The Evolution of Modern Economic Theory

In order to understand why the Federal Reserve has chosen its policies of the past three decades, we need to understand the New Keynesians. The response by neoclassical economists to the New Keynesians is the new classical macroeconomics, also sometimes called the new classical economics.  

Originally, the Keynesians were primarily interested in the aggregates of macroeconomics and the neoclassical economists were mostly interested in the microeconomics that governed the business cycle. The neoclassical economists believed that the workings of Adam Smith’s invisible hand together with the effects of the law of marginal utility were sufficient to heal any imbalances between supply and demand and keep the economy healthy. Keynesians, on the other hand, were convinced the fear in bad economic times of both producers and consumers would keep them from either investing or consuming. This would cause a reduction in the total demand for the economy’s fruits (AKA aggregate demand), which would cause more fear, which would cause a further decrease in aggregate demand in a vicious feedback loop. The negative feedback, Keynesians thought, could only be broken if somehow a significant increase in demand could be injected into the economy. Since the normal actors in the private sector were not capable of making the needed injection, that left government as the only entity that could provide the needed stimulating economic demand.

It was inevitable that both sides in this ideological combat of economic ideas would poach on the territory of the other to make their arguments more convincing. From this evolution sprang the neo-Keynesians (not to be confused with the New Keynesians) and the new classical macroeconomics.

The New Keynesians also use Keynesian ideas with neoclassical microeconomic ideas, but they also have adapted to the monetary criticisms of Milton Friedman. The result is often called the new neo-classical synthesis. This label is to distinguish this neo-classical synthesis from the older one produced by the prior neo-Keynesians. This older version dominated economic thought from the 1950s into the 1970s. The advent of stagflation, thought to be impossible by the older neo-Keynesians, and Milton Friedman’s criticisms gave rise to the new neo-classical synthesis. Nowadays the older neo-Keynesians are sometimes called the Old-Keynesians.  Got all that straight?

From this point on, we will refer to the new Keynesian neo-classical synthesis as simply the neo-classical synthesis. The core of these ideas is the addition of the effects of “sticky” wages and prices to the neoclassical model. The New Keynesian accepts that the economy will eventually heal itself under Adam Smith’s invisible hand and the law of marginal utility, but he says the needed adjustments are held back by wages and prices that stubbornly resist change. A worker will naturally not want to accept a lower wage, and a producer will not want a lower price for his good. As a result there will be a (perhaps very long) lag time before they both adjust to the bad economic times and allow quantities and prices of goods to adjust to their new equilibrium values. Once supply and demand balance for most goods, the economy will be in a position to grow again. In order to eliminate a long lag time to recovery, the New Keynesian advocates the same government stimulus programs of the original and neo-Keynesians.

Additionally, as part of the neoclassical part of their neo-classical synthesis, the New Keynesians include studies of market failures that cause recession-inducing imbalances between supply and demand. A neoclassical economist would give the rejoinder that it is far more probable for government failures due to government intervention in the economy to cause such imbalances.

Another change introduced by New Keynesian thought is the integration of monetary theory to answer the criticisms of Milton Friedman. Using the idea of “sticky” prices, New Keynesians theorized that an “easy” money policy by the central bank could stimulate the economy, just as an expansive fiscal policy on the part of the federal government could. This addition of monetary policy as another arrow in the Keynesian quiver would have profound consequences beginning with the Federal Reserve chairmanship of Alan Greenspan.

Simultaneously with the evolution of neo-Keynesians into New Keynesians, the neoclassical economists were adding a macroeconomic theory of their own called the New Classical Macroeconomics. Beginning in the early 1970s with the work of Robert Lucas, Thomas Sargent, Neil Wallace, and Edward Prescott, this theory is built entirely from neoclassical ideas. It assumes that all agents in the economy (investors, producers, and consumers) make decisions that are rational with the information they have, and that these decisions  averaged over time drive all prices toward their “equilibrium” values where Marshall’s supply and demand curves intersect. Initially, these new classical models had low predictive and explanatory power: they could not explain both the magnitude and duration of observed business cycles. As a result most new classical economists had to accept the new Keynesian idea of “sticky” prices and wages. Nevertheless they continue to believe that averaged over time attempts to stimulate the economy with an “easy” monetary policy will not work. People will be guided by their rational expectations of how the economy will behave in ways that negate the stimulative effect of an “easy” monetary policy. Expectations of inflation can enhance inflation by increasing the velocity of money. Once inflation (or for that matter deflation) degrades the capacity of prices to send signals to producers and consumers as to what should be produced and consumed and how much and at what price, even more imbalances between supply and demand will arise.

These developments, while showing a small amount of convergence, still leave neoclassical and New Keynesian economists miles apart as to what the proper monetary policy of the Federal Reserve should be. In the next post on the current economic effects of the Federal Reserve, we will see them interact in a surprising way to create “sterilized” quantitative easing.

GO TO HOME

Sharing is caring!