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Randall Wright is o professor of economics at the University of Pennsylvania and serves as a consultant to the Federal Reserve Bank of Minneapolis. The author thanks Don Thornton for useful comments on on earlier draft, and Lee Ohonian for several useful discussions.

assertion itself. To focus the discussion, I 45 Commentary propose to debate the following position: ~3r~ We have made little progress in macroeconomics since the Keynesian-monetarist debates, and Randall Wright existing models built on micro-foundations are neitherfruitful nor promising. I perceive this a han Meltzer raises a variety of issues, position to be a fair reflection of the view fr~

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call their dynamic general-equilibrium (GE) are estimating dynamic GE models using model. (This is a more accurate label than traditional econometric methods (see, the more common real business cycle, or for example, McGrattan, 1994). RBC, model, given that many people work (4) The HP filter is simply a convenient with monetary versions of the model). tool, and obsessing over its merits or It included many complications, such as demerits is like debating whether the time-to-build, non-time-separable utility, mean, median or mode is the “correct” and signal extraction problems, which, while measure of central tendency still included in some applications, are not parts of the current standard benchmark The consensus today is that the dynamic model. ‘Why were those complications there? GE models are useful tools for studying busi- They thought a simple model wouldn’t stand ness cycles. Of course, this does not mean a chance. On one interpretation, the entire that business cycle research is a solved prob- exercise was to see just how had things were, lem. There are many unanswered or partially so we would have some idea where to go answered questions, such as the correlation next (for example, in terms of adding other between employment hours and productivity, impulses and propagation mechanisms). the equity premium, and the relations between To everyone’s surprise, however, even real and nominal variables, Much work has very simple dynamic GE models do quite been done to address these questions with well at replicating key aspects of the macro some, but not total, success. There are still time series. Output is more volatile than interesting puzzles out there—but this is consumption, not as volatile as investment, why working in the area is exciting. The and about as volatile as the labor input; and, point is that we now have a standard niodel of the coherence of all these series is high. the business cycle, a base case from which to Furthermore, the model is consistent with generalize when the situation warrants it. these features of the data at a quantitative The dynamic GE approach is a tool level, not just a qualitative level. for macroeconomics the way that the Traditional macroeconomists, especially supply-and-demand approach is a tool for Keynesians. reacted to these findings with microeconomics. One should not ask: “is much suspicion, and virtually every aspect the model true?” but only: “Is it useful?” of the analysis was called into question. In Have we made progress understanding busi- retrospect, many controversial issues turned ness cycles? Yes. Are these models based on ottt to he red hert’ings, including the following: microeconomic foundations? Yes. They are (I) Abstracting from heterogeneity (that based on the standard economic principles of is, focusing on a representative agent) is constrained optimization (which, in a dynamic an assumption that, depending on the context, obviously concerns intercemporal questions, is sometimes appropriate and substitution) and a coherent concept of sometimes inappropriate, but is never equilibrium. Can the base model accommo- good or bad as a matter of principle. date frictions, money heterogeneity private information and so on? Yes. Do we need to (2) Abstracting from market failures, throw out dynamic GE theory in favor of frictions and money is a proper first new micro-foundations or a retrograde macro step—no one should advocate complica- approach? No, no more than we need to throw tion for its own sake—and the fact that out supply-and-demand curves, simple models can he solved efficiently Of course, a base model is always sim- by exploiting the welfare theorems does plistic. In the case of supply and demand, not mean that users of these models for example, suppose we want to know what believe the real world is “first best” nor will happen to the price of orange juice after chat policy is unworthy of discussion. a frost in Florida or a Vitamin C craze, Is it (3) Calibration is a way of taking models OK to abstract from private information, to the data that avoids many complica- strategic issues, reputation and so on, and tions; although these days many of us proceed by shifting the supply or demand

