Yet Another Note on Understanding the Terrain of the Macroeconomics Debate

Paul Krugman attributes the healthier state of international macroeconomics (i.e. him, Ken Rogoff, and company) than non-international macroeconomics (i.e. Ed Prescott, Robert Lucas, and company) to (a) the fact that reality in international macro had more of a Keynesian bias, and (b) the influence of Rudi Dornbusch. I actually think Paul understates the contribution of Rudi Dornbusch…

Paul’s point is that the Post-Modern Chicago-Minnesota New-Classial “monetary policy doesn’t matter” view was obviously and ridiculously inadequate in international macroeconomics because there was a very important real price–the real exchange rate–that clearly jumped far and fast in response to changes in monetary policy. Thus it was prima facie ludicrous to claim that monetary policy did not have important real effects.

But non-international macroeconomics also has an important real price that clearly jumps far and fast in response to changes in monetary policy: the real value of the stock market–monetary policy affects the terms on which old capital trades for consumption goods. Thus it was similarly prima facie ludicrous to claim that monetary policy did not have important, systematic, and persistent real effects. But that did not stop them…

Paul Krugman: Rudi Dornbusch and the Salvation of International Macroeconomics:

What’s interesting… is that the revival of Keynesian ideas was taking place at a time when Chicago was proclaiming Keynes gone, vanquished, consigned to the dustbin of history, pushing up the daisies, joined the choir invisible (hand invisible?)…. One answer, I’d suggest, was [Stan Fischer’s] friendship and collaboration with Rudi Dornbusch… leading international macroeconomics in a direction very different from where Lucas and later Prescott were taking the domestic side of the field….

Even a cursory look at international data makes a compelling case for short-run price stickiness. Exchange rates behave like asset prices, swinging wildly year to year; goods prices move much less, which means that the real exchange rate–the relative price of two currencies, deflated by the ratio of price levels in the two countries, fluctuates wildly too. But the real exchange rate is the relative price of two bundles of goods; it’s a real variable. It’s very hard to tell a story about why it should move the way it does without invoking some kind of price stickiness….

So international macro was probably going to stay relatively Keynesian, simply because the facts had such a well-known Keynesian bias. But Rudi Dornbusch… showed how to bring rational expectations… into the sticky-price paradigm, and… do interesting, fun stuff with the combination…. Ken Rogoff had a very good paper on all this, in which he also says something about the state of affairs within the economics profession at the time:

The Chicago-Minnesota School maintained that sticky prices were nonsense and continued to advance this view for at least another fifteen years. It was the dominant view in academic macroeconomics. Certainly, there was a long period in which the assumption of sticky prices was a recipe for instant rejection at many leading journals. Despite the religious conviction among macroeconomic theorists that prices cannot be sticky, the Dornbusch model remained compelling to most practical international macroeconomists. This divergence of views led to a long rift between macroeconomics and much of mainstream international finance

[…]

There are more than a few of us in my generation of international economists who still bear the scars of not being able to publish sticky-price papers during the years of new neoclassical repression.

Notice that this isn’t the evil Krugman talking; it’s the respectable Rogoff…. What he gets wrong is in the part I’ve elided with my “…”, in which he asserts that this is all behind us. As we saw when crisis struck, Chicago/Minnesota had in fact learned nothing and was pretty much unaware of the whole New Keynesian enterprise — and from what I hear about macro hiring, the suppression of ideas at odds with the cult remains in full force.

Anyway, the point was that international macro — which was my home within macro–never bought into the nonsense, largely thanks to the Dornbusch influence.Thank you, Rudi.