Advances in Macroeconomic Theory

This volume collects the 16 invited lectures on macroeconomics delivered at the Twelfth World Congress of the International Economic Association in Buenos Aires, 23–27 August 1999. Responsibility for issuing the invitations and suggesting topics rested with me, so I am fully accountable for selection bias. Authors knew that they were addressing a general audience. They were urged to cover a broad topic rather than a sharp contribution, and to present their own views rather than a balanced survey. The typical lecture summarized, with a minimum of technicality, the main conclusions of the author’s research over a decade or more in some broad area of relevance to macroeconomics. Beyond the value of the individual lectures, this volume offers a selective but largely spread-out picture of ongoing research in macroeconomics. I first summarize the lectures (section 1.1), then offer some speculative conclusions of my own on the state of the discipline (section 1.2).

The puzzle I want to discuss — at least it seems to me to be a puzzle, though part of the puzzle is why it does not seem to be a puzzle to many of my younger colleagues — is this. More than forty years ago, I — and many others, especially Trevor Swan and James Tobin — worked out what has since come to be called neoclassical growth theory. It may not be clear exactly what we or I — I had better speak for myself — thought growth theory applied to, what it was trying to describe. We may have to talk more about that later. But it was clear from the very beginning what I thought it did not apply to, namely short-run fluctuations in aggregate output and employment, what used to be called the business cycle and is now often called that again. In those days I thought growth theory was about the supply side of the economy, whereas the business cycle was mostly to be analysed in terms of changes in aggregate demand.

As a full-time academic, I have led a rather uneventful life. Yet, I have engaged in two venturesome explorations. On my 65th birthday, my wife and I took off in our 42-ft sloop and sailed around the world. Also, I have explored some macroeconomic issues. That second venture proved more hazardous, more demanding and rather less rewarding than the first.

The rational expectations hypothesis is by far the most common expectations assumption used in macroeconomic research today. This hypothesis, which simply states that people’s expectations are the same as the forecasts of the model being used to describe those people, was first put forth and used in models of competitive product markets by John Muth in the 1960s. But it was not until the early 1970s that Robert Lucas (1972, 1976) incorporated the rational expectations assumption into macroeconomics and showed how to make it operational mathematically. The ‘rational expectations revolution’ is now as old as the Keynesian revolution was when Robert Lucas first brought rational expectations to macroeconomics.

The widespread development of models of imperfect information has provided a wealth of new perspectives for investigating the impact of monetary policy on both long-term economic growth and cyclical fluctuations.¹ This body of work describes a number of new theoretical mechanisms which may affect the role of monetary policy. Indeed, a complete enumeration of the potential monetary effects in question is beyond the scope of any single paper of manageable length, and this chapter does not attempt to provide such a summary. Instead it analyses monetary policy in the context of a single particular model. Nevertheless, the focused model presented in this chapter has broad implications which capture many of the general features of the new imperfect-information-based monetary models, particularly the ways in which they differ from traditional classical and Keynesian alternatives. Monetary policy in this model does have consistent real effects on output, but it operates as much by reducing business risk and by redistributing resources to the business sector as it does by stimulating aggregate demand through interest rate reductions. Moreover, these effects do not depend on many of the familiar price-rigidity and closed-economy features which drive other models of monetary policy effectiveness.

If prices and wages were perfectly flexible, monetary policy would be irrelevant. But casual observation suggests both that nominal prices and wages are at least somewhat rigid and that monetary policy has real effects. Economists’ understanding of the nature of these rigidities has improved in recent years. At the same time, policy makers have begun to incorporate economists’ theoretical and empirical findings in their institutions and actions. This chapter explores the ways in which our empirical understanding of nominal rigidities informs three key dimensions of the conduct of monetary policy: how we measure core inflation, how we control inflation, and how we choose inflation targets.

Capitalist countries have historically had quite different labour market institutions and social policies: high mobility and flexibility in the United States, lifetime employment and steep seniority profiles in Japan, corporatism in the Nordic countries and Austria, apprenticeships in Germany, the SMIC minimum wage and legislated work-time in France. Throughout the EU, ‘social partners’ negotiate arrangements, whereas in North America the term has no meaning. The labour market is potentially the most idiosyncratic market in advanced capitalism.

