IN THIS CHAPTER

Meeting ten influential macroeconomists

Understanding their contributions

Like any academic discipline, macroeconomics relies on the incremental progress of researchers, each building upon and improving previous work — like bricks holding up a wall or, more salubriously, adding new ingredients to old cocktail drinks.

Here are ten famous economists who had a huge impact on macroeconomics. Ladies and gentlemen, it gives us great pleasure to introduce…

Adam Smith (1723–1790)

Here he is … the big daddy, not just of macroeconomics but economics as a whole. Adam Smith was the first person to think seriously about modern economic problems. His ability to observe the world around him and to describe the motives and mechanisms that underlie what he saw remains impressive to this day. It lies at the heart of all good social science.

Smith wrote his most influential work in 1776: An Inquiry into the Nature and Causes of the Wealth of Nations. He argued that people acting in their own self-interest may serve the common good better than if they try to “do good” intentionally. Smith writes:

It is not from the benevolence of the butcher, the brewer, or the baker, that we expect our dinner, but from their regard to their own interest. We address ourselves, not to their humanity but to their self-love, and never talk to them of our own necessities but of their advantages.

This idea was — and still is — extremely radical in the deep sense of getting to the root of the matter. Smith thought that individuals and firms acting according to their own interests can lead to a socially desirable allocation of goods and services. As Smith put it, although each individual is pursuing her own best interest, each acts as if “led by an invisible hand to promote” the efficient social outcome. That is, people naturally do what is right for them and for society simultaneously.

John Maynard Keynes (1883–1946)

If Adam Smith is the father of economics, John Maynard Keynes is the father of modern-day macroeconomics.

In 1936, he wrote The General Theory of Employment, Interest and Money. He was writing during the Great Depression, a prolonged period from 1929 until the late 1930s that saw large and persistent falls in output and high unemployment. The classical economists of the day had a hard time explaining the causes of the Great Depression.

The Keynesian analysis fits readily in the aggregate supply and aggregate demand framework that we develop in Chapter 12. In Keynes’ view, wage (and price) stickiness made the aggregate supply curve fairly flat in the short run. Hence, movements in aggregate demand had a big impact on real GDP and not just on the price level. Indeed, Keynes thought that it often took a very long time for output to return to its long-run potential. Thus, a clear case existed for governments to intervene with expansionary policies (see Chapters 14 and 15) in order to get economies out of recession.

In recommending short-run government intervention, Keynes also argued that expansionary fiscal policy would likely be the best tool in times like the Great Depression. This is because he thought that in such situations, the economy would face a liquidity trap (see Chapter 15). In that case, the nominal interest rate is at its lower bound of zero. Therefore, expansionary monetary policy cannot lower the rate further as it needs to do to stimulate spending.

Keynes famously quipped that “in the long run, we are all dead.” He meant that policy-makers shouldn’t be concerned only about what happens to an economy in the long run — the short run lasts long enough that it matters a lot, too.

Milton Friedman (1912–2006)

The ideas in Keynes’s General Theory (see the preceding section) dominated macroeconomics for several decades. Indeed, many macroeconomists identified themselves as Keynesian, and today a widely used approach to macroeconomics is called the New Keynesian model.

There was opposition to Keynes’ ideas very early on, however. Much of this opposition was led by Milton Friedman, who was foremost among a small group of influential economists known as the monetarists. The monetarists were very concerned that economists understood very little about how the economy works. They argued that Keynesian calls for intervention amounted to trying to fine tune the economy in the absence of understanding it and that this was likely to lead to more instability — not less. They believed that just following simple rules was a better policy. In addition, they doubted that fiscal policy would have much impact on aggregate demand, so they focused on a simple rule for monetary policy. The “Friedman Rule” as it came to be called was the central policy recommendation of the monetarists. It called for setting the rate of growth in the money supply at some (low) rate that would be constant forever — regardless of the state of the economy.

Friedman made many lasting contributions. He was among the first to recognize that in making their spending decisions, consumers look at their long-run income, and to recognize the important implications this had for fiscal policy. As explained in Chapter 16, Friedman was also an early and prophetic critic of the original Phillips curve — arguing that the apparent trade-off between unemployment and inflation was temporary and couldn’t exist in the long run. His view that once inflationary expectations are taken into account there would be no long-run trade-off between unemployment and inflation ultimately proved correct. It is now a standard feature of all macroeconomic models. The monetarist policy recommendation calling for freezing the rate of money growth, however, is rarely proposed any longer. He was awarded the Nobel Memorial Prize in Economic Sciences in 1976.

