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Competing schools of thought in macroeconomics - an ever-emerging consensus? Gerrard, Bill . Journal of Economic Studies ; Glasgow  Vol. 23, Iss. 1,  (1996): 53+.

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ABSTRACT  

Modern macroeconomics is a diverse and fast-developing subject area. It needs to be surveyed continually to

show how individual contributions generate collective progress towards a better understanding of the behavior of

the macro economy. However, most surveys of macroeconomics tend to focus on the existence of competing

schools of thought. A Modern Guide to Macroeconomics: An Introduction to Competing Schools of Thought by

Snowdon et al. (1994) provides a very comprehensive and detailed survey of macroeconomics to be recommended

to all those studying macroeconomics at an intermediate level or beyond. The guiding principle of the survey is

that economists disagree and these disagreements can be best understood in terms of seven competing schools

of thought: orthodox Keynesian, monetarist, new classical, real business cycle theory, new Keynesian, Austrian and

post-Keynesian. Leeds concludes: "There is a large amount of competition between the rival schools in economics

and an emphasis placed upon differences rather than similarities." But the "emphasis placed upon differences" is a

matter of interpretation. Undoubtedly macroeconomics is characterized by deep divisions, but there is also much

in the way of agreement between the schools which is often obscured by the concentration on disagreement. FULL TEXT  

Bill Gerrard: University of Leeds, Leeds, UK

ACKNOWLEDGMENT: This article is based on the following books: Chrystal and Price (1994), Cowen and Kroszner

(1994), Davidson (1994), Dore et al. (1994), Farmer (1993) and Snowdon et al. (1994).

Introduction

Modern macroeconomics is a diverse and fast-developing subject area.It needs to be surveyed continually to show

how individual contributions generate collective progress towards a better understanding of the behaviourof the

macro economy. However, most surveys of macroeconomics tend tofocus on the existence of competing schools

of thought (for example, Chrystal and Price, 1994; Phelps, 1990). A Modern Guide to Macroeconomics: An

Introduction to Competing Schools of Thought by Snowdon et al. (1994) provides a very comprehensive and

detailed survey of macroeconomics to be recommended to all those studying macroeconomics at an intermediate

level or beyond. The guiding principle of the survey is that economists disagree and these disagreements can be

best understood in terms of seven competing schools of thought: orthodox Keynesian, monetarist, new classical,

real business cycle theory, new Keynesian, Austrian and post-Keynesian. The authors conclude: "There is a large

amount of competition between the rival schools in economics and an emphasis placed upon differences rather

than similarities" (p. 418). But the "emphasis placed upon differences" is a matter of interpretation. Undoubtedly

macroeconomics is characterized by deep divisions, but there is also much in the way of agreement between the

schools which is often obscured by the concentration on disagreement.

This survey follows Snowdon et al. (1994) and others in considering the macroeconomic debate in terms of

different schools of thought. Seven schools are differentiated and classified as orthodox, new or radical. The two

orthodox schools, ISLM Keynesian and neoclassical/monetarist, were the early mainstream schools which

focused primarily on the determination of aggregate demand. The three new schools, new classical, real business

cycle and new Keynesian, are more recent mainstream schools which have put much greater emphasis on deriving

macro outcomes from choice-theoretic foundations.The two radical schools, Austrian and post-Keynesian, provide

a critique of mainstream methods of analysis and seek to develop alternative macro models which allow more

adequately for the essential dynamic nature of a monetary production economy. But, having set out the

differences between the schools, the degree of agreement is discussed. It is argued that macroeconomics can be

seen as an evolving classical-Keynesian debate from which a developing consensus is ever-emerging as current

disagreements are resolved, but new disagreements continually appear requiring the consensus to re-emerge.

The orthodox schools

Modern macroeconomics began with Keynes's General Theory (1936), which set the terms of the classical

Keynesian debate pursued ever since by the various schools of thought. Initially the debate followed Keynes in

focusing on aggregate demand and the possibility of involuntary unemployment due to deficient aggregate

demand. The standard presentation of Keynes's macro analysis is provided by the ISLM model, first proposed by

Hicks (1937). The ISLM model is derived from the three fundamental aggregate demand-side behavioural

functions: consumption (and saving), investment and demand-for- money. The two orthodox schools, the ISLM

Keynesian school and the neoclassical/monetarist school, can usefully be differentiated within the ISLM

flamework with respect to their views on the form of the three aggregate demand-side behavioural functions and

the macro implications. In essence, the orthodox schools differed over the strength of the Hicksian mechanism

(Modigliani, 1977). The Hicksian mechanism is the process by which a goods-market shock is automatically

partially offset by money-market feedback. Suppose there is a negative goods-market shock. The fall in income will

tend to reduce money demand, inducing a fall in the rate of interest which, in turn, will tend to stimulate investment

(and, possibly, consumption), thereby offsetting the initial demand shock. The strength of the Hicksian mechanism

depends on whether or not the rate of interest is primarily a goods-market or money-market phenomenon. The

classical view, enshrined in the loanable funds theory, is that the rate of interest is a goods-market phenomenon.

