There is much about which all economists agree. There are also differences of opinion, both
in the positive economics of how the world actually works and in the normative economics
of how the government should behave.
Economic theories should be tested against the facts. In some cases, tests do not yield
conclusive answers. Some variables, such as expectations, are unobservable. The world is
also changing. It may be impossible to obtain enough data on the world as it is today to
allow definitive empirical tests of competing theories.
The major schools of macroeconomic thought can be viewed in relation to four key issues:
the speed with which the labour market clears, how expectations are formed, the possibility
of hysteresis and the relative importance of short run and long run.
New Classical macroeconomists assume market clearing is almost instant. Only
predetermined contracts prevent continuous full employment. Rational expectations imply
predetermined variables reflect the best guess at the time about their required equilibrium
value. Any foreseeable change is already built into these variables. Only pure surprises
cause temporary departures from full employment until preset variables can be altered and
full employment restored. With the economy near potential output, demand management is
pointless. Government policy should minimize surprises. Surprises apart, movements in
output reflect movements in potential output. Policy should pursue price stability and
supply-side policies to raise potential output.
Real business cycle theorists neglect even temporary departures from full market clearing.
They argue intertemporal decisions of households, firms and government can explain even
short-term fluctuations as movements in potential output.
Gradualist monetarists believe that restoration of potential output, though not instant, takes
only a few years. A big rise in interest rates could induce a deep albeit temporary recession
and should be avoided. Attempts at demand management may be counterproductive if the
economy is already recovering by the time a recession is diagnosed. The government
should not ‘fine-tune’ aggregate demand but concentrate on long-run policies to keep
inflation down and promote supply-side policies to raise potential output.
Moderate Keynesians believe automatic restoration of full employment can take many years
but will happen eventually. Although demand management cannot raise output without limit,
active stabilization policy is worth undertaking to prevent booms and slumps that could last
several years and therefore are diagnosed relatively easily. In the long run, supply-side
policies are still important but eliminating big slumps is important if hysteresis has
permanent effects on long-run equilibrium.
New Keynesians provide microeconomic foundations for Keynesian macroeconomics.
Menu costs may explain nominal rigidities. These are compounded by real rigidities in the
labour market. Several channels for hysteresis have now been developed.
Extreme Keynesians believe departures from full employment may be protracted. Keynesian
unemployment does not make real wages fall and may not even reduce inflation. Even if it
does, aggregate demand may not respond to lower interest rates if pessimism is high. The first responsibility of government is not supply-side policies to raise potential output that is
not attained anyway, but restoration output to potential output by expansionary fiscal and
monetary policy, especially the former.
