Journal of Economic Literature

Vol. XXVIII (December 1990), pp. 1645-1 660

A Quick Refresher Course

Macroeconomics
BY M ANKIW

N . GREGORY
Harvard University and NBER

This paper, though new, draws heavily on my previous paper, "Recent

Developments in Macroeconomics: A Very Quick Refresher Course,"
Journal of Money, Credit, and Banking, August 1988, Part 2. I am
grateful to Moses Abramovitz, David Laidler, and Thomas Mayer
for comments, and to the National Science Foundation for jinancial
support.

Introduction Council (MPS) model. The job of refining

these models generated many disserta-
WENTY YEARS AGO, it was easier being tions. Private and public decision makers
a student of macroeconomics. Mac- confidently used the models to forecast
roeconomists felt more sure of the an- important economic time series and to
swers they gave to questions such as, evaluate the effects of alternative macro-
"What causes output and employment to economic policies.
fluctuate?" and "How should policy re- Today, macroeconomists are much less
spond to these fluctuations?" sure of their answers. The IS-LM model
At the textbook level, the accepted rarely finds its way into scholarly jour-
model of the economy was the IS-LM nals; some economists view the model
model. It was little changed from John as a relic of a bygone age and no longer
Hicks' (1937) interpretation of John May- bother to teach it. The large-scale mac-
nard Keynes' (1936) once revolutionary roeconometric models are mentioned
vision of the economy. Because the IS- only occasionally at academic confer-
LM model took the price level as given, ences, often with derision. A graduate
a Phillips curve of some sort was ap- student today is unlikely to devote his
pended to explain the adjustment of dissertation to improving some small sec-
prices. Some thought the Phillips curve tor of the MPS model.
had the natural rate property, implying In contrast to this radical change in
that the economy was self-correcting in the way academic macroeconomists view
the long run. their field of study, applied macroecd-
At the more applied level, this consen- nomists have not substantially changed
sus was embodied in the large-scale the way they analyze the economy. The
macroeconometric models, such as the IS-LM model, augmented by the Phillips
MIT-Penn-Social Science Research curve, continues to provide the best way
1645

1646 Journal of Economic Literature, Vol. XXVZZZ (December 1990)

to interpret discussions of economic pol- Approximately five centuries ago,

icy in the press and among policy makers. Nicholas Copernicus suggested that the
Economists in business and government sun, rather than the earth, is the center
continue to use the large-scale macro- of the planetary system. At the time, he
econometric models for forecasting and mistakenly thought that the planets fol-
policy analysis. The theoretical develop- lowed circular orbits; we now know that
ments of the past twenty years have these orbits are actually elliptical. Com-
had relatively little impact on applied pared to the then prevailing geocentric
macroeconomics. system of Ptolemy, the original Coperni-
Why is there such a great disparity be- can system was more elegant and, ulti-
tween academic and applied macroeco- mately, it proved more useful. But at the
nomics? The view of some academics is time it was proposed and for many years
that practitioners have simply fallen be- thereafter, the Copernican system did
hind the state of the art, that they con- not work as well as the Ptolemaic system.
tinue to use obsolete models because For predicting the positions of the plan-
they have not kept up with the quickly ets, the Ptolemaic system was superior.
advancing field. Yet this self-serving view Now imagine yburself, alternatively, as
is suspect, for it violates a fundamental an academic astronomer and as an ap-
property of economic equilibrium: It as- plied astronomer when Copernicus first
sumes that a profit opportunity remains published. If you had been an academic
unexploited. If recent developments in astronomer, you would have devoted
macroeconomics were useful for applied your research to improving the Coperni-
work, they should have been adopted. can system. The Copernican system held
The observation that recent develop- out the greater promise for understand-
ments have had little impact on applied ing the movements of the planets in a
macroeconomics creates at least the pre- simple and intellectually satisfying way.
sumption that these developments are of Yet if you had been an applied astrono-
little use to applied macroeconomists. mer, you would have continued to use
One might be tempted to conclude the Ptolemaic system. It would have
that, because the macroeconomic re- been foolhardy to navigate your ship by
search of the past 20 years has had little the more promising yet less accurate Co-
impact on applied economists, the re- pernican system. Given the state of
search has no value. Yet-this conclusion knowledge immediately after Coperni-
also is unwarranted. The past 20 years cus, a functional separation between aca-
have been a fertile time for macroeco- demic and applied astronomers was rea-
nomics. Recent developments have just sonable and, indeed, optimal.
not been of the sort that can be quickly In this paper I survey some of the re-
adopted by applied economists. cent developments in macroeconomics.
My intended audience includes those ap-
A. A Parable for Macroeconomics
plied economists in business and govern-
A tale from the history of science is ment who often view recent research
helpful for understanding the current with a combination of amusement, puzz-
state of macroeconomics. Because I am lement, and disdain. My goal is not to
not an historian of science, I cannot proselytize. Rather, it is to show how sev-
vouch for its accuracy. But regardless of eral recent developments point the way
whether it is true in detail, the story toward a better understanding of the
serves nicely as a parable for macroeco- economy, just as Copernicus' suggestion
nomics today. of the heliocentric system pointed the
 Mankiw: A Quick Refresher Course i n Macroeconomics 1647

way toward a better understanding of tion in unemployment.