Paul Samuelson (1915–2009)

Paul Samuelson was one of the great economists of the twentieth century. He was among the first to stress the importance of modeling economic phenomena mathematically. His work completely changed the way that both microeconomists and macroeconomists look at the world.

Samuelson introduced two key principles:

• Constrained optimization: Individuals choose the best option they can from all the options available. Although sounding rather obvious, this idea means that economists can mathematically model consumers as individuals who try to maximize their utility (their welfare) subject to their budget constraint (the things they can afford). Similarly, firms can be mathematically modeled as maximizing their profits subject to their technology constraint (how well they can turn inputs into output).
• Equilibrium: The idea that most of the time economic systems should be “at rest” — that is, with no tendency for things to change. This simple but powerful idea is used throughout economics: for example, in the AD–AS model (see Chapter 12) economists assume that the price level and output adjust to ensure that aggregate demand equals aggregate supply.

Samuelson also introduced formal dynamics into macroeconomic modeling. Most previous work focused on what is usually referred to as comparative statics — comparing the equilibrium under one set of policies with what the equilibrium would be under a different set of policies. Samuelson showed that it was important to understand the dynamic process of how the economy would actually move from one equilibrium to another. In some cases, that process would not converge and the economy would never reach the new equilibrium. That meant one had to consider whether the static equilibrium model being used really made sense. He was awarded the Nobel Memorial Prize in Economic Sciences in 1970.

James Tobin (1918–2002)

James Tobin was among the early American disciples of Keynes and one of the foremost developers of the Keynesian model. Like Milton Friedman (see earlier), Tobin wrote widely for the general public as well as for academic publications.

Tobin is best known for his work linking financial markets to macroeconomic outcomes. He was the first to introduce a monetary sector into the neoclassical growth model. More generally, he was among the first to see money as just one of many assets that investors could use to store their wealth. This led to an understanding that financial disturbances other than monetary ones could have important consequences for real GDP and employment. Consideration of different assets and investors’ optimal portfolios led Tobin to develop the mutual fund separation theorem that states that, under some not too restrictive conditions, all investors will earn the highest return per unit of risk by splitting their wealth between just two assets: a safe, risk-free asset and a broad index mutual fund reflecting all risky assets as a group. The only difference would be that more risk-averse investors would put more of their wealth in the risk-free asset. This result is central to the Capital Asset Pricing Model that lies at the foundation of modern theories of asset pricing.

Policy discussions continue to refer to concepts developed by Tobin. “Tobin’s q” is a widely used measure of the climate for business capital investment defined as the ratio of the stock market value of a corporation relative to the cost of replacing its capital assets. It is also used frequently to determine a corporation’s legitimate value.

The “Tobin tax” is a tax on financial transactions first proposed by Tobin to reduce the speed and the size of the international capital flows that move exchange rates dramatically with potentially damaging effects on a country’s net exports and real GDP. It has subsequently been proposed to deal with what many consider to be inefficiently large and sudden financial flows more generally. The European Union is currently scheduled to impose such a tax in late 2016.

Tobin also worked on issues of income distribution and empirical methodology. His estimation technique, known as Tobit estimation, is a standard statistical way to handle variables whose values are truncated so that they cannot fall below a specific lower bound. He was awarded the Nobel Memorial Prize in Economic Sciences in 1981.

Robert Solow (1924–)

Robert Solow is best known for his fundamental work on economic growth. In two path-breaking articles in 1956 and 1957, he laid out the basic mathematics for the model of economic growth described in Chapter 8, and provided empirical evidence on its implications. That model has since become central to all long-run macroeconomic analysis and is widely known as the neoclassical growth model. It’s still the starting point for standard analyses of economic growth.

Solow’s model implies that two things explain why living standards grow over time:

• Capital stock per person: Basically, the more capital each person has to work with, the higher are both her average and marginal labor productivity. In other words, with more capital, each worker can produce more stuff. So, real GDP per capita rises.
• Technology: Even if each generation of workers has the same amount of capital as the one before it, each can still see rising productivity and living standards if either the capital or the labor (or both) are getting better or smarter. Again, real GDP per capita rises.

Of the two factors, Solow’s evidence implied that technology was by far the more important in terms of explaining rising GDP per capita over time.

Another important feature of Solow’s model was that the growth process was stable. This may seem obvious today. But growth requires that both capital and labor inputs steadily increase, and a number of scholars in the 19th and early 20th centuries, including Karl Marx in particular, believed that the process of capital accumulation was destined to produce unstable business cycles, possibly culminating in a gigantic crash. For many the Great Depression was the definitive proof of this view that economic growth is inherently unstable. Solow’s model was an important antidote to this somewhat gloomy view.

