Blanchard 2000 Introducción para Todo Curso de Macro

DE ECONOMIST 148, NO.
5, 2000
WHAT DO WE KNOW ABOUT MACROECONOMICS THAT FISHER AND

WICKSELL DID NOT?**
BY
OLIVIER BLANCHARD*
Summary
The answer to the question in the title is: A lot. In this essay, I argue that the history of macroeco-
nomics during the 20th century can be divided into three epochs:
Pre-1940. A period of exploration, where macroeconomics was not macroeconomics yet, but mon-
etary theory on one side, business cycle theory on the other. A period during which all the right
ingredients, and quite a few more, were developed. But also a period where confusion reigned, be-
cause of the lack of an integrated framework.
From 1940 to 1980. A period of consolidation. A period during which an integrated framework was
developed – starting with the IS-LM, all the way to dynamic general equilibrium models – and used
to clarify the role of shocks and propagation mechanisms in fluctuations. But a construction with an
Achille’s heel, namely too casual a treatment of imperfections, leading to a crisis in the late 1970s.
Since 1980. A new period of exploration, focused on the role of imperfections in macroeconomics,
from the relevance of nominal price setting, to incompleteness of markets, to asymmetric information,
to search and bargaining in decentralized markets. Exploration often feels like confusion. But behind
it may be one of the most productive periods of research in macroeconomics.
Key words: macroeconomics, business cycles, fluctuations, history of thought
1 INTRODUCTION
The theme of this lecture was triggered by a question from the editors of the
Quarterly Journal of Economics. To celebrate the new century, they commis-
sioned a number of essays on the theme: What do we know about field x that
Marshall did not know? 1 I took up the challenge for macroeconomics and this
lecture is the result.
* MIT and NBER.

** Thirteenth Tinbergen lecture, delivered on October 15, 1999 at De Nederlandsche Bank, Amster-
dam. I thank Daron Acemoglu, Ben Bernanke, Ricardo Caballero, Thomas Cool, Peter Diamond, Rudi
Dornbusch, Stanley Fischer, Bengt Holmström, Larry Katz, David Laibson, N. Greg Mankiw, David
Romer, Paul Samuelson, Andrei Shleifer, Robert Solow, Justin Wolfers, and Michael Woodford for
useful comments and discussions. This lecture is a slightly modified version of an article with the
same title, forthcoming in the Quarterly Journal of Economics, November 2000.
1 The essays have been and will be published in the various issues of the journal during 2000.
De Economist 148, 571–601, 2000.

© 2000 Kluwer Academic Publishers. Printed in the Netherlands.
572 O. BLANCHARD
The first thing to say is that, in the case of macroeconomics and with due
respect to Marshall, he is probably not the right reference. 2 But if we replace his
name by those of Wicksell and Fisher, the two dominant figures in the field at
the start of the 20th century, then the answer is very clear: We have learned a lot.
Indeed, progress in macroeconomics may well be the success story of 20th cen-
tury economics. 3
Such a strong statement will come as a surprise to some. On the surface, the
history of macroeconomics in the 20th century appears as a series of battles, revo-
lutions and counterrevolutions, from the Keynesian revolution of the 1930s and
1940s, to the battles between Monetarists and Keynesians of the 1950s and 1960s,
to the Rational Expectations revolution of the 1970s, and the battles between New
Keynesians and New Classicals of the 1980s. These suggest a field starting anew
every twenty years or so, often under the pressure of events, and with little or no
common core. But this would be the wrong image. The right one is of a surpris-
ingly steady accumulation of knowledge. The most outrageous claims of revolu-
tionaries make the news, but are eventually discarded. Some of the others get
bastardized, then integrated. The insights become part of the core. In this article,
I focus on the accumulation of knowledge rather than on the revolutions and
counterrevolutions. Admittedly, this makes for worse history of thought, and it
surely makes for worse theater. But it is the best way to answer the question in
the title. 4
Let me state the thesis that underlies this essay. I believe the history of mac-
roeconomics during the 20th century can be divided in three epochs, the third
one currently playing: 5
Ê Pre 1940. A period of exploration, where macroeconomics was not macroeco-
nomics yet, but monetary theory on one side, business cycle theory on the
other. A period during which all the right ingredients, and quite a few more,
were developed. But also a period where confusion reigned, because of the
lack of an integrated framework.
2 Marshall published two books about macroeconomics, the first early in his professional career,
The Economics of Industry, in 1879; the second one year before his death in 1924, Money, Credit and
Commerce, which largely repeated the themes of the first. In his ‘in memoriam’ biography of Mar-
shall, Keynes argues that Marshall anticipated many of the points developed by Fisher and Wicksell.
But his assessment surely reflects in part the kindness required under the circumstances.
3 The two most relevant books here are Wicksell’s Interest and Prices, published in 1898 in Ger-
man, but translated in English only much later, and Fisher’s Purchasing Power of Money, published
in 1911.
4 A nice, largely parallel, review of macroeconomics in the 20th century, taking the alternative,
more historical, approach is given by Woodford 共1999兲.
5 For the purpose of this article, I shall define macroeconomics as the study of fluctuations, mun-
dane – recessions and expansions, or sustained – sharp recessions, long depressions, sustained high
unemployment. I shall exclude both the study of growth and the political economy of macroeconom-
ics. Much progress has been made there as well, but covering these two topics would extend the
length of this essay to unmanageable proportions.
WHAT DO WE KNOW ABOUT MACROECONOMICS 573
Ê From 1940 to 1980. A period of consolidation. A period during which an in-

tegrated framework was developed – starting with the IS-LM, all the way to
dynamic general equilibrium models – and used to clarify the role of shocks
and propagation mechanisms in fluctuations. But a construction with an Achil-
le’s heel, namely too casual a treatment of imperfections, leading to a crisis in
the late 1970s.
Ê Since 1980. A new period of exploration, focused on the role of imperfections
in macroeconomics, from the relevance of nominal wage and price setting, to
incompleteness of markets, to asymmetric information, to search and bargain-
ing in decentralized markets, to increasing returns in production. Exploration
often feels like confusion, and confusion there indeed is. But behind it may be
one of the most productive periods of research in macroeconomics.
Let me develop these themes in turn.
2 PRE-1940. EXPLORATION
To somebody who reads it today, the pre-1940 literature on macroeconomics feels