The strength of the Hicksian mechanism is positively associated with the interest elasticity of consumption and

investment. The Keynesian view, presented in the liquidity preference theory, is that the rate of interest is

determined mainly by monetary conditions. The strength of the Hicksian mechanism is negatively associated with

the interest elasticity of money demand. A strong Hicksian mechanism implies that there is little need for

stabilization policies and that fiscal policy is relatively ineffective due to the crowding-out effect. The ISLM

Keynesian analysis implied that the Hicksian mechanism is weak. In contrast, the neoclassical/monetarist

analysis implies that the Hicksian mechanism is strong.

The ISLM Keynesian school

The ISLM Keynesian school dominated macroeconomics in the post-war period until the late 1960s. This school

sought to develop and extend Keynes's macro analysis within the ISLM framework. ISLM Keynesian analysis

supported the view that the rate of interest had little impact on the goods market. The simple Keynesian

consumption function implies that current income is the primary determinant of current consumption.

Subsequently this was justified as a disequilibrium phenomenon in Clower's dual decision hypothesis (Clower,

1965). More recently Campbell and Mankiw (1989) have argued that the sensitivity of current consumption to

current income is a reflection of binding liquidity constraints. ISLM Keynesian analysis also denied that the rate of

interest has a significant impact on investment. In contrast to the classical view of investment as a process of

factor substitution governed by relative factor prices, ISLM Keynesians stressed the capacity-adjustment role of

investment in the accelerator theory in which investment depends on changes in output (Chenery, 1952).

ISLM Keynesians treated the rate of interest as being of little significance in the goods market, but central to the

operation of the money and bonds markets. Keynes's own analysis had suggested that the speculative demand for

money is highly interest-elastic owing to the link between interest-rate movements and expectations of capital

gains or losses from holding bonds. In the extreme, in the so-called liquidity trap, the demand for money becomes

infinitely interest-elastic. The development of Keynesian microfoundations for the demand-for-money function

further strengthened the view that the demand for money is highly interest-elastic. The Baumol-Tobin inventory

model showed how the rate of interest would influence the transactions demand for money, as rational agents

sought to minimize the opportunity cost of holding non-interest-bearing money balances (Baumol, 1952; Tobin,

1956). Tobin (1958) also developed a portfolio model in which the demand for money is treated as part of a general

portfolio allocation problem with rational agents facing a choice between a range of assets offering differing risk-

return combinations.

Taken together the ISLM Keynesian theories of the aggregate demand-side behavioural functions implied that the

macro economy is potentially highly volatile. The weakness of the Hicksian mechanism implied that macro shocks

would result in significant multiplier effects. This Keynesian conclusion was extended to both long-run growth and

the short-run dynamics of the business cycle. The Harrod-Domar growth model showed that the multiplier and

accelerator mechanisms implied an equilibrium (or warranted) growth rate with knife-edge properties (Domar,

1946; Harrod, 1939). Analysed in the form of difference equations, the multiplier-accelerator interaction can

generate cycles and, possibly, explosive instability (Hicks, 1949; Samuelson, 1939).

However, the ISLM Keynesian proposition of involuntary unemployment because of deficient aggregate demand

rested on assumptions about aggregate supply. Modigliani (1944) showed that, except for extreme cases of

demand-side maladjustment, such as the liquidity trap or interest-inelastic investment, the Keynesian proposition

rested on the assumption of rigid money wages. This conclusion was further reinforced by the subsequent

neoclassical emphasis on the wealth effect, especially the Pigou effect, as the means by which price deflation

could automatically offset a negative demand shock. Modigliani's critique provided the basis of the neoclassical

synthesis in which Keynes was seen as a theorist of the macro implications of price and wage rigidity.