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curve? I don’t know the answer definitively multiple equilibrium considerations, and so hut I think, provisionally yes. Similarly if on, each may have some elements of truth to we want to ask something basic about busi- them, Moreover, these models are not mutu- ness cycles, it seems reasonable to use the ally inconsistent, but are complimentary basic dynamic GE framework as the bench- special cases of a general framework (see mark, To readers interested in studying this Mortensen, 1989). We should not look for a in more detail, I recommend the hook simple single answer, Frontiers ofBusiness Cycle Research, edited by Are frictions in the labor market impor- Thomas Cooley tant, as Meltzer suggests? Yes, Can private information be a relevant consideration, as 4444545 Meltzer suggests? Yes. Does this mean a 4.44,44. 44r5_55545444, 44s4-554544444t move away from micro-foundations, or a It is commonly believed that unemploy- move to new micro-foundations, is the answer? ment is a major economic and social problem. No. Many researchers have been working on We have not come up with a definitive model incorporating frictions and informational that explains unemployment or gives us a considerations into the standard paradigm panacea to cure unemployment. That is, we for years. It has been successful. Given this have not solved the problem. But we know success, I do not see any reason to argue to something about it and can study it scientifi- return to a reduced-form Phillips Curve cally We know that incentives matter, approach. My preferred alternative is to whereby I mean things like unemployment learn search theory and forge ahead, insurance, dismissal restrictions, tax policy ~8’~ and so on. These things can be built into economic models built on standard micro- ,454455fl4N Sfl.Sv 41 foundations (constrained optimization and Not so long ago, there did not exist in coherent equilibrium concepts), and analyzed the literature a serious formal model of a both qualitatively and quantitatively dynamic monetary economy The overlap- Some of the issues are more or less ping-generations (OLG) model, invented by static: for example, the incentive effects of Samuelson (1958) and developed by many unemployment insurance on layoffs and hours people (see, for example, Wallace, 1980), has per worker (see, for example, Burdett and remedied this deficiency That model has Wright, 1989). Others are intrinsically been and continues to be an extremely dynamic. A major recent success concerns useful framework within which to illustrate the application of search models of labor theoretical properties of monetary economies, market dynamics to worker and job flow data, to interpret episodes in economic history to Combining the job creation-job destruction shed light on policy debates, and to discover data analysis of Davis and Haltiwanger (1990) new things about economics generally with the theoretical framework laid out, for Concerning the latter, it is worth remarking example, in Pissarides (1990) has proved that many technical discoveries, such as the fruitful. These authors have used dynamic possible inefficiency of competitive equilibrium, GE models based on search theory to or the potential for endogenous limit cycles account for the main empirical features of and sunspot equilibria, revolved closely the labor market, like the job creation and around the analysis of OLG models (see, for job destruction data (see, for example, example, Azariadis, 1993), These discoveries Mortensen, 1994). These models can be seem important for macroeconomics. used to study policy interventions qualita- When Meltzer criticizes the OLG model, tively and quantitatively perhaps what he has in mind is that there are Of course, as I stated earlier, there is certain phenomena for which it is ill-designed more than one model of unemployment. to explain. One could belabor the obvious This is as it should be. There is more than and argue that money in the OLG model is one type of unemployment. Efficiency wage only a store of value and not a medium of considerations, insider-outsider considerations, exchange. But a model need not capture

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every feature or nuance of money in order to brought to bear on more mundane policy teach us something about monetary theory affairs. We have seen some of them discussed or policy More to the point, we now have at this conference. theoretical models in which money clearly Is it a problem that pure and applied and indisputably is a medium of exchange. monetary economics have not converged? Some of these models are built around search In any science, it should not be too surpris- frictions that capture Jevons’ famous “double ing that progress in pure and applied theory coincidence of wants” problem with direct proceeds in counterpoint and not in unison, barter; see, for example, Kiyotaki and Wright That is why monetary economics today is (1989) or Trejos and Wright (1995). Others vibrant and flourishing. are built around private information prob- lems; see, for example, Williamson and Wright (1994). GROYSTS Allan Meltzer, along with Karl Brunner, It was only about a decade ago that is on record as saying that private information macroeconomists were relatively uninterested is the driving force behind the use of money in growth theory and in policy directed toward in modern economies. He reiterates this economic growth. One reason may be that position in the current paper. Some of us our attention was directed toward other who work in monetary theory have taken issues—business cycles, unemployment and his position to heart and have attempted to money Another reason is that we were look- formalize these ideas. We do not think of ing at the wrong models. Although models ourselves as abandoning micro-foundations; with perpetual growth have been around for the models are built on search or private decades, the standard Solow model in the information frictions incorporated into textbooks is in the unfortunate position of microeconomic models with optimizing not explaining growth, except as a transitory agents and coherent equilibrium concepts. phenomenon on the way to a steady state I agree with Professor Meltzer when he or as the outcome of exogenous technical argues that we need to develop theories that progress. We owe something to Romer (1986) incorporate not only money but also other and Lucas (1988) for redirecting our attention. aspects of the real world, like brokers, dealers, There is now a plethora of endogenous market makers, intermediaries and so on, growth theories—arguably too many Given this, it seems that search-based models However, these models all have common of the sort analyzed by Rubinstein and threads that I hope will allow us to distill Wolinsky (1987), for example, are promising. common essence, We know that growth is Like much of the search-based monetary important as a matter of welfare, As com- theory, these models are primitive, but they pared to eliminating cyclical fluctuations in do address many of the issues that Meltzer GNP, getting the growth rate up a few per- correctly identifies as important. centage points is an order of magnitude more Due to their rudimentary nature, the important. Can we achieve higher growth by models to which Iamreferring are not yet better policy? Can we understand why dii very good at providing policy guidance. They ferent economies grow at different rates? do not answer, “What should we do at the The jury is still out, but these are obviously discount window next week?” I for one do interesting questions. The way to answer not think that this is the most interesting them is with standard economic theory. question in monetary economics. Even if When I say “standard economic theory,” one is interested mainly in policy there is Idonot mean that we should stick to the potential value in building qualitative models status quo when confronting issues for that help edify us and our students regarding which the textbook model is inappropriate. more basic issues. At the same time, monetary But going from Solow’s leading exatuple to a dynamic GE models currently exist that, model with non-decreasing returns is hardly although not as well-grounded in terms of a scientific revolution. Is there a role for first principles of microeconomics, can be private information or other frictions in