like an 共intellectual兲 witch’s brew: many ingredients, some of them exotic, many
insights, but also a great deal of confusion. 6
The set of issues that would now be called macroeconomics fell under two
largely disconnected headings: Monetary Theory, and Business Cycle Theory. 7, 8
At the center of Monetary Theory was the quantity theory – the theory of how
changes in money lead to movements in output and prices. The focus was both
on long-run neutrality and on short-run non-neutrality. The discussion of the short-
run effects of an increase in money on output was not much improved relative
to, say, the earlier treatments by Hume or Thornton. Some stressed the effects
from money to prices and from prices to output: Higher money led to higher
6 This assessment should be taken with a grain of salt. Paul Samuelson once chided Stanley Fischer
and me for having, in our graduate macro text, few if any references to articles written before 1980.
Some of the confusion may therefore be in the eyes of this ignorant beholder.
7 The word ‘macroeconomics’ does not appear until the 1940s. According to JSTOR 共the electronic
data base which includes the articles from most major journals since their inception兲, the first use of
‘macro-economic’ in the title of an article is by De Wolff in 1941, in ‘Income Elasticity of Demand,
a Micro-economic and a Macro-economic Interpretation’; the first use of ‘macroeconomics’ in the
title of an article is by Klein in 1946, in an article called, fittingly, ‘Macroeconomics and the Theory
of Rational Behavior.’ But the word ‘macrodynamics’ can be found in writings by Frisch and Kalecki
in the early 1930s. And Paul Samuelson tells me that, in an analogy with thermodynamics, his Har-
vard teacher, Gottfried Haberler was using the words ‘macroscopic’ and ‘microscopic’ to indicate dif-
ferent ways of looking at the economy.
8 In the 1920s, the two graduate ‘macro’ courses at Harvard University were called ‘Principles of
Money and Banking’ and ‘Commercial Crises.’ The latter course became ‘Economic Trends and Fluc-
tuations’ in 1930, and ‘Business Cycles and Economic Forecasting’ in 1934. Except for 1933, the
year in which Schumpeter taught a unified course, this separation held until the 1940s.
574 O. BLANCHARD
prices, higher prices ‘excited’ business and led in turn to higher output. Others
stressed the effects from money to output, and from output to prices: Higher
money increased demand and output, and the increase in output led in turn to an
increase in prices over time.
Business Cycle Theory was not a theory at all, but rather a collection of ex-
planations, each with its own rich dynamics. 9 Most explanations focused on one
factor at a time: Real factors 共weather, technological innovations兲, or expecta-
tions 共optimistic or pessimistic firms兲, or money 共banks or the central bank兲.
When favorable, these factors led firms to invest more, banks to lend more, until
things turned around, typically for endogenous reasons, and the boom turned into
a slump. Even when cast as general equilibrium, the arguments, when read today,
feel incomplete and partial equilibrium in nature: It is never clear how, and in
which markets, output and the interest rate are determined.
In retrospect, one can see the pieces of a macroeconomic model slowly falling
into place. 10
At the center was the difference, emphasized by Wicksell, between the natural
rate of interest 共the rate of return on capital兲 and the money rate of interest 共the
interest rate on bonds兲. This would become a crucial key in allowing for the even-
tual integration of goods markets 共where the natural rate is determined兲 and fi-
nancial markets 共where the money rate is determined兲. It would also prove to be
the key in allowing for the eventual integration of monetary theory 共where an
increase in money decreases the money rate relative to the natural rate, triggering
higher investment and higher output for some time兲 and business cycle theory 共in
which several factors, including money, affect either the natural rate or the money
rate, and thus the difference between the two兲.
Where the literature remained confused, at least until Keynes and for some
time after, was how this difference between the two rates translated into move-
ments in output. Throughout the 1920s and 1930s, the focus was increasingly on
the role of the equality of saving and investment, but the semantic squabbles
which dominated much of the debate 共the distinctions between ‘exante,’ and ‘ex-
post,’ ‘planned’ and ‘realized’ saving and investment, the discussion of whether
the equality of saving and investment was an identity or an equilibrium condi-
tion兲 reflected a deeper confusion. It was just not clear how shifts in saving and
investment affected output.
In that context, the methodological contributions of the General Theory 共1936兲
made a crucial difference:
9 The variety and the complexity of these explanations is reflected in Mitchell 共1923兲, or in the
textbook of the time, Prosperity and Depression by Haberler 共1937兲.
10 There is always the risk here of seeing more than there actually was. An example of this is
Alvin Hansen’s textbook, published in the early 1950s, of the history of macroeconomic thought
through a thoroughly Keynesian filter: How close various authors had gotten to S ⫽ I, to what deter-
mined S, to what affected I. There is little question that the filter is highly distorting.
Ê Keynes explicitly thought in terms of three markets 共the goods, the financial,
and the labor markets兲, and of the implications of equilibrium in each.
Ê Using the goods market equilibrium condition, he showed how shifts in sav-
ing and investment led to movements in output.
Ê Using equilibrium conditions in both the goods and the financial markets, he
then showed how various factors affected the natural rate of interest 共which he
called the ‘marginal efficiency of capital’兲, the money rate of interest, and out-
put. An increase in the marginal efficiency of capital – coming, say, from more
optimistic expectations about the future – or a decrease in the money rate –
coming from expansionary monetary policy – both led to an increase in out-
put.
A quote from Pigou’s Marshall lectures, ‘Keynes’s General Theory, A Retrospec-

tive View,’ 共1950兲 puts it well: 11
‘Nobody before him, so far as I know, had brought all the relevant factors,
real and monetary at once, together in a single formal scheme, through which
their interplay could be coherently investigated.’
The stage was then set for the second epoch of macroeconomics, a phase of
consolidation and enormous progress.
3 1940-1980. CONSOLIDATION.
Macroeconomists often refer to the period from the mid 1940s to the mid 1970s
as the golden age of macroeconomics. For a good reason: Progress was fast, and
visible.
3.1 Establishing a Basic Framework
The IS-LM formalization by Hicks and Hansen may not have captured exactly
what Keynes had in mind. But, by defining a list of aggregate markets, writing
demand and supply equations for each one, and solving for the general equilib-
rium, it transformed what was now becoming ‘macroeconomics.’ It did not do
this alone. Equally impressive in their powerful simplicity were, for example, the
model developed by Modigliani in 1944, with its treatment of the labor market
and the role of nominal wage or price rigidities, or the model developed by Met-
zler in 1951, with its treatment of expectations, wealth effects, and the govern-
ment budget constraint. These contributions shared a common structure: The re-
duction of the economy to three sets of markets – goods, financial, and labor –
and a focus on the simultaneous determination of output, the interest rate and the
11 Pigou’s first assessment of the General Theory, in 1936, had been far less positive, and for un-
derstandable reasons: Keynes was not kind to Pigou in the General Theory; but, by 1950, time had
passed, and Pigou clearly felt more generous.
576 O. BLANCHARD
price level. This systematic, general equilibrium approach to the characterization