The Phillips curve (Phillips, 1958) was eagerly embraced by the ISLM Keynesian school as a means of introducing

price dynamics into its model. The empirical claim of a stable relationship between the rate of change of money

wages and unemployment fitted the simple Keynesian demand-pull theory of inflation. The rate of price inflation

could now be determined endogenously within the extended ISLM model, thus establishing a direct link between

aggregate demand and unemployment, under conditions of price flexibility.It also implied the possibility of a stable

trade-off for policymakers between inflation and unemployment.

Overall the ISLM Keynesian school denied that either the rate of interest (i.e. the Hicksian mechanism) or price

deflation (i.e. the wealth effect) could provide an effective self-correcting mechanism in response to aggregate

demand shocks. Hence there is a role for stabilization policy to maintain sufficient aggregate demand to ensure

continuous full employment.

The neoclassical/monetarist school

The neoclassical/monetarist school emerged as a response to ISLM Keynesianism, restating and developing the

classical view that the macro economy is self-adjusting towards full employment. The neoclassical/monetarist

school gradually shifted the emphasis of the macroeconomic debate to the behaviour of the supply side,

introducing the concept of the natural rate of unemployment which has become the starting point for all

subsequent mainstream schools of thought.

The neoclassical/monetarist school highlighted the importance of the rate of interest in determining consumption

and investment. Neoclassical/monetarist theories of the consumption function adopted an intertemporal

perspective. The permanent income hypothesis (Friedman, 1957) and the life cycle hypothesis (Ando and

Modigliani, 1963) downplayed the role of current income, stressing instead the importance of expected future

income, the stock of wealth and the rate of interest. The incorporation of rational expectations into the

intertemporal consumption function implied that changes in consumption follow a random walk (Hall, 1978).

Similarly, the neoclassical/monetarist approach to investment focused on the cost of capital, with the rate of

interest as a key component (Jorgenson, 1967).

The neoclassical/monetarist treatment of the rate of interest as a goods-market phenomenon went hand-in-hand

with the revival of the quantity theory of money. Friedman (1956) adopted a portfolio allocation approach and

argued that the demand for money is a highly stable function of a limited number of variables. Unlike the ISLM

Keynesian emphasis on the money-bonds substitution, Friedman stressed that money should be viewed as a

substitute for a wide range of financial and real assets, implying that the demand for money is not highly interest-

elastic. This portfolio allocation approach also implies that changes in the money supply can have a direct impact

on aggregate demand.

The development of the neoclassical/monetarist approach culminated in the natural rate model. Friedman (1968)

explained the breakdown of the Phillips curve as a misspecification problem. The original Phillips curve postulated

a relationship between the rate of change of money wages and unemployment. Friedman argued that a

consideration of the microeconomics of the labour market would suggest a relationship between the expected rate

of change of real wages and unemployment. This expectations-augmented Phillips curve allowed for shifts in the

short-run unemployment-inflation trade-off owing to changes in expected inflation. However, in the long run there

is no trade-off.The economy tends to the natural rate of unemployment, the long-run supply-side equilibrium

determined by the real structural characteristics of the macro economy. The equilibrium rate of inflation is

determined by the rate of monetary expansion.

The neoclassical/monetarist school viewed the macro economy as essentially self-adjusting. Hence there is no

general need for stabilization policies. Demand management policies could only affect the rate of interest and

unemployment in the short run, but fine-tuning of the macro economy is unattainable, since policy makers have

inadequate information of the lag structure. Policy makers should aim to create a stable environment for the

effective operation of the real economy by preventing monetary forces from being a major source of disturbance.

In particular, Friedman (1968) advocated a publicly-stated policy of steady, moderate monetary growth.

The new schools

The initial macroeconomic debate focused on the determination of aggregate demand, but the emphasis gradually

shifted towards the supply side and its microfoundations. The process began with the neoclassical synthesis

which interpreted Keynesian economics as the economics of price and wage rigidity. The lack of adequate

microfoundations for Keynesian macroeconomics came to be seen as critical following the breakdown of the

Phillips curve. Friedman's natural rate hypothesis explicitly introduced the supply side and explained short-run

fluctuations in output and employment as the consequence of expectational errors. This formed part of the "new

microeconomics" of unemployment and inflation (Phelps, 1970) in which macro outcomes are explained in terms

of informational imperfections at the micro level, the major example being search theories of unemployment. This

change in focus has led to the development of three new mainstream schools of thought: the new classical school,

the real business cycle school and the new Keynesian school. All three new schools are characterized by the

objective of explaining the behaviour of the macro economy in choice-theoretic terms.