planetary motion. Yet just as Copernicus The breakdown of the Phillips curve
did not see his vision fully realized in and the prescience of Friedman and
his lifetime, we should not expect these Phelps made macroeconomists ready for
recent developments, no matter how Robert Lucas' (1976) more comprehen-
promising, to be of great practical use sive attack on the consensus view. Lucas
in the near future. In the long run, how- contended that many of the empirical re-
ever, many of these developments will lations that make up the large-scale mac-
profoundly change the way all econo- roeconometric models were no better
mists think about the economy and eco- founded on microeconomic principles
nomic policy. than was the Phillips curve. In particular,
the decisions that determine most macro-
B. The Breakdown of the Consensus
economic variables, such as consumption
The consensus in macroeconomics and investment, depend crucially on
that prevailed until the early 1970s fal- expectations of the future course of
tered because of two flaws, one empirical the economy h4acroeconometric models
and one theoretical. The empirical flaw treated expectations in a cavalier way,
was that the consensus view could not most often by resorting to plausible but
adequately cope with the rising rates of arbitrary proxies. Lucas pointed out that
inflation and unemployment experienced most policy interventions change the way
during the 1970s. The theoretical flaw individuals form expectations about the
was that the consensus view left a chasm future. Yet the proxies for expectations
between microeconomic principles and used in the macroeconometric models
macroeconomic practice that was too failed to take account of this change in
great to be intellectually satisfying. expectation formation. Lucas concluded,
These two flaws came together most therefore, that these models should not
dramatically and most profoundly in the be used to evaluate the impact of alterna-
famous prediction of Milton Friedman tive policies.
(1968) and Edmund Phelps (1968). Ac- The "Lucas critique" became the rally-
cording to the unadorned Phillips curve, ing cry for those young turks intent on
one could achieve and maintain a perma- destroying the consensus. Defenders of
nently low level of unemployment the consensus argued that users of
merely by tolerating a permanently high macroeconometric models were already
level of inflation. In the late 1960s, when aware of the problem Lucas defined so
the consensus view was still in its heyday, forcefully, that the models were nonethe-
Friedman and Phelps argued from mi- less informative if used with care and
croeconomic principles that this empiri- judgment, and that the Lucas critique
cal relationship between inflation and un- was right in principle but not important
employment would break down if policy in practice. These defenses were not
makers tried to exploit it. They reasoned heeded.
that the equilibrium, or natural, rate of As I have mentioned, the consensus
unemployment should depend on labor in macroeconomics broke down because
supply, labor demand, optimal search of two flaws. Both were crucial. Neither
times, and other microeconomic consid- the empirical flaw nor the theoretical flaw
erations, not on the average rate of was, by itself, sufficient to cause the
money growth. Subsequent events breakdown. As an exercise in intellectual
proved Friedman and Phelps correct: In- history, it is instructive to consider two
flation rose without a permanent reduc- counterfactuals.
1648 Journal of Economic Literature, Vol. XXVIZI (December 1990)

Suppose the macroeconometric mod- teric and useless. Indeed, for practical
els had failed to explain the events of purposes, it is.
the 1970s, but macroeconomists had felt Let me divide recent developments in
confident in the theoretical underpinning macroeconomics into three catagories.
of these models. Undoubtedly the events Like most taxonomies of complex phe-
could have been explained away. As de- nomena, the one I propose is imperfect.
fenders of the consensus view often as- Some developments fall into more than
sert, much of the stagflationary 1970s can one of the three catagories, and a few
be attributed to the OPEC supply fall naturally into none of them. Yet the
shocks. The remainder could always have taxonomy is useful, for it helps in under-
been attributed to a few large residuals. standing the motivation and goals of the
Heteroskedasticity has never been a rea- research programs undertaken by many
son to throw out an otherwise good academic macroeconomists in recent
model. years.
Alternatively, suppose the macro- One large category of research tries
econometric models had performed won- to model expectations in a more satisfac-
derfully in the 1970s, but that Friedman, tory way than was common 20 years ago.
Phelps, and Lucas had nevertheless More careful attention to the treatment
spelled out their inadequate microfoun- of expectations can often extract new and
dations. In that case, the feeble founda-
surprising implications from standard
tions would have disturbed only the theo-
models. The widespread acceptance of
retically obsessive. The prediction of
the axiom of rational expectations is per-
Friedman and Phelps would have been
haps the largest single change in macro-
forgotten, even if it had never been put
economics in the past two decades.
to a test. The Lucas critique might have
A second category of research attempts
haunted theoretical eccentrics, but the
to explain macroeconomic phenomena
general response would have been "If it
ain't broke, don't fix it." using new classical models. These mod-
As it turned out, however, the macro- els maintain the assumption that prices
econometric models and the consensus continually adjust to equilibrate supply
view did fail both empirically and theo- and demand. Twenty years ago, macro-
retically. This failure led to a period of economists commonly presumed that a
confusion, division, and excitement in nonmarket-clearing theory of some sort
macroeconomics which still continues to- was necessary to explain economic fluctu-
day. ations. Recent research has shown that
market-clearing models have much
C . Directions of Research richer implications than was once
Much of the research in macroeco- thought and are not so easily dismissed.
nomics during the past 20 years attempts A third category of research attempts
to deal with the problems that caused to reconstruct macroeconomics using
the breakdown of the consensus. Econo- new Keynesian models. This last category
mists have focused renewed and more is the most compatible with the text-
intensive effort on building macroeco- book model that combines the IS-LM
nomics on a firm microeconomic founda- model with a modern Phillips curve.
tion. Very often, the relevance of the re- This research can be viewed1 as at-
search to current economic problems is tempting to put textbook Keynesian anal-
sacrificed. To macroeconomic practition- ysis on a firmer microeconomic founda-
ers, much of the research must seem eso- tion.
 Mankiw: A Quick Refresher Course i n Macroeconomics 1649