of macroeconomic equilibrium became the standard, and, reading the literature,
one is struck at how much clearer discussions became once this framework had
been put in place.
This approach was brought to a new level of rigor in Money, Interest, and
Prices by Patinkin 共1956兲. Patinkin painstakingly derived demand and supply re-
lations from intertemporal optimizing behavior by people and firms, he charac-
terized the equilibrium, and, in the process, laid to rest many of the conceptual
confusions which had plagued earlier discussions. It is worth making a – non
limitative – list 共if only because some of these confusions have a way of coming
back in new forms兲:
Ê ‘Say’s law’: False. In the same way as the supply of any particular good did
not automatically generate its own demand 共the relative price of the good has
to be right兲, the supply for all goods taken together did not generate its own
demand either: The intertemporal price of goods, the real interest rate, also
had to be right.
Ê ‘Walras’ law’: True. So long as each agent took all his or her decisions under
one budget constraint, then equilibrium in all markets except one implied equi-
librium in the remaining one.
Ê The ‘Classical Dichotomy’ between the determination of the price level on the
one hand, and the determination of relative prices on the other: False. ‘Neu-
trality,’ the proposition that changes in money were ultimately reflected in pro-
portional changes in the price level, leaving relative prices unaffected, was true.
But this was an equilibrium outcome, not the result of a dichotomous model
structure.
Ê ‘Value theory versus Monetary Theory’ – the issue of whether standard meth-
ods used in value theory could be used to think about the role and the effects
of money in a monetary economy. The answer was: Yes. One could think of
real money balances as entering either the indirect utility of consumers, or the
production function of firms. One could then treat real money balances as one
would treat any other good.
Ê ‘Loanable Funds or Liquidity Preference’ – the issue of whether the interest
rate was determined in the goods markets 共through the equality of saving and
investment兲, or in the financial markets 共through the equality of the demand
and the supply of money兲. The answer, made clear by the general equilibrium
structure of the models, was: In general, both.
3.2 Back to Dynamics
Keynes himself had focused mostly on comparative statics. Soon after however,
the focus shifted back to dynamics. Little if any of the old business cycle litera-
ture was used, and most of the work was done from scratch.
Key to these developments was the notion of ‘temporary equilibrium,’ devel-

oped by Hicks in Value and Capital 共1939兲. The approach was to think of the
economy as an economy with few future or contingent markets, an economy in
which people and firms therefore had to make decisions based partly on state
variables – variables reflecting past decisions – and partly on expectations of the
future. Once current equilibrium conditions were imposed, the current equilib-
rium depended partly on history, partly on expectations of the future. And given
a mechanism for the formation of expectations, one could trace the evolution of
the equilibrium through time.
Within this framework, the next step was to look more closely at consump-
tion, investment, and financial decisions, and their dependence on expectations.
This was accomplished, in a series of extraordinary contributions, by Modigliani
and Friedman who examined the implications of intertemporal utility maximiza-
tion for consumption and saving, by Jorgenson and Tobin who examined the im-
plications of value maximization for investment, and by Tobin and a few others
who examined the implications of expected utility maximization for financial de-
cisions. These developments would warrant more space, but they are so well
known and recognized 共in particular, by many Nobel prizes兲 that there is no need
to do so here.
The natural next step was to introduce rational expectations. The logic for tak-
ing that step was clear: If one was to explore the implications of rational behav-
ior, it seemed reasonable to assume that this extended to the formation of
expectations. 12 That step however took much longer. It is hard to tell how much
of the delay was due to technical problems – which indeed were substantial –
and how much to objections to the assumption itself. But this was eventually
done, and by the late 1970s, most of the models had been reworked under the
assumption of rational expectations. 13
With the focus on expectations, a new battery of small models emerged, with
more of a focus on intertemporal decisions. The central model was a remake of a
model first developed by Ramsey in 1928, but now reinterpreted as a temporary
equilibrium model with infinitely lived individuals facing a static production
technology. 14 This initial structure was then extended in many directions. 15
Among these:
12 As Solow 共1999兲 put it: ‘The big intellectual advantage of rational expectations is that it is defi-
nite. The complement of rational expectations is a very large grab-bag.’
13 This is where a more historical approach would emphasize that this was not a smooth evolu-
tion... At the time, the introduction of rational expectations was perceived as an attack on the re-
ceived body of macroeconomics. But, with the benefit of hindsight, it feels much less like a revolu-
tion than like a natural evolution. 共Some of the other issues raised by the same economists who
introduced rational expectations proved more destructive, and are at the source of the crisis I discuss
below.兲
14 Ramsey had thought of his model as purely normative, indicating how a central planner might
want to allocate consumption over time.
578 O. BLANCHARD
Ê The introduction of costs of adjustment for capital, leading to a well defined

investment function, and a way of thinking about the role of the term struc-
ture of interest rates in achieving the equality of saving and investment.
Ê The introduction of money as a medium of exchange, and the extension of the
Baumol-Tobin model of money demand to general equilibrium.
Ê The introduction of some dimensions of heterogeneity, for example allowing
for finite lives and extending the overlapping generations model first devel-
oped by Samuelson and Diamond.
Ê The introduction of a leisure/labor choice, in addition to the consumption/sav-
ing decision.
Ê The extension to an economy open both in goods and financial markets.
Initially, these models were solved either under perfect foresight, a simplifying
but rather unappealing assumption in a world of uncertainty and changing infor-
mation. That introducing uncertainty was essential was driven home by an article
by Hall 共1978兲 who showed that, under certain conditions, optimizing behavior
implied that consumption should follow a random walk – a result which initially
came as a shock to those trained to think in terms of the life cycle model. Under
the leadership of Lucas and Sargent 共for example, Lucas and Stokey 共1989兲, Lu-
cas 共1987兲, and Sargent 共1987兲兲, developments in stochastic dynamic programing
together with progress in numerical methods and the development of more pow-
erful computers were used to characterize behavior under uncertainty. This in turn
allowed the exploration of a new and important set of issues, the implications of
the absence of some future or contingent markets in affecting consumption and
investment decisions, and, in turn, the macroeconomic equilibrium.
Compared to the first generation of models 共the IS-LM, Metzler, and
Modigliani models兲, these models, in either their perfect foresight or their sto-
chastic versions, were more tightly specified, less eclectic. In their initial incar-
nation, they often ignored imperfections which many macroeconomists saw as
central to an explanation of macroeconomic fluctuations. But they provided a ba-
sic set of off-the-shelf structures on which to build, and indeed, in which to in-
troduce imperfections. Getting ahead of my story: This is indeed what has hap-
pened since the early 1980s, and I shall return to it later.
3.3 From Models to Data
Starting in the 1940s, in macroeconomics as in the rest of economics, research