The new classical school

The new classical school emerged in the early 1970s, with the objective of developing the monetarist macro model

on a far more secure axiomatic basis. The two characteristic assumptions of the new classical school are the

rational expectations hypothesis (REH) and continuous market clearing. Friedman's expectations-augmented

Phillips curve had focused attention on the role of expectations in determining the dynamic adjustment path of the

macro economy in response to an exogenous shock. But Friedman's conclusion of a short-run inflation-output

trade-off depends on adaptive expectations.The notion of backward-looking agents prone to systematic

expectational errors does not sit easily with the axiom of rationality. The REH, developed by Muth (1961), proposes

that forward-looking agents form their expectations as the mathematical expectation conditional on the available

information set. The REH offers a more acceptable assumption in choice-theoretic terms since rational

expectations display the twin properties of unbiasedness and orthogonality, thereby ruling out systematic

expectational errors.

The principal initial challenge faced by the new classical school was to reconcile the existence of serially-

correlated fluctuations about the natural rate (i.e. business cycles) with the twin assumptions of rational

expectations and continuous market-clearing. Lucas (1973) showed that monetary shocks could cause short-run

fluctuations even if agents are rational and forward-looking, because of the signal extraction problem. Agents have

insufficient information to distinguish between relative and absolute price changes. As a result, following a general

monetary expansion, it is rational to attach a non-zero probability to an observed price rise being a relative price

rise requiring a supply response. The supply response will tend to be negatively associated with the degree of past

variability in the general price level. Lucas (1975) developed this monetary-misperceptions model of aggregate

supply into an equilibrium business cycle theory, in which monetary shocks act as the impulse mechanism and

lags in investment act as the propagation mechanism.

The major contribution of the new classical school has been a thoroughgoing critique of stabilization policies.

Sargent and Wallace (1975) derived the policy irrelevance proposition by showing that, under rational expectations,

preannounced monetary policies could not generate expectational errors and, therefore, could not engineer any

movement away from the natural rate. Barro (1974) used the REH to develop the Ricardian equivalence proposition

that tax-financed and debt-financed fiscal expansions are equivalent, since forward-looking agents recognize that

the difference is the timing of tax liabilities and this has no effect on the intertemporal optimization provided there

are no liquidity constraints. Another implication of the REH is the Lucas critique of the use of large-scale

macroeconometric models for policy simulations and evaluations (Lucas, 1976). Such simulations are based on

the assumption that the model parameters remain invariant with respect to policy changes, but invariance is at

best problematic in the context of forward-looking agents whose behaviour may adjust in response to regime

shifts. A final important policy contribution of the new classical school has been the time inconsistency problem

arising from the strategic nature of policy announcements (Kydland and Prescott, 1977). Time-inconsistent

policies are optimal ex ante but generate incentives ex post for the policy maker to renege. Forward-looking agents

will recognize the incentive to renege and, therefore, the initial policy announcement is not credible. Barro and

Gordon (1983) show that a credible monetary policy can be established through reputation effects, but the

outcome is necessarily second-best compared to the unenforceable time-inconsistent first-best policy.

The real business cycle school

The real business cycle school grew out of the new classical school in the 1980s. The real business cycle school

rejects the importance that the monetarist and new classical schools attach to the non-neutrality of money in the

short run. Instead, the real business cycle school focuses almost entirely on the real economy. Money tends to be

treated as neutral, a side-show with little relevance to understanding fluctuations in output. The seminal paper

which initiated the real business cycle school is Kydland and Prescott (1982).

The real business cycle school emphasizes the importance of understanding economic behaviour from the

perspective of intertemporal optimization.In particular, much stress is put on the intertemporal aspects of the

labour supply decision. Intertemporal labour substitution implies that aggregate supply is affected by movements

in the real rate of interest. This creates a transmission mechanism whereby changes in real aggregate demand can

induce changes in output.

The real business cycle school rejects the new classical emphasis on monetary shocks as the impulse mechanism

generating business cycles.Rather, the impulse mechanism is provided by real technological shocks which shift

the aggregate production function, either permanently or temporarily. These technological shocks generate,

respectively, long-run growth and short-run cyclical fluctuations via two propagation mechanisms: the

embodiment of technological progress in the capital stock via investment and real wealth effects on consumption.

The time-to-build nature of technology (i.e. lags in investment) is viewed as the major cause of the observed serial

correlation in output movements.

