Keynesian Economics vs New Classical

Topics: Keynesian economics, Macroeconomics, Economics Pages: 14 (4867 words) Published: July 28, 2013

New Classicals and Keynesians, or the Good Guys and the Bad Guys By Robert J. Barro, Harvard University

Keynesian Models When I was a graduate student at Harvard in the late 1960s, the Keynesian model was the only game in town as far as macroeconomics was concerned. Therefore, while I had doubts about the underpinnings of this analysis, it seemed worthwhile to work within the established framework to develop a model that was logically more consistent and hopefully empirically more useful. Collaborating with Herschel Grossman, we made some progress in clarifying and extending the Keynesian model. But that research also made obvious the dependence of the central results on fragile underlying assumptions. The model stressed the failure of private enterprise economies to ensure full employment and production, and the consequent role for active macro policies as instruments to improve outcomes. Shocks to aggregate demand - but not aggregate supply - were the key to business fluctuations, and mere changes in optimism or pessimism turned out to be self fulfilling. These properties, which seem odd to economists who think in terms of price theory and well-functioning private markets, suggest coordination problems on a grand scale. But this perspective hardly accords with the basic source of market failure that characterizes the standard Keynesian model. It is the mere stickiness of prices or wages, primarily in the downward direction, that accounts for the principal results. Of course, many macroeconomists think of price stickiness as an "as if" device - a problem that is not to be viewed literally, but instead as a proxy for serious matters, such as incomplete information, adjustment costs, and other problems of coordination among economic agents. But this viewpoint has not been borne out by subsequent research. For example, the incorporation of these serious matters does not support the Keynesian stress on aggregate demand, and also does not provide a normative basis for activist government policies of the usual Keynesian type. One important function of a macroeconomic model is to isolate the sources of disturbances that cause aggregate business fluctuations. Keynesian analyses focus on shocks to aggregate demand, and typically attribute these shocks either to governmental actions (disruptive or corrective fiscal and monetary policies), or to shifts in private preferences that influence consumption or investment demand. Keynes's own discussion referred to the "animal spirits" of businessmen, and the consequent volatility of investment demand due to shifting moods of optimism or pessimism. Thus, aside from governmental actions, the Keynesian model is not strong at pinpointing observable, objective events that cause recessions or booms.

Schweiz. Zeitschrift für Volkswirtschaft und Statistik, Heft 3/1989

264 One reason that Keynes may not have been troubled by this "deficiency" is that he viewed the private economy as inherently unstable. It did not take large (and presumably objectively observable) shocks to trigger a recession, because even a small shock - when interacting with the multiplier (and, in some models, also the investment accelerator) - could generate a significant and sustained drop in output and employment. Curiously, however, later Keynesian developments deemphasized the multiplier. For example, in the well-known IS/LM model (in which interest rates adjust and matter for aggregate demand) or in Keynesian analyses that incorporate some version of the permanent-income hypothesis, multipliers need not exist. These extensions do improve the model's fit with some facts about business cycles, such as the apparent absence of a multiplicative response of output to changes in government purchases and the relative stability of consumption over the business cycle. But the elimination of the multiplier means also that large responses of output, as in a substantial recession, require large impulses; hence, it...
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