Expectations can generate only inflation that is ex-

pected; it cannot produce unexpected in-
The notion of rational expectations has flation and therefore cannot affect unem-
its roots in John Muth's (1961) brilliant ployment. If correct as a description of
but long-neglected paper. Economists the world, this result would render policy
routinely assume that firms rationally rules such as "Increase money growth
maximize profits, and that consumers ra- when the economy looks as though it is
tionally maximize utility. It would be an going into a recession" ineffective.
act of schizophrenia not to assume that Much confusion once prevailed over
economic agents act rationally when they the meaning of the Sargent-Wallace re-
form their expectations of the future. sult. Policy irrelevance was sometimes
Much of the research in macroeconom- said to be the implication of rational ex-
ics since the breakdown of the consensus pectations per se. We now know that ra-
has explored the assumption of rational tional expectations is not the issue at all.
expectations. By itself, the assumption As Stanley Fischer (1977) showed, it is
of rational expectations has no empirical entirely possible to construct models
implication, just as the assumption of with rational expectations in which sys-
utility maximization has no direct empiri- tematic monetary policy can stabilize the
cal implication. Yet together with other economy.. Fischer's model, in which
auxiliary hypotheses, many of which sticky wages play a crucial role, produces
predate the introduction of rational ex- Keynesian policy prescriptions, despite
pectations and at the time seemed un- the presence of rational expectations.
objectionable, the assumption of rational The Sargent-Wallace paper was impor-
expectations can have profound and star- tant not because of its substantive result
tling implications. of policy irrelevance, but because it
A. Policy Irrelevance helped familiarize macroeconomists with
the use of rational expectations. It
One of the earliest and most contro- showed that models could be solved
versial applications of rational expecta- without invoking arbitrary proxies for ex-
tions was made by Thomas Sargent and pectations, and that the solution with ra-
Neil Wallace (1975). They asserted that tional expectations could look very differ-
systematic monetary policy is irrelevant ent from the more conventional solution.
to the path of output and employment. The paper by Sargent and Wallace was
To reach this conclusion, Sargent and one of the earliest applying rational ex-
Wallace merely applied rational expec- pectations to macroeconomic theory, and
tations to the expectations-augmented it illustrated vividly the potential impor-
Phillips curve of Friedman and Phelps. tance of that application.
This Phillips curve posits that inflation Once the attention of macroeconomists
that is expected does not influence unem- turned to the central role of expectations,
ployment, but that unexpected inflation many questions took on a new appear-
temporarily lowers unemployment below ance. Rethinking macroeconomic theory
its natural rate. The assumption of ra- to take into account how private decision
tional expectations, however, implies makers form expectations appropriate to
that people cannot be surprised by their environment became a major job
events that occur systematically or by for academic macroeconomists. It re-
policies that are applied in a uniform and placed work on the large-scale macro-
consistent fashion. Sargent and Wallace econometric models as the primary focus
reasoned that systematic monetary policy of research.
1650 Journal of Economic Literature, Vol. XXVlIl (December 1990)

B . Rules Versus Discretion trade-off between inflation and unem-

ployment. But an announcement of a
Of the many questions that have been policy of low inflation is not credible.
reexamined, perhaps the most important Once expectations are formed, the au-
is whether public policy should be con- thority has an incentive to renege on its
ducted by rule or by discretion. Various announcement in order to reduce unem-
authors have provided a new and often ployment. Private economic actors un-
persuasive reason to be skeptical about derstand the incentive to renege and
discretionary policy when the outcome therefore do not believe the announce-
depends on the expectations of private ment in the first place. Just as a president
decision makers (Finn Kydland and Ed- facing a hostage crisis is sorely tempted
ward Prescott 1977; Guillermo Calvo to negotiate the hostages' release, a mon-
1978; Fischer 1980; Robert Barro and etary authority with discretion is sorely
David Gordon 1983). tempted to inflate to reduce unemploy-
The argument against discretion is il- ment. And just as terrorists discount an-
lustrated most simply in an example in- nounced policies of never negotiating,
volving not economics but politics-spe- private economic actors discount an-
cifically, public policy about negotiating nounced policies of low inflation.
with terrorists over the release of hos- The shrprising implication of this anal-
tages. The announced policy of the ysis is that policy makers can sometimes
United States and many other nations is better achieve their own goals by having
that the government will not negotiate their discretion taken away from them.
over hostages. Such an announcement is In the case of hostages, there will be
intended to deter terrorists: If there is fewer hostages taken and fewer hostages
nothing to be gained from kidnapping, killed if governments are bound to follow
rational terrorists won't take hostages. the seemingly harsh rule of abandoning
But, in fact, terrorists are rational enough any hostages that are taken. In the case
to know that once hostages are taken, of monetary policy, there will be lower
the announced policy may have little inflation without higher unemployment
force, and that the temptation to make if the monetary authority is committed
some concession to obtain the hostages' to a policy of zero inflation.
release may become overwhelming. The This theory of monetary policy has a
only way to deter truly rational terrorists trivial but important corollary. Under
is somehow to take away the discretion one circumstance, a monetary authority
of policy makers and commit them to a with discretion achieves the same out-
rule of never negotiating. If policy mak- come as a monetary authority bound to
ers were truly unable to make conces- a fixed rule of zero inflation. If the au-
sions, the incentive for terrorists to take thority dislikes inflation much more than
hostages would be substantially reduced. it dislikes unemployment, inflation un-
The same problem arises less dramati- der discretion is near zero, because the
cally in the conduct of monetary policy. monetary authority has little incentive to
Consider the dilemma of a monetary au- inflate. This finding provides some guid-
thority concerned about both inflation ance to those who have the job of ap-
and unemployment in a world governed pointing central bankers. An alternative
by the expectations-augmented Phillips to imposing a fixed rule is to appoint indi-
curve of Friedman and Phelps. The au- viduals with a fervent distaste for infla-
thority wants everyone to expect low in- tion.
flation, so that it will face a favorable The issue raised here in the context
 Mankiw: A Quick Refresher Course i n Macroeconomics 1651

