History of Modern Macroeconomics Lecture 10. The Great Moderation (1975-1995) Kevin D. Hoover Department of Economics Department of Philosophy Center for the History of Political Economy Duke University Econ 314S History of Modern Macroeconomics Lecture 10, Fall 2017 1 19 69 -0 119 0 71 1 -0 119 0 73 1 -0 119 0 75 1

-0 119 0 77 1 -0 119 0 79 1 -0 119 0 81 1 -0 119 0 83 1 -0 119 0 85 1 -0 119 0 87 1 -0 119 0 89 1 -0 119 0

91 1 -0 119 0 93 1 -0 119 0 95 1 -0 119 0 97 1 -0 119 0 99 1 -0 120 0 01 1 -0 120 0 03 1 -0 120 0 05 1 -0 120

0 07 1 -0 101 GDP Growth Rate (percent per year) Turmoil and Calm 8.0 7.0 Variance 1969-1984: 7.5 1985-2007: 1.5 Standard Deviation 1969-1984: 2.7 1985-2007: 1.2 6.0 5.0 4.0 3.0 2.0 1.0 0.0

-1.0 -2.0 Econ 314S History of Modern Macroeconomics Lecture 10, Fall 2017 2 0.0 1969-01- 01 1970-01- 01 1971-01- 01 1972-01- 01 1973-01- 01 1974-01- 01 1975-01- 01 1976-01- 01 1977-01- 01 1978-01- 01 1979-01- 01 1980-01- 01 1981-01- 01 1982-01- 01 1983-01- 01 1984-01- 01 1985-01- 01 1986-01- 01

1987-01- 01 1988-01- 01 1989-01- 01 1990-01- 01 1991-01- 01 1992-01- 01 1993-01- 01 1994-01- 01 1995-01- 01 1996-01- 01 1997-01- 01 1998-01- 01 1999-01- 01 2000-01- 01 2001-01- 01 2002-01- 01 2003-01- 01 2004-01- 01 2005-01- 01 2006-01- 01 2007-01- 01 Percen t per Y ear TheConquestof Infl ationandtheReturnof Prosperity 16.0 14.0

Infl ation Rate 12.0 10.0 UnemploymentRate 8.0 6.0 4.0 2.0 Econ 314S History of Modern Macroeconomics Lecture 10, Fall 2017 3 Lucas and Sargent Before the New Classical Macroeconomics Robert E. Lucas, Jr. (1937- )

Chicago Berkeley Chicago (History Economic History Economics) Keynesian education at Chicago Early work on investment and labor in Kleins microfoundation tradition First job: Carnegie Tech Thomas J. Sargent (1943- ) Berkeley Harvard Politically left Connected to Carnegie-Mellon 16 years at University of Minnesota Principal subject of Esther-Mirjam Sents The Evolving Rationality of Rational Expectations (working title: Resisting Sargent) Econ 314S History of Modern Macroeconomics Lecture 10, Fall

2017 4 Carnegie Tech in the 1950s: Herbert Simon Polymath: economist, political scientist, sociologist, psychologist Cowles Commission: seminal work on causality and identification Intellectual leader of Carnegies Graduate School of Industrial Administration Key work on Herbert Simon (19162001)

bounded rationality self-fulfilling expectations investment Econ 314S History of Modern Macroeconomics Lecture 10, Fall 2017 5 Carnegie Tech in the 1950s: Two Key Players 1 Franco Modigliani (1918-2003) Nobel Laureate (1985) Econ 314S History of Modern Macroeconomics Lecture 10, Fall 2017 6 Carnegie Tech in the 1950s: Two Key Players 2

John F. Muth (19302005) Photo? If you Google Image on John F. Muth you get photos of John Muth (1930-2005) Lucas Sargent Prescott Arrow Simon Samuelson Dornbusch Econ 314S History of Modern Macroeconomics Lecture 10, Fall 2017

