The Ultimate "Slippery Slope" Argument
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History of Macroeconomics

Paul Krugman asks an important question: the mid-1970s were a key "agonizing reappraisal" moment for the MIT macroeconomists. Why weren't the early 1980s the same for the Chicago macroeconomists? Or were they?

Paul Krugman:

Memories of the Carter Administration - Paul Krugman Blog - The late 1970s was when macroeconomics experienced its great divide.... As I remember it, it all began with the [Edmund] Phelps [ed.] volume: Microeconomic Foundations of Employment and Inflation Theory.... Keynes (and, for that matter, Milton Friedman) argued that a decline in aggregate demand due to, say, a fall in the money supply would lead to a fall in employment and output--and experience showed that they were right. Yet standard microeconomic theory implies that production should respond only to changes in relative prices... that money should be “neutral”: a 20 percent fall in the money supply should lead to a 20 percent fall in the overall price level, but no change in output or employment.

Phelps and others tried to explain why the economy looks so Keynesian in terms of imperfect information: workers and firms respond to a change in the price level as if it were a change in relative prices, because they can’t at first tell the difference. Over time, however, they will realize their mistake--so that, for example, a rise in the inflation rate will reduce unemployment at first, but won’t do so on a sustained basis, because eventually inflation will get built into expectations. So the new theory predicted the emergence of stagflation....

But where do expectations come from? Robert Lucas married Phelps-type models of employment with rational expectations... that people... use all available information to make predictions. And this led to a startling conclusion.... Only surprise changes in, say, the money supply matter – which means that you can’t [systematically] use monetary or fiscal policy to stabilize the economy. The Lucas view took the economics profession by storm – not because there was any solid evidence for it, but because it was so clever, because it led to nice math, because it let macroeconomists give in to their inner neoclassicists.

But by the late 70s it was already clear that rational expectations macro didn’t work. Why? Because people have too much information.... [In the Lucas story] a contraction in the money supply can produce a recession... only as long as people don’t know that there’s a recession! You see, if people do know that there’s a recession, they know that the low prices they’re being offered reflect low overall demand.... [Lucas] models broke down... as soon as you let people... [look] at interest rates, or reading a newspaper.... [R]eality... is that recessions persist long after everyone knows that there’s a recession... [when] the confusion required by Lucas-type models is long since gone.... [B]y 1980 or 1981 it was... clear... that the Lucas project--the attempt to explain the evidently Keynesian behavior of the economy in terms of nothing but imperfect information--had failed.... [M]acroeconomic theorists... split. One faction... “OK: we can’t explain what we think we see in terms of full maximization. So we have to assume that there are some limits to maximization – costs of changing prices, bounded rationality, whatever.” That faction became New Keynesian, saltwater economics.

The other faction... “OK: we can’t explain what we think we see in terms of full maximization. So we must be interpreting the data wrong--things like changes in the money supply must not be driving recessions, because theory says they can’t.” That faction became real business cycle, freshwater economics.

But... the freshwater school no longer remembers any of that – largely because they purged Keynesian and even monetarist thought from their classes. All they know is that Keynesianism was “disproved”, and that none of it--not even New Keynesian models with rational expectations (an approach which, as Greg Mankiw says, “provides a rationale for government intervention in the economy, such as countercyclical monetary or FISCAL POLICY.”)--is worth listening to. So that’s how we got to where we are today.