EPILOGUE

1. THE KEYNESIAN REVOLUTION n The birth of macroeconomics: J.M. Keynes, “General Theory of Employment, Interest and Money”, 1936 (towards the end of Depression) n Keynes was a man of many talents - during the First World War he had worked in the UK treasury - he criticized the harsh reparations imposed on Germany, arguing that Germany could not pay for the war and would be destabilized by the economic burden of the Treaty

1. THE KEYNESIAN REVOLUTION n He assembled a group of brilliant economists at Cambridge University n One important message: fiscal policy can be used to fight recessions in particular when monetary policy is ineffective n In most of Europe, Keynesian ideas are very much alive, although their limits are generally well recognized n Keynes’s theory was not fully workout: - his book is difficult to read - it frequently lacks precision - it can be confusing

1. THE KEYNESIAN REVOLUTION n European macroeconomists were not particularly productive during this period n Exceptions: the Mundell-Fleming model (Marcus Fleming ( ), a British economist working in the IMF, and Robert Mundell (1932-), inspired by the smallness and openness of his native Canada and Switzerland) n An important implication of Keynesian economics: countries as a whole could be a research subject n Pre-Keynesian economics was mostly preoccupied with sectors and firms, and had little to say about questions such as growth or employment n Aggregate data (GDP, the unemployment rate, the CPI) were sporadically collected and very rarely the subject of research

1. THE KEYNESIAN REVOLUTION n The rise of Keynesian economics started in the late 1930s n The main contributions: USA and Great Britain (Simon Kuznets ( ), from Columbia University and Richard Stone ( ), a Keynes student from Cambridge) n Once data were available and with the introduction of the first computers, economists started to build large-scale models that mimic the economy. n Despite the subsequent decline of Keynesian economics, these models continues to influence considerably day-to- day decisions by government, banks and businesses

1. THE KEYNESIAN REVOLUTION n The neoclassical theory - the Keynesian equilibrium is a special case, which occurs when prices are sticky n The next task: to explain how prices move, when they eventually do n The missing equation: discovered by Phillips ( ) at the London School of Economics n The next question: what is the theory behind the Phillips curve? n The curve started to vanish: the disappearance of the Phillips curve, predicted by Friedman in the late 1960s, paved the way for the rise of the monetarists……….they exposed what was seen as fundamental flaws in Keynesian economics

2. THE MONETARIST REVOLUTION n By the late 1940s, the Keynesian school was strong in the USA, where most of macroeconomic research was conducted n The University of Chicago (“Chicago School”) led against the Keynesians an intellectual attack n The success of the Chicago School is due to MILTON FRIEDMAN: extraordinary intellectual vigor, leadership charisma, government experience, communication skills n He assembled a group of young economists: “Workshop in Money and Banking” n He devoted much time and effort to popularize his ideas

2. THE MONETARIST REVOLUTION - Friedman’s main ideas 1. A strong defender of free markets. He actively promoted the view that governments are a threat to freedom, and not just in economic matters. 2. He confronted Keynes’s view that fiscal policy is a useful tool for macroeconomic stabilization and that monetary policy is useless - MONETARIST “A Monetary History of the United States, ” - it fundamentally changed the way we look at monetary policy - at empirical level, it attributes the Great Depression to bad monetary policies (Keynes blamed procyclical fiscal policies) - at theoretical level, it reestablished the classic “quantity equation”: MV=PY, the NEUTRALITY OF MONEY

2. THE MONETARIST REVOLUTION - Friedman’s main ideas 3. A study of consumption patterns in the USA: “A Theory of the Consumption Function” (1956) - he argued that Keynes consumption function had little theoretical foundation and questionable empirical validity - he put forward the permanent income hypothesis - he weakened the significance of the Keynesian multiplier and the view that fiscal policy can be a tool for output stabilization 4. Friedman explained why the Phillips curve would vanish as soon as the authorities attempted to exploit the output- inflation trade-off

