The Fall and Rise of Keynesian Economics* ALAN S. BLINDER Princeton Universiry Keynesian economics came under much criticism in the 1970s This paper argues that the decline in Keynesian economics and the rise in, notably, new classical economics in this period related to their respective theoretical appeal rather than their ability to explain recognized, and with the development of sound microeconomic /Introduction we now call new classical economics. By about According to T.S. Kuhn's The S 1980, it was hard to find an American academic Scientific Revolutions(1962 macroeconomist under the age of 40 who professed science' requires an agreed-upon etical to be a Keynesian. That was an astonishing framework or 'paradig ntellectual turnabout in less than a decade, an work to solve paradigm change w e might surmise that the data of the 1970s had and unequivocal rejection of . He would look for some anom ent that did to lid to Newton succ e in Section dancy as inst back to theory wa observation and, in tive ideology over a Kuhnian menon that non nomin but with existent ur. The first and evaluate t define especially in the Unite What it Means to be a Keynesian The word 'Keynesian' means many things to *lam grateful to Ben Bemanke, John Campbell, Stephe Goldfeld, John Seater, Steven Sheffrin an ISee Blinder (1979)and Blinder (1987a), Chapter for helpful comments on an earlier draft 278
1988 KEYNESIAN ECONOMICS 279 many people. Decades ago, it was a carelessly necessary to have some sort of nominal rigidi applied label for economic liberals and in the model; otherwise, an interventionists in general. For a while in the late like a currency reform which changes all prices 1970s and early 1980s it became a pejorative term equiproportionately 4 So Keynesian models more or less synonymous with old-fashioned. No generally either assume or try to rationalize two people have precisely the same definition of nominal rigidities. Because supply and demand Keynesian economics. But, as one of the few curves derived from standard neoclassical American economists of my generation who never maximizing principles are always homogeneous of shunned the label, I feel entitled to my own degree zero in nominal quantities, this is not an definition. To me, the heart of Keynesianism easy task. Real effecis aged on sicily ses. ernment purc consists of six principal tenets First and foremost, Keynesian economics is a classical grounds. s theory of aggregate demand and of the effects of Since prices do not absorb all shocks to deman aggregate demand on real output and inflation. The fluctuations in any component of spending will first three tenets follow from this cause sympathetic movements in output. In most I A Keynesian believes that aggregate demand Keynesian models, the latter are larger than the influenced by a host of economic decisions, both former because of the multiplier; but a multiplier private and public, and sometimes behaves greater than one is not central to Keynes erratically. Some decades ago, there were active analysis. a positive real multiplier is mpassioned debates over the propositions that(a) Although real effects from demand fluctuations monetary policy is powerless because money are often called Keynesian effects,most demand is infinitely elastic, or(b)fiscal policy is monetarists accept the idea as well-at least as powerless because money demand is totally it pertains to monetary policy. So this tenet does elastic. But both of these are dead issues now. not really divide those two schools of thought Essentially all Keynesians and most monetarists now However, at least some new classicals insist that believe that both fiscal and monetary policy afect changes in money affect real output only if they aggregate demand. 2 Many new classicals, however, are unanticipated believe in debt neutrality-the doctrine that 3 Keynesians believe that goods markets and substitutions of debt for taxes have no effects on especially, labour markets respond onty sluggishly to shocks, ie. that prices and wages do not move 2 According to Keynesian theory, changes in quickly to clear markets. This issue, once again, aggregate demand, whether anticipated or divides Keynesians more from new classicals than ipated, have their greatest shor - nun impact from monetarists-although monetarists tput and employment, not on prices, and place more faith in the economy's natural servo- bout.3 mechanism than Keynesians do. Milton Friedma In textbook expositions, this idea is conveyed by (1968, p. 13), for example, has written thatUnder a short-run aggregate supply curve that is upward any conceivable institutional arrangements, and sloping,and probably quite flat except at high levels certainly those that now prevail in the United States utilizatio changes in aggregate there is only a limited amount of flexibility in prices demand are normally not dissipated in higher and