What Do We Know about Macroeconomics that Fisher and Wicksell Did Not

What Do We Know about Macroeconomics that Fisher and Wicksell Did Not? Author(s): Olivier Blanchard Reviewed work(s): Source: The Quarterly Journal of Economics, Vol. 115, No. 4 (Nov., 2000), pp. 1375-1409 Published by: Oxford University Press Stable URL: http://www.jstor.org/stable/2586928 . Accessed: 08/01/2012 01:50 Your use of the JSTOR archive indicates your acceptance of the Terms & Conditions of Use, available at . http://www.jstor.org/page/info/about/policies/terms.jsp JSTOR is a not-for-profit service that helps scholars, researchers, and students discover, use, and build upon a wide range of content in a trusted digital archive. We use information technology and tools to increase productivity and facilitate new forms of scholarship. For more information about JSTOR, please contact support@jstor.org. Oxford University Press is collaborating with JSTOR to digitize, preserve and extend access to The Quarterly Journal of Economics. http://www.jstor.org WHAT DO WE KNOW ABOUT MACROECONOMICS THAT FISHER AND WICKSELL DID NOT?* OLIVIER BLANCHARD This essay argues that the history of macroeconomics during the twentieth century can be divided into three epochs. Pre-1940: a period of exploration, during which all the right ingredients were developed. But also a period where confusion reigned, because of the lack of an integrated framework. From 1940 to 1980: a period during which an integrated framework was developed-from the IS-LM to dynamic general equilibrium models. But a construction with an Achilles' heel, too casual a treatment of imperfections, leading to a crisis in the late 1970s. Since 1980: a new period of exploration, focused on the role of imperfections in macroeconomics. Exploration often feels like confusion. But behind it is one of the most productive periods of research in macroeconomics. The editors of the Quarterly Journal of Economics have commissioned a series of essays on the theme: what do we know about field x that Marshall did not? In the case of macroeconomics, Marshall is not the right reference. But if we replace his name with those of Wicksell and of Fisher, the two dominant figures in the field at the start of the twentieth century, the answer is very clear: we have learned a lot. Indeed, progress in macroeconomics may well be the success story of twentieth century economics. Such a strong statement will come as a surprise to some. On the surface, the history of macroeconomics in the twentieth century appears as a series of battles, revolutions, and counterrevo- lutions, from the Keynesian revolution of the 1930s and 1940s, to the battles between Monetarists and Keynesians of the 1950s and 1960s, to the Rational Expectations revolution of the 1970s, and the battles between New Keynesians and New Classicals of the 1980s. These suggest a field starting anew every twenty years or so, often under the pressure of events, and with little or no common core. But this would be the wrong image. The right one is of a surprisingly steady accumulation of knowledge. The most outrageous claims of revolutionaries make the news, but are eventually discarded. Some of the others get bastardized and then integrated. The insights become part of the core. In this article I * I thank Daron Acemoglu, Ben Bernanke, Ricardo Caballero, Thomas Cool, Peter Diamond, Rudiger Dornbusch, Stanley Fischer, Bengt Holmstr6m, Lawrence Katz, David Laibson, N. Gregory Mankiw, David Romer, Paul Samuelson, Andrei Shleifer, Robert Solow, Justin Wolfers, and Michael Woodford for useful comments and discussions. An earlier version was given as the Tinbergen lecture in Amsterdam in October 1999. ? 2000 by the President and Fellows of Harvard College and the Massachusetts Institute of Technology. The Quarterly Journal of Economics, November 2000 1375 1376 QUARTERLY JOURNAL OF ECONOMICS focus on the accumulation of knowledge rather than on the revolutions and counterrevolutions. Admittedly, this makes for worse history of thought, and it surely makes for worse theater. But it is the best way to answer the question in the title.1 Let me state the thesis that underlies this essay. I believe that the history of macroeconomics during the twentieth century can be divided into three epochs, the third one currently playing.2 * Pre-1940. A period of exploration, where macroeconomics was not macroeconomics yet, but monetary theory on one side and business cycle theory on the other. A period during which all the right ingredients, and quite a few more, were developed. But also a period where confusion reigned, because of the lack of an integrated framework. * From 1940 to 1980. A period of consolidation. A period during which an integrated framework was developed- starting with the IS-LM, all the way to dynamic general equilibrium models-and used to clarify the role of shocks and