Macroeconomics analyzes economies in their entirety. It seeks to provide answers to some of the most important questions that concern our societies. Why some countries are rich and others are poor? What determines the improvement of living standards and the process of economic growth? Why are there recessions and upswings in economic activity? What are the causes and consequences of inflation? What are the determinants of unemployment? What are the possibilities for government policy to promote economic growth, to avoid recessions and to maintain low inflation and unemployment?
These, and a number of related questions, have concerned social thinkers even before economics was founded as a discipline by Adam Smith’s pathbreaking 1776 book, The Wealth of Nations. Smith sought to systematically analyze the causes of differences in wealth and living standards among countries. In the process, he founded economics as a separate academic discipline. 160 years later, in 1936, with the publication of The General Theory of Employment, Interest and Money, John Maynard Keynes helped establish macroeconomics as a distinct major field of economics.
The subject matter of macroeconomics is since divided into two main areas. The analysis of long run economic growth, which was the main focus of Smith and other classical economists, and the analysis of aggregate fluctuations, which was the main focus of Keynes, but also many other economists, before and after the publication of the General Theory.
Macroeconomics, as a separate major branch of economics, did not exist before the publication of the General Theory. However, there were at least three important theoretical streams that foreshadowed macroeconomics.
One was the analysis of long run economic growth, one of the main concerns of classical economists such as Smith, Malthus, Ricardo and Mill. The classical economists sought to explain economic growth in terms of population growth, the accumulation of capital and the increase in the efficiency of production, as determined by the division of labor and technological progress. These factors, interacted with land, a factor of production which was assumed to be in fixed supply.
The second stream was monetary theory. Monetary theory was quite advanced even before the development of classical economics. Hume (1752) is an important example of monetary analysis before Smith. By the 20th century, monetary theory had established the quantity theory of money, the classical dichotomy between“real” and “nominal” variables, and a number of monetary explanations of the business cycle. The quantity theory of money suggested that increases in the money supply lead, at least eventually, to proportional increases in the general level of prices. The classical dichotomy suggested that, at least in the long run, “real” variables are determined purely by non-monetary factors. Monetary theories of the business cycle attributed the business cycle to the short term real impact of monetary factors, interacting either with the gradual adjustment of wages and prices, or with temporary deviations of the interest rate from its equilibrium value.
The third stream, consisted of various types of trade cycle or business cycle theories, both monetary and real. Apart from the monetary theories, there were a number of alternative theories, which had attempted to explain aggregate fluctuations in terms of over-investment, under-consumption, over-indebtedness, “psychology”, technology, or harvest and agricultural cycles. These theories were essentially macroeconomic in nature.
In any event, The General Theory, as formulated by Hicks (1937), prevailed in the development of macroeconomics. Macroeconomics integrated the three streams mentioned above, and experienced explosive growth, as well as significant transformations, during the rest of the twentieth century. It now constitutes one of the two main fields of economics, along with microeconomics.
Keynesian and Classical Macroeconomics
In seeking to explain long run economic growth and fluctuations in aggregate economic activity, modern macroeconomics is, almost by definition, dynamic. The element of time is indispensable for understanding and explaining both types of phenomena. In seeking to explain aggregate fluctuations, macroeconomics is also stochastic, in that it explains aggregate fluctuations in terms of the response of dynamic economic systems to random disturbances.
This dynamic stochastic approach to aggregate fluctuations follows a tradition which was also founded in the 1930s, by Frisch (1933) and Slutsky (1937). This tradition was subsequently followed and extended in various directions by econometricians such as Tinbergen (1937), Haavelmo (1944), the Cowles Commission, Burns and Mitchell (1946) and others.
Following the Keynesian revolution of the 1930s, macroeconomics originally evolved without too much reliance on underlying microeconomic theory. For the most part, micro based macroeconomics was dismissed as classical macroeconomics. In the then dominant paradigm of keynesian macroeconomics, most of the key relations such as the consumption function, the investment function, the relation between inflation and unemployment and others, were postulated rather than derived from firm microeconomic foundations. Surprisingly, this applied to both models of long run economic growth, as well as models of aggregate fluctuations.
For example, the Solow (1956) model of economic growth, although based on a neoclassical production function, also relied on a postulated Keynesian consumption function, based on the assumption that consumption is an exogenous fraction of current income. It took some time before Cass (1965) and Koopmans (1965) rediscovered and extended the Ramsey (1928) representative household model of savings, and re-established the missing link between macroeconomic growth theory and optimizing households. At the same time, Diamond (1965) extended the Samuelson (1958) model of overlapping generations, which was a different type of optimizing general equilibrium model of aggregate savings. Diamond used this model to analyze economic growth and the effects of government debt. Both the representative household model and overlapping generations models are now used widely in growth theory, as they both are dynamic general equilibrium models, with firm microeconomic foundations.