wages. In current parlance, that would prices In macroeconometric models, the same idea certainly be called a Keynesian position is captured by treating output and employment as The next three tenets have to do directly with run and letting policy, and here Friedman and other monetarists an inertial Phillips curve determine inflation part company with most Keynesians For a theoretical model to produce real effects ffects 4 To a Keynesian, the actual levels of rom anticipated monetary policy, it is usually 4 2 That does sum transfers. Open harket swaps of money for bonds are often( effects of fiscal policy by controlling nominal GNP. non-neutral because they change interest rates. Monetar on-neutrality can also be rationalized by distribution for example, the division of any given change in ffects but these are typically considered unimportant GNP into real effects and price effects might ely whether or not the change is anticipated uS, See, for example, Bao(1981b)
THE ECONOMIC RECORD DECEMBER employment and unemployment have no special unemployment than about co optimality-partly because However, there are plenty of anti-inflation unemployment is subject to the caprice of Keynesians; most of the worlds current and past aggregate demand, and partly because they believe central bankers, for example, merit this title that markets clear only gradually. In fact, whether they like it or not. Needless to say, relative Keynesians typically see unemployment as both too attitudes toward unemployment and inflation high on average and too variable, although they heavily influence the policy advice that economists know that rigorous theoretical justification for give and that policy makers accept. As a broad these positions is hard to come by. Keynesians also generalization, I think it safe to say that Keynesians feel certain that periods of recession or depression are typically more aggressive about expanding are economic maladies, not Pareto-optimal aggregate demand than are non -Keynesians. responses to unattractive technological My six tenets divide naturally into two equal opportunities. All this is summarized in the term groups: the first three are clearly assertions about involuntary unemployment, which Keynesians positive economics while the even he div difficult to define 6 On this tenet new classicals to positive and normative differ sharply from Keynesians, with monetarists to understanding both the 5 Many, but not all Keynesians advocate activist Positive Keynesianism is a matter of scientifi labilization policy to reduce the amplitude of judgement. a positive Keynesian believes that both business cycles, which they rank among the most monetary and fiscal policy can change aggregate important of all economic monetarists generally join new classicals, as well have real effects, and that prices and wages de as some conservative Keynesians, in doubting both not move rapidly to clear markets. No p the efficacy of stabilization policy and the wisdom prescriptions follow from these beliefs alone. And further and question whether business cycles are call themselves Keynesian would nevertheles a serious problem at all. 7 The argument that economic knowledge is not Normative Keynesians add both value secure enough to support what used to be called judgements and political judgements to the fine tuning is by now widely accepted, even by preceding list. a normative Keynesian believes that most Keynesians. Yet many Keynesians believe government should use its leverage over aggregate that more modest goals for stabilization policy demand to reduce the amplitude of business cycles. coarse tuning, if you will-are not only defensible He or she is probably also far more interested in but sensible. For example, an economist need not filling in cyclical troughs than in shaving off peaks. have detailed quantitative knowledge of lag These normative propositions are based on structures to prescribe a dose of expansionary judgements that(a) macroeconomic fluctuations monetary policy when the unemployment rate ignificantly reduce social welfare, (b)the 10 per cent or more-as it has been in many government is knowledgeable and capable enough countries in this decade. Furthermore, and this may to improve upon free-market outcomes, and(c) be the most important point, the nature of unemployment is a more important problem that government seems to abhor a vacuum of economic inflation. y dvice. If economists with admittedly limited The long, and to some extent continuing, battle knowledge refuse to offer their expert (if uncertain) between Keynesians and monetarists, you will note, counsel, assorted quacks with owledge at all will surely rush in to fill the void 8 I include myself here. See Blinder(1987a, Chapter 6 Finally, and even less unanimo Keynesians are more concerned abe the realm of positive economics. There is a huge literatu For this reason, I recently proposed that we rename ny Keynesians like m mployment as pornographic evidence that the costs of lot (1988) and readily avoidable. Nonetheless, value judgements are See Lucas( 1987)for an example. For a rebuttal, still involved in the trade-off between unemployment and see Blinder (1987b inflation
