D FYI F~ MAY/JUNE 1005 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~<and re’c tews and extends some research expressed in the paper. But even if this IfS he and his collaborators have been pur- is not exactly what Professor Meltzer had suing over the years. Some of the more or in mind, I believe that it is an interesting less technical points he presents, both with issue to debate. I hope the reader will regard to the theory and the evidence, will forgive me if it appears Iamdebating a straw undoubtedly be of interest to many macro- man, and indulge me the opportunity to economists. He does a good job of presenting present some of my own views on the state these technical points, and so my plan is not of macroeconomics. to discuss them in any detail here. Instead, I As I see it, economists have made want to address some more general method- remarkable progress in understanding things ological issues. That is, I plan to comment that bewildered us just two or three decades mainly on some remarks Meltzer makes on ago. I will describe this progress in four of the state of macroeconomics. the most important areas of macroeconomics: To provide some motivation for the business cycles; the labor market; monetaoy discussion, I would like to begin with a few economics; and growth. I will also discuss quotations from the Introduction to his some more general methodological issues paper. Meltzer says that “For decades, toward the end. This is not meant to say macroeconomists have listened to criticism that I am totally unsyanpathetic to the views from their professional colleagues about the of Professor Meltzer, merely that I think absence of micro-foundations for most of he overstates the case when he asserts that what they say and dolt is time to question existingmacroeconomic models are neither whether this now widely accepted approach fruitful nor promising. is likely to be fruitful.” He appears from his remarks to be of the 4545 N N opinion that the answer is no. While con- ceding that we may have learned one or two Two decades ago, few would have believed things over the years, the suggestion is that the following assertion: A frictionless, much of modern macroeconomics is at a dead competitive, non-monetary model built end, For example, “Overlapping generations around the one-sector growth model, models of money, intertemporal substitution abstracting from heterogeneity, distortionary theories of unemployment and productivity taxation, and many other [eatures of reality shock theories of the business cycle have not can generate time series that Look like proved frcaitful...[and] the results to date are those in the data when hit by impulses that not promising” [emphasis added]. He further seem like a reasonable representation of suggests that the current state of af[airs com- stochastic technological progress. Since pares to the Keyncsian-monetarist debates of the work of Kydland and Prescott (1982), a generation or so ago. Hansen (1985) and others, we know that the Presumably; he puts forward this assertion assertion is true, But I am sure that even so that the reader will he more sympathetic Kydland and Prescott would not have to the alternative approach provided in his expected it cx ante. paper. But what I want to do is question the Consider the original version of what I will FEDERAL RESERVE BANK OF ST. LOUIS 119 llFYIF~ MAY/JUNE 1995 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 FEDERAL RESERVE BANK OF ST. LOUIS 120 H FYI F~ MAT/JUNE 199$ 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.