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Modern Macroeconomics

This paper provides a critique of the DSGE models that have come to dominate macroeconomics during the past quarter-century. It argues that at the heart of the failure were the wrong microfoundations, which failed to incorporate key aspects of economic behavior, e.g. incorporating insights from information economics and behavioral economics. Inadequate modelling of the financial sector meant they were ill-suited for predicting or responding to a financial crisis; and a reliance on representative agent models meant they were ill-suited for analysing either the role of distribution in fluctuations and crises or the consequences of fluctuations on inequality. The paper proposes alternative benchmark models that may be more useful both in understanding deep downturns and responding to them.

Modern Macroeconomics

Macroeconomists have also been profitably applying the basic tools ofgeneral equilibrium theory, computational techniques, and a deepunderstanding of key features of the data to a wide area of phenomenaoutside of narrowly defined macroeconomics. These include incomedifferences across countries, fertility behavior across time andcountries, the dynamics of the size distribution of firms, and theefficiency costs of the welfare state. A good illustration of this kindof work is the study of differences in labor market performance betweenthe United States and Europe. Although work of this kind has not yetdirectly affected policy, it will once its policy lessons, carefullygrounded in theory and data analysis, are clearly communicated topolicymakers and the public.

Thus, modern macroeconomic theory argues that positive nominal interestrates are optimal only if the set of instruments available to thegovernment is restricted. Since this situation is highly likely inpractice, optimal monetary policy involves a compromise between thegoals of zero nominal interest rates and other goals. The robust findingis not that nominal interest rates should be literally zero but thatnominal interest rates and inflation rates should be low.

Although the changes in the practice of monetary policy documented abovecannot be definitively linked to the recent theoretical developments inmacroeconomics, the most straightforward explanation for these changesis that they are due to the identification of the time inconsistencyproblem by macroeconomic theorists.

The toilers in academe are uniquely placed to develop analyses ofinstitutions and to educate the public and policymakers about economictrade-offs. The essence of our argument is that, at least inmacroeconomics, these toilers have delivered large returns to societyover the last several decades.

The generation following Keynes combined the macroeconomics of the General Theory with neoclassical microeconomics to create the neoclassical synthesis. By the 1950s, most economists had accepted the synthesis view of the macroeconomy.[8] Economists like Paul Samuelson, Franco Modigliani, James Tobin, and Robert Solow developed formal Keynesian models and contributed formal theories of consumption, investment, and money demand that fleshed out the Keynesian framework.[10]

New classical macroeconomics further challenged the Keynesian school. A central development in new classical thought came when Robert Lucas introduced rational expectations to macroeconomics. Prior to Lucas, economists had generally used adaptive expectations where agents were assumed to look at the recent past to make expectations about the future. Under rational expectations, agents are assumed to be more sophisticated. A consumer will not simply assume a 2% inflation rate just because that has been the average the past few years; they will look at current monetary policy and economic conditions to make an informed forecast. When new classical economists introduced rational expectations into their models, they showed that monetary policy could only have a limited impact.

By the late 1990s, economists had reached a rough consensus. The nominal rigidity of new Keynesian theory was combined with rational expectations and the RBC methodology to produce dynamic stochastic general equilibrium (DSGE) models. The fusion of elements from different schools of thought has been dubbed the new neoclassical synthesis. These models are now used by many central banks and are a core part of contemporary macroeconomics.[16]

The IS-LM model is often used to demonstrate the effects of monetary and fiscal policy.[21] Textbooks frequently use the IS-LM model, but it does not feature the complexities of most modern macroeconomic models.[21] Nevertheless, these models still feature similar relationships to those in IS-LM.[21]

According to a 2018 assessment by economists Emi Nakamura and Jón Steinsson, economic "evidence regarding the consequences of different macroeconomic policies is still highly imperfect and open to serious criticism."[6] Nakamura and Steinsson write that macroeconomics struggles with long-term predictions, which is a result of the high complexity of the systems it studies.[6]

The study of macroeconomics can seem a daunting project. The field is complex and sometimes poorly defined and there are a variety of competing approaches. It is easy for the senior bachelor and starting master student to get lost in the forest of macroeconomics and the mathematics it uses extensively. Foundations of Modern Macroeconomics is a guide book for the interested and ambitious student. Non-partisan in its approach, it deals with all the major topics, summarising the important approaches and providing the reader with a coherent angle on all aspects of macroeconomic thought. Each chapter deals with a separate area of macroeconomics, and each contains a summary section of key points and a further reading list. Using nothing more than undergraduate mathematical skills, it takes the student from basic IS-LM style macro models to the state of the art literature on Dynamic Stochastic General Equilibrium, explaining the mathematical tricks used where they are first introduced. Fully updated and substantially revised, this third edition of Foundations of Modern Macroeconomics now includes brand new chapters covering highly topical subjects such as dynamic programming, competitive risk sharing equilibria and the New Keynesian DSGE approach.

Ben J. Heijdra received his education in the Netherlands and in Canada. Before joinin the Faculty of Economics and Business of the University of Groningen in the Spring of 1998 he held academic positions at various universities in Australia and the Netherlands. His research focuses on policy-relevant (theoretical) macroeconomics. Topics include ageing and macroeconomic performance, annuitization and the macro-economy, and environmental macroeconomics. Heijdra is a Senior Researcher of Netspar, a network dedicated to the study of ageing and pension issues, and a Fellow of CESifo (Munich). He has been on the editorial board of De Economist since January 2005.

The second striking trait follows from the fact that macroeconomics is concerned with policy matters. At bottom, these concern the respective roles of government and markets in the economy. Different issues ensue. For example, can ideological inclinations be harnessed? Do macroeconomists pursue a political agenda? 041b061a72


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