7 Carnegie Investment Planning Project Key Book: Charles C. Holt, Franco Modigliani, John F. Muth, and Herbert A. Simon. Planning Production, Inventories, and Work Force, 1960. Econ 314S History of Modern Macroeconomics Lecture 10, Fall 2017 8 Modeling Expectations A simple expectations model (remember the expectations-augmented Phillips curve): X te = X t 1 Adaptive expectations (Phillips, Cagan, Friedman): X te = X t 1 ( X te 1 X t 1 ) where||< 1. Adaptive expectations implies that current expectations are geometric averages of past prices:

X te = (1 ) j X t j j 1 Econ 314S History of Modern Macroeconomics Lecture 10, Fall 2017 9 Adaptive Expectations are Always Wrong X Adjustment of expectations to a one-time, unexpected change in X expected value actual value time Econ 314S History of Modern Macroeconomics Lecture 10, Fall 2017 10 Muths Seminal Papers

Rational Expectations and the Theory of Price Movements (Econometrica 1961) main theory published second John F. Muth. Optimal Properties of Exponentially Weighted Forecasts (Journal of the American Statistical Association 1960) key example refers to later paper in its draft form Econ 314S History of Modern Macroeconomics Lecture 10, Fall 2017 11 The Rational Expectations Hypothesis expectations, since they are informed predictions of future events, are essentially the same as the predictions of the

relevant economic theory. ... The hypothesis can be rephrased a little more precisely as follows: that expectations of firms (or, more generally, the subjective probability distribution of outcomes) tend to be distributed, for the same information set, about the prediction of the theory (or the objective probability distributions of outcomes). The hypothesis asserts three things: (1) Information is scarce, and the economic system generally does not waste it. (2) The way expectations are formed depends specifically on the structure of the relevant system describing the economy. (3) A public prediction, in the sense of Grunberg and Modigliani, will have no substantial effect on the operation of the economic system (unless it is based on inside information). [Muth 1961, p. 316] Econ 314S History of Modern Macroeconomics Lecture 10, Fall 2017 12 The Cobweb and Rational Expectations Econ 314S History of Modern Macroeconomics Lecture 10, Fall 2017 13

Lucas and Friedman Non-Friedmanian Roots Samuelsons Foundations of Economic Analysis receptive to Walrasian theory preference for rigor and formal theory Debt to Friedman preference for radical simplification natural rate hypothesis/expectations-augmented Phillips curve: market-clearing explanation of apparent disequilibrium based in asymmetric information Econ 314S History of Modern Macroeconomics Lecture 10, Fall 2017 14 Lucas and Rapping: The First

New Classical Papers Lucas and Leonard Rapping [1933-1991]: Real Wages, Employment, and Inflation (JPE 1969) Price Expectations and the Phillips Curve (AER 1969) adaptive expectations; mentions does not model rational expectations exploitable tradeoff between inflation and unemployment market clearing with asymmetrical information surprise-only or Lucas aggregate supply function: y = (p pe) intertemporal substitution of labor Econ 314S History of Modern Macroeconomics Lecture 10, Fall 2017 15

Two Ways of Viewing Aggregate Supply New Classical Phillips Curve Inflation New Classical Aggregate Supply Curve Inflation Long-run Phillips Curve Long-run Aggregate Supply Curve Short-run (virtual) Aggregate Supply Curve Short-run (virtual) Phillips Curve Natural rate of Unemployment Unemployment Natural rate of Output Econ 314S History of Modern Macroeconomics Lecture 10, Fall 2017 Real GDP

16 The Adoption of Rational Expectations into Macro: Key Expectations Lucas Papers and the Neutrality of Money (JET 1972) Econometric Testing of the Natural Rate Hypothesis (Fed Conference Volume 1972) Some International Evidence on OutputInflation Tradeoffs (AER 1973) "Econometric Policy Evaluation: A Critique". (Carnegie-Rochester Conference Series on Public Policy 1976) Econ 314S History of Modern Macroeconomics Lecture 10, Fall 2017 17 Expectations and the Neutrality of Money (JET 1972)

Lucas and Rapping paper in Phelps, editor. Microeconomic Foundations of Employment and Inflation Theory. Phelpss island model Signal extraction Stylized, but rigorous, model of the surprise-only aggregate supply function The ephemeral Phillips curve More cited than used Econ 314S History of Modern Macroeconomics Lecture 10, Fall 2017 18 Some International Evidence on Output-Inflation Tradeoffs Empirical test (AER of JET1973) 1972 paper

