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WHAT DO WE KNOW ABOUT MACROECONOMICS THAT FISHER AND WICKSELL DID NOT?*
OLIVIER BLANCHARD
This essay argues that the history of macroeconomics during the twentieth century can be divided into three epochs. Pre-1940: a period of exploration, during which all the right ingredients were developed. But also a period where confusion reigned, because of the lack of an integrated framework. From 1940 to 1980: a period during which an integrated framework was developed—from the IS-LM to dynamic general equilibrium models. But a construction with an Achilles' heel, too casual a treatment of imperfections, leading to a crisis in the late 1970s. Since 1980: a new period of exploration, focused on the role of imperfections in macroeconomics. Exploration often feels like confusion. But behind it is one of the most productive periods of research in macroeconomics.
The editors of the Quarterly Journal of Economics have commissioned a series of essays on the theme: what do we know about field x that Marshall did not? In the case of macroeconomics, Marshall is not the right reference. But if we replace his name with those of Wicksell and of Fisher, the two dominant figures in the field at the start of the twentieth century, the answer is very clear: we have learned a lot. Indeed, progress in macroeconomics may well be the success story of twentieth century economics. Such a strong statement will come as a surprise to some. On the surface, the history of macroeconomics in the twentieth century appears as a series of battles, revolutions, and counterrevo- lutions, from the Keynesian revolution of the 1930s and 1940s, to the battles hetween Monetarists and Keynesians of the 1950s and 1960s, to the Rational Expectations revolution of the 1970s, and the battles hetween New Keynesians and New Classicals of the 1980s. These suggest a field starting anew every twenty years or so, often under the pressure of events, and with little or no common core. But this would he the wrong image. The right one is of a surprisingly steady accumulation of knowledge. The most outrageous claims of revolutionaries make the news, hut are eventually discarded. Some of the others get bastardized and then integrated. The insights hecome part of the core. In this article I
- I thank Daron Acemoglu, Ben Bernanke, Ricardo Caballero, Thomas Cool, Peter Diamond, Rudiger Dombusch, Stanley Fischer, Bengt Holmstrom, Lawrence Katz, David Laibson, N. Gregory Mankiw, David Romer, Paul Samuelson, Andrei Shleifer, Robert Solow, Justin Wolfers, and Michael Woodford for useful comments euid discussions. An earlier version was given as the Tinbergen lecture in Amsterdam in October 1999.
© 2000 by the President and Fellows of Harvard College and the Massachusetts Institute of Technology. The Quarterly Journal ofEconomics, November 2000
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focus on the accumulation of knowledge rather than on the revolutions and counterrevolutions. Admittedly, this makes for worse history of thought, and it surely makes for worse theater. But it is the best way to answer the question in the title. ^ Let me state the thesis that underlies this essay. I believe that the history of macroeconomics during the twentieth century can be divided into three epochs, the third one currently playing.^
- Pre-1940. A period of exploration, where macroeconomics was not macroeconomics yet, but monetary theory on one side and business cycle theory on the other. A period during which all the right ingredients, and quite a few more, were developed. But also a period where confusion reigned, because ofthe lack of an integrated framework.
- From 1940 to 1980. A period of consolidation. A period during which an integrated framework was developed— starting with the IS-LM, all the way to dynamic general equilibrium models—and used to clarify the role of shocks and propagation mechanisms in fluctuations. But a con- struction with an Achilles' heel, namely too casual a treatment of imperfections, leading to a crisis in the late 1970s.
- Since 1980. Anew period of exploration, focused on the role of imperfections in macroeconomics, from the relevance of nominal wage and price setting, to incompleteness of markets, to asymmetric information, to search and bargain- ing in decentralized markets, to increasing returns in production. Exploration often feels like confusion, and confusion there indeed is. But behind it may be one ofthe most productive periods of research in macroeconomics. Let me develop these themes in turn.