was radically transformed by the increasing availability of data and the develop-
ment of econometric methods. But another element, specific to macroeconomics,
15 The basic Ramsey model and many of these extensions form the core of today’s graduate text-
books. See for example Blanchard and Fischer 共1989兲, or Obstfeld and Rogoff 共1996兲.
played a central role: the coincidence between the implications of linear dynamic
models and the time series representation of economic variables.
The old business cycle literature had been groping towards non-linear endog-
enous cycle models, models where the expansion created the conditions for the
next recession, the recession the conditions for the next expansion, and so on. As
early as 1933 however, Ragnar Frisch had argued that much simpler systems,
linear difference systems with shocks, could provide a better account of aggre-
gate fluctuations. In an economy described by such systems, one could think of
fluctuations as the result of the combination of impulses – random shocks con-
stantly buffeting the economy – and propagation mechanisms, the dynamic ef-
fects of these shocks implied by the linear system. This point was reinforced by
Samuelson’s 1939 analysis of the multiplier accelerator, which showed how a
given shock to spending could generate rich dynamic responses of output. The
convenience of the approach, and its easy mapping to the data, quickly led to the
dominance of linear models with shocks as the basic approach to fluctuations,
and alternative non-linear approaches largely faded from the scene.
These early steps were followed by the specification and estimation of struc-
tural models. Using the approach to identification developed by Koopmans and
others at the Cowles Commission, individual equations for consumption, invest-
ment, and money demand, were estimated and integrated in larger and larger mac-
roeconometric models, starting with the work of Tinbergen in the 1930s, and cul-
minating, on the academic side, in models such as the MPS, developed by
Modigliani and co-authors in the 1960s and early 1970s.
In the late 1970s, the focus shifted, at least on the academic side, to smaller
models. The feeling was that the immense effort to construct large structural mod-
els had been overambitious, that the identification conditions used in estimation
of individual equations were often dubious, and that the equation-by-equation con-
struction of econometric models did not in any way insure that the reduced form
of the estimated model fitted the basic characteristics of the data.
This was the motivation behind the return to smaller, more transparent, struc-
tural models, whose limited size had the additional advantage of making them
solvable under rational expectations. It was also the motivation behind the devel-
opment of a new statistical tool, vector autoregressions or VARs – namely the
direct estimation of the joint stochastic process describing the variables under con-
sideration. VARs were then used in two ways: to obtain a set of stylized statis-
tical facts that models had to match and to see whether, under a minimal set of
identification restrictions, the evidence was consistent with the dynamic effects of
shocks implied by a particular theory or class of theories.
The constant back and forth between models and data, and the increasing avail-
ability of macro and micro data, has made macroeconomics a radically different
field from what it was in 1940. Samuelson once remarked that one of his disap-
pointments was that econometric evidence had led to less convergence than he
had hoped when the first econometric steps were taken 共in Snowdown and Vane
580 O. BLANCHARD
共1999兲, p 323兲. It is nevertheless true that progress has been been nothing short
of amazing. When Kahn 共1931兲 first tried to get a sense of the value of the mar-
ginal propensity to consume, all he had were a few observations on proxies for
aggregate production, imports, and investment. When Modigliani and Brumberg
共1954兲 tried to assess the empirical fit of the life cycle hypothesis, they could use
the time series recently put together for the National Income Accounts by Kuz-
nets and others, and a few cross sections on income and saving. Today, studies of
consumption have access to long repeated cross sections, or even long panel data
sets 共see for example Deaton 共1992兲兲. This allows not only for much sharper ques-
tions about consumption behavior, but also for a more convincing treatment of
identification 共through the use of ‘natural experiments’, tracing the effects of
changes in the economic environment affecting some but not all consumers兲 than
was feasible earlier.
So far, the tone of this essay has been that of a panegyric, the description of
a triumphal march towards truth and wisdom. Let me now turn to the problem
that macroeconomics largely ignored, and which led to a major crisis in the late
1970s.
3.4 The Casual Treatment of Imperfections
From Keynes on, there was wide agreement that some imperfections played an
essential role in fluctuations. 16 Nominal rigidities, along the lines suggested by
Keynes, and later formalized by Modigliani and others, played an explicit and
central role in most formalizations. They were crucial to explaining why and how
changes in money and other shifts in the demand for goods affected output, at
least in the short run.
These nominal rigidities, when combined with later developments such as ra-
tional expectations, proved to have rich and relevant implications. For example,
in an extension of the Mundell-Fleming model, 共the version of the IS-LM model
for an economy open in both goods and financial markets兲 Dornbusch 共1976兲
showed that the large swings in exchange rates, which had been observed after
the adoption of flexible exchange rates in the early 1970s and were typically at-
tributed to irrational speculation, could be interpreted instead as the result of ar-
bitrage by speculators with rational expectations in an economy with a slowly
adjusting price level. The lesson was more general: nominal rigidities in some
markets led to more price volatility in others, here in the foreign exchange mar-
ket.
16 A semantic clarification: Following tradition, I shall refer to ‘imperfections’ as deviations from

the standard perfect competition model. Admittedly, there is more than just a semantic convention
here. Why give such status to such an utterly unrealistic model? The answer is because most current
research is organized in terms of what happens when one relaxes one or more assumptions in that
model. This may change one day. But, for the time being, this approach provides a common research
strategy and makes for easier communication among macroeconomic researchers.
But, as the early models were improved in many dimensions, the treatment of
imperfections remained surprisingly casual. The most obvious example was the
treatment of wage adjustment in the labor market. In early models, the assump-
tion was typically that the nominal wage was fixed, and that the demand for la-
bor then determined the outcome. Later on, these assumptions were replaced by a
Phillips curve specification, linking inflation to unemployment. But there was sur-
prisingly little work on what exactly laid behind the Phillips curve, why and how
wages were set this way, why there was little apparent relation between real
wages and the level of employment. As a result, most macro models developed
in the 1960s and 1970s had a schizophrenic feeling: a careful modeling of con-
sumption, investment, and asset demand decisions on the one hand, and a-theo-
retical specification of price and wage setting on the other.
The only systematic theoretical attempt to explore the implications of nominal
rigidities, the ‘fixed price equilibrium’ approach developed in the 1970s, turned
out to be a dead end. This was for reasons intrinsic to the macroeconomic ap-
proach at the time, and so it is worth looking at the episode more closely.
The approach was based on the insights of Clower and Patinkin, and a sys-
tematic treatment was given by Barro and Grossman 共1976兲. The strategy was to
assume a competitive economy, to allow the vector of prices to differ from the
flexible price equilibrium vector, and then to characterize the determination of
output under these conditions. Equilibrium in each market was assumed equal to
the minimum of supply and demand. The complexity and the richness of the
analysis came from the fact that, if people or firms were on the short side in one
market, they then modified their supply and demand functions in other markets.
The results were tantalizing. The analysis showed that, if the price vector was
such as to yield a state of generalized excess supply 共in both goods and labor
markets兲, the economy behaved very much as in the Keynesian model. Firms,
constrained in the goods market, employed only as many workers as they needed:
The demand for labor was determined by output, and was independent of the real
wage. Workers, constrained in the labor market, took employment and labor in-
come as given in making consumption decisions. The economy exhibited a de-
mand multiplier: Increases in demand led to more production, more income, more
demand, and so on.
This was clearly good news for the prevailing view of fluctuations. But the
same approach showed that, if the price vector was such as to yield instead a
state of generalized excess demand, things looked very different, indeed much
more like what one saw in the Soviet Union at the time than in market econo-
mies. The multiplier was a supply multiplier: The inability to buy goods led
people to reduce their labor supply, decreasing output, leading to even more ra-
tioning in the goods market, and so on. An increase in government spending led
to more rationing of consumers, a decrease in labor supply, and a decrease in
output.
582 O. BLANCHARD
This raised an obvious issue: Without a theory of why prices were not right in
the first place, the second outcome appeared just as likely as the first. So, why
was it that we typically observed the first outcome, not the second? The answer
clearly required a theory of price setting, and so the explicit introduction of price
setters 共so that somebody other than the auctioneer was in charge兲. But if there
were explicit price setters, there was then no particular reason why the market
outcome should be equal to the minimum of supply and demand. If, for example,
price setters were monopolistic firms, and demand turned out larger than they
expected, then they might well want to satisfy this higher level of demand, at
least as long as their price exceeded marginal cost. So, to make progress, one
had to think hard about market structure, and who the price setters were. But
such focus on market structure, and on imperfections more generally, was alto-
gether absent from macroeconomics at the time. 17
At roughly the same time 共circa 1975兲, this intellectual crisis was made worse
by another development, the collapse of traditional conclusions when rational ex-
pectations were introduced in otherwise standard Keynesian models. Working
within the standard model at the time 共an IS-LM model plus an expectations-
augmented Phillips curve兲, Sargent 共1973兲 showed that, if one assumed rational
expectations of inflation, the effects of money on output lasted only for a brief
moment, until the relevant information about money was released. So, even on
its own terms, once rational expectations were introduced, the standard model
seemed unable to deliver its traditional conclusions 共such as for example, lasting
effects of money on output兲.
Thus, by the end of the 1970s, macroeconomics faced a serious crisis. The
reaction of researchers was to follow two initially very different routes.
The first, followed by the ‘New Keynesians’, was based on the belief that the
traditional conclusions were indeed largely right, and that what was needed was
a deeper look at imperfections and their implications for macroeconomics.
The second, followed by the ‘New Classicals’ or ‘Real Business Cycle’ theo-
rists, was instead to question the traditional conclusions and explore how far one
could go in explaining fluctuations without introducing imperfections 共Prescott
共1986兲兲.
At the time, macroeconomics looked 共and felt兲 more divided than ever before
共the intensity of the debate is well reflected in Lucas and Sargent 共1978兲兲. Yet,
nearly 20 years later, the two routes have surprisingly converged. The method-
ological contributions of the Real Business Cycle approach, namely the develop-
ment of stochastic dynamic general equilibrium models, have proven important
and have been widely adopted. But the initial propositions that money did not
matter, that technological shocks could explain fluctuations, and that imperfec-
tions were not needed to explain fluctuations, have not held up. The empirical
17 As it was absent from general equilibrium theory, leading economists working on stability and
formalizations of real time tatonnement processes into similar dead ends.
evidence continues to strongly support the notion that monetary policy affects
output. And the idea of large, high frequency movements in the aggregate pro-
duction function remains an implausible black box; the relation between output
and productivity appears more likely to reflect reverse causality, with movements
in output leading to movements in measured total factor productivity, rather than
the other way around.
For those reasons, most if not all current models, in either the New Keynesian
or the New Classical mode 共these two labels will soon join others in the trash
bin of history of thought兲 now examine the implications of imperfections, be it in
labor, goods, or credit markets. This is the body of work that I now turn to.
4 POST 1980. I. WORKING OUT THE QUANTITY THEORY.
In discussing the role of imperfections in macroeconomics, it is useful to divide