2. THE MONETARIST REVOLUTION - Friedman’s main ideas - He restored the importance of expectations (the expectations-augmented Phillips curve) and he invented the long-run vertical aggregate supply schedule In general, Europe was slow to recognize the power of the monetarists’ attack and did not contribute much to the research effort. UK was dominated by Keynesians, until Mrs. Thatcher was elected and she brought in Friedman as an advisor. The Chicago school also contributed much to our understanding of the open economies; much of Mundell’s work was produced when he was in Chicago (the “monetary approach to the exchange rate”)

3. THE RATIONAL EXPECTATIONS REVOLUTION n Another attack on Keynesian economics: the rational expectations revolution n The expectations-augmented Philips curve of Friedman had left an important question unanswered: what drives expectations? n Most economists: expectations are gradually catching up with actually observed inflation (adaptive expectations) n A major step: Robert E.Lucas Jr. (Nobel prize laureate), a student of Friedman, led the rational expectations revolution n They noted that: if the forward-looking component dominates and if expectations are not systematically biased, the Phillips curve is always vertical and systematic policy does not work

3. THE RATIONAL EXPECTATIONS REVOLUTION n Their conclusion: monetary policy only affects output and employment if and only if it creates inflation surprises n The RE revolution’s message: macroeconomic policies should not be used on and off with complete discretion. Policy should obey rules and aim at establishing credibility by sticking to these rules.

4. THE MICROFOUNDATIONS OF MACROECONOMIS n The RE hypothesis attracted huge interest and opened the way for further innovations n Question: if it is appropriate to assume that expectations are rational, then why shouldn’t all other economic decisions be rational as well? n Researchers at some universities in the USA (Chicago, Minnesota, Rochester, Carnegie-Mellon, Pennsylvania) established the microeconomic foundations of consumption, investment, etc.

4. THE MICROFOUNDATIONS OF MACROECONOMIS n However, business cycles remain a fact of life that must be explained n Neoclassical economists created the Real Business Cycles (RBC) research programme (Kydland and Prescott, Nobel prize in 2004). Its aim: to show that models with flexible prices and fully rational agents can reproduce the key features of actual business cycles. However, this has not been an empirical success. Many of the most important stylized facts remain unaccounted for (price stickiness simply appears to be a fact)

4. THE MICROFOUNDATIONS OF MACROECONOMIS n New Keynesians: wanted to show that price stickiness is not incompatible with microeconomic foundations and full rationality. They produced a new synthesis, which fully rests on rational behavior but deliver the traditional Keynesian results n The RBC school reached the same conclusion n In the end, the IS-LM model is alive and well. From the policy perspective, the view that fiscal and monetary policies can be used as tools for output and employment stabilization is now generally accepted. n It is also recognized that the role of expectations requires much more prudence and care than the traditional Keynesians dared to admit.

5. GROWTH AND DEVELOPMENT n One of the most important issues: the wealth and poverty of nations n The neoclassical growth model (Robert Solow, Nobel prize) has two implications 1. Capital is more productive where it is scarce 2. The key source of sustained growth is unexplained technological progress Both implications were unsatisfactory…..

5. GROWTH AND DEVELOPMENT 1. Robert E. Lucas Jr. - explain why capital does not flow from rich to poor countries - poor countries are characterized by low capital intensity and in theory must have a much higher marginal productivity of capital than rich countries - productivity may be high in theory, but in reality is significantly reduced by poor institutions that allow corruption, instability and war to discourage investment

5. GROWTH AND DEVELOPMENT 2. Technological progress could be treated as endogenous - Paul Romer (1955- ) Education is an investment in human capital, and is deterred by poor institutions, like investment in physical capital Other contributions: Robert Barro (1944-, Harvard University), Xavier Sala-i-Martin (1963-, Columbia University) The result of this research: a thorough understanding of underdevelopment and of policies that try to deal with extreme poverty in many parts of the world