CHAPTER TWO

THE STATE OF MACROECONOMICS: EVOLUTION AND RECENT

DEVELOPMENTS
1. INTRODUCTION

Macroeconomic thought has evolved considerably over time. We cannot hope to

understand fully our modern theories and debates if we do not understand the history
of our thoughts and how they have evolved. To understand our present we have to
know and understand our past; because there is a high thread of unity in human
thinking: current ideas are old ideas but with some changes in form or shape. In other
words, to understand present theories well we have to be clear with theories in the
past since the later contributed a lot for the development of the former. This can
clearly be understood from the following statement by one of the giant scientists,
Isaac Newton:
If I have seen further than others, it is because I was standing on the
shoulders of the giants (cited in Jones, 2002:101).

Exploring the evolution of macroeconomic thought will also provide several other
benefits as you will learn a lot of economics in the process, you will learn some
important historical knowledge, and you will understand better the policy debates that
occur between our political parties. The theoretical framework we will tend to use is
the IS-LM/AS-AD model that we will develop later in chapter two.

As we defined earlier, macroeconomics is concerned with the structure, performance

and behaviour of the economy as a whole. The prime concern of macroeconomists is
to analyze and attempt to understand the underlying determinants of the main
aggregate trends in the economy with respect to the total output of goods and services
(GDP), unemployment, inflation, and international transactions. In particular,
macroeconomic analysis seeks to explain the cause and impact of short-run
fluctuations in GDP (the business cycle), and the major determinants of the long-run
path of GDP (economic growth). Obviously the subject matter of macroeconomics is
of crucial importance because in one way or another macroeconomic events have an
important influence on the lives and welfare of all of us.
In general, in almost all countries of the world there are about four main objectives at
the macroeconomy level as we discussed earlier. To recite them: steady and
sustainable growth, stable price level (avoid unpredictability in price level), avoid
involuntary unemployment or high employment (create job opportunity to all those
who are willing and able to work at a reasonable pay), and maintain
reasonable/manageable balances in government budget as well as the balance of
payment of the economy in its transaction with the rest of the world.

Almost all macroeconomists agree that the above mentioned are the major objectives
of the macroeconomy and hence macroeconomists. However, macroeconomists
disagree on how the economy can achieve these goals as well as whether these
objectives are compatible or not (that is whether these objectives can be achieved
simultaneously or not). One of the prominent economist, Milton Friedman, explained
this issue as follows:

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 There is wide agreement about the major goals of economic policy [at
the macro level]: high employment, stable prices, and rapid growth.
There is less agreement that these goals are mutually compatible or,
among those who regard them as incompatible, about the terms at
which they can and should be substituted for one another. There is
least agreement about the role that various instruments of policy can
and should play in achieving the several goals.(Friedman 1968; cited
in Snowdon and Vane, 2005: 7; emphasis added)

The quotation attempts to generalize that the points of disagreements among

economists (macroeconomists) are mainly theoretical issues, empirical evidence, and
the choice of policy instruments than the ultimate objectives of policy. The choice of
appropriate instruments in order to achieve the ‘major goals’ of economic policy will
depend on a detailed analysis of the causes of specific macroeconomic problems. To
make such detailed analysis of the economy we need to have a model or
theoretical/conceptual framework of what the economy looks like and how it operates.
However, economists significantly disagree on what they consider to be the ‘correct’
model of the economy. Based on this difference we can categorize the intellectual
traditions in macroeconomics into two broad groups: the classical and the Keynesian
approaches. All the other schools of macroeconomic thought are the outgrowths of
these two approaches in one way or another. It is when we examine how policy
objectives are interconnected and how different economists view the role and
effectiveness of markets in coordinating economic activity that we find the
fundamental question that underlies disagreements between economists on matters of
policy, namely, what is the proper role of government in the economy?

In the following sections we will try to discuss the main schools of macroeconomic
thought emphasizing the historical backgrounds, the basic tenets and the policy
implications of each tenet as well as the failures of the tenets, in case they failed.

2. CLASSICAL ECONOMICS

Classical economics is really the start of economics as we know it. They did not have
a macroeconomic theory as such, but their ideas could be interpreted in a
macroeconomic framework, which we will do. The classical economists were famous
for attacking and successfully refuting the mercantilist doctrine. Mercantilists
believed that:
– 1. The wealth and power of a nation is determined by its stock of precious metals (in
the old parlance) or today it would be in its stock of foreign currency assets.
– 2. The government should actively intervene (through export subsidies and import
duties) to ensure that a nation’s stock of precious metals or foreign currency assets
was maximized.
Even today there are still various groups who believe, despite the arguments having
been refuted theoretically and empirically, that these principles hold true. Usually
they are cast as:
– 1. We shouldn’t allow foreigners to own land, companies, and the like because they
will make the government do bad things (hurt the environment, cause low wages, take
your pick).
– 2. Free trade, especially referred to as globalisation, is a bad thing because it hurts
the poor and low skilled or the things imported are worthless and not necessary, and

23
the like, or other countries are unfair because they have cheap labour, low
environmental standards, and the like. Oddly enough exports are usually seen as a
good thing (if no one is allowed to import who buys the exports?).
• Influential classical economists included:
– David Hume (1711-76) — Scottish philosopher.
– Adam Smith (1723-90) — Professor of Logic and then Professor of Moral
Philosophy in Scotland.
– Thomas Malthus (1766-1834) — Village Parson and then Professor of History and
Political Economy in England.
– David Ricardo (1772-1823) — stock market speculator and early retiree! [He made
a lot of money through his speculations.]
– John Stuart Mill (1806-1873) — was one of the best philosophers of his time.
– Karl Marx (1818-1883) — studied philosophy and gained a doctorate, editor of a
German newspaper, banished from Germany, lived in London.
– Alfred Marshall (1842-1924) — Professor of Political Economy in England.
– Arthur Pigou (1877-1959) — Professor of Political Economy in England.

Classical economists focused on real assets, rather than financial assets, as being
important because they determined the productive capacity of an economy. They also
argued that markets would act to co-ordinate people’s plans (i.e. the “invisible hand”
of Adam Smith). This view is captured by Say’s law.
– Jean-Baptiste Say (1767-1832) — French businessman, then Professor of Industrial
Economy, and finally Professor of Political Economy, both in France.
– Say’s Law states that the sum of the values of all commodities produced always
equals the sum of the values of all commodities bought. This definition was by
Keynes, and he may have misinterpreted what Say was actually saying! One version
of what Say said is that “for every buyer there must be a seller”, which is a much
weaker version. Commonly we say that “supply creates its own demand” and this is
the interpretation we will use. Finally it should be said that there was and is no unified
Classical macroeconomic theory. In fact macroeconomics as such did not exist before
Keynes. We will look at the basic tenets of this school of economic thought and their
policy implications.

