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A Quick Refresher Course in Macroeconomics BY N. GREGORYMANKIW

A Quick Refresher Course in Macroeconomics BY N. GREGORYMANKIW

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A Quick Refresher Course in Macroeconomics BY N. GREGORYMANKIW

Journal of Economic Literature
Vol. XXVIII (December 1990), pp. 1645-1 660

This paper, though new, draws heavily on my previous paper, "Recent
Developments in Macroeconomics: A Very Quick Refresher Course,"
Journal of Money, Credit, and Banking, August 1988, Part 2. I am
grateful to Moses Abramovitz, David Laidler, and Thomas Mayer
for comments, and to the National Science Foundation for jinancial
support.
A Quick Refresher Course in Macroeconomics BY N. GREGORYMANKIW

Journal of Economic Literature
Vol. XXVIII (December 1990), pp. 1645-1 660

This paper, though new, draws heavily on my previous paper, "Recent
Developments in Macroeconomics: A Very Quick Refresher Course,"
Journal of Money, Credit, and Banking, August 1988, Part 2. I am
grateful to Moses Abramovitz, David Laidler, and Thomas Mayer
for comments, and to the National Science Foundation for jinancial
support.

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Journal of Economic LiteratureVol. XXVIII (December
1990),
pp.
1645-1 660
A
Quick Refresher CourseMacroeconomics
BY
N.
GREGORY
MANKIW 
Harvard University and NBER 
This paper, though new, draws heavily on my previous paper, "RecentDevelopments in Macroeconomics: A Very Quick Refresher Course,"
Journal of Money, Credit, and Banking,
August
1988,
Part
2.
I
amgrateful to Moses Abramovitz, David Laidler, and Thomas Mayerfor comments, and to the National Science Foundation for jinancialsupport.Introduction
WENTY YEARS
AGO,
it was easier being
a
student of macroeconomics. Mac-roeconomists felt more sure of the an-swers they gave to questions such as,"What causes output and employment tofluctuate?" and "How should policy re-spond to these fluctuations?"At the textbook level, the acceptedmodel of the economy was the IS-LMmodel. It was little changed from JohnHicks' (1937) interpretation of John May-nard Keynes' (1936) once revolutionaryvision of the economy. Because the IS-LM model took the price level as given,a Phillips curve of some sort was ap-pended to explain the adjustment ofprices. Some thought the Phillips curvehad the natural rate property, implyingthat the economy was self-correcting inthe long run.At the more applied level, this consen-sus was embodied in the large-scalemacroeconometric models, such as theMIT-Penn-Social Science ResearchCouncil (MPS) model. The job of refiningthese models generated many disserta-tions. Private and public decision makersconfidently used the models to forecastimportant economic time series and toevaluate the effects of alternative macro-economic policies.Today, macroeconomists are much lesssure of their answers. The IS-LM modelrarely finds its way into scholarly jour-nals; some economists view the modelas a relic of a bygone age and no longerbother to teach it. The large-scale mac-roeconometric models are mentionedonly occasionally at academic confer-ences, often with derision.
A
graduatestudent today is unlikely to devote hisdissertation to improving some small sec-tor of the MPS model.In contrast to this radical change inthe way academic macroeconomists viewtheir field of study, applied macroecd-nomists have not substantially changedthe way they analyze the economy. TheIS-LM model, augmented by the Phillipscurve, continues to provide the best way1645 
 
