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A Macroeconomic Earthquake | Q&A with Larry Christiano

In this episode of “Where is the General Theory of the 21st Century?”, we talk to Professor Lawrence J. Christiano, chairman of the Department of Economics and Professor of Economics at Northwestern University and one of the leading researchers in Macroeconomics and DSGE models.


Is there another Keynesian Revolution?

Q: EconReporter C: Larry Christiano

Q: Do you think that there are any “revolutionary” changes in the macroeconomics since the Great Recession?

C: I think what we saw after the Great Recession is largely an acceleration of the changes that had been in existence before. That is in the same way as the Great Depression, and Keynesian Revolution was not something that was started in the 30s, but really in existence before.

There has been a debate for a long period over what it is that caused the fluctuation. Is it things that are on the supply side of the economy? Or is it things on the demand side of the economy? One very important reminder from the 2008 crisis was that the demand side of the economy could be very very important.

The demand side of the economy is one of the features that the earlier Keynesian Revolution had captured. And as a consequence, all of those things that are part of the Keynesian Revolution actually became part of conventional wisdom about macroeconomics. But in terms of sudden change of thinking and wholly new ideas, that we did not see. But nor did we see that in the Great Recession.

Q: In the note “The Great Recession: A Macroeconomic Earthquake” for the Minneapolis Fed, you have mentioned that the Great Recession has two impacts on the macroeconomics. One is that the ISLM perspective becomes relevant again, which is now incorporated in the New Keynesian models.

To what extent, you think New Keynesian is an extension of ISLM?

C: I think in every broad way of thinking about macroeconomics has a really really simple model associated with it. A model that you can teach to undergraduates. The model that is best associated with the center of gravity in academics in the 80s and the 90s was probably the Real Business Cycle model (RBC). That was a simple model that you could convey to the undergraduates, and it would also capture the general thinking of people researching in the area. The model itself simplified what researchers are thinking about, yet it captured the essence of the framework.

The current conventional model, i.e. the oversimplified representation of that model, now has shifted from the RBC model to the ISLM model which captures very much the ideas that are in modern dynamic models. Technically, the modern dynamic model is built on the RBC, although the economics of them is very different.

I guess I see ISLM as the new oversimplified representation of the way people think about the economy now. What I mean by oversimplified is that the fundamental question can’t actually be answered by this version of the model. It is just the simple language for people to talk about things, but not a substitute for careful thinking. For example, you don’t even know if the depreciation of the exchange rate shifts the IS curve to the right or the left. That requires much more elaborate model which was very much in contact with the data, particularly with microdata.

So, the ISLM model is more like the language that is used to teach the undergraduate but not as a substitute for serious dynamic models. As in the RBC, no one thought literally that the Solow production function is the best characterization of the data, but it captures the spirit of the theories.



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