of hostages and monetary policy is more a simple and surprising implication of the
generally called the time inconsistency theory: Changes in consumption should
of optimal policy. It arises in many other be unpredictable. According to the per-
contexts. For example, the government manent income theory, consumers facing
may announce that it will not tax capital an intertemporal budget constraint try
in order to encourage accumulation; but their best to smooth the path of their
once the capital is in place, the govern- consumption over time. As a result, con-
ment may be tempted to renege on its sumption reflects consumers' expecta-
promise because the taxation of existing tions about their future income; con-
capital is nondistortionary. As another sumption changes only when consumers
example, the government may announce revise these expectations. If consumers
that it will prosecute all tax evaders vigor- are using all available information opti-
ously; but once the taxes have been mally, the revisions in their expectations
evaded, the government may be tempted should be unpredictable, and so should
to declare a "tax amnesty" to collect some changes in their consumption. In es-
extra revenue. As a third example, the sence, Hall applied the logic of the effi-
government may announce that it will cient markets hypothesis, which econo-
give a temporary monopoly to inventors mists have long used to explain the
of new products to encourage innovation; unpredictability of stock prices, to the
but once a product has been invented, permanent income hypothesis.
the government may be tempted to re- Formulated in this way, the perma-
voke the patent to eliminate the distor- nent income hypothesis is easily tested.
tion of monopoly pricing. In each casd, One merely regresses the change in con-
rational agents understand the incentive sumption on some set of lagged variables
for the government to renege, and this to see if these variables can forecast
expectation affects their behavior. And changes in consumption. When Hall ran
in each case, the solution is to take away these regressions, he found, to the sur-
the government's discretionary power by prise of many economists, that the theory
binding it to a fixed policy rule. passed this test, at least as a first approxi-
mation. Changes in aggregate consump-
C. Rational Expectations in Empirical
tion from quarter to quarter are largely
Work
unpredictable. Like stock prices, con-
So far I have been emphasizing devel- sumption is close to a randoin walk.
opments in macroeconomic theory. But To see how revolutionary Hall's ap-
the widespread acceptance of rational ex- proach was, consider how an empirical
pectations as a methodological tenet has researcher gauges success. Twenty years
also had a profound influence on empiri- ago, empirical research on consumption
cal work. By focusing attention on how most often entailed estimating consump-
economic actors should behave under tion functions. Success was measured by
uncertainty, the rational expectations how well the estimated equation fit the
revolution has changed the way macro- data; that is, success was a high R" Hall
economists formulate their theories and turned this standard on its head, arguing
the way they use data to test them. that the permanent income theory is
An example of a topic that has been valid precisely because he found a low
extensively reexamined in the light of ra- R ~ This
. difference arises because Hall
tional expectations is the permanent in- did not estimate a consumption function,
come theory of consumption. In a semi- but instead examined the intertemporal
nal paper, Robert Hall (1978)pointed out first-order condition of a representative
1652 Journal of Economic Literature, Vol. XXVZZZ (December 1990)

consumer to check whether this con- be fixed relatively easily. It seemed that
sumer was making systematic errors in the imperfect proxies for expectations
optimization. merely needed to be replaced by rational
In retrospect, it is clear that Hall's con- expectations. This view, it turned out,
tribution was more methodological than was too optimistic: There was much more
substantive. Hall concluded that the evi- work to be done. The goal of the new
dence strongly favored the permanent in- classical revolution was to rebuild macro-
come hypothesis. Subsequent research, economics beginning with microeco-
some of which has followed Hall's ap- nomic primitives of preferences and
proach, has found that current income technology. The new classical economists
has a stronger influence on consumption pursued this goal while maintaining the
than the permanent income hypothesis axioms that individuals always optimize
predicts (Marjorie Flavin 1981; Hall and and, more controversially, that markets
Frederic Mishkin 1982; John Campbell alway's clear.
and Gregory Mankiw 1989, 1990; Chris
A. Imperfect Information
Carroll and Lawrence Summers 1989).
There remains much controversy about The earliest new classical models had
the validity of the permanent income hy- the aim of generating a monetary busi-
pothesis, but there is little doubt that ness cycle. To do this, they departed
Hall changed forever the terms of the slightly from the Walrasian paradigm by
debate. assuming imperfect information regard-
Once revolutionary, the rational ex- ing prices (Lucas 1972, 1973). Individuals
pectations approach to empirical work is were assumed to be more aware of the
now standard. It finds its most advanced prices of the goods they produce than
development in the Euler equation they are of the prices of the goods they
methods that evolved from Hall's work purchase. They therefore tend to confuse
on consumption. Researchers have ap- movements in the overall price level
plied these methods to study labor (which should not matter) with move-
supply, labor demand, spending on ments in relative prices (which should
consumer durables, business fixed matter). An unanticipated inflation leads
investment, and inventory accumulation. individuals to infer that the relative
Although these new techniques are un- prices of the goods they produce are tem-
likely to replace old-fashioned economet- porarily high, which induces them to in-
ric approaches completely, they have crease the quantity supplied. This story
earned a permanent place in the empiri- thus implies that output depends on the
cal economist's toolbox. deviation of inflation from expected infla-
tion. In this way, the assumption of
New Classical Macroeconomics imperfect information was used to gener-
ate the expectations-augmented Phillips
Because Lucas' initial attack on stan- curve of Friedman and Phelps.
dard macroeconomic practice empha- Although this theory of the business
sized the inadequate way expectations cycle received much attention in the
were treated, the first task facing macro- 1970s, it has attracted few adherents in
economists was to learn how to deal with more recent years. The reason for its de-
the foresight of rational economic agents. cline in popularity is not clear. Critics
At the early stages of the new classical argue that confusion about the price level
revolution, some economists believed cannot plausibly be so great as to gener-
that the macroeconometric models could ate the large changes in output and em-
 Mankiw: A Quick Refresher Course i n Macroeconomics 1653