The core mechanism that drives economic growth in modern market economies is the massive ongoing restructuring and factor reallocation by which new technologies replace the old. This process of Schumpeterian ‘creative destruction’ permeates major aspects of macroeconomic performance — not only long-run growth, but also economic fluctuations and the functioning of factor markets. At the microeconomic level, restructuring demands innumerable decisions to create or destroy production units. The efficiency of those decisions hinges on the existence of sound institutions that provide a proper transactional framework. Failure along this dimension can have dire macroeconomic consequences. By limiting the economy’s ability to tap new technological opportunities and adapt to a changing environment, institutional failure can result in dysfunctional factor markets, economic stagnation, and exposure to deep crises.

In this survey, I intend to describe the latest efforts of labour economists to analyse wage rigidity both in its existence and in its consequences in various countries, in particular the United States and France. There has been recently a renewed interest in questions surrounding wage rigidity, a central concern of many macroeconomists. In addition, the existence of wage rigidities has been viewed by some analysts as the main reason for the high level of European unemployment, in contrast to the North American situation. The stakes are clear enough so that I do not need to spend much time in this introduction on justifying why we should, as economists, be interested in this topic.

As the proverb says, it is wisdom that we want and much of what we do is aimed at acquiring it. On reflection, the acquisition of wisdom is a twostage process. In the first stage ideas are accumulated and explored; in the second those ideas that have withstood the ‘experience test’ are retained and recounted to others as insights. Macroeconometric modelling involves the same dichotomy and it was one that was fruitfully exploited by the Cowles Commission researchers, albeit informally. In the first stage, evidence needs to be assembled and summarized in a convenient and meaningful way, while, in the second, effort is devoted to interpreting the evidence through a set of principles or theories.¹ For the Cowles Commission the two stages were represented by the construction of a reduced form and a structure. Thus the distinction has a distinguished history in econometrics. However, all too often it has been ignored and the two stages are blurred together. Indeed, this blurring of the two categories goes back to the very beginnings of macroeconometrics and even features one of the most prominent members of the Cowles Commission, Tjalling Koopmans. The occasion was his famous critique of Burns and Mitchell’s (1947) work on the business cycle.

Rational expectations (RE) is currently the standard approach to modelling expectations in macroeconomics. However, refinements to modelling expectations formation have recently been developed and the literature on learning dynamics has grown rapidly. The basic idea in models of learning is that agents have limited information about the structure of the economy and they have to act inductively like scientists when they forecast the relevant aspects of its future course. Some forecasting is necessary since, as is common in economics, the decisions of individual agents depend on the future and these agents are forward looking in their decision-making. The RE hypothesis is weakened to the assumption that expectations follow a real-time learning rule which often will make expectations converge to RE over time.

One of the main tasks of macroeconomists is to explain why there are fluctuations in output and employment and why growth is not a steady process.

In recent years, developing countries in different regions of the world have been struggling to create an economic and social environment conducive to sustainable growth with a reduction of poverty. In the process, countries have introduced policy and institutional reforms aimed at restoring macroeconomic stability, improving overall economic efficiency and promoting opportunities for the poor. Progress has differed among countries, depending on the government objectives, the strategies followed, and the capacity of the governments to gather support and to carry through their policies. However, most countries have made substantial progress in the narrow area of stabilizing their economies and in opening their economies to foreign trade. A more stable macroeconomic situation and the resultant dismantling of protection reduced the anti-export bias of the trade regime, facilitating an expansion of export activities. In turn, for a given size of the trade balance deficit, export expansion led to a higher level of imports. The higher level and better quality of imports, in turn, have had positive effects on consumers’ welfare and on total factor productivity.

Less-developed countries (LDCs) have provided the economics profession with a wide range of macroeconomic experiences. Many are experiences of failure, a few of success. It is my belief that useful lessons can be obtained from all those experiences. Contrary to the widely held belief that it is not possible to transfer to LDCs theories and policies designed for developed countries, I hold the position that there is only one body of economic theory and that the best policies apply to all patients and are, for most cases, the simplest: market rules, free trade and orthodox monetary and fiscal policy.

In this chapter l describe some empirical regularities in cross-country patterns of aggregate economic growth, and discuss how theoretical reasoning has guided their analysis.