Michel De Vroey delves into the global history of macroeconomic theories from real business cycles to persistent monetary effects.

Laura Hermes

2023-02-07 08:26:00 Tue ET

Michel De Vroey delves into the global history of macroeconomic theories from real business cycles to persistent monetary effects.

Michel De Vroey (2016)


A history of macroeconomics from Keynes to Lucas and beyond


Michel De Vroey discusses the global history of macroeconomic thought from real business cycles and neoclassic monetarist propositions to monetary non-neutrality and the New Keynesian framework. In the almost 90+ years since the publication of The General Theory of Employment, Interest, and Money by Sir John Maynard Keynes, the Great Depression and mass unemployment have gradually lost their key position as economic maladies in most rich countries such as America, Britain, and Europe, except for brief periods in the stagflation of the 1970s and the Global Financial Crisis and Great Recession of 2008-2009. In recent times, real business cycle issues share prominence with many other macro riddles and puzzles in both economic growth and development, asset market stabilization, political economy, income and wealth inequality, macrofinancial credit, globalization, and many more.

Michel De Vroey provides an excellent account of how the macroeconomic science has evolved from the quantitative methods and agendas of Keynes in the 1930s to the counterparts of both Robert Lucas and Ed Prescott and their co-authors and then all the way back to the New Keynesians in the new century. De Vroey draws a methodological distinction between Marshallians and Walrasians. As the former emphasize short-run quantity adjustments to external shocks, these Marshallians often tend to view prices and expectations as exogenous. The latter focus on the dynamic adjustments for prices, quantities, and expectations in both the short run and the long run because these Walrasians such as Lucas and Prescott consider rational expectations and their effects on economic output, employment, inflation, capital investment, and labor supply. This distinct emphasis responds to the quest of Keynes and his followers by identifying market failures that the government has to correct at least in the medium run.

The De Vroey long list of milestones marks the highway from Keynes to Lucas and Prescott and so includes the invention of the Keynesian cross by John Hicks back in 1937; the resurgence of neoclassic monetarism in the 1950s; the natural rate of unemployment in the 1960s; the substantive introduction of rational expectations in macroeconomics by Lucas, Prescott, and Thomas Sargent in the 1970s; sticky prices, wages, and other nominal rigidities in the 1980s; the design and calibration of real business cycle (RBC) macro models by Finn Kydland and Edward Prescott in the 1980s; and more recent research articles of Jordi Gali, Julio Rotemberg, and Michael Woodford on the microfoundations of the New Keynesian paradigm in the late-1990s and early-2000s.

Our newfound knowledge includes quantitative tools and nomological themes from the one-sector and multi-sector economic growth theory of Robert Solow, Trevor Swan, Hirofumi Uzawa, David Cass, and Tjalling Koopmans in the 1950s to 1960s; the consumption-driven asset pricing models of Robert Lucas, Rajnish Mehra, and Ed Prescott in the 1970s and 1980s; the new endogenous growth theories of Paul Romer, Robert Lucas, Philippe Aghion, and Peter Howitt in the 1980s and 1990s; the Keynesian search theory with bubbles and indeterminate multiple-equilibrium unemployment rates by David Cass, Karl Shell, Douglas Diamond, Jess Benhabib, and Roger Farmer in the 1980s and 1990s; the political economy of institutions by William Nordhaus, Douglass North, Alberto Alesina, Daron Acemoglu, and James Robinson since 1990; wealth and income inequality by Thomas Piketty, Emmanuel Saez, and their co-authors since 2000; monetary economics by Robert Townsend, Nobuhiro Kiyotaki, and Randall Wright since 1990; as well as several fundamental advances in dynamic stochastic general equilibrium (DSGE), risk and uncertainty, and asymmetric information from numerous eminent economists such as George Akerlof, Robert Shiller, Joseph Stiglitz, Raghuram Rajan, and so forth.


What have we learned from macroeconomics as we move from Keynes and Solow to Lucas, Prescott, and the New Keynesians?

At the heart of macroeconomics is the quest of Keynes and Lucas to tame business cycles. Bank insolvency and mass unemployment have been with us long before Keynes since the launch of capitalism in most western countries. This quest adds grist to the mill of social theorists such as Karl Marx (who might think of trade cycles as virulent diseases that only socialism can cure in time). Keynes and Lucas serve as the top figures in the De Vroey historical account of macroeconomics. Keynes commands the first 30 years of macroeconomics, then Lucas commands the next 30, and a reasonable balance between New Keynesians and Lucasians marks the most recent 30 years.

