Dynamic Macroeconomics

15.6 Conclusion
In this chapter, we have considered the basic Keynesian approach, which
was associated with the development of macroeconomics from the mid-
1930s to the end of the 1960s.
We have seen that what separates classical from Keynesian models is the
assumption of nominal rigidity or gradual adjustment in nominal wages and

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the price level.
We have looked at the structure of the basic Keynesian models, assuming
initially a constant level of prices or nominal wages, and then gradual
adjustment of prices and nominal wages, based on the Phillips curve. We
also explored the theory of discretionary aggregate demand policy that was
originally developed on the basis of these models.
According to the basic Keynesian model, combined with the Phillips
curve, an increase in aggregate demand—either through government
expenditure (or a tax cut) or through an increase in the money supply—leads
to an increase in real income and employment, a reduction of unemployment,
and increased inflation. Conversely, a decline in aggregate demand leads to a
decline of real income and employment, an increase in unemployment, and
reduced inflation. As argued by Samuelson and Solow [1960], the short-term
objective of macroeconomic policy can be seen as the appropriate selection
of a discretionary mix of monetary and fiscal policies that would deliver the
desired combination of unemployment and inflation. Thus, the adoption of the
Keynesian approach led to a shift toward discretion in the determination of
monetary and fiscal policies.
The instability of the original Phillips curve observed in the late 1960s,
and the interpretation given to this instability by Phelps [1967] and Friedman
[1968], have since sparked a revolution in the analysis of aggregate
fluctuations and the evaluation of aggregate demand policies.
The literature has since moved in three directions. First, great emphasis
was placed on the microeconomic foundations of the determination of wages,
prices, the supply and demand for goods and services, and the determination
of the equilibrium unemployment rate. The result is that today both the new
classical and the new Keynesian approaches to aggregate fluctuations are
based on DSGE models with consistent dynamic microeconomic foundations.
Second, the instability of the original Phillips curve eventually led to the
adoption of the hypothesis of rational expectations: the hypothesis that
households and firms form inflationary expectations that take into account the
motives of governments and central banks to choose between inflation and
unemployment. The hypothesis of rational expectations is currently the key
hypothesis regarding the formation of expectations, not only about inflation,
but also about all future variables that affect the behavior of households,

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firms, and governments. This hypothesis is used by both the new classical
and the new Keynesian approaches.
Third, the debate on the appropriate use of monetary and fiscal policy has
shifted in favor of rules rather than discretion. The problem of
macroeconomic policy design is no longer a question of rules versus
discretion, but a question of the appropriate design of policy rules.
In the next four chapters, we analyze simplified dynamic stochastic
versions of new Keynesian models, highlighting their similarities to and
differences from new classical models in accounting for aggregate
fluctuations. We also consider the implications of different stabilization
policy rules.
1
. Keynes’ criticism of what he termed the “classical” theory focused on two fundamental postulates:
the equality of the real wage to the marginal product of labor and the equality of the real wage to the
marginal disutility of labor. See Keynes [1936, p. 5]. It is exactly these two postulates that determine
employment in the stochastic growth model we examined in chapter 13 and the competitive models
without capital of chapter 14. Keynes himself maintained the first postulate but dropped the second,
defining unemployment as involuntary.
2
. In many ways, as a primarily empirical relationship, the original Phillips curve was the ultimate
macroeconomic relationship without adequate microeconomic foundations. It was one of the first such
relationships to break down when policymakers attempted to exploit it.
3
. Keynes was fully confident of the novelty of the General Theory, not only about the equilibrating
mechanisms of markets for goods and services and labor, but also about capital markets. For example,
in a paper on the role of the interest rate, published after the General Theory, Keynes states that “the
initial novelty lies in my maintaining that it is not the rate of interest, but the level of incomes which
ensures equality between saving and investment.” (Keynes [1937, p. 250]).
4
. Whether this is because of an implicit assumption about liquidity constraints or the assumption that the
income and substitution effects from the interest rate cancel each other out is unclear from the
arguments put forward in chapter 8. A characteristic passage with regard to the role of the interest rate
is: “There are not many people who will alter their way of living because the rate of interest has fallen
from 5 to 4 per cent, if their aggregate income is the same as before” (Keynes [1936, p. 85]).
5
. The diagrammatic depiction of the Keynesian cross is due to Samuelson [1948], the first edition of
probably the most successful introductory textbook of economics ever. It was this textbook that first
embraced and popularized Keynesian macroeconomics in the United States and the rest of the world.
6
. The assumptions here are that output is at less than full employment and that an increase in aggregate
demand causes firms to increase labor demand, employment, and output. Implicitly, because of
involuntary unemployment, labor supply is assumed perfectly elastic in the short run.
7
. The explanation of the aggregate consumption function and the multiplier take up chapters 8 to 10 in
Keynes [1936] and constitute the most important analytical chapters of the early part of the General
Theory.

