Macroeconomics Models & Policy Prescriptions

At the urging of two of my colleagues here at BYU, I have been reading through an article by Chari, Kehoe & McGratten in the inaugural issue of the American Economic Journal Macroeconomics. A couple of quotes in the introduction caught my eye, especially with regard to the current debate over the stimulus package and the use of TARP funds.

Until recently, the major conflicts in macro policy in the postwar era were between the Old Keynesians and the neoclassicals. The Old Keynesian view is eloquently and forcefully summarized by Franco Modiglianai, who argues that the fundamental, practical policy implication that Old Keynesians agree on is that the private economy "needs to be stablized, can be stabilized, and therefore should be stabilized by appropriate monetary and fiscal policies." The neoclassical economists, of course, recommend quite different policies: commitment to low average inflation rates on the monetary side and tax-smoothing on the fiscal side. Moreover, neoclassicals argue that even efficient allocations could fluctuate sizably.

Something insufficiently appreciated today is that even though the New Keynesian model has many elements of the Old Keynesian stories, such as sticky prices, the New Keynesian policy implications are drastically different from those of the Old Keynesians and are remarkably close to those of the neoclassicals.


Most modern macroeconomists of both traditions use equilibrium models with forward-looking private agents, so a commitment to rules is essential for good economic performance. Even in the frictionless versions of modern models, efficient allocations fluctuate sizably. So, even under optimal policy, a model will display sizable business cycle fluctuations. Eliminating all of them is considered bad policy.