Why Macroeconomists Disagree

Differentiate between the classical and Keynesian approaches to macroeconomics.

policy. A positive analysis of an economic policy examines the economic con­sequences of a policy but doesn't address the question of whether those conse­quences are desirable.

Economists may agree on the positive analysis of a question yet disagree on the normative part because of differences in values. Value differences also are common in other fields: Physicists may be in general agreement about the conse­quences of a meltdown of a nuclear reactor (a positive analysis). Yet there might be extensive disagreement among these physicists about whether a new nuclear power plant should be built (a normative question).

Disagreement may occur on positive issues, however, and these differences are important in economics. In macroeconomics there always have been many schools of thought, each with a somewhat different perspective on how the econ­omy works. Examples include monetarism and supply-side economics, both of which we discuss in this book. However, the most important—and enduring— disagreements on positive issues in macroeconomics involve the two leading schools of thought: the classical approach and the Keynesian approach.

Classicals Versus Keynesians

The classical approach and the Keynesian approach are the two major intellectual traditions in macroeconomics. We discuss the differences between the two approaches briefly here and in much greater detail later in the book.

The Classical Approach. The origins of the classical approach go back more than two centuries, at least to the famous Scottish economist Adam Smith. In 1776 Smith published his classic, The Wealth of Nations, in which he proposed the con­cept of the "invisible hand." The idea of the invisible hand is that if there are free markets and individuals conduct their economic affairs in their own best interests, the overall economy will work well. As Smith put it, in a market economy, indi­viduals pursuing their own self-interests seem to be led by an invisible hand to maximize the general welfare of everyone in the economy.

However, we must not overstate what Smith claimed: To say that an invisible hand is at work does not mean that no one in a market economy will be hungry or dissatisfied; free markets cannot insulate a nation from the effects of drought, war, or political instability. Nor does the invisible hand rule out the existence of great inequalities between the rich and the poor because in Smith's analysis, he took the initial distribution of wealth among people as given. Rather, the invisible-hand idea says that given a country's resources (natural, human, and technological) and its initial distribution of wealth, the use of free markets will make people as eco­nomically well off as possible.

Validity of the invisible-hand idea depends on a key assumption: The various markets in the economy, including financial markets, labor markets, and markets for goods and services, must function smoothly and without impediments such as minimum wages and interest rate ceilings. In particular, wages and prices must adjust rapidly to equate quantities demanded and supplied. In a market in which there are no impediments, equating quantities demanded and supplied will bring the market into equilibrium—a situation in which there is no pressure for wages or prices to change.

Wage and price flexibility is crucial to the invisible-hand idea because in a free-market system, changes in wages and prices are the signals that coordinate the actions of people in the economy. To illustrate, suppose that war abroad dis­rupts oil imports. This drop in supply will drive up the price of oil. A higher oil price will make it profitable for domestic oil suppliers to pump more oil and to drill more wells. The higher price will also induce domestic consumers to con­serve oil and to switch to alternative sources of energy. Increased demand for alternative energy sources will raise their prices and stimulate their production, and so on. Thus, in the absence of impediments such as government price controls, the adjustment of prices helps the free-market economy respond in a constructive and coordinated way to the initial disruption of supplies.

The classical approach to macroeconomics builds on Smith's basic assump­tions that people pursue their own economic self-interests and that prices adjust reasonably quickly to achieve equilibrium in all markets. With these two assump­tions as a basis, followers of the classical approach attempt to construct models of the macroeconomy that are consistent with the data and that can be used to answer the questions raised at the beginning of this chapter.

The use of the classical approach carries with it some strong policy implications. Because the classical assumptions imply that the invisible hand works well, classical economists often argue (as a normative proposition) that the government should have, at most, a limited role in the economy. As a positive proposition, classical econ­omists also often argue that government policies will be ineffective or counterpro­ductive at achieving their stated goals.

The Keynesian Approach. Compared with the classical approach, the Keynesian approach is relatively recent. The book that introduced it, The General Theory of Employment, Interest, and Money by British economist John Maynard Keynes, appeared in 1936—160 years after Adam Smith's The Wealth of Nations. In 1936 the world was suffering through the Great Depression: Unprecedentedly high rates of unemployment had afflicted most of the world's economies for years, and the invis­ible hand of free markets seemed completely ineffective. From the viewpoint of 1936, the classical theory appeared to be seriously inconsistent with the data, creat­ing a need for a new macroeconomic theory. Keynes provided this theory.

In his book, Keynes offered an explanation of persistently high unemploy­ment.^[8] He based this explanation on an assumption about wage and price adjust­ment that was fundamentally different from the classical assumption. Instead of assuming that wages and prices adjust rapidly to equate quantities demanded and supplied in each market, as in the classical tradition, Keynes assumed that wages and prices adjust slowly. Slow wage and price adjustment meant that quan­tities demanded might not equal quantities supplied for long periods of time. In the Keynesian theory, unemployment can persist because wages and prices don't adjust to equalize the number of people that firms want to employ with the num­ber of people who want to work.