ployment observed over the business cy- First, real business cycle theory as-
cle. The empirical evidence has also been sumes that the economy experiences
generally unfavorable (Barro and Zvi large and sudden changes in the available
Hercowitz 1980; Mishkin 1983). But production technology. Many real busi-
there is no completely compelling evi- ness cycle models explain recessions as
dence that explains why this approach periods of technological regress-that is,
has been so widely abandoned. declines in society's technological ability.
Critics argue that large changes in tech-
B. Real Business Cycles
nology, and especially technological re-
Those working in the new classical gress, are implausible (Summers 1986;
tradition have recently been emphasizing Mankiw 1989). It is a more common pre-
"real" business cycle theory (John Long sumption that technological progress oc-
and Charles Plosser 1983; Barro and Rob- curs gradually.
ert King 1984; Prescott 1986). This the- Second, real business cycle theory as-
ory proceeds from the assumption that sumes that fluctuations in employment
there are large random fluctuations in the reflect changes in the amount people
rate of technological change. Because want to work. Because employment fluc-
these fluctuations in technology lead to tuates substantially while the determi-
fluctuations in relative prices, individuals nants of labor supply-the real wage and
rationally alter their labor supply and the real interest rate-vary only slightly,
consumption. The business cycle is, ac- these models require that leisure be
cording to this theory, the natural and highly substitutable over time. This as-
efficient response of the economy to sumption conflicts with many economet-
changes in the available production tech- ric studies of labor supply using data on
nology. individuals, which typically find small in-
The strengths of real business cycle tertemporal elasticities of substitution
models are that they are highly parsimo- (Joseph Altonji 1986). It also conflicts
nious and, at the same time, rigorously with the strong prior beliefs of many
founded on microeconomic principles. economists that high unernployment in
They are often standard intertemporal recessions is largely involuntary.
general equilibrium models, common in Third, real business cycle theory as-
the study of economic growth, amended sumes-and this is the assumption from
only slightly to include random changes which the theory derives its name-that
in technology. These models mimic the monetary policy is irrelevant for eco-
behavior of important economic time se- nomic fluctuations. Before real business
ries surprisingly well. Edward Prescott cycle theory entered the debate in the
provocatively concludes that the business early 1980s, almost all macroeconomists
cycle is not a puzzle; rather, because eco- agreed on one proposition: Money mat-
nomic fluctuations are a natural implica- ters. Although there was controversy
tion of standard growth models, it would about whether systematic monetary pol-
be a puzzle if we did not observe business icy could stabilize the economy, it was
cycles. universally accepted that bad monetary
Real business cycle theory contrasts policy could be destabilizing. Real busi-
sharply with the consensus view of the ness cycle theorists have challenged that
1960s. I will mention briefly three as- view using the old Keynesian argument
sumptions of these models that 20 years that any correlation of money with output
ago would have been considered ridicu- arises because the money supply is en-
lous and that today remain controversial. dogenous (King and Plosser 1984). They
1654 Journal of Economic Literature, Vol. XXVZZZ (December 1990)

also give little weight to anecdotal evi- Advocates of the sectoral shift theory
dence on the effects of monetary policy- argue that evidence of this sort is not
like the Volcker disinflation of the early persuasive. It is possible that because the
1980s-that seems to shape the views of process of sectoral adjustment requires
many other economists. a period of high unemployment and low
income,. it lowers the demand for the
C. Sectoral Shijts
products of all sectors. Thus, we might
Another new classical approach to the observe low vacancies and low move-
business cycle is the sectoral shift theory, ment during recessions, even if reces-
which emphasizes the costly adjustment sions are initially caused by the need to
of labor among sectors (David Lilien reallocate labor among ~ectors.In this
1982; Fischer Black 1987). Like real busi- form, it is not clear how to distinguish
ness cycle theory, the sectoral shift the- empirically the sectoral shift theory from
qry observes the classical dichotomy by real business cycle theories that empha-
giving no role to monetary disturbances. size economy-wide fluctuations in tech-
But unlike real business cycle theory, it nology or Keynesian theories that
departs slightly from the Walrasian para- emphasize fluctuations in aggregate
digm by assuming that when a worker demand.
moves from one sector to another, a pe-
riod of unemployment is required, per- New Keynesian Macroeconomics
haps for job search. According to the sec-
toral shift theory, recessions are periods At the same time that many macroeco-
during which there are more sectoral nomists have been attempting to explain
shocks and thus a greater need for secto- economic fluctuations within the Walra-
ral adjustment. sian paradigm, many other macroeco-
Although there is still much empirical nomists have been working within the
work being done, the weight of the avail- non-Walrasian approach that has evolved
able evidence appears not to support the from Keynes' General Theory. The ru-
sectoral shift theory. If workers are un- bric "Keynesian" is so broad and so vague
employed voluntarily in recessions be- that many researchers have applied the
cause they are moving to new jobs in term to their theory. If there is a single
other sectors, we would expect to find theme that unites Keynesian economics,
high unemployment coinciding with high it is the belief that economic fluctuations
job vacancy. Yet observed fluctuations reflect not the Pareto-efficient response
have just the opposite pattern: High un- of the economy to changes in tastes and
employment rates coincide with low lev- technology, but rather some sort of mar-
els of help wanted advertising (Katharine ket failure on a grand scale.
Abraham and Lawrence Katz 1986). The market imperfection that recurs
Moreover, although t h e sectoral shift most frequently in Keynesian theories is
theory suggests that workers are moving the failure of wages and prices to adjust
between sectors during recessions, the instantly to equilibrate supply and de-
opposite appears to be the case: The mea- mand. Certainly, the short-run sluggish-
sured movement of workers is strongly ness of wages and prices was the key as-
procyclical (Kevin Murphy and Robert sumption of the consensus view of the
Tope1 1987). These findings suggest that 1960s. And the absence of an adequate
the sectoral shift theory is unlikely to be theoretical justification for that assump-
plausibly reconciled with observed eco- tion was one of the fatal flaws that under-
nomic fluctuations. mined the consensus. Here I examine.
 Mankiw: A Quick Refresher Course in Macroeconomics 1655

