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lity 131 instead kydland and prescott built parsimonious models that explained business cycles with changes in technology and productivity 127 employment levels changed because these technological and productivity changes altered the desire of people to work 127 rbc rejected the idea of high involuntary unemployment in recessions and not only dismissed the idea that money could stabilize the economy but also the monetarist idea that money could destabilize it 132 real business cycle modelers sought to build macroeconomic models based on microfoundations of arrow debreu 133 general equilibrium 134 135 136 137 rbc models were one of the inspirations for dynamic stochastic general equilibrium dsge models dsge models have become a common methodological tool for macroeconomists even those who disagree with new classical theory 129 new keynesian economics edit main article new keynesian economics new classical economics had pointed out the inherent contradiction of the neoclassical synthesis walrasian microeconomics with market clearing and general equilibrium could not lead to keynesian macroeconomics where markets failed to clear new keynesians recognized this paradox but while the new classicals abandoned keynes new keynesians abandoned walras and market clearing 138 during the late 1970s and 1980s new keynesian researchers investigated how market imperfections like monopolistic competition nominal frictions like sticky prices and other frictions made microeconomics consistent with keynesian macroeconomics 138 new keynesians often formulated models with rational expectations which had been proposed by lucas and adopted by new classical economists 139 nominal and real rigidities edit stanley fischer 1977 t responded to thomas j sargent and neil wallace s monetary ineffectiveness proposition and showed how monetary policy could stabilize an economy even in a model with rational expectations 139 fischer s model showed how monetary policy could have an impact in a model with long term nominal wage contracts 140 john b taylor expanded on fischer s work and found that monetary policy could have long lasting effects even after wages and prices had adjusted taylor arrived at this result by building on fischer s model with the assumptions of staggered contract negotiations and contracts that fixed nominal prices and wage rates for extended periods 140 these early new keynesian theories were based on the basic idea that given fixed nominal wages a monetary authority central bank can control the employment rate 141 since wages are fixed at a nominal rate the monetary authority can control the real wage wage values adjusted for inflation by changing the money supply and thus impact the employment rate 141 by the 1980s new keynesian economists became dissatisfied with these early nominal wage contract models 142 since they predicted that real wages would be countercyclical real wages would rise when the economy fell while empirical evidence showed that real wages tended to be independent of economic cycles or even slightly procyclical 143 these contract models also did not make sense from a microeconomic standpoint since it was unclear why firms would use long term contracts if they led to inefficiencies 141 instead of looking for rigidities in the labor market new keynesians shifted their attention to the goods market and the sticky prices that resulted from menu cost models of price change 142 the term refers to the literal cost to a restaurant of printing new menus when it wants to change prices however economists also use it to refer to more general costs associated with changing prices including the expense of evaluating whether to make the change 142 since firms must spend money to change prices they do not always adjust them to the point where markets clear and this lack of price adjustments can explain why the economy may be in disequilibrium 144 studies using data from the united states consumer price index confirmed that prices do tend to be sticky a good s price typically changes about every four to six months or if sales are excluded every eight to eleven months 145 while some studies suggested that menu costs are too small to have much of an aggregate impact laurence ball and david romer 1990 u showed that real rigidities could interact with nominal rigidities to create significant disequilibrium real rigidities occur whenever a firm is slow to adjust its real prices in response to a changing economic environment for example a firm can face real rigidities if it has market power or if its costs for inputs and wages are locked in by a contract 146 147 ball and romer argued that real rigidities in the labor market keep a firm s costs high which makes firms hesitant to cut prices and lose revenue the expense created by real rigidities combined with the menu cost of changing prices makes it less likely that firm will cut prices to a market clearing level 144 coordination failure edit in this model of coordination failure a representative firm e i makes its output decisions based on the average output of all firms ē when the representative firm produces as much as the average firm e i ē the economy is at an equilibrium represented by the 45 degree line the decision curve intersects with the equilibrium line at three equilibrium points the firms could coordinate and produce at the optimal level of point b but without coordination firms might produce at a less efficient equilibrium 148 149 coordination failure is another potential explanation for recessions and unemployment 150 in recessions a factory can go idle even though there are people willing to work in it and people willing to buy its production if they had jobs in such a scenario economic downturns appear to be the result of coordination failure the invisible hand fails to coordinate the usual optimal flow of production and consumption 151 russell cooper and andrew john 1988 v expressed a general form of coordination as models with multiple equilibria where agents could coordinate to improve or at least not harm each of their respective situations 152 cooper and john based their work on earlier models including peter diamond s 1982 w coconut model 153 which demonstrated a case of coordination failure involving search and matching theory 154 in diamond s model producers are more likely to produce if they see others producing the increase in possible trading partners increases the likelihood of a given producer finding someone to trade with as in other cases of coordination failure diamond s model has multiple equilibria and the welfare of one agent is dependent on the decisions of others 155 diamond s model is an example of a thick market externality that causes markets to function better when more people and firms participate in them 156 other potential sources of coordination failure include self fulfilling prophecies if a firm anticipates a fall in demand they might cut back on hiring a lack of job vacancies might worry workers who then cut back on their consumption this fall in demand meets the firm s expectations but it is entirely due to the firm s own actions 152 labor market failures edit new keynesians offered explanations for the failure of the labor market to clear in a walrasian market unemployed workers bid down wages until the demand for workers meets the supply 157 if markets are walrasian the ranks of the unemployed would be limited to workers transitioning between jobs