An important methodological contribution of the real business cycle school, beyond the use of intertemporal

optimization, has been the tendency to move away from traditional econometric estimation as a means for judging

the empirical relevance of macro models. Instead, the real business cycle school has tended to rely on calibration

methods. This has, in part, been a response to the Lucas critique and the inherent difficulties in identifying the

"deep parameters" of macro models. The calibration method involves building a general equilibrium model with

specific functional forms and parameter values, and attempting to mimic the behaviour of the actual economy by

running computer simulations of the model subjected to a series of random technological shocks.

The new Keynesian school

The new Keynesian school emerged out of the reinterpretation of Keynes as a disequilibrium theorist, associated

with Patinkin (1956), Clower (1965) and Leijonhufvud (1968). From this perspective, involuntary unemployment is

seen as the outcome of quantity constraints generated by trading at non-market-clearing prices. Models of

generalized disequilibrium were developed by Solow and Stiglitz (1968), Barro and Grossman (1971) and

Malinvaud (1977). However, these disequilibrium models focus only on the effects of slow price and wage

adjustment. No explicit choice-theoretic explanation of price and wage rigidities is provided. This is the starting

point of the new Keynesian school. The new Keynesian economics represents the attempt to examine, by a

rigorous choice-theoretic method, the macroeconomic consequences of market failures at the micro level because

of a variety of structural, informational and other imperfections.

New Keynesian models can be classified usefully into four broad groups:

- (1) imperfect competition;

- (2) endogenous price and wage rigidity;

- (3) multiple equilibria and co-ordination failures; and

- (4) credit rationing.

Imperfect competition models investigate the macroeconomic implications of the quantity-restricting effects of

monopoly power. For example, Mankiw (1988) considered the case of an imperfectly competitive goods market but

perfectly competitive labour market, and showed that the size of the fiscal multiplier depends on the degree of

competition in the goods market. Dixon (1987) introduced a unionized labour market and found that the

equilibrium outcome is characterized by lower levels of output and employment, but fiscal policy is totally

ineffective. Imperfect competition in the labour market is considered by McDonald and Solow (1981), who showed

that the monopoly union model can explain involuntary unemployment, but this result does not generalize to the

efficient bargain model. The insider-outsider model of Lindbeck and Snower (1986) allows for the asymmetric

distribution of bargaining power between the employed and unemployed. One explanation of this asymmetry is the

existence of firm-specific skills (Okun, 1981).

New Keynesian models of endogenous price and wage rigidity seek to explain price and wage rigidity as the result

of optimizing choices by rational agents. There are three principal models of price rigidity in the goods market:

conjectural equilibrium (Hahn, 1978; Negishi, 1979); menu costs (Mankiw, 1985); and near-rationality (Akerlof and

Yellen, 1985). Conjectural equilibrium explains price rigidity as the optimizing response of locally-rational atomistic

firms which act on the basis of conjectured local demand curves kinked at the current price. Menu costs are the

costs of altering prices set in advance of the transaction date. The principal effect of menu costs is to create an

asymmetry between contractions and expansions. From the social welfare perspective, there is too little price

adjustment after a negative demand shock but too much after a positive demand shock. The social costs of

involuntary unemployment are not reflected in the private costs affecting price-setting agents. This creates the

possibility of social gains from stabilization policy. Near-rationality models are based on the premiss that

imperfectly competitive firms may not fully optimize by adjusting prices in response to exogenous shocks, since

the private gains are only second-order. But simulations show that near-rationality behaviour can generate

significant first-order losses at the aggregate level, implying that monetary policy is effective in the short run.

There are three main new Keynesian models of endogenous wage rigidity: implicit contracts (Azariadis, 1975; Baily,

1974; Gordon, 1974); efficiency wages (Salop, 1979; Shapiro and Stiglitz, 1984; Solow, 1979; Weiss, 1980); and

long-term wage contracts (Fischer, 1977; Taylor, 1979). Implicit contracts are optimal risk-sharing arrangements

which can yield real wage rigidity and layoff unemployment. Efficiency wage models postulate that the

productivity of labour depends on the real wage. The optimal efficiency wage depends on the wage elasticity of

labour effort. The optimal efficiency wage may be above the market-clearing level, thus creating involuntary

unemployment. Efficiency-wage effects can arise because of effort-monitoring costs, labour turnover costs or an

adverse selection problem owing to screening costs. Long-term nominal wage contract models show that the new

classical policy irrelevance results are not robust to multi-period wage contracts, either synchronized or staggered,

even if agents form their expectations rationally.

