Summary of The Macroeconomist as Scientist and Engineer (Mankiw)

  • Mankiw quote “God put macroeconomists on earth not to propose and test elegant theories but to solve practical problems”
  • “This essay offers a brief history of macroeconomics, together with an evaluation of what we have learned. My premise is that the field has evolved through the efforts of two types of macroeconomist—those who understand the field as a type of engineering and those who would like it to be more of a science. Engineers are, first and foremost, problem-solvers. By contrast, the goal of scientists is to understand how the world works.” (Macro vs Micro more or less)
  • Provides a timeline of econ thought beginning with Keynes’ General Theory (1930s)
  • Hicks and Modigliani extended and explained his model more fully via the IS-LM model (1930-40s)
  • Econometricians then used these concepts to build models for forecasting/policy analysis (e.g., Fed Reserve) (1960s)
  • All had a basic Keynesian structure: “an IS curve relating financial conditions and fiscal policy to the components of GDP, an LM curve that determined interest rates as the price that equilibrates the supply and demand for money, and some kind of Phillips curve that describes how the price level responds over time to changes in the economy”
  • By the 1960s, cracks began to appear in the K consensus
  • “The first wave of new classical economics was monetarism, and its most notable proponent was Milton Friedman. Friedman’s (1957) early work on the permanent income hypothesis was not directly about money or the business cycle, but it certainly had implications for business cycle theory. It was in part an attack on the Keynesian consumption function, which provided the foundation for the fiscal policy multipliers that were central to Keynesian theory and policy prescriptions. If the marginal propensity to consume out of transitory income is small, as Friedman’s theory suggested, then fiscal policy would have a much smaller impact on equilibrium income than many Keynesians believed.”
  • “Friedman and Schwartz suggested that economic instability should be traced not to private actors (‘animal spirits’) but rather to inept monetary policy.”
  • “Friedman argued that the tradeoff between inflation and unemployment would not hold in the long run when classical principles should apply and money should be neutral. The tradeoff appeared in the data because, in the short run, inflation is often unanticipated and unanticipated inflation can lower unemployment. The particular mechanism that Friedman suggested was money illusion on the part of workers. More important for the development of macroeconomics was that Friedman put expectations on center stage.”
  • The second wave of new classical was the Rational Expectations group, with Robert Lucas leading in the 1970s. They “proposed a business cycle theory based on the assumptions of imperfect information, rational expectations, and market clearing. In this theory, monetary policy matters only to the extent to which it surprises people and confuses them about relative prices. Barro (1977) offered evidence that this model was consistent with U.S. time-series data. Sargent and Wallace (1975) pointed out a key policy implication: Because it is impossible to surprise rational people systematically, systematic monetary policy aimed at stabilizing the economy is doomed to failure.”
  • “The third wave of new classical economics was the real business cycle theories of Kydland and Prescott (1982) and Long and Plosser (1983). Like the theories of Friedman and Lucas, these were built on the assumption that prices adjust instantly to clear markets—a radical difference from Keynesian theorizing. But unlike the new classical predecessors, the real business cycle theories omitted any role of monetary policy, unanticipated or otherwise, in explaining economic fluctuations. The emphasis switched to the role of random shocks to technology and the intertemporal substitution in consumption and leisure that these shocks induced.”
  • Beginning the 70s, the first wave of the New Keynesians began with Barro, Grossman and Malinvund; they aimed to use Gen Equil analysis to “understand the allocation of resources that results when markets do not clear.” “Recessions and depressions result from a vicious circle of insufficient demand, and a stimulus to demand can have multiplier effects.”
  • “The second wave of new Keynesian research aimed to explore how the concept of rational expectations could be used in models without the assumption of market clearing.”
  • “Because so much of the Keynesian tradition was based on the premise that wages and prices fail to clear markets, the third wave of new Keynesian research aimed to explain why this was the case.” Contained folks like Mankiw in the 80s.
  • Overall outcome: “When firms have market power, they charge prices above marginal cost, so they alwayswant to sell more at prevailing prices. In a sense, if all firms have some degree of market power, then goods markets are typically in a state of excess supply. This theory of the goods market is often married to a theory of the labor market with above-equilibrium wages, such as the efficiency-wage model. In this case, the "Keynesian" regime of generalized excess supply is not just one possible outcome for the economy, but the typical one. In my judgment, these three waves of new Keynesian research added up to a coherent microeconomic theory for the failure of the invisible hand to work for short-run macroeconomic phenomena.”
  • Makes the point that neoclassicals stayed in the “ivory tower”, whereas new Keynesians took posts within gov’t to try and solve econ problems
  • Regards this culimination of work as the “new systhesis”. “Like the neoclassical-Keynesian synthesis of an earlier generation, the new synthesis attempts to merge the strengths of the competing approaches that preceded it. From the new classical models, it takes the tools of dynamic stochastic general equilibrium theory. Preferences, constraints, and optimization are the starting point, and the analysis builds up from these microeconomic foundations. From the new Keynesian models, it takes nominal rigidities and uses them to explain why monetary policy has real effects in the short run. The most common approach is to assume monopolistically competitive firms that change prices only intermittently, resulting in price dynamics sometimes called the new Keynesian Phillips curve. The heart of the synthesis is the view that the economy is a dynamic general equilibrium system that deviates from a Pareto optimum because of sticky prices (and perhaps a variety of other market imperfections).”
  • Comments that no matter these differences in thought or attempts to help, “Recent developments in business cycle theory, promulgated by both new classicals and new Keynesians, have had close to zero impact on practical policymaking.”
  • Comments that central banking may have been improved, but it would be overly confident to link it directly to the contributions of academics
  • However, notes that Keynesian thought framed the Bush tax cuts 2001 and 2003
  • Ends by saying the intellectual competition is how the field advances and that New Synthesis will hopefully spur progress in both theory and practical application