History of Modern Macroeconomics

Lecture 10. The Great Moderation (1975-1995)

Kevin D. Hoover
Department of Economics
Department of Philosophy
Center for the History of Political Economy
Duke University

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Econ 314S History of Modern Macroeconomics
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Lucas and Sargent Before the New
Classical Macroeconomics
 Robert E. Lucas, Jr. (1937- )
 Chicago  Berkeley  Chicago (History 
Economic History  Economics)
 Keynesian education at Chicago
 Early work on investment and labor in Klein’s
microfoundation tradition
 First job: Carnegie Tech

 Thomas J. Sargent (1943- )

 Berkeley  Harvard
 Politically left
 Connected to Carnegie-Mellon
 16 years at University of Minnesota
 Principal subject of Esther-Mirjam Sent’s The
Evolving Rationality of Rational Expectations
(working title: Resisting Sargent)

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Carnegie Tech in the 1950s: Herbert
Simon
 Polymath: economist,
political scientist,
sociologist, psychologist
 Cowles Commission:
seminal work on causality
and identification
 Intellectual leader of
Carnegie’s Graduate School
of Industrial Administration
 Key work on
 bounded rationality
 self-fulfilling expectations
Herbert Simon (1916-2001)  investment

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Carnegie Tech in the 1950s: Two Key
Players – 1
 Franco Modigliani
(1918-2003)
 Nobel Laureate
(1985)

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Carnegie Tech in the 1950s: Two Key
Players – 2
 John F. Muth (1930-2005)
 Photo? If you Google
Image on John F. Muth you
get photos of
 Lucas
 Sargent
 Prescott
 Arrow
 Simon
 Samuelson
John Muth (1930-2005)
 Dornbusch

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 Carnegie Investment Planning
Project
Key Book:

Charles C. Holt, Franco Modigliani, John F.

Muth, and Herbert A. Simon. Planning
Production, Inventories, and Work Force, 1960.

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 Modeling Expectations

A simple expectations model (remember the expectations-

augmented Phillips curve):

X te = X t 1
Adaptive expectations (Phillips, Cagan, Friedman):

X te = X t 1   ( X te1  X t 1 )
where||< 1.

Adaptive expectations implies that current expectations

are geometric averages of past prices:

X te = (1   )  j X t  j
j 1
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Adaptive Expectations are Always Wrong

X
Adjustment of expectations to a one-time,
unexpected change in X

expected value

actual value

time

Econ 314S History of Modern

Macroeconomics Lecture 10, Fall 2017 10
 Muth’s Seminal Papers
 “Rational Expectations and the Theory of Price
Movements” (Econometrica 1961)
 main theory
 published second

 John F. Muth. “Optimal Properties of Exponentially

Weighted Forecasts” (Journal of the American
Statistical Association 1960)
 key example
 refers to later paper in its draft form

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 The Rational Expectations
Hypothesis
expectations, since they are informed predictions of future events, are
essentially the same as the predictions of the relevant economic theory.
...
The hypothesis can be rephrased a little more precisely as follows: that
expectations of firms (or, more generally, the subjective probability
distribution of outcomes) tend to be distributed, for the same
information set, about the prediction of the theory (or the “objective”
probability distributions of outcomes).
The hypothesis asserts three things: (1) Information is scarce, and the
economic system generally does not waste it. (2) The way expectations
are formed depends specifically on the structure of the relevant system
describing the economy. (3) A “public prediction,” in the sense of
Grunberg and Modigliani, will have no substantial effect on the
operation of the economic system (unless it is based on inside
information). [Muth 1961, p. 316]

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The Cobweb and Rational Expectations

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 Lucas and Friedman
 Non-Friedmanian Roots
 Samuelson’s Foundations of Economic Analysis
 receptive to Walrasian theory
 preference for rigor and formal theory

 Debt to Friedman
 preference for radical simplification
 natural rate hypothesis/expectations-augmented Phillips
curve: market-clearing explanation of apparent
disequilibrium based in asymmetric information

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 Lucas and Rapping: The First New
Classical Papers
 Lucas and Leonard Rapping [1933-1991]:
 “Real Wages, Employment, and Inflation” (JPE 1969)
 “Price Expectations and the Phillips Curve” (AER 1969)
 adaptive expectations; mentions does not model rational
expectations
 exploitable tradeoff between inflation and unemployment
 market clearing with asymmetrical information
 surprise-only or Lucas aggregate supply function:
y = (p – pe)
 intertemporal substitution of labor