propagation mechanisms in fluctuations. But a con- struction with an Achilles' heel, namely too casual a treatment of imperfections, leading to a crisis in the late 1970s. * Since 1980. A new period of exploration, focused on the role of imperfections in macroeconomics, from the relevance of nominal wage and price setting, to incompleteness of markets, to asymmetric information, to search and bargain- ing in decentralized markets, to increasing returns in production. Exploration often feels like confusion, and confusion there indeed is. But behind it may be one of the most productive periods of research in macroeconomics. Let me develop these themes in turn. I. PRE-1940: EXPLORATION To somebody who reads it today, the pre-1940 literature on macroeconomics feels like an (intellectual) witch's brew: many 1. A nice, largely parallel, review of macroeconomics in the twentieth century, taking the alternative, more historical, approach is given by Woodford [1999]. 2. For the purpose of this article, I shall define macroeconomics as the study of fluctuations, mundane-recessions and expansions-or sustained-sharp reces- sions, long depressions, sustained high unemployment. I shall exclude both the study of growth and of the political economy of macroeconomics. Much progress has been made there as well, but covering these two topics would extend the length of this essay to unmanageable proportions. WHAT DO WE KNOW ABOUT MACROECONOMICS? 1377 ingredients, some of them exotic, many insights, but also a great deal of confusion. The set of issues that would now be called macroeconomics fell under two largely disconnected headings: Monetary Theory and Business Cycle Theory.3 At the center of Monetary Theory was the quantity theory- the theory of how changes in money lead to movements in output and in prices. The focus was both on long-run neutrality and on short-run nonneutrality. The discussion of the short-run effects of an increase in money on output was not much improved relative to, say, the earlier treatments by Hume or by Thornton. Some stressed the effects from money to prices and from prices to output: higher money led to higher prices; higher prices "excited" business and led in turn to higher output. Others stressed the effects from money to output, and from output to prices: higher money increased demand and output, and the increase in output in turn led to an increase in prices over time. Business Cycle Theory was not a theory at all, but rather a collection of explanations, each with its own rich dynamics.4 Most explanations focused on one factor at a time: real factors (weather, technological innovations), or expectations (optimistic or pessimis- tic firms), or money (banks or the central bank). When favorable, these factors led firms to invest more, banks to lend more, until things turned around, typically for endogenous reasons, and the boom turned into a slump. Even when cast as general equilibrium, the arguments, when read today, feel incomplete and partial equilibrium in nature: it is never clear how, and in which markets, output and the interest rate are determined. In retrospect, one can see the pieces of a macroeconomic model slowly falling into place. At the center was the difference, emphasized by Wicksell [1898], between the natural rate of interest (the rate of return on capital) and the money rate of interest (the interest rate on bonds). This would become a crucial key in allowing for the 3. The word "macroeconomics" does not appear until the 1940s. According to JSTOR (the electronic database that includes the articles from most major journals since their inception), the first use of "macro-economic" in the title of an article is by De Wolff in 1941, in "Income elasticity of demand, a micro-economic and a macro-economic interpretation;" the first use of "macroeconomics" in the title of an article is by Klein [1946] in an article called, fittingly, "Macroeconomics and the Theory of Rational Behavior." 4. The variety and the complexity of these explanations is reflected in Mitchell [1923], or in the textbook of the time, Prosperity and Depression, by Haberler [1937]. 1378 QUARTERLY JOURNAL OF ECONOMICS eventual integration of goods markets (where the natural rate is determined), and financial markets (where the money rate is determined). It would also prove to be the key in allowing for the eventual integration of monetary theory (where an increase in money decreases the money rate relative to the natural rate, triggering higher investment and higher output for some time), and business cycle theory (in which several factors, including money, affect either the natural rate or the money rate, and thus the difference between the two). Where the literature remained confused, at least until Keynes and for some time after, was how this difference between the two rates translated into movements in output. Throughout the 