The Dismal Science: A Personal Reflection – Part Two

Part 2: Mainstream Macroeconomics – A Nothing-New Consensus?

When I started to study economics in the mid-1970s, it was a period of rapid theoretical development in mainstream macroeconomics. The established post-war consensus in mainstream macroeconomics built around the Neoclassical Synthesis was breaking down because of the obvious disconnect between the rational-agent/constrained-optimisation models of microeconomics and the simple IS-LM and AD-AS macro models based on seemingly ad hoc behavioural assumptions. The search was on for the appropriate microfoundations of macroeconomics. Those of a more Keynesian disposition focused initially on disequilibrium models, providing a sophisticated treatment of quantity adjustments when prices are slow to adjust. But this still left open the question as to why prices, particularly, wages were sticky. Ultimately this led to the emergence of the New Keynesian Economics (NKE) in the 1980s/1990s with a veritable proliferation of choice-theoretic models of price and wage stickiness. The invisible-hand theorem of self-equilibrating markets requires a whole set of structural and informational conditions to be met. Relaxing any of these assumptions and allowing for imperfections could explain why prices and wages might be slow to adjust, or indeed never adjust fully, to the perfectly competitive (full-employment) equilibrium. The NKE is effectively just the macroeconomics of market failures.

              The alternative search for microfoundations focused on the dynamic behaviour of rational agents under conditions of stochastic uncertainty. The New Classical Economics (NCE) rejected the ad hoc assumption of adaptive expectations that had been used in the expectations-augmented Phillips curve (EAPC) to justify the possibility of effective short-run stabilisation policy. The NCE adopted instead the rational expectations hypothesis (REH), assuming that rational economic agents are fully informed of the systematic behaviour of the economy with expectational errors due to unpredictable shocks to the economic system. The NCE integrated the REH into a market-clearing equilibrium model of the macro economy to provide a powerful theoretical argument against policy activism. The NCE argued for a Panglossian world characterised by REH, information-efficient markets, and policy irrelevance. Two influential NCE propositions were Ricardian equivalence and the Lucas critique, both of which reinforced policy irrelevance. Ricardian equivalence implies that forward-looking rational agents treat debt-financing and tax-financing as equivalent so that fiscal policy has no first-order impact on aggregate demand. The Lucas critique recognises the endogeneity of behaviour responses to policy changes with forward-looking rational agents, making the construction optimal policy responses to economic shocks as something of a will-o’-the wisp.

The New Consensus Macroeconomics combines elements of both NKE and NCE. The simple macro model is in many ways just a modern version of the ISLM and AD-AS models of the Neoclassical Synthesis. The IS and AD curves are retained with the supply side represented by the EAPC (incorporating the REH) and the LM curve replaced by a Taylor-type monetary rule relating the nominal interest rate to deviations in inflation and output from their target levels. The case for activist stabilisation policy remains an empirical question of the speeds of adjustment and the degree of price and wage stickiness. In a very real sense the New Consensus Macroeconomics is a Nothing-Fundamentally-New Consensus Macroeconomics.

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• The Dismal Science – A Personal Reflection Part 1, 6^th Sept 2023