A Macroeconomics Reader

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

Introduction

The Keynesian propositions of involuntary unemployment, non-neutrality of money and extensive market failures do not rest easily alongside the Walrasian theory of general competitive equilibrium characterized by continuously cleared markets. Although these two strands of economics were brought together during the era of the neoclassical synthesis, the marriage was always potentially explosive. By the early 1970s the Keynesian model was under attack from both monetarists and the newly emerging new classical theorists, the latter being committed to Walrasian formalism with respect to their methodology. This crisis in macroeconomic theory could be reconciled in two ways. Either macroeconomic models could be adapted so as to be consistent with choice-theoretic neoclassical microeconomic theory within a general equilibrium framework, or, alternatively, microeconomic theory could be adapted so as to be consistent with Keynesian propositions. New classical economists chose the former route, new Keynesian economists have followed the latter route (see Greenwald and Stiglitz 1987; Snowdon et al. 1994). Hence new Keynesian economists inhabit a brave new world where co-ordination failures and macroeconomic externalities result from market imperfections such as those arising out of imperfect competition, incomplete markets, heterogeneous labour and asymmetric information (see Romer 1996; Dixon 1997).

New Keynesians and new classical/real business cycle theorists differ substantially over the ability and desirability of stabilizing the economy via the use of monetary and fiscal policy. However, new Keynesians fully endorse the call, initiated by Lucas, that macroeconomic models should be based on coherent microfoundations. Beyond this, however, there is little agreement on what constitutes an acceptable model of how markets work. Whereas new classical and real business cycle theorists employ the traditional neoclassical perfectly competitive framework based on a rational representative agent, new Keynesians recognize that whenever information is imperfect or markets are imperfectly competitive and incomplete the economy will fail to be Pareto efficient. Modern Keynesians regard these real world imperfections as the heart of the problem facing business cycle theorists. By incorporating the insights provided by modern market theory

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