Wednesday, January 10, 2007

Macroeconomics revolution in sight?

Let’s talk about macroeconomics --a subject that discusses the national output, inflation, unemployment, and the likes. If you fancy more thorough definition of macroeconomics, you can always consult the text-book, of course.

But firstly we need to imagine how a (national) economy works. And in this respect, I think the credit goes to John Maynard Keynes and his General Theory of Employment, Interest, and Money, who brought the macroeconomics into the world, as a result of his thinking on Great Depression in 1930s. This was the first revolution.

With help of IS-LM model of Hicks (1937), how an economy work, in Keynesian way, can be best described as interaction between goods market (equilibrium of aggregate demand that consist of consumption, investment, government spending, and, export import; and output) and assets market (equilibrium of money market and asset market), connected by the interest rate.

This is a powerful model, at least until the 1970s. It also gives a room for government to fine-tune the economy along its cyclical pattern of boom and bust through fiscal policy (in goods market) and monetary policy (in money market).

But in 1970s the assault of Keynesian model came from two directions, empirically and theoretically (Akerlof, 2007). Empirically, the Philips curve, one of main feature of Keynesian model, for converse relationship between inflation and unemployment didn’t hold, mainly in US. They had stagflation.

And theoretically, and more interestingly, some of basic Keynesian model tenets were no longer valid as a result of the discovery of five neutralities: the independence of consumption and current income, the independence of investment and finance decision, inflation stability at natural rate of unemployment, and ineffective monetary policy with rational expectation; and Ricardian equivalence.

Alright, OK, I see you raise you eyebrows. That’s OK, don’t bother too much, I just want to say that the science gave birth to its second revolution, particularly after the Lucas rational expectation theory, and called the outcome New Classical macroeconomics.

And this took places by mainly adopting the micro-foundations approach of firms profit maximising and consumer utility maximising; and lending heavy weigh on market perfection. And they believe, more or less, any government intervention and fine-tuning effort would be useless.

Afterward the works have been going on, as well as the battle between two schools of thought. By incorporating market imperfection (frictions) into the model to defend the old Keynesian pre-suppositions, the New Keynesian reacted to New Classical Model. And the newest proposal came from Akerlof (2007), in pdf, who introduces sociological term of norm into equation to nullify five neutralities championed by New Classical macroeconomists abovementioned.

But, in my opinion, the New Classical revolution and the works afterward haven’t really brought a new general model of the economy, they way Keynesian did. All are only partial assaults on the Keynesian framework, without producing a comparable great model on how the economy works.

I once emailed one of the authorities in the field, Gregory Mankiw, asking for another possibility of scientific revolution in Macroeconomics:

I was expecting that Asia crisis in 1998 brought a revolution in the field, the way Great Depression in 1930s delivered Keynesian revolution. Alas, it wasn't the case. Why?
-r

And his answer

Good question, I don’t know.

greg

Maybe you know the answer?

P/s: This is the extension of this old posting, adding a little methodological issue into the discussion here.

5 comments:

  1. Why didn't the Asian crisis bring about a revolution in economics?

    -- Probably because economists already had the tools to analyse the crisis.

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  2. -- Probably because economists already had the tools to analyse the crisis.

    I think John's right. The tools are there to apply.

    Other explanation: institutional economics is starting to get popular in the '90s. People then got tempted to analyze the crisis from institutional economics perspective (bad governance, bad regulation, bad politics etc.).

    So, there was no revolution in macroeconomics. But there was an evolution in the other area (or in economics in general).

    Like Lindauer and Prithcett (2002) said: It's hard to get a big idea nowadays. So perhaps we don't need another big idea...

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  3. John and a.p

    On the tools. But which one? Keynesian, some say, is empirically irrelevant, so is New Classical (I guess Mankiw wrote this).

    On big idea, an economy is indeed a big stuff, and come to think of it, you can't avoid to have a "big idea" in your mind while doing macroeconomics analysis.

    I am actually expecting that all of those evolutionary works from both schools (great works as they are), following Kuhnian logics, would lead to the revolution as a birth of coherent collection of knowledge -- a paradigm shift.

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  4. "The tools are there to apply."

    And certain Asian govts at the time (who will remain nameless) had *zippo* economic wherewithal to apply them.

    However economists have this frustrating habit of saying "i told you so" /after/ a bloody crisis :):) -- so maybe Rizal is correct to a certain degree -- economists did fail to predict the crisis, and the economic boffins at the WB for example seemed to only exacerbate things afterwards...

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    I /really/ need to read up more about the crisis. any recommendations? -- arya recommended "the chastening" (but unfortunately i haven't been able to get my hands on it...).

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  5. please consider Taylor Rule Mechanism for inflation control.

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