Cross-country analysis Implication of signal extraction: Phillips curve (aka: Lucas supply function) steeper in high variance of inflation environment Confirmed, but contested in the literature Econ 314S History of Modern Macroeconomics Lecture 10, Fall 2017 19 Aggregate Supply and Noise New Classical Aggregate Supply Curve Inflation Long-run Aggregate Supply Curve Short-run AS Curve high variability of inflation Short-run AS Curve low variability of inflation Natural rate of

Output Real GDP Econ 314S History of Modern Macroeconomics Lecture 10, Fall 2017 20 Econometric Testing of the Natural Rate Hypothesis (Fed Conference Volume 1972) Friedmans not really a natural rate model regression tests the wrong test of the natural rate hypothesis (cf. Muth 1960) correct test: overidentifying crossequation restrictions (early example of solution methods for rational expectations models characterizes policy by a fixed rule proto-policy invariance critique Econ 314S History of Modern Macroeconomics

Lecture 10, Fall 2017 21 Econometric Policy Evaluation: A Critique (Carnegie-Rochester Conference Series on Public Policy 1976) Pivotal macroeconomics paper of the second half of the 20th century Foreshadowed by Tinbergen, Simon, Marschak, et al. (Cowles Commission) Novelty: rational expectations as source of invariance Critique of Tinbergens policy framework: targets and instruments = engineering paradigm cant neglect rational action or economists inside the game Solution model tastes and technology GE microfoundations essential doing Cowles right Econ 314S History of Modern

Macroeconomics Lecture 10, Fall 2017 22 Sargent Independent introduction of rational expectations real interest rates hyperinflation Phillips curve Integration of rational expectations to timeseries econometrics (Christopher Sims (Nobel Prize 2011) a colleague at Minnesota) More empirically oriented than Lucas Econ 314S History of Modern Macroeconomics Lecture 10, Fall 2017

23 Sargent and Wallace: Policy Ineffectiveness 1 Neil Wallace (1938- ) Chicago Ph.D under Friedman Faculty of University of Minnesota Rational Expectations, the Optimal Monetary Policy and the Optimal Money Supply Rule (JPE 1975) Rational Expectations and the Theory of Economic Policy (JME 1976) Econ 314S History of Modern Macroeconomics Lecture 10, Fall 2017 24 Sargent and Wallace: Policy Ineffectiveness 2

IS-LM model with Lucas aggregate supply function = classical dichotomy and continuously clearing markets + rational expectations = no microfoundations = no short-run deviations of expectations from reality except randomly Policy Ineffectiveness = pure AD policies affect output only randomly

+ Fixed M rules price level control + Interest-rate rules or feedback rules indeterminancy Startling, suits conservative rhetoric Econ 314S History of Modern Macroeconomics Lecture 10, Fall 2017 25 Key Tenets of the New Classical Macroeconomics 1. 2. 3. Real economic decisions based on real, not nominal (i.e., monetary) factors = classical dichotomy Agents, to the limits of their information, are successful optimizers = market clearing conditional on information Agents make no systematic errors in evaluating their economic environments = rational expectations hypothesis Econ 314S History of Modern Macroeconomics Lecture 10, Fall 2017

26 Consolidation of the New Classical School Sargents graduate textbook: Macroeconomic Theory 1979 Lucas and Sargent, editors. Rational Expectations and Econometric Practice 1981 aggregative macro/not microfoundational emphasis on systems or GE implications of rational expectations emphasis on econometrics Econ 314S History of Modern Macroeconomics Lecture 10, Fall 2017 27 The Manifestos

Lucas and Sargent After Keynesian Macroeconomics (Minneapolis Fed Quarterly Review 1979) framed as attack on Keynes despite Keynesian roots earlier critical targets Klein and Tinbergen Sargent Beyond Demand and Supply Curves in Macroeconomics (AER 1982) optimizing microfoundations with rational expectations ignores earlier microfoundational programs Econ 314S History of Modern Macroeconomics Lecture 10, Fall 2017 28 The Euthanasia of