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8
. This form of the Keynesian model, which is a generalization of the Keynesian cross, is the most
popular and best-known version of the Keynesian model, as, following its adoption by Hansen [1949,
1953], it became the dominant model used in most intermediate macroeconomics textbooks.
9
. Keynes was fully aware of Fisher’s distinction between the nominal and the real interest rate, as is
evident in the discussion on pp. 140–143 of the General Theory. However, the implicit assumption in
his analysis was that inflationary expectations are given. This was, after all, consistent with the
assumption of short-run price rigidity.
10
. In chapter 13 (p. 172) of the General Theory, Keynes remarks that “Nevertheless, circumstances
can develop in which even a large increase in the quantity of money may exert a comparatively small
influence on the rate of interest.” In chapter 15 (p. 207) he returns to this issue, further remarking that,
“There is the possibility … that, after the rate of interest has fallen to a certain level, liquidity-preference
may become virtually absolute in the sense that almost everyone prefers cash to holding a debt which
yields so low a rate of interest. In this event the monetary authority would have lost effective control
over the rate of interest. But whilst this limiting case might become practically important in future, I
know of no example of it hitherto.” This case, although underplayed by Keynes himself, was given
prominence later by Keynesians who favored fiscal rather than monetary policy. As discussed in
chapter 20, this case acquired practical significance after the Great Recession of 2008–2009, when
short-term interest rates hit the zero lower bound.
11
. Again, this aggregate supply function has its origins in the General Theory. To quote: “with a given
organisation, equipment and technique, real wages and the volume of output (and hence employment)
are uniquely correlated, so that, in general, an increase in employment can only occur to the
accompaniment of a decline in the rate of real wages. Thus, I am not disputing this vital fact, which the
classical economists have (rightly) asserted as indefeasible” (Keynes [1936, p. 17]).
12
. This diagrammatic representation of the AD-AS model is due to Patinkin [1956].
13
. Here we are discussing full employment output, ignoring frictional or natural unemployment. The
definition of the natural rate of unemployment would depend on the particular labor market model
employed (Friedman [1968]). We examine the concept of the natural rate of unemployment in section
15.5 and analytical models of the natural rate in chapters 17 and 18.
14
. This model forms the basis of the so-called neoclassical synthesis, in the sense that depending on the
assumption about the flexibility of nominal wages, one could get either Keynesian or classical results.
15
. Supply shocks are thus not incompatible with the Keynesian approach. Negative supply shocks
seem to have been the cause of the problem of stagflation in the 1970s. See Bruno and Sachs [1985].
16
. The principle of acceleration, as a basis for a theory of investment, has a long history in the analysis
of business cycles. It assumes that investment is a positive function of the change in total output or the
change in consumption. Aftalion [1909], Bickerdike [1914], and Clark [1917] presented early analyses
of business cycles based on this principle. See Knox [1952] for a survey.
17
. For the solution of second-order linear difference equations, see appendix D.
18
. See Theil [1954, 1964] for a justification and an extensive discussion of such quadratic social
welfare functions.
19
. The curve actually estimated by Phillips [1958] had wage inflation and not price inflation on the left-
hand side. However, the same negative relationship applied to price inflation. Note that this negative
relationship between price inflation and unemployment had already been highlighted in the 1920s in a
neglected article by Irving Fisher. See Fisher [1926]. Thus, Fisher could also be credited with the
discovery of the Phillips curve, although for more than 30 years, his paper had no impact at all.

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20
. In effect, Samuelson and Solow [1960] applied the Tinbergen-Theil framework to an IS-LM model
augmented by a Phillips curve, although they did not put their argument in such terms. Also note that
Samuelson and Solow [1960] were very cautious in their interpretations of the evidence. They certainly
did not advocate that stabilization policy be conducted as if the Phillips curve were a stable and
immutable relationship.
21
. The concept of the natural rate of unemployment was defined by Friedman [1968, p. 8] as follows:
“The natural rate of unemployment … is the level that would be ground out by the Walrasian system of
general equilibrium equations, provided there is imbedded in them the actual structural characteristics of
the labor and commodity markets, including market imperfections, stochastic variability in demands and
supplies, the cost of gathering information about job vacancies and labor availabilities, the costs of
mobility, and so on.”
22
. To quote again from Friedman [1968, p. 17]: “By setting itself a steady course and keeping to it, the
monetary authority could make a major contribution to promoting economic stability.” This was a clear
argument in favor of policy rules rather than discretion. It is worth noting that Friedman was a
consistent advocate of policy rules. His favored policy was a constant rate of growth for the money
supply, as he thought that a policy of constant inflation was not feasible. See Friedman [1960].
23
. Equation 
(15.40)
 can be consistent with a number of alternative interpretations in analytical terms, as
the Phillips curve 
(15.39)
is postulated and not derived from specific analytical microeconomic
foundations. In chapter 17, we present a model in which the Phillips curve and the natural rate of
unemployment are determined by the behavior of labor market insiders, setting wages in order to secure
their own employment, while in chapter 18 we present a much richer matching model of frictions and
inefficiencies in the labor market, which also determines the natural rate of unemployment
endogenously.
24
. See chapter 9 for an introduction to and discussion of the adaptive expectations hypothesis.
25
. This case is sometimes referred to as the “accelerationist” hypothesis, as inflation is increasing
constantly. It was alluded to by Friedman [1968].
26
. Sometimes the natural rate of unemployment is referred to as the “nonaccelerating inflation rate of
unemployment,” because under adaptive expectations, it is the only unemployment rate at which
inflation is not changing continuously but remains constant.
27
. This is essentially an analysis of the optimal discretionary policy of the Tinbergen-Theil variety.
28
. Of course, the converse is also true. If the government pursues an unemployment target that is
above the natural rate, steady state inflation will be below the government target for inflation.
29
. See Lucas [1972], who introduced the hypothesis of rational expectations of Muth [1961] to
macroeconomics. We have studied models with rational expectations in chapter 9.
30
. Note that, following the insights of Kydland and Prescott [1977], Barro and Gordon [1983a,b],
Rogoff [1985], and others have provided a detailed analysis of the problem of rules versus discretion for
the case of the Phillips curve under rational expectations. We shall return to a more extensive and
formal analysis of the rules-versus-discretion debate in chapter 20 on the role of monetary policy.