An important theme to emerge from the new Keynesian economics is the possibility of multiple equilibria, with

some of these equilibria being Pareto-inefficient. Cooper and John (1988) have provided a game-theoretic analysis

of co-ordination failures (i.e. Pareto-inefficient equilibria). A necessary condition for the existence of multiple

equilibria is strategic complementarity.Co-ordination failures occur if there are positive spillovers, such as

technological externalities, owing to complementarities between factor inputs, trading externalities in which the

costs of market behaviour depend on the number of active participants, and demand externalities across sectors.

Diamond (1982), for example, proposed a search equilibrium model with multiple equilibria owing to trading

externalities. The possibility of co-ordination failures implies a role for stabilization policy to move the economy to

the Pareto-efficient equilibrium.

A final strand emerging in the new Keynesian literature is the possibility of non-market-clearing in the credit

market. Using an adverse selection argument similar to the efficiency wage model, Stiglitz and Weiss (1981) have

proposed that credit rationing (i.e. excess demand for credit) can be interpreted as an equilibrium outcome in

situations in which interest rate changes affect the average riskiness of the potential group of borrowers. Mankiw

(1986) has shown that the informational asymmetries in the credit market lead to an inefficient market equilibrium

which can be improved by government intervention. Furthermore, the market equilibrium is precarious such that

increases in the interest rate can lead to the collapse of the credit market.

The radical schools

The orthodox and new schools constitute mainstream macroeconomics. Beyond the confines of mainstream

macroeconomics lie the radical schools. The two most important radical schools in macroeconomics are the

Austrian schooland the post-Keynesian school. Both of these radical schools have become increasingly significant

in recent years. They share a number of common themes, such as the importance of time, money and uncertainty,

and the need for methodological change in mainstream macroeconomics, but their respective analyses lead to

very different views on the effectiveness of stabilization policy.

The Austrian school

The Austrian school originated during the marginalist revolution in the work of Menger, Bohm-Bawerk and von

Wieser. The Austrian approach was maintained and extended by Mises (1934) and Hayek (1931), but the influence

of the school declined markedly from the 1930s onwards until the last 20 years or so when it has undergone a

remarkable revival, particularly in the USA, as evidenced, for example, in the contributions of Garrison (1978) and

O'Driscoll and Rizzo (1985).

The key elements of the Austrian approach are time, uncertainty, money and the capital structure. The

methodology is individualistic and subjectivist.The Austrian approach focuses on the decisions of individuals who

have limited and ever-changing information about their economic situation. Thus, unlike mainstream

macroeconomics, Austrian economics has always been grounded in microfoundations. Macro outcomes are the

aggregate consequence of individual decisions made under conditions of uncertainty. Agents try to make the best

possible use of their partial knowledge. Entrepreneurs are motivated to exploit potentially profitable but uncertain

opportunities. The economy is viewed as an inherently dynamic process. Hence Austrian economists have

fundamental misgivings about the usefulness of the concept of equilibrium.

The central element in Austrian economics pertaining to the behaviour of the macro economy is the theory of the

business cycle. Mises (1934) and Hayek (1931) developed a monetary theory of business cycle, in which monetary

shocks have real effects via the rate of interest. Changes in the rate of interest affect the optimum length of the

production process. This, in turn, necessitates changes in the capital structure through investment. These

changes are not sustainable and are eventually reversed.

In many respects the Austrian school is classical in outlook, albeit with far more emphasis on the dynamics of the

adjustment process rather than equilibrium and comparative statics. The price mechanism is seen as an effective

means of co-ordination but prone to distortion by monetary disturbances. Hence the policy implications are

classical in the extreme. Stabilization policies are unnecessary and, indeed, likely to be harmful.

The post-Keynesian school

The post-Keynesian school is a very heterogeneous grouping, linked by a common Keynesian heritage and the

rejection of neoclassical economics. Post-Keynesians believe that Keynes broke away from orthodox economics in

a fundamental way. Hence they do not accept the mainstream Keynesian research programme as a legitimate

interpretation and development of Keynes's General Theory (1936). However, beyond the rejection of neoclassical

economics, the principal characteristic of the post-Keynesian school is its diversity, encompassing a number of

alternative, and sometimes conflicting, radical perspectives such as the institutionalist, behavioural, Marxist,

Kaleckian and Sraffian. The objective of the post-Keynesian school is to justify, within a non-neoclassical

framework, the possibility of involuntary unemployment and the necessity and effectiveness of stabilization policy.