L PRE-1940: EXPLORATION To somebody who reads it today, the pre-1940 literature on macroeconomics feels like an (intellectual) witch's brew: many
- Anice, largely parallel, review of macroeconomics in the twentieth century, taking the alternative, more historical, approach is given by Woodford [1999].
- For the purpose of this article, I shall define macroeconomics as t;he study of fluctuations, mundane—recessions and expansions—or sustained—sharp reces- sions, long depressions, sustained high unemployment. I shall exclude both the study of growth and of the political economy of macroeconomics. Much progress has been made there as well, but covering these two topics would extend the length of this essay to unmanageable proportions.
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eventual integration of goods markets (where the natural rate is determined), and financial markets (where the money rate is determined). It would also prove to be the key in allowing for the eventual integration of monetary theory (where an increase in money decreases the money rate relative to the natural rate, triggering higher investment and higher output for some time), and business cycle theory (in which several factors, including money, affect either the natural rate or the money rate, and thus the difference between the two). Where the literature remained confused, at least until Keynes and for some time after, was how this difference between the two rates translated into movements in output. Throughout the 1920s and 1930s the focus was increasingly on the role ofthe equality of saving and investment, but the semantic squabbles that domi- nated much ofthe debate (the distinctions between "ex ante," and "ex post," "planned" and "realized" saving and investment, the discussion of whether the equality of saving and investment was an identity or an equilibrium condition) reflected a deeper confu- sion. It was just not clear how shifts in saving and investment affected output. In that context, the methodological contributions of the General Theory [1936] made a crucial difference.
- Kejmes explicitly thought in terms of three markets (the goods, the financial, and the labor markets), and of the implications of equilibrium in each.
- Using the goods market equilibrium condition, he showed how shifts in saving and in investment led to movements in output.
- Using equilibrium conditions in both the goods and the financial markets, he then showed how various factors affected the natural rate of interest (which he called the "marginal efficiency of capital"), the money rate of interest, and output. An increase in the marginal efficiency of capital—coming, say, from more optimistic expectations about the future—or a decrease in the money rate—coming from expansionary monetary policy—both led to an in- crease in output. A quote from Pigou's Marshall lectures, Keynes's General Theory: A Retrospective View" [1950], puts it well:^ "Nobody before
- Pigou's first assessment of The General Theory, in 1936, had been far less positive, and for understandable reasons: Keynes was not kind to Pigou in The
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him, so far as I know, had brought all the relevant factors, real and monetary at once, together in a single formal scheme, through which their interplay could be coherently investigated." The stage was then set for the second epoch of macroeconom- ics, a phase of consolidation and enormous progress.
II. 1940-1980: CONSOLIDATION Macroeconomists often refer to the period from the mid-1940s to the mid-1970s as the golden age of macroeconomics. For a good reason: progress was fast and visihle.
II.l. Establishing a Basic Framework The IS-LM formalization hy Hicks [1937] and Hansen may not have captured exactly what Keynes had in mind. But, hy defining a list of aggregate markets, writing demand and supply equations for each one, and solving for the general equihhrium, it transformed what was now hecoming "macroeconomics." It did not do this alone. Equally impressive in their powerful simplicity were, among others, the model developed hy Modighani in 1944, with its treatment of the lahor market and the role of nominal wage or price rigidities, or the model developed hy Metzler in 1951, with its treatment of expectations, wealth effects, and the government hudget constraint. These contrihutions shared a common structure: the reduction of the economy to three sets of markets—goods, financial, and lahor—and a focus on the simulta- neous determination of output, the interest rate, and the price level. This systematic, general equilihrium, approach to the characterization of macroeconomic equihhrium hecame the stan- dard, and, reading the literature, one is struck hy how much clearer discussions hecame once this framework had heen put in place. This approach was hrought to a new level of rigor in "Money, Interest, and Prices" hy Patinkin [1956]. Patinkin painstakingly derived demand and supply relations from intertemporal optimiz- ing hehavior hy people and hy firms, characterized the equihh- rium, and, in the process, laid to rest many of the conceptual confusions that had plagued earlier discussions. It is worth
General Theory. But, by 1950, time had passed, and Pigou clearly felt more generous.
