The Evolution of Macroeconomic Theory and Policy

The Evolution of Macroeconomic

Theory and Policy

Kamran Dadkhah

The Evolution

of Macroeconomic

Theory and Policy

123

Kamran Dadkhah

Department of Economics

Northeastern University

Boston, MA 02115

USA

[email protected]

ISBN 978-3-540-77007-7 e-ISBN 978-3-540-77008-4

DOI 10.1007/978-3-540-77008-4

Springer Dordrecht Heidelberg London New York

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To Karen with love

Preface

If anyone had a doubt regarding the importance of macroeconomics, the financial

and economic crisis of 2007–2009 should have relieved him/her of it. Furthermore,

at times the unfolding drama and its historical background was an education in

macroeconomics in itself. It seemed everyone was anxious to learn about the causes

of the crisis, its turns and twists, and the possible remedies and their effective￾ness. This is befitting since macroeconomics as we know it now was the product

of another economic crisis.

On Thursday, October 24, 1929 (known as Black Thursday), the stock market

crashed. Within a year, the number of jobless workers climbed to more than four

million and hungry protesters took to the streets of New York. Thus began the Great

Depression, which in the course of the decades to come changed the economies

of industrial countries, fundamentally transformed our vision of the economy and

economic policy, and brought into prominence a branch of economics that in 1933

Ragnar Frisch christened macroeconomics.

Over the next 80 years the interaction of economic events, economic theory, and

economic policy resulted in a body of knowledge that is an integral part of political

and economic discourse and indeed of everyday life in the United States and around

the world. Economists, business leaders, policy makers, and all concerned citizens

need to be familiar with macroeconomics.

Macroeconomics is best understood in a historical context. The book offers

an introduction to macroeconomic theory and policy as they relate to events and

developments of the past 80 years. The United States economy and its fiscal and

monetary policies are the main concerns, but because the United States economy

and world economies are intertwined, the stories of their interactions will also be

recounted.

Let me emphasize that the book is neither an economic history of the United

States nor a history of economic thought. The purpose of this book is to teach

macroeconomics in the context of actual events and with emphasis on the relation￾ships between macroeconomic theory and policy.

Students of economics, professional economists, and the interested public are

the target audience. The book can be used as the main text or a supplement in

advanced undergraduate and beginning graduate courses in macroeconomics. Pro￾fessional economists may find it a useful reference. The book is not intended for

vii

viii Contents

readers with no background in economics. But anyone who is ready to expend the

effort and is not put off by occasional equations could benefit from reading it.

I would like to thank Springer-Verlag editors Barbara Fess and Christiane Beisel

for their help, support, and understanding during the writing of this book. I also

would like to thank Anna Dittrich of Springer-Verlag and Saranya Baskar and her

colleagues at Integra for their excellent work in producing the book. Colleagues,

friends, and students helped with their comments and questions. In particular I

would like to thank Neil Alper, Oscar Brookins, William Dickens, Tess Forsell,

Amarita Natt who read all or large parts of the book and made extensive suggestions

and corrections. My thanks also goes to Andrew Sum and Maria Luengo-Prado who

made useful comments. Students in my graduate macroeconomics class Yuan Gao

(Highfar), Emily Halle, Yelena Kuznetsov, Alicia Parillo, and Brian Sieben detected

errors and made suggestions for improvement.

My great indebtedness is to Karen Challberg, who read the entire manuscript

and made many corrections and helpful suggestions. Without her, the project would

have never been conceived and carried out.

