© Brian Snowdon and Howard R. Vane, 2002 All rights reserved. No part of this publication may be reproduced, stored in a retrieval system or transmitted in any form or by any means, electronic, mechani- cal or photocopying, recording, or otherwise without the prior permission of the publisher, Published by Edward Elgar Publishing Limited Glensanda House Montpellier Parade Cheltenham Glos GL50 1UA UK Edward Elgar Publishing, Ine. 136 West Street Suite 202 Northampton Massachusetts 01060 USA A catalogue record for this book is available from the British Library Library of Congress Cataloguing in Publication Data An eneyclopedia of macroeconomics / edited by Brian Snowdon and Howard R. Vane. p. em. 1, Mactoeconomics—Eneyelopedias, 2. Economies—Encyclopedias. I Snowdon, Brian. II. Vane, Howard R. HBI72.5 .E5S. 2003 339'.03—de21 2002026392, ISBN | 84064 3870 Printed and bound in Great Britain by MPG Books Ltd, Bodmin, CornwallContents List of contributors of main entries Preface Abramovitz, Moses Absolute Income Hypothesis* Absorption Approach to the Balance of Payments Accelerator Principle Activism Activist Policy Rule Acyclical Variable Adaptive Expectations AD-AS Model Adjustable Peg System Adverse Selection Model Aggregate Demand Aggregate Demand Management Aggregate Production Function Aggregate Supply Akerlof, George A. Alesina, Alberto American Economic Association Animal Spirits Anticipated Inflation Appreciation (Nominal) of a Currency Assignment Problem Asymmetric Information Automatic Stabilizers Autonomous Expenditure Average Propensity to Consume Average Propensity to Save Average Tax Rate Balance of Payments Balance of Payments-constrained Economic Growth Balance of Payments: Keynesian Approach Balance of Payments: Monetary Approach Balanced Budget Multiplier Barro, Robert J. * Main entries are in bold face. xv xxiiivi Contents Bastard Keynesianism Blanchard, Olivier J. Blaug, Mark Blinder, Alan S. Boom Bretton Woods Brookings Institution Brunner, Karl Budget Balance Budget Deficits: Cyclical and Structural Built-in Stabilizers Burns, Arthur F. Business Cycle Business Cycles: Austrian Approach Business Cycles: Keynesian Approach Business Cycles: Marxian Approach Business Cycles: Monetarist Approach Business Cycles: New Classical Approach Business Cycles: Political Business Cycle Approach Business Cycles: Real Business Cycle Approach Business Cycles: Stylized Facts Cagan, Philip D. Calibration Capital Account Capital_Labour Ratio Capital-Output Ratio Capital-stock Adjustment Principle Catching Up and Convergence Central Bank Central Bank Accountability and Transparency Central Bank Independence Central Parity Classical Dichotomy Classical Economics Classical Model Clean Float Clower, Robert W. Coddington, Alan Cold Turkey Comparative Advantage Consumption Function Contractionary Phase ConvergenceCoordination Failures Cost-push Inflation Council of Economic Advisers Countercyclical Policy if Countercyclical Variable Cowles Commission Crawling Peg Credibility and Reputation Credit Channels Credit Views in Macroeconomic Theory Crowding Out Current Account Cyclical Unemployment Cyclically Adjusted Budget Balance Davidson, Paul Deflation Demand for Money: Buffer Stocks Demand for Money: Friedman’s Approach Demand for Money: Keynesian Approach Demand Management Demand-deficient Unemployment Demand-pull Inflation Denison, Edward F. Depreciation (Nominal) of a Currency Depression. Devaluation Dirty Float Discount Rate Discretionary Policy Disinflation Disposable Income Domar, Evsey D. Dornbusch, Rudiger Dual Decision Hypothesis Duesenberry, James S. Ecological Macroeconomics Econometric Society Economic Growth Economic Growth and the Role of Institutions Efficiency Wage Efficiency Wage Theory Elasticities Approach to the Balance of Payments Employment Act of 1946 Contents vii 140 145 145 145 146 146 146 146 151 156 161 165 166 166 167 167 167 172 175 181 181 181 182 182 182 183 183 184 184 184 184 184 185 185 186 187 191 191 191 200 200 201 201viii Contents Endogenous Growth Theory Endogenous Variable Equation of Exchange Euro European Central Bank European Currency Unit European Monetary System. European Monetary Union European Union Euroscelerosis Evolutionary Macroeconomics Ex Ante, Ex Post Ex Post Exchange Rate Determination: Monetary Approach Exchange Rate Mechanism Exogenous Variable Expansionary Phase Expectations-augmented Phillips Curve Expenditure Reducing Policy Expenditure Switching Policy Federal Funds Rate Federal Open Market Committee Federal Reserve System Feedback Rule Feldstein, Martin Financial Instability Fine Tuning Fiseal Policy: Role of Fischer, Stanley Fisher Effect Fisher, Irving Fixed Exchange Rate System Flexible Exchange Rate System Floating Exchange Rate System Forecasting Foreign Exchange Reserves Foreign Trade Multiplier Frictional Unemployment Friedman, Milton Frisch, Ragnar A.K. Full Employment Full Employment Budget Balance 221 221 224 271 271 284 285 285Full Employment Output Functional Finance GDP Deflator GDP in Current Prices GDP in Real Prices General Agreement on Tariffs and Trade General Theory Globalization Gold Standard Golden Age Growth Gordon, Robert J. Government Budget Constraint Gradualism Gradualism versus Cold Turkey Great Depression Great Inflation Greenspan, Alan Gross Domestic Product Gross National Product Group of Five Group of Seven Growth Accounting Hansen, Alvin H. Harrod, Roy F. Harrod—Domar Growth Model Hayek, Friedrich A. von Heckscher-Ohlin Approach to International Trade Hicks, John Richard High-powered Money Human Capital Hume, David Hydraulic Keynesianism Hyperinflation Hysteresis Identity Implementation Lag Incomes Policy Indexation Inflation Inflation: Alternative Theories of Infla Costs of Inflation: Costs of Reducing Contents ix 286 286 287 287 287 287 288 288 293 297 298 299 299 299 300 307 308 308 309 309 309 309 315 315 316 321 322 322 326 326 326 327 328 328 337 337 337 344 345 345 351 356x Contents Inflation Rate Inflation Targeting Inflation Tax Inside Lag Inside Money Insider—Outsider Theory International Monetary Fund Intertemporal Substitution of Labour Investment: Accelerator Theory of Investment: Neoclassical Theories of Involuntary Unemployment in Keynes’s General Theory Involuntary Unemployment in Keynesian Economics IS-LM Model: Closed Economy IS-LM Model: Open Economy John Bates Clark Medal Johnson, Harry G. Jorgenson, Dale W. Kahn, Richard F. Kaldor, Nicholas Kalecki, Michal Keynes Effect Keynes, John Maynard Keynes's General Theory Keynesian Cross Keynesian Economics Keynesian Economics: Reappraisals of Kindleberger, Charles P. Klein, Lawrence R. Kuznets, Simon S. Kydland, Finn E. Laffer Curve Leijonhufvud, Axel Lender of Last Resort Lerner, Abba P. Lewis, W. Arthur Life Cycle Hypothesis Lipsey, Richard G. Liquidity Liquidity Preference Liquidity Trap Loanable Funds Theory Long-run Phillips Curve 360 361 365 365 366 366 391 397 397 398 399 399 400 400 401 405 409 411 417 421 422 422 423 425 432 433 433 434 434 436 437 437 437 439 440Lucas Critique Lucas, Robert E. Jr Lucas ‘Surprise’ Supply Function Macroeconometric Models Malinvaud, Edmond Managed Float Mankiw, N. Gregory Marginal Efficiency of Capital Marginal Efficiency of Investment Marginal Propensity to Consume Marginal Propensity to Import Marginal Propensity to Save Marginal Propensity to Withdraw Marginal Tax Rate Marshall-Lerner Condition Marxian Macroeconomics: An Overview Marxian Macroeconomics: Some Key Relationships Mayer, Thomas Meade, James E. Meltzer, Allan H. Menu Costs Minsky, Hyman P. Mismatch Unemployment Mitchell, Wesley C. Modigliani, Franco Monetarism Monetary Approach to Exchange Rate Determination Monetary Approach to the Balance of Payments Monetary Base Monetary Policy: Role of Money Iilusion Money Supply: Endogenous or Exogenous? Multiplier Multiplier-Accelerator Model Mundell, Robert A. Mundell-Fleming Model Muth, John F. NAIRU National Bureau of Economic Research National Income Natural Rate of Unemployment Neoclassical Growth Model Contents xi 440 445xii Contents Neoclassical Synthesis Net Capital Flows Net Exports Neutrality of Money New Classical Economics New Economy New Keynesian Economics New Neoclassical Synthesis New Political Macroeconomics Nobel Prize in Economics Nominal Exchange Rate Nominal GDP Nominal Interest Rate Nominal Rigidity North American Free Trade Agreement Okun, Arthur M. Okun’s Law Open Economy Trilemma Open Market Operations Optimum Currency Area Organization for Economic Cooperation and Development Organization of Petroleum-exporting Countries Outside Lag Outside Money Passive Policy Rule Patinkin, Don Peak Permanent Income Hypothesis Phelps, Edmund S. Phillips Curve Phillips, A. William H. Pigou Effect Pigou, Arthur C. Policy Ineffectiveness Proposition Post Keynesian Economics Potential Output Precautionary Balances Prescott, Edward C. Present Value Price Index Procyclical Variable Productivity Slowdown 522 526 526 526 533 539 541 545 546 550 551 551 552 552 558 559 559 561 561 570 570 570 571 572 572 573 573 580 581 586 586 586 587 588 597 597 597 598 598 598 598Contents Public Sector Borrowing Requirement Purchasing Power Parity Theory Quantity Theory of Money Random Walk Rational Expectations Reaganomics Real Balance Effect Real Business Cycle Model Real Exchange Rate Real GDP Real Interest Rate Real Money Balances Real Rigidity Real Wage Recession Recognition Lag Relative Income Hypothesis Replacement Ratio Representative Agent Model Reputation Revaluation Ricardian Equivalence Robinson, Joan Romer, Paul M. Rostow, Walt W. Rough Tuning Royal Economic Society Rules versus Discretion Sacrifice Ratio Samuelson, Paul A. Sargent, Thomas J. Say’s Law Schools of Thought in Macroeconomics Schumpeter, Joseph A. Schwartz, Anna J. Search Unemployment Seasonal Unemployment Seigniorage Shackle, George