1988 KEYNESIAN ECONOMICS 281 as fought over the normative specific questions do, of c on ho issues-particularly(b) and(c). 10 Thus, by my expectations are modelled. And, for some issues most monetarists are positive the expectational mechanism is crucial. 14 But, for Keynesians but not normative Keynesians. So are the most part, these are not central to the debate other conservatives who shun the label K between new classical and Keynesian economists, 15 issues but make different value judgements and hypothesis. Pre-1970 Keynesianism included a seat-of-the-pants political judgements, and so Phillips curve that was negatively sloped even in reach different conclusions about policy. Their the long run. This idea was rejected theoretically disagreements in many ways mirror disagreements by Milton Friedman(1968), a monetarist, and among policy-makers Edmund Phelps(1968), a Keynesian, and shortly The briefer, but more intense, debate between thereafter was also rejected in econometric stud eynesians and new classicals had, by contrast, by Keynesians like Robert Gordon(1972). Since been fought primarily over the tenets of positive about 1972, a Phillips curve that is vertical in the Keynesianism. New classicals argue that long run has been an integral part of Keynesian economics. So the natural utput; that markets, including the labour market, essentially no role in the intellectual ferment lear quickly by pricel; and that business cycles the 1972-1985 period. Ironically, however. may be Pareto optimal. Here objective' scientific questions about its validity are now playing a role evidence can be brought to bear and, in my in the Keynesian renaissance. Specifically, models judgement, the evidence on all three issues points with hysteresis have reopened the theoretical and trongly in the Keynesian direction. 1 2 But rather empirical debate over the natural rate hypothesis, than try to summarize that evidence now, I only especially for Europe. (More on this below. want to make one point: that arguments over the d, I have ignored the choice between positive aspects of Keynesian economics are monetary and fiscal policy as the preferred potentially resolvable by the accumulation of instrument of stabilization policy. People differ scientific evidence in a way that disputes over along this dimension and occasionally change sides normative issues are not. my definition, however, it is perfectly possible Before leaving the realm of definition, let me to be a Keynesian and still believe either that nderscore several glaring and intentional responsibility for stabilization policy should in omissIons. principle be ceded to the monetary authority or First, I have said nothing about rational that it is in practice so ceded expectations. Many Keynesians are doubtful about the validity of rational expectations as a behavioral llI The fall of Keynesian Economics willing to accept it. But, when it comes to the large issues with which I have concerned myself so promoted with, let me first dispose of the view quarters, that the de nothing much rides on whether or not expectations eynesian economics was due to the doctrines are rational. In particular, rational expectations poor empirical predictions. Seven years ago,Robert models with sticky pnces-like those of Fischer Lucas (1981, page 559)wrote that'Keynesian (1977)and Taylor (1980), for example-are orthodoxy is in deep trouble, the deepest kind of thoroughly Keynesian by my definition. Details of trouble in which an applied body of theory can model construction and giving seriously wron swers to the most basic questions of macro- economic policy.. He was talking about the collapse of the Phillips curve in the US during the the old debate ove ther or not the lm curve is 1970s, which he and Thomas Sargent(1978,page vertical. This has long been a dead issu 57)had characterized as 'econometric failure on II The 'price'may be multi-faceted. Complicated a grand scale contractual agreements are allowed within the new nd to join the should be noted that some new classicals disagree evidence and see rational expectations ee, for example, Blinder( 1987b)and Lovell (1986). to the debat
