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The Neoclassical Synthesis and Microfoundations

History of Modern Macroeconomics Lecture 6. The Empirical Microfoundations of Macroeconomics (1945-1970) Kevin D. Hoover Department of Economics Department of Philosophy Center for the History of Political Economy Duke University. The Neoclassical Synthesis and Microfoundations.

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The Neoclassical Synthesis and Microfoundations

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  1. History of Modern MacroeconomicsLecture 6. The Empirical Microfoundations of Macroeconomics (1945-1970)Kevin D. HooverDepartment of EconomicsDepartment of PhilosophyCenter for the History of Political EconomyDuke University Econ 314S History of Modern Macroeconomics Fall 2017

  2. The Neoclassical Synthesis and Microfoundations • How are micro and macro related? • distinct, but compatible • Neoclassical synthesis: Samuelson, Economics: An Introductory Analysis, 3rdedition (1955) • Interventionist attitude • The Neoclassical Synthesis: • already in Keynes: classical is special case of the general theory • picked up by Klein (The Keynesian Revolution) Econ 314S History of Modern Macroeconomics Fall 2017

  3. The New Empirical Macroeconomics • Walrasian: • general equilibrium • individual optimization (microfoundations) • IS-LM Keynesian • Aggregation • practice demands • must be eliminable in theory • work towards maximum disaggregation Lawrence Klein (1920- 2013 ) Econ 314S History of Modern Macroeconomics Fall 2017

  4. IS-LM-AS Sets the Agenda for Macroeconmetric Models Econ 314S History of Modern Macroeconomics Fall 2017

  5. The “Keynesian” Microfoundational Program • Consistency with microeconomics vs. derivation from microeconomics • Microeconomics as an analogical resource Econ 314S History of Modern Macroeconomics Fall 2017

  6. Microfoundations : Transactions Demand for Money (Baumol) – 1 Econ 314S History of Modern Macroeconomics Fall 2017

  7. Microfoundations : Transactions Demand for Money (Baumol) – 2 Econ 314S History of Modern Macroeconomics Fall 2017

  8. Microfoundations : Transactions Demand for Money (Baumol) – 3 • Implications: • Income-elasticity of money demand = ½ • Interest-elasticity of money demand = –½ • Compare to the Traditional Quantity Equation: • Income-elasticity of money demand = 1 • Interest-elasticity of money demand = undetermined (possibly zero) Econ 314S History of Modern Macroeconomics Fall 2017

  9. Microfoundations: The Kuznet’s Puzzle – 1 The “Keynesian” linear consumption function: C = a + bY mpc = b; if a > 0, then apc = C/Y = a/Y + b and falls as Y rises C Consumption Function mpc = b C* a apc = C/Y Y Y* Econ 314S History of Modern Macroeconomics Fall 2017

  10. Microfoundations: The Kuznet’s Puzzle – 2 Short-run consumption function Long-run consumption function falling apc constant apc Econ 314S History of Modern Macroeconomics Fall 2017

  11. The Permanent Income Hypothesis – 1 Individual Intertemporal Optimization Problem Qualitative Analogies Resolution of the Puzzle consumption related to asset value of income stream transitory income adds little to asset value  low mpc in short run transitory income cancels out over time higher mpc in long run Macroeconomic Implications Include interest rate and/or calculation of permanent income distinguish populations wage and salary earners from self employed separate analysis for nondurable consumption and durable consumption goods Econ 314S History of Modern Macroeconomics Fall 2017

  12. The Permanent Income Hypothesis – 2 The “Keynesian” linear consumption function: C = a + bY mpc = b; if a > 0, then apc = C/Y = a/Y + b and falls as Y rises Permanent Consumption Function C Apparent Consumption Function C* a Y* + rY apc = C/Y Y Y* + Y Y* Econ 314S History of Modern Macroeconomics Fall 2017

  13. The “Keynesian” Macroeconometric Strategy • Individual optimization analysis for each of the main “functions” in the macroeconomic model: • consumption function • investment function • money demand and supply functions • labor demand and supply functions • production functions • Use results as qualitative analogies: • variable choice • disaggregation • choice of functional form • Test at aggregate level Econ 314S History of Modern Macroeconomics Fall 2017

  14. Microfoundations of the Various “Keynesian” Functions • Transaction Demand for Money: Baumol (1952) • Speculative Demand for Money: Tobin (1958) • Consumption Function: Duesenberry (1949); Modigliani and Brumberg (1952); Friedman (1945; 1955) • Investment: Jorgensen (1966) • Production Function: (Franklin Fisher 1969) • Labor Supply: Lucas and Rapping (1969) Econ 314S History of Modern Macroeconomics Fall 2017

  15. Klein’s Modeling Agenda In contrast with the parsimonious view of natural simplicity, I believe that economic life is enormously complicated and that the successful model will try to build in as much of the complicated interrelationships as possible. That is why I want to work with large econometric models and a great deal of computer power. Instead of the rule of parsimony, I prefer the following rule: the largest possible system that can be managed and that can explain the main economic magnitudes as well as the parsimonious system is the better system to develop and use. [Klein 1992] Econ 314S History of Modern Macroeconomics Fall 2017

  16. Thanks  The End Econ 314S History of Modern Macroeconomics Fall 2017

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