2.1. Basic tenets of the classical school

1. The economy is inherently stable and this is achieved since prices and wages are
fully flexible. According to classical economists, the economy is always at its full
employment equilibrium. It is worth mentioning that classical economists were well
aware that a capitalist market economy could deviate from its equilibrium level of
output and employment. However, they believed that such disturbances would be
temporary and very short-lived. Their collective view was that the market mechanism
would operate relatively quickly and efficiently to restore full employment
equilibrium.
Implication: This tenet of the classical school has very important policy
implication. That is, there is no need for the intervention by the governments into the
economy via policy instruments since markets left to them selves can adjust quickly.
Hence, the best policy is to do nothing or follow the laissez faire principle/laissez
passer principle-No need for government intervention.

2. All economic agents (firms and households) are rational and aim to maximize their
profits or utility; furthermore, they do not suffer from money illusion.

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 Implication: The assumption of rationality and absence of money illusion
implies that money is super neutral. That is, changes in nominal variables (like change
in money supply) will not affect the real variables instead they affect only nominal
variables like prices.

3. All markets are perfectly competitive, so that agents decide how much to buy and
sell on the basis of a given set of prices which are perfectly flexible. That is, all the
assumptions underlying perfectly competitive markets hold.
Implication:

4. All agents have perfect knowledge of market conditions and prices before engaging
in trade. That is, no economic agent will cheat any other economic agent as a result of
perfect information or absence of information imperfection or information
asymmetry.
Implication:

5. Trade only takes place when market-clearing prices have been established in all
markets, this being ensured by a fictional Walrasian auctioneer whose presence
prevents false trading. According to this principle, in all markets transaction will take
place when equilibrium price is set after negotiations (via fictional auctioneer).
Implication:

6. Economic agents have stable expectations.

2.2. Classical aggregate supply and demand

According to classical economists, workers and firms in the labour market were
thought to learn reasonably quickly about their economic environment. Prices and
wages were also thought to adjust quickly and fully to economic changes. Firms also
acted to maximize the profits of their owners. If the price level increases, then both
workers and firms learn about this reasonably quickly. Firms increase the quantity of
labour they demand and workers decrease the quantity of labour they supply at the
initial nominal wage. The nominal wage is bid up to the point where the new real
wage is exactly equal to the old real wage. The aggregate supply curve is thus
vertical. The only things that were thought by the Classical economists to change the
position of the AS curve were changes in:
– 1. The capital stock.
– 2. Technology.
– 3. The skills of the workers.
– 4. etc.

On the other hand, the classical theory of aggregate demand centers on the quantity
theory of money. The basis for this theory is the theory of exchange:
MV ≡ PT
where,
– M = the quantity of money in circulation.
– V = the transaction velocity of money.
– P = the price level.
– T = the volume of transactions.

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The equation of exchange is an identity, in that it must hold always. With further
assumptions the equation becomes a theory. In particular, Classical economists argued
that:
1. Constant Short-Run Transactions Velocity of Money
The transactions velocity of money was assumed to be determined by institutional
factors involved with the payment habits and the payment technology of society such
as:
◦ The average length of the pay period (e.g. shorter pay periods implied a smaller
average holding of money for any income level and hence the velocity would
increase).
◦ The prevalence of trade credit among businesses.
◦ The practice of using credit cards and other money substitutes.
It was also assumed that these changed only infrequently thus the velocity could be
regarded as fixed in the short-run.

2. Volume of Transactions Proportional to Real Output

The volume of transactions was assumed to be equivalent to the level of real output
produced in an economy and is regarded as determined by factors controlling the
labour market and production technology. This meant that we can replace T by Y,
where Y is output, and that output is fixed given the preferences of workers and firms,
the level of technology, and the amount of capital available. Note that classical
economists assumed that the economy is always at its full employment level
equilibrium or at potential output level of the economy. But the potential output level
is determined by the resource endowment and state of technology which are
reasonably constant in the short run imply that the output level is also constant in the
short-run. (Note that shift in the potential output level comes as a result of growth
which is a long-run concept).

3. Exogenous Money Stock

The money stock was determined by factors such as the government and taken as
given. These assumptions imply the quantity theory of money,
MV = PY
A change in the money stock feeds through into the price level, but has no impact on
output. This can be modeled as assuming a downward sloping AD curve which
depends only on the stock of money.

2.3. Equilibrium output and the price level

Putting the Classical AD and AS curve representations together we get the following
picture:
[See Classical AS-AD graph]
If the money stock increases, then AD (effectively — as the quantity theory is only an
implicit theory of aggregate demand) increases but the only thing that happens is that
the price level increases. It is a story of “too much money chasing too few goods”, so
that prices increase to restore equilibrium. This also shows the classical assertion that
money is super neutral- change in money stock in the economy will affect only the
price level (nominal variable) and not real variables like output.

2.4 Equilibrium interest rate

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The Classical theory predicts that the price level and output level are determined
independently of the interest rate. That said, the interest rate is still important in the
Classical system. The role of the interest rate is to stabilise aggregate demand. The
interest rate was considered by the Classical economists to be determined in the
market for loanable funds, the market in which bonds are sold and bought.

Net Suppliers of Bonds (Net Borrowers) are assumed to be:

1. Firms

Firms routinely undertake investment projects. The firms look at the expected
profitability of the projects which depend (positively) on future expected demand, and
(negatively) on interest costs. Investment is thus expected to depend negatively on the
interest rate.

2. Government.
Governments need to fund their deficits through borrowing. It is assumed that this
depends on government expenditure and taxation, both of which are not affected by
other economic variables, that is they are exogenous and are affected by such things
as wars and natural disasters.
Net Purchasers of Bonds (Net Lenders) are assumed to be:
1. Households.
People save for the future. Since saving is forgoing consumption today some payment
is required to induce people to do this with positive interest rates reward people for
saving. It is assumed that a higher interest rate will induce people to save more today
(and thus consume less today). The equilibrium interest rate ensures that the amount
of bonds supplied by borrowers equaled the amount of bonds demanded by the
lenders. We can show this situation graphically by:
[See Classical loanable funds graph]
Say that firms believe that future demand would be higher and thus believe that more
investment projects are profitable than currently is the case. The demand for loanable
funds would shift to the right as shown in the following graph:

[See increase in investment demand graph]

The increase in the demand for loanable funds leads to the following series of changes
in behaviour. First, it results into an increase in the interest rate. Then the higher
interest rate leads to a smaller number of extra projects going ahead compared to the
increase in demand at the initial interest rate (although some new projects do still get
undertaken). The higher interest rate also leads to an increase in the supply of
loanable funds because the higher interest rate increases savings by the lenders. The
increased saving by households is achieved by reducing the amount of consumption
undertaken. Overall, the increase in the demand for investment goods exactly matches
the decrease in the demand for consumption goods and so AD is unaffected. This
shows how the interest rate acts as a stabilizing mechanism in the Classical model.

2.5 Implications of the classical model

We can sum up the important implications of the Classical model as follows:
1. Money supply changes have no affect on current output, and only affect the price
level.