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approach was to think of the economy as an economy with few future or contingent markets, an economy in which people and firms therefore had to make decisions based partly on state variahles—^variables reflecting past decisions—and partly on ex- pectations ofthe future. Once current equilihrium conditions were imposed, the current equilihrium depended partly on history and partly on expectations of the future. And given a mechanism for the formation of expectations, one could trace the evolution ofthe equilihrium through time. Within this framework, the next step was to look more closely at consumption, investment, and financial decisions, and their dependence on expectations. This was accomplished, in a series of extraordinary contrihutions, hy Modigliani and Friedman who examined the implications of intertemporal utility maximization for consumption and saving, hy Jorgenson and Tohin who exam- ined the implications of value maximization for investment, and hy Tohin and a few others who examined the implications of expected utility maximization for financial decisions. These devel- opments would warrant more space, hut they are so well-known and recognized (in particular, hy many Nohel prizes) t h a t there is no need to do so here. The natural next step was to introduce rational expectations. The logic for taking t h a t step was clear. If one was to explore the implications of rational hehavior, it seemed reasonahle to assume t h a t this extended to the formation of expectations. That step, however, took much longer. It is hard to tell how much ofthe delay was due to technical prohlems—which indeed were suhstantial— and how much to ohjections to the assumption itself. But this was eventually done, and hy the late 1970s, most of the models had heen reworked under the assumption of rational expectations.^ With the focus on expectations, a new hattery of small models emerged, with more of a focus on intertemporal decisions. The central model was a remake of a model first developed hy Ramsey in 1928, hut now reinterpreted as a temporary equilihrium model with infinitely lived individuals facing a static production technol-
- This is where a more historical approach would emphasize that this was not a smooth evolution.... At the time, the introduction of rational expectations was perceived as an attack on the received body of macroeconomics. But, with the benefit of hindsight, it feels much less like a revolution than like a natural evolution. (Some ofthe other issues raised by the same economists who introduced rational expectations proved more destructive, and are at the source ofthe crisis I discuss below.)
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ogy.^ This initial structure was then extended in many directions.^ Among them were the following:
- The introduction of costs of adjustment for capital, leading to a well-defined investment function, and a way of think- ing about the role of the term structure of interest rates in achieving the equality of saving and investment.
- The introduction of money as a medium of exchange, and the extension of the Baumol-Tobin model of money demand to general equilibrium.
- The introduction of some dimensions of heterogeneity, for example, allowing for finite lives and extending the overlap- ping-generation model first developed by Samuelson and Diamond.
- The introduction of a leisure/labor choice, in addition to the consumption/saving decision.
- The extension to an economy open both in goods and financial markets. Initially, these models were solved under perfect foresight, a simplifying but rather unappealing assumption in a world of uncertainty and changing information. That introducing uncer- tainty was essential was driven home in an article by Hall [1978], who showed that, under certain conditions, optimizing behavior implied that consumption should follow a random walk—a result that initially came as a shock to those trained to think in terms of the life-cycle model. Under the leadership of Lucas and Sargent (for example, Lucas and Stokey [1989], Lucas [1987], and Sargent [1987]), developments in stochastic dynamic programing together with progress in numerical methods and the development of more powerful computers, were used to characterize behavior under uncertainty. This in turn allowed the exploration of a new and important set of issues, the implications of the absence of some future or contingent markets in affecting consumption and invest- ment decisions, and, in turn, the macroeconomic equilibrium. Compared with the first generation of models (the IS-LM, Metzler, and Modigliani models), these models, in either their perfect foresight or their stochastic versions, were more tightly specified, less eclectic. In tbeir initial incarnation, they often
- Ramsey had thought of his model as purely normative, indicating how a central planner might want to allocate consumption over time.