L.S. Shirking Model Shoe Leather Costs Short-run Phillips Curve xiii 599 599 603 608 608 6ll 6ll 615 615 615 615 616 616 620 620 621 621 622 623 628 628 628 632 632 633 634 634 634 644 644 649 650 653 660 661 661 661 661 662 662 663xiv Contents Slump Solow, Robert M. Speculative Balances Speculative Bubbles Stabilization Policy Stagflation Staggered Wage Contracts Steady State Growth Sterilization Stiglitz, Joseph E. Stone, J. Richard N. Structural Budget Balance Structural Unemployment Summers, Lawrence H. Supply-side Economics Taylor, John B. Taylor's Rule Temin, Peter Term Structure of Interest Rates Terms of Trade Thatcherism Theory and Measurement in Macroeconomics: Role of Time Inconsistency Tinbergen, Jan Tobin, James Tobin's 9 Trade Balance Trade Union Density Transactions Balances Transitory Income Trough Unanticipated Inflation Unemployed Unemployment Rate Vector Autoregressions Velocity of Circulation Wallace, Neil Weintraub, Sidney Wicksell, Knut World Bank World Trade Organization Yield Curve 663 663 668 668 672 672 674 674 676 676 677 678 678 678 679 690 691 691 692 693 693 693 699 703 704 709 709 709 709 710 TM 7 71 712 716 717 718 718 720 721Contributors of main entries Ahmad, Syed (Prof.), McMaster University, Hamilton, Ontario, Canada Demand for Money: Keynesian Approach Backhouse, Roger E. (Prof.), University of Birmingham, Birmingham, UK Keynesian Cross; Say's Law Baddeley, Michelle (Dr), Gonville and Caius College, Cambridge, UK Investment: Accelerator Theory of: Speculative Bubbles Bain, Andrew D. (Hon. Prof.), University of Glasgow, Glasgow, Scotland, UK Demand for Money: Friedman's Approach Benz, Matthias, University of Zurich, Zurich, Switzerland Business Cycles: Political Business Cycle Approach Blaug, Mark (Vis. Prof.), University of Amsterdam, Amsterdam, Netherlands Endogenous Growth Theory Bleaney, Michael (Prof.), University of Nottingham, Nottingham, UK Purchasing Power Parity Theory Boumans, Marcel (Dr), University of Amsterdam, Amsterdam, Netherlands Calibration Burmeister, Edwin (Prof.), Duke University, Durham, NC. USA Samuelson, Paul A. xvxvi Contributors of main entries Colander, David C. (Prof.), Middlebury College, Middlebury, VT, USA Tobin, James Cornwall, John L. (Prof.), Dalhousie University, Halifax, Nova Scotia, Canada Catching Up and Convergence; Evolutionary Macroeconomics Cornwall, Wendy (Prof.), Mount St. Vincent University, Halifax, Nova Scotia, Canada Catching Up and Convergence; New Political Macroeconomics Cross, Rod B. (Prof.), University of Strathclyde, Glasgow, Scotland, UK Hysteresis Davidson, Paul (Prof.), University of Tennessee, Knoxville, TN, USA Post Keynesian Economics Dawson, Graham J.A. (Dr), Open University, Milton Keynes, UK Ecological Macroeconomics; Inflation: Costs of: Inflation: Costs of Reducing: Menu Costs Demirbas, Dilek (Dr), University of Northumbria, Newcastle-upon-Tyne, UK Optimum Currency Area De Vanssay, Xavier (Assoc. Prof.), York University, Toronto, Ontario, Canada Marshall-Lerner Condition De Vroey, Michel (Dr), Université Catholique de Louvain, Louvain-La- Neuve, Belgium Involuntary Unemployment in Keynes's General Theory; Involuntary Unemployment in Keynesian Economics; Keynesian Economics: Reappraisals ofContributors of main entries xvii Dimand, Robert W. (Prof.), Brock University, St. Catharine’s, Ontario, Canada. Balance of Payments: Keynesian Approach; Hicks, John R.; Real Balance Effect, Ricardian Equivalence; Schools of Thought in Macroeconomics Dixon, Huw D. (Prof.), University of York, York, UK Real Rigidity Dore, Mohammed H.I. (Prof.), Brock University, St. Catharine’s, Ontario, Canada Representative Agent Model Dow, Sheila C. (Prof.), University of Stirling, Stirling, Scotland, UK Money Supply: Endogenous or Exogenous? Dowd, Kevin (Prof.), University of Nottingham Business School, Nottingham, UK Gold Standard, Time Inconsistency Eijffinger, Sylvester C.W. (Prof.), Tilburg University, Tilburg, Netherlands. Central Bank Accountability and Transparency; Central Bank Independence Falvey, Rod (Prof.), University of Nottingham, Nottingham, UK Comparative Advantage Fender, John (Prof.), University of Birmingham, Birmingham, UK Nominal Rigidity Fletcher, Gordon (Dr), University of Liverpool, Liverpool, UK Neoclassical Synthesis Frazer, William (Prof.), University of Florida, Florida, Gainesville, FL, USA Friedman, Miltonxviii Contributors of main entries Frey, Bruno S. (Prof.), University of Zurich, Zurich, Switzerland Business Cycles: Political Business Cycle Approach Garrison, Roger W. (Prof.), Auburn University, Auburn, AL,USA. Business Cycles: Austrian Approach Gausden, Robert (formerly at the University of Northumbria, Newcastle- upon-Tyne, UK) Absolute Income Hypothesis, Permanent Income Hypothesis Gerrard, Bill (Dr), University of Leeds, Leeds, UK Keynes's General Theory Grieve Smith, John, Robinson College, Cambridge, UK Bretton Woods Hammond, J. Daniel (Prof.), Wake Forest University, Winston-Salem, NC, USA Business Cycles: Monetarist Approach Hamouda, Omar F. (Prof.), York University, North York, Ontario, Canada Keynes, John Maynard Hargreaves Heap, Shaun P. (Dr), University of East Anglia, Norwich, UK New Keynesian Economies Harrington, Richard L., University of Manchester, Manchester, UK Classical Dichotomy Healey, Nigel M. (Prof.), Manchester Metropolitan University, Manchester, UK AD-AS Model, Credibility and ReputationContributors of main entries xix Holden, Ken (Prof.), Liverpool John Moores University, Liverpool, UK Forecasting; Macroeconometric Models; Vector Autoregressions Howitt, Peter (Prof.), Brown University, Providence, RI, USA Coordination Failures Humphrey, Thomas M. (Vice President and Economist), Federal Reserve Bank of Richmond, Richmond, VA, USA Adaptive Expectations; Balance of Payments: Monetary Approach Hunt, Andrew, University of Northumbria, Newcastle-upon-Tyne, UK Incomes Policy Jackson, Peter M. (Prof.), University of Leicester, Leicester, UK Budget Deficits: Cyclical and Structural Junankar, P.N. Raja (Prof.), University of Western Sydney, Macarthur, Campbelltown, NSW, Australia Investment: Neocle cal Theories of Laidler, David E.W. (Prof.), University of Western Ontario, London, Ontario, Canada Quantity Theory of Money Leeson, Robert (Assoc. Prof.), Murdoch University, Perth, Australia Expectations-augmented Phillips Curve Mayer, Thomas (Prof.), University of California, Davis, CA, USA Monetarism; Monetary Policy: Role of McCombie, John (Dr), Downing College, Cambridge, UK Balance of Payments-constrained Economic Growth Middleton, Roger (Dr), University of Bristol, Bristol, UK Solow, Robert M.xx Contributors of main entries Minford, A. Patrick L. (Prof.), University of Wales, Cardiff, Wales, UK Supply-side Economics Mishkin, Frederic S, (Prof.). Columbia University, New York, NY, USA Inflation Targeting Mizen, Paul (Dr), University of Nottingham, Nottingham, UK Credit Channels, Demand for Money: Buffer Stocks Muhhearn, Chris J. (Dr), Liverpool John Moores University, Liverpool, UK Expenditure Reducing Policy; Expenditure Switching Policy O’Brien, Denis P. (Prof.), University of Durham, Durham, UK Classical Economics Peston, Maurice (Prof.), University of London, London, UK Crowding Out, IS~LM Model: Closed Economy; IS-LM Model: Open Economy Reuten, Geert (Dr), University of Amsterdam, Amsterdam, Netherlands Business Cycles: Marxian Approach, Marxian Macroeconomics: An Overview; Marxian Macroeconomics: Some Key Relationships Ryan, Cillian (Dr), University of Birmingham, Birmingham, UK Business Cycles: Real Business Cycle Approach; Business Cycles: Stylized Facts Sandilands, Roger J., University of Strathclyde, Glasgow, Scotland, UK Great Depression Setterfield, Mark (Assoc. Prof.), Trinity College, Hartford, CT, USA Inflation: Alternative Theories of Shaw, G.K. (Prof.), University of Buckingham, Buckingham, UK. Balanced Budget Multiplier, Keynesian EconomicsContributors of main entries xxi Sheffrin, Steven M. (Prof.), University of California, Davis, CA, USA Fiscal Policy: Role of Shone, Ronald, University of Stirling, Stirling, Scotland, UK Exchange Rate Determination: Monetary Approach Simkins, Scott P, (Assoc. Prof.), North Carolina A and T State University, Greenboro, NC, USA Lucas Critique; Theory and Measurement in Macroeconomics: Role of Smithin, John (Prof.), York University, North York, Ontario, Canada Phillips Curve Snowdon, Brian, University of Northumbria, Newcastle-upon-Tyne, UK Business Cycles: New Classical Approach; Economic Growth and the Role of Institutions, Growth Accounting; Harrod-Domar Growth Model, Lucas, Robert E. Jr.; Modigliani, Franco, Multiplier; Mundell, Robert A.; New Classical Economics, Rules versus Discretion Solow, Robert M. (Prof.), Massachusetts Institute of Technology, Cambridge, MA, USA Neoclassical Growth Model Spindler, Zane A. (Prof.), Simon Fraser University, Burnably, British Columbia, Canada Laffer Curve Stevenson, Andrew (Honorary Senior Research Fellow), University of Glasgow, Glasgow, Scotland, UK Fixed Exchange Rate System: Flexible Exchange Rate System Thompson, John L. (Prof.), Liverpool John Moores University, Liverpool, UK Natural Rate of Unemployment; Rational Expectationsxxii Contributors of main entries Trautwein, Hans-Michael (Prof.), Carl von Ossietzky University Oldenburg, Germany Credit Views in Macroeconomic Theory ‘Trigg, Andrew B., Open University, Milton Keynes, UK Business Cycles: Keynesian Approach Vane, Howard R. (Prof.), Liverpool John Moores University, Liverpool, UK Business Cycles: New Classical Approach; Economic Growth and the Role of Institutions; Growth Accounting; Harrod-Domar Growth Model: Lucas, Robert E, Jr; Modigliani, Franco; Multiplier; Mundell, Robert A.: New Classical Economics; Rules versus Discretion Visser, Hans (Prof.), Free University of Amsterdam, Amsterdam, Netherlands Neutrality