1920s and 1930s the focus was increasingly on the role of the equality of saving and investment, but the semantic squabbles that domi- nated much of the debate (the distinctions between "ex ante," and "ex post," "planned" and "realized" saving and investment, the discussion of whether the equality of saving and investment was an identity or an equilibrium condition) reflected a deeper confu- sion. It was just not clear how shifts in saving and investment affected output. In that context, the methodological contributions of the General Theory [1936] made a crucial difference. * Keynes explicitly thought in terms of three markets (the goods, the financial, and the labor markets), and of the implications of equilibrium in each. * Using the goods market equilibrium condition, he showed how shifts in saving and in investment led to movements in output. * Using equilibrium conditions in both the goods and the financial markets, he then showed how various factors affected the natural rate of interest (which he called the "marginal efficiency of capital"), the money rate of interest, and output. An increase in the marginal efficiency of capital-coming, say, from more optimistic expectations about the future-or a decrease in the money rate-coming from expansionary monetary policy-both led to an in- crease in output. A quote from Pigou's Marshall lectures, Keynes's General Theory: A Retrospective View" [1950], puts it well:5 "Nobody before 5. Pigou's first assessment of The General Theory, in 1936, had been far less positive, and for understandable reasons: Keynes was not kind to Pigou in The WHAT DO WE KNOW ABOUT MACROECONOMICS? 1379 him, so far as I know, had brought all the relevant factors, real and monetary at once, together in a single formal scheme, through which their interplay could be coherently investigated." The stage was then set for the second epoch of macroeconom- ics, a phase of consolidation and enormous progress. II. 1940-1980: CONSOLIDATION Macroeconomists often refer to the period from the mid-1940s to the mid-1970s as the golden age of macroeconomics. For a good reason: progress was fast and visible. II. 1. Establishing a Basic Framework The IS-LM formalization by Hicks [1937] and Hansen may not have captured exactly what Keynes had in mind. But, by defining a list of aggregate markets, writing demand and supply equations for each one, and solving for the general equilibrium, it transformed what was now becoming "macroeconomics." It did not do this alone. Equally impressive in their powerful simplicity were, among others, the model developed by Modigliani in 1944, with its treatment of the labor market and the role of nominal wage or price rigidities, or the model developed by Metzler in 1951, with its treatment of expectations, wealth effects, and the government budget constraint. These contributions shared a common structure: the reduction of the economy to three sets of markets-goods, financial, and labor-and a focus on the simulta- neous determination of output, the interest rate, and the price level. This systematic, general equilibrium, approach to the characterization of macroeconomic equilibrium became the stan- dard, and, reading the literature, one is struck by how much clearer discussions became once this framework had been put in place. This approach was brought to a new level of rigor in "Money, Interest, and Prices" by Patinkin [1956]. Patinkin painstakingly derived demand and supply relations from intertemporal optimiz- ing behavior by people and by firms, characterized the equilib- rium, and, in the process, laid to rest many of the conceptual confusions that had plagued earlier discussions. It is worth General Theory. But, by 1950, time had passed, and Pigou clearly felt more generous. 1380 QUARTERLY JOURNAL OF ECONOMICS making a-nonlimitative-list (if only because some of these confusions have a way of coming back in new forms). * "Say's law": False. In the same way as the supply of any particular good did not automatically generate its own demand (the relative price of the good has to be right), the supply for all goods taken together did not generate its own demand either. The intertemporal price of goods, the real interest rate, also had to be right. * "Walras law": True. As long as each agent took all his or her decisions under one budget constraint, then equilibrium in all markets except one implied equilibrium in the remain- ing one. * The "Classical Dichotomy" between the determination of the price level on the one hand, and the determination of relative prices on the other: False. "Neutrality," the proposi- tion that changes in money were ultimately reflected in proportional changes in the price level, leaving relative prices unaffected, was true. But this was an equilibrium outcome, not the result of a dichotomous model structure. * "Value Theory versus Monetary Theory"-the issue of