26.3 Balancing keynesian and neoclassical models

Finding the balance between Keynesian and Neoclassical models can be compared to the challenge of riding two horses simultaneously. When a circus performer stands on two horses, with a foot on each one, much of the excitement for the viewer lies in contemplating the gap between the two. As modern macroeconomists ride into the future on two horses—with one foot on the short-term Keynesian perspective and one foot on the long-term neoclassical perspective—the balancing act may look uncomfortable, but there does not seem to be any way to avoid it. Each approach, Keynesian and neoclassical, has its strengths and weaknesses.

The short-term Keynesian model, built on the importance of aggregate demand as a cause of business cycles and a degree of wage and price rigidity, does a sound job of explaining many recessions and why cyclical unemployment rises and falls. By focusing on the short-run adjustments of aggregate demand, Keynesian economics risks overlooking the long-term causes of economic growth or the natural rate of unemployment that exists even when the economy is producing at potential GDP.

The neoclassical model, with its emphasis on aggregate supply, focuses on the underlying determinants of output and employment in markets, and thus tends to put more emphasis on economic growth and how labor markets work. However, the neoclassical view is not especially helpful in explaining why unemployment moves up and down over short time horizons of a few years. Nor is the neoclassical model especially helpful when the economy is mired in an especially deep and long-lasting recession, like the Great Depression of the 1930s. Keynesian economics tends to view inflation as a price that might sometimes be paid for lower unemployment; neoclassical economics tends to view inflation as a cost that offers no offsetting gains in terms of lower unemployment.

Macroeconomics cannot, however, be summed up as an argument between one group of economists who are pure Keynesians and another group who are pure neoclassicists. Instead, many mainstream economists believe both the Keynesian and neoclassical perspectives. Robert Solow , the Nobel laureate in economics in 1987, described the dual approach in this way:

At short time scales, I think, something sort of ‘Keynesian’ is a good approximation, and surely better than anything straight ‘neoclassical.’ At very long time scales, the interesting questions are best studied in a neoclassical framework, and attention to the Keynesian side of things would be a minor distraction. At the five-to-ten-year time scale, we have to piece things together as best we can, and look for a hybrid model that will do the job.

Many modern macroeconomists spend considerable time and energy trying to construct models that blend the most attractive aspects of the Keynesian and neoclassical approaches. It is possible to construct a somewhat complex mathematical model where aggregate demand and sticky wages and prices matter in the short run, but wages, prices, and aggregate supply adjust in the long run. However, creating an overall model that encompasses both short-term Keynesian and long-term neoclassical models is not easy.

Key concepts and summary

The Keynesian perspective considers changes to aggregate demand to be the cause of business cycle fluctuations. Keynesians are likely to advocate that policy makers actively attempt to reverse recessionary and inflationary periods because they are not convinced that the self-correcting economy can easily return to full employment.

The neoclassical perspective places more emphasis on aggregate supply. The level of potential GDP is determined by long term productivity growth and that the economy typically will return to full employment after a change in aggregate demand. Skeptical of the effectiveness and timeliness of Keynesian policy, neoclassical economists are more likely to advocate a hands-off, or fairly limited, role for active stabilization policy.

While Keynesians would tend to advocate an acceptable tradeoff between inflation and unemployment when counteracting a recession, neoclassical economists argue that no such tradeoff exists; any short-term gains in lower unemployment will eventually vanish and the result of active policy will only be inflation.

Reference

Carvalho, Carlos, Stefano Eusepi, and Christian Grisse. “Policy Initiatives in the Global Recession: What Did Forecasters Expect?” Federal Reserve Bank of New York: Current Issues in Economics and Finance , 18, no. 2 (2012). http://www.newyorkfed.org/research/current_issues/ci18-2.pdf.