the set of questions into two:
Ê The old Quantity Theory questions: Why does money affect output? What are
the origin and the role of nominal rigidities in the process? These may be the
central questions of macroeconomics, not because shifts in money are the ma-
jor determinant of fluctuations 共they are not兲, but because the non neutrality of
money is so obviously at odds with the predictions of the benchmark, flexible
price model.
Ê The old Business Cycle questions: What are the major shocks that affect out-
put? What are their propagation mechanisms? What is the role of imperfec-
tions in that context?
This section focuses on the first set of questions, the next section on the second
set.
Most macroeconomists would, I believe, agree today on the following descrip-
tion of what happens in response to an exogenous increase in nominal money: 18
Ê Given the price level, an increase in nominal money leads to an increase in
the aggregate demand for goods. At given nominal prices – and so at given
relative prices – this translates to an increase in the demand for each good.
共‘Prices’ is used generically here. I do not distinguish between wages and
prices兲.
Ê Increasing marginal cost/disutility implies that this increase in the demand for
each good leads each price setter to want to increase his price relative to oth-
ers.
Ê If all individual prices were set continuously, the attempt by each price setter
to increase his price relative to others would clearly fail. All prices, and by
18 Most but not all. While other explanations, based for example on distribution 共‘limited partici-
pation’兲 effects of open market operations, have until now turned out to be dead ends, a number of
macroeconomists remain skeptical of nominal rigidities as the source of the real effects of money.
584 O. BLANCHARD
implication, the price level would rise until the price level had adjusted in
proportion to the increase in nominal money, demand and output were back to
their original level, and there was no longer any pressure to increase relative
prices. This would happen instantaneously. Money would be neutral, even in
the short run.
Ê Individual prices however are adjusted discretely rather than continuously, and
not all prices are adjusted at the same time. This discrete, staggered adjust-
ment of individual prices leads to a slow adjustment of the average level of
prices – the price level. 19
Ê During the process of adjustment of the price level, the real money stock re-
mains higher, and aggregate demand and output remain higher than their origi-
nal value. Eventually, the price level adjusts in proportion to the increase in
nominal money. Demand, output, and relative prices return to their original
value. Money is neutral, but only in the long run.
This story feels simple and natural. Indeed, it is not very different from the ac-
count given by the quantity theorists of the 19th century. What the recent re-
search has done has been to clarify various parts of the argument, and point to a
number of unresolved issues.
4.1 Staggering, and the Adjustment of the Price Level
A tempting analogy to the proposition that staggered adjustment of individual

