The Movement Back To Growth Supply

The Movement Back to Growth and Supply

New classical economics notably influenced macroeconomics, but it did not garner significantly more proof for its theories than had Keynesian macroeco­nomics. The empirical data were simply insufficient to provide any answers. At that point macroeconomists stopped looking at business-cycle issues and started to focus macroeconomics on growth. This fit with the events of the time, as the U.S. economy grew throughout the 1990s and did not experience a business cycle.

The analysis of growth started by going back to the Solow growth model, which had been developed in the 1950s as a response to the Harrod-Domar model. That model had argued that growth was a knife edge and that, unless the economy was extremely lucky, it would likely fall into a depression. Solow's model challenged that conclusion by eliminating the assumption of a fixed capital/labor ratio; it showed that the economy would always come back to a balanced growth path. The economy was stable, not unstable. The Solow growth model, also called the neoclassical growth model, focused completely on supply; demand played no role in determining output. New classicals found it to their liking and developed it further as they attempted to explain why growth rates among countries differed.

The movement of macroeconomics toward an emphasis on growth changed the nature of macroeconomics. Growth models were supply-based models: they had no role for demand in them. Thus, as growth models became more prominent, Keynesian models became less so. As these growth models worked their way first into intermediate books and then into introductory books, the association of macroeconomics with Keynesian economics faded, and instead the quantity theory of money and the growth theories became the focus of modern macroeconomics. Classical growth theory was supplemented with new endo­genous growth theory. In endogenous growth theory, technological change was not considered something that occurred outside the economic model; it was endogenous to the model. It was the natural result of investment in research and development. Endogenous growth theory allowed increasing returns to over­whelm diminishing marginal returns, and the result of this could be continual growth and no eventual movement to the stationary state. Thus it brought mainstream macroeconomics back into the optimist, rather than the pessimist, fold.

The focus on growth displaced much of Keynesian macroeconomics. Keynes-ian-type models were still used, but the multiplier was deemphasized and any discussion of demand policy was downplayed. Monetary policy was to be used to prevent inflation; fiscal policy was impractical, and the real policy focus had to do with supply-side incentives.
But questions also arose about the Solow growth model: it did not neatly fit the empirical events. Two modifications helped to solve this problem: it was adjusted, and it was replaced by new growth theory, which focused on technol­ogy, and goes back to Smith.

Modern Macroeconomics in Perspective

To understand how these developments fit in with our assertion that a new economics has developed, you first have to understand that Keynesian macro­economics never really fit in with neoclassical economics. It was something extraneous that was allowed to exist because it seemed to fill a policy need and explain economic events better than standard classical models.

The new classical revolution challenged Keynesian macroeconomics because of that incompatibility, and tried to bring macroeconomics into the fold of microeconomics. It was, in a sense, the last hurrah of neoclassical thinking, and it succeeded in undermining the theoretical base for macroeconomics, but, failed to bring macroeconomics back into the neoclassical fold. It simply fragmented it and allowed a variety of inconsistent models to develop and be used wherever they suited particular applications. Within this new reality, there was little to separate Keynesian from classical economics; both were simply aspects of modern economics—the use of models to try to understand reality.