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 Two Ways of Viewing Aggregate Supply

New Classical Phillips Curve New Classical Aggregate Supply Curve

Inflation Long-run Aggregate Supply Curve
Long-run Phillips Curve Inflation

Short-run (virtual) Aggregate

Short-run (virtual) Phillips Curve Supply Curve

Unemployment Real GDP

Natural rate of Natural rate of
Unemployment Output

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 The Adoption of Rational Expectations
into Macro: Key Lucas Papers
 “Expectations and the Neutrality of Money”
(JET 1972)
 “Econometric Testing of the Natural Rate
Hypothesis” (Fed Conference Volume 1972)
 “Some International Evidence on Output-
Inflation Tradeoffs” (AER 1973)
 "Econometric Policy Evaluation: A Critique".
(Carnegie-Rochester Conference Series on Public
Policy 1976)
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 “Expectations and the Neutrality of
Money” (JET 1972)
 Lucas and Rapping paper in Phelps, editor.
Microeconomic Foundations of Employment and
Inflation Theory.
 Phelps’s “island model”
 Signal extraction
 Stylized, but rigorous, model of the
“surprise-only” aggregate supply function
 The ephemeral Phillips curve
 More cited than used
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 “Some International Evidence on
Output-Inflation Tradeoffs” (AER 1973)
 Empirical test of JET 1972 paper
 Cross-country analysis
 Implication of signal extraction: Phillips
curve (aka: Lucas supply function) steeper in
high variance of inflation environment
 Confirmed, but contested in the literature

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 Aggregate Supply and Noise

New Classical Aggregate Supply Curve

Inflation Short-run AS Curve – high
Long-run Aggregate variability of inflation
Supply Curve

Short-run AS Curve – low

variability of inflation

Real GDP
Natural rate of
Output

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 “Econometric Testing of the Natural
Rate Hypothesis” (Fed Conference
Volume 1972)
 Friedman’s not really a natural rate model
 regression tests the wrong test of the natural
rate hypothesis (cf. Muth 1960)
 correct test: overidentifying cross-equation
restrictions (early example of solution
methods for rational expectations models
 characterizes policy by a fixed rule  proto-
policy invariance critique
Econ 314S History of Modern
Macroeconomics Lecture 10, Fall 2017 21
 “Econometric Policy Evaluation: A Critique”
(Carnegie-Rochester Conference Series on Public
Policy 1976)
 Pivotal macroeconomics paper of the second half of the 20 th
century
 Foreshadowed by Tinbergen, Simon, Marschak, et al. (Cowles
Commission)
 Novelty: rational expectations as source of invariance
 Critique of Tinbergen’s policy framework:
 targets and instruments = engineering paradigm

 can’t neglect rational action or economists inside the game

 Solution
 model tastes and technology  GE microfoundations essential

 doing Cowles right

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 Sargent

 Independent introduction of rational

expectations
 real interest rates
 hyperinflation
 Phillips curve
 Integration of rational expectations to time-
series econometrics (Christopher Sims (Nobel
Prize 2011) a colleague at Minnesota)
 More empirically oriented than Lucas
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 Sargent and Wallace: Policy
Ineffectiveness – 1
 Neil Wallace (1938- )
 Chicago Ph.D under Friedman
 Faculty of University of Minnesota
 “Rational Expectations, the Optimal
Monetary Policy and the Optimal Money
Supply Rule (JPE 1975)
 “Rational Expectations and the Theory of
Economic Policy” (JME 1976)

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 Sargent and Wallace: Policy
Ineffectiveness – 2
 IS-LM model
 = no microfoundations
 with Lucas aggregate supply function
 = classical dichotomy and continuously clearing markets
 + rational expectations
 = no short-run deviations of expectations from reality except
randomly
  Policy Ineffectiveness = pure AD policies affect
output only randomly
 + Fixed M rules  price level control
 + Interest-rate rules or feedback rules  indeterminancy
 Startling, suits conservative rhetoric
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 Key Tenets of the New Classical
Macroeconomics
1. Real economic decisions based on real, not
nominal (i.e., monetary) factors = classical
dichotomy
2. Agents, to the limits of their information,
are successful optimizers = market clearing
conditional on information
3. Agents make no systematic errors in
evaluating their economic environments =
rational expectations hypothesis
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 Consolidation of the New Classical
School
 Sargent’s graduate textbook: Macroeconomic
Theory 1979
 Lucas and Sargent, editors. Rational
Expectations and Econometric Practice 1981
 aggregative macro/not microfoundational
 emphasis on systems or GE implications of
rational expectations
 emphasis on econometrics