In his General Theory, Keynes delves into the 3 main themes in macroeconomics. First, Keynes judiciously splits unemployment into normal frictional unemployment and abnormal involuntary unemployment. The former can arise from cyclical shifts in employment, whereas, the latter indicates either labor shortages or unfortunate byproducts of insufficient aggregate demand. Second, Keynes can understand the vital role of high uncertainty (a lack of reliable news, investor sentiments, or animal spirits) about the economic growth outcome of capital investment decisions. Third, Keynes manages to accomplish his General Theory of Employment in a Marshall-Walras model of perfect competition with no rigid prices and wages (but possibly with incorrect adaptive expectations in the short run).

Klein and Goldberger (1955) design a structural model of the American economy with 15 equations. In the investment liquidity preference and money supply (IS-LM) paradigm, the Klein-Goldberger model features capital accumulation and technical progress through an investment demand schedule. The structural economic model relies on maximum likelihood estimation of U.S. data. Despite several theoretical limitations due to price and wage adjustments, the Klein-Goldberger IS-LM model serves as the first successful macroeconometric model of the U.S. economy. The subsequent MIT-Penn-Social Science Research Council coordination extends this IS-LM model with core technical improvements for U.S. economic forecasts led by Franco Modigliani and Albert Ando. Praising Klein, Goldberger, and their followers for this achievement, Robert Lucas (1977) regards the IS-LM model approximately as a full artificial economy that often tends to imitate the time-series behaviors of actual economies over many decades. In light of this neoclassical synthesis, many economists attempt to reconcile Keynesian ideas and expectations with dynamic stochastic general equilibrium (DSGE) in the subsequent real business cycle (RBC) school of macroeconomic thought.

With more than 100 years British macro data, William Phillips shows the short-run trade-off between wage inflation and unemployment. This research suggests large non-neutrality of money. By printing inflationary currency, the government can help reduce the rate of unemployment. Later Milton Friedman and Edmund Phelps find that if future inflation expectations often adjust to actual inflation rates, there would be no long-run trade-off between inflation and unemployment. In this positive light, monetary policy should be neutral in the long run and probably in the short run too (if inflation expectations react quickly to actual inflation observations).

Phelps delves deeper into the interplay of job vacancies and unemployment rates. This deeper analysis offers the impetus for subsequent extensions of labor market search frictions by Peter Diamond, Dale Mortensen, and Christopher Pissarides. Friedman somehow wins the popularity contest over Phelps by inventing the term the natural rate of unemployment. The natural rate of unemployment refers to the lowest unemployment rate that the economy can sustain with minimal inflationary pressure. The natural rate of unemployment contains at least 3 major components: structural unemployment, frictional unemployment, and surplus unemployment. In practice, structural unemployment results from the inexorable mismatch between worker skills and employer needs. Frictional unemployment refers to temporary job vacancies that arise from life events such as retirement, pregnancy, or illness etc. Surplus unemployment often tends to occur when the government intervenes with minimum wage laws or short-run price-wage controls. Thanks to better technology, long-term trends that drive down the natural rate of unemployment often outweigh the short-term adverse effects of U.S. recessions. As Friedman and Lucas would suggest, monetary policy instruments often cannot be useful in manipulating labor market outcomes (except perhaps over a short time horizon).

Because Robert Lucas serves as one of the eminent economists and practitioners of Walrasian macroeconomics in the Keynesian age, De Vroey regards the Lucas research program as another stage in the long struggle between macroeconomic opposites (i.e. Marshallians versus Walrasians, disequilibrium versus equilibrium, and short-term transitional states of dynamism versus long-term steady states of rest). Lucas and his co-authors and followers look for fresh analytical tools beyond IS-LM, Keynesian fiscal stimulus and investment multipliers, and the Phillips curve. In his seminal research article on Expectations and the Neutrality of Money, Lucas (1972) designs a full-blown dynamic stochastic general equilibrium (DSGE) model that displays monetary non-neutrality under flexible prices and wages and rational expectations. Dynamic inefficiency yields a new demand for a bubble-prone asset like fiat money or legal tender. Real national income changes if producers cannot pierce the veil of monetary shocks from technological ones. Unforeseen monetary shocks can move real GDP (even though most economic agents are invariant to predictable monetary shocks in principle). Nonetheless, empirical validation for this new classical real business cycle theory would arise about 10 years later until the seminal contribution of Finn Kydland and Edward Prescott (1982).

