Blog o’ Burns

Mankiw, Gregory N. “A Quick Refresher Course in Macroeconomics.” Journal of Economic Literature 28 (December 1990): 1645-1660.

In this article, Mankiw attempts to reconcile why developments in economic theory had not yet been translated into changes in applied macroeconomics. Until the 1970s, John Hicks’ interpretation of John Maynard Keynes’ vision of the economy through the IS-LM model was deemed the general consensus among economists at the time. Such theory became embodied in more practical, large-scale macroeconometric models such as the MIT-Penn-Social Science Research Council model. However, support for the IS-LM model dwindled in the early 1970s due to its inability to explain stagflation and its lack of adequate micro foundations. Friedman and Phelps’ prediction that the empirical relationship between inflation and unemployment would break down if exploited came true. Lucas also scored a blow on Keynesian thought with his critique arguing that many key macroeconomic variables depend on expectations. If a model cannot account for changes in expectations then it cannot evaluate alternative policies.

This breakdown in consensus caused economists to branch out in three directions of research to build macro models on firm micro foundations; these directions included: 1) modeling expectations (particularly rational expectations); 2) explaining macro phenomena using new classical models; and 3) resurrecting Keynesian theory with new Keynesian models.

New Keynesian Macroeconomics

While new classical models attempted to explain economic fluctuations within the Walrasian market-clearing framework, new Keynesians took another look at the possibility for market failure on a grand scale. They needed to explain why wages and prices failed to adjust instantly to equilibrate supply and demand. Lack of a theoretical justification for price and wages stickiness had helped bring down the original Keynesian model. Such an explanation would need firm mico reasoning as well.

Fixed Prices and General Disequilibrium

During the 1970s, Keynesians spent much time and energy trying to determine how markets interact when prices are fixed at nonmarket-clearing levels, primarily demonstrating economic policy’s influence on output and unemployment under such a regime. These models showed that the behavior of the economy depends greatly on which markets have excess supply and which have excess demand. The excess supply of labor (unemployment) can occur under two regimes: 1) classical unemployment in which real wages are too high all workers to be profitably employed; and 2) Keynesian unemployment in which unemployment occurs because firms cannot sell all they want to at the market price. In the classical case, unemployment occurs due to disequilbrium in the labor market, while the Keynesian case implies a disequilibrium in the goods market. Where is the problem? If imperfections exist in both markets, how do they interact? What keeps prices from adjusting to clear markets?

After the new classical revolution, American Keynesians switched focus to modeling the price adjustment process. Economists typically work under the assumption of perfect competition in which all firms are price-takers. However to model price adjustments, new Keynesians acknowledged that some economic actors have the power to be price-setters.

Labor Contracts and Sticky Wages

To explain sticky wages, a popular line of research was to model labor market failure as caused by labor contracts that specify nominal wages in advance. Such models were appealing because they reflected obseved institutions and implied that policy does have relevant effects on employment. Since nominal wages cannot adjust to economic disturbances, monetary policy can systematically determine real wages and thus employment.

Such models faced criticism on three grounds: 1) what micro foundation is there for firms and employees to enter into potentially harmful contracts?; 2) why should nominal wages play such an important role in determining employment?; and 3) shouldn’t real wages be countercyclical if this theory were true?

Monopolistic Competition and Sticky Prices

In the 1980s, Keynesians shifted focus from the labor market to the goods market. In particular, they looked at monopolistically competitive firms who face small “menu costs” when changing prices. Such costs include the time it takes to inform customers, the risk of making customers angry, and the effort to determine whether prices should change or not. If these costs exceed the benefit of changing prices, they will maintain socially sub-optimal prices.

“Menu costs” reflect nominal rigidities in the goods market. However, real rigidities may exist in the labor market in the form of efficiency wages. In such models, a cut in wage corresponds with a drop in productivity, since it causes the best workers to quit. Since firms monitor effort imperfectly, workers sometimes shirk their responsibilities and risk getting fired. Lower wages imply lower opportunity costs for losing one’s job, thus increasing the likelihood of shirking. If the cost of lost productivity outweighs the benefit of cutting wages, firms will not reduce wages in response to an excess supply of labor. Such real rigidities alone only cause classical unemployment; however when coupled with nominal rigidities, they provide a powerful explanation for Keynesian disequilibrium.