- The basic Ramsey model and many of these extensions form the core of today's graduate textbooks. See, for example, Blanchard and Fischer [1989] or Obstfeld and Rogoff [1996].
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construct large structural models had heen overamhitious, that the identification conditions used in estimation of individual equations were often duhious, and that the equation-hy-equation construction of econometric models did not in any way insure that the reduced form of the estimated model fitted the basic character- istics of the data.
This was the motivation behind the return to smaller, more transparent, structural models, whose limited size had the addi- tional advantage of making them solvable under rational expecta- tions. It was also the motivation behind the development of a new statistical tool, vector autoregressions or VARs—namely the direct estimation of the joint stochastic process descrihing the variables under consideration. VAKs were then used in two ways: to obtain a set of stylized statistical facts that models had to match; and to see whether, under a minimal set of identification restrictions, the evidence was consistent with the djTiamic effects of shocks implied by a particular theory or class of theories. The constant back and forth hetween models and data, and the increasing availability of macro and micro data, has made macroeconomics a radically different field from what it was in
- Samuelson once remarked that one of his disappointments was that econometric evidence had led to less convergence than he had hoped when the first econometric steps were taken (in Snowdon and Vane [1999], p. 323). It is nevertheless true that progress has been nothing short of amazing. When Kahn [1931] first tried to get a sense of the value of the marginal propensity to consume, all he had were a few observations on proxies for aggregate production, imports, and investment. When Modigliani and Brumberg [1954] tried to assess the empirical fit of the life-cycle hypothesis, they could use the time series recently put together for the National Income Accounts by Kuznets and others, and a few cross sections on income and saving. Today, studies of consumption have access to long repeated cross sections, or even long panel data sets (see, for example, Deaton [1992]). This allows not only for much sharper questions about consumption behavior, but also for a more convincing treatment of identification (through the use of "natural experiments," tracing the effects of changes in the economic environment affecting some hut not all consumers) than was feasible earlier. So far, the tone of this essay has heen that of a panegyric, the description of a triumphal march toward truth and wisdom. Let
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me now turn to the prohlem that macroeconomics largely ignored, and which led to a major crisis in the late 1970s.
II.4. The Casual Treatment of Imperfections From Keynes on, there was wide agreement that some imperfections played an essential role in fluctuations.^ Nominal rigidities, along the lines suggested hy Keynes, and later formal- ized hy Modigliani and others, played an explicit and central role in most formalizations. They were crucial to explaining why and how changes in money and other shifts in the demand for goods affected output, at least in the short run. These nominal rigidities, when comhined with later develop- ments such as rational expectations, proved to have rich smd relevant implications. For example, in an extension of the Mundell- Fleming model (the version of the IS-LM model for an economy open in hoth goods and financial markets), Dornhusch [1976] showed that the large swings in exchange rates, which had heen ohserved after the adoption of flexihle exchange rates in the early 1970s and were typically attrihuted to irrational speculation, could he interpreted instead as the result of arhitrage by specula- tors with rational expectations in an economy with a slowly adjusting price level. The lesson was more general: nominal rigidities in some markets led to more volatility in others, here in the foreign exchange market. But, as the early models were improved in many dimensions, the treatment of imperfections remained surprisingly casual. The most ohvious example was the treatment of wage adjustment in the lahor market. In early models, the assumption was typically that the nominal wage was fixed, and that the demand for lahor then determined the outcome. Later on, these assumptions were replaced hy a Phillips curve specification, linking infiation to unemployment. But there was surprisingly little work on what exactly lay hehind the Phillips curve, why and how wages were set this way, and why there was little apparent relation hetween real wages and the level of employment. As a result, most macro
- A semantic clarification: following tradition, I shall refer to "imperfections" as deviations from the standard perfect competition model. Admittedly, there is more than just a semantic convention here. Why give such status to such an utterly unrealistic model? The answer is because most current research is organized in terms of what happens when one relaxes one or more assumptions in that model. This may change one day. But, for the tinie being, this approach provides a common research strategy, and makes for easier communication among macroeco- nomic researchers.