Christopher Sims and Thomas Sargent (1977) propose the use of structural vector autoregressions (SVAR) in business cycle analysis with prior theoretic restrictions. This research shows that transient monetary policy shocks can drive real economic output and inflation outcomes. Subsequent research establishes several economic time-series facts. First, it would be best to view monetary policy as an interest rate rule. The standard interest rate rule often leads to welfare loss minimization in both stochastic calibration and empirical estimation. Second, most variation in monetary policy instruments (such as interest rates and inter-bank reserves) comprises new systematic reactions to asset fluctuations in the general state of the U.S. economy. Random monetary disturbances, however, explain little of business cycle variation. Third, real GDP economic output responds to interest rate changes with a lag, and price inflation reacts to interest rate changes with an even longer lag. These macro features prevail in both the U.S. and many other countries with sound and efficient financial development.

The real business cycle (RBC) theory proves to be a watershed event for modern macroeconomics. Kydland and Prescott (1982) add persistent technology shocks to a dynamic stochastic general equilibrium (DSGE) version of the optimal growth model due to Brock and Mirman (1972). Data discipline comes through calibration, which serves as a new methodology of soft hypothesis test evidence. This method avoids the trouble of estimating large structural models (e.g. the Klein-Goldberger structural core model comprises 15 equations and 5 identities). Simple and intuitive calibration typically uses parameter values for consumer tastes, firm preferences, endowments, and technological advances drawn from microeconomic data, panel observations, industry empirics, and so forth. Kydland and Prescott (1982) can add highly persistent exogenous shocks to total factor productivity (TFP). The artificial model generates imaginary macroeconomic time series on real GDP and its major components, labor supply, capital investment, and other endogenous variables of interest. Kydland and Prescott (1982) find that their model matches pretty well the dispersion of U.S. macroeconomic time series (except for one small fundamental flaw that labor supply fluctuates much more than wage growth in the data).

The RBC macro model explains several salient features of the post-war economy. First, economic boom-bust fluctuations exhibit no regular cyclical pattern. At more or less random intervals, many exogenous disturbances of various types and sizes perturb the economy. These random disturbances would then propagate through the economy. Second, the major components of output show uneven distributions of boom-bust fluctuations. Although inventory investment on average accounts for only a small fraction of U.S. GDP, capital inventory fluctuations account for almost half of U.S. GDP in recessions relative to normal booms. Consumer purchases of durable goods and residential and non-residential business investments account for almost the other half of U.S. GDP. Third, U.S. GDP exhibits some asymmetry in time-series movements. American output seems to be above its usual trend path over relatively long time horizons with brief periods when U.S. output retrenchment persists below its typical trend path. Fourth, the U.S. economy enjoys remarkable macrofinancial stability during the Great Moderation from the early-1980s to 2020. This expansionary episode represents the longest boom in U.S. economic history. During this specific period, the natural rate of interest has fallen substantially with low and stable inflation. The Global Financial Crisis 2008-2009 represents a sharp change from the macroeconomic stability of recent decades. However, one severe long recession is not enough for most macroeconomists to bring average volatility back to its long-run average in the early post-war decades. The global corona virus crisis of 2020-2021 represents a severe but brief recession as the global economy gradually returns to the new normal steady state. It is probably too soon to know whether the recent crises represent the end of the Great Moderation or some one-time aberration. Finally, the conjunction of declines in both productivity gains and labor work hours suggests that changes in the unemployment rate are smaller than changes in U.S. GDP. The Okun law shows the robust relation between changes in U.S. GDP and the unemployment rate. In particular, a 3% shortfall in U.S. GDP relative to normal growth often produces a 1%-point increase in the unemployment rate. Overall, the RBC macro model calibration matches well these salient features of the post-war economy.