roughly in order of historical develop- sions located in the labor market or in

ment, three recent lines of research that the goods market? If there are imperfec-
each in its own way emphasizes the fail- tions in both markets, how do they inter-
ure of prices to clear markets. Much of act? These questions have also received
this research can be viewed as attempting attention recently from Keynesian theo-
to resurrect the consensus view, with rists pursuing a quite different research
some modifications, by providing a co- program, and I return to them below.
gent theoretical foundation of hard- Because these general disequilibrium
headed microeconomic reasoning. models were proposed prior to the break-
down of the prevailing consensus of the
A. Fixed Prices and General
1960s, they are not directly aimed at
Disequilibrium
remedying the flaws that caused the
Beginning with the seminal paper by breakdown. To concentrate on the impli-
Barro and Herschel Grossman (1971), cations of fixed prices, these models beg
much research in the 1970s used the tools the question of why prices do not adjust
of general equilibrium theory to examine to clear markets. In the wake of the new
how markets interact when prices are classical revolution, which appears to
fixed at nonmarket-clearing levels. This have had a greater impact on this side
research program was especially popular of the Atlantic, American Keynesians
among European macroeconomists (Ed-' were less concerned with the details of
mond Malinvaud 1977; John Muellbauer quantity adjustment under fixed prices.
and Richard Portes 1978; Jean-Pascal Be- They directed their efforts at modeling
nassy 1982). It showed in the most rigor- the price adjustment process.
ous terms how quantities adjust when Once attention turns to the question
prices cannot and how economic policies of price adjustment, an incongruity of
influence output and employment under these general disequilibrium models be-
fixed prices. comes apparent. These models impose
A significant result of these models is fixed prices on otherwise Walrasian econ-
that the behavior of the economy de- omies. Yet to analyze the question of how
pends crucially on which markets are ex- prices adjust, it is necessary to admit that
periencing excess demand and which are some economic actors have control over
experiencing excess supply. Unemploy- prices. Thus, one needs to go beyond
ment-an excess supply of labor-arises the price-taking assumption of general
in two regimes. In the first regime, called equilibrium theory and explicitly incor-
classical unemployment, firms can sell all porate price-setting agents, such as
they want in the goods market; unem- unions or firms that enjoy some degree of
ployment arises because the real wage market power. Once one starts to think
is too high for all of the labor force to about an economy with price setters,
be profitably employed. In the second however, it appears unlikely that it will
regime, called Keynesian unemployment, behave like an economy in which prices
firms are unable to sell all they want at are set by a Walrasian auctioneer who,
the going price; unemployment arises for some unspecified reason, fails to
because of this quantity constraint in the choose equilibrium prices. Therefore,
goods market. The difference between the general disequilibrium models stem-
these regimes highlights some important ming from Barro and Grossman may not
questions that recur in Keynesian theori- provide the best framework for address-
zing. Is the key market imperfection ing even the issues for which they are
causing high unemployment in reces- designed, such as quantity adjustment
1656 Journal of Economic Literature, Vol. XXVZZZ (December 1990)

under fixed prices. Put simply, it seems inefficient fluctuations in output and em-
impossible to divorce the issue of quan- ployment, why do workers and firms
tity adjustment from the issue of price write these contracts? There has been
adjustment. much theoretical work studying optimal
risk-sharing arrangements between firms
B. Labor Contracts and Sticky Wages
and workers. It is clear that optimal con-
Most attempts a t explaining why the tracting cannot produce the nominal
economy departs from the Walrasian wage stickiness on which these Keynes-
ideal have centered on the labor market. ian contracting models rely. Because
Keynes himself emphasized the sluggish unemployed workers value their leisure
behavior of wages. Therefore, when less than the firm values their labor,
economists skeptical of the new classical these contracts leave substantial and ob-
revolution tried to defend Keynesian vious gains from trade unexploited.
economics, the labor market was the nat- Second, despite the existence of labor
ural place for them to start. contracts determining nominal wages in
A prominent line of research modeled advance, it is not obvious that these
the labor market as failing to clear be- wages play an important role in the de-
cause of labor contracts that specify in termination of employment, as these
advance the nominal wage at which firms models assume. Many workers hold life-
will be able to purchase labor (Jo Anna time jobs. In the context of a long-term
Gray 1976; Fischer 1977; John Taylor relationship, a wage paid in any given
1980). The primavy appeal of these mod- period need not equal the marginal prod-
els is that they mirror observed institu- uct of labor, as it would in a spot market.
tions. Many workers are covered by for- Instead, the wage may be like an install-
mal contracts predetermining a nominal ment payment. For example, some uni-
wage, and many others appear to be cov- versities- pay professors' annual salary
ered by informal agreements with em- equally over nine months, while other
ployers. Incorporated into a macroeco- unversities pay the annual salary equally
nomic model, this observation has over twelve months; yet surely this dif-
important implications for the conduct ference has no relation to the work effort
of monetary policy. One of these implica- or marginal product of the professors
tions is that the Sargent-Wallace policy- over the course of the year. Similarly,
irrelevance proposition does not hold: If the observation that some wages are
the nominal wage is unable to respond sticky need not imply that the allocation
to economic disturbances, then monetary of labor is determined inefficiently.
policy that does systematically respond Third, the cyclical behavior of the real
to them is a potent tool for stabilizing wage does not appear consistent with
the economy, despite the assumption of models incorporating a predetermined
rational expectations. In essence, a fixed nominal wage and movements along a
nominal wage gives the monetary author- standard, downward-sloping labor de-
ity control over the real wage and thus mand schedule. In most of these models,
control over employment. a negative shock to aggregate demand
These models based on nominal wage lowers the price level, raises the real
contracts were criticized on three wage (because the nominal wage is fixed),
grounds. First, the existence of such con- and thus reduces the quantity of labor
tracts is never explained from microeco- demanded. To the extent that fluctua-
nomic principles. If these nominal wage tions are driven by aggregate demand,
contracts are responsible for large and real wages should be countercyclical. Yet
 Mankiw: A Quick Refresher Course i n Macroeconomics 1657