Macroeconomics If these developments succeed, the term macroeconomics will simply disappear from use, and the modifer micro will become superfluous. We will simply speak, as did Smith, Ricardo, Marshall, and Walras, of economic theory. [Lucas Models of Business Cycles 1987] The inversion of Kleins program: Klein: data first (analogical consistency with theory) Lucas: theory first (analogical consistency with data) Econ 314S History of Modern Macroeconomics Lecture 10, Fall 2017 29 The Problem of Business Cycles The empirical failure of the monetary shocks approach

no difference between anticipated and unanticipated money no reaction to data revisions unaccountable serial correlations Ad hoc solutions lagged dependent variables without a rationale Econ 314S History of Modern Macroeconomics Lecture 10, Fall 2017 30 Lucas: A Positive Program for Business Cycles Continuous market-clearing, dynamic equilibrium against Keyness involuntary unemployment

involuntary unemployment is not a fact or a phenomenon which it is the task of the theorist to explain. It is, on the contrary, a theoretical construct which Keynes . . . hope[d] would be helpful in discovering a correct explanation for a genuine phenomenon: large-scale fluctuations in measured, total unemployment. Is it the task of modern theoretical economics to explain the theoretical constructs of our predecessors, whether or not they have proved fruitful? Business cycle phenomena: not objects, but patterns of covariation picked up by Kydland and Prescott surprising respect for Burns and Mitchell Econ 314S History of Modern Macroeconomics Lecture 10, Fall 2017 31 The Simulacrum Account of Models

j j j pattern prediction vs. forecasting testing rules vs. conditional forecasts Turing and Adelman tests Econ 314S History of Modern Macroeconomics Lecture 10, Fall 2017 32 The Transition to the Real Business Cycle Model Lucass 1975 Business Cycle Model growth, capital, and the propagation

mechanism the last gasp of the monetary surprises alternative rationales for money Kydland and Prescott, Time to Build and Aggregate Fluctuations technology shocks the absence of monetary shocks the irrelevance of time-to-build Econ 314S History of Modern Macroeconomics Lecture 10, Fall 2017 33 The Rise of the Representative Agent The neoclassical growth model

Solow optimal growth in the 1960s the planning roots of the representative agent Ignoring aggregation Econ 314S History of Modern Macroeconomics Lecture 10, Fall 2017 34 New Keynesian Macroeconomics Immediate objections to the policy ineffectiveness proposition: John Taylor Stanley Fischer

overlapping labor contracts Rational expectations is not the issue Central Issues: apparent effectiveness of monetary policy = e.g., Friedman & Schwartz the problem of business cycles Econ 314S History of Modern Macroeconomics Lecture 10, Fall 2017 35 Sources of Friction New Keynesians Slow price adjustment

= imperfectionists concede the ideal model to New Classicals implies policy effectiveness provides basis for cycles Sources: menu costs efficiency wages fixed contracts Econ 314S History of Modern Macroeconomics Lecture 10, Fall 2017 36 Perfectionist New Keynesians Sunspot Models Multiple equilibrium models Econ 314S History of Modern

Macroeconomics Lecture 10, Fall 2017 37 The Saltwater and Freshwater Schools New Classicals = Freshwater: near lakes (Universities of Chicago, Minnesota, and Rochester New Keynesians = Saltwater: near oceans (Universities of California, Berkeley, Harvard, MIT Econ 314S History of Modern Macroeconomics Lecture 10, Fall 2017 38 Two Victories New Classicals won the methodological battle

representative-agent microfoundations imperfectionist models major defeat for the Klein program New Keynesians won the empirical battle price stickiness widely accepted needed to explain business cycles supports policy effectiveness Econ 314S History of Modern Macroeconomics Lecture 10, Fall 2017 39 The New Neoclassical Synthesis The Dynamic Stochastic General Equilibrium Model (DSGE)

intertemporal optimization rational expectations representative agent microfoundations frictions as necessary e.g., reaction to 2007-2009 crisis: DSGE + financial frictions An end to the Saltwater/Freshwater split? Econ 314S History of Modern Macroeconomics Lecture 10, Fall 2017 40 Thanks The End Econ 314S History of Modern Macroeconomics Lecture 10, Fall 2017

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