Solow also did important work on the economics of natural resources, the environment, and labor markets, the last of which supported the Keynesian model. He was awarded the Nobel Memorial Prize in Economic Sciences in 1987.

Robert Lucas (1937–)

Robert Lucas was at the forefront of a critical reevaluation of macroeconomics that ultimately changed the way macroeconomists model the economy in fundamental ways. Sometimes called the new classical macroeconomics, Lucas and others insisted that macroeconomic models had to be consistent with the rational, optimizing behavior of microeconomic theory. Expectations were no exception to this rationality requirement, and this led to the development of rational expectations models. In models with both rational expectations and flexible wages and prices, government intervention can have no real effects because households and firms rationally foresee the intervention and therefore recalibrate their behavior to offset it. For example, a government policy to raise money growth whenever real GDP falls below potential will simply lead all agents to raise their expectations of money growth whenever real GDP is less than potential. They will then alter their wage and price demands such that when the higher money growth happens, it has no effect on employment or real GDP.

Both because it implied that government macroeconomics stabilization efforts were largely ineffective and because it emphasized underlying microeconomic foundations, the new classical paradigm directly challenged the dominant Keynesian approach of that day, and gave support to simple policy rules such as Friedman’s money growth rule (see earlier). When Keynesians countered with empirical evidence purporting to demonstrate that Keynesian policy rules worked better, Lucas responded with his famous Lucas Critique (see Chapter 16), arguing that such empirical evidence was misleading because it reflected the policies in effect for the time that the data was collected. It couldn’t be used to predict what would happen with a different policy because if a different policy were enacted, consumers and businessmen would rationally change their policy expectations and therefore their behavior.

Although Keynesian analysis rooted in sticky wages and prices survived, both rational expectations and the Lucas Critique have become permanent parts of macroeconomic modeling, as did the general insistence on microeconomic foundations. It is now recognized that models that do not have these elements are unlikely to describe the macroeconomy accurately.

Lucas also made important contributions to economic growth theory showing in particular the critical role of human capital formation, that is, education and training. He was awarded the Nobel Memorial Prize in Economic Sciences in 1995.

Edward Prescott (1940–)

Edward Prescott was a leader in the second round of the new classical macroeconomics (see preceding entry) that also permanently changed macroeconomic modeling.

One branch of his work focuses on a fundamental inconsistency in discretionary policy-making. Suppose that if you work really hard, your company will make an extra $20,000. So, to give you an incentive, your boss says that if you work really hard you’ll get a big bonus of $15,000. That way, you both come out ahead. There’s just one slight catch. If there’s an emergency due to some market shock that really cuts into profits, the boss can cancel the bonus. This may seem reasonable because it gives your boss some discretion to respond to changing economic circumstances. The problem is that after you work hard, the boss always has some incentive to say that some shock occurred and so avoid paying the bonus. At that point, you can’t undo your hard work. However, if you have rational expectations, you’ll see that the boss’s bonus promise is empty from the start. The only equilibrium is one where you don’t work hard and you’re both worse off — you don’t get the $15,000 bonus, and the company doesn’t get $5,000 in profit. The boss’s discretion makes the bonus suspect. If she just made a flat commitment to paying you the bonus so long as you worked hard, you would — and everyone would gain.

Prescott applied this argument to macroeconomic policy in general. We may think that policy-makers should have discretion to choose which policy is best in any setting. But this flexibility gives them the ability to deviate from their promises, such as keeping inflation low or limiting the buildup of government debt. Good long-run outcomes therefore require that flexibility be abandoned and policy be committed to a clear rule, possibly a Friedman-type rule that freezes money growth permanently.

A second branch of Prescott’s work pioneered the integration of short-run and long-run analysis in one unified model (see Chapter 3). An important insight of this analysis is that when real GDP falls, it can be very difficult to determine whether this is a case of real output being below trend or a case in which both actual and potential GDP have fallen. Only the former might warrant government intervention. Prescott built a unified model showing that in an economy described by the neoclassical growth process (see earlier) and with flexible wages and prices, the optimal response of households and businesses to random shocks would generate movements in real GDP that look a lot like the business cycle data of the real world. However, because these reflect optimal behavior, no government intervention is needed.

Although these models capture real GDP movements fairly well, they do much less well in replicating labor market outcomes. You typically need to add sticky wages and prices for this purpose and that opens up an avenue for government policy to improve things. Nevertheless, Prescott’s contribution is a lasting one. The unified modeling approach that he pioneered — now usually referred to as Dynamic Stochastic General Equilibrium modeling — has become standard in macroeconomic analysis.