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2. Changes in government expenditure have no effect on current output and only
affect the interest rate, and the amount of investment and consumption undertaken.
To see this consider what happens if government expenditure increases:
[see increase in G graph]

The increase in G increases the demand for loanable funds given the initial level of
taxation. The interest rate increases in response. This causes investment demand to
decrease (this is “crowding out” with implications for future output). It also causes
saving to increase and consumption demand to decrease. The increase in G is exactly
offset by the fall in I and the fall in C.
3. Changes in the overall level of taxation do not affect current output.
4. Changes in marginal tax rates can cause current output to change.
A decrease in the marginal income tax rate, say, would cause after-tax income to
increase inducing an increase in the supply of labour. Equilibrium employment will
increase and as a result the aggregate supply curve will shift to the right.
• The end result from this analysis is that:
1. Traditional government policy tools will not affect output or employment.
2. Traditional government policy tools will in fact add instability or decrease future
output.
3. Markets quickly adapt to economic changes.
4. There is a basic stability about the economic system when left to itself.
5. Given 1-4, if the economy does work this way, then letting markets work properly
is the best thing that governments can do (i.e. get rid of taxes, subsidies, price controls
like minimum wages etc).

3. ORTHODOX KEYNESIAN MACROECONOMICS

The Classical school of thought was dominant until the 1930s. During this time two
separate schools of thought also arose:
1. Marxist economics in the 1840s
2. Austrian economics in the 1870s
But they were not the dominant ways of thinking about macroeconomics, although
they did influence classical economic thinking. In the 1930s a major world event
occurred that gave rise to a new way of thinking about the operation of the
macroeconomy, Keynesian economics, which challenged the dominance of classical
economics. This event also led to the formal creation of the branch of economics that
we know of as macroeconomics. Influential Keynesian economists included:
– 1. John Maynard Keynes (1883-1946) — lecturer of economics at Cambridge
University, position at the UK Treasury, studied mathematics, philosophy and
economics, chief architect of the IMF. [He increased the assets of the superannuation
fund of Cambridge University considerably through speculations he made on its
behalf, not to mention making a fortune for himself. There are, however, some who
claim that this was based on inside information.]
– 2. Paul Sameulson (1915-) — Chair of Economics at MIT, much more a
microeconomist, than a macroeconomist, but his textbook had a profound influence in
bringing Keynesian economics into the mainstream, won the Nobel prize in 1970.
– 3. James Tobin (1918-) — Professor of Economics at Yale, won the Nobel prize in
1981.
– 4. Franco Modigliani (1918-) — Professor of Economics and Finance at MIT,
learnt law first, won the Nobel prize in 1985.

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– 5. Robert Solow (1924-) — Professor of Economics at MIT, won the Nobel prize in
1987.
The major work of Keynes’s was his “The General Theory of Employment, Interest
and Money” published in 1936. This was a response to the Depression era, and
ushered in Keynesian economics. Sir John Hicks (1904-) interpreted the work of
Keynes’s in a graphical and algebraic fashion and gave rise to the IS-LM model.
– Sir John Hicks (1904-) — Professor of Political Economy at Oxford University,
won the Nobel prize in 1972.
Keynes, through his work, created the subject of macroeconomics, which did not
explicitly exist until he came along. Oddly enough there is considerable doubt Keynes
was actually a Keynesian in the orthodox Keynesian sense! Some people argue that
the work of Keynes was misinterpreted by those we now refer to as Keynesians.

3.1 The great depression

What challenged the theories of the Classical economists and motivated Keynes was
the effects of the Depression of 1929-1933. It seemed that even if the views of the
Classical economists accurately described the macroeconomy in the long-run, they
did not seem able to explain something like the Great Depression. Classical
economists argued that markets in an economy could experience a temporary
disequilibrium but would attain equilibrium relatively quickly. This means that
economies are inherently stable and that self-correcting mechanisms exist to move an
economy back to equilibrium quickly. This prediction was contradicted by 25%
unemployment, which seems to reflect a large degree of economic disequilibrium, and
since this existed for many years it did not look as though markets adjusted very well
or very quickly. It looked like the Classical views of the economy could not explain
relatively short-run fluctuations such as the Great Depression. This weakness was
what Keynes addressed.

3.2 Basic tenets of the orthodox Keynesian model and their policy implications
1. The Economy is inherently Unstable and Is Subject to Erratic Shocks
It was believed that most of the economic shocks originated in investment plans of
firms because of changes in business confidence about the future demand for output
and hence the profitability of the relevant projects. That is, there is a lot of uncertainty
(non-quantifiable) relative to risk (quantifiable) about expected benefits from
investment projects, which makes investment inherently volatile. It was then argued
that these “animal spirits” in investment plans could produce sudden and large
changes in AD and output.
Implication: An implication of this argument is that there is always the
possibility that an economy may get “stuck” producing less than full employment
level of output. A severe example of this type of behaviour was taken to be the Great
Depression where investment dropped, and international trade collapsed due to
increased worldwide protection.
2. The Economy Can Take a Long Time to Return to Being Close To Full
Equilibrium after Being Subjected To a Shock
The economy is not rapidly self-equilibrating and could have high unemployment and
low output for long spells (i.e. because the effective demand curve was different from
the notional demand curve).

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3. Need for Government Intervention
An obvious implication of the orthodox Keynesian model given 1. and 2. is that there
are times when government intervention may be required. Furthermore, given the
animal spirits nature of investment plans, governments should always be watchful and
ready to “fine-tune” when necessary. The Great Depression was seen as being such a
time when the economy was demand constrained and government action was needed
to increase aggregate demand.
4. AD Is the Predominant Determinant of Output and Employment, and AD Can
Be Altered By the Authorities
The fall in investment demand and the demand for exports was used as evidence for
this claim. Government policies can affect aggregate demand and return an economy
to full-employment.
5. Fiscal Policy Is Preferred To Monetary Policy in Carrying Out Stabilization
Policies
Monetary policy takes too long if it is going to have any effect and is likely to have a
weak effect if it has an effect at all. The effects of fiscal policy are immediate and
strong. As a result, fiscal policy is much better than monetary policy for fine-tuning
since it is more direct, more predictable, and faster acting on aggregate demand than
is monetary policy.

6. Information is The Key

Keynesian theories put the spotlight on the key facet of the working of markets, that
the price system acts to efficiently transmit all the necessary information to market
participants so as to co-ordinate all of their plans. If prices are not allowed to change
to carry new information, or if people are not capable of seeing all of the relevant new
information, then the market system may not work well.
• There are three points worth noting from these conclusions:
1. Take Results In Context.
At the time that orthodox Keynesian economic policies were being developed the
government was not a major part of the economy (i.e. G/Y and T/Y were quite small
compared to today). It is doubtful that Keynes wished the government to as involved
as it is today. There are also claims that just before he died that he was about to
publicly criticize the actions promoted by people in the name of Keynes, because he
felt his theories and work were being misused and misapplied!
2. Contrast between Orthodox Keynesians and Classical Economists
Notice the contrast in the stance taken by orthodox Keynesians versus that of the
classical economists. As we shall see the conflict between the basic tenets of the
Classical and Keynesian economists repeats itself throughout macroeconomics in
different guises and is very dependent on the experience of the economy at the time
the views are formulated!