Contents

1 The Great Depression and Mr. Keynes ................ 1

The Crash of 1929 ............................ 1

The Great Depression . . . . . . . . . . . . . . . . . . . . . . . . . . 3

Depression Around the World ...................... 6

FDR and the New Deal . . . . . . . . . . . . . . . . . . . . . . . . . 6

“We Must Act and Act Quickly” . . . . . . . . . . . . . . . . . . . . 9

The New Deal Policies . . . . . . . . . . . . . . . . . . . . . . . . . . 10

Irving Fisher’s Theory of Debt-Deflation . . . . . . . . . . . . . . . . 13

Money and the Great Depression . . . . . . . . . . . . . . . . . . . . 15

The Keynesian Vision of the Economy . . . . . . . . . . . . . . . . . 15

John Hicks and the IS-LM Model . . . . . . . . . . . . . . . . . . . . 20

Keynes and FDR . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23

The Fundamental Question . . . . . . . . . . . . . . . . . . . . . . . 23

Paternalistic Economic Policy . . . . . . . . . . . . . . . . . . . . . . 25

2 The Post-War Economic Order . . . . . . . . . . . . . . . . . . . . 29

The G.I. Bill . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30

The Employment Act of 1946 . . . . . . . . . . . . . . . . . . . . . . 31

The Council of Economic Advisers . . . . . . . . . . . . . . . . . . . 33

The Birth of the Welfare State . . . . . . . . . . . . . . . . . . . . . . 34

The Bretton Woods Agreement . . . . . . . . . . . . . . . . . . . . . 37

The International Monetary Fund (IMF) . . . . . . . . . . . . . . . . 38

The Bank for Reconstruction and Development (the World Bank) . . . 39

General Agreement on Tariffs and Trade (GATT) . . . . . . . . . . . . 40

The Marshall Plan . . . . . . . . . . . . . . . . . . . . . . . . . . . . 41

The Point Four . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 43

The Brave New Post War World . . . . . . . . . . . . . . . . . . . . . 44

3 Laying the Foundations of Keynesian Economics . . . . . . . . . . 45

Aggregate Supply and Aggregate Demand . . . . . . . . . . . . . . . 46

National Income Accounting . . . . . . . . . . . . . . . . . . . . . . 51

The Rise of Econometrics . . . . . . . . . . . . . . . . . . . . . . . . 53

Simultaneity and Identification . . . . . . . . . . . . . . . . . . . . . 55

Errors in Variables . . . . . . . . . . . . . . . . . . . . . . . . . . . . 57

ix

x Contents

Adaptive Expectations Model . . . . . . . . . . . . . . . . . . . . . . 58

Partial Adjustment Model . . . . . . . . . . . . . . . . . . . . . . . . 61

Discounting and Present Value . . . . . . . . . . . . . . . . . . . . . 61

The Consumption Function . . . . . . . . . . . . . . . . . . . . . . . 62

Permanent Income Hypothesis . . . . . . . . . . . . . . . . . . . . . 65

Cross Section Estimate of Propensity to Consume . . . . . . . . . . . 68

Life Cycle Hypothesis . . . . . . . . . . . . . . . . . . . . . . . . . . 69

The Investment Function . . . . . . . . . . . . . . . . . . . . . . . . . 71

Tobin’s q . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 74

Demand for Money . . . . . . . . . . . . . . . . . . . . . . . . . . . 74

The Growth Model of Harrod and Domar . . . . . . . . . . . . . . . 76

Solow’s Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 80

Solow Residual . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 82

The Golden Age of Macroeconomics . . . . . . . . . . . . . . . . . . 83

4 Keynesian Economics in Action . . . . . . . . . . . . . . . . . . . . 85

Okun’s Law . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 89

The Phillips Curve . . . . . . . . . . . . . . . . . . . . . . . . . . 91

Stagflation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 93

The Natural Rate of Unemployment . . . . . . . . . . . . . . . . . 95

Rational Expectations . . . . . . . . . . . . . . . . . . . . . . . . . 96

The Augmented Phillips Curve . . . . . . . . . . . . . . . . . . . . 98

Income Distribution . . . . . . . . . . . . . . . . . . . . . . . . . . 100

5 Macroeconomics of an Open Economy . . . . . . . . . . . . . . . . 103

Equilibrium in an Open Economy . . . . . . . . . . . . . . . . . . . . 108

Fixed Exchange Rates with Capital and Foreign

Exchange Controls . . . . . . . . . . . . . . . . . . . . . . . . . . . 109

Monetary and Fiscal Policies Under Capital Mobility . . . . . . . . . 110

Monetary Policy Under Fixed Exchange Rates . . . . . . . . . . . . . 111

Fiscal Policy Under Fixed Exchange Rates . . . . . . . . . . . . . . . 113

Monetary Policy Under Flexible Exchange Rates . . . . . . . . . . . 114

Fiscal Policy Under Flexible Exchange Rates . . . . . . . . . . . . . 115

The Preeminence of Monetary Policy in the 21st Century . . . . . . . 116

6 The Collapse of Post-War International Economic Order . . . . . . 117