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modern growth theory? Potentially The approach. We have been since then mostly interaction of growth with financial develop- engaged in what Kuhn (1962) calls “normal ment and intermediation may be interesting science.” To be sure, there are disagreements, and important. Some work has been done and but there is a core of good people working more is in progress. But I did not see anything on interesting and important questions and in Meltzer’s approach that makes me want to making progress. stray from mainstream growth theory. The bottom line is that macroeconomics has made impressive advances on a large c~J~raJ f METHGGGLGGICAL, number of fronts. Today we have models built 5 4 on first principles—that is, on constrained 444: N *44 *44 44 optimization and a consistent concept of There have been many technical devel- equilibrium—of business cycles, unemploy- opments that have paved the way for these ment, money and growth. It is still true that successes in macroeconomics, One obvious good economists often have difficulty with innovation involves computational ability questions like, “What should we do at the Graduate students now have machines on discount window next week?” This may their desks that allow them to solve and sim- suggest the questions are ill-posed (although ulate dynamic GE models as homework in a Ido understand and have sympathy for the good first year macro-course. If one really many professional economists who cannot thinks that heterogeneity incomplete markets, ignore such questions because they get paid income distribution or related issues are to come up with answers), important, we now have the technology Perhaps I am too sanguine. How about and the power to solve models with these our failures? One thing that Melt,zer empha- complications; see Rios-Rull (1995). sizes that we are not so good at explaining There have been developments outside is sticky prices. This may be because we the domain of hardware, The publication of sometimes take the pricing aspect of the Stokey and others (1989) illustrates how we Arrow-Debreu paradigm too seriously We now all have access to a set of tools that few know that there are many ways to decentralize macroeconomists were comfortable with not a given allocation, Contracts, core-like coali- so long ago. The analysis of multiple equi- tions, reputation and several other institutions libria, including dynamic multiplicity are also possibilities, as Meltzer mentions. It endogenous limit cycles and phenomena like may be that agents get the allocation right sunspot equilibria have given us a new set of without using prices in the way that our ways to think about the world, Game theory textbooks assume. That is, in principle, prices has provided us with new’ ways of posing may “look” sticky but this need not have and solving strategic questions, including implications for welfare or policy bilateral bargaining problems that are central When do sticky prices matter? Sticky to some of the phenomena that Meltzer prices can he studied in dynamic GE models, emphasizes (see the references in the section as Ohanian and Stockman (1994), Cho and of monetary economics). Analysis of data, Cooley (1994) and others have shown. These like the job creation and destruction data, or authors do not explain why prices are sticky; the cross-country growth data, have given us rather, they investigate the implications of new things to think about and new ways of varying degrees of exogenous stickiness. confronting our models with reality Should we try to explain stickiness endoge- Lucas (1980) emphasized the interplay nously? Maybe, hut I was not convinced by between technical developments, on the one Mehtzer’s current article, hand, and deviations between theory and I would like to conclude by saying that I facts, on the other hand, as what leads to have always learned from Professor Meltzer, progress and change. He argues that this especially on questions in monetary econom- interplay was behind the emergence in the ics. It is worthwhile trying to take seriously 1970s of “rational expectations” macroeco- his notions of information theory as a foun- nomics and the downfall of the IS-LM dation for monetary theory In other areas, he

