NBER WORKING PAPER SERIES NEW CLASSICALS AND KEYNESIANS, OR THE GOOD GUYS AND THE BAD GUYS Robert J. Barro Working Paper No.2982 NATIONAL BUREAU OF ECONOMIC RESEARCH 1050 Massachusetts Avenue Cambridge, MA 02138 may,1989 Prepared for presentation at the 125th anniversary meeting of the Swiss Economic Association, April 1989. This paper is part of NBER's research program in Economic Fluctuations. Any opinions expressed are those of the author not those of the National Bureau of Economic Research
NBER Working Paper #2982 May 1989 NEW CLASSICALS AND KEYNESIANS, OR THE GOOD GUYS AND THE BAD GUYS Old-style Keynesian models relied on sticky prices or wages to explain unemployment and to argue for demand-side macroeconomic policies. This approach relied increasingly on a Phillips-curve view of the world, and therefore lost considerable prestige with the events of the 1970s. The new classical macroeconomics began at about that time, and focused initially on the apparent real effects of monetary disturbances. Despite initial successes, this analysis ultimately was unsatisfactory as an explanation for an important role of money in business fluctuations. Nevertheless, the approach achieved important methodological advances, such as rational expectations and new methods of policy evaluation. Subsequent research by new classicals has deemphasized monetary shocks, and focused instead on real usiness cycle models and theories of endogenous economic growth. These eas appear promising at this time. another development is the so-called new Keynesian economics, which includes long-term contracts, menu costs, efficiency wages and insider-outsider theories, and macroeconomic models with imperfect competition. Although some of these ideas may prove helpful as elements in real business cycle models, my main conclusion is that the new Keynesian economics has not been successful in rehabilitating the Keynesian pproach Robert J. Barro Harvard University Department of Economics Littauer Center Cambridge, MA 02138
Keynesian Model When I was a graduate student at Harvard in the late 1960s, the Keynesian model was the only game in town as far as macroeconomics was concerned Therefore, while I had doubts about the underpinnings of this analysis, it seemed worthwhile to work within the established framework to develop a model that was logically more consistent and hopefully empirically more useful Collaborating with Herschel Grossman(Barro and Grossman, 1971), we made some progress in clarifying and extending the Keynesian model. But that research also made obvious the dependence of the central results on fragile underlying assumptions. The model stressed the failure of private enterprise economies to ensure full employment and production, and the consequent role for active macro policies as instruments to improve outcomes. Shocks to aggregate demand--but not aggregate supply--were the key to business fluctuations, and mere changes in optimism or pessimism turned out to be self fulfilling These properties, which seem odd to economists who think in terms of price heory and well-functioning private markets, suggest coordination problems on a grand scale. But this perspective hardly accords with the basic source of market failure that characterizes the standard Keynesian model. It is the mere stickiness of prices or wages, primarily in the downward direction, that accounts for the principal results. Of course, many macroeconomists think of price stickiness as an as if device--a problem that is not to be viewed literally, but instead as a proxy for serious matters, such as incomplete information,adjustment costs, and other problems of coordination among economi ic agents. But this viewpoint has not been borne out by subsequent research. For example, the incorporation of these serious matters does not
support the Keynesian stress on aggregate demand, and also does not provide normative basis for activist government policies of the usual Keynesian type One important function of a macroeconomic model is to isolate the sources of disturbances that cause aggregate business fluctuations. Keynesi analyses focus on shocks to aggregate demand, and typically attribute these shocks either to governmental actions(disruptive or corrective fiscal and monetary policies, or to shifts in private preferences that influence consumption or investment demand. Keynes's own discussion(Keynes, 1935 hapter 12)referred to the I spirits"of businessmen, and the consequent volatility of investment demand due to shifting moods of optimism or pessimism. Thus, aside from governmental actions, the Keynesian model is not strong at pinpointing observable, objective events that cause recessions or boom One reason that Keynes may not have been troubled by this " deficiency" is that he te economy as inherently unstable. It did not take large(and presumably objectively observable)shocks to trigger a recession because even a small shock--when interacting with the multiplier(and, in some models, also the investment accelerator )--could generate a significant and sustained drop in output and employment. Curiously, however, later Keynesian developments deemphasized the multiplier. For example, in the well-known IS/LM model (in which interest rates ad just and matter for aggregate demand)or in Keynesian analyses that incorporate some version of the permanent- income hypothesis, multipliers need not exist. These extensions do improve the model's fit with some facts about business cycles ch as the apparent absence of a multiplie e of output changes in government purchases and the relative stability of consumption
3 over the business cycle. But the elimination of the multiplier means also that large responses of output, as in a substantial recession, require large impulses; hence, it again becomes important to identify the kinds of shocks that typically matter for aggregate fluctuations I think that the desire to find observable, aggregate shocks motivated many Keynesians--although not Keynes nor many of his immediate followers--to assign a substantial weight to monetary disturbances as a source of the business cycle. Within a framework where prices adjust slowly and output is determined by aggregate demand, it is easy to conclude that an increase in money raises output and also leads gradually to a higher price level Moreover, the positive correlation between money and output--and perhaps between the price level and output--showed up in some data During the 1960s and early 1970s, Keynesian analysis became increasingly identified with this Phillips curve- view of the world. Thus, this analysis also lost considerable prestige when the Phillips curve disappeared in the mid 1970s; the rise in unemployment along with the increasing rate of inflation was difficult to explain in this kind of model. New Keynesians have,however,demonstrated their flexibility by arguing that the old ynesian model merely need to be patched up to incorporate the supply side Bu argument does not work. In a single market, one can think of qua as determined by demand with the excess supply rationed--as in the Keynesian model--so that changes in quantity depend only Then if this situation applies to the majority of markets, one can generate orthodox Keynesian prescriptions for demand-oriented governmental policies Alternatively, quantity in a typical market could be determined by supply with the excess demand rationed--as in markets subject to effective price