282 HE ECONOMIC RI DECEMBER It is, of course, true that pre-1972 Phillips curves from the demand side. Analogously, pre-1973 were ill-equipped to handle the food and energy Keynesian theory produced a negatively sloped shocks that dominated the period from 1972 to statistical Phillips curve because of an unstated 1981 and, in consequence, badly underestimat sumption that m macroeconomic shocks com inflation. But it is also true that Keynesians quickly solely from the demand side-an assumption added supply-side variables (like oil or import proven wrong by the events of the 1970s and 1980s prices) to what had up to then been an entirely The very same model generates a positively sloped lemand-oriented theor on thereafter supply hillis curve if the shocks come from the supply shocks were also appended to empirical Phillips side, which is just what the econometric evidence curves. 17 By the early 1980s says happened in the 1973-1981 period documented the fact that a conventional Phillips If you don' t trust econometrics, the following curve equation with a supply-shock variable(any back-of-the envelope calculation should help drive one of several will do)fits the US data of the 1970s home the point Keynesian economists in the US and 1980s extremely well. 18 The charge that in the 1960s and early 1970s developed what I mpirical Keynesian models were, in Lucas and sed to call the Brookings Sargent's(1978)words, wildly incorrect' is, wel One objection frequently raised by supporters of a percentage point. Using a 5.6 per cent natural of new classical economics is that saving the rate, the US experienced about 15 point-years of Phillips curve after the fact by adding supply extra unemployment between 1980 and 1985 and variables is like saving Ptolemaic astronomy by during those years, the inflation rate declined about adding a new epicycle. I disagree. any economic .7 percentage points. Once you see how well model is fundamentally a set of statements about rule of thumb worked, you understand he behaviour underlying supply and demand and conventional Phillips curves fit data from the 1980s the nature of the shocks impinging on each. For so wel example, an empirical mode le market for Why, then, was the alleged demise of the Phillips wheat consists of a negatively sloped demand curve trumpeted so loudly and so widely? I think curve, a positively sloped supply curve, and some the reason was the conjunction of two events- assumptions about the shocks hitting each. one historical, the other intellectual specify not only aggregate demand and supply data in the 1970s, the familiar negative correlation behaviour but also the nature of the shocks that between inflation and unemployment-which is buffet the economy clearly visible on a scatter diagram of data for The empirical correlations implied by either sort the 1950s and 1960s-disappeared. The Phillips of model depend on both the model's structure and curve could no longer be depicted in two he shocks that predominate during a particular dimensions. To those too unsophisticated to historic period. For example, the same structural distinguish between a simple correlation and a modelof the wheat market will predict that price multivariate relationship, that seemed equivale and quantity are negatively correlated if most of to the death of the Phillips curve the shocks emanate from the supply side but Second, Lucas(1976)insightful critiqu of positively correlated if most of the shocks come econometric policy evaluation provided an elega a prion argument for why an empirical Phillips curve might collapse under the weight of a more For the rudimentary theory, see Phelps(1978)and inflationary policy. 19 Briefly, the argument went Gordon(1975). Phelps' ideas on the subject were first like this. a prototypical empirical Phillips curve by lagged inflation and 1 1974: Gordons were first offered at a Already in January 1974, Princeton graduate students Pr =a(L)P-1+f(Up+er were being asked(by me! to analyze supply shocks in 17 See Gordon (1977). 9 Though Lucass paper was published only in 1976 Some examples are Ando and Kennickell (1983), it had been given at a Carnegie-Rochester conference B Friedman(1983), Gordon(1985), and Perry(1983). in April 1973 and was well known in academic circles years
1988 KEYNESIAN ECONOMICS 283 but is meant to signify a theory in which inflation for statistically significant breaks really depends on expected inflation and autoregression at the ends of 1970, 1971.1972 and 1973. The resulting Fstatistics were as follows P=Er-1(A)+f(Up+er It thus el distributed lag a(l)p 1971:4/1972: ucas pointed out 19724/1973:1 that (1)will continue to fit the data well only as 9734/197 long as a(L)Pt-I remains the best predictor(i.e. None of these F statistics is remotely close to the rational expectation) of inflation. If policy conventional significance levels Thus, there is no changes, the best forecasts of future inflation might evidence for a shift in the lag coefficients a(L) also change, making(I)break down even if nd that, in turn, suggests that the breakdown of Academic readers of Lucas put two and two attributed to the reason emphasized by Lucas. The together and jumped like lemmings to the wrong strongest evidence for a break emerges if the onclusion. The facts were(a) that inflation rose sample is split 1955: 2-1970: 4 vS. 1971: 1-1987: 4 and (b) that the correlation between inflation and In that case, the a(L) coefficients sum to 0. 