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 get 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 nominal wages and prices. 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.