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 The Manifestos
 Lucas and Sargent “After Keynesian
Macroeconomics” (Minneapolis Fed Quarterly Review
1979)
 framed as attack on Keynes despite
 Keynesian roots
 earlier critical targets Klein and Tinbergen
 Sargent “Beyond Demand and Supply Curves in
Macroeconomics” (AER 1982)
 optimizing microfoundations with rational expectations
 ignores earlier microfoundational programs

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 The Euthanasia of Macroeconomics

 If these developments succeed, the term

“macroeconomics” will simply disappear from use,
and the modifer “micro” will become superfluous.
We will simply speak, as did Smith, Ricardo,
Marshall, and Walras, of economic theory. [Lucas
Models of Business Cycles 1987]
 The inversion of Klein’s program:
 Klein: data first (analogical consistency with theory)
 Lucas: theory first (analogical consistency with data)

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 The Problem of Business Cycles

 The empirical failure of the monetary shocks

approach
 no difference between anticipated and
unanticipated money
 no reaction to data revisions
 unaccountable serial correlations
 Ad hoc solutions
 lagged dependent variables without a rationale

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Lucas: A Positive Program for Business
Cycles
 Continuous market-clearing, dynamic equilibrium
 against Keynes’s involuntary unemployment
 “involuntary unemployment is not a fact or a phenomenon which
it is the task of the theorist to explain. It is, on the contrary, a
theoretical construct which Keynes . . . hope[d] would be helpful
in discovering a correct explanation for a genuine phenomenon:
large-scale fluctuations in measured, total unemployment. Is it
the task of modern theoretical economics to ‘explain’ the
theoretical constructs of our predecessors, whether or not they
have proved fruitful?”
 Business cycle phenomena:
 not objects, but patterns of covariation
 picked up by Kydland and Prescott
 surprising respect for Burns and Mitchell

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The Simulacrum Account of Models

 j
 j
 j
 pattern prediction vs. forecasting
 testing rules vs. conditional forecasts
 Turing and Adelman tests

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 The Transition to the Real Business
Cycle Model
 Lucas’s 1975 Business Cycle Model
 growth, capital, and the propagation mechanism
 the last gasp of the monetary surprises
 alternative rationales for money
 Kydland and Prescott, “Time to Build and
Aggregate Fluctuations”
 technology shocks
 the absence of monetary shocks
 the irrelevance of time-to-build
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The Rise of the Representative Agent

 The neoclassical growth model

 Solow
 optimal growth in the 1960s
 the planning roots of the “representative agent”

 Ignoring aggregation

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 New Keynesian Macroeconomics
 Immediate objections to the policy
ineffectiveness proposition:
 John Taylor
 Stanley Fischer
 overlapping labor contracts
 Rational expectations is not the issue
 Central Issues:
 apparent effectiveness of monetary policy = e.g.,
Friedman & Schwartz
 the problem of business cycles
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 Sources of “Friction”
 New Keynesians
 = “imperfectionists”
 concede the ideal model to New Classicals
 Slow price adjustment
 implies policy effectiveness
 provides basis for cycles
 Sources:
 menu costs
 efficiency wages
 fixed contracts
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 “Perfectionist” New Keynesians

 Sunspot Models

 Multiple equilibrium models

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Macroeconomics Lecture 10, Fall 2017 37
The Saltwater and Freshwater Schools

New Classicals = Freshwater: near New Keynesians = Saltwater: near oceans

lakes (Universities of Chicago, (Universities of California, Berkeley,
Minnesota, and Rochester Harvard, MIT

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Macroeconomics Lecture 10, Fall 2017 38
 Two Victories

 New Classicals won the methodological

battle
 representative-agent microfoundations
 imperfectionist models
 major defeat for the Klein program
 New Keynesians won the empirical battle
 price stickiness widely accepted
 needed to explain business cycles
 supports policy effectiveness

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Macroeconomics Lecture 10, Fall 2017 39
 The New Neoclassical Synthesis

 The Dynamic Stochastic General Equilibrium

Model (DSGE)
 intertemporal optimization
 rational expectations
 representative agent microfoundations
 “frictions” as necessary
 e.g., reaction to 2007-2009 crisis: DSGE + financial
frictions
 An end to the Saltwater/Freshwater split?
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Macroeconomics Lecture 10, Fall 2017 40
Thanks

The End

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