Keynes's proposed solution to high unemployment was to have the govern­ment increase its purchases of goods and services, thus raising the demand for output. Keynes argued that this policy would reduce unemployment because, to meet the higher demands for their products, businesses would have to employ more workers. In addition, Keynes suggested, the newly hired workers would have more income to spend, creating another source of demand for output that would raise employment further.

The Evolution of the Classical-Keynesian Debate. Because the Great Depression so strongly shook many economists' faith in the classical approach, the Keynesian approach dominated macroeconomic theory and policy from World War II until about 1970. At the height of Keynesian influence, economists widely believed that, through the skillful use of macroeconomic policies, the government could pro­mote economic growth while avoiding inflation or recession. The main problems of macroeconomics apparently had been solved, with only some details to be filled in.

However, in the 1970s the United States suffered from both high unemploy­ment and high inflation—called stagflation, or stagnation plus inflation. This expe­rience weakened economists' and policymakers' confidence in the traditional Keynesian approach, much as the Great Depression had undermined the tradi­tional classical approach. In addition, the Keynesian assumption that prices and wages adjust slowly was criticized as being without sound theoretical foundations. While the Keynesian approach was coming under attack, developments in eco­nomic theory made classical macroeconomics look more interesting and attractive to many economists. Starting in the early 1970s, a modernized classical approach enjoyed a major resurgence among macroeconomic researchers, although classical macroeconomics did not achieve the dominance that Keynesianism had enjoyed in the early postwar years.

In the past three decades, advocates of both approaches have reworked them extensively to repair their weaknesses. Economists working in the classical tradi­tion have improved their explanations of business cycles and unemployment. Keynesians have worked on the development of sound theoretical foundations for the slow adjustment of wages and prices, and Keynesian models can now accom­modate stagflation.

A Unified Approach to Macroeconomics

In writing this book, we needed a strategy to deal with the fact that there are two major macroeconomic schools of thought. One strategy would have been to emphasize one of the two schools of thought and to treat the other only briefly. The problem with that strategy is that it would not expose you to the full range of ideas and insights that compose modern macroeconomics. Alternatively, we might have presented the two approaches separately and then compared and contrasted their conclusions—but you would have missed the opportunity to explore the large common ground shared by the two schools of thought.

Our choice was to take an approach to macroeconomics that is as balanced and unified as possible. In keeping with this unified approach, all our analyses in this book—whether of economic growth, business cycles, inflation, or policy, and whether classical or Keynesian in spirit—are based on a single economic model, or on components or extensions of the basic model. This economic model, which draws heavily from both the classical and Keynesian traditions, has the following characteristics.

1. Individuals, firms, and the government interact in goods markets, asset markets, and labor markets. We have already discussed the need for aggregation in macro­economics. In the economic model of this book, we follow standard macroeco­nomic practice and aggregate all the markets in the economy into three major markets: the market for goods and services, the asset market (in which assets such as money, stocks, bonds, and real estate are traded), and the labor mar­ket. We show how participants in the economy interact in each of these three markets and how these markets relate to one another and to the economy as a whole.

2. The model's macroeconomic analysis is based on the analysis of individual behavior. Macroeconomic behavior reflects the behaviors of many individuals and firms interacting in markets. To understand how individuals and firms behave, we take a "bottom-up" approach and focus our analysis at the level of individual decision making (as in "In Touch with Data and Research: Developing and Testing an Economic Theory," where we discuss a model of individual choices about the route to take to work). The insights gained are then used for study­ing the economy as a whole.

The guiding principle in analyzing the behavior of individuals and firms is the assumption that they try to maximize their own economic satisfaction, given their needs, desires, opportunities, and resources. Although the founder of classical economics, Adam Smith, emphasized this assumption, it is generally accepted by Keynesians and classicals alike, and it is used in virtually all modern macro­economic research.

3. Although Keynesians reject the classical assumption that wages and prices quickly adjust in the short run, Keynesians and classicals both agree that, in the long run, prices and wages fully adjust to achieve equilibrium in the markets for goods, assets, and labor. Because complete flexibility of wages and prices in the long run is not controversial, we examine the long-term behavior of the econ­omy (Chapters 3-7) before discussing short-run issues associated with busi­ness cycles (Chapters 8-13).

4. The basic model that we present may be used with either the classical assumption that wages and prices are flexible or the Keynesian assumption that wages and prices are slow to adjust. This aspect of the model allows us to compare classical and Keynesian conclusions and policy recommendations within a common theo­retical framework.

►