A New Economic Policy . . . . . . . . . . . . . . . . . . . . . . . . . 117

The Aftermath . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 122

The End of Bretton Woods . . . . . . . . . . . . . . . . . . . . . . . 123

Milton Friedman and Flexible Exchange Rates . . . . . . . . . . . . . 125

The Oil Shocks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 126

OPEC . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 127

The Sources of Oil Shocks . . . . . . . . . . . . . . . . . . . . . . . . 128

7 The New Classical Revolt Against Activist Economic Policy . . . . 131

Microfoundations . . . . . . . . . . . . . . . . . . . . . . . . . . . . 132

Coordination Mechanism . . . . . . . . . . . . . . . . . . . . . . . . 133

Contents xi

Empirical Validity of the Keynesian Model . . . . . . . . . . . . . . . 135

The Identification Problem . . . . . . . . . . . . . . . . . . . . . . . 135

The New Classical Criticism of Keynesian Policies . . . . . . . . . . 136

Policy Ineffectiveness . . . . . . . . . . . . . . . . . . . . . . . . . . 136

The Lucas Critique . . . . . . . . . . . . . . . . . . . . . . . . . . . . 138

Time Series Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . 142

Stationary Series and ARIMA Models . . . . . . . . . . . . . . . . . 142

Wold’s Theorem . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 143

Spurious Regression . . . . . . . . . . . . . . . . . . . . . . . . . . . 146

Causality . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 147

VAR Modeling . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 147

Deterministic vs. Stochastic Trend . . . . . . . . . . . . . . . . . . . 148

Cointegration and Error Correction . . . . . . . . . . . . . . . . . . 150

8 Business Cycles: Evidence, Theory, and Policy . . . . . . . . . . . . 153

Forecasting Recessions and Recovery . . . . . . . . . . . . . . . . . . 155

Frisch’s Theory of Cycles . . . . . . . . . . . . . . . . . . . . . . . . 157

Samuelson’s Model of Interaction Between Multiplier and Acceleration 159

Hicks’s Model of Two Limits . . . . . . . . . . . . . . . . . . . . . . 160

A Critique of Keynesian Models of Business Cycles . . . . . . . . . . 162

Real Business Cycles Theory . . . . . . . . . . . . . . . . . . . . . . 162

A Simple Model of Real Business Cycles . . . . . . . . . . . . . . . 162

Dynamic Stochastic General Equilibrium Models . . . . . . . . . . . 164

Calibration . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 166

A Bayesian Interpretation of Calibration . . . . . . . . . . . . . . . . 168

New Keynesian Models with Nominal and Real Rigidities . . . . . . . 169

Convergence in Macroeconomics: DSGE Models with New

Keynesian Features . . . . . . . . . . . . . . . . . . . . . . . . . . . 170

Business Cycles and Economic Policy . . . . . . . . . . . . . . . . . 171

Economic Model as a Means of Communication . . . . . . . . . . . . 173

An Anti Empirical Trait Among Economists . . . . . . . . . . . . . . 174

9 Money, Monetary Policy, and Monetarism . . . . . . . . . . . . . . 179

The Quantity Theory of Money . . . . . . . . . . . . . . . . . . . . . 182

The Money Supply Process . . . . . . . . . . . . . . . . . . . . . . . 184

The Federal Funds Market . . . . . . . . . . . . . . . . . . . . . . . 187

Open Market Operation and FOMC . . . . . . . . . . . . . . . . . . . 188

Targeting Money Supply vs. the Federal Funds Rate . . . . . . . . . . 189

Central Bank’s Credibility . . . . . . . . . . . . . . . . . . . . . . . . 190

Central Bank’s Independence . . . . . . . . . . . . . . . . . . . . . . 190

Inflation Targeting . . . . . . . . . . . . . . . . . . . . . . . . . . . . 192

Monetarism Program for Monetary Stability . . . . . . . . . . . . . . 193

Rules vs. Discretion . . . . . . . . . . . . . . . . . . . . . . . . . . . 193

Time Inconsistency of Optimal Plans . . . . . . . . . . . . . . . . . . 194

The Term Structure of Interest Rates . . . . . . . . . . . . . . . . . . 195

The Market Segmentation Hypothesis . . . . . . . . . . . . . . . . . . 197

xii Contents

The Expectations Hypothesis . . . . . . . . . . . . . . . . . . . . . . 198

Liquidity Preference Hypothesis . . . . . . . . . . . . . . . . . . . . . 198

10 Government Budget and Fiscal Policy . . . . . . . . . . . . . . . . 201

An Overview of Revenues and Expenditures

of the US Government . . . . . . . . . . . . . . . . . . . . . . . . . . 202

Government Budget Constraint . . . . . . . . . . . . . . . . . . . . . 203

The Ricardian Equivalence . . . . . . . . . . . . . . . . . . . . . . . 204

The Crowding Out Effect . . . . . . . . . . . . . . . . . . . . . . . . 206

Taxes and Incentives to Work and Save . . . . . . . . . . . . . . . . . 207