prices leads to a slow price level adjustment is to the movements of a chain gang.
Unless gang members can coordinate their movements very precisely, the chain
gang will run slowly at best. The shorter the length of the chain between two
gang members, or the larger the number of members in the gang, the slower it is
likely to run.
Research on the aggregate implications of specific price rules and staggering
structures has shown that the analogy is typically right. In most cases, discrete
adjustment of individual prices leads indeed to a slow adjustment of the price
level. 20 And the more each desired price depends on other prices, the slower the
adjustment. But this research has also come with a number of warnings. In a
celebrated counterexample to the general proposition, Caplin and Spulber 共1987兲
have shown that, under some conditions, the reverse proposition may in fact hold.
Discrete adjustment of individual prices may still lead to a completely flexible
19 An earlier hypothesis for slow adjustment of individual prices, developed by Lucas 共1973兲 and
based on incomplete information rather than staggering, has been largely abandoned. It is perceived
to rely on implausible assumptions about the structure of information on macroeconomic aggregates.
20 The most influential model here is surely Taylor 共1980兲. See Taylor 共1998兲 for a recent survey.
price level. 21 The conditions under which their conclusion holds are more likely
to be satisfied at high inflation, and this has an important implication. The effects
of money on output are likely to be shorter, the higher the average rate of money
growth and the associated rate of inflation.
4.2 Real and Nominal Rigidities
If individual price changes are staggered, the price level will increase only if at
least some individual price setters want to increase their relative price. Once the
price level has fully adjusted to the increase in money, and demand and output
are back to their original level, desired relative prices end up the same as they
were before the increase in money; but this is true only in the end.
This observation has one important implication. The speed of adjustment of
the price level depends on the elasticity of desired relative prices in response to
shifts in demand. The higher this elasticity, the more each individual price setter
will want to increase his price when he adjusts, the faster the price level will
increase, the shorter will be the effects of money on output. Research suggests
that, to generate the slow adjustment of the price level one observes in the data,
this elasticity must indeed be small, smaller than one would expect if for ex-
ample the price set by firms reflected the increase in marginal cost for firms, and
the wage reflected the increase in the marginal disutility of work for workers. 22
This proposition is sometimes stated as follows: ‘Real rigidities’ 共a small elas-
ticity of the desired relative price to shifts in demand兲 are needed to generate
substantial ‘nominal rigidity’ 共a slow adjustment of the price level in response to
changes in money兲. The terminology may be infelicitous. But the conclusion is
an important one and points to an interaction between nominal rigidities and other
imperfections. If these other imperfections are such as to generate real rigidities
共a big if兲, they can help explain the degree of nominal rigidity we appear to ob-
serve in modern economies.
4.3 Demand versus Output
Suppose that the price level responds slowly, so an increase in money leads to an
increase in the demand for goods for some time. In the absence of further infor-
mation on the structure in goods and labor markets, there is no warranty that this
increase in demand will lead to an increase in output. It will do so only if sup-
pliers of both labor and goods are willing to supply more. This was indeed the
main unresolved issue in the fixed price equilibrium approach. For increases in
21 Their result requires two conditions: That prices be changed according to an Ss rule, and that
each desired nominal price be a non decreasing function of time. Caplin and Leahy 共1991兲 show what
happens when only the first condition holds. Money is then typically non neutral.
22 See Blanchard and Fischer 共1989兲, chapter 8, and Chari et al. 共1998兲 for a recent discussion.
586 O. BLANCHARD
demand to translate into increases in output, the market structure must be such
that the price setters are willing to supply more even at the existing price.
There are market structures where this will be the case. Suppose for example
that the goods market is composed of monopolistically competitive price setters.
At the initial equilibrium, monopoly power implies that their price is above their
marginal cost. This implies in turn that, even at an unchanged price, they will be
willing to satisfy an increase in demand, at least so long as the marginal cost
remains smaller than the price. So, under this market structure, shifts in demand,
so long as they are not too large, will lead to an increase in output.
For this reason, a typical assumption in recent research has been one of mo-
nopolistic competition. In the goods market, the assumption that price setters have
some monopoly power and so may be willing to increase output in response to a
shift in demand seems indeed reasonable. The assumption of monopolistic com-
petition in the labor market is clearly much less appealing, and the question of
whether the same conclusion will derive from more realistic descriptions of wage
setting remains open. More generally, this points to yet another interaction be-
tween nominal rigidities and other imperfections. To understand why output and
employment respond to shifts in demand, we need a better understanding of the
structure of both goods and labor markets.
4.4 Money as Numeraire and Medium of Exchange
The argument underlying non-neutrality relies on two properties of money, money

as the the medium of exchange and money as the numeraire.
Staggering of individual price changes delivers slow adjustment of the average
price of goods in terms of the numeraire. If, in addition, the numeraire is also the
medium of exchange – which it need not be as a matter of logic, but typically is
– slow adjustment of the average price of goods in terms of the numeraire means
slow adjustment of the average price of goods in terms of the medium of ex-
change. It is these two features which, when combined, imply that changes in the
stock of nominal money lead to changes in the value of the stock of money in
terms of goods, leading in turn to movements in the interest rate, the demand for
goods, and output.
This coincidence is crucial to the story. It suggests that delinking the numer-
aire and the medium of exchange would lead to very different effects of changes
in nominal money – and more generally, of shifts in the demand for goods – on
output. Put more strongly, it might change the nature of short run fluctuations.
The idea of having a numeraire separate from the medium of exchange is an old
idea in macroeconomics, an idea explored by Irving Fisher in particular. But, de-
spite some recent work 共for example Shiller 共1999兲兲, we still lack a good under-
standing of what macroeconomic implications, and by implication what potential
benefits, could come from such a separation.
The set of results I have described above is sometimes called the ‘menu costs’
explanation of the short-run non-neutrality of money. 23 The expression correctly
captures the notion that small individual costs of changing prices can have large
macroeconomic effects. At the same time, the expression may have been a public
relations disaster. It makes the explanation for the effects of money on output
look accidental, when in fact the effects appear to be intrinsic to the workings of
an economy with decentralized price and wage setting. In any economy with de-
centralized price and wage setting, adjustment of the general level of prices in
terms of the numeraire is likely to be slow relative to a 共fictional兲 economy with
an auctioneer.
5 POST 1980. II. THE ROLE OF OTHER IMPERFECTIONS
Leaving aside nominal rigidities, there are three main reasons why macroecono-
mists working on fluctuations should care about imperfections: 24
Ê Imperfections lead to very different efficiency and welfare characteristics of
the equilibrium, and thus modify the way we think about fluctuations and the
role of policy. Think for example of the question of whether the equilibrium
rate of unemployment is too high or too low, and its implications for macro-
economic policy. 25
Ê Imperfections may lead to very different propagation mechanisms of shocks.
Think for example of the role of the interactions of nominal and real rigidities
in determining the persistence of changes in money on output I discussed in
the previous section.
Ê Imperfections may lead to new sources of shocks. Think for example of bank
runs, which may affect not only the supply of money, but also the functioning
of the financial intermediation system, leading to long-lasting effects on out-
put.
These are the motivations behind the research on imperfections and macroeco-
nomics which has developed in the last 20 years or so. As I indicated in the
introduction, this phase is still very much one of exploration. The thousand flow-
ers are still blooming, and it is not clear what integrated macroeconomic model
will emerge, if any. Let me describe four major lines along which substantial
progress has already been made.
23 See in particular Mankiw 共1985兲 and Akerlof and Yellen 共1985兲.