73 in employment changed. The(untested) assertion n the first period and 0. 88 in the second, which is as that the lucas critique explained why (b) an increase, though not a dramatic one followed from (a): the government had adopted I have already noted that like their ance borary Phillips curves look much a more inflationary policy, which in turn had are added, con It was remarkable how uncritically the Lucas not only provide a more parin go. Supply shocks changed a(l) rs of 15 years critique was accepted. Had governments really for both the rise of inflation and the fall of the decided to ride up 'the Phillips curve toward higher Phillips curve, but one that can be substantiated inflation, as Lucas claimed, or had they simply empirically. Yet academic economists, at least encountered bad luck from the supply side? The American academic economists, opted en masse quantitatively 20 Did the more inflationary environ- my personal answers. They are rooted in the seek evidence on this point, partisans of the Lucas in ideology--not in empiricism. I take up the three rtique became econometric nihilists Theory, not factors in turn data, was suppose theory allegedly said yes But. in fa se in inflation need no Many people have observed that economics ha that the univariate autoregressive representation of become a highly technical subject in recen inflation must change(other than its constant). decades, more so in the US than elsewhere. And Whether or not the lag coefficients a(L) actually technicians, of whatever discipline, prize techniqe shifted in the early 1970s is an empirical question. it's how the young cut their The ration To investigate whether or not such a shift took expectations revolution was a godsend for aspiring or Us young technicians. It not only pushed place, I estimated simple autoregressions 1987:4 macroeconomic theory in more abstract and subperiods. As a way of guarding against the mathematical directi quarters)and the price index(the GNP deflator) sought to replace. 2 vere specified a priori and never changed. I tested The tools needed to carmy out the new of theory and econometrics could not be brands for the US and supports the statement, which hold 21 Thomas Sargent and Lars Hansen led in developing ough the world-wide boom of 1972-1973 the new econometric methods. Sargent always referred to it as'a technology
THE ECONOMIC RECORD DECEMBER in the kit bags of the older economists, mpenetrable prose, regularly impress referees and the young a heavy competitive edge. Ne they better trained mathematicall ounger, more flexible of mind, but they were also government, where the important thing is to ss distracted by other pursuits and hence more oduce the right answer-or, rather, to appear to willing and able to absorb the new techniques. as roduce the right answ an extra bonanza, the Lucas critique provided a innovation and purity count for little, cuteness for reason to shun the previously accumulated stock nothing, and technical virtuosity is unappreciated of econometric results as unreliable. Thus freed A professional forecaster seeks accuracy, not f any need to absorb the knowledge of the past, scholarly kudos. a policy analyst wants to newly-minted Ph. D economists could concentrate communicate with policy makers, not to dazzle on developing what they saw as the wave of the them with technique That new classical ideas failed to migrate from for generational conflict within the enough, the young government-as Keynesian ideas had done 40 recruited disproportionately into the new classical ears earlier-suggests that they failed to meet the ranks while few older economists converted, 22 nonacademic market test: they did not produce Traditional Keynesian tools like IS/LM and \sg> useful results. But that is getting ahead of my story ale macroeconometric models came to be vie s relics of the past and, in a strange kind of guilt y association, Keynesian ideas like those discussed The Nature of economic Thec in Section 2 also came to be seen as outmoded. The triumph of new classical ideas in academia By 1980 or so, the adage there are no Keynesians was also rooted in the nature of economic theory under the age of 40"was part of the folklore of and in economists' fierce loyalty to it. w (A The saying, of course, was meant to encompass lower social sciences by pointing to our illustrious eoretical heritage. In the economists world, in the elite institutions. In fact, virtually no non- rational and self-interested people optimize subject academic economists converted to new classicism. to constraints. The resulting decision rules equating Why the sharp bifurcation between professors on marginal this to'marginal that' lead to supplies the one hand and business and govermment and demands, which interact in