3. Historical Accuracy Questionable

It is debatable how much of the depression was the fault of markets and how much it
was the fault of poor government policies. Government policies likely caused the
world financial crisis through the vengeful reparations imposed on Germany after
World War I and then heavily restricting trade by using tariffs and quotas against
imports. Governments likely exacerbated the economic recession because they tried to
run balanced budgets through heavy decreases in government spending. Government
exchange rate policies also seem to have been important in exacerbating the recession

30
because the value of currencies were tied to gold or silver and thus were not allowed
to depreciate in value. Those countries not tied to silver or gold had much milder and
shorter economic downturns than those who did tie their currencies to these precious
metals.

4. MONETARIST MACROECONOMICS
Keynesian economics was the dominant macroeconomic way of thinking until the
1950s when the work of an economist at the University of Chicago challenged its
position. It did not really challenge the framework of analysis, as Keynesian
economics had done with classical economics. It was more about the importance of
various factors in describing how the macroeconomy worked and was thus really an
empirical argument. Influential monetarist economists included:
– 1. Milton Friedman (1912-) — taxation analyst in the US Treasury, Professor of
Economics at the University of Chicago, won the Nobel prize in 1976.
– 2. Karl Brunner (1916-) — worked for a bank, Professor of Economics at the
University of Berne.
– 3. Allan Meltzer (1928-) — Professor of Economics at Carnegie Mellon University.
– 4. David Laidler (1938-) — Professor of Economics at the University of Western
Ontario.

The impetus for monetarism did not seem to be due to an external event, to the best of
my knowledge, but was due to the research work of an individual based on
introspection and casual empirical observation. Monetarism came in two waves, first
in the mid-1950s to the mid-1960s and then from the mid-1960s to the mid-1970s, but
it originated with Friedman who attempted to revive the quantity theory of money.
Essentially Friedman did not believe that the Keynesian view that money had little or
no macroeconomic impact and so he set out to see whether this was the case. Much of
what followed in the first wave was not a rejection of the IS-LM type of framework,
but a debate about the actual values of the parameters of the model. There were also
disagreements, particularly in the second wave, about policy issues that really could
not be addressed in the IS-LM type of model.
4.1. Basic tenets of the Monetarist school of thought and their implications
1. Importance of the Quantity Stock of Money
Monetarists argued that changes in the money stock are the predominant, though not
the only, factor explaining changes in money income. Monetarists thus thought
monetary policy was the predominant policy tool, whereas fiscal policy was seen as
unimportant.
2. Inflation and the Balance of Payments are Essentially Monetary Phenomena
We have seen above that changes in M tend to cause changes in P, hence the belief
that inflation is essentially a monetary phenomenon. The amount of money in
circulation, and inflation, also impacts on the exchange rate, imports, and exports, as
we have seen, hence the link with the balance of payments.
3. No Long-run Tradeoff Between Inflation and Unemployment
The short and long run Phillips curves were accepted as how price and quantity
adjustment occurred given an economic shock. This implies that the long-run Phillip’s
curve is vertical at the natural rate of unemployment. Differences in opinion did occur
over the speed of the adjustment — relatively quickly for monetarists, relatively
slowly for Keynesians.
4. Stable Macroeconomy

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Monetarists thought that governments were the main source of shocks (e.g. The
economy is inherently stable unless disturbed by erratic monetary growth).
Monetarists said that the market system was not perfect, but that governments would
only make things a lot worse. When subjected to some disturbance Monetarists thus
argued that the economy will return fairly rapidly to the neighbourhood of long-run
equilibrium at the natural rate of unemployment. They argue that the depression was a
bad recession turned into a bad depression by bad government monetary policy.
5. Policy Rules
Monetarists argued that it is optimal for the authorities to follow rules for monetary
aggregates to ensure long-run price stability. They also argued that fiscal policy could
only be used to influence the distribution of income and wealth, and the allocation of
resources.
6. Monetarists Argued That the Only Way to Increase Output Permanently
Was To Make Markets Work Better
e.g. get rid of minimum wages, reduce the power of unions, do not have things like
affirmative action, get rid of tariffs, quotas, subsidies, etc.
The basic difference between monetarists and orthodox Keynesians can be ascertained
in the following quote from Franco Modigliani taken from his 1977 Presidential
Address to the American Economic Association:
“Nonmonetarists accept what I regard to be the fundamental practical
message of The General Theory: that a private economy using an
intangible money needs to be stabilized, can be stabilized, and
therefore should be stabilized by appropriate monetary and fiscal
policies. Monetarists take the view that there is no serious need to
stabilise the economy; that even if there were a need, it could not be
done, for stabilisation policies would be more likely to increase than
decrease instability.”

4.4 THE PHILLIPS CURVE

The second “wave” of monetarism dealt with the split of the effects of changes in the
rate of monetary expansion between nominal and real magnitudes. This had to do with
the Phillips curve which was discovered in 1958 by a New Zealand born engineer
who lived in the UK called A. Phillips:
– Alban Phillips (1914-1975) — electrical engineer, served in the RAF, lectured at the
LSE, Professor of Economics at the University of London, and then Professor of
Economics at the Australian National University. He found the following relationship:
[see original Phillips curve graph]
There seemed to be a systematic relationship between the rate of change in money
wages and the rate of unemployment for the UK. The key characteristics of this
relationship was that it was inverse and non-linear. This finding was repeated in
studies of other countries. The explanation for the finding was that:
1. Increases in the demand for output would increase money wages or incomes
because of increases in the demand for labour.
2. Increases in the demand for output would decrease the rate of unemployment
because demand for labour would increase so as to produce the output.
Typically the Phillips curve is given as a relationship between the inflation rate and
the unemployment rate. This can be justified on two grounds:
1. If prices are just markups from wages then the two will move together.

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2. Empirically, the evidence shows that movements in prices and wages are very
similar (e.g. prices depend on costs, and a major cost of production is the wage and
salary bill).
Using these arguments the “normal” Phillips curve is given by:
[see “normal” Phillips curve graph]

Algebraically the Phillips curve is given as:

where,

We can use the AS-AD model to show the economics behind the Phillips curve
relationship as follows:
[see AS-AD Phillips curve graph]
Note that this is in terms of levels, instead of growth rates, but this is of only minor
importance and the underlying arguments follow through for growth rates. The
Keynesians jumped on this finding as showing that there is a permanent trade-off
between inflation and unemployment, although it also meant that the Keynesians
abandoned the version of the SAS curve which is perfectly horizontal.

