Macroeconomics — Disputes Between Schools Are Bundles of Assumptions
Macroeconomics — The Name of a School Is a Nickname for a Bundle of Assumptions
Debates in macroeconomics are often presented as battles between schools, such as “Keynesian versus classical.” But each school’s conclusions are the result of switching a few assumptions on or off. Knowing the assumptions lets you predict the conclusions without the school names, and judge which conclusion fits a new situation.
1. Three switches
Three main assumptions separate the conclusions of macroeconomic models.
| Assumption | When switched on | When switched off |
|---|---|---|
| Flexible prices and wages | Shocks are absorbed by prices and output stays at potential | Output and employment respond to demand shocks (gaps open) |
| Rational expectations | Anticipated policy is reflected in expectations at once | Expectations adjust slowly, so short-run effects last longer |
| Announced policy rules | Systematic policy is anticipated and has no effect | Only surprise policy works; credibility problems |
2. Assumptions and conclusions by school
| School | Core assumptions | Cause of fluctuations | Policy implication |
|---|---|---|---|
| Classical | Flexible prices, Say's law | Mainly real factors | Money is neutral; no need to intervene |
| Keynesian | Rigid prices and wages, effective demand | Changes in aggregate demand, expectations (animal spirits) | Stabilize with fiscal and monetary policy |
| Monetarist | Short-run non-neutrality, long-run neutrality, adaptive expectations | Unstable money supply | Money growth rule |
| New classical | Flexible prices, rational expectations | Unanticipated monetary shocks | Anticipated policy is ineffective; rules |
| Real business cycle (RBC) | Flexible prices, rational expectations, technology shocks | Productivity shocks | Fluctuations are efficient responses; no need to stabilize |
| New Keynesian | Rational expectations + sticky prices + imperfect competition | Both demand and supply shocks | Short-run stabilization works; long-run neutrality; credibility matters |
New Keynesians do not “just assume” price stickiness; they explain it with microeconomics. Small costs of changing prices (menu costs) can cause large welfare losses for the economy as a whole, and when firms change prices at different times (staggered price setting), the overall price level moves slowly. The standard model used by central banks today is the New Keynesian DSGE model, which adds New Keynesian rigidities to the RBC method (optimizing agents, rational expectations); the loss function and Taylor rule of Chapter 13 are discussed within it.
3. What the evidence says
Whether monetary policy affects output is hard to identify because policy changes respond to economic conditions (rates may have been raised because the economy was already overheating). Researchers have identified monetary policy shocks by picking out policy changes unrelated to the economic outlook from central bank records, or by using changes in market rates in the few minutes after a policy announcement. These studies generally find that an unexpected tightening reduces output with a lag of one to two years, and that the effect fades over several years. The evidence fits both short-run non-neutrality and long-run neutrality.
4. After the financial crisis
The 2008 financial crisis exposed a weakness of the standard model: it contained almost no financial sector. Models have since been extended in two directions.
- Financial frictions: channels through which bank capital and collateral constraints amplify shocks (Chapter 18)
- Heterogeneous agents: instead of a single representative household, households with different incomes and wealth, used to analyse how the high marginal propensity to consume of liquidity-constrained households changes the effects of fiscal and monetary policy (HANK models)
Check your understanding
In an economy where nominal wages are set in one-year contracts, the central bank raises inflation by 3 points without warning. What happens to output in the first year? The price-flexibility switch is off, so real wages fall by about 3% during the contract, firms hire more and output rises above potential. When contracts reflect the new price level the following year, real wages return to their original level and output returns to potential. Had the same policy been announced in advance, it would already have been built into the first-year contracts and the output effect would be small.
References
- Robert Lucas, “Econometric Policy Evaluation: A Critique,” Carnegie-Rochester Conference Series (1976)
- Christina Romer and David Romer, “A New Measure of Monetary Shocks: Derivation and Implications,” American Economic Review (2004)
- Jordi Galí, Monetary Policy, Inflation, and the Business Cycle, ch. 1–3
- N. Gregory Mankiw, Macroeconomics, ch. 14–15
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