Flat Tax and Negative Income Tax . . . . . . . . . . . . . . . . . . . . 208

Consumption Tax . . . . . . . . . . . . . . . . . . . . . . . . . . . . 209

Political Economy of Budgets and Reforms . . . . . . . . . . . . . . . 210

The Illusion of Populist Economic Programs . . . . . . . . . . . . . . 211

11 The Reagan-Thatcher Revolution: The Age of Hayek and

Schumpeter . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 213

Hayek’s Vision . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 214

Schumpeter’s Theory of Business Cycles and Growth . . . . . . . . . 215

Supply Side Economics . . . . . . . . . . . . . . . . . . . . . . . . . 216

The Laffer Curve . . . . . . . . . . . . . . . . . . . . . . . . . . . . 218

A Change of Emphasis from Stabilization to Growth . . . . . . . . . . 220

The Ramsey Problem . . . . . . . . . . . . . . . . . . . . . . . . . 220

The Overlapping Generations Model . . . . . . . . . . . . . . . . . 221

Endogenous Growth Theory . . . . . . . . . . . . . . . . . . . . . . . 223

In Search of the Elements of Growth . . . . . . . . . . . . . . . . . . 225

The Reagan Years . . . . . . . . . . . . . . . . . . . . . . . . . . . . 225

The Great Moderation . . . . . . . . . . . . . . . . . . . . . . . . . 228

12 Macroeconomics of Globalized Economies . . . . . . . . . . . . . . 231

World Trade Organization (WTO) . . . . . . . . . . . . . . . . . . . . 234

The North American Free Trade Agreement (NAFTA) . . . . . . . . . 235

The European Union . . . . . . . . . . . . . . . . . . . . . . . . . . 236

Other Aspects of Globalization . . . . . . . . . . . . . . . . . . . . . 236

The International Monetary System . . . . . . . . . . . . . . . . . . . 236

Sovereign Debt . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 238

Sovereign Funds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 238

International Economic Policy Coordination . . . . . . . . . . . . . . 239

13 The Financial and Economic Crisis of 2007–2009 . . . . . . . . . . 241

Enough Blame to Go Around . . . . . . . . . . . . . . . . . . . . . . 241

The American Dream of Homeownership . . . . . . . . . . . . . . . . 241

Fannie Mae and Freddie Mac . . . . . . . . . . . . . . . . . . . . . . 243

Subprime Mortgage . . . . . . . . . . . . . . . . . . . . . . . . . . . 244

The Housing Crisis . . . . . . . . . . . . . . . . . . . . . . . . . . . 244

The Function of Finance and Financial Institutions . . . . . . . . . . . 245

Assets, Risk, and Diversification . . . . . . . . . . . . . . . . . . . . 246

Contents xiii

Long, Short, and Neutral . . . . . . . . . . . . . . . . . . . . . . . . . 248

Hedging, Arbitrage, and Speculation . . . . . . . . . . . . . . . . . . 248

Financial Innovations . . . . . . . . . . . . . . . . . . . . . . . . . . 249

Derivatives . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 250

Asset-Backed Securities, Collateralized Debt Obligations

(CDOs), and Credit Default Swaps (CDSs) . . . . . . . . . . . . . . . 251

Fraud in Financial Markets . . . . . . . . . . . . . . . . . . . . . . . 252

The Financial Crisis . . . . . . . . . . . . . . . . . . . . . . . . . . . 253

The Stock Market . . . . . . . . . . . . . . . . . . . . . . . . . . . . 253

The Effects on the Real Economy . . . . . . . . . . . . . . . . . . . . 254

Government Response to the Crisis . . . . . . . . . . . . . . . . . . . 255

Back to the Future . . . . . . . . . . . . . . . . . . . . . . . . . . . . 259

References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 261

Index . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 265

Chapter 1

The Great Depression and Mr. Keynes

More important, a host of unemployed citizens face the grim

problem of existence, and an equally great number toil with

little return. Only a foolish optimist can deny the dark realities

of the moment.

From the inaugural speech of President Franklin Roosevelt,

1933

I believe myself to be writing a book on economic theory which

will largely revolutionize—not, I suppose, at once but in the

course of the next ten years—the way the world thinks about

economic problems.

From Keynes’s letter of January 1, 1935 to

George Bernard Shaw

The Crash of 1929

The 24th of October, 1929, known as Black Thursday, started just like any other day.

It rained in New York City, and the temperature fluctuated between a low of 44 and a

high of 59 degrees Fahrenheit. The previous day, according to the New York Times,

“firm tone” prevailed on the London Exchange, “French stocks [were] uneven,”

and on the German Boerse “losses due to profit-taking [were] mostly recovered.”

Perhaps the only indication that something was amiss was the Times report that in

the previous day unlisted stocks had sharply declined.

