I have a Google Doc with a long list of posts I’ve been meaning to write.
asserted
I → have → posts
Far down the list was a line that read “New Keynesian macroeconomics deserves a Nobel”.
asserted
macroeconomics → read → Nobel
Somehow I never got around to writing that post, and now I never will.
asserted
I → get → post
Because today, it happened!
asserted
it → happen → ?
This year’s Econ Nobel went to Bob Hall and Mike Woodford, two of the theory’s most important creators.
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Nobel → go → creators
First, let me say that this prize is long overdue.
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prize → let → ?
In 2009, I asked my PhD advisor, Miles Kimball, who was the greatest living macroeconomist.
asserted
who → ask → advisor
Without hesitation, he answered “Bob Hall”, and said he would be very surprised if Hall didn’t win the Nobel at some point.
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Hall → answer → point
Hall’s work is breathtakingly broad; if you want good summaries, I recommend Alex Tabarrok and Tyler Cowen (as usual).
asserted
I → want → Tabarrok
As for Michael Woodford, everyone I know assumed that if New Keynesian macro ever did get the prize, Woodford would be included, as he literally wrote the book on it.1
But anyway, let’s talk about New Keynesian economics — what it is, how it came about, why it’s important, and why it didn’t get a Nobel until now.
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it → know → Nobel
Let’s start with a brief history of modern macroeconomics.
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’s → let → macroeconomics
Back in the 1960s and early 1970s, most economists tried to understand the macroeconomy by looking at relationships between macroeconomic aggregates.
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economists → try → aggregates
For example, “If income goes up by 10%, how much will spending go up?”.
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spending → go → %
Or “If inflation goes up by 3 percentage points, how much will unemployment go down?”.
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unemployment → go → points
Suppose you see that when inflation rises, unemployment goes down.
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unemployment → suppose → ?
That correlation is called a Phillips Curve.
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correlation → call → ?
So you think “OK, if we raise inflation, more people will get jobs”.
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people → think → jobs
But you try that, and it doesn’t work — you push inflation up (by printing more money), but unemployment stays high.
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unemployment → try → money
The correlation you saw before has now broken down.
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you → see → ?
Now you’ve got two problems instead of one!
asserted
you → get → problems
This is a very simplified version of what a lot of economists think happened in the 1970s.
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lot → think → 1970s
Whether that’s what really happened is a story for another day.
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what → ’ → day
But the stagflation of the 1970s prompted the econ profession as a whole to rethink how it modeled the macroeconomy.
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it → prompt → macroeconomy
A lot of researchers asked: What parts of the macroeconomy are invariant to policy?
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parts → ask → policy
What are the solid foundations we can stand on, so that when we try to make some sort of change, we don’t cause our own theories to crumble?
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theories → stand → change
The answer most economists settled on was called “microfoundations”.
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economists → settle → ?
They reasoned that the basic drivers of individual and corporate economic behavior shouldn’t change when macro policies like interest rates and government spending change.
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policies → reason → rates
Most importantly, those drivers include:
Technology
Consumer preferences
The process by which people and businesses form expectations of the future
Do all three of these really stay the same when economic policy changes?
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policy → include → these
But it gave macroeconomists a place to start.
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it → give → place
So in the late 1970s and early 1980s, economists started to build macro models based on theories of individual and corporate behavior.
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economists → start → behavior
These were called “microfounded” macro models.
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These → call → ?
The last of those three “microfoundations” — expectations — was particularly thorny to think about.
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last → think → microfoundations
Almost any sort of expectation-formation process that you write down allows policymakers to trick people over and over, by surprising them systematically.
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policymakers → write → them
Economists thought that eventually, people should wise up to the government’s tricks.
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people → think → tricks
So they came up with the idea that consumers and businesses should, on average, be as smart as the economists making the models.
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consumers → come → models
If economists write down a model of how the world works, that model should be the average person’s mental model in the model.
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model → write → model
Basically, people generally know how the economy works, and they plan accordingly.
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they → know → ?
This idea is called “rational expectations”.
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idea → call → ?
In 1978, Bob Hall wrote a very influential paper that convinced a lot of economists that this was the right track.
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this → write → economists
Hall wanted to test a simple idea, originally developed by Milton Friedman: If people plan out their consumption in advance, then changes in the level of consumption should be completely random.3
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changes → want → consumption
…and 93 more, not listed.
The Aporia
