Modern Macroeconomics in Practice: How Theory Is Shaping Policy

_________________________________________________________________________ Theoretical advances in macroeconomics made in the last three decades have had a major influence on macroeconomic policy analysis. Moreover, over the last several decades, the United States and other countries have undertaken a variety of policy changes that are precisely what macroeconomic theory of the last 30 years suggests. The three key developments that have shaped macroeconomic policy analysis are the Lucas critique of policy evaluation due to Robert Lucas, the time inconsistency critique of discretionary policy due to Finn Kydland and Edward Prescott, and the development of quantitative dynamic stochastic general equilibrium models following Finn Kydland and Edward Prescott. _____________________________________________________________________________________ *We thank Kathy Rolfe and Joan Gieseke for excellent editorial assistance. The views expressed herein are those of the authors and not necessarily those of the Federal Reserve Bank of Minneapolis or the Federal Reserve System. Over the last three decades, macroeconomic theory and the practice of macroeconomics by economists have changed significantly—for the better. Macroeconomics is now firmly grounded in the principles of economic theory. These advances have not been restricted to the ivory tower. Over the last several decades, the United States and other countries have undertaken a variety of policy changes that are precisely what macroeconomic theory of the last 30 years suggests. The evidence that these theoretical advances have had a significant effect on the practice of policy is often hard to see for policymakers and advisers who are involved in the hurly-burly of day-to-day policymaking, but easy to see if one steps back and takes a longer-term perspective. Examples of the effects of theory on the practice of policy include increased central bank independence, adoption of inflation targeting and other rules to guide monetary policy, increased reliance on consumption and labor taxes instead of capital income taxes, and increased awareness of the costs of policies that distort labor markets. Three key developments in academic macroeconomics have shaped macroeconomic policy analysis: the Lucas critique of policy evaluation due to Robert Lucas (1976), the time inconsistency critique of discretionary policy due to Finn Kydland and Edward Prescott (1977), and the development of quantitative dynamic stochastic general equilibrium models following Finn Kydland and Edward Prescott (1982). Lucas argued that economic theory implies that preferences and technology are invariant to the rule describing policy but that decision rules describing private agents’ behavior are not. In a series of graphic examples, he showed that then standard policy analyses which presumed invariance of decision rules lead to dramatically undesirable policy prescriptions. Kydland and Prescott argued that a regime in which policymakers set state-