solow, robert - is there a core of usable macroeconomics

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American Economic Association

Is There a Core of Usable Macroeconomics We Should All Believe In?Author(s): Robert M. SolowSource: The American Economic Review, Vol. 87, No. 2, Papers and Proceedings of theHundred and Fourth Annual Meeting of the American Economic Association (May, 1997), pp.230-232Published by: American Economic AssociationStable URL: http://www.jstor.org/stable/2950921.

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IS THEREA COREOF PRACTICALMACROECONOMICSTHATWESHOULDALLBELIEVE?

Is There a Core of Usable MacroeconomicsWe Should AllBelieve In?By ROBERT M. SOLOW*

Real output in most advanced capitalisteconomies fluctuates around a rising trend.One can argueabout whether it is best to thinkabout that trendas passing through successivecyclical averages, defined in one way or an-other, or best to think of it as passing throughcyclical peaks, or some othermeasure of po-tential output. While the outcome of that ar-gumenthas consequences for macroeconomictheory, I will bypass it for now.The important observation is that, on thewhole, the observed fluctuationsaround trendare contained within a moderatelynarrowcor-ridor. Unemployment rates tend to run be-tween, say, 5 percent and 10 percent in theUnited States. (Other countrieshave differenttypical ranges, and in each of them, the rangecan shift from time to time. It is important,theoretically and practically, to understandwhy;but thatremains anopen question.)Thereare notable exceptions to this generalization,of course, the most famous being the depres-sion of the 1930's; but they are exceptions.Again it is important o know why fluctuationsare so contained. This could reflect some nat-ural equilibrating process, or it could reflectthe intervention of automatic or discretionarygovernmentpolicy, or it could be a mixture ofboth. That is another issue on which opinionsdiffer.I think it is partof the usable common coreof macroeconomics that the trend movementis predominantlydriven by the supply side ofthe economy (the supply of factors of produc-tion and total factorproductivity) and thattheappropriate vehicle for analyzing the trend

motion s some sortof growthmodel,prefer-ablymine.Now, what about hose fluctuationsroundthe trendof potential utput?A momentago Iput the normalrangeof unemploymentatesat 5-10 percent.By Okun's aw I am talkingabout luctuationsf real GDP with an ampli-tude of 8-10 percent or so from peak totrough-contained, but not trivial. In mypictureof the usablecommoncore of macro-economics, those fluctuationsare predomi-nantlydrivenby aggregatedemandmpulses,and heappropriateehicleforanalyzing hemis some model of the various sources ofexpenditure.I amnotso obtuseas notto haveobservedthatthe whole pointof real-business-cycletheory is the assertion hatthese short-runmotionsof the economy are in fact supply-driven.But my view is thatthis explanationhas beenan empiricalailure,or at best a non-success.There arenow two possibilities.Asfor the first,I entertainhehopethatflexible,observantmembers f thereal-business-cycleschool, like MartinEichenbaum ndhis co-workers,have come moreor less to the sameconclusion, ndthey havefoundwaysto openupthefabricof theirunderlyingmodelso thatit will allow-or insist-that demand-sideimpulsesplay the dominant ole in short-runmacroeconomicluctuations.Thenthisprop-osition is indeed part of the usable core ofmacroeconomics,ndeconomists an go on toargueback and forth about the best way ofmodeling hose demand-sideorces.The othercase is that he situation s as be-fore,andthe real-business-cyclechool holdsmonolithicallyo theview thatshort-runluc-tuationsare just optimal supply-sideadjust-ments to unforeseeablehocksto tastes and* Departmentof Economics, MassachusettsInstituteofTechnology, Cambridge,MA 02139.