in the data, real wages appear to have plagued the Keynesian model based on
no consistent relationship with economic sticky wages alone.
activity, or perhaps appear a bit procycli- First, these new models can explain
cal. For example, in the severe 1982 re- in rigorous microeconomic terms the fail-
cession, which was allegedly driven by ure of price setters to restore equilib-
contractionary monetary policy, real rium. Monopolistically competitive firms
wages were not very different from what do not have much incentive to cut their
they were a few years earlier or a few prices when the demand for their goods
years later. The prediction of counter- declines. Yet because of the preexisting
cyclical real wages cannot be easily rec- distortion of monopoly pricing, the bene-
onciled with the evidence. fit to the society of a price cut may be
Economists differ about whether they large (first-order) even when the benefit
view these criticisms as serious. At the to the firm is small (second-order). If
very least, these problems with the labor firms face even a small menu cost, they
contracting models placed Keynesians on might maintain their old prices, despite
the defensive in the academic debate. the substantial social loss from this price
stickiness.
C. Monopolistic Competition and Sticky
Second, unlike nominal wages, many
Prices
of the rigid prices we observe have a
Dissatisfaction with models empha- clearly important function in allocating
sizing the stickiness of nominal wages resources. For example, the prices of
turned the attention of Keynesian magazines at newsstands often remain
macroeconomists in the 1980s away from unchanged for years at a time (Stephen
the labor market and toward the goods Cecchetti 1986). It is hard to argue that
market. Much effort has been devoted these prices are merely installment pay-
to examining the behavior of monopolis- ments within the context of a long-term
tically competitive firms who face small relationship and therefore irrelevant.
"menu costs" when they change prices Third, these models with menu costs
(Mankiw 1985; George Akerlof and Janet do not imply a countercyclical real wage.
Yellen 1985; Michael Parkin 1986; Oli- Once price rigidity is introduced as an
vier Blanchard and Kiyotaki Nobuhiro important element to explain the re-
1987; Julio Rotemberg and Garth Saloner sponse of the economy to changes in ag-
1987; Laurence Ball, Mankiw, and David gregate demand, real wages can be pro-
Romer 1989). Taken literally, these cyclical or acyclical. Moreover, if price
menu costs are the resources required rigidity is combined with the view that
to post new price lists. More metaphori- observed wages are merely installment
cally and more realistically, these menu payments, one can obtain Keynesian re-
costs include the time taken to inform sults while leaving the path of wages in-
customers, the customer annoyance determinate and irrelevant.
caused by price changes, and the effort For these reasons, the search for nomi-
required even to think about a price nal rigidities has shifted from the labor
change. market to the goods market. It would
This line of research is still too new be incorrect to infer, however, that
to judge how substantial its impact will Keynesians now embrace an equilibrium
be or to guess what problems will be labor market. Rather, it is more common
judged most serious. What is clear now to explain unemployment by various
is that this emphasis on the goods market sorts of real rigidities that prevent real
can avoid the three problems that wages from falling to equilibrate the labor
1658 Journal of Economic Literature, Vol. XXVZIZ (December 1990)