4.5 Expectations and the Phillips curve

Short-Run: Money Illusion
The Phillips curve result gave a strong justification for Keynesian stabilisation
policies and also showed what governments needed to do to stabilise the economy.
This approach seemed to work well until the late 1960s and early 1970s when
problems began to emerge with the Phillips curve.
What was being found was that the Phillips curve was not stable over longer time
frames, it changed position. In particular, higher inflation rates seemed to be
associated with lower levels of unemployment initially, but then the unemployment
rate seemed to return to its value before inflation had increased. Both Keynesian and
Monetarist economists were puzzled as to why this phenomenon occurred and tried to
figure out what was going one. Edmund Phelps (not a monetarist, but a new
Keynesian) and Friedman arrived at the same answer independently. The trade-off
between inflation and unemployment required that workers suffered from money
illusion. That is, workers based their decisions on the nominal but not real wage. Both
Friedman and Phelps argued that workers and firms do enter into contracts which set a
nominal wage, and the real wage and hence unemployment may change over the
period of the contract which is why there seems to be this trade-off between inflation
and unemployment in the short-run.
Long-Run: No Money Illusion
Both Friedman and Phelps argued that in the long-run this trade-off is untenable since
such contracts tended to be for a finite period, say a year, however, at which time the
workers would try and “catch-up” with the intervening inflationary period and the real
wage would return to its initial higher level. What is more, it must be the case that
when entering such contracts that workers and firms bargain on the basis of their
expectation of the price level, and hence the real wage, over the contract period. In

33
other words there can be a short-run trade-off between inflation and unemployment,
but not a long-run trade-off. This view won the day and the evidence seems to
confirm this point of view!
This data tends to show that eventually all that happens with a change in M is a
change in P with no change in Y in the long-run.

Combining the Short-Run and the Long-Run

Graphically, the empirical results suggested the following sort of explanation:
[see SR and LR Phillips curve graph]
noting that wage contracts are usually staggered so there will be some changes in
wages over any given period. Algebraically the expectations adjusted Phillips curve is
given as:

34
5. NEW CLASSICAL MACROECONOMICS

Monetarism and Keynesian economics battled it out until the early 1970s, after which
a combination of two things were to lead to their demise as the main schools of
macroeconomic thought. The successor macroeconomic way of thinking did,
however, include a lot of the ideas of the monetarists. Influential new classical
economists include:
– 1. Robert Lucas (1937-) — undergraduate degree in history, Professor of Economics
at the University of Chicago, won the Nobel prize in 1995 (in a divorce settlement, his
wife put a clause in the agreement saying that she was to get half the proceeds if he
won a Nobel prize. She got half a million US dollars as a result!).
– 2. Neil Wallace (1939-) — worked in the US Federal Reserve Banks, Professor of
Economics at the University of Minnesota.
– 3. Thomas Sargent (1943-) — Professor of Economics at the University of
Minnesota.
– 4. Robert Barro (1944-) — undergraduate degree in physics, Professor of
Economics at Harvard University.
New classical economics was initiated by Robert Lucas and arose for two reasons:
– 1. Theoretical: introspection and a dislike for the monetarist and Keynesian
modeling of the macroeconomy (this was the impact of the genie out of the bottle).
– 2. Empirical: inconsistencies between Keynesian and monetarist models and what
actually happened in the 1970s resulting from the oil price shocks.

5.1 Stagflation and aggregate supply

The Phillips curve relationship found in 1958 and elaborated on in the 1960s seemed
to promise that there was a stable trade-off between inflation and unemployment. The
experience of the late 1960s and, in particular, the 1970s blew this relationship apart.
During this period, most economies experienced both high rates of inflation and high
rates of unemployment (or almost stagnant levels of real output) referred to as
stagflation.
In addition, inflation and unemployment seemed equally likely to move together, as to
move in opposite directions. Obviously a single short-run Phillips curve would have
trouble explaining these movements, hence the expectations augmented inflation
curve.

35
In addition, the magnitude of the changes in unemployment, given the size of the
changes in inflation seemed very large. Some economists argued that the size of these
changes seemed inconsistent with adaptive expectations, which implied that people
would adjust their explanations slowly over time. To be fair to the adaptive
expectations proponents, the size of the adjustment does depend on the difference
between the previous and current values (i.e. on the size of the error). This means that
larger changes will cause larger errors and therefore larger adjustments in people’s
expectations. Some economists still thought that the movements were much larger
than could be explained by this sort of argument. Finally, the shocks to the world
economies that seemed to cause the changes in the 1970s were not the standard run-
of-the-mill shocks that people and economists were used to.

The oil-price shocks are obviously the main ones, but there were other shocks for
other countries. Notice that these were not changes in investment demand, nor in
fiscal and monetary policy. These were changes that affected the production of
output; they were shocks to the AS curve. Up till this time economists had really just
focused on AD since the Great Depression and Keynes, and the events of the 1970s
caused economists to think once again about the supply-side of an economy.
• In summary the following occurred:
– 1. Unemployment and inflation were equally likely to change in the same direction
as the opposite direction.
– 2. The changes in inflation, unemployment, and output were a lot larger than
predicted by adaptive expectation theories and models.
– 3. The economic shocks that were occurring were not of the normal types. And the
IS-LM/AS-AD and PC models couldn’t capture all of these phenomena. A puzzle
indeed!

5.2 Rational expectations

Keynesians and monetarists both believe that there is a difference between the short-
run and long-run views of the world. The key here is the view that expectations about
the price level by employees are fixed in the short-run. This means that the labour
supply schedule does not change with government policies (that is, people don’t react
to the policy changes); hence government policies can affect employment and output.
Note that in the long-run expectations adjust to the effects of the policy action, it is in
the short-run that they differ. Note also that in the orthodox Keynesian world that
expectations are effectively static, that is they never change (except for those formed
by businesses about future profit levels!). Expectations are backward looking in the
Keynesian and monetarist worlds and so they change slowly with people making
systematic predictable mistakes. In the early 1960s an economist called John Muth
developed a model where agents had forward looking expectations. He argued that:
1. People Would Look To the Future
People do not just look to the past, but would also look to the future. In doing so they
would use every piece of information they had available to predict what was going to
happen in the future.
2. People Would Use Information Intelligently
People would form expectations using the relevant economic theory. That is, people
would understand the way in which the economic variables they observe affect the
variable they are forming expectations about (or trying to predict).

36
3. People Would Not Make Systematic Errors
When forming expectations people would not keep getting it wrong. This is in
contrast to the Keynesian theory of expectation formation people make systematic
errors. The thing to notice is that these systematic errors make people worse off than
if they had made no errors when forming their expectations. This means that people
have an incentive to avoid making systematic errors and therefore will not make such
errors. John Muth argued that expectations are formed rationally.
– Rational Expectations are forecasts that use all of the relevant information available
about past and present events, and that have the least possible errors.
People who form rational expectations do make mistakes, but they do not make
systematic mistakes. That is, people’s expectations are correct on average. This
development had obvious differences compared to the previous schools of thought:
1. Different From Classical Economics
The New Classical view is different from that of the Classical economists who
believed that except in the very short-run that people had perfect information.
2. Keynesian and Monetarist Economists Argue That Expectations Are Not
Formed Rationally
Information is costly to obtain and it is unlikely that people will have all the
information necessary. There are situations where asymmetric information occurs
between sellers and buyers. People are not machines and are not perfect at processing
what information they have, they tend to use “rules of thumbs”. We do not even agree
upon a “right theory” of the macroeconomy, so why should we assume that people
behave as though there is only right theory.

