Three principles. The GEM Project identifies three principles that constitute the core of usable macro theory in highly specialized economies. The compact set supports stabilization and growth policymaking while still being fully microfounded by rational transactions organized by dynamic general decision-rule equilibrium. The first two are recognized as the familiar hypotheses from which Samuelson cobbled together his Neoclassical Synthesis in the 1950s. (For elaboration, see Solow et al. (1997).) The third is a generalized-exchange innovation that transforms the two Early Keynesian (EK) assumptions into fundamental principles that are consistent with both with the relevant evidence and the neoclassical tenets of optimization and equilibrium.
First, the trend behaviors of total production and employment are predominately driven by the supply side of the economy, i.e., input dynamics and total factor productivity. Potential GDP largely depends on growth in the labor force and overall worker productivity, which in the GEM two-venue model class depends on capital accumulation, technological change, market efficiency, Lewis Transfer, and the organization of large-scale production. The last two determinants are uniquely associated with the generalization of exchange. (See below.)
Second, fluctuations around macro trends are predominately motivated by disturbances in total nominal demand. This core proposition necessitates the careful construction of coequal real-side and nominal objectives by stabilization authorities, informing the discretionary management of aggregate spending, and has powerful implications for public policy. Nominal-to-real causality has, for at least a century, stirred great controversy among economists. Samuelson and other Early Keynesians simply assumed the centrality of nominal spending in their short-term macro modeling. More recently, the principal alternative view (supply-driven fluctuations) has been vigorously pushed by Real Business Cycle (RBC) and, less enthusiastically, New Keynesian theorists.
The key here is meaningful wage rigidity. Given MWR, it is indisputable that aggregate fluctuations are largely demand driven. The core problem has long been that the MWR Channel has no coherent place in friction-augmented general-market-equilibrium (FGME) modeling. The resulting dilemma has consumed generations of theorists. The demand-centric thesis fits the evidence but not rational behavior, while the supply thesis is consistent with market-centric optimization and equilibrium but flunks the test of the data. The shifting upper-hand in that fundamental debate has provoked century-long swings in the academy’s view of the usable macro core.
The third principle settles the usable-core debate. The GEM Project has demonstrated that MWR exists in continuous-equilibrium, rational-behavior macro modeling. It becomes the keystone of the usable macro core. Samuelson’s Neoclassical-Synthesis assumptions are converted into fundamental, fully microfounded principles of highly specialized economies. With the generalized-exchange derivation of a robust channel through which adverse nominal disturbances induce proportional involuntary job loss, the argument that fluctuations are predominately supply, not demand, driven becomes an artifact of arbitrarily restricting rational price-mediated exchange to the marketplace. The RBC-fluctuations thesis is rejected, this time definitively. Exchange generalization has produced a clear-cut winner in the long-standing debate over how to specify a usable macro core in which we all can, and should, believe.
FGME modeling and the practical macro core. Some additional thoughts on the market-centric general-equilibrium model class reinforce the Project’s main argument. RBC theory pioneered by Prescott and Kydland is rightly celebrated as the literature’s bedrock expression of coherent general-market-equilibrium (GME) thinking, providing foundations for early 21st-century mainstream macro analysis in the academy. Fluctuations in equilibrium employment must be voluntary, and the various shocks and associated propagations inducing those variations are inherently nonmonetary. Despite its well-earned status as a major intellectual achievement, GME high theory has been, and always will be, in conflict with much of the most important evidence on the stability of specialized economies. It must exist outside the usable core of macroeconomics.
Conscientious New Keynesians, desiring stabilization relevance and the familiarity of single-venue general-equilibrium macrodynamics, have made a career bet that they can identify one or more GME-endogenous frictions capable of rationally suppressing wage recontracting. The will-o’-the-wisp Super Friction would enable reconciliation of significant elements of the usable macro core and market-centric general-equilibrium modeling, breaking down the classical dichotomy and generating forced job loss in response to adverse demand shifts. Such a friction would likely not fully correct the failure to explain stabilization in modern economies but would solve a range of associated problems, providing greatly improved analysis of garden-variety business cycles.
The central difficulty with such aspirations is that the New Keynesians, like the great Early Keynesians who founded separate-branch macroeconomics, have badly underestimated the commanding internal coherence of the GME model class. The sought-after Super Friction remains elusive simply because it does not exist. The inherent power of wage recontracting within the coherent market-centric general-equilibrium framework enforces its nonexistence. New Keynesians must someday, hopefully sooner rather than later, accept that working wholly within the FGME model class makes their stabilization policy advice irrelevant and dangerous.
Addendum. The more general version of GEM microfounded nominal wage rigidities are manifested in MWR and chronic pure wage rent. PWR is extraordinarily powerful. Perhaps most notable is its capacity, in the workplace-marketplace synthesis, to ration workweek hours for LEV workers and good jobs for SEV workers. Rational wages chronically pushes all employees off the neoclassical market-centric labor-supply schedule, overturning significant operational theorems of mainstream friction-augmented general-market-equilibrium thinking. The implications for the first principle above are enormous.
Blog Type: New Keynesians Chicago, Illinois