New Macroeconomic Paradigms

Since the triumph of Keynesian economics with the tax cut of 1964, there have been increasing criticism of this paradigm. Milton Friedman led a resurgence of an updated monetary theory. New approaches to macroeconomics are:

_____1. Supply Side economics
_____2. Social Choice Theory (Buchanan)
_____3. Neoclassical (Lucas and allies)

Supply Side Economics

While few academic economists are supply siders, this movement has many devoted adherents outside academia. Supply siders believe that Keynesian economics places far to much emphasis on demand. Economic policy should be devoted to stimulating demand through tax cuts and reduction of business regulation. Supply siders had some influence on policy in the early years of the Reagan administration with his tax cut policy.

At some point we will insert a small simulation model so that you can study the issue of whether a tax cut can ever stimulate the economy so much that tax revenues actually increase.

Social Choice Theory

Keynesian economics implicitly assumes that representatives governments can implement his policy in the national interest. That means that a representative government would run a deficit when the economy is below the potential growth path and a surplus when the economy is above the potential growth path. Over the business cycle there will be no deficit because the money saved when the government is in surplus will cover the costs when the government is in deficit. The correct Keynesian policy is shown in the figure below:

As pointed out by Buchanan, Keyes ignored the incentives which operate on the representatives as individuals. If we assume the representatives enjoy power, then we must consider what actions will they take during the Keynesian reaction to the business cycle. Representatives will take actions to please their constituents to maintain their votes. To get reelected a government surplus is an opportunity to fund more projects to gain voter approval.

If you will examine the deficit since the tax cut of 1964, which made Keynesian policy public policy, you will discover that the US federal government has run a surplus only three times.

Reelection incentives are too great to allow a representative government to run a surplus or take politically unpopular actions to balance the budget.

Neoclassical Macroeconomic

The development of neoclassical macroeconomic follows from the incorporation of a formal model of expectations and the Lucas supply function.

Expectations relate to the ability of individuals to use current information in order to forecast the future. Certainly as students you are aware that individuals can not precisely forecast the future. Take for example weather forecasts. The weather forecast gives the probability of rain the next day and subsequent days. The issue for economic modeling is whether individuals can accurately forecast averages. For example, if we flipped a fair coin, no one could accurately forecast the sequence of heads and tails. But individuals could forecast that if we flipped the coin, say, the percent of head would be approximately 50%.

The rational expectations hypothesis assumes that people know the true model of the economy and that they accurately forecast expected values of economic variables. With rational expectations markets on average would be in equilibrium and that disequilibrium such as unemployment occurs as a result of random, unpredictable shocks.

The Lucas supply function assumes that output Y depends on the difference between the actual price level and the expected price level:

_____Y = f(P - Pe)_____ (1)

The Lucas supply function is based in information differentials. Managers know more about prices in their industry and other industries and workers know more about their wages than wages in other industries. A price surprise is the difference between the actual price and the expected price. If there is a positive price surprise then output goes up because managers will expand output and workers will be willing to work longer hours.

If we consider the policy implications of the Lucas supply model, government can increase output only be fooling managers and workers into perceiving a positive price surprise. If we assume that economic agents have rational expectations then any announced policy will have no affect of real output because the announced policy will affect the price level and expected price level in the same way.

Norman's Opinion

Macroeconomics has come full circle since the 1930s. In the classical model, government had no fiscal policy. This position is reasserted in the neoclassical model.

Macroeconomists are divided into neoclassical adherents and more eclectic thinkers who consider the neoclassical assumptions far too strong. The point is that most macroeconomists believe that government can do much less to effectively stablize the economy than was believed in the 1960s.

Much of the focus in macroeconomics has shifted from stabilization policy to growth policy. Can we stimulate the economy to grow an extra 1% a year. This would increase real incomes and might reduce racial tension.