BE HAVI ORAL MACR OEC ON O MICS AND MACR OEC ON O MIC BE HAVI OR Prize Lecture, Dece mber 8, 2001 by G E OR GE A. A KERL OF * Depart me nt of Eco no mics, U niversity of Califor nia, Berkeley, C A 94720-3880, U S A. Think about Richard Scarry’s Cars and Trucks and Things That Go. 1 T hi n k abo ut w hat t hat book wo ul d have looke d like i n seq ue ntial deca des of t he last ce ntury had Ric hard Scarry bee n alive i n eac h of t he m to delig ht a nd a muse children and parents. Each subsequent decade has seen the develop ment of ever more specialized vehicles. We started with the model- T Ford. We no w have more models of backhoe loaders than even the most precocious four- y e ar ol d c a n i d e ntify. W hat releva nce does t his have for eco no mics? I n t he late 1960s t here was a s hift i n t he job descri ptio n of eco no mic t heorists. Prior to t hat ti me micro- econo mic theory was mainly concerned with analyzing the purely co mpetiti- ve, general equilibriu m model based upon profit maxi mization by fir ms and utility maxi mizatio n by co nsu mers. T he macroeco no mics of t he day, t he so- called neoclassical sy nt hesis, appe nded a fixed mo ney wage to suc h a ge neral equilibriu m syste m. “Sticky money wages” explained departures fro m full e mploy me nt a nd busi ness cycle fluctuatio ns. Si nce t hat ti me, bot h micro a nd macroeco no mics have developed a Scarry-ful book of models desig ned to i n- cor porate i nto eco no mic t heory a w hole variety of realistic be haviors. For ex- a mple, “ The Market for ‘ Le mons’” explored ho w markets with asy m metric in- for mation operate. Buyers and sellers co m monly possess different, not identical infor mation. My paper exa mined the pathologies that may develop u n der t hese more realistic co n ditio ns. For me, t he st u dy of asy m metric i nfor matio n was a very first ste p to war d t he realization of a drea m. That drea m was the develop ment of a behavioral macroecono mics in the original spirit of Keynes’ Ge neral Theory. M a cr o- eco no mics would t he n no lo nger suffer fro m t he a d hockery of t he ne oclassical sy nt hesis, w hic h had over-ridde n t he e mp hasis i n The Ge neral Theory o n t he r ole of psyc h ol ogical a n d s oci ol ogical fact ors, s uc h as c og nitive bias, reci pr o- * T he a ut hor wo ul d like to t ha nk Ja net Yelle n for extraor di narily hel pf ul disc ussio ns a n d e dito- rial assista nce. He would also like to t ha nk He nry Aaro n, Willia m Dicke ns, Er nst Fe hr, Willia m Gale, and Robert Shiller for invaluable co m ments and the Canadian Institute for Advanced Researc h for ge nerous fi na ncial support. 1 See Ric har d Scarry (1974). 3 6 5 city, fair ness, her di ng, a n d social stat us. My drea m was to stre ngt he n macro- e c o n o mi c t h e or y by i n c or p or ati n g ass u m pti o ns h o n e d t o t h e o bs er v ati o n of suc h be havior. A tea m of people have participated i n t he realizatio n of t his drea m. Kurt Vo n negut would call t his tea m a ker ass, “a group of people who are unkno wingly working together to ward so me co m mon goal fostered by a larger cos mic in fluence.” 2 I n t his lect ure I s hall describe so me of t he be ha- vioral models developed by t his ker ass to provide plausible expla natio ns for macroecono mic pheno mena that are central to Keynesian econo mics. For t he sake of backgrou nd, let me take you back a bit i n ti me to revie w so me history of macroeco no mic t houg ht. I n t he late 1960s t he Ne w Classical econo mists sa w the sa me weaknesses in the microfoundations of macroeco- no mics t hat have motivate d me. T hey hate d its lack of rigor. A n d t hey sacke d it. They then held a celebratory bonfire, with an article entitled “ After Keynesian Macroecono mics.” 3 The ne w version of macroecono mics that they produced beca me sta ndard i n t he 1970s. Follo wi ng its neoclassical sy nt hesis predecessor, Ne w Classical macroecono mics was based on the co mpetitive, g e n er al e q uili bri u m m o d el. B ut it diff er e d i n b ei n g m u c h m or e z e al o us i n i n- sisti ng t hat all decisio ns – co ns u m ptio n a n d labor s u p ply by ho use hol ds, o ut- put, e mploy me nt a nd prici ng decisio ns by producers, a nd t he wage bargai ns bet ween both workers and fir ms – be consistent with maxi mizing behavior. 4 Ne w Classical macroecono mics therefore gave up the assu mption of sticky money wages. To account for une mploy ment and econo mic fluctuations, Ne w Classical eco no mists relied first o n i mperfect i nfor matio n a nd later o n tec h nology s hocks. T he ne w t heory was a step for ward i n at least o ne respect: price a nd wage decisio ns were no w based upo n explicit microfou ndatio ns. But t he be havioral assu mptio ns were so pri mitive t hat t he model faced extre me dif ficulty i n ac- counting for at least six macroecono mic pheno mena. In so me cases, logical i nco nsiste ncy wit h key ass u m ptio ns of t he ne w classical mo del le d to o utrig ht de nials of t he p he no me na i n q uestio n; i n ot her cases, t he ex pla natio ns offer- ed were merely tortuous. The six pheno mena are: – The existence of involuntary une mploy ment : In the ne w classical model, an u ne mployed worker ca n easily obtai n a job by offeri ng to work for just a s midgeo n less t ha n t he market-cleari ng salary or wage; so i nvolu ntary u n- e mploy ment cannot exist. – T he i m p act of mo net ary policy o n o ut p ut a n d e m ploy me nt : I n t h e n e w cl assi c al m o- del, mo netary policy is all but i neffective i n c ha ngi ng output a nd e mploy- me nt. O nce c ha nges i n t he mo ney supply are fully foresee n, prices a nd wa- 2 See http:// w w w.gibbsonline.co m/gibbsbooks.ht ml. 3 See Lucas a nd Sarge nt (1979). 4 Most of t hese p uzzles were dor ma nt at t he ti me; t hey were i n here nt i n t he literat ure, b ut t here was no active discussio n of t he m. Probably t he most active researc h progra m i n macroeco no mics during the late1960s was the develop ment of large scale macroecono metric models. The models of search une mploy ment by Phelps et al (1970) appeared i n t he late 1960s to a ns wer t he ques- tion: what is the meaning of une mploy ment? But they adopted a fra me work of search une mploy- me nt, w hic h was, by nat ure, vol u ntary. 3 6 6 ges c ha nge pro portio nately; real wages a n d relative prices are co nsta nt; a n d t here is no i mpact o n t he real eco no my w hatsoever. – The failure of de flation to accelerate when une mploy ment is high : The New Classical mo del pro d uces a n acceleratio nist P hilli ps C urve wit h a u niq ue na- tural rate of u ne mploy me nt. If u ne mploy me nt falls belo w t his natural rate, i n flatio n accelerates.