24 The arguments would be even stronger if the focus of this article were extended to cover growth.
Much of the recent progress in growth theory has come from looking at the role of imperfections and
institutions 共externalities from R&D and patent laws, bankruptcies and bankruptcy laws, restrictions
to entry by new firms, institutions governing corporate governance, etc.兲 in growth.
25 For example, the implications for monetary policy emphasized by Barro and Gordon 共1983兲.
588 O. BLANCHARD
5.1 Unemployment and the Labor Market
The notion that the labor market was somehow special was reflected in early Key-
nesian models by the crude assumptions that the nominal wage was given, and
employment was determined by the demand for labor. It was reflected in the con-
fused debates about whether unemployment was involuntary or voluntary. It was
reflected by the continuing use of an ad hoc formalization of wage behavior –
the Phillips curve – even in theoretical models. It was reflected by the unease
with which the neo-classical formulation of labor supply, developed by Lucas and
Rapping 共1969兲, with its focus on intertemporal substitution, was received by
most macroeconomists.
For a long time, the basic obstacle was simply how to think of a market where,
even in equilibrium, there were some unsatisfied sellers – there was unemploy-
ment. The basic answer was given in the early 1970s, in a set of contributions to
a volume edited by Phelps 共1970兲: One should think of the labor market as a
decentralized market, in which there were workers looking for jobs, and firms
looking for workers. In such a market, there would always be, even in equilib-
rium, both some unemployment and some vacancies.
Research started in earnest in the 1980s, based on a number of theoretical con-
tributions to search and bargaining in decentralized markets, in particular by Dia-
mond 共1982b兲, Mortensen 共1982兲, and Pissarides 共1985兲. The conceptual struc-
ture that has emerged is known as the flow approach to the labor market: 26
Ê The labor market is a decentralized market. At any point in time, because of
shifts in the relative demand for goods, or changes in technology, or because a
firm and a worker no longer get along, a number of employment relations are
terminated, and a number of new employment relations are started.
The workers who separate from firms, because they quit or are laid off, look
for new jobs. The firms, which need to fill new jobs or replace the workers
who have left, look for workers. At any point in time, there are both workers
looking for jobs – unemployment – and firms looking for workers – vacan-
cies.
Ê When a worker and a firm meet and conclude that the match seems right,
there is typically room for bargaining.
The wage is then likely to depend on labor market conditions. If unemploy-
ment is high, and vacancies are low, the firm knows it will be able to find
another worker easily, and the worker knows it will be hard to find another
job. This is likely to translate into a low wage. If unemployment is low, va-
cancies high, the wage will be high.
Ê The level of the wage in turn affects the evolution of both vacancies and un-
employment. A high wage means more terminations, less starts, and so a de-
crease in vacancies and an increase in unemployment. Conversely, a low wage
26 For recent surveys, see Pissarides 共2000兲, or Mortensen and Pissarides 共1999兲.
leads to an increase in vacancies and a decrease in unemployment. Given these

dynamics, the economy typically converges to a set of equilibrium values for
unemployment and vacancies. One can then think of the natural rate of unem-
ployment as the value to which the unemployment rate converges.
It is clear that in such an economy, there should and always will be some
unemployment 共and some vacancies兲. Operating the economy at very low un-
employment would be very inefficient. But the equilibrium level of unemploy-
ment typically has no claim to being the efficient level. The equilibrium level,
and its relation to the efficient level, depend on the nature of the process of
search and matching, as well as on the nature of bargaining between workers
and firms.
One way of assessing progress is to go back to a famous quote by Friedman

共1968兲 about the natural rate of unemployment:
‘The natural rate of unemployment is the level which would be ground out by
the Walrasian system of general equilibrium equations, provided that there is im-
bedded in them the actual structural characteristics of the labor and commodity
markets, including market imperfections, stochastic variability in demands and
supplies, the cost of gathering information about job vacancies and labor avail-
abilities, the costs of mobility, and so on.’
What we have done is to go from this quote to a formal framework in which
the role of each of these factors 共and many others兲 can be understood and then
taken to the data. 27 Today, we have a much better sense of the role and the de-
terminants of job creation and job destruction, of quits and layoffs, of the nature
of the matching process between firms and workers, of the effects of labor mar-
ket institutions from unemployment benefits to employment protection, on unem-
ployment. This line of research has shown for example how higher employment
protection leads to lower flows in the labor market, but also to longer unemploy-
ment duration. Lower flows and longer duration unambiguously change the na-
ture of unemployment. But because, in steady state, unemployment is the product
of flows times duration, together they have an ambiguous effect on the unem-
ployment rate itself. Both the unambiguous effects on flows and duration are in-
deed clearly visible when looking across countries with different degrees of em-
ployment protection.
Many extensions of this framework have been explored. While the basic ap-
proach focuses on the implications of the specificity of the product being trans-
acted 共labor services by a particular worker to a particular firm兲, and the room
for bargaining that this creates, a number of contributions have focused on other
dimensions, such as the complexity of the product being transacted, and the in-
formation problems this raises. For example, how much effort a worker puts in
his job can be hard to monitor for a firm. If the firm just paid this worker his
27 For a more detailed assessment, see Blanchard and Katz 共1997兲.

590 O. BLANCHARD
reservation wage, he would not care about being found shirking and being fired.
One way the firm can induce him not to shirk is by paying him a wage higher
than his reservation wage, so as to increase the opportunity cost of being found
shirking and being fired. This particular effect has been the focus of an influen-
tial paper by Shapiro and Stiglitz 共1984兲, who have shown that, even absent is-
sues of matching, the implication would be positive equilibrium unemployment.
As they have argued, in this case, equilibrium unemployment plays the role of a
共macroeconomic兲 ‘discipline device’ to induce effort on the part of workers.
So far however, our improved understanding of the determinants of the natural
rate of unemployment has not translated into a much better understanding of the
dynamic relation between wages and labor market conditions. In other words, we
have not made much progress since the Phillips curve. In particular, current theo-
retical models appear to imply a stronger and faster adjustment of wages to labor
market conditions than is the case in the data. One reason may be the insufficient
attention paid to yet another dimension of labor transactions, namely that they
typically are not spot transactions, but rather long-term relations between workers
and firms. Long-term relations often allow for better outcomes, for reasons em-
phasized by the theory of repeated games. For example, they may allow the wage
to play less of an allocational role, more of a distributional or insurance role. 28
Here may lie one of the keys to explaining observed wage behavior. That firms
might want to develop a reputation for good behavior and, by so doing, achieve
a more efficient outcome, is indeed one of the themes of the research on ‘effi-
ciency wages.’ But after much work in the 1980s, this direction of research has
tapered off, without the emergence of a clear picture or an integrated view. 29 This
is a direction in which more work is clearly needed.
5.2 Saving, Investment, and Credit
Issues of financial intermediation, from ‘credit crunches’ to ‘liquidity scrambles,’

figured heavily in the early accounts of fluctuations. 30 With the introduction of
the IS-LM model, the focus shifted away. Issues of financial intermediation were
altogether absent from the IS-LM model and most of its descendants. The treat-
ment of financial intermediation in larger models was often schizophrenic. Asset
markets were typically formalized as competitive markets, with a set of arbitrage
relations determining the term structure of interest rates and stock prices. Among
financial intermediaries, typically only banks, because of their relevance to the
determination of the money supply, were treated explicitly. Credit problems were
dealt with implicitly, by allowing for the presence of current cash flow in invest-
28 See for example Espinosa and Rhee 共1989兲.