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is also posing interesting questions. Standard Pissarides, Christopher. Equilibrium Unemployment Theory Blockwell, macroeconomic GE models provide a venue 1990. for their analysis. Rios-Rull, Jose-Victor, “Models with Hetengeneous Agents,” in Thomas F. Cooley led.) Frontiers of Business Cycle Research. Princeton University Press, 1995, pp. 98-1 25. REFE RENCE 5 Ararindis, Costus. Inteitemparal Macroeconomics, Blnrkwell, 1993. Romer, Paul M. “Increasing Returns and long-Run Growth,’ Journal of Political Economy (October 1986), pp. 1002-37. Burden, Kenneth, and Randall Wright. “Unemploynent Insurance and Short-Time Compensation: The Effects on [ayoffs, Hours per Worker, Ruhinstein, Ariel, nod Asher Woliosky. “Middlemen,” QuarterlyJournal and Wages,” Journal of Political Economy (December 1989), pp. of Economics (August1987), pp. 581-93, 1419-96. Samuelsoo, Paul. “An Exact Consumption-Loan Model of Interest With Brunner, Karl, and Allan H. Meltrer, “The Uses of Money: Money in the or Without the Social Connivance of Money,’ Journal of Politicol Theory of an Exchange Economy,” The American Economic Review Economy (December 1958), pp. 467-82. (December 1971), pp. 784-805. Stokey, Nancy 1., Robert F. lucas, Jr., and Edward C. Prescott, Recursive Cho, lang-Ok, and Thomas F. Cooley. “The Business Cycle with Nominal Methods in Economic Dynamics. Harvard University Press, 1989. Contracts,” working paper (1994). Trelos, Alberta, and Randall Wright. “On the State of Macroeconomics,” Caoley, Thomas F. Frontiers of Business Cycle Research. Princeton Journal of Political Economy (No, 1, 1995), pp. 118-41. University Press, 1995. Wallace, Neil. “The Overlapping Generations Model of Fiat Money,” in Davis, Steven 1., and John Haltiwanger. ‘Gross Job Creation and John H. Kareken and Neil Wallace, eds. Models ofMonetary Destruction: Microeconomic Evidence and Macroeconomic Economies, Federal Reserve Bank of Minneapolis, 1980, Implications,” National Bureau of Economic Research Macroeconomics Williamson, Steve, and Randall Wright. “Bader and Monetary Exchange Annual (1990). Under Private Information,” The Americon Economic Review (March Hansen, Gary D. “Indivisible labor and the Business Cycle,” Journolof 1994), pp. 104-23, Monetary Economics (November1985), pp. 309-27. lucas, Rabert E., Jr, “On the Mechanics of Economic Development,” Journal of Monetary Economics (July 1988), pp. 3-42.

______“Methods and Problems in Business Cycle Theory,” Joumol of Money, Credit and Banking (November 1980, part 2), pp. 696Jl 5, Kiyotaki, Nabuhira, and Randall Wright. ‘On Money as a Medium of Exchange,” Journal ofPolitirol Economy (August1989), pp. 927-54, Kuhn, Thomas S. The Structure of Scientific Revolutions. University of Chicago Press, 1962, Kydtand, Finn E,, and Edward C. Prescott, “Time to Build and Aggregate Fluctuations,” Ecanometrico (November 1982), pp. 1345-/0, McGrotton, Ellen R, “The Macroeconomic Effects of Distortionary Taxation,” Journalof Monetary Economics (June1994), pp. 573-601, Mortensen, Dale f “The Cyclical Behavior of Job and Worker Flaws,” Journal of Economic Dynamics and Control (November 1994), pp.1 121-42.

______“The Persistence and Indeterminacy of Unemployment in Search Equilibrium,” Scandinavian Journal of Economics (June 1989), pp, 347-70, Dhanian, lee E,, and Alan C. Stockman. “Short Run Independence of Monetary Policy under Pegged Exchange Rates,” working paper (1994).

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