Federal Reserve Bank of Minneapolis Quarterly R6ViCW , Spring 1979 # * S 3 ^ £c After Keynesian Macroeconomics (P. n \ Cc;.%. ^SERsJt ^ ^ A Cloudy Future for Minnesota's Businesses (P. nf District Conditions (p. 24) Federal Reserve Bank of Minneapolis Quarterly Review vol. 3, no. 2 This publication primarily presents economic research aimed at improving policymaking by the Federal Reserve System and other governmental authorities. Produced in the Research Department. Edited by Arthur J. Rolnick, Kathleen S. Rolfe, and Alan Struthers, Jr. Graphic design by Phil Swenson and charts drawn by Mary K. Steffenhagen, Graphic Services Department. Address requests for additional copies to the Research Department, Federal Reserve Bank, Minneapolis, Minnesota 55480. The views expressed herein are those of the authors Articles may be reprinted if the source is credited and the Research and not necessarily those of the Federal Reserve Department is provided with copies of reprints. Bank of Minneapolis or the Federal Reserve System. After Keynesian Macroeconomics* Robert E. Lucas, Jr. Thomas J. Sargent Professor of Economics Adviser, Research Department University of Chicago Federal Reserve Bank of Minneapolis and Professor of Economics University of Minnesota For the applied economist, the confident and appar- ments involved) to other advanced countries and in ently successful application of Keynesian principles many cases have been amplified. These events did to economic policy which occurred in the United not arise from a reactionary reversion to outmoded, States in the 1960s was an event of incomparable "classical" principles of tight money and balanced significance and satisfaction. These principles led to budgets. On the contrary, they were accompanied by a set of simple, quantitative relationships between massive government budget deficits and high rates of fiscal policy and economic activity generally, the ba- monetary expansion, policies which, although bear- sic logic of which could be (and was) explained to the ing an admitted risk of inflation, promised according general public and which could be applied to yield to modern Keynesian doctrine rapid real growth and improvements in economic performance benefitting low rates of unemployment. everyone. It seemed an economics as free of ideologi- That these predictions were wildly incorrect and cal difficulties as, say, applied chemistry or physics, that the doctrine on which they were based is fun- promising a straightforward expansion in economic damentally flawed are now simple matters of fact possibilities. One might argue as to how this windfall involving no novelties in economic theory. The task should be distributed, but it seemed a simple lapse of now facing contemporary students of the business logic to oppose the windfall itself. Understandably cycle is to sort through the wreckage, determining and correctly, noneconomists met this promise with which features of that remarkable intellectual event skepticism at first; the smoothly growing prosperity called the Keynesian Revolution can be salvaged and of the Kennedy-Johnson years did much to diminish put to good use and which others must be discarded. these doubts. Though it is far from clear what the outcome of this We dwell on these halcyon days of Keynesian process will be, it is already evident that it will neces- economics because without conscious effort they are sarily involve the reopening of basic issues in mone- difficult to recall today. In the present decade, the tary economics which have been viewed since the U.S. economy has undergone its first major depression thirties as "closed" and the reevaluation of every since the 1930s, to the accompaniment of inflation aspect of the institutional framework within which rates in excess of 10 percent per annum. These events monetary and fiscal policy is formulated in the ad- have been transmitted (by consent of the govern- vanced countries. This paper is an early progress report on this process of reevaluation and reconstruction. We begin *A paper presented at a June 1978 conference sponsored by the Federal Reserve Bank of Boston and published in its After the Phillips by reviewing the econometric framework by means Curve: Persistence of High Inflation and High Unemployment, Con- of which Keynesian theory evolved from disconnect- ference Series No. 19. Edited for publication in this Quarterly Review. ed, qualitative talk about economic activity into a The authors acknowledge helpful criticism from William Poole and Benjamin Friedman. system of equations which can be compared to data J in a systematic way and which provide an operational A0yt + A,yt-i + ... + Amyt_m = B()xt + B,xt-i (1) guide in the necessarily quantitative task of formulat- ing monetary and fiscal policy. Next, we identify + ... + BnXt-n + et those aspects of this framework which were central to its