The Keynesian models of aggregate fluctuations that prevailed in the 1950s and the 1960s suffered from similar defects to an even greater extent. This applied to both econometric models, and theoretical models, based on the IS-LM framework of Hicks (1937). For example, the multiplier-accelerator model of Samuelson (1939), relied on a postulated consumption function, with consumption a linear function of past income, and investment a constant multiple of the change in consumption. The marginal propensity to consume defined the multiplier, and the marginal propensity to invest defined the accelerator. Yet, neither the multiplier nor the accelerator were derived from an optimizing microeconomic model for households and firms. This state of affairs was a significant concern to many economists, who were unhappy with many of the postulated macroeconomic relations, and sought to provide better links between macroeconomics and microeconomics.
Microeconomic Foundations of Macroeconomics
Modigliani and Brumberg (1954) and Friedman (1957) provided dynamic microeconomic foundations for the consumption function, based on inter-temporal considerations. Hence, the life cycle and permanent income theories of consumption, which differed from the simple keynesian consumption function. Jorgensen (1963) introduced the flexible accelerator model of investment, based on profit maximization by firms. His contribution led to modern optimizing theories of investment. Baumol (1952), Tobin (1956), Friedman (1956) and Patinkin (1956) derived the demand for money from optimizing behavior by households and firms. These are only some of the early attempts to provide microeconomic foundations for the postulated key relations of Keynesian models of aggregate fluctuations.
The Phillips curve is probably the most important case in point. This was just an empirical relation, an inverse relation between inflation and unemployment discovered by Phillips (1958), with very little underlying theory to explain it. The Phillips curve was used in Keynesian econometric models as the missing aggregate supply function, and helped determine the extent to which changes in aggregate demand were translated into changes in prices or changes in real output and employment. Samuelson and Solow (1960) were quick to suggest that aggregate demand policies could be used to select the socially desirable combination of inflation and unemployment along the Phillips curve. However, in the late 1960s, the Phillips curve appeared to break down empirically. Phelps (1967) and Friedman (1968) explained the breakdown in terms of shifts in inflationary expectations, using the first rudimentary optimizing models of the Phillips curve.
An important research program, seeking to provide firm dynamic microeconomic foundations for the Phillips curve, followed almost immediately. Phelps et al (1970) kickstarted this program. The rational expectations revolution followed, when Lucas (1972) applied to the Phillips curve the rational expectations hypothesis of Muth (1961), instead of the hypothesis of adaptive expectations that was used until then.
Soon after, dynamic stochastic general equilibrium (DSGE) models of aggregate fluctuations started being developed, following Lucas (1977) and Kydland and Prescott (1982). These models were initially in the classical tradition, and led to what is now called new classical macroeconomics. Soon, alternative dynamic stochastic general equilibrium models were developed in the keynesian tradition of gradual adjustment of prices and nominal wages, in conditions of imperfect competition and labor market imperfections. Mankiw and Romer (1991) is an early collection of papers in what is now called new keynesian macroeconomics. Both traditions coexist today.
Dynamic and Dynamic Stochastic General Equilibrium Models
The present book is almost entirely based on such dynamic and dynamic stochastic general equilibrium models. Such models form the backbone of modern macroeconomics. We present the main theories of economic growth and aggregate fluctuations, through a sequence of such models, based on inter-temporal optimization on the part of economic agents, such as households, firms and the government. Some of the precursors to these models are also discussed.
The models are treated as tools for understanding the main macroeconomic phenomena of long run economic growth, aggregate fluctuations, inflation and unemployment, and the role of monetary and fiscal policy. The book thus highlights both their potential, as well as their limitations.
It is worth reemphasizing that modern macroeconomics is not based on a single, generally accepted all encompassing model. For this reason, this book examines a plurality of models, each of which is suitable for investigating specific questions and addressing specific problems. However, there are some unifying principles in the models that we present. It is assumed throughout that economic agents base their decisions on inter-temporal optimization of some well defined objective function, under appropriate constraints. Thus, for the most part, we rely on dynamic general equilibrium models with firm microeconomic foundations. Where there are theoretical disagreements, alternative approaches are juxtaposed, their pros and cons are analyzed, and their compatibility with the empirical evidence is also discussed.