Post-Keynesian economics emerged from the attempts by Cambridge economists, primarily Robinson, Kahn and

Kaldor, to extend Keynes's analysis to the issues of growth, income distribution and inflation. Increasingly they

found ISLM Keynesianism to be too limited. Three particular developments in the late 1950s and the 1960s

provided the impetus for the emergence of post-Keynesianism as a recognized school in the 1970s: the capital

controversy, the breakdown of the Phillips curve and the Patinkin-Clower-Leijonhufvud reinterpretation of Keynes.

Eichner and Kregel (1975) identified four characteristic themes of post-Keynesian economics:

- (1) the growth and dynamics of an economic system expanding over time in the context of history;

- (2) the distributional effects of economic expansion;

- (3) the Keynesian constraints (i.e. the principle of effective demand);

- (4) a concern for the microeconomic base.

Harcourt (1982) also highlighted similar characteristic themes:

- an emphasis on the significance of time and uncertainty;

- the effects on the economic sphere of activity of social relationships and the institutional framework;

- the search for non-neoclassical microfoundations to Keynesian macroeconomics.

One prominent strand of thought within post-Keynesian economics is fundamentalist Keynesianism initiated by

Robinson (1964) and Shackle (1967), who stressed that the essential element in Keynes's break from classical

theory is his analysis of the importance of uncertainty as set out in Chapter 12 of the General Theory (1936) and in

the subsequent QJE 1937 article. This "old" Keynesian fundamentalism focused on the limitations of orthodox

methods of analysis in dealing with situations of uncertainty which cannot be modelled adequately in terms of

probability distributions. Robinson (1964) and Shackle (1967) were very critical of the concepts of equilibrium and

perfect foresight, arguing that Keynes had brought (historical) time back into economic theory. In recent years

there has been considerable development in the fundamentalist approach as a result of the analysis of Keynes's

earlier writings, especially A Treatise on Probability (1921) in which Keynes expounded a logical theory of

probability, with probabilities viewed as rational degrees of belief. This "new" Keynesian fundamentalism,

associated with Lawson (1985), Carabelli (1988), Fitzgibbons (1988) and O'Donnell (1989) among others, is

providing new possibilities for the development of a radical analysis of decision making under conditions of

genuine uncertainty.

Another important strand within post-Keynesian economics is the Kaleckian approach, which considers Kalecki's

independent formulation of Keynesian ideas to have more satisfactory microfoundations than Keynes's own

analysis. Kalecki assumed an economy made up of social classes and an industrial sector consisting of

imperfectly competitive firms engaging in mark-up pricing (see Sawyer, 1982; 1985). These twin microfoundations

have become characteristic assumptions of post-Keynesian macro models (e.g. Dutt, 1984; Rowthorn, 1981). A key

issue in the post-Keynesian approach has been the determination of the mark-up. Kalecki argued that the size of

the mark-up depends on the degree of monopoly, whereas Eichner (1973) developed a model of the large firm in

which the mark-up is set with respect to the objective of generating internal funds to finance investment.

Although there are tensions between different strands of thought within the post-Keynesian school, the general

tendency has been towards the acceptance of the need for greater pluralism. Increasingly, post-Keynesian

economics has become characterized by the "horses-for-courses" approach (Hamouda and Harcourt, 1988) or the

Babylonian mode of thought (Dow, 1985). There is a recognition of the need to draw on different perspectives to

understand economic behaviour more fully. Thus a post-Keynesian macroeconomics would incorporate Kaleckian

microfoundations of mark-up pricing and differential savings propensities for wage and profit income, the

Keynesian principle of effective demand, fundamentalist concerns on uncertainty and expectations, as well as a

more adequate treatment of the financial sector allowing for the endogeneity of the money supply. Davidson

(1994) is a representative statement of post-Keynesian macroeconomic theory and its foundation for successful

economic policies. Post-Keynesians have also remained more wedded to the need for price and wage controls

rather than monetary policy to prevent accelerating inflation. (See Dore et al., 1994, for a collection of essays

reassessing the possible future role of incomes policy.)

Some concluding thoughts: an ever-emerging consensus?