1646
Journal of Economic Literature, Vol. XXVZZZ (December
1990)
to interpret discussions of economic pol-icy in the press and among policy makers.Economists in business and governmentcontinue to use the large-scalemacro-econometric models for forecasting andpolicy analysis. The theoretical develop-ments of the past twenty years havehad relatively little impact on appliedmacroeconomics.Why is there such a great disparity be-tween academic and applied macroeco-nomics? The view of some academics isthat practitioners have simply fallen be-hind the state of the art, that they con-tinue to use obsolete models becausethey have not kept up with the quicklyadvancing field. Yet this self-serving viewis suspect, for it violates a fundamentalproperty of economic equilibrium: It as-sumes that a profit opportunity remainsunexploited. If recent developments inmacroeconomics were useful for appliedwork, they should have been adopted.The observation that recent develop-ments have had little impact on appliedmacroeconomics creates at least the pre-sumption that these developments are oflittle use to applied macroeconomists.One might be tempted to concludethat, because the macroeconomic re-search of the past
20
years has had littleimpact on applied economists, the re-search has no value. Yet-this conclusionalso is unwarranted. The past
20
yearshave been a fertile time for macroeco-nomics. Recent developments have justnot been of the sort that can be quicklyadopted by applied economists.A.
A
Parable for Macroeconomics
A tale from the history of science ishelpful for understanding the currentstate of macroeconomics. Because
I
amnot an historian of science, I cannotvouch for its accuracy. But regardless ofwhether it is true in detail, the storyserves nicely as a parable for macroeco-nomics today.Approximately five centuries ago,Nicholas Copernicus suggested that thesun, rather than the earth, is the centerof the planetary system. At the time, hemistakenly thought that the planets fol-lowed circular orbits; we now know thatthese orbits are actually elliptical. Com-pared to the then prevailing geocentricsystem of Ptolemy, the original Coperni-can system was more elegant and, ulti-mately, it proved more useful. But at thetime it was proposed and for many yearsthereafter, the Copernican system didnot work as well as the Ptolemaic system.For predicting the positions of the plan-ets, the Ptolemaic system was superior.Now imagine yburself, alternatively, asan academic astronomer and as an ap-plied astronomer when Copernicus firstpublished. If you had been an academicastronomer, you would have devotedyour research to improving the Coperni-can system. The Copernican system heldout the greater promise for understand-ing the movements of the planets in asimple and intellectually satisfying way.Yet if you had been an applied astrono-mer, you would have continued to usethe Ptolemaic system. It would havebeen foolhardy to navigate your ship bythe more promising yet less accurate Co-pernican system. Given the state ofknowledge immediately after Coperni-cus, a functional separation between aca-demic and applied astronomers was rea-sonable and, indeed, optimal.In this paper
I
survey some of the re-cent developments in macroeconomics.My intended audience includes those ap-plied economists in business and govern-ment who often view recent researchwith a combination of amusement, puzz-lement, and disdain. My goal is not toproselytize. Rather, it is to show how sev-eral recent developments point the waytoward a better understanding of theeconomy, just as Copernicus' suggestionof the heliocentric system pointed the
 
Mankiw:
A
Quick Refresher Course in Macroeconomics
1647way toward a better understanding ofplanetary motion. Yet just as Copernicusdid not see his vision fully realized inhis lifetime, we should not expect theserecent developments, no matter howpromising, to be of great practical usein the near future. In the long run, how-ever, many of these developments willprofoundly change the way all econo-mists think about the economy and eco-nomic policy.
B.
The Breakdown of the Consensus
The consensus in macroeconomicsthat prevailed until the early 1970s fal-tered because of two flaws, one empiricaland one theoretical. The empirical flawwas that the consensus view could notadequately cope with the rising rates ofinflation and unemployment experiencedduring the 1970s. The theoretical flawwas that the consensus view left a chasmbetween microeconomic principles andmacroeconomic practice that was toogreat to be intellectually satisfying.These two flaws came together mostdramatically and most profoundly in thefamous prediction of Milton Friedman(1968) and Edmund Phelps (1968). Ac-cording to the unadorned Phillips curve,one could achieve and maintain a perma-nently low level of unemploymentmerely by tolerating a permanently highlevel of inflation. In the late 1960s, whenthe consensus view was still in its heyday,Friedman and Phelps argued from mi-croeconomic principles that this empiri-cal relationship between inflation and un-employment would break down if policymakers tried to exploit it. They reasonedthat the equilibrium, or natural, rate ofunemployment should depend on laborsupply, labor demand, optimal searchtimes, and other microeconomic consid-erations, not on the average rate ofmoney growth. Subsequent eventsproved Friedman and Phelps correct: In-flation rose without a permanent reduc-tion in unemployment.The breakdown of the Phillips curveand the prescience of Friedman andPhelps made macroeconomists ready forRobert Lucas' (1976) more comprehen-sive attack on the consensus view. Lucascontended that many of the empirical re-lations that make up the large-scale mac-roeconometric models were no betterfounded on microeconomic principlesthan was the Phillips curve. In particular,the decisions that determine most macro-economic variables, such as consumptionand investment, depend crucially onexpectations of the future course ofthe economyh4acroeconometric modelstreated expectations in a cavalier way,most often by resorting to plausible butarbitrary proxies. Lucas pointed out thatmost policy interventions change the wayindividuals form expectations about thefuture. Yet the proxies for expectationsused in the macroeconometric modelsfailed to take account of this change inexpectation formation. Lucas concluded,therefore, that these models should notbe used to evaluate the impact of alterna-tive policies.The "Lucas critique" became the rally-ing cry for those young turks intent ondestroying the consensus. Defenders ofthe consensus argued that users ofmacroeconometric models were alreadyaware of the problem Lucas defined soforcefully, that the models were nonethe-less informative if used with care andjudgment, and that the Lucas critiquewas right in principle but not importantin practice. These defenses were notheeded.As
I
have mentioned, the consensusin macroeconomics broke down becauseof two flaws. Both were crucial. Neitherthe empirical flaw nor the theoretical flawwas, by itself, sufficient to cause thebreakdown. As an exercise in intellectualhistory, it is instructive to consider twocounterfactuals.

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