whether standard methods used in value theory could be used to think about the role and the effects of money in a monetary economy. The answer was: Yes. One could think of real money balances as entering either the indirect utility of consumers, or the production function of firms. One could then treat real money balances as one would treat any other good. * "Loanable Funds or Liquidity Preference"-the issue of whether the interest rate was determined in the goods markets (through the equality of saving and investment), or in the financial markets (through the equality of the demand and the supply of money). The answer, made clear by the general equilibrium structure of the models, was, in general, both. II.2. Back to Dynamics Keynes himself had focused mostly on comparative statics. Soon after, however, the focus shifted back to dynamics. Little if any of the old business cycle literature was used, and most of the work was done from scratch. Key to these developments was the notion of "temporary equilibrium," developed by Hicks in Value and Capital [1939]. The WHAT DO WE KNOW ABOUT MACROECONOMICS? 1381 approach was to think of the economy as an economy with few future or contingent markets, an economy in which people and firms therefore had to make decisions based partly on state variables-variables reflecting past decisions-and partly on ex- pectations of the future. Once current equilibrium conditions were imposed, the current equilibrium depended partly on history and partly on expectations of the future. And given a mechanism for the formation of expectations, one could trace the evolution of the equilibrium through time. Within this framework, the next step was to look more closely at consumption, investment, and financial decisions, and their dependence on expectations. This was accomplished, in a series of extraordinary contributions, by Modigliani and Friedman who examined the implications of intertemporal utility maximization for consumption and saving, by Jorgenson and Tobin who exam- ined the implications of value maximization for investment, and by Tobin and a few others who examined the implications of expected utility maximization for financial decisions. These devel- opments would warrant more space, but they are so well-known and recognized (in particular, by many Nobel prizes) that there is no need to do so here. The natural next step was to introduce rational expectations. The logic for taking that step was clear. If one was to explore the implications of rational behavior, it seemed reasonable to assume that this extended to the formation of expectations. That step, however, took much longer. It is hard to tell how much of the delay was due to technical problems-which indeed were substantial- and how much to objections to the assumption itself. But this was eventually done, and by the late 1970s, most of the models had been reworked under the assumption of rational expectations.6 With the focus on expectations, a new battery of small models emerged, with more of a focus on intertemporal decisions. The central model was a remake of a model first developed by Ramsey in 1928, but now reinterpreted as a temporary equilibrium model with infinitely lived individuals facing a static production technol- 6. This is where a more historical approach would emphasize that this was not a smooth evolution.... At the time, the introduction of rational expectations was perceived as an attack on the received body of macroeconomics. But, with the benefit of hindsight, it feels much less like a revolution than like a natural evolution. (Some of the other issues raised by the same economists who introduced rational expectations proved more destructive, and are at the source of the crisis I discuss below.) 1382 QUARTERLY JOURNAL OF ECONOMICS ogy.7 This initial structure was then extended in many directions.8 Among them were the following: * The introduction of costs of adjustment for capital, leading to a well-defined investment function, and a way of think- ing about the role of the term structure of interest rates in achieving the equality of saving and investment. * The introduction of money as a medium of exchange, and the extension of the Baumol-Tobin model of money demand to general equilibrium. * The introduction of some dimensions of heterogeneity, for example, allowing for finite lives and extending the overlap- ping-generation model first developed by Samuelson and Diamond. * The introduction of a leisure/labor choice, in addition to the consumption/saving decision. * The extension to an economy open both in goods and financial markets. Initially, these models were solved under perfect foresight, a simplifying but rather unappealing assumption in a world of uncertainty and changing information. That introducing uncer- tainty was essential was driven home in an article by Hall [1978], who showed that, under certain con