Macroeconomics has been characterized by an ever-evolving classical-Keynesian debate. The classical view is

that the macro economy is essentially self-regulating with the price mechanism acting as an effective co-

ordinating device ensuring the optimal outcome and rendering stabilization policy irrelevant. In contrast, the

Keynesian view is that the macro economy is subject to co-ordination failures necessitating the active use of

stabilization policy. These two conflicting views have provided the essential tension promoting progress in the

development of macroeconomics.

The defining characteristic of mainstream macroeconomics is the presupposition that the macro economy should

be interpreted as the aggregate outcome of optimizing choices by rational agents seeking to allocate scarce

resources between competing ends in a set of markets regulated by theprice mechanism. Within mainstream

macroeconomics a clear case can be made that the competing schools of thought have generated cumulative

progress. From this perspective, the Keynesian proposition of the possibility of co-ordination failure in the macro

economy has resulted in the elaboration of the macroeconomic consequences of structural, informational and

other imperfections at the micro level The different schools of thought have focused on different types of

imperfections. Mainstream Keynesians have tended to model those imperfections causing price and wage

rigidities and creating scope for effective stabilization policy. Mainstream classical schools, on the other hand,

have focused on informational imperfections which affect the quantities agents offer to trade, resulting in

equilibrium outcomes which deviate from the full-information equilibrium. The assumption of rational expectations

limits the nature of these informational imperfections to unpredictable stochastic shocks and, as a consequence,

severely limits the possibility of effective stabilization policy. It could be suggested that mainstream

macroeconomics is reaching the stage at which there is a theoretical consensus on the macro implications of

different types of imperfections. If this is the case, then mainstream macroeconomics needs to move towards

resolving the empirical question as to the nature and extent of the observed imperfections in the actual economy.

However, it is unlikely that mainstream macroeconomics will become a conflict-free zone in the foreseeable future,

given the difficulties in empirical testing between alternative theories in economics. An emerging disagreement is

whether or not econometrics should remain the principal method of empirical testing in macroeconomics or be

replaced by calibration methods, as advocated by the real business cycle school.

The radical schools represent an increasingly important source of dissent from the mainstream consensus. But

here too there are elements of agreement. There is a growing interconnection between the Austrian and post-

Keynesian schools, given their common concerns with time, uncertainty, money and the role of investment as a

transmission mechanism for business fluctuations.Both of these radical schools question the adequacy of

mainstream methodsof analysis, especially the excessive concern with equilibrium under conditions in which

agents have full information on the deterministic structure of the economic environment. But there are

developments in mainstream macroeconomics which parallel and merge with radical developments.For example,

the imperfect competition strand in the new Keynesian economics parallels the Kaleckian strand in post-

Keynesian economics. There is a merging of new classical and Austrian perspectives in the new monetary

economics (see Cowen and Kroszner, 1994, for a survey and historical perspective). There are also elements of

Austrian business cycle theory in the new classical equilibrium business cycle theory. Indeed, there is almost

universal agreement across schools that investment is the crucial propagation mechanism generating business

cycles. More controversially it can also be argued that mainstream schools are beginning to appreciate the

significance of the radical preoccupation with uncertainty and bounded rationality. The REH is having a radical

subjectivist impact on mainstream macroeconomics as attention turns to the implications of limited information

sets and the possibility of self-fulfilling prophecies and multiple RE equilibria (see Farmer, 1993 for a

comprehensive survey of these developments).

In conclusion macroeconomics is, and will remain, controversial as classical and Keynesian schools provide

contending views on the self-adjusting nature of the macro economy and the necessity or otherwise of

stabilization policy.This classical-Keynesian debate has been progressive and an ever-emerging, albeit partial,

consensus has resulted. However, there is an ever-present danger of fragmentation and excessively dogmatic

analysis and policy prescription.All schools of thought need to recognize more fully the inherent limitations of their

own perspectives. Progress in macroeconomics requires competition and co-operation.

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Vol. 88, pp. 526-38. DETAILS

Subject: Macroeconomics; Economic theory

Classification: 9130: Experimental/theoretical; 1120: Economic policy &planning

Publication title: Journal of Economic Studies; Glasgow

Volume: 23

Issue: 1

Pages: 53+

Number of pages: 0

Publication year: 1996

Publication date: 1996

Publisher: Emerald Group Publishing Limited

Place of publication: Glasgow

Country of publication: United Kingdom

Publication subject: Business And Economics

ISSN: 01443585

Source type: Scholarly Journals

Language of publication: English

Document type: Feature

ProQuest document ID: 220668840

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