and workers who choose not to work because wages are too low to attract them 158 they developed several theories explaining why markets might leave willing workers unemployed 159 of these theories new keynesians were especially associated with efficiency wages and the insider outsider model used to explain long term effects of previous unemployment 160 where short term increases in unemployment become permanent and lead to higher levels of unemployment in the long run 161 insider outsider model edit economists became interested in hysteresis when unemployment levels spiked with the 1979 oil shock and early 1980s recessions but did not return to the lower levels that had been considered the natural rate 162 olivier blanchard and lawrence summers 1986 x explained hysteresis in unemployment with insider outsider models which were also proposed by assar lindbeck and dennis snower in a series of papers and then a book y insiders employees already working at a firm are only concerned about their own welfare they would rather keep their wages high than cut pay and expand employment the unemployed outsiders do not have any voice in the wage bargaining process so their interests are not represented when unemployment increases the number of outsiders increases as well even after the economy has recovered outsiders continue to be disenfranchised from the bargaining process 163 the larger pool of outsiders created by periods of economic retraction can lead to persistently higher levels of unemployment 163 the presence of hysteresis in the labor market also raises the importance of monetary and fiscal policy if temporary downturns in the economy can create long term increases in unemployment stabilization policies do more than provide temporary relief they prevent short term shocks from becoming long term increases in unemployment 164 efficiency wages edit in the shapiro stiglitz model workers are paid at a level where they do not shirk preventing wages from dropping to full employment levels the curve for the no shirking condition labeled nsc goes to infinity at full employment in efficiency wage models workers are paid at levels that maximize productivity instead of clearing the market 165 for example in developing countries firms might pay more than a market rate to ensure their workers can afford enough nutrition to be productive 166 firms might also pay higher wages to increase loyalty and morale possibly leading to better productivity 167 firms can also pay higher than market wages to forestall shirking 167 shirking models were particularly influential 168 carl shapiro and joseph stiglitz 1984 z created a model where employees tend to avoid work unless firms can monitor worker effort and threaten slacking employees with unemployment 169 if the economy is at full employment a fired shirker simply moves to a new job 170 individual firms pay their workers a premium over the market rate to ensure their workers would rather work and keep their current job instead of shirking and risk having to move to a new job since each firm pays more than market clearing wages the aggregated labor market fails to clear this creates a pool of unemployed laborers and adds to the expense of getting fired workers not only risk a lower wage they risk being stuck in the pool of unemployed keeping wages above market clearing levels creates a serious disincentive to shirk that makes workers more efficient even though it leaves some willing workers unemployed 169 new growth theory edit further information endogenous growth theory empirical evidence showed that growth rates of low income countries varied widely instead of converging to a uniform income level 171 as expected in earlier neoclassical models 172 following research on the neoclassical growth model in the 1950s and 1960s little work on economic growth occurred until 1985 55 papers by paul romer aa ab were particularly influential in igniting the revival of growth research 173 beginning in the mid 1980s and booming in the early 1990s many macroeconomists shifted their focus to the long run and started new growth theories including endogenous growth 174 173 growth economists sought to explain empirical facts including the failure of sub saharan africa to catch up in growth the booming east asian tigers and the slowdown in productivity growth in the united states prior to the technology boom of the 1990s 175 convergence in growth rates had been predicted under the neoclassical growth model and this apparent predictive failure inspired research into endogenous growth 172 three families of new growth models challenged neoclassical models 176 the first challenged the assumption of previous models that the economic benefits of capital would decrease over time these early new growth models incorporated positive externalities to capital accumulation where one firm s investment in technology generates spillover benefits to other firms because knowledge spreads 177 the second focused on the role of innovation in growth these models focused on the need to encourage innovation through patents and other incentives 178 a third set referred to as the neoclassical revival expanded the definition of capital in exogenous growth theory to include human capital 179 this strain of research began with mankiw romer and weil 1992 ac which showed that 78 of the cross country variance in growth could be explained by a solow model augmented with human capital 180 endogenous growth theories implied that countries could experience rapid catch up growth through an open society that encouraged the inflow of technology and ideas from other nations 181 endogenous growth theory also suggested that governments should intervene to encourage investment in research and development because the private sector might not invest at optimal levels 181 new synthesis edit main article new neoclassical synthesis based on the dsge model in christiano eichenbaum and evans 2005 ad impulse response functions show the effects of a one standard deviation monetary policy shock on other economic variables over 20 quarters a new synthesis or new neoclassical synthesis emerged in the 1990s drawing ideas from both the new keynesian and new classical schools 182 from the new classical school it adapted rbc hypotheses including rational expectations and methods 183 from the new keynesian school it took nominal rigidities price stickiness 150 and other market imperfections 184 the new synthesis implies that monetary policy can have a stabilizing effect on the economy contrary to new classical theory 185 186 the new synthesis was adopted by academic economists and soon by policy makers such as central bankers 150 under the synthesis debates have become less ideological concerning fundamental methodological questions and more empirical woodford described the change 187 it sometimes appears to outsiders that macroeconomists are deeply divided over issues of empirical methodology there continue to be and probably will always be heated disagreements about the degree to which individual empirical claims are convincing a variety of empirical methods are used both for data characterization and for estimation of structural relations and researchers differ in their taste for specific methods often depending on their willingness to employ methods that involve more specific a priori assumptions but the existence of such debates should not conceal the broad agreement on more basic issues of method both calibrationists and the pra...