29 For a survey of work up to 1986, see Katz 共1986兲.
30 See, for example, the 1949 survey by McKean.
ment decisions, and of current income in consumption decisions. 31 One can there-
fore see recent research as returning to old themes, but with better tools 共asym-
metric information兲 and greater clarity.
The starting point, when thinking about credit, must be the physical separation
between borrowers and lenders. Lending means giving funds today in anticipa-
tion of receiving funds in the future. Between now and then, many things can go
wrong. The funds may not be invested but squandered. They may be invested in
the wrong project. They may be invested, but not paid back. This leads potential
lenders to put limits on how much they are willing to lend, and to ask borrowers
to put some of their own funds at risk. How much borrowers can borrow there-
fore depends on how much cash or marketable assets they have to start with, and
on how much collateral they can put in – including the collateral associated with
the new project.
This fact alone has a number of implications for macroeconomic fluctuations:
Ê The distribution of income and marketable wealth between borrowers and lend-
ers matters very much for investment.
Ê The expected future matters less, the past and the present – through their ef-
fect on the accumulation of marketable assets by firms – matter more for in-
vestment. Transitory shocks, to the extent that they affect the amount of mar-
ketable assets, can have lasting effects. Higher profits today lead to a higher
cash flow today, and thus more investment today and more output in the fu-
ture, a mechanism emphasized by Bernanke and Gertler.
Ê Asset values play a different role than they do in the absence of credit prob-
lems. Shocks which affect the value of marketable assets can affect investment
even when they do not have a direct effect on future profitability – a channel
explored for example by Kiyotaki and Moore 共1997兲.
In such a world, the importance of having marketable assets leads in turn to a

demand for marketable, or ‘liquid,’ assets by consumers and firms. Because con-
sumers find it hard to either insure against idiosyncratic income shocks, or to
borrow against future labor income, consumers save as a precaution against ad-
verse shocks 共Carroll 共1997兲, Deaton 共1992兲兲. Here, theoretical and empirical re-
search on saving have made clear that both life cycle and precautionary motives
play an important role in explaining saving behavior. Similar considerations ap-
ply to firms. Because firms may need funds to start a new project, or to continue
with an existing project, they also have a demand for marketable assets, a de-
mand for liquidity. A new set of general equilibrium questions arises: Will the
31 A notable exception here is the work by Eckstein and Sinai 共summarized in Eckstein and Sinai
共1986兲兲, and reflected in the DRI model. With its focus on balance sheets of firms and intermediaries,
it was surpringly at odds with the language and the other models of the time. But many of its themes
have since come back into fashion.
592 O. BLANCHARD
economy provide such marketable assets? Can the government for example im-
prove things by issuing such liquid instruments as T-bills? 32
In such a world also, there is clearly scope for financial intermediaries to al-
leviate information and monitoring problems. But their presence raises a new set
of issues. To have the right incentives, financial intermediaries may need to have
some of their own funds at stake. Thus, not only the marketable assets of ulti-
mate borrowers, but also the marketable assets of intermediaries matter. Shocks
in one part of the economy which decrease the value of their marketable assets
can force intermediaries to cut on lending to the rest of the economy, resulting in
a credit crunch 共Holmström and Tirole 共1997兲兲. And to the extent that financial
intermediaries pool funds from many lenders, coordination problems may arise.
An important contribution along these lines is the clarification by Diamond and
Dybvig 共1983兲 of the nature and the necessary conditions for bank runs.
Because some of their liabilities are money, banks play a special role among
financial intermediaries. In that light, recent research has looked at and clarified
an old question, namely whether monetary policy works only through interest
rates 共the standard ‘money channel’兲, or also by affecting the amount of bank
loans and cutting credit to some borrowers who do not have access to other
sources of funds 共the ‘bank lending’ channel兲. 33 The tentative answer at this point:
The credit channel probably played a central role earlier in time, especially dur-
ing the Great Depression, but, because of changes in the financial system, its
importance may now be fading.
Research on credit is one of the most active lines of research today in mac-
roeconomics. Much progress has already been made. This is already reflected, for
example, in the 共ex post兲 analyses of the Asian crisis, and in the analysis of the
problems of financial intermediation in Eastern Europe.
Let me turn to the two remaining themes. I shall be more succinct because
less progress has been made, in the first case because the evidence remains elu-
sive, in the second because much remains to be done.
5.3 Increasing Returns
The potential relevance of increasing returns to fluctuations is another old theme

in macroeconomics. The argument is straightforward:
Ê If increasing returns to scale are sufficient to offset the short-run fixity of some
factors of production such as capital, short-run marginal cost may be constant
or even decreasing with output. Firms may be willing to supply more goods at
roughly the same price, leading to longer lasting and larger effects of shifts in
32 See for example Holström and Tirole 共1998兲.

33 Bernanke and Gertler 共1995兲 give a general discussion of the way credit market imperfections
can modify the effects of monetary policy on output.
aggregate demand on output 共a version of the interaction between nominal and

real rigidities discussed earlier兲.
Ê Indeed, if returns are increasing enough, the economy may have multiple equi-
libria, a low-efficiency low-output equilibrium and a high-efficiency high-out-
put equilibrium. Many examples of such multiple equilibria have been worked
out. Some have been based on increasing returns in production 共Kiyotaki
共1988兲兲, others on increasing returns in exchange 共Diamond 共1982a兲兲.
A related line of research has focused on countercyclical mark-ups 共of price over
marginal cost兲. Just like increasing returns, countercyclical mark-ups may explain
why firms are willing to supply more output at roughly the same price. Like in-
creasing returns, countercyclical mark-ups imply that the economy may operate
more efficiently at higher output, in this case not because productivity is higher
but because distortions 共the gap between price and marginal cost兲 are lower. A
number of models of mark-ups, based on imperfect competition, have been de-
veloped, some indeed predicting countercyclical mark-ups 共for example, Rotem-
berg and Woodford 共1991兲兲, others however predicting procyclical mark-ups
共Phelps 共1992兲兲.
Turning to the empirical research gives the same feeling of ambiguity. It ap-
pears to be true that, in response to exogenous shifts in demand, firms are willing
to supply more at nearly the same price 共for example Shea 共1993兲兲. How much is
due to flat marginal cost or to countercylical mark-ups is still unclear. Counter-
cyclical mark-ups appear indeed to play a role 共for example Bils 共1987兲兲, but the
source of such countercyclicality 共nominal rigidities, lags in the adjustment of
prices to cost, changes in the desired or in the sustainable mark-up if the mark-up
is thought to result from a game among oligopolistic firms兲 remains to be estab-
lished. For the time being, the possibility of multiple equilibria, due either to
increasing returns or countercyclical mark-ups, remains an intriguing but un-
proven hypothesis.
5.4 Expectations as Driving Forces
This last theme, movements in expectations as an important source of fluctua-

tions, is once again an old one. It was a dominant theme of pre-1940 macroeco-
nomics. It was a major theme in Keynes, and beyond. But, with the introduction
of rational expectations in the 1970s, expectations became fully endogenous, and
the theme was lost.
To most macroeconomists, rational expectations is the right benchmark. But
this only means that the burden of the proof is on those who insist on the pres-
ence of deviations from rational expectations, on their relevance for asset prices,
and in turn for output fluctuations. This is indeed where a lot of research on
‘behavioral finance’ has recently taken place.
594 O. BLANCHARD
Research has taken place along two fronts. 34 The first has looked at the way
people form expectations. A substantial body of empirical – often experimental –
evidence has documented that most people form their expectations in ways which
are not consistent with the economists’ definition of full rationality, for example
in ways inconsistent with Bayes’ rule. Some sequences of realizations are more
‘salient’ than others, and have more effect on