Wednesday, July 22, 2015

Who is the real revolutionary figure in modern macro, Friedman or Lucas?

Who's your daddy?

Just finished my summer macro class (last Friday actually; grades were due Monday). One of the things that always becomes important in the course is how to define the break between Keynes, or at least Keynes and the Old Neoclassical Synthesis, on the one hand, and Friedman and Lucas, in the case of the latter both the New Classical models (monetary misperception) and Real Business Cycle (RBC) models, on the other. Many authors suggest that Lucas should be considered, after Keynes himself, the great scientific revolutionary, and that Friedman's break is incomplete. It is the implicit view in Alessandro Vercelli's book  Methodological Foundations of Macroeconomics: Keynes After Lucas or explicitly in the more recent book by Michel De Vroey's Keynes, Lucas, d'une macroéconomie à l'autre.

The reasons adduced are associated to Friedman's model, which remains in many respects similar to the Neoclassical Synthesis one, that is, an ISLM with a Phillips Curve (PC) with gradual adjustment to the equilibrium position. In one sense it is true that in Lucas' equilibrium model endogenous variables are determined on the basis of real phenomenon, technology, preferences, and factor endowments. The model, which was further developed by RBC authors, emphasizes the intertemporal choices of between leisure and consumption, and the fact that production takes time, and requires inputs over several periods, and has led many to label it Walrasian, in contrast to the supposedly Marshallian model used by Friedman and the Neoclassical Synthesis Keynesians. The other significant difference is that stochastic processes, rather than deterministic ones, become relevant, and Dynamic Stochastic General Equilibrium (DSGE) became dominant [more on that in another post; issues have been dealt to some extent here].

Traditionally a Walrasian model is a General Equilibrium (GE) one, while a Marshallian model represents partial equilibrium. In that sense, the label is a bit of a misnomer, since the ISLM cum Phillips Curve model behind the Friedman’s aggregate demand and aggregate supply model is also a GE model. The Neoclassical Synthesis model solves for the simultaneous equilibrium of the goods, labor, money and bond markets. What Friedman added explicitly is the natural rate. The supply constraint.

The difference between Friedman and Lucas is really that in the Neoclassical Synthesis and Monetarist models some behavior is not derived from intertemporal maximization of individual agents, while that is not true in the RBC models. That should be seen not as a Walrasian feature, but as a result of the abandonment of the Principle of Effective Demand (PED), and the use of a Ramsey Intertemporal model to determine consumption. That is, a dynamic version of Say's Law. In that sense, like the New Classical School, the fundamental change, in this context, is that the equilibration between savings and investment is done by changes in the rate of interest, not income, and that only rigidities would deviate investment from full employment savings.

On the basis of these changes, it is hard to say that Lucas is the more revolutionary figure in modern macro. True, in Lucas framework, the main Monetarist conclusions are less effective or irrelevant. Only unanticipated monetary shocks have effects, and those are strange things to conceive. When shocks are anticipated, monetary shocks have no effects. However, when forced to discuss the Great Depression, Lucas admits that there is little evidence for the RBC view.

Lucas asks: “where is the productivity shock that cuts output in half in that period? Is it a flood or a hurricane? If it really happened, shouldn’t we be able to see it in the data?”* Lucas, even though he has accepted that most cycles are explained by productivity shocks remains convinced that the Great Depression resulted from a monetary contraction by the Fed, as in the Monetarist views of Friedman. And one wonders why that monetary contraction was unanticipated.

Also, even if more extreme, the results do not change the situation in the long run. That is, for Friedman too in the long run (anticipated or not) monetary shocks have no effects. The crucial theoretical variable is the natural rate.

In this sense, it seems that Friedman, and the return of the natural rate of unemployment, and implicitly the interest and output ones too, is crucial for explaining the return of the pre-Keynesian Wicksellian framework that is dominant with the New Macroeconomics Consensus (NMC). Even if Friedman had exogenous money, and a quantitative rule, rather than an interest one, and even if he believed in monetary shocks, rather than the real ones that Wicksell and modern macroeconomists emphasize. Modern macro is neo-Wicksellian, but it owes that to Friedman, more than to Lucas.

* Cited in DeVroey and Pensieroso here.

2 comments:

  1. Friedman himself described his movement as a "counter-revolution" for what it's worth. Also have you seen Vela Velupillai's work on Friedman's natural rate and Recursive Macro vs. Computable Macro?

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  2. Velupillai says: "The Lucasian revolution has, however, all but decimated the visions and prescriptions, for good and evil, propagated by Keynes and Friedman." My point is that there is a Monetarist Counter-Revolution, and that Lucas' stuff is not really central, at least not in the sense that Friedman is. The natural rate is the key concept, and that is Friedman. Lucas role is overrated. Velupillai seems to agree with the consensus. He is also to sympathetic with Friedman, which is not untypical of those that think that the major break was with Lucas.

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