of Money Went, Robert (Dr), University of Amsterdam, Amsterdam, Netherlands Globalization Wray, L. Randall (Prof.), University of Missouri, Kansas City, MO, USA Financial InstabilityPreface Over recent years we have collaborated in writing and/or editing a number of books on macroeconomics. In the first of these, 4 Modern Guide to Macroeconomics: An Introduction to Competing Schools of Thought (Edward Elgar, 1994), we sought to provide a comprehensive introduction to the central tenets underlying, and policy implications of, the main schools of thought in macroeconomics. That book, which is primarily aimed at intermediate undergraduates, traces the origins and development of modern macroeconomics in historical perspective. Adopting the same approach, our edited volume A Macroeconomics Reader (Routledge, 1997), contains a collection of 26 insightful and accessible articles for intermedi- ate undergraduates which shed light on the development of, and selected important controversies within, modern macroeconomics. That book was followed by the publication of Reflections on the Development of Modern Macroeconomics (Edward Elgar, 1997), an edited book containing eight original essays which focus on a number of important issues relating to the development of modern macroeconomics. More recently, in our Conversations with Leading Economists: Interpreting Modern Macro- economics (Edward Elgar, 1999) we sought to shed new light on the origins, development and current state of macroeconomics through interviewing 14 leading economists (including five Nobel Laureates) who have made a pro- found contribution to the controversies witnessed in the fields of macro- economic theory and policy, the way macroeconomics is taught and the history and methodology of macroeconomic research. The main idea behind the present volume is to provide a major reference book for intermediate undergraduates, postgraduates and lecturers in the field of macroeconomics. Within the alphabetically ordered book the reader will find two types of entry: short entries (written by ourselves) and main entries (mainly, but not exclusively, written by invited contributors). In the former case we have included three types of short entry: (a) defini- tions of important terms and concepts which appear in the macroeconom- ics literature; (b) brief biographical details of economists who have made important contributions to the research agenda in macroeconomics (many of these details were taken from Mark Blaug’s monumental Who's Who in Economics, 3rd edn, Edward Elgar, 1999); and (c) cross-references to main entries. In the latter case, the main entries entail lengthier pieces on selected important topics and individuals associated with the development and current state of macroeconomics. The brief we set contributors in writing xxiiixxiv Preface these main entries was that they should be between 1000 and 1500 words in length, but, in the course of commenting on first drafts of these entries, we soon came to realize that we had set many of our contributors an almost impossible task. In consequence, either as a result of editorial discretion or, in a few instances, owing to our inability to rein in some contributors (including ourselves at times), the length of a number of these main entries extends beyond that originally envisaged. While other academics would no doubt have included topics not covered, and excluded topics from those covered, in the final list of entries, our inten- tion has been to provide our target audience with an accessible and, it is hoped, valuable reference book. A project of this kind inevitably involves making compromises in terms of both breadth and depth of coverage, against a constraint of length of manuscript contracted with the publisher. Finally, anyone who has ever been involved in a project of this kind will appreciate that it should contain a ‘health warning’ for the editors con- cerned. Establishing the list of contributors, commenting on their entries, answering queries and so on has involved more than 600 letters, 500 e-mails and numerous phone calls, all of which have helped maintain the profitabil- ity of the UK postal service and British Telecom. On a far more positive note, our word processing skills have been transformed beyond recognition, More importantly, we have gained in knowledge and as editors we would like to express our gratitude to the 73 contributors listed in the preliminary pages for their valuable contributions to this volume. BRIAN SNOWDON Howarp R. VANEAbramovitz, Moses (1912-2001) Moses Abramovitz (b.1912, New York City, New York, USA) obtained his BA from Harvard University in 1932 and his PhD from Columbia University in 1939. His main past posts included the following: Research Associate at the National Bureau of Economic Research (NBER), 1938-42; Lecturer in Economics at Columbia University, 1940-42 and 1946-8: Principal Economist of the US War Production Board in 1942; Principal Economist at the US Office of Strategic Services in 1943; Director of Business Cycle Studies at the NBER, 1946-8; and Professor of Economics and Economic History at Stanford University, 1948-77. From 1977 until his death in 2001 he was the Coe Professor of American Economic History, Emeritus, at Stanford University. Between 1975-7 and 1981-5 he was managing editor of the Journal of Economic Literature. He is best known for his work on inventories and business cycles, which helped to establish the importance of inventory accumulation in explaining fluctuations in output; and his study of economic growth in industrialized countries. In the latter case this included work showing that ‘long swings’ in growth can be attributed to the interaction between the intensities of resource use and the growth of factors of production. Abramovitz also emphasized social capability as a prerequisite for successful economic growth. Among his best known books are Inventories and Business Cycles (NBER, 1950) and Capital Formation and Economic Growth (ed.) (Princeton University Press, 1955). His most widely read articles include ‘Resource and Output Trends in the United States since 1870" (American Economic Review, 46, May 1956): ‘Catching Up, Forging Ahead and Falling Behind’ (Journal of Economic History, 46, June 1986); and ‘What Economists Don't Know About Growth’ (Challenge, 42, January-February 1999). See also Catching up and Convergence; National Bureau of Economic Research. Absolute Income Hypothesis The Absolute Income Hypothesis (AIM) is a theory of consumption that is closely associated with the work of Keynes - in particular, The General Theory of Employment, Interest and Money (GTEIM), published in 1936. Indeed, the ATH has the interpretation of a simple representation of the more quantitative aspects of Keynes's views concerning the determination of aggregate consumption expenditure. The AIH can be presented as the following four conjectures:2 Absolute income hypothesis 1. real consumption (C) is a stable function of real disposable income (Y); 2. the marginal propensity to consume (mpc) has a value which is greater than zero but less than one; 3. _as the value of income increases, the value of the average propensity to consume (apc) falls, such that ape>mpe; 4. as the value of income increases, the value of mpc falls. With respect to conjecture (1), Keynes maintained that ‘aggregate income. . . is, asa rule, the principal variable upon which the consumption- constituent of the aggregate demand function will depend’ (GTEIM, p.96). Also, towards the end of section II of Chapter 8 of the General Theory, he concluded that ‘the propensity to consume may be considered a fairly stable function’ (GTEIM, p.95). Furthermore, when discussing the first of the principal objective factors which influence consumption, Keynes's initial statement was that ‘Consumption is obviously much more a function of (in some sense) real income than of money-income’ (GTEIM, p.91). Conjecture (2) arises from Keynes’s ‘fundamental psychological law’. This stated that ‘men are disposed, as a rule and on the average, to increase their consumption as their income increases, but not by as much as the increase in their income’ (GTEIM, p.96). Keynes gave two reasons why, as a rule, as the value of real income increases, a greater proportion of income is saved. The first explanation related to short-run behaviour, whereas the second was of a more general nature. Keynes asserted that ‘a man’s habitual standard of life usually has the first claim on his income’ (GTEIM, p.97). Later, he maintained that ‘the satisfaction of the immediate primary needs of a man and his family is usually a stronger motive than the motives towards accumulation, which only acquire effective sway when a margin of comfort has been attained” (GTEIM, p.97). Concerning conjecture (4), it was Keynes’s view that mpc is not constant for all levels of employment or values of real income. More specifically, he alleged that ‘it is probable that there will be, as a rule, a tendency for it to diminish as employment increases’ (GTEIM, p. 120). The most common mathematical representation of the AIH is the linear consumption function, shown below: C=atbY, where a>0 and 0 M) occurs when output exceeds absorption (Y> A). In this situation the excess of total output relative to absorption is sold abroad generating a current account surplus. Conversely, a balance of payments deficit (¥<_M) occurs when absorption is greater than total output (Y< 4). If the current account of the balance of payments is to improve then there must be: (1) a reduction in absorption relative to output, (2) an increase in output relative to absorption, or (3) some combination of both. As such the absorption approach recognizes that in a situation of full employment, when output cannot be increased, devaluation