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as likely as the first. So, why was it that we typically observed the first outcome and not the second? The answer clearly required a theory of price setting, and so the explicit introduction of price
. setters (so that somebody other than the auctioneer was in charge). But if there were explicit price setters, there was then no particular reason why the market outcome should be equal to the minimum of supply and demand. For example, if price setters were monopolistic firms, and demand turned out larger than they expected, then they might well want to satisfy this higher level of demand, at least as long as their price exceeded marginal cost. So, to make progress, one had to think hard about market structure, and who the price setters were. But such focus on market structure, and on imperfections more generally, was altogether absent from macroeconomics at the time.^" At roughly the same time (circa 1975), this intellectual crisis was made worse by another development, the collapse of tradi- tional conclusions when rational expectations were introduced in otherwise standard Keynesian models. Working within the stan- dard model at the time (an IS-LM model plus an expectations- augmented Phillips curve), Sargent [1973] showed that, if one assumed rational expectations of infiation, the effects of money on output lasted only for a brief moment, until the relevant informa- tion about money was released. So, even on its own terms, once rational expectations were introduced, the standard model seemed unable to deliver its traditional conclusions (such as, for example, lasting effects of money on output). Thus, by the end ofthe 1970s, macroeconomics faced a serious crisis. The reaction of researchers was to follow two initially very different routes. The first, followed by the "New Keynesians," was based on the belief that the traditional conclusions were indeed largely right, and that what was needed was a deeper look at imperfections and their implications for macroeconomics. The second, followed by the "New Classicals" or "Real Busi- ness Cycle" theorists, was instead to question the traditional conclusions, and explore how far one could go in explaining fiuctuations without introducing imperfections [Prescott 1986]. At the time, macroeconomics looked (and felt) more divided than ever before (the intensity of the debate is well refiected in
- As it was absent from general equilibrium theory, leading economists working on stability and formalizations of real time tatonnement processes into similar dead ends.
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Lucas and Sargent [1978]). Yet, nearly twenty years later, tbe two routes bave surprisingly converged. Tbe metbodological contribu- tions of tbe Real Business Cycle approacb, namely tbe develop- ment of stocbastic dynamic general equilibrium models, bave proved important and bave been widely adopted. But tbe initial propositions tbat money did not matter, tbat technological sbocks could explain fiuctuations, and tbat imperfections were not needed to explain fiuctuations, bave not beld up. Tbe empirical evidence continues to strongly support the notion tbat monetary policy affects output. And tbe idea of large, bigb frequency, movements in tbe aggregate production function remains an implausible black box; tbe relation between output and productivity appears more likely to refiect reverse causality, witb movements in output leading to movements in measured total factor productivity, ratber tban tbe otber way around. For tbose reasons, most, if not all, current models, in eitber tbe New Keynesian or tbe New Classical mode (tbese two labels will soon join otbers in tbe trasb bin of bistory of tbougbt) now examine tbe implications of imperfections, be it in labor, goods, or credit markets. Tbis is tbe body of work to wbicb I now turn.
III. POST-1980: I. WORKING OUT THE QUANTITY THEORY In discussing tbe role of imperfections in macroeconomics, it is useful to divide tbe set of questions into two.
- Tbe old Quantity Tbeory questions: Wby does money affect output? Wbat are tbe origin and tbe role of nominal rigidities in tbe process? Tbese may be tbe central ques- tions of macroeconomics, not because sbifts in money are tbe major determinant of fiuctuations (tbey are not), but because tbe nonneutrality of money is so obviously at odds witb tbe predictions of tbe bencbmark, fiexible price, model.
- Tbe old Business Cycle questions: Wbat are tbe major sbocks tbat affect output? Wbat are tbeir propagation mechanisms? Wbat is tbe role of imperfections in tbat context? Tbis section focuses on tbe first set of questions, tbe next on tbe second. Most macroeconomists would, I believe, agree today on tbe
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to clarify various parts of tbe argument, and to point to a number of unresolved issues.