With the RBC macroeconomic theory, this empirical success is quite remarkable for an artificial economy with no frictions of any kind (i.e. no public goods, no money or credit flows, no information asymmetries, and no capital adjustment costs). Near the Great Lakes and elsewhere, many macroeconomists from Chicago, Minnesota, Rochester, and Carnegie Mellon establish themselves as the vanguard of the RBC world of modern macroeconomics.

Mainstream macroeconomists along the U.S. east and west coasts tend to find the Kydland-Prescott innovation less impressive as the RBC model seems to entrench the concept of monetary neutrality for freshwater Lucasians. In contrast, saltwater New Keynesians prefer their own tribe and model of monetary non-neutrality since the Phillips curve shines light on the mysterious and inexorable trade-off between inflation and unemployment. This macro trade-off would later set the dual mandate of price stability and maximum sustainable employment for U.S. Federal Reserve System and other central banks worldwide. One of the eminent saltwater macro economists, Robert Solow (1988), offers an informative critique: economic growth models can help study long-run phenomena but not business cycles or boom-bust fluctuations, whereas, the RBC framework rules out many of the phenomena that macroeconomists build models to explain in due course. These macro phenomena include strategic interactions and market failures. These reasonable objections by Solow (1988) turn out to be prescient for subsequent New Keynesians to evaluate their workhorse macroeconomic models.

De Vroey regards the RBC model as a valid intellectual paradigm that provides a useful description of economic reality. However, many of its assumptions abstract a great deal from most modern market economies. On balance, De Vroey credits Kydland and Prescott (1982) for helping us better understand normal fluctuations (in stark contrast to rare disasters such as the Great Depression of the 1930s and the Great Recession of 2008-2009).

New Keynesians introduce Calvo (1983) nominal rigidities and price markups due to Dixit and Stiglitz (1977) monopolistic competition (e.g. Clarida, Gali, and Gertler (2000) and Gali (1999 and 2015)) in order to enrich the basic DSGE macro model. First-order conditions for the representative household and monopolistic firm yield a dynamic IS curve, a Phillips curve, and a Taylor interest rate rule. The IS curve describes the real effect of interest rate adjustments on economic output. Also, the Phillips curve shows the mysterious and inexorable trade-off between inflation and unemployment. The Taylor interest rate reflects the central bank response to both inflation expectations and the output gap. As the output gap highly correlates with inflation with wider fluctuations, the New Keynesian calibration affirms the use of explicit inflation targets for welfare loss minimization. New Keynesians often refer to the equivalent calibration of both inflation and the output gap from their targets as the divine coincidence. Overall, the dynamic IS curve, the Phillips curve, and a Taylor interest rate rule render the New Keynesian framework look like the IS-LM elements of the neoclassical synthesis with time lags.

Just like the RBC macro model calibration, the New Keynesian calibration matches well the dispersion of post-war macroeconomic time series such as U.S. GDP and capital accumulation. Nevertheless, neither approach accords with the hump-style impulse responses of both inflation and output in structural vector autoregressions. It is much easier to shoehorn additional features such as capital adjustment costs and irreversible investments into the New Keynesian framework. In a positive light, these features help make the New Keynesian framework suitable for econometric macro policy evaluation.

De Vroey applauds monetary non-neutrality in the New Keynesian framework that serves as a legitimate member of the canonical DSGE fraternity with both inflexible price adjustments and monopolistic markups. The core 3-equation New Keynesian framework, however, leaves little scope for physical and human capital investment accumulation, no demand for cash and credit, and minimal role of product market competition and industrial organization.

In a nutshell, the canonical DSGE macro model becomes the universal language for most macroeconomists. Robert Lucas receives enormous credit for pioneering the use of the Walrasian recursive competitive equilibrium macro model family that we now know as DSGE. Lucas and his co-authors improve the internal consistency of macroeconomics. Kydland and Prescott and their followers lead the use of new classical growth theory in the meticulous study of real business cycles. Their macro model calibration takes DSGE to post-war U.S. data. Sargent and Sims blaze the trail for applying structural vector autoregressions to establish empirical facts about U.S. macroeconomic time series.