5.4 Basic tents of New Classical economics and their implications

• The position of New Classical economists and what they tend to believe about how
economies work can be summarised as follows:
1) Expectations Are Formed Rationally
NCEs argue that logical tells us that people will not make consistent mistakes if they
can avoid it, and that this, plus the available evidence supporting this argument, mean
that expectations of firms and consumers in a model should be consistent with the
predictions of the model used to characterize the economy.
2) Markets Continuously Clear
This is a rejection of the Keynesian view that the economy can be demand deficient.
NCEs argue that prices and wages will adjust quickly to clear markets and that any
unemployment occurs because of government intervention such as minimum wages or
is due to the normal operation of an economy such as resources being transferred from
less to more productive uses.
3) Short-Run Aggregate Supply Is Upward Sloping
NCEs argue that the short-run AS curve is upward sloping because of information
imperfections (this is the firm and worker imperfect information type of model) and
that furthermore, the SAS also depends on expectations about all of the relevant
exogenous economic variables, including M, G, and T.
4) Long-Run Aggregate Supply Is Vertical
NCEs argue that in the long-run people have perfect information implying that the
LAS curve is vertical and that in the long-run the AS curve is altered only by making
markets work more efficiently, by increases in the capital stock, or by better
technologies. These beliefs by new classical school economists about how economies
work have two major implications:
1) Policy Ineffectiveness Postulate

37
New Classical economists argued that the policy ineffectiveness postulate held in the
behaviour of economies:
◦ Policy Ineffectiveness Postulate states that real output and employment are
unaffected by systematic, and therefore predictable, changes in aggregate demand
policy.
Let us use an example to see why New Classical economists argued this.
Example: Unanticipated Autonomous Decline In Investment Demand
◦ Unanticipated ↓ I: Say autonomous investment falls from I0 To I1 because firms
expect that profits in the future will be lower than previously thought.
[unanticipated fall in I graph]
The AD curve will shift to the left. If nothing else occurs then Y and P both fall (to Y1
and P1). The fall in P is confused as a fall in the relative prices of firm’s output and
subsequently as a fall in the real wage by workers. Both the Ls and Ld curves will
shift to the left (labour traded falls from L0 to L1). This is the reason output falls.
◦ Policy Response: Say now that the government takes an expansionary policy action
to offset the fall in I, say an increase in G. It is likely that people will know that the
government is taking an expansionary policy, so it will be anticipated (ie. Ge 1 > Ge
0). For example a Labour government believes that employment is important and that
monetary and fiscal policies should be used to keep unemployment low. The increase
in G will shift the AD curve out to its original position.
[unanticipated fall in I graph]
People expect this to happen and adjust their expectations of P accordingly, based on
the fact that Ge has increased and that people know the underlying working of the
economy. Both the Ls and Ld curves stay to the left where they ended up when I ↓,
since both curves depend upon the expected level of government spending, among
other things. Effectively, the AS curve shifts to the left. In the end government
spending has no effect on output or employment, but does cause P to increase, to P2
relative to P1, where P1 is the price level if government spending does not change.
The logical conclusion is that the government cannot offset negative shocks, such as
the fall in investment demand.
◦ Anticipated ↓ I: Consider what happens if people anticipate that I will fall. It is the
same story as above for AD.
[anticipated fall in I graph]
It is a different story for AS. People’s expectations of P depend on their expectations
of I. If Ie falls then people believe that P1 < P0. Both Ls and Ld do not change
position. The AS curve effectively shifts to the right. There is no change in output or
employment from the fall in I.
The basis of these results is that expectations are formed rationally, which means that
suppliers of, and demanders for, labour do not make systematic mistakes in
forecasting the price level. As a result, anticipated policy actions will only affect
nominal variables in both the short-run and the long-run. This implies that only
unanticipated policy actions have any effect in a new classical world and so
governments cannot deliberately offset any economic shocks. The result of all of this
is that the New Classical view of the world
implies that there is no role for government policy, other than not to destabilize the
economy — that is random government policies and lots of inflation are undesirable.
2. Economy Is Self-Correcting
While the initial affect of an economic shock is to alter employment and output, this
will not last as people learn about what has happened. Once people have learnt what
has happened then expectations will adjust to the new situation and employment and

38
output will return to their original values. We saw this above as once people learnt
about the fall in I they adjusted their expectations and the economy went back to its
original levels of employment and output.

6. REAL BUSINESS CYCLE MACROECONOMICS

New classical theory became the dominant school of macroeconomic thought and in
some ways it still is, although two other schools of thought have subsequently arisen
during the 1980s. One was an extension of new classical economics. The other was an
extension of an earlier school of thought which incorporated the ideas introduced by
new classical macroeconomics. Neither of these latest developments challenged the
underlying framework of new classical economics. As with the debate between
monetarists and Keynesians, this debate tended to be empirically based. We will look
at one of these schools now, and then the other school. Influential RBC economists
include:
– 1. Ed Prescott (1940-) — Advisor at the Federal Reserve Bank of Minneapolis and
Professor of Economics at the University of Minnesota (and also a dreadful public
speaker!).
– 2. Charles Plosser (1948-) — Dean and Professor of Economics at the University of
Rochester.
• While new classical economics revolutionised macroeconomics, particularly
because of the introduction of rational expectations, it had trouble explaining an
important empirical fact. This was that deviations from capacity output tended to be
prolonged and correlated, or in the same direction). New classical economics implied
that such deviations should be short-lived and random in direction. One explanation
was that there were informational time lags, that it took several periods in the future
before people would fully learn what had happened. Many people found this to have a
ring of truth to it, but not to be able to explain the magnitude and length of some
recessions and expansions. Furthermore, the AD-AS model was static in nature and
missed out all this inter-temporal behaviour so it was an inappropriate tool to use to
think about economic behaviour of several years. This gave rise to the real business
cycle theory of economic fluctuations. A lot of this work is computationally very
intensive, and it just happened to coincide with the advances in cheap personal
computing power in the 1980s.

6.1 Random walks

• The key empirical fact that gave rise to the RBC school of thought was the finding
that shocks to US output changed the path of output over time. In technical terms this
is to say that output exhibited a random walk. Another way of putting it is that output
did not revert back to its trend. The following graph shows the difference between a
trend reverting case and a random walk case.
[random walk and trend reversion graph]
Since output did not revert back to its trend value, shocks to output could not result
from monetary sources but must be from real sources, hence the view that business
cycles are caused by real shocks.