111.1. Staggering, and the Adjustment of the Price Level
A tempting analogy to tbe proposition tbat staggered adjust- ment of individual prices leads to a slow price level adjustment is to tbe movements of a cbain gang. Unless gang members can coordinate tbeir movements very precisely, tbe cbain gang will run slowly at best. Tbe sborter tbe length of tbe cbain between two gang members, or tbe larger tbe number of members in tbe gang, tbe more slowly it is likely to run. Research on tbe aggregate implications of specific price rules and staggering structures bas sbown tbat tbe analogy is typically rigbt. In most cases, discrete adjustment of individual prices indeed leads to a slow adjustment of tbe price level.^^ And the more eacb desired price depends on otber prices, tbe slower tbe adjustment. But tbis researcb bas also come witb a number of warnings. In a celebrated counterexample to tbe general proposi- tion, Caplin and Spulber [1987] bave sbown tbat, under some conditions, tbe reverse proposition may in fact bold: discrete adjustment of individual prices may still lead to a completely fiexible price level." Tbe conditions under wbicb tbeir conclusion bolds are more likely to be satisfied at bigb infiation, and tbis bas an important implication: tbe effects of money on output are likely to be sborter, tbe bigber tbe average rate of money growtb and tbe associated rate of infiation.
777.2. Real and Nominal Rigidities If individual price cbanges are staggered, tbe price level will increase only if at least some individual price setters want to increase tbeir relative price. Once tbe price level bas fully adjusted to tbe increase in money, and demand and output are back to tbeir original level, desired relative prices end up tbe same as tbey were before tbe increase in money; but tbis is true only in tbe end. Tbis observation bas one important implication: tbe speed of adjustment of tbe price level depends on tbe elasticity of desired
- The most influential model here is surely Taylor [1980]. See Taylor [1998] for a recent survey.
- Their result requires two conditions: that prices be changed according to an Ss rule, and that each desired nominal price be a nondecreasing function of time. Caplin and Leahy [1991] show what happens when only the flrst condition holds. Money is then typically nonneutral.
WHAT DO WE KNOW ABOUT MACROECONOMICS? 1 3 9 1
relative prices in response to shifts in demand. The higher this elasticity, the more each individual price setter will want to increase his price when he adjusts, the faster the price level will increase and the shorter will be the effects of money on output. Research suggests that, to generate the slow adjustment of the price level one observes in the data, this elasticity must indeed be small, smaller than one would expect if, for example, the price set by firms reflected the increase in marginal cost for firms, and the wage reflected the increase in the marginal disutility of work for workers. 1^ This proposition is sometimes stated as follows: "Real rigidi- ties" (a small elasticity of the desired relative price to shifts in demand) are needed to generate substantial "nominal rigidity" (a slow adjustment of the price level in response to changes in money). The terminology may be infelicitous, but the conclusion is an important one and points to an interaction between nominal rigidities and other imperfections. If these other imperfections are such as to generate real rigidities (a big if), they can help explain the degree of nominal rigidity we appear to observe in modern economies.
III.3. Demand versus Output Suppose that the price level responds slowly, so an increase in money leads to an increase in the demand for goods for some time. In the absence of further information on the structure in goods and labor markets, there is no warranty that this increase in demand will lead to an increase in output. It will do so only if suppliers of both labor and goods are willing to supply more. This was indeed the main unresolved issue in the flxed price equilib- rium approach. For increases in demand to translate into in- creases in output, the market structure must be such that the price setters are willing to supply more even at the existing price. There are market structures where this will be the case. Suppose, for example, that the goods markets is composed of monopolistically competitive price setters. At the initial equilib- rium, monopoly power implies that their price is above their marginal cost. This implies in turn that, even at an unchanged price, they will be willing to satisfy an increase in demand, at least as long as marginal cost remains smaller than the price. So, under
15, See Blanchard and Fischer [1989, Chapter 8] and Chari, Kehoe, and McGrattan [1998] for a recent discussion.
