Right in the Short Run

Mark Thoma has another extraordinary post at Economist’s View, this time taking on Bruce Bartlett’s claim that “hardly any economist believes what the Keynesians believed in the 1970s and most accept the basic ideas of supply-side economics.”

If you are looking for a quick primer on the two main schools of thought in Macroeconomics, I cannot recommend Professor Thoma’s post enough. Just scroll past the quoting of Bruce Bartlett’s article and look for the pretty charts. Some excerpts:

Real Business Cycle (RBC) theorists believe that most if not all fluctuations in the economy are due to supply side shocks, aggregate demand shocks such as changes in the money supply, changes in taxes, and changes in government spending affect nominal variables such as prices but have little to do with changes in output over time (however, government intervention does causes inefficiencies in these models so that less intervention is generally preferred to more). …

New Keynesians (NK) do not deny that shocks to aggregate supply can affect GDP nor that supply shocks can be large and important. However, New Keynesians also believe that aggregate demand shocks are important…

New Keynesians attempt to stabilize actual output around the natural rate as shown above. Why does NK policy tend to focus on demand shocks rather than supply shocks? The answer is that although it would be ideal if we could use supply-side polices to smooth short-run fluctuations in output arising from supply shocks, the reality is that we cannot do this. As Bartlett notes, supply-side polices are very blunt, slow-acting policies that can affect output in the long-run, but they are all but useless in dealing with short-run fluctuations in the economy (thus, RBC theorists tend to focus mainly long-run growth).

Since supply cannot be managed in the short-run, that leaves demand management policies, i.e. monetary and fiscal policy. …

For those who are already familiar with the tenets of New Keynesian and Real Business Cycle models, the post includes some political insight that’s also worth checking out.

Why do Republicans tend to endorse the RBC (real business cycle) framework? I believe in many cases that belief in the RBC model arises from an honest view that the evidence is most supportive of this class of models. But in other cases I believe it is an ideological marriage. The RBC model has two features that make it attractive.

First, because it says short-run stabilization policy is ineffective, and that government intervention through either spending or taxes generates economic distortions, the RBC framework supports an approach where the role of government in the economy is minimized.

Second, because the RBC framework allows for tax cuts to produce higher growth by reducing inefficiencies, and because it is then possible to argue that tax revenues might increase, it gives two reasons for supporting tax cuts - higher growth and less than a full loss of tax revenue, i.e. a dollar tax cut does not cost a dollar (or, for serious ideologues, the tax-cuts even pay for themselves).

The NK model, on the other hand, supports active government intervention which is at odds with this ideology. In addition, because the focus in NK models is on stabilization of output around the natural rate, not on growth of the natural rate, tax-cuts do not have the dynamic long-run effects as in RBC models (though these can be added) and hence there is not as much ideological support for tax cuts in the NK framework.

Check it out, and read through the comments to catch a glimpse of Paul Krugman butting heads with Bruce Bartlett.