De Vroey remains ambivalent about DSGE even when macroeconomists extend the baseline to include the IS-Taylor rule and Phillips curve in the New Keynesian framework. These macro models can often prove to be suitable to the quantitative study of normal business cycles. Such macro models, however, lack sophistication for the analytic evaluation of specific monetary policies that aim to tame substantial fluctuations such as the Great Depression of the 1930s, Great Recession of 2008-2009, and the global corona virus crisis of 2020-2021. De Vroey shares the shrewd judgment that the best workhorse macro model must serve as a good yardstick for assessing progress in how well we understand the causes of, and cures for, market failures. Future research can shine fresh light on the special role of financial capital in most macro models. In this alternative view, asset market stabilization becomes an essential policy goal in the typical Taylor interest rate rule.


Many macro riddles and puzzles remain mysterious and persistent in the post-war global economy.

Exogenous changes in total factor productivity account for more than half of cross-country differences in real GDP growth rates. In comparison, convergence in per capita income fails impressively in Latin America and sub-Saharan Africa. Another growth anomaly pertains to global differences in the growth rates of consumption among rich nations with open and complete financial markets. Moreover, the global distribution of both income and wealth skews disproportionately toward billionaires. Specifically, the richest 5% of wealth holders own more than half of financial wealth in America, Britain, Canada, Europe, Japan, Singapore, and other OECD countries. Despite much progress in better understanding business cycles and growth rates, most macro riddles, puzzles, and anomalies remain mysterious and persistent in the post-war global economy.

Daron Acemoglu, Simon Johnson, and James Robinson (2001 and 2002) present empirical analysis of the robust nexus between colonialism and subsequent poor social infrastructure (and thus subpar economic growth). In their institutional view, geographic differences between (sub)tropical and temperate areas at the time of colonization have caused Europeans to colonize with both extractive and inclusive institutions. The different strategies of colonization affect subsequent institutional development. For this reason, the chosen establishment of inclusive or extractive institutions serves as a crucial source of global differences in social infrastructure and economic growth nowadays.

Acemoglu, Johnson, and Robinson (2001) empirically emphasize the geographic disease environment. Europeans face extremely high mortality risks in key tropical areas (particularly from malaria and yellow fever), but the average death rates are substantially lower in temperate regions. In the tropical high-disease environments, European colonizers establish extractive states or authoritarian institutions in order to exploit natural resources from these colonies with little settlement and property protection. In the temperate low-disease environments, European colonizers tend to establish inclusive states or settler colonies with democratic rule of law.

Acemoglu, Johnson, and Robinson (2002) focus on the previous level of economic development on the eve of colonization. In key colonies with dense population and greater institutional development, it proves to be more attractive for Europeans to establish extractive states than inclusive states and settler colonies. This particular colonization strategy leads to the great reversal of fortune that the settler colonies with inclusive institutions tend to experience better economic growth and middle-class income stability (in stark contrast to extractive states). This key empirical fact prevails in the economic comparison of North America versus South America.

Mehra and Prescott (1985) both derive and show the U.S. equity premium puzzle in light of neoclassic representative household consumption. With constant relative risk aversion (CRRA) and constant intertemporal elasticity of substitution (CES), Mehra and Prescott (1985) present the mathematical proof that the representative consumer would require the equity premium (or the average stock return in excess of the risk-free Treasury rate) as his or her CRRA parameter times the covariance of consumption growth with the stock market return. The U.S. equity premium has been historically 6% on average. The covariance of U.S equity excess return with consumption growth is about 0.2%. Back-of-the-envelope calculations suggest a hefty and counterintuitive CRRA parameter of 30. Either this CRRA parameter is too high for the rational risk-averse investor, or the covariance between the stock market return and consumption growth is too low to justify the U.S. historical long-run average equity premium. This equity premium puzzle has long been a primary topic for modern asset return prediction and anomaly discovery.