failure in the seventies. In so doing, our intent is to R e + R,e -, + ... + R e _ = u , R = I. (2) establish that the difficulties are fatal: that modern 0 t t r t r t () macroeconomic models are of no value in guiding policy and that this condition will not be remedied by Here yt is an (LX1) vector of endogenous variables, xt modifications along any line which is currently being is a (KX1) vector of exogenous variables, and et and pursued. This diagnosis suggests certain principles ut are each (LX1) vectors of random disturbances. which a useful theory of business cycles must have. The matrices Aj are each (LXL); the Bj's are (LXK), We conclude by reviewing some recent research con- and the Rj's are each (LXL). The (LXL) disturbance sistent with these principles. process ut is assumed to be a serially uncorrelated process with Eut = 0 and with contemporaneous co- Macroeconometric Models variance matrix Eutu! — £ and Eutu's = 0 for all t ^ s. The Keynesian Revolution was, in the form in which The defining characteristics of the exogenous vari- it succeeded in the United States, a revolution in ables xt is that they are uncorrelated with the e's at all method. This was not Keynes' (1936)1 intent, nor is it lags so that EutXs is an (LXK) matrix of zeroes for all the view of all of his most eminent followers. Yet if t and s. one does not view the revolution in this way, it is Equations (1) are L equations in the L current impossible to account for some of its most important values yt of the endogenous variables. Each of these features: the evolution of macroeconomics into a structural equations is a behavioral relationship, quantitative, scientific discipline, the development of identity, or market clearing condition, and each in explicit statistical descriptions of economic behavior, principle can involve a number of endogenous vari- the increasing reliance of government officials on ables. The structural equations are usually not regres- technical economic expertise, and the introduction 3 sion equations because the et's are in general, by the of the use of mathematical control theory to manage logic of the model, supposed to be correlated with an economy. It is the fact that Keynesian theory lent more than one component of the vector yt and very itself so readily to the formulation of explicit econo- possibly one or more components of the vectors yt_ b metric models which accounts for the dominant sci- • • • yt-nv entific position it attained by the 1960s. The structural model (1) and (2) can be solved for Because of this, neither the success of the yt in terms of past y's and x's and past shocks. This Keynesian Revolution nor its eventual failure can be reduced form system is understood at the purely verbal level at which Keynes himself wrote. It is necessary to know something of the way macroeconometric models are constructed yt = -Piyt-1 —... — Pr+myt-r-m + Qoxt +... (3) and the features they must have in order to "work" as + Or+nX -n-r + Ao'^t aids in forecasting and policy evaluation. To discuss t these issues, we introduce some notation. where4 An econometric model is a system of equations involving a number of endogenous variables (vari- ables determined by the model), exogenous variables (variables which affect the system but are not af- 'Author names and years refer to the works listed at the end of this fected by it), and stochastic or random shocks. The paper. 2 idea is to use historical data to estimate the model and Linearity is a matter of convenience, not principle. See Linearity section below. then to utilize the estimated version to obtain esti- 3A regression equation is an equation to which the application of mates of the consequences of alternative policies. ordinary least squares will yield consistent estimates. For practical reasons, it is usual to use a standard 4 2 In these expressions for Ps and Qs, take matrices not previously linear model, taking the structural form defined (for example, any with negative subscripts) to be zero. 2 Federal Reserve Bank of Minneapolis Quarterly Review/Spring 1979 1 Ps = Ao . £ RjAs-j other components, selected by policy, one needs to = 00 j — know the structural parameters. This is so because a change in policy necessarily alters some of the struc- QS = V. £ RjBs-j. tural parameters (for example, those describing the past behavior of the policy variables themselves) and The reduced form equations are regression equa- therefore affects the reduced form parameters in a highly complex way (see the equations defining Ps tions, that is, the disturbance vector A~dut is orthog- onal toy -i, ..., y - _ ,x , ..., Xt-n-r-This follows and Os above). Unless one knows which structural t t r m t parameters remain invariant as policy changes and from the assumptions that the xs are exogenous and which change (and how), an econometric model is of that the u's are serially uncorrelated.