A Macroeconomics Reader

By Brian Snowdon; Howard R. Vane | Go to book overview

17

Understanding real business cycles

Charles I. Plosser

Journal of Economic Perspectives (1989) 3, Summer, pp. 51-77

The 1960s were a time of great optimism for macroeconomists. Many economists viewed the business cycle as dead. The Keynesian model was the reigning paradigm and it provided all the necessary instructions for manipulating the levers of monetary and fiscal policy to control aggregate demand. Inflation occurred if aggregate demand was stimulated ‘excessively’ and unemployment arose if demand was ‘insufficient’. The only dilemma faced by policymakers was determining the most desirable location along this inflation-unemployment tradeoff or Phillips curve. The remaining intellectual challenge was to establish coherent microeconomic foundations for the aggregate behavioral relations posited by the Keynesian framework, but this was broadly regarded as a detail that should not deter policymakers in their efforts to ‘stabilize’ the economy.

The return of the business cycle in the 1970s after almost a decade of economic expansion, and the accompanying high rates of inflation, came as a rude awakening for many economists. It became increasingly apparent that the basic Keynesian framework was not the appropriate vehicle for understanding what happens during a business cycle nor did it seem capable of providing the empirically correct answers to questions involving changes in the economic environment or changes in monetary or fiscal policy. The view that Keynesian economics was an empirical success even if it lacked sound theoretical foundations could no longer be taken seriously.

The essential flaw in the Keynesian interpretation of macroeconomic phenomenon was the absence of a consistent foundation based on the choice theoretic framework of microeconomics. Two important papers, one by Milton Friedman (1968) and the other by Robert Lucas (1976), forcefully demonstrated examples of this flaw in critical aspects of the Keynesian reasoning and set the stage for modern macroeconomics.

A central feature of the Keynesian system of the 1960s was the tradeoff between inflation and some measure of real output or unemployment. Friedman argued that basic microeconomic principles demanded that this long-run Phillips curve must be vertical. That is, general microeconomic principles implied that individuals (firms) maximizing their utility (profit) resulted in real demand (and supply) curves that are homogeneous of degree

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