6.2 Intertemporal substitution

• The major question this behaviour raises is how do such shocks result in prolonged
correlations of deviations of output from trend? The key is how the shocks (or
impulses) are transmitted (or propagated) in the economy. For RBC theories this

39
involves explicitly acknowledging that an economy is intertemporal in nature and that
shocks have impacts over time.
• Example: A Favourable Period of Technological Innovation
– First note that this is favourable real shock to the economy. RBC economists would
then argue that is affects the economy in the following ways:
1. The Labour Market
The favourable technology shock makes all factors more productive, including labour.
As a result, the MPL increases and real wages paid to labour increase. This causes the
real wage today to be relatively higher than the real wage tomorrow and so people
substitute labour tomorrow for labour today. The end result is that employment
increases (ie. hours, if no frictions: no. of people, if search type of model).
2. Savings and Investment
Capital also becomes more productive. This increases the MPK, and the return to
capital, or the real interest rate, increases. The increase in r means that the price of
consumption today relative to tomorrow increases, and so people transfer their
consumption from today to tomorrow. That is, the level of savings increase. As a
result, investment increases because that is how people save from one period to the
next in the end.
3. Output Tomorrow
The higher investment today means a higher capital stock tomorrow. A higher capital
stock increases the MPL, ensuring that labour is transferred from the future to the then
current period. The resulting increase in the available factors of production, capital
and labour imply that output will be higher than it would have been for the shock.
– Eventually, another shock, either negative or positive, will occur and start a similar
process of effects.
• Finally, you should note that the RBC is really not able to be graphically shown on
the AS-AD graph we have been using because the theories involve inter-temporal
trade-offs with the key variable affecting output today being the real interest rate and
not the price level. We can however think of the RBC theories as being similar to
those of the classical school with the AS curve being vertical so that changes in M or
G have no effect on employment or output and long-run changes in employment and
output occur because of shifts in the position of the AS curve.

6.3 Basic tenets of RBC School of Economics and their implications

The position of Real Business Cycle economists and what they tend to believe about
how economies work can be summarised as follows:
1. Expectations Are Formed Rationally
RBCEs argue that it is logically inconsistent for people to make systematic mistakes.
They argue that if a theory predicts certain relationships between variables, then
people “living in the theoretical world” should use the theory to form their
expectations.

2. Market Are Always Clearing

RBCEs also argue that microeconomics tells us that prices and wages adjust to clear
markets. They argue that macroeconomics should be consistent with microeconomics,
because it is just the adding up of individual markets. The implication is that
unemployment in this world can only be through the normal operation of the market
economy or because of government interventions such as minimum wages.

40
3. Money Is Neutral
Typically we have seen that periods where the growth of the money supply is reduced
leads to lower inflation and higher unemployment, so how do RBC economists
explain this fact? RBCEs argue that the supply of money does change with changes in
output but that they argue that central and commercial banks change the amount of
money in circulation to accommodate increases in demand arising from changes in
income. This implies that the money supply is endogenous. This theory is also exactly
the opposite position to that taken by Monetarists. It just reinforces the point that
causality is a difficult thing to prove in many cases in economics given the paucity of
accurate data about people’s behaviour .
4. Economic Fluctuations Are Due Only To Supply Side Factors
Given the assumptions about the way an economy behaves in 1-3, RBCEs argue that
the implication is that output and employment change because of changes to things
like:
◦ The rate of technological change.
◦ Natural disasters or good growing seasons.
◦ Tax rates.
◦ Input price changes.
◦ Changes to incentives from things like the social welfare system.
In the first wave of RBC theories, essentially what holds for the classical school of
economics also holds for the RBC school. There are some differences (ie. There is no
real concept of AD in the IS-LM sense in the RBC theory, but there is in the classical
theory), but the basic conclusions are the same. The second wave of RBC research has
broadened in its approach to include market imperfections on the supply side (say due
to imperfect information, contract on nominal variables, etc) and have found that lo
and behold that in such situations money is not neutral in the short-run.

7. NEW KEYNESIAN MACROECONOMICS

At the same time as RBC theories were emerging, so too was another set of theories.
This was an attempt to reincarnate (revive) earlier thoughts about how the
macroeconomy worked, but dressed up in the new classical framework. The
underlying points of disagreement were of an empirical nature. Influential new
Keynesians include:
– 1. Edmund Phelps (1933-) — Professor of Economics at Columbia University.
– 2. Greg Mankiw (1958-) — Professor of Economics at Harvard University (has a
dog called Keynes).
– 3. David Romer (-) — Professor of Economics at the University of California at
Berkeley
While the new classical and RBC schools of thought assumed clearing markets, it
appeared to some economists that in recessions some people who were unemployed
did not want to be. On the other hand, they had no convincing reason as to why there
should be “involuntary unemployment”. This led several people to sit down and have
a think. Their basic goal was to see if they could come up with a model with agents
forming their expectations rationally, which had good ties with microeconomics, but
in which unemployment could occur and in which changes in the money supply had
an affect.

41
7.1 Empirical criticisms of New Classical and RBC theory

• There were three main criticisms of New Classical and RBC theories:
1. Unhappy Workers
Firms and workers do not appear to be happy to cut production and hours worked
during a downturn. If it was voluntary then surely they would be happy because it was
in their interests.
2. The 1982 US Recession
After a period of historically high levels of inflation, the US Federal Reserve
announced ahead of time that it was going to take strong action to reduce inflation by
decreasing the rate of growth in the money supply. Such an action seems as though it
should be perfectly expected by people and therefore should have no real effects, but
it seemed to have caused a long and severe recession.
3. Intertemporal Substitution of Labour
The available evidence concerning the substitution of labour between periods seems
to suggest that such substitutions are not nearly as large as required by RBC theories
of the economy, although it is not conclusive.
7.2 Price and wage rigidities
New Keynesians have suggested several possible reasons as to why changes in the
money supply and other changes to aggregate demand may have real effects, as well
as supply side shocks. We have seen several of them before:
– 1. Efficiency Wages
– 2. Insider-Outsider Union Models
– 3. Contracts and the Staggering of Price and Wage Changes
– 4. Menu Costs and Imperfect Competition
As with the RBC theories, the AS-AD model does not really capture many of the
features of the new Keynesian school of thought. This is not helped by the fact that
there really is no general new Keynesian theory at present!

7.3 Basic tenets of New Keynesian school of economics and their implications

The position of New Keynesian economists and what they tend to believe about how
economies work can be summarised as follows:
1. Market Imperfections Exist
Some firms have market power, because of increasing returns to scale, or
monopolistic competition. Buyers tend to have less information about the quality of
what they are buying than the sellers, that is, asymmetric information exists.
2. Prices and Wages Are Sticky In the Short-Run
Even with rational expectations and better microeconomic foundations prices and
wages may be slow to adjust. Market imperfections such as imperfect competition or
asymmetric information can lead to sticky prices and wages.

3. Money Is Non-Neutral
This is a natural consequence of 2.
4. AS Shocks Are Important
No one doubts what happened during the oil price shocks period. Note that this is
different from the original Keynesians where only AD mattered.
At this stage there is little consensus about what governments should or should not do.
Some New Keynesian economists argue that while their theories support the idea that
involuntary unemployment can occur, the shocks are irregular and unpredictable. This

42
means that governments should not fine tune the economy, which sounds like
monetarist conclusions! New Keynesians do, however, argue that strong recessions
warrant government intervention, to move the economy to a “higher level”
equilibrium. Another implication seems to be that governments should use
microeconomic policies to ensure that markets work smoothly as possible. Again,
this is a monetarist, and even classical, conclusion.