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the "menu costs" explanation of the short-run nonneutrality of money. 1^ The expression correctly captures the notion that small individual costs of changing prices can have large macroeconomic effects. At the same time, the expression may have been a public relations disaster. It makes the explanation for the effects of money on output look accidental, when in fact the effects appear to be intrinsic to the workings of an economy with decentralized price and wage setting. In any economy with decentralized price and wage setting, adjustment of the general level of prices in terms ofthe numeraire is likely to be slow relative to a (fictional) economy with an auctioneer.
IV. POST-1980: II. THE ROLE OF OTHER IMPERFECTIONS Leaving aside nominal rigidities, there are three main rea- sons why macroeconomists working on fluctuations should care about imperfections. 1^
- Imperfections lead to very different efficiency and welfare characteristics ofthe equilibrium, and thus modify the way we think about fluctuations and the role of policy. For example, think of the question of whether the equilibrium rate of unemplo3mient is too high or too low, and its implications for macroeconomic policy. ^^
- Imperfections may lead to very different propagation mecha- nisms of shocks. For example, think of the role of the interactions of nominal and real rigidities in determining the persistence of changes in money on output that I discussed in the previous section.
- Imperfections may lead to new sources of shocks. For example, think of bank runs, which may affect not only the supply of money, but also the functioning of the financial intermediation system, leading to long-lasting effects on output. These are the motivations behind the research on imperfec- tions and macroeconomics which has developed in the last twenty
- See, in particular, Mankiw [1985] andAkerlof and Yellen [1985].
- The arguments would be even stronger if the focus of this article were extended to cover growth. Much ofthe recent progress in growth theory has come from looking at the role of imperfections and institutions (externalities from R&D and patent laws, bankruptcies and bankruptcy laws, restrictions to entry by new firms, institutions governing corporate governance, etc.) in growth.
- For example, the implications for monetary policy emphasized by Barro and Gordon [1983].
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years or so. As I indicated in the introduction, this phase is still very much one of exploration. The thousand flowers are still hlooming, and it is not clear what integrated macroeconomic model will emerge, if any. Let me describe four major lines along which substantial progress has already been made.
IV. 1. Unemployment and the Labor Market
The notion that the labor market was somehow special was reflected in early Keynesian models by the crude assumptions that the nominal wage was given, and employment was deter- mined by the demand for labor. It was reflected in the confused debates about whether unemployment was involuntary or volun- tary. It was reflected by the continuing use of an ad hoc formaliza- tion of wage behavior—the Phillips curve—even in theoretical models. It was reflected by the unease with which the neoclassical formulation of labor supply, developed by Lucas and Rapping [1969], with its focus on intertemporal substitution, was received by most macroeconomists. For a long time, the basic obstacle was simply how to think of a market where, even in equilibrium, there were some unsatisfled sellers—there was unemployment. The basic answer was given in the early 1970s, in a set of contributions to a volume edited by Phelps [1970]: one should think of the labor market as a decentral- ized market, in which there were workers looking for jobs, and firms looking for workers. In such a market there would always be, even in equilibrium, both some unemplo3rment and some vacancies. Research started in earnest in the 1980s, based on a number of theoretical contributions to search and bargaining in decentral- ized markets, in particular by Diamond [1982], Mortensen [1982], and Pissarides [1985]. The conceptual structure that has emerged is known as the flow approach to the labor market. ^^
- The labor market is a decentralized market. At any point in time, because of shifts in the relative demand for goods, or changes in technology, or because a firm and a worker no longer get along, a number of employment relations are terminated, and a number of new employment relations are started. The workers wbo separate from firms, because they quit or
- For recent surveys, see Pissarides [1999] or Mortensen and Pissarides [1998].
