The Development of Modern Macroeconomic Thought

Macroeconomic Theory and Policy, Macroeconomic Theory Notes

Interest in macroeconomic issues has fluctuated throughout the years, reaching its nadir around the turn of the nineteenth century. The attitude of the economics profession toward macroeconomic thought at that time could be characterized as one of benign neglect. The macroeconomic thinking that did exist, moreover, was somewhat confused. Alfred Marshall, who had codified and organized microeconomics in his Principles of Economics, always intended to do the same for macroeconomics, but he never did. He limited his discussion of macroeconomics to a determination of the general level of prices, as did F. W. Taussig in his introductory textbook.

Growth, which had been the focus of Adam Smith's work, received only slight emphasis in the later classical and neoclassical periods. Instead, the profession focused on developing formal models of allocation and distribution using the static reasoning that Ricardo championed; Smith's ambiguities lost out to Ricardo's more formal models. Business cycles also received only fleeting reference; the standard assumption of full employment of all resources precluded greater consideration of them. That full employment assumption was often justified by reference to Say's Law, supply creates its own demand.

Analysis that used the full employment assumption and focused on explaining the forces determining the general level of prices continued until the 1930s, when the Great Depression led to new work on understanding business cycles. During the period from the 1930s to the late 1970s, macroeconomics continued to focus on business cycles, an approach that came to be known as "Keynesian econom­ics." The classification is not totally correct, since Keynesian ideas quickly merged with neoclassical ideas; the actual macroeconomics that developed in the texts might more appropriately be called neo-Keynesian economics. This chapter describes this evolution and its historical foundation.

The 1970s saw a reaction against neo-Keynesian economics in the form of the new classical revolution, which moved the focus of macroeconomics away from business cycles and toward growth. Since the 1990s the primary focus of cutting-edge macroeconomics has been on growth.

This chapter will first consider early work on macroeconomic issues, then deal with the development of Keynesian macroeconomics. It will then cover the new classical revolution, and finally consider the current state of macroeco­nomics.

Historical Forerunners Of Modern Macroeconomics

Modern macroeconomics consists primarily of monetary theory, growth theory, and business-cycle theory. Emphasis on these has fluctuated over the years, in part as the experience of the economy has changed and in part as techniques have allowed economists to deal with issues that they previously found unman­ageable. We will begin with a discussion of growth theory.

Early Work on Growth Theory

Analysis of economic growth was the primary concern of Adam Smith, who emphasized the relationships between free markets, private investment spending, laissez faire, and economic growth. Ricardo refocused economics, turning it away from economic growth and toward the issue of the forces determining the distribution of income. This change in viewpoint between Smith and Ricardo concerning the essential subject matter of economics was fundamentally a reorientation of economics away from the growth macroeconomics of Smith and toward Ricardo's microeconomic concerns—what determines wages, rents, profits, and other prices, and thus the distribution of income. This emphasis on microeconomics, the allocation problem, continued to dominate mainstream economic thought from Ricardo in the first quarter of the nineteenth century until the major depression that engulfed the industrialized world in the 1930s. Joseph Schumpeter, in the discussion of growth in his famous book on the history of economic thought, distinguishes two types of economists by their thinking about growth: the optimists and the pessimists. He argues that most mainstream economists fall within the pessimist group, the strongest pessimists being Malthus, Ricardo, and James Mill. These mainstream economists strongly emphasized decreasing returns, ever-increasing rent, and the stationary state toward which the economy was progressing. They did this even as the economy around them was growing at rates far exceeding those of earlier times. As Schumpeter notes, "They were convinced that technological improvement and increases in capital would in the end fail to counteract the fateful law of decreasing returns."

Somewhat of an exception to this among the major mainstream economists was John Stuart Mill, who discussed growth and technology more than Malthus or Ricardo did, and who, moreover, was much more optimistic about the possibility of continued growth. But a close reading of Mill shows that he did not base his belief so much on the continued growth of technology and capital as on his belief that societies would ultimately voluntarily restrict the birth rate and thus slow the inevitable diminishing marginal returns.

Toward the end of his life, Mill became more of a pessimist. He seemed convinced that the stationary state was near. However, he did not see this result as necessarily bad. Rather, he saw the stationary state as a comfortable state in which there was moderate prosperity and reasonable equality. This followed because he saw the distribution of income as being determined by social as well as economic forces.

It was left to heterodox economists such as Henry Carey (1793-1879) and Friedrich List to support the optimist vision. List, discussed in Chapter 12, was part of the German historical school, which emphasized empirical observation and history over theory. Since he could see that the economy was growing at a faster rate than it had earlier, it was only natural for him to believe that growth could continue, possibly indefinitely. Carey was an American economist who deemphasized theory and emphasized history and empirical observation. This led him to the same conclusion as List: there seemed no end in sight to the growth of the economy. Given the American experience at the time, with an expanding frontier and ever-increasing agricultural land, it was natural that diminishing returns would be less emphasized in the American context.

It is interesting that the optimists, List and Carey, supported tariffs, whereas the pessimists, such as Ricardo, generally supported free trade. This difference probably flowed from their view of theory and use of assumptions. Ricardo's theoretical comparative advantage model directed thinking toward the advan­tages of a policy of free trade. But the static nature of the model also led to the view that once the gains of trade had been achieved, growth would stop. List and Carey focused less on theory and more on observation and history. Direct observation of the economy suggested the importance of technology and the possibility of continued growth. It also suggested that protecting that technology by tariffs was important. Smith's argument that trade expands technology through expanding the division of labor and learning by doing, and therefore can be beneficial for all, is a much more complicated argument to make; it follows from a dynamic view of the economy that is difficult to capture in formal models.

Mainstream economists of the time vigorously attacked both List's and Carey's views and delighted in pointing out their theoretical mistakes. But in doing so the mainstream economists failed to grasp the broader lesson of List's and Carey's work that diminishing marginal returns could be overcome, possibly forever, by technological development. Modern economists were likewise blind to Marx's insights concerning growth.

As neoclassical economics developed, the movement away from a focus on growth accelerated. The neoclassicals, with the possible exception of Alfred Marshall, whose views on growth resembled Mill's, focused more on static equilibrium. Both Mill and Marshall held that technological progress could temporarily create the conditions of growth but that the law of diminishing returns in agricultural and raw materials would ultimately win out.

For the most part, economists in the first half of the twentieth century did not deal with growth. An important exception was Joseph Schumpeter, who does not fit neatly into any school.