Much of Prescott’s work has been done collaboratively with his colleague, Finn Kydland. Both shared the Nobel Memorial Prize in Economic Sciences in 2004.

Robert Barro (1944–)

Robert Barro, like Robert Lucas and Edward Prescott (see earlier), is one of the intellectual heavyweights behind the new classical revolution rooted in optimizing, forward-looking behavior and rational expectations of what the future — including future economic policy — would bring.

Barro has contributed to many areas of macroeconomics, including important work on the empirical determinants of economic growth. However, he is probably most famous for his work that resurrected and built on much older work by the 19th century classical economist, David Ricardo. The Barro-Ricardian insight was that the government budget constraint must imply budget balance in the long run. Debts today must be paid off at some time in the future. As a result, a tax cut leading to a budget deficit today means higher taxes in the future to pay off the new debt the deficit creates. Hence, there’s no difference between financing government expenditures with taxes or with debt. The two are ultimately equivalent. Combined with rational expectations, this Ricardian Equivalence implies that tax cuts (and spending increases) will not raise aggregate demand. Rational, forward-looking consumers will foresee the future tax increases that the resulting deficit implies. They will therefore cut back on spending now in order to have the extra funds needed to pay those future higher taxes. This argument is a direct challenge to the Keynesian view that fiscal policy can be used to counter recessions.

Barro’s work with David Gordon built on Kydland and Prescott’s work (see the preceding section) on time inconsistency. They applied that model explicitly to discretionary monetary policy. They showed that when inflation is expected to be low, policy-makers always have an incentive to increase it a bit and thereby reduce unemployment, as indicated by the expectations-augmented Phillips Curve (see Chapter 16). A public that has rational expectations, however, will learn to foresee this and so will begin to expect high inflation. Once this happens, the incentive to raise inflation still higher disappears because the costs of more inflation increase dramatically when it’s already at a high rate. The result of discretionary monetary policy then is an equilibrium with no reduction in unemployment and with the public expecting and the policy-makers setting inflation at a high rate even though everyone would be better off if it were low. That is, allowing the monetary authorities discretion leads to an upward inflation bias. The economy’s long-run equilibrium is at the natural rate of unemployment with more inflation than there would otherwise be. A strict policy rule that commits the authorities to a low inflation policy would be better.

Janet Yellen (1946–)

Sadly, like many areas of business and academia, macroeconomics has a dearth of women at the top. With the new generation of talented female scholars coming through, there’s reason to hope that this situation will change in the years to come. Janet Yellen’s career is a sign that change may already be happening. She’s managed to reach the very top of macroeconomic policy-making. Currently, she’s the Chair of the Federal Reserve. Previously, she served as head of the Council of Economic Advisors under President Bill Clinton.

Having overall responsibility for monetary policy in the United States makes her one of the most powerful people in the world — certainly the most powerful economist. Monetary policy (see Chapter 5) determines a nation’s inflation rate in the long run, and in the short run has a strong influence on unemployment and output (see Chapter 14). The U.S. is still the largest economy by far, and so the Fed’s decisions reverberate throughout the world economy.

Although Yellen has given much of her life to public service, she also has had a distinguished academic career with important contributions to both microeconomics and macroeconomics. In the former field, her paper on product-bundling (written with W.J. Adams) is a pioneering piece on why firms often sell separate goods bundled together, such as the standard bundle of networks in a cable television package, or the bundling of options in a specific model by car dealers. Yellen and Adams show that this allows firms to separate consumers into different groups to whom they effectively offer different prices and so earn greater profits. This insight is central to all modern work on price discrimination.

Because of her deep microeconomics understanding, Yellen was perhaps better able than many Keynesians to respond to the new classical demand that macroeconomic analysis have solid microeconomic foundations. In a series of papers with George Akerlof, Yellen developed the model of efficiency wages (see Chapter 7). In this model, firms pay wages higher than the going market rate in order to minimize turnover and motivate more consistent effort. Yellen and Akerlof show that when this model is combined with small price adjustment costs (or with a small amount of “irrationality”), even anticipated shocks to aggregate demand can have large effects on real GDP and unemployment. Such models are essential ingredients of the New Keynesian macroeconomics. The New Keynesian analysis preserves the main conclusions of Keynes while taking seriously new classical insights such as rational expectations. By the way, George Akerlof is not only Janet Yellen’s colleague but also her husband (and a co-winner of the 2001 Nobel Memorial Prize in Economic Sciences — and one of the ten great microeconomists in Microeconomics For Dummies!)