markets to economists on the other? Part of the answer is determine prices. These prices, in turn, guide the that scholars are naturally the producers of ne allocation of resources and the distribution of ideas while practitioners are the consumers. income. If not interfered with, markets tend to be Fundamental debates over theory and statistical highly competitive and have a strong tendency to method belong in the academy, where the clear by price. (Here the consensus begins to fray protagonists are better equipped to deal with them a bit. and have the luxury of a long time horizon. That, These are the canons of our faith. They are what I suppose, is what ivory towers are for gives economics the unity and cohesion that, say, But another part of the explanation lies in the sociology lacks. Rightly or wrongly, they also different market tests the two groups must meet. imbue economists with an imperialistic attitude In academia, as in fashion, it is more importan to be fresh and creative than to be correct. Cute Kiplings attitude toward India. We have a tight models, after all, make snappy papers; the real theory; they don 't We should treat the heathen world can be left to less original minds. I have kindly, if condescendingly, while we firmly heard it said that the surest route to academic success is to devise a clever proof of an absurd proposition. And dazzling displays of technical is entirely microeco fireworks, perhaps accompanied by some nomics coexists with central k at best In at least some Keynesian models, workers are Regretfully, I have no data to support this less than rational. (For example, they may harbour quantitati Barro, and Wallace money illusions )Relative wag nd notions of are, of course,older economists'in this context. But they faimess probably matter in labour markets were the founders of the new school of thought Decision makers frequently bump into corners, so
KEYNESIAN ECONOMICS that optimal decisions are no longer described by and, at first, took the new classical baggage along neoclassical marginal conditions. Markets may not with it periods of time; so trading takes place at 'false The Role of Conservative ldeology prices. In all these respects and others, Keynesians There were also ideological overtones in the have long been infidels in the neoclassical temple. neoclassical revival which I have yet to mention. The strength of neoclassical fundamentalism has but which played an important role ebbed and flowed over the decades The worldwide The basic neoclassical paradigm is profound depression of the 1920s and 1930s undermined conservative, as other social scientists-and it severely, thus paving the way for the Keynesian sometimes, our own students-remind us. Those volution. The prosperity of the 1960s and early 1970s probably helped restore it. New class economy tend toward the Panglossian view neoclassical orthodoxy, a return to what Lucas at government intervention. When this world view (1987)echoing Marshall, called'the only engine is transported from microeconomics to for the discovery of truth Keynesians had long felt an agonizing tension which business cycles are benign, unimportant, or ween the macroeconomics they taught on inevitable-perhaps all three. And it leads, as usual, Mondays and Wednesdays and the micro to laissez-faire policy recommendations. For economics they taught on Tuesdays and Thursdays. example, Edward Prescott(1986)asserts that New classicals explicitly sought to end this tension costly efforts at stabilization are likely to be by making macroeconomics more like counterproductive' because the free-market icroeconomics. All supply and demand decisions business cycle is Pareto optimal were to be derived rigorously from neoclassical Keynesians, as I indicated in Section IL, do first principles,. Aggregate demand and supply buy any of this. They argue that the very existence hedules were to be viewed as blow-ups of inter of macroeconomics as a subdiscipline owes to the lutions to individual optimization problems. massive market failures that we observe during Markets were to be viewed as perfectly competitive recessions but which the neoclassical paradigm and clearing. If necessary. bothersome empirical rules out. They believe that recessions are phenomena like involuntary unemployment were important, malign, and ameliorable, and so are to be ignored, defined out of existence, or ready to support government interventions ngeniousl ly rationalized by convoluted theoretical designed to stabilize aggregate economic activity Methodological purity has a seductive attraction about Okun gaps than har arked hey lesrymore erger trangles to mathematically minded technicians-which The relative strengths of conservative and liberal helps explain why rational expectations came to ideology obviously vary both over time and through be so intimately tied up in the debate. Modelling space. My argument