alone will be insufficient to improve the current account of the balance of payments. At full employment the balance of payments will only improve if absorption is reduced relative to output. See also: Balance of Payments; Devaluation; Expenditure Reducing Policy; Expenditure Switching Policy. Accelerator Principle The theory that relates changes in net investment to changes in output. See also: Investment: Accelerator Theory of. Activism The active use of fiscal and monetary policy to offset changes in private sector expenditure in order to help stabilize the economy. See also: Countercyclical Policy; Discretionary Policy; Fine Tuning; Rough Tuning Activist Policy Rule A pre-specified rule for the conduct of policy which is linked to the state of the economy; also known as a feedback rule. An example of an activist monetary policy rule would be one where the money supply is targeted to grow at a rate of, say, 3 per cent per annum if unemployment is 6 per cent, but monetary growth is automatically increased (or decreased) by | percentAdaptive expectations 7 per annum for every | per cent by which unemployment rises above (or falls below) 6 per cent. If unemployment rose to 8 per cent, monetary growth would be increased to 5 per cent. Conversely, if unemployment fell to 5 per cent, monetary growth would be reduced to 2 per cent. See also: Rules versus Discretion. Acyclical Variable A variable that moves in no consistent direction over the business cycle. See also: Business Cycles: Stylized Facts. Adaptive Expectations The adaptive expectations hypothesis states that people form their expec- tations of the future values of economic variables, notably the rate of price inflation, from the mean or weighted average of lagged past values of those same variables. Such expectations are entirely backward looking and pre- determined inasmuch as they are formed from mechanical extrapolations of the past history of the particular variable being forecast. Equivalently, the hypothesis states that forecasters periodically revise or adjust their expectations in corrective, error-learning fashion when those expectations turn out to be wrong; that is, when realized actual values of the variables differ from those expected. When applied to inflationary expectations the error-learning formula takes its name from the notion that inflation forecasters learn from their mistakes and so adapt their predic- tions by some fraction of their forecasting errors. The basic idea of the lagged adjustment of expectations to experience dates back at least to David Hume, who described the slowness with which workers, employers and consumers perceive inflation rate changes and adapt to them. Irving Fisher, in the 1920s and the early 1930s, invented the concept of distributed lags to model the output, employment and real inter- est rate effects of sluggishly adjusting inflation perceptions and expecta- tions. But the modern origins of the hypothesis begin in the early 1950s. It was then that Philip Cagan (1956), who with Milton Friedman was study- ing the behaviour of money’s circulation velocity in hyperinflations, sought to find an empirical proxy for expected inflation, an unobservable variable8 Adaptive expectations that measures the depreciation cost of holding money. Friedman described Cagan’s problem to the New Zealand economist A.W. Phillips, who sug- gested relating changes in the expected rate of inflation to the difference between actual inflation and expected inflation (see Leeson, 2000). Friedman conveyed Phillips's suggestion to Cagan who, upon converting the implied differential equation into an exponentially weighted average of past inflation rates, found it worked well as an empirical proxy for inflation- ary expectations in money demand functions. Thus was born the adaptive expectations hypothesis, with Phillips its originator and Cagan its influen- tial early propagator. Phillips expressed the hypothesis in its error-learning form, dp*ldt=b( p—p*), where the differential operator d/di applied to the expected rate of inflation p* indicates the rate of change (time derivative) of that variable, p—p* is the expectations or forecast error (that is, the difference between actual and expected price inflation) and 4 is the adjustment fraction or coefficient of adaptation. Assuming, for example, an adjustment fraction of 1/2, Phillips's equation says that if the actual and expected rates of inflation are 10 per cent and 4 per cent, respectively — that is, the expectational error is six percentage points — then forecasters will revise upwards their predictions of the expected rate by an amount equal to half the error, or three percent- age points. Provided the actual inflation rate remains unchanged, such revi- sion will continue until the expectational error is eliminated and inflation predictions are fully realized. The closer the adjustment fraction, or coeffi- cient of adaptation, is to unity the faster the adjustment — a unit coefficient implying instantaneous adjustment and a zero coefficient no adjustment at all. Solving Phillips’s error-learning equation, Cagan obtained the equiva- lent equation 1 Pe=> (lee pn < expressing expected inflation p* as a weighted average of all past rates of inflation p,_, with the weights (I—e~)e~™ declining exponentially and summing to unity, The exponentially declining weights imply that forecast- ers give more attention to recent than to older price history in forming their forecasts. How fast the weights decline depends on the rate at which fore- casters’ memories of inflation decay. Rapidly declining weights indicate that memories are short, so that expected inflation depends primarily on recent inflation experience. Slowly declining weights imply long memories,Adaptive expectations 9 so that expectations are influenced significantly by inflation rates in the more distant past. As for the unit-sum-of-weights property, it ensures that any stable (constant) rate of inflation will eventually be fully anticipated as expectations catch up with reality. As mentioned, Cagan used adaptive expectations to represent the depre- ciation-cost-of-holding-money variable in money demand, or velocity, functions. In the 1960s and 1970s, Milton Friedman (1968), Edmund Phelps (1967) and others used adaptive expectations to represent antici- pated inflation in the augmented Phillips curve equation p-p*=f(U- U,), expressing a functional, trade-off relationship between unexpected infla- tion p—p* (the difference between actual and expected inflation) and the unemployment rate U measured in terms of deviations from its natural equilibrium rate, Uy. Here adaptive expectations proved instrumental in the derivation of three propositions that dominated macroeconomic policy dis- cussion in the 1970s and early 1980s. First was the natural rate hypothesis according to which no permanent trade-offs exist between inflation and unemployment. Such trade-offs nec- essarily vanish when expectations fully adjust, as the unit-sum-of-weights property ensures they must, to any stable rate of inflation established by the central bank. At this point, the expectations error p—p* goes to zero and unemployment returns to its natural rate such that no trade-offs remain to be exploited. Second was the accelerationist proposition asserting that, whereas adap- tive expectations rule out permanent trade-offs between inflation and unemployment, they permit permanent trade-offs between unemployment and the rate of acceleration of the inflation rate. That is, because adaptive expectations adjust to actual inflation with a lag, policy makers can perma- nently peg unemployment below its natural level by continually raising the inflation rate so that it always stays a step ahead of expectations and frus- trates their attempt to catch up. Third was the costly-disinflation proposition that adaptive expectations, which posit that agents revise their inflation expectations downwards only when actual inflation turns out to be Jower than expected, might render disinflationary policy too painful to pursue. For if the policy makers sought to eradicate inflationary expectations — an absolute necessity of any successful disinflationary policy — they would have to force actual inflation below expected inflation in order to induce the latter to adjust to the former as it converged to the desired target rate. To achieve such dis- inflation, the authorities would apply contractionary measures to raise10 Adaptive expectations unemployment above its natural level. The resulting excess unemployment would put downward pressure on the actual rate of inflation to which the expected rate would adjust with a lag. Through this long and painful error-learning adjustment process, both actual and anticipated inflation eventually would be squeezed out of the economy, albeit at the cost of much lost output and employment. Small wonder that some economists in the 1970s and 1980s thought it might be better to learn to live with infla- tion than to fight it. The foregoing accelerationist and costly-disinflation propositions, however, proved only as convincing as the expectations hypothesis under- lying them. The propositions lost credence when adaptive expectations came under attack in the 1970s. On at least three grounds, critics faulted adaptive expectations for constituting an irrational and therefore unrealis- tic means of forecasting. First, why would profit-maximizing forecasters look only at past infla- tion when other relevant and freely available information, especially infor- mation on current and likely future policy moves, would improve their inflation predictions? Second, given that adaptive expectations systematically underpredict accelerating inflation, why would forecasters seeing such persistent and pre- dictable series of one-way errors not