market. It is only in explaining nominal have little incentive to cut prices. Hence,
rigidities and the non-neutrality of although real wage rigidity alone is little
money that emphasis has turned to the help in understanding economic fluctua-
goods market. tions because it leads only to classical un-
Of the many sorts of real rigidities in employment and gives no role to aggre-
the labor market that have received at- gate demand, real wage rigidity together
tention, the "efficiency wage" models are with menu costs provide a new and pow-
probably the most popular (Yellen 1984; erful explanation for Keynesian disequili-
Jeremy Bulow and Summers 1986; Katz brium.
1986; Joseph Stiglitz 1986). The common
feature of this class of models is that firms Conclusion
do not reduce wages in the face of persis-
tent unemployment because to do so I began by suggesting that recent de-
would reduce productivity. Various rea- velopments in macroeconomics are akin
sons have been proposed to explain how to the Copernican revolution in astron-
wages may affect productivity. A socio- omy: Immediately they may have little
logical explanation is that lower-paid practical value but ultimately they will
workers are less loyal to the firm. An point the way to a deeper understanding.
explanation based on adverse selection Perhaps the analogy is too optimistic. Co-
is that a lower wage reduces the average pernicus had a vision not only of what
quality of the work force because only was wrong with the prevailing paradigm,
the best workers quit. The most popular but also of what a new paradigm would
explanation of efficiency wages is "shirk- look like. In the past decade, macroeco-
ing." Because firms monitor effort imper- nomists have taken only the first step in
fectly, workers sometimes shirk their re- this process; there remains much dis-
sponsibilities and risk getting fired; a agreement on how to take the second
lower wage reduced the cost of getting step. It-is undoubtedly easier to criticize
fired and thus raises the amount of shirk- the state of the art than to improve it.
ing. In all of these efficiency wage theo- Yet some developments of the past two
ries, the impact of wages on productivity decades are now widely accepted. Al-
diminishes the incentive for a firm to cut though some economists still doubt that
wages in response to an excess supply expectations are rational, and despite the
of labor. If this productivity effect is suffi- mixed evidence from surveys of expecta-
ciently large, the normal competitive tions, the axiom of rational expectations
forces moving the labor market to the is as firmly established in economic
equilibrium of supply and demand are methodology as the axioms that firms
absent. maximize profit and households maxi-
In an important paper, Laurence Ball mize utility. The debate over rules versus
and David Romer (1990) have shown that discretion continues, but time inconsis-
nominal rigidities caused by menu costs tency is generally acknowledged to be a
are enhanced by real rigidities such as problem with discretionary policy. Most
efficiency wages. Menu costs prevent fundamentally, almost all macroecono-
prices from falling in response to a reduc- mists agree that basing macroeconomics
tion in aggregate demand. Rigidity in real on firm microeconomic principles should
wages prevents wages from falling in re- be higher on the research agendd than
sponse to the resulting unemployment. it has been in the past.
The failure of wages to fall keeps firms' On the crucial issue of business cycle
costs high and thus ensures that they theory, however, there appears to be lit-
 Mankiw: A Quick Refresher Course in Macroeconomics

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A Quick Refresher Course in Macroeconomics
N. Gregory Mankiw
Journal of Economic Literature, Vol. 28, No. 4. (Dec., 1990), pp. 1645-1660.
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Cyclical Unemployment: Sectoral Shifts or Aggregate Disturbances?

Katharine G. Abraham; Lawrence F. Katz
The Journal of Political Economy, Vol. 94, No. 3, Part 1. (Jun., 1986), pp. 507-522.
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The American Economic Review, Vol. 58, No. 1. (Mar., 1968), pp. 1-17.
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Stochastic Implications of the Life Cycle-Permanent Income Hypothesis: Theory and Evidence
Robert E. Hall
The Journal of Political Economy, Vol. 86, No. 6. (Dec., 1978), pp. 971-987.
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The Sensitivity of Consumption to Transitory Income: Estimates from Panel Data on

Households
Robert E. Hall; Frederic S. Mishkin
Econometrica, Vol. 50, No. 2. (Mar., 1982), pp. 461-481.
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Mr. Keynes and the "Classics"; A Suggested Interpretation

J. R. Hicks
Econometrica, Vol. 5, No. 2. (Apr., 1937), pp. 147-159.
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Money, Credit, and Prices in a Real Business Cycle

Robert G. King; Charles I. Plosser
The American Economic Review, Vol. 74, No. 3. (Jun., 1984), pp. 363-380.
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Rules Rather than Discretion: The Inconsistency of Optimal Plans

Finn E. Kydland; Edward C. Prescott
The Journal of Political Economy, Vol. 85, No. 3. (Jun., 1977), pp. 473-492.
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Sectoral Shifts and Cyclical Unemployment

David M. Lilien
The Journal of Political Economy, Vol. 90, No. 4. (Aug., 1982), pp. 777-793.
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Real Business Cycles

John B. Long, Jr.; Charles I. Plosser
The Journal of Political Economy, Vol. 91, No. 1. (Feb., 1983), pp. 39-69.
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Some International Evidence on Output-Inflation Tradeoffs

Robert E. Lucas, Jr.
The American Economic Review, Vol. 63, No. 3. (Jun., 1973), pp. 326-334.
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Macroeconomic Models with Quantity Rationing

John Muellbauer; Richard Portes
The Economic Journal, Vol. 88, No. 352. (Dec., 1978), pp. 788-821.
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Rational Expectations and the Theory of Price Movements

John F. Muth
Econometrica, Vol. 29, No. 3. (Jul., 1961), pp. 315-335.
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The Output-Inflation Trade-off When Prices Are Costly to Change

Michael Parkin
The Journal of Political Economy, Vol. 94, No. 1. (Feb., 1986), pp. 200-224.
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Money-Wage Dynamics and Labor-Market Equilibrium

Edmund S. Phelps
The Journal of Political Economy, Vol. 76, No. 4, Part 2: Issues in Monetary Research, 1967. (Jul. -
Aug., 1968), pp. 678-711.
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The Relative Rigidity of Monopoly Pricing

Julio J. Rotemberg; Garth Saloner
The American Economic Review, Vol. 77, No. 5. (Dec., 1987), pp. 917-926.
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"Rational" Expectations, the Optimal Monetary Instrument, and the Optimal Money Supply
Rule
Thomas J. Sargent; Neil Wallace
The Journal of Political Economy, Vol. 83, No. 2. (Apr., 1975), pp. 241-254.
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Aggregate Dynamics and Staggered Contracts

John B. Taylor
The Journal of Political Economy, Vol. 88, No. 1. (Feb., 1980), pp. 1-23.
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Efficiency Wage Models of Unemployment

Janet L. Yellen
The American Economic Review, Vol. 74, No. 2, Papers and Proceedings of the Ninety-Sixth
Annual Meeting of the American Economic Association. (May, 1984), pp. 200-205.
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