But “Hell broke loose” on that Thursday. The volume was high with 12,894,650

shares traded, and prices dropped. The sharpest decline happened between 11:15

am and 12:15 pm. The high volume caused the tickers to lag more than four hours.

Rumors started floating and made the situation worse. At one point the rumor was

that eleven speculators had committed suicide. The decline was not confined to

the New York Stock Exchange and spread to other markets. It caused panic on the

Chicago Commodities Exchange.

Yet, despite the sharp drop during the day, at the close the decline was not pre￾cipitous: Dow Jones Industrials fell from 305.85 to 299.47, that is, a decline of

about 2.1%. During the day the Federal Reserve Board had two extended meetings.

The second meeting was presided over by Treasury Secretary, Andrew W. Mellon.

K. Dadkhah, The Evolution of Macroeconomic Theory and Policy, 1

DOI 10.1007/978-3-540-77008-4_1, C Springer-Verlag Berlin Heidelberg 2009

2 1 The Great Depression and Mr. Keynes

But the board decided that the situation was not serious enough to issue a formal

declaration. Apparently the board had contemplated such an announcement but the

recovery at the end of the day had resulted in putting it off. As the Times put it the

next day: “Leaders Confer, Find Conditions Sound.”

President Herbert Hoover issued a reassuring statement. In reply to a question by

the press regarding the business situation, the president said:

The fundamental business of the country, that is production and distribution of commodi￾ties, is on a sound and prosperous basis. The best evidence is that although production

and consumption are at high levels, the average prices of commodities as a whole have

not increased and there have been no appreciable increases in the stocks of manufactured

goods. Moreover, there has been a tendency of wages to increase and the output per worker

in many industries again shows an increase, all of which indicates a healthy condition.

But this optimism and confidence were misplaced. The market was on a down￾ward trend. A crash was on the horizon although even many prominent economists,

such as Irving Fisher, did not recognize it.

Although the market steadied on October 25, on the next Monday the Dow Jones

Industrials fell by more than 40 points, or 13.47%. There would be further ups and

downs. The market reached the low of 198.69 on November 13, that is, slightly less

than 48% below the high of 381.17 reached on September 3. In other words, in 71

days the market shares, as represented by the Dow Jones Index, had lost close to

half of their value and investors had lost half of their wealth.

Worse was still to come. Again the market recovered for a brief period. But the

slide continued, and on July 8, 1932 the Dow Jones Index was down to 41.22. Com￾pared to its high in September 3, 1929, the index had lost more than 89% of its value.

Although the index stabilized and even showed an upward trend from 1932 to 1937,

it declined in 1937. From 1942 until the end of the War the index showed a moderate

upward trend, but it did not reach its high of 1929 even several years after the War.

It took until November 23, 1954 for the Dow to gain its former peak (Fig. 1.1).

Fig. 1.1 Daily closing of Dow Jones industrial average 1926–1955

The Great Depression 3

An important factor contributing to the severity of the crash was that many had

bought stocks on margin. That is, they had borrowed from banks and brokers to

buy stocks. An investor buys 1000 shares of stocks at $5 each. But she pays only a

percentage of their value, say 10%, or $500. The remaining $4500 is her debt to the

bank or broker and the stocks are collateral. If the stock price increases to $7, she

can sell the stocks, pay off her debt, and pocket $2000 profit less interest on the loan

and transactions costs. On the other hand, if the price falls to $3, the value of the

collateral for the debt of $4500 is only $3000. So there will be a margin call, that is,

she is asked to make up the difference. Unless she has cash lying around (in which

case she probably wouldn’t be buying on margin), she has to sell the same or other

stocks to raise cash. But such a sell further depresses the price of stocks.

The crash of 1929 became the stuff of legends, such as investors jumping out

of the windows of skyscrapers. There are many references to the era in Hollywood

films. Nevertheless, what was to happen next, or perhaps had already happened and

the crash was one of its symptoms, wrought far more hardship.

The Great Depression

According to the National Bureau of Economic Research (NBER), which monitors

business cycles in the United States, the economy had reached its peak in August

1929. For the next 43 months, that is, all the way to March 1933, the economy would

experience a decline. Recovery was slow and as late as 1936 the GDP had hardly

reached its 1929 level. It was only during the World War II that the economy took

off (see Fig. 1.2).

The fall in output was accompanied by massive unemployment. The number of

unemployed in the United States rose from about 1.4 million in 1929 to more than

4.3 million in 1930 and reached more than 11 million in 1932 and 10.6 million in

Fig. 1.2 The United States real GDP, 1929–1947 (billions of chained 2000 dollars)