abandon the mechanism producing them for more accurate expectations-generating schemes? Third, why indeed would forecasters resort to any formula that is incon- sistent with the way inflation is actually generated in the economy? Why would they not discover the true inflation-generating process and then use all information pertinent to it in forming their expectations? For example, suppose central banks generate inflation by creating excess money growth when currently observed unemployment rises above its natural rate. Would not rational forecasters learn to form their expectations of future inflation by looking, not at past inflation, but rather at the same unemployment vat- iable that central banks respond to? The upshot of these criticisms was to discredit the adaptive expectations hypothesis and render it unreliable in policy analysis. By the mid-1980s, economists had largely abandoned it for the rival rational expectations hypothesis (Muth, 1961) according to which agents form their expectations ina way that avoids all systematic (predictable) errors. With adaptive expec- tations in retreat, so too were the associated accelerationist and costly-dis- inflation propositions. Rational expectations, with their capacity to foresee all systematic inflationary processes, including those involving higher time derivatives, promised to render accelerationist policy null and void. Ever- rising inflation had no power to stimulate real activity as long as agents could anticipate the rate of rise of the inflation rate and never be fooled byAD-AS model 11 it (see Lucas, 1972). As for fears of costly disinflation, they too were laid to rest by the rational expectations undertaker. Provided central bankers con- ducted disinflationary policy in a systematic, predictable manner, rational expectations implied that agents would anticipate such policy actions and incorporate them in their forecasts. Actual and expected rates of inflation and disinflation would coincide, leaving no gap to develop between them. With no gap, there would be no need for excess unemployment to generate it. Inflation, actual and expected, could be brought to its target level with only minor costs in terms of excess unemployment. Today, the adaptive expectations hypothesis finds few adherents. The once-popular notion of expected inflation as a backward-looking, pre- determined (by past history) phenomenon has given way to the notion of inflationary expectations as forward-looking phenomena determined by current and anticipated future events. THOMAS M. HUMPHREY See also: Cagan, Philip D.; Expectations-augmented Phillips Curve; Inflation: Costs of Reducing: Natural Rate of Unemployment; Phillips, A. William H.: Rational Expectations. Bibliography Cagan, P. (1956), ‘The Monetary Dynamics of Hyperinflation’, in M. Friedman (ed.), Studies in the Quantity Theory of Money, Chicago: University of Chicago Press. Friedman, M. (1968), ‘The Role of Monetary Policy’, American Economic Review, 58, March, pp.1-17. Leeson, R. (ed.) (2000), 4. WH. Phillips: Collected Works in Contemporary Perspective, ‘Cambridge: Cambridge University Press. Lucas, R.E. Jr. (1972), “Expectations and the Neutrality of Money’, Journal of Economic Theory. 4, April, pp. 103-24. Muth, LF. (1961), ‘Rational Expectations and the Theory of Price Movements’, Econometrica, 29, July, pp.315-35. Phelps, E.S. (1967), ‘Phillips Curves, Expect Time’, Economica, 34, August, pp.254-81 ions of Inflation and Optimal Inflation Over AD-AS Model ‘Keynesianism’ became the dominant macroeconomic paradigm in the post-World War II era. Based on interpretations of the macroeconomic theories propounded by Keynes (1936), two basic textbook models emerged as standard Keynesian teaching and analytical tools: the introduc- tory income-expenditure (45 degree line) framework invented by Samuelson (1939) and the more advanced IS-LM approach pioneered by Hicks (1937). The essential insight of the Keynesian school of thought is that output is determined by effective (aggregate) demand and that, owing12. AD-AS model to price and wage stickiness, effective demand may be insufficient to support the full-employment level of output. This analysis provided a com- pelling explanation for the prolonged depression in the United States and the United Kingdom in the 1930s. Reflecting the growing political influence of Keynesianism, the UK wartime coalition government published its famous ‘White Paper on Employment Policy’ in 1944, committing future peacetime governments to stabilize output at its full-employment level. Over the following three decades, ‘discretionary’ macroeconomic policy was used in an attempt to maintain the economy at a permanently high rate of employment. The Keynesian income-expenditure and IS-LM frameworks shared two limitations, which were steadily exposed by changes in macroeconomic per- formance across the developed world. First, these models did not explicitly deal with aggregate supply. Given the primacy of aggregate demand in determining output, aggregate supply was assumed to respond passively to changes in aggregate demand up to the full-employment level of output. Second, these models did not explain the price level, which was assumed to be constant below the full-employment level of output and to rise only when aggregate demand exceeded the full-employment level of output (so that there was an ‘inflationary gap’). Major supply-side shocks, most notably the 1973 rise in oil prices, and rapidly increasing inflation through- out the developed world in the late 1960s and 1970s, presented major chal- lenges to the relevance of these simple versions of the Keynesian model. The aggregate demand (AD) and aggregate supply (AS) model was devel- oped in direct response and, while it is theoretically flawed, it has subse- quently become the standard textbook model for analysing the macro economy (see, Colander, 1995). The aggregate demand and supply model is presented in its early (Keynesian) form in Figure |. The vertical axis measures the aggregate price level, P (the GDP deflator), while the horizontal axis measures aggre- gate output, Y (or real GDP). The supply schedule, 4S, represents the aggregate supply of final goods and services by all firms in the economy. In this simple Keynesian version, the aggregate supply schedule is horizontal up to the full-employment level of income, Y,, at which point it becomes vertical. The demand schedule, 4D, represents the aggregate demand for domes- tic goods and services by households (C), firms (/), government (G) and the foreign sector (net exports, X— M); that is, AD=C+I+ G+ X-M. The aggregate demand schedule may be derived formally from either the income-expenditure or IS-LM models. In simple terms, however, when the price level rises, households demand a smaller quantity of real goods and services for three main reasons:AD-AS model 13 Price level (P) 1 AS PL Po AD, ADy Y; Yy Yr Output (Y) Figure 1 1. the ‘real balance (or Pigou wealth) effect’ (as prices rise, the real value of wealth declines and households reduce current spending to rebuild their savings); the ‘interest rate (or Keynes) effect’ (as prices rise, the demand for money increases, interest rates rise and firms and households reduce borrowing and spending); and 3. the ‘open economy (or net export) effect’ (as domestic prices rise, con- sumers switch from domestically produced goods to relatively lower priced foreign goods, reducing net exports) v On this basis, the behaviour of the economy can be easily modelled. Below full employment fluctuations in aggregate demand result in changes in output. If, for example, the government cuts income tax, the aggregate demand schedule will shift to the right, from AD, to AD,, and output will increase until the economy reaches full capacity at Y,. Prices will then begin to rise until equilibrium is reached with prices higher at P,. This model can also be used to capture the impact of a supply-side shock. For example, an oil price hike will shift the aggregate supply schedule upwards for example, from P, to P,. If aggregate demahd is unchanged at AD,, the effect of the adverse supply-side shock is to reduce output to Y, and increase prices to P,. Recasting the Keynesian model in terms of aggregate demand and14. AD-AS model supply provided an accessible framework within which both supply-side shocks and inflation could be analysed. It highlighted the possibility that inflation could emanate on the supply side (‘cost-push’ inflation) as well as the demand side (‘demand-pull’ inflation) of the economy and this form of the aggregate demand and supply framework was quickly adopted in the late 1970s as a standard teaching tool. A common modification, designed to reflect the commonsense observation that bottlenecks would begin to appear in some parts of the economy before others, was to assume that the aggregate supply schedule is horizontal (perfectly elastic) at low levels of output, but becomes positively sloped as the economy approaches Y,, before becoming vertical (perfectly inelastic) when the full- employment level of output is reached (this is certainly more in keeping with Keynes's discussion of aggregate supply on page 296 of the General Theory). By the end of the 1970s, however, the Keynesian paradigm was under increasing attack from the monetarists and the closely related ‘New Classical’ school of thought. Arguably, the reason for the enduring popu- larity of the aggregate demand and supply model has been that it provides a common framework within which competing perspectives on macroeco- nomic theory can be presented and assessed. For example, the New Classical counter-revolution stressed the centrality of the ‘invisible hand’ in coordinating economic activity. While prices and wages were clearly sticky in the real world, it was argued that