Rethinking Macroeconomics in the Light of the Financial Crisis
24 Pages Posted: 21 Oct 2011
Date Written: October 20, 2011
The recent financial crisis showed that mainstream economics was quite unprepared to deal with it. Mainstream macroeconomics failed to envisage even the possibility of a financial crisis like the one that took place in 2008. Even worse, the institutional changes which made the crisis possible were inspired by the neoclassical thought based on the holy trinity of utter competition, rationality and efficiency.
In this paper, I start with an example showing how the neoclassical business cycle model does not contribute to the understanding of the recent economic crisis. But the dominance of this approach has deeply damaged the reputation of macroeconomics. So, it is time to question what has gone wrong with it and try to put it right. I argue that, due to the asymmetric behavior of prices and wages, an increase and a fall in aggregate demand require different approaches in macroeconomic theory. It seems much more reasonable to consider separately, on the one hand, the macroeconomics of inflation and, on the other hand, the macroeconomics of recession and depression. This would not be a different situation to the one we have today in physics where to describe the universe physicists employ different theories in different situations. I also argue that macroeconomics has to go back to its roots and recover its original aims and methodology.
This discipline was founded by Keynes. So, it seems natural to recover his original ideas as stated in the General Theory, which often differ from the so called Keynesian ones. A central contribution made by Keynes was to focus attention of economics on the economic aggregates. Another main Keynesian contribution is the concept of involuntary unemployment as an equilibrium state. The other key contribution by Keynes has been to identify the crucial role of investment in determining the level of output. Following Keynes´ ideas, Minsky added instability as a normal result of modern financial capitalism and developed his financial fragility theory. His work provides an agenda for policy reforms to attenuate economic fluctuations and avert economic crises. I also survey the contributions made by the different branches of Keynesian thought. In particular, I discuss the New Keynesian approach where unemployment is modeled as a disequilibrium phenomenon due to sticky prices and wages or to coordination failures. Although this approach departs from Keynes´ original definition of involuntary unemployment it allows developing the analysis in a general equilibrium framework, which permits taking into account the interactions across different markets as well as using DSGE models. I argue that sticky prices/wages may be postulated as assumptions in a model in order to represent their minor effect on quantities but economists should remember that this is why the assumption was introduced and not be tempted to argue that price/wage flexibilization may be the panacea to reaching full employment.
Keywords: macroeconomics, Keynes, RBC, coordination failures, New Keynesians, sticky prices, involuntary unemployment, price asymmetry, wealth effect
JEL Classification: E20, E12, B22, B40
Suggested Citation: Suggested Citation