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VOL. 87 NO. 2 IS THEREA CORE OF PRACTICALMACROECONOMICS? 231

technology. In that case, I think they are mis-taken. I would still nominate the aggregate-demand origin of most short-runfluctuationsas part of the common core of macroeconom-ics, but I would have to recognize that there issome dissent from thatproposition.If fluctuations in aggregate demand domi-nate short-run variations in real output, thatmust be because some wages and prices arenot flexible enough to clear their marketsmore or less continuously. A lot of analyticaland econometric ingenuity has gone into fig-uring out why this is so. Probably severalmechanisms are at work, and many of them(especially, but not exclusively, in the labormarket) have been elucidated. Luckily therest of macroeconomics does not have tostand aroundand wait for this issue to be clar-ified further.There remains the question of the propermodeling strategyfor the macroeconomics ofaggregate demand in the short run. There aretwo main options; I know which I prefer, butI also know thatsome macroeconomists, evenamong those who would agree with me up tothis point, prefer the other.My choice would be to model the maincomponentsof aggregatedemandmore or lessopportunistically. By opportunistically Imean that whatever works (empirically)works. By more or less I mean I wouldwantconsumption functions, investment func-tions, importfunctions, and the like to look asif they could plausibly arise from aggregationof economic behavior of some reasonable kindat the micro level. That has always been thecustom in macroeconomics, and I would notwant to abandonit.The alternative, of course, is to impose thestructureof intertemporalutility-maximizationfrom the very beginning. Then the only ad-missible expenditure functions are those thatare very nearly exact aggregatesof first-orderconditions of some well-defined householdoptimization problem. This is obviously notthe time to rehash the argumentspro (other-wise you miss the deep, stable parametersal-together and replace them with too manysuperficialand unstableones) andcon (house-holds and firms are heterogeneous, satisficersat best, and driven by all sorts of motivesanyway).

Unless there is recent news, this argumentis still unsettled. I have said where I stand. Iwould nominate as part of the usable core ofmacroeconomics any reasonable, empiricallysuccessful set of equations for describing ag-gregate demand.Most such macroeconometricmodels are modified or extended versions ofsomething like IS-LM. One has to expect thestandardapproach n this area to change fromtime to time, both because economists learn todo these things better and because the under-lying behavior patterns actually do changefrom time to time, for all sorts of reasons thatare either too deep or too unpredictableto betreated as endogenous. I described this as anomination; I do not know if it could win anelection at all, let alone by any sort of com-fortable margin.So far I have left expectations out of theaccount, although all would agree that the re-sponse of the macroeconomy to disturbancewill depend on the beliefs, perceptions, andexpectationsof participants. would not knowwhat set of statements about these things de-serves to be included in the core of usablemacroeconomics.I feel acutely uncomfortablewith this unobservable fudge factor that is ca-pable of having drastic effects but is so con-jecturalthat it can be used to explain just aboutanything.Maybe there is a better way, but noone knows what it is.I supposeI shouldsay that the main, perhapsthe only, merit of the rational-expectationshy-pothesis in the macro field appears to be itsdefiniteness. The question is whether thatshould be thought of as a plus or a minus. Ican see a role for rational expectations inthe modeling of long-run equilibrium. Inthe short-run part of macroeconomics, therational-expectations hypothesis seems tohave little to recommend it. In that context, Isuspect that expectations are best handled adhoc, thatis, in a commonsense way. This takesself-discipline. If the dangerwith the rationalexpectations hypothesis is that it is too oftendefinitely wrong, the dangerwith my sugges-tion is that it may be vacuously right. That iswhat you get for dealing with unobservables.Here is one last observationin this connec-tion. One majorweakness in the core of mac-roeconomics as I have represented t is the lackof real coupling between the short-runpicture



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232 AEA PAPERS AND PROCEEDINGS MAY1997and the long-runpicture.Since the long runandthe shortrunmerge nto oneanother, nefeels they cannotbe completely ndependent.Thereare someobvious,perfunctoryonnec-tions:everyyear'srealizednvestment ets in-corporated n the long-run model. That isobvious. A more interesting question iswhethera major pisode n thegrowthof po-tentialoutputcanbe driven romthe demandside.Can demand reate ts own supply?Themagnitudes uggestthat it would be awfullydifficultfor a surgeof aggregatedemand ogenerate nough nvestment o provide heca-pacitynecessary oaccommodatet. In specialcircumstances t might be done, say, in aneconomythathas a pool of labor(rural, or-

eign) that t can mobilize.It mightalso workif strongaggregatedemand an inducea risein total factorproductivityTFP). This maybe less far-fetched hanit sounds, f we rec-ognizethata largepartof TFPoriginatesnotin the research aboratory, ut on the shopfloor,as productionworkers igureouthow togain a little efficiencyhereand a little there.The demand-drivenrowth torysoundsquiteimplausible o me under current onditions;but it is an exampleof the kind of questionthatneeds to be asked.Even thissparepictureof the core of prac-ticalmacroeconomicss far romempty.Thereis plenty o use. Therewill alwaysbe more ofind out.


solow, robert - is there a core of usable macroeconomics

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