such stickiness was transitory and resulted from incomplete information rather than persistent market failure. By focusing on the microfoundations of aggregate supply, the monetar- ist school (see Friedman, 1968) linked the shape and position of the aggre- gate supply schedule, via the aggregate production function (in which output is a function of, inter alia, labour employed), to the labour market. In the labour market, both the supply of, and demand for, labour are func- tions of the real wage (that is, the nominal, or money, wage deflated by the aggregate price level). In the short run, there is an information asymmetry, insofar as firms know precisely the real wages they are paying their workers from day to day (the money wage deflated by the current price of their product), whereas workers know the money wages they are receiving, but have to make some assumption about the behaviour of the aggregate price level to gauge their real wages. In the basic, expectations-augmented aggregate demand and supply model, workers perceive their real wages to be their actual money wages deflated by the expected price level over the next time period. If the actual price level increases above the expected level, real wages fall. Because this fall is not immediately apparent to workers, they continue to offer the sameAD-AS model 15 quantity of labour at a lower real wage. This amounts to a (temporary) rightwards shift in the supply schedule for labour (relative to real wages) and the labour market clears at a higher quantity of labour. In terms of the aggregate supply schedule, a higher price level calls forth higher output, but only because workers are ‘fooled’ into accepting lower real wages. In the next time period, price expectations adapt to the higher actual price level and the labour supply schedule returns to its original position. Price level (P) LRAS SRAS (P* = Py) Py SRAS (P® = Pp) Py AD, Po ADy Yy ¥, Output (¥) Figure 2 Figure 2 illustrates the dynamics of the model. ¥, is the natural level of output, which is the level of output consistent with full equilibrium in the labour market, with the expected and actual price level equal at P,. If the price level rises above P,, in the short run the economy will slide up the short-run aggregate supply schedule, SRAS (P*= P,). Thus an increase in aggregate demand from 4D, to AD, will move the economy to P,, Y,. As the higher price level is subsequently built into wage bargains to restore real wages (that is, as price expectations catch up with the actual price level), so the short-run aggregate supply schedule shifts leftwards to SRAS (P*= P,), until equilibrium is finally restored at the natural level of output, Y,, with the price level stabilizing at P, (the long-run price level consistent with the new, higher level of aggregate demand). The long-run aggregate supply schedule (LRAS) is vertical at the natural level of output. The introduction of price expectations into the aggregate demand and16 AD-AS model supply model fundamentally changes its policy implications. The Keynesian version suggests that, by flexible, discretionary demand manage- ment, the government can respond to aggregate demand and supply shocks by adjusting aggregate demand and stabilizing the economy at the full- employment level of output, with little or no cost in terms of rising prices. The expectations-augmented monetarist version implies, in stark contrast, that there is no long-run trade-off between prices and output. Indeed, depending upon the way in which workers form their expectations of the price level, even the short-run trade-off implied by a positively sloped short- run aggregate supply curve may be qualified. If expectations are adaptive, in the sense that they are formed by looking backwards at historic price levels, there is scope to exploit a short-run trade-off at the cost of ever-rising prices. If expectations are rational, in the sense that agents are forward- looking and take account of the policy maker’s likely behaviour, any pre- dictable expansion of aggregate demand will be built into their price expectations. The only way of exploiting the short-run trade-off is by ‘sur- prising’ workers and firms by engineering an unpredicted price increase, which implies that anticipated macroeconomic policy pursued according to the principles of optimal control cannot have even short-run effects on output. The aggregate demand and supply model is often presented in a dynamic form, with inflation replacing the price level on the vertical axis, the aggre- gate supply schedule representing the level of output at different inflation rates and the demand schedule relating to the growth of aggregate demand. The attraction of this conversion is that it makes the model more intuitively appealing, since it operates in terms of inflation, rather than the more unfa- miliar, artificial construct of the general price level. In this formulation, the short-run aggregate supply schedule is simply the Lucas ‘surprise function’: Y=Yta-a+e, where 7 is inflation, 7 is expected inflation and ¢ is a random disturbance term with a mean of zero. Figure 3 illustrates the dynamic version of the aggregate demand and supply model. Figure 3 shows that, with a given rate of growth of aggregate demand, AD,, the economy is in equilibrium with inflation at 7, and output at its natural level, Y,. Faster demand growth of AD, leads, with adaptive expectations, to a temporary output gain at the cost of higher inflation, 7,, but ultimately only to higher inflation, Ty as expectations (and nominal wages) adjust. With rational expectations, this short-run expansion in output only occurs to the extent that the increase in the growth of aggregate demand is not anticipated by workers and firms, given their knowledge of the government's policy objectives.AD-AS model 17 Inflation (1) SRAS (n° = 12) am SRAS (n° = %) m AD, T% ADy Yy ¥, Output (¥) Figure 3 A key advantage of this version of aggregate demand and supply is that it can be directly linked, via ‘Okun’s Law’ (that there is an inverse relation- ship between changes in output and unemployment), to the expectations- augmented Phillips curve model, which relates unemployment to inflation. For any given set of inflationary expectations, there is a short-run aggregate supply schedule, SRAS (1 =71,). which shows the rate of output associated with any actual inflation rate, and this corresponds with a unique, short- run Phillips Curve, SR PC (x* = 71,), which shows the rate of unemployment associated with different actual inflation rates (see also Romer, 2000; Taylor, 2000). The main problem with the aggregate demand and supply framework from a Keynesian perspective is that, despite its intuitive appeal, it conflicts with the key insight of the Keynesian approach. The aggregate supply curve assumes that firms can sell all their output at the going price, whereas the income-expenditure and /S-LM models preserve the essential Keynesian idea that producers and workers may be quantity-constrained by insuffi- cient, effective aggregate demand. In other words, the underlying Keynesian model explicitly assumes that aggregate demand and supply are interlinked and co-determined (that is, households are both producers and consumers), rather than representing — as in the microeconomic parallel ~ independent sets of producers and consumers brought together in the market place to interact. From a monetarist perspective, there are also weaknesses. For example, the positively sloped short-run aggregate supply18 Adjustable peg system schedule depends critically upon workers having incomplete information about the price level (or inflation), but the model ignores the possibility of the same informational problems distorting consumption and investment decisions on the demand side. Nevertheless, the simplicity and tractability of the aggregate demand and supply model have ensured that it has remained the standard textbook approach to macroeconomic analysis for the last two decades. NIGEL M. HEALEY See also: Adaptive Expectations; Expectations-augmented Phillips Curve; Inflation: Alternative Theories of; S-LM Model: Closed Economy; /S-LM Model: Open Economy: Keynes Effe Keynesian Cross; Keynesian Economics; Lucas ‘Surprise’ Supply Function; Monetaris New Classical Economics; Okun’s Law: Policy Ineffectiveness Proposition; Rational Expectations; Real Balance Effect. Bibliography Colander, D. (1995), ‘The Stories We Tell: A Reconsideration of the AS/AD Analysis’, Journal of Economic Perspectives, 9, Summer, pp. 169-88, Friedman, M. (1968), “The Role of Monetary Policy’, American Economic Review, 58, March, pp.1-17. Hicks, J, (1937), Mr Keynes and the “Classics”: A Suggested Interpretatio 5, April, pp. 147-59. Keynes, LM. (1936), The General Theory of Employment, Interest, and Money, New Yor Harcourt Brace. Romer, D. (2000), ‘Keynesian Macroeconomics Without the LM Curve’, Journal of Economic Perspectives, 14, Spring, pp. 149-69. Samuelson, P. (1939), ‘A Synthesis of the Principle of Acceleration and the Multiplier", Journal of Political Economy, 47, December, pp 786-97. Taylor, J.B. (2000), “Teaching Macroeconomics at the Principles Level’, American Economic Review, 90, May, pp.90-94, Econometrica, Adjustable Peg System An exchange rate system where the exchange rate is fixed or pegged, but where the exchange rate can be adjusted or changed according to certain rules. The Bretton Woods system provides the best example of such a system. The rules of the system permitted devaluations and revaluations of up to 10 per cent, but permission had to be obtained from the International Monetary Fund if the change in the exchange rate was greater than 10 per cent. See also: Bretton Woods; Devaluation; Fixed Exchange Rate System; International Monetary Fund; Revaluation.Aggregate demand