8. OTHER SCHOOLS OF THOUGHT

There are three other notable schools of thought:
– 1. Marxist economics
– 2. Austrian economics
– 3. Post-Keynesian Macroeconomics
The first theories have had strong influences on the thinking of economists at various
times. Marxist economics has probably been shown by historical events to be a failed
theory, although Marxist interpretations of society are still highly prevalent in the
other social sciences and in humanities. Austrian economics is still going strong and
was very influential in the 1930s. The third school of thought has had little impact. I
know very little of them and cannot do them justice, and since they are not
mainstream in any event I will leave them at this stage.

9. THE EVOLUTION OF MACROECONOMIC THOUGHT — THE OVERALL

PICTURE

Before proceeding I should put the disclaimer in that the history of economic thought
is not my specialty, and so be aware that I may have some (unintended) factual errors
here. I am also not an expert in the philosophy of science, so I may be open to
criticism about my analysis! When we look at a time line of the evolution of
macroeconomic thought we get the following:

1. Pre-Adamite Economics or Mercantilism (1500s-1600s)

This probably arose because of the underlying economic structure. The economies,
even though becoming more sophisticated (rise of cities, banking, better farming
methods) tended to be wholly agrarian and subject to major droughts, floods, wars,
plague, etc. Trade was growing between people from different countries, due to
changes from the Renaissance (14th-16th centuries) and the Reformation (16th
century), but it was still relatively small. Building up reserves of material wealth such
as gold or land in a very uncertain world may seem like the best thing to do in such
circumstances.

2. Classical and Neo-Classical Economics (1770s-1930s).

This followed the Enlightenment (mid 18th centuries) and the start of the Industrial
Revolution (late 18th-early 19th centuries), both profound events in human history.
This centred economic debate around the individual, instead of society as a
“collective individual”. Furthermore, the economies in Europe were less agrarian and
more industrial than had been the case, especially in Britain, and trade had expanded a
great deal. It is not surprising that economics developed ideas about specialization,
gains from trade, and the importance of individual welfare maximization. The
Enlightenment which deemed reason superior in all departments of human intellectual
matters, coupled with a period of seemingly amazing technological change, no doubt

43
gave people great confidence in the ability of humans. This probably led to the
emphasis on self-adjusting economic systems.

3. Marxist Economics (1840s-1980s)

The industrial revolution caused massive economic, social, and political change
(which people on average tend to fear and resist). Marx’s analysis led him to believe
that unemployment and poverty would increase, while wealth would be increasingly
concentrated in a few. Thus he argued that a class struggle would result. It seems
reasonable given what he was witnessing i.e. large overcrowded cities, appalling
unhealthy and dangerous working conditions, large sums of wealth being made by
people who owned the machines etc. It turns out that he was wrong, but it is easy to
say this after 100 years!

4. Austrian Economics (1870s-)

There is no doubt that Austrian economics and classical economics had a lot in
common, but there were also clear differences, particularly in thinking about how
economies evolved over time. Austrian economics places a great deal of emphasis on
the evolutionary nature of economies, especially the role that markets play in
selecting fit behaviours given the economic environment the people and firms of an
economy find themselves. This is probably related to the development of evolutionary
biology after the publication of the Origin of Species by Charles Darwin in 1859.

5. Keynesian Economics (1930s-1970s)

What can one say, the Depression was major event. What is more, it did not look like
the economies were self-correcting as predicted by classical economics! Hence it is
easy to see why Keynes drew his conclusions in the way he did, that an economy may
need government intervention to get it to adjust to an economic shock.

6. Post Keynesian Economics. (1940s-)

From the little I know, this was not the result of any discernible (noticeable) ‘event’.
It seemed to arise from a group of thinkers in the UK who had a different
interpretation of Keynes’ work than did most other economists and were pissed off
with the way things were working out!

7. Monetarism (1950s-1970s)
I can’t trace this to any one ‘event’ either. It just seems to have come about because
one man, Milton Friedman at the University of Chicago, was working away and
discovered some facts that did not sit well with the theory of the day.

8. New Classical (1970s-)

This was the combination of the work of one man, Robert Lucas at the University of
Chicago, and the oil price shock. Lucas was not happy with the existing theories
because they seemed to be illogical. The oil price shocks, which had a huge impact,
caused economies to behave in ways that contradicted the predictions of the then
existing standard Keynesian macroeconomic theories. Again it is easy to see why this
school of thought arose.

9. Real Business Cycle Economics (1980s-)

44
During the 1970s and 1980s there was a tremendous increase in computer power
available. In addition, physicists, chemists, biologists etc were using this computer
power to increase their understanding and to test theories by running simulations of
computer models: examples being the evolution of the solar system, the working of
stars, reactions between different chemicals etc. Some people took this approach and
used it in economics, extending the new classical framework.

10. New Keynesian Economics (1980s-)

This does not seem traceable to any one event. It seems to be the result of a group of
people who did not like the current theories of the day, and who did not think that
their predictions matched with the data combined with some developments in
microeconomics about when buyers and sellers have different information about
quality of goods or effort by workers, and such things.

From the above description we can conclude that macroeconomic thought has evolved
in two ways:

1. Individuals Coming Up With Different Ideas and Facts

Examples are Friedman and monetarism, or RBC and new Keynesian theories. These
are the scientific research based approach and tend to lead to challenges to an existing
school of thought, but within the existing framework.

2. External Shocks Challenging the Status Quo

Examples are the enlightenment (cultural) and classical economics, or oil price shocks
(political) and new classical economics. These are things that are influenced by major
changes in society such as politics, culture, technologies, wars, and the like, and tend
to lead to challenges to an existing school of thought, but from a different framework.

10. CONCLUSION

1. Macroeconomic Thought Evolves Over Time.

As we have seen, macroeconomic theories and evidence have changed over time,
typically based on previous thinking and reflecting a battle between two opposing
views of people, markets, and government. Empirical work leads to a set of facts,
which people seek to explain and understand by developing theories using what we
know of the world. The forms of those bodies of thought tend to reflect the nature of
society at the time they are thought up: mercantilist thinking was dominated by the
vagaries of nature; classical thinking was dominated by the hopes of the
Enlightenment; Keynesian thinking was dominated by the apparent helplessness of
people to fix their own problems; and so on. The new theories give rise to new sets of
questions to ask, which starts new empirical work etc. Also thrown in there are
personal prejudices, major unexpected events, the seeking of glory, etc.

2. Battle between Two Basic Opposing Views

There seem to be two basic veins of thought throughout the history of
macroeconomics: those who view the market economy as relatively stable, self-
correcting and not in need of government intervention, and those that think market
economies are unstable, prone to getting stuck in the wrong situations, and need
government intervention. Another way of looking at this is as two types of belief
about individuals versus collective organizations (particularly those with coercive

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powers): those that have confidence in the ability of individual people free from
coercive interference by the state to live their lives, and those that have confidence in
the ability of coercive interference by the state to improve the lives of people.
Normally it is not a matter of either/or, but a question of how much of each type. This
battle will no doubt continue and is healthy and we now understand a lot more than
we did because of this battle. It is also ironic; maybe people are incapable of learning
from the past and are doomed to repeat it!!

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