A good account of predicting the average opinion of multiple predictions is the main beauty contest that Keynes attempts to propose in his General Theory. This beauty contest is an early example of multiple equilibrium in the iterative game of market coordination. In this game, the winner is not necessarily the person that individual judges regard as most attractive. Instead, the winner often tends to be the one that most judges predict to be favorable in the eyes of their colleagues with their animal spirits, sunspot beliefs, self-fulfilling prophecies, or capricious investor sentiments. Shiller (1981) gauges the harm of irrational exuberance as excess volatility in U.S. stock prices. U.S. stock prices often fluctuate 5 times more than actual changes in dividends and interest rates. Keynesian search theory helps reconcile the animal spirits of General Theory with the microfoundations of dynamic general equilibrium with at least 3 major contributions. First, there is a broad continuum of steady-state equilibrium unemployment rates. Second, the self-fulfilling beliefs of stock markets help select the prevalent steady-state equilibrium unemployment rate. Third, some government policies such as fiscal stimulus and asset market stabilization can help substantially increase social welfare by reducing involuntary unemployment over time. Keynesian search theory offers a credible and internally coherent alternative paradigm that differs substantially from the New Keynesian framework. If investors think stock prices are likely to rise tomorrow, these investors place buy orders with their brokers, and stock prices tend to increase over time. This syllogism confirms prior self-fulfilling beliefs and so motivates many macroeconomists who work with recursive competitive equilibrium models. Keynesian search theory explains most salient features of the Great Depression of the 1930s and Great Recession 2008-2009 (i.e. rare disasters in real business cycles). Another important conclusion of Keynesian search theory is that asset market intervention through active control of stock market fluctuations can be more effective than traditional fiscal stimulus from a fundamental welfare perspective.


Are the welfare costs of key business cycles large enough for macroeconomists to justify monetary policy actions and interest rate adjustments?

In terms of the welfare costs of business cycles, Robert Lucas (2003) gauges that if all consumption risk vanishes from U.S. data, the representative household with unitary relative risk aversion would gain no more than 0.05% in certainty-equivalent consumption. Moreover, many RBC macroeconomists estimate the welfare costs of inflation to be only 0.01% to 0.03% of U.S. GDP. Other economists regard these welfare costs as enormous supply shocks. How can we identify these shocks that have caused past movements in output, employment, and capital accumulation? How can these shocks percolate through the global economy? Are DSGE macro models statistically relevant in structural vector autoregressions? Do these models help us better understand post-war business cycles? Do these models help inform the econometric evaluation of alternative fiscal and monetary policy decisions?

In a nutshell, both canonical RBC and New Keynesian macro models can calibrate well the first and second moments of major economic time series. However, these macro models cannot replicate dynamic hump-style impulse responses to external shocks. In the econometric legacy of Christopher Sims and Thomas Sargent, these issues remain open to controversy nowadays.


Do the workhorse models work well in accordance with the welfare theorems?

We can perhaps better understand the major conceptual differences between the RBC, Keynesian search, and New Keynesian workhorse macroeconomic models (all of which are DSGE structures) by connecting these models to the static general equilibrium welfare theorems. The first welfare theorem asserts that markets work well when every competitive equilibrium valuation is Pareto optimal in an exchange economy with no public goods and externalities. Also, the second welfare theorem states that the free market mechanism helps reach every desirable Pareto optimal outcome in a competitive economy. Specifically, the lump-sum redistribution of key initial endowments helps achieve the resultant optimal allocation of resources. The welfare theorems collectively amount to a belief in the power of a market economy for better aligning private incentives with social welfare results.

Macroeconomists who accept both welfare theorems as approximate hypotheses tend to gravitate toward the representative household model of Lucas (1978) and Kydland and Prescott (1982). Other macroeconomists who prefer neither theorem feel some affinity for the New Keynesian framework of Rotemberg and Woodford (1997), Gali (1999), and Clarida, Gali, and Gertler (2000). Keynesian search macro economists believe that it is plausible for the government to provide fiscal stimulus and asset market stabilization in order to help improve social welfare.

A major contribution of the DSGE representative macro model has been to adapt the long-run apparatus of growth theory to the careful study of short-term business cycles of Kydland and Prescott (1982) and quantitative asset prices of Lucas (1978) and Mehra and Prescott (1985). A fortunate byproduct is the invention of DSGE or a new language for macroeconomics that provides precise descriptions of how key fundamental factors and forces determine dynamic equilibrium outcomes over time. Despite this success, many central bankers continue to rely on IS-LM and its New Keynesian extensions to evaluate fiscal and monetary policy decisions. These core decisions often shine fresh light on how interest rate adjustments affect economic output with an arguable trade-off between inflation and unemployment. In essence, the central bank and national treasury make monetary and fiscal policy decisions by trying to reduce the welfare costs of boom-bust fluctuations over time.


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