only in times of economic crises that there is any real movement in public policies and shift in the balance of power among theorists.  Bruno and Easterly (1996) suggest that economic crises, in this case crises triggered by bouts of hyperinflation, can speed the process of economic reform in lower income countries and that the return of growth will be faster in those countries that experienced the hyperinflation.  If we follow the logic a bit further we end up where Albert Hirschman (1987) did and conclude that "inflation has acted as the equivalent of war in eliciting change" or Alesina and Drazen (1991) who "model delayed stabilization as a war of attrition." 

As we work our way through the story you will find that there are two dominant themes. One theme is the proper scope of government - a theme that actually pervades all economics courses and discussions.  It is the flip side of the discussion of how well the economy operates on its own - how well it can adjust to the inevitable external shocks such as the Asian financial crises of 1997-98. 

A second, and clearly related theme, is the relative power of macroeconomic policies. If economies do not adjust adequately to external shocks, if they get "stuck" out of equilibrium, can the government improve the situation with an appropriate mix of monetary and fiscal policies? This discussion will focus on how the supply of money - those dollar bills in your pockets - and the level of government spending on education, highways, and social security - affect the economy; on whether we could rely on government policy officials to "fine-tune" the economy and dampen the business cycles that are a pervasive feature of modern economies.

The Story: An Outline

The modern story of Macroeconomics begins in the 1930s.  In 1931 England was "forced" off the gold standard as the world moved into the Great Depression, and in the US the Depression was certainly made worse by macroeconomic policy responses grounded in the prevailing view of the macroeconomy - the Classical model.   For this reason we start with an overview of the Classical model in an effort to understand the policy decisions of the time. The discussions here will be focused on monetary policy which will include our introduction to the Fed - the central bank of the US. The key concept in this discussion of the macroeconomy, the one that dominated thinking on macroeconomics prior to the Depression, is "crowding - out," a term you will revisit a half-century later.

As the U.S. economy moved further into the Depression, there was growing awareness of the Classical model's inability to either explain the problem or provide guidelines for appropriate macro policies. Into the theoretical and policy void stepped John Maynard Keynes, a British economist, who provided the foundation of post World War II prosperity. Through the work of Keynes, macroeconomic thinking was revolutionized and the outlines of that theory are discussed in the section on the Challenger: Keynesian Economics.  In this section we draw attention to the magnitude of the economic decline and its links to changes in thinking on how the economy operates. The unit also highlights the radical nature of Roosevelt's ideas on public policy and Keynes' on economic theory. Keynes' idea of the multiplier is introduced and shown to be critical for understanding changes in national income. The idea that a small change in government spending could cause much larger changes in national income was a cornerstone of the post World War II system and justified an active role for the public sector in economic stabilization. In the "Classical world," an increase in government spending will "crowd-out" the private sector, while in the Keynesian world we have the private sector multiplying he effect of a change in government spending.

By the 1960s we entered a period described as the zenith of Keynesian economics - a time where we would test the limits of fiscal policy. The Kennedy Tax Cut of 1964 is a classic example of using government taxes and spending to manage the economy, while the Johnson tax surcharge in 1968 is a classic policy error. In this unit we will examine the extent  to which Keynesian anti-depression economics could be transformed into anti-recession economics, how fiscal policy could be employed to eliminate one of the scourges of the US economic system - business cycles.  The specifics of this economic program are discussed, as is the political management of taxes and the possibility of a politically induced business cycle. Issues of equity and ideology came to the fore once again, as tax policy showed that macroeconomic activism had potential for economic gains, as well as the possibility of political abuses. The tax cut, the military buildup in Vietnam and the increase in domestic social spending under Johnson led directly to overheating of the economy which caused the post World War II system to unravel. 

The unit begins with a detailed treatment of aggregate demand.  If government was to steer the economy on a path of uninterrupted growth, it would do so by managing aggregate demand, and therefore it was important to understand the components of demand.  Once these components were better understood, economists could forecast the macroeconomy - a prerequisite if the government were to be able to effectively use monetary and fiscal policy to smooth out the business cycle.  Unfortunately, the optimism of the early 1960s had been tempered by the late 1960s as economists had begun to build inflation and timing into their models.  It is here where we will talk about the Phillips Curve, the relationship between inflation and unemployment that constrained policy makers, and lags that tended to further weaken policymakers' ability to fine-tune the economy. 

If the 1960s was a decade where we experimented with fiscal policy, the 1970s was a decade where we experimented with monetary policy and the international financial system.  The decade opened with President Nixon's New Economic Policy which was affected by his attempt to both win and end the war in Vietnam. His speech announcing the incomes policies and the abandonment of the gold standard spelled the end of U.S. economic, and possibly political, hegemony. Where Presidents Kennedy and Johnson tried to preserve the postwar system, President Nixon chose to end it. Economic policy making became more nationalistic under Nixon and, as a consequence, the U.S. became less concerned with saving the system than with improving its own position within it.

In this unit we will begin by focusing on the evolution of the international monetary system from the gold standard through the Bretton Woods system and then to flexible exchange rates. The end of the Bretton Woods financial system ushered in a period in which the dollar fell substantially. We examine the decline of the dollar and provide a general theory of exchange rate determination. The decline of the dollar under President Carter is a good example of economic and political forces affecting exchange rates. Carter's advisors tried to use dollar depreciation to stimulate employment and growth, but the resulting inflation (exacerbated by the second oil "shock") caused instability in financial markets.  The resulting decline of the dollar panicked major creditors, such as the Saudis, who held their oil wealth in dollars. Essentially, the U.S. economy was "squeezed" to preserve the dollar's international role.

The resulting flight to gold led directly to the shift to monetarism at the Federal Reserve as the Fed explicitly announced it would target the rate of growth of the money supply, not interest rates.  In the second section of the unit we will look more closely at monetary policy - the money supply process, whereby money is introduced into the economy, and the transmission mechanism, where we trace the link between money and other macroeconomic indicators such as output (GDP), unemployment, and inflation.  The attempt by the Fed to fight inflation with high interest rates represented the first step in the shift to more conservative economic policies, but the volatility of the financial markets and the ongoing deregulation of the financial system made the situation quite unstable. The new monetary policy was the beginning of the great "disinflation," the regressive redistribution of income and the dramatic rise of the dollar through the mid-1980s.

If monetarism was one theoretical pillar of the new conservatism, supply side economics was another. The 1980s was a period where the US experimented with supply-side economics and the economics profession refocused its efforts on unlocking the secrets to economic growth.  President Reagan inherited an economic situation in 1981 so bleak that budget director David Stockman likened it to an "economic Dunkirk." Supply side economics was essentially the pre-Keynesian classical theory in newer and trendier language, but it was quite different from what were perceived to be the failed policies of the 1970s. The individual pieces of the Reagan program had some logic, but the Reagan program clearly promised too much at too little cost.

The result was the monstrous budget deficits that dominated policy discussions in the 1990s. Given the power of the deficit in the 1990s to influence public policy, we will discuss the causes and consequences of the budget deficit. This will provide us with the basis for our closing discussion of Modern Macroeconomics where we will examine the question posed to a number of experts in a recent symposium. ["Is there a core of practical macroeconomics that we should all believe?"  American Economic Review, May 1997]