management 19 Adverse Selection Model A model in which firms that offer higher wages will not only attract the best or most productive applicants, but will also deter the most productive workers from quitting. In the labour market asymmetric information pre- dominates, with applicants having more information about their abilities, honesty and commitment than potential employers. Given the non-trivial costs associated with hiring and training new employees, firms clearly prefer not to hire workers only later to find that they need to fire those with low productivity, incurring an additional set of firing costs. One way to avoid this potential problem is to offer higher wages. If workers’ abilities are closely related to their reservation wage then high wage offers will attract the most productive applicants. Indeed, any applicant who offers to work for less than the efficiency wage will be regarded as a potential ‘lemon’. Higher wages will also deter the most productive workers from quitting. See also: Asymmetric Information; Efficiency Wage Theory. Aggregate Demand The total demand for goods and services comprising consumer expenditure (C), investment expenditure (/), government expenditure (G) and exports (X) minus imports (7). In the Keynesian cross model the level of output and employment is determined by aggregate demand. See also: AD-AS Model; Aggregate Demand Management; Keynesian Cross. Aggregate Demand Management The discretionary use of fiscal and/or monetary policy to influence the level of aggregate demand in order to reduce the severity of short-term cyclical fluctuations in aggregate economic activity and help stabilize the economy. Aggregate demand management may entail (1) the frequent use of fiscal and monetary policy in an attempt to maintain output and employment at, or near, their full employment or natural levels (so-called ‘fine tuning’) or (2) the occasional use of fiscal and monetary policy in response to a large divergence in output and employment from their full employment or natural levels (so-called ‘rough tuning’).20 Aggregate demand management Activist aggregate demand management is synonymous with Keynesian economics. In the Keynesian view the economy is inherently unstable, expe- riencing shocks that cause undesirable and inefficient economic fluctua- tions. Not only do Keynesians stress the need for stabilization policy but they also contend that the authorities can, and therefore should, stabilize the economy via aggregate demand management. New Keynesians do not support attempts (popular in the 1950s and 1960s among orthodox Keynesians) to fine tune the economy, but have instead championed the case for rough tuning. In particular, hysteresis effects provide new Keynesians with a strong case that the authorities should be given the dis- cretionary power to stimulate aggregate demand during a prolonged reces- sion. In contrast, the view held by monetarists and new classicists is that there is no need for activist stabilization policy involving the management of aggregate demand and that discretionary fiscal and monetary policy cannot, and therefore should not, be used to stabilize the economy. Believing the economy to be inherently stable, in that it will fairly rapidly self-equilibrate around the natural rate of output and employment after being subjected to some disturbance, they question the need for stabiliz- ation policy involving the management of aggregate demand. Highlighting a number of problems associated with attempts to stabilize the economy (including those associated with time lags, forecasting and uncertainty over reliable estimates of the natural rate of unemployment), monetarists argue that discretionary policy activism may make matters worse. Instead they advocate that discretionary aggregate demand policies should be replaced by policy based on rules. New classicists’ support for rules over discretion is based on the insights provided by the policy ineffectiveness proposition, the problem of time inconsistency and the Lucas critique. Finally, in the real business cycle view there is no role for the authorities to stabilize fluctuations in output and employment through aggregate demand management. See also: Hysteresis; Keynesian Economics: Lucas Critique; Monetarism; Natural Rate of Unemployment; New Classical Economics; New Keynesian Economics; Policy Ineffectiveness Proposition; Real Business Cycle Model; Rules versus Discretion; Time Inconsistency.Aggregate production function 21 Aggregate Production Function A functional relationship between the quantity of aggregate output pro- duced in an economy and the quantities of inputs used in production. This relationship can be written as: Y= A(t) F(K, L), where Y is real output, A(/) represents technological know-how at time f, and F is a function that relates real output to K, the quantity of capital inputs, and L, the quantity of labour inputs. Real output will increase over time if there is an increase in the quantity of factors inputs (capital and/or labour) and/or if there is an increase in the productivity of capital and labour inputs (that is, an increase in output per unit of factor input) due to an increase in technological know-how. In the neoclassical growth model developed by Robert Solow in the mid- 1950s, the aggregate production function obeys three key properties. First, factor inputs of labour and capital can be smoothly substituted for each other in the production process (that is, firms can use more capital inputs and fewer labour inputs, or vice versa) to produce the same quantity of output. Second, factor inputs experience diminishing returns. For example, while an increase in the quantity of labour inputs with the quantity of capital inputs held constant will result in an increase in real output, output will increase at an ever-declining rate. Similarly, diminishing returns will result from an increase in the capital stock to a fixed labour force. Third, the aggregate production function exhibits constant returns to scale, meaning that, when all factor inputs increase in some proportion, real output will increase in the same proportion. For example, if both the quan- tity of labour and capital inputs were doubled, the amount of real output would also be doubled. Given the assumption of constant returns to scale, then, for a given technology, the aggregate production function can also be expressed in per worker terms. This relationship can be written as: YIL= A(t) f (KIL), where output per worker (Y/L) depends on the amount of capital input per worker (K/L). See also: Neoclassical Growth Model; Solow, Robert M.22 Aggregate supply Aggregate Supply The total amount of output firms produce in an economy. See also: AD-AS model. Akerlof, George A. George Akerlof (6.1940, New Haven, Connecticut, USA) obtained his BA from Yale University in 1962 and his PhD from Massachusetts Institute of Technology (MIT) in 1966. His main past posts have included Assistant Professor (1960-70) and Associate Professor (1970-71) at the University of California, Berkeley; Senior Economist, US President's Council of Economic Advisers, 1973-4; Visiting Research Economist, Board of Governors, Federal Reserve Board, 1977-8; and Professor at the London School of Economics, 1978-80. Since 1977 he has been Professor at the University of California, Berkeley. In 2001 he was jointly awarded, with Joseph Stiglitz and Michael Spence, the Nobel Prize in Economics ‘for their analyses of markets with asymmetric information’. He is best known for his important contributions to the new Keynesian literature. His books include Efficiency Wage Models of the Labour Market (ed. with J.L.Yellen) (Cambridge University Press, 1986). His most widely read articles include ‘The Market for “Lemons”: Quality Uncertainty and the Market Mechanism’ (Quarterly Journal of Economics, 84, August 1970); ‘Labour Contracts as Partial Gift Exchange’ (Quarterly Journal of Economics, 97, November 1982); ‘Can Small Deviations from Rationality Make Significant Differences to Economic Equilibria?’ (co-authored with J.L. Yellen) (American Economic Review, 75, September 1985); and ‘A Near-Rational Model of the Business Cycle, with Wage and Price Inertia’ (co-authored with JL. Yellen) (Quarterly Journal of Economics, 100, Supplement 1985). See also: Council of Economic Advisers; Efficiency Wage Theory; New Keynesian Economics; Nobel Prize in Economics, Alesina, Alberto Alberto Alesina (b.1957, Broni, Italy) obtained his Laurea from the Universita Bocconi, Milan in 1981 and his PhD from Harvard UniversityAmerican Economic Association 23 in 1986. His main past posts have included the following: Assistant Professor of Economics at Carnegie-Mellon University, 1987-8; Assistant Professor of Economics and Government (1988-90) and Associate Professor of Political Economy (1991-3) at Harvard University. Since 1993 he has been Professor of Economics and Government at Harvard University. He is best known for his contributions, in terms of both theo- retical analysis and of empirical investigation, to the various forms of inter- action between politics and macroeconomics; and his influential work on politicoeconomic cycles, the origin and implications of fiscal deficits, and the relationship between political stability and economic growth. Among his best known books are Partisan Politics, Divided Government and the Economy (co-authored with H. Rosenthal) (Cambridge University Press, 1995); Political Cycles and the Macroeconomy (co-authored with N. Roubini) (MIT Press, 1997); and The Size of Nations (co-authored with E. Spolare) (MIT Press, 2002). His most widely read articles include ‘Macroeconomic Policy in a Two-Party System as a Repeated Game’ (Quarterly Journal of Economics, 102, August 1987), ‘Political Cycles in OECD Economies’ (co-authored with