is that new classical theor attracted a large follo to informational constraints-is the analogue of country and at a time when right-wing ideology modeling consumers as maximizing utility and was on the ascendancy, as was true in the United producers as maximizing States in the 1970s and 1980s. 23 Though w therefore a natural academics live in ivory towers, the social winds nt-and, indeed, a major impetus Many observers have noticed that the new accident, then that those who favoured frictionless. classical revolution was mainly restricted to the ptimizing, market-clearing models were United States; it never really caught on in Europe immediately attracted to rational expectations as That was no coincidence, I think, for right-wing a behavioural hypothesis without bothering to loc classicism(thus leaving 'irrational expectations to the Keynesians) helped the new theory w 23 Symmetncally, a conservative might argue that in the same way that celebrity endorser (like that of the Great Depression) in which left-wing ideology was ascendant. Neither statement says anything were predisposed to believe in rational exp about the valdty of either doctrine
THE ECONOMIC RECORD DECEMBER ideology has long found more in the us new classical economists sought than in Europe. The timing macroeconomics in the image of neoclassical new classicism took root just microeconomics, recent developments in economi balance in America was shifting the right. theory may eventually lead to a reformulation of i don' t believe such ideas would have sold in micro theory that resembles Keynesian economics. American academia during the 1960s I will discuss each of these in turn, beginning with What I have just said about the theoretical and empirics ideological roots of new classical economics could Emnirical Evidence Against the New Classical ually well have been said about old classical economics. But the 1970s did not witness a revival of Pigou, or even of Friedman. It saw, instead In view of the normally strong interplay between movement towards the high-tech economic theory events and ideas, it is somewhat astounding that of Lucas and the high-tech econometrics of new classical economics caught on during the Sargent. The secret to the success of the new second half of the 1970s-a time when most of lassical economics is that it managed to be at the world s industrial economies were struggling once ideologically backward looking and to emerge, often unsuccessfully, from deep and long technologically forward looking. Given the temperrecessions of the times, that was a winning formula True to its classical roots, new classical theory Or, rather, it was a winning formula in academia dutton economy to cure recessions by wage-price mphasized the ability of a competitive price Outside the academy, the emphasis on theoreti purity(at the possible expense of empirical validity) deflation. Its early forms attributed downturns to and technical wizardry were liabilities, not assets. misperceptions about relative prices(such as real In addition, the leaders of the new school, wages) that arise when people do not know the particularly Lucas and Sargent, were disinclined current price level, and implied that unemployment to press their views on policy makers because they should vibrate randomly around its natural rate eemed macroeconomic science insufficiently ut such n misperceptions surely cannot be large in developed to support such advice. Finally, as we societies in which price indexes are published shall see the next section, the empirical monthly and the typical monthly inflation rate is of new classical theory were wide of under I per cent; and they cannot be persistent or all these reasons, the theory that if expectations are rational. Yet economic mia made hardly a ripple in the world fluctuations in the late 1970s and 1980s were bot large and persistent Later versions of new classical theory replaced I The Rise of Keynesian Economics perceived intertemporal terms of trade and added I have argued that empirical evidence played several features which produced persistent move little or no role in the fall of Keynesian economics ments in employment and output. 25 But empirical in academia, which I have attributed instead to research has never been able to find large inter- the theory's weak microeconomic underpinning to the curious sociology of our discipline, and to temporal substitution effects. And theories that the rise of right-wing ideology. 4 The story behind side of the labour market stumble over the facts eyne sanism is quite that labour supply looks to be quite inelastic(at different, for here the empirical failures of new least in the uS)and real wages are nearly constant classical economics are central. In additi over the business cycle. They also ha however,new strains of theory are beginning to time making the jump from persistent changes in resolve the tension between icroeconomics and macroeconomics in a fascinating way. Whereas nvoluntary-unemployment. In stark contrast, the Keynesian model may be no empirical problems. The most prominent one wa it is certainly a model of obably the collapse of the the US, Canada, and many other countries. While this So the events of the late 1970s seemed to suppo is commonly, and correctly, considered a disaster for ory and monetarism, it also poses a serious problem for the 25 For a review, see Barro(198 la)
1988 KEYNESIAN ECONOMICS 287 challenger. Yet the challenger prevailed. Curious Naive Keynesian analysis, by contrast, sees the Next came the 1980s, which were ushered in same event as an outward shift of the is curve by another oil shock but were dominated by the If the LM curve is unchanged, real interest rates Reagan-Volcker fiscal and monetary policy shocks real output, and the price level should all rise. If, and the European depression. I think it fair to say as happened in the US,, the stimulus to demand that new classical economics shed little light on is snuffed out by contractionary monetary policy any of these events. The events, however, cast deep real interest rates should rise even more. There shadows across the theor 1 According to new classical theory, a correctly rise perceived deceleration of money growth affects Econometric studies of the Barro hypothesis have real output only via its effects on anticipated yielded highly inconclusive results. The answer inflation and real i tually seems to depend on who asks the question 28 thinks real interest rate effects are very large, wl Observation of the real world seems to deliver a the Federal Reserve and the bank of England massively in the US between 1981 and 1984. Given announced that monetary policy would be the thin economic rationale for the policy, the tightened to fight inflation, and then made good Reagan tax cuts come as close to a truly exogenous n their promises, severe recessions followed in fiscal experiment as we are ever likely to get each country. 26 Could it have been that the just the sort of thing that helps scholars discriminate tightening was unanticipated? Perhaps in part. The among competing theories. What happened? The Fed did seem to get carried away, and perhaps private saving rate did not rise. Real interest rates both central banks lacked credibility at first. But soared, even though a surprisingly large part of surely the broad contours of the restrictive policies the shock was absorbed in exchange rates rather were anticipated, or at least correctly perceived than in interest rates(so that net exports were crowded out rather than domestic investment ). Real Old-fashioned Keynesian theory, which says that GNP growth seems not to have been affected; it ny monetary restricion is contractionary because grew at about the same rate it had in the recent firms and individuals are locked into nominal past contracts, seems more consistent with actual sical the events, even though it doesn' t explain why nominal offers no explanation for these events. A sudden contracts exist. Strike one against the new theory. rise in the productivity of capital in the US would &2 an offshoot of new classical theory due to be expected to raise domestic interest rates(and arro(1974)argued that debt-financed tax rates of return), draw in capital from abroad(thus ductions should have neither real nor nominal causing a current account deficit), and appreciate effects because rational agents, correctly the currency The only trouble with this explanation their future tax liabilities or those of is that the alleged jump in the productivity of capital would act to offset them. The only example, did it not also happen in other countries?29 consequence of such a policy, on this ald be a rise in private saving to offset why did meas he accelerate? Furthermore, neither private saving nor investment really rose much as a share of US GNP. The neoclassical explanation does successfull 26 The story is even than this because money explain the puzzling rise in the US stock market growth did not actually decelerate, except fleetingly, in But, if the productivity of capital soared only in either country. But that has to do with financial innovation the US, why did stock markets boom all over the and the collapse of the money-demand equation, which world? And if the rise in capitals productivity was global, why did capital come pouring into the 27 In the case of the 1973-1975 recession, Blinder (1981)points out that'unanticipated money, as defined or a com Brunner(1986). close to explaining the recession. I know of 9 The US corporate tax cuts enacted in 1981 have alculation for the 1980s but it would also ne been suggested as an explanation. But there is controversy ng about this. See Blanchard and Summers(1984), Niskanen money growth, that made money tight in 1981-198 (1988)and Bosworth(1985)