N. Roubini) (Review of Economic Studies, 59, October 1992); ‘Central Bank Independence and Macroeconomic Performance: Some Comparative Evidence’ (co-authored with L.Summers) (Journal of Money, Credit and Banking, 25, May 1993); ‘Distributive Politics and Economic Growth’ (co-authored with D. Rodrik) (Quarterly Journal of Economics, 109, May 1994); and ‘The Political Economy of the Budget Surplus in the US’ (Journal of Economic Perspectives, 14, Summer 2000). See also: Business Cycles: Political Business Cycle Approach; New Political Macroeconomics) American Economie Association The AEA was organized in 1885 at Saratoga, New York. Currently based at Nashville, Tennessee its present-day mission statement includes (1) the encouragement of economic research, (2) the issue of publications on eco- nomic subjects, and (3) the encouragement of perfect freedom of economic discussion, including an annual meeting. Among its publications are the prestigious American Economic Review (first published in 1911) and the Journal of Economic Literature (first published in 1963). Approximately 22.000 economists are members of, and 5500 institutes subscribe to, the AEA. Over half of its membership is associated with academic institutions, just over a third with business and industry, and the balance largely with24 Animal spirits federal, state and local government agencies. For more information the reader is referred to the official website of the AEA at (hitp://www. vanderbilt. edul AEA). Animal Spirits A term first used by John Maynard Keynes in The General Theory of Employment, Interest and Money (Macmillan, 1936) to describe how, in Keynes’s view, investment decisions depend on the whims or spontaneous urges (optimistic or pessimistic) of entrepreneurs ~— see also Keynes's article “The General Theory of Employment’ (Quarterly Journal of Economics, 51, February 1937). The term was subsequently popularized by the Cambridge University economist Joan Robinson (1903-83) who emphasized Chapter 12 ‘The State of Long-Term Expectation’, where the term appears, as the key chapter in the General Theory. See also: Keynes's General Theory; Keynes, John Maynard; Robinson, Joan Anticipated Inflation The rate of inflation which is expected over some future time period. In a hypothetical situation in which the actual rate of inflation is equal to the expected rate, inflation is said to be perfectly anticipated. In reality infla- tion is imperfectly anticipated as the actual rate of inflation will rarely coin- cide with the anticipated or expected rate. Debate exists about how best to model the way economic agents form expectations. See also: Adaptive Expectations; Inflation: Costs of; Rational Expectations; Unanticipated Inflation. Appreciation (Nominal) of a Currency An increase in the price of one currency in terms of other currencies in a flexible exchange rate system; an increase in the nominal exchange rate ina flexible exchange rate system. See also: Flexible Exchange Rate System; Nominal Exchange Rate.Automatic stabilizers 25 Assignment Problem The problem of assigning each policy instrument to the ultimate policy objective or target on which it has the most influence. For example, in the IS-LM (Mundell-Fleming) model of the open economy this involves the assignment of monetary policy to attain external balance (balance of pay- ments equilibrium on the combined current and capital accounts) and fiscal policy to attain internal balance (full employment). See also: IS-LM model: Open Economy; Mundell, Robert A. Asymmetric Information Asymmetric information occurs where parties to a market transaction possess different information about the good, service or asset that is being traded. The labour market is a good example of a market where asymmet- ric information predominates. Applicants for a job will, for example, have more information about their abilities, honesty and commitment than potential employers. Asymmetric information is one reason why firms may offer higher wages not only to attract the best or most productive applicants but also to deter the most productive workers from quitting, in line with the adverse selection model. The reader is referred to B. Hillier, The Economics of Asymmetric Information (Macmillan, 1997) for an accessible discussion of recent developments in the economics of asymmetric information, including the markets for investment, insurance and labour. See also: Adverse Selection Model; Akerlof, George A.; Stiglitz, Joseph E. Automatic Stabilizers Automatic stabilizers exist within an economy where there is a built-in mechanism that automatically produces offsetting changes to current movements in GNP. The most important examples arise from the govern- ment’s budget position and include progressive income tax and unemploy- ment insurance. For example, in a recession when GNP falls the government's tax receipts fall, while at the same time unemployment insu- rance payments increase as unemployment rises. These arrangements prevent the fall (or rise in the case of an upturn in economic activity) in26 Autonomous expenditure GNP from being as large as it would otherwise have been in their absence. Asa result, they reduce the severity of cyclical fluctuations in the economy. One of the main advantages of built-in stabilizers is that they operate auto- matically without a planned or discretionary policy change being initiated by the government. In other words, with automatic stabilizers there is no inside lag. Furthermore, by reducing the size of the multiplier, automatic stabilizers reduce the extent of economic fluctuations due to autonomous disturbances in aggregate demand See also: Budget Balance; Inside Lag: Multiplier. Autonomous Expenditure Expenditure that does not depend on the level of income. For example, in the Keynesian cross model government expenditure (G), investment expen- diture (7) and exports (X) are assumed to be independent of the level of income. See also: Keynesian Cross. Average Propensity to Consume Aggregate consumption (C) expressed as a proportion of aggregate income (Y). The average propensity to consume (C/Y) can be expressed as the ratio of aggregate consumer expenditure to either aggregate disposable income or national income. The average propensity to consume will equal the marginal propensity to consume when the consumption function (a) is linear and (b) passes through the origin. See also: Absolute Income Hypothesis: Consumption Function; Disposable Income; Marginal Propensity to Consume; National Income; Permanent Income Hypothesis; Relative Income Hypothesis.Average tax rate 27 Average Propensity to Save Aggregate savings (S) expressed as a proportion of aggregate income ( Y). The average propensity to save (S/Y) can be expressed as the ratio of savings to either aggregate disposable income or national income. See also: Disposable Income; National Income. Average Tax Rate Total tax payments expressed as a proportion of total income. While the concept can be applied in the context of a variety of taxes, more often than not it is used to express the fraction of total income paid in income tax.Balance of Payments The balance of payments is an accounting record of a country’s interna- tional transactions with the rest of the world over a given time period (for example, a year). All receipts from non-residents are termed credits and give rise to supplies of foreign currency and a demand for domestic cur- rency. In contrast, all payments by residents to non-residents are termed debits and give rise to a demand for foreign currency and supplies of domestic currency. Credits and debits in the balance of payments can arise from transactions in (a) goods and services, which are recorded in the current account, and (b) capital assets (both real and financial), which are recorded in the capital account. The current account will be in deficit when the total value of imported goods and services is greater than the total value of goods and services exported, and vice versa. The capital account will be in deficit when outflows of capital (for example to finance overseas invest- ment) are greater than inflows of capital, and vice versa. In both cases a deficit corresponds to a situation where payments (debits) to non-residents are greater than receipts (credits) from abroad. Conversely, a surplus corre- sponds to a situation where receipts (credits) from non-residents are greater than payments (debits) abroad. As a financial statement, the overall balance of payments (on the combined current and capital accounts) should sum to zero, with a deficit on the current account offset by a surplus on the capital account, and vice versa. Under a system of flexible exchange rates the exchange rate adjusts to clear the foreign exchange market, ensuring overall balance of payments equilibrium. In contrast, under a system of fixed exchange rates it is pos- sible for a country, at least in the short run, to experience balance of pay- ments disequilibria (deficits and surpluses). Deficits may be financed by running down gold and foreign currency reserves and/or government bor- rowing from abroad, while surpluses allow a country to add to its reserves and/or repay official government debt. Three main approaches to remedy balance of payments disequilibria can be found in the literature. The elas- ticities approach examines the conditions under which devaluation will be successful in remedying a balance of payments deficit on the current account. The absorption approach also examines the way in which govern- ment policy intervention can improve the current account of the balance of payments. In contrast, the monetary approach concentrates on the sum of the current and capital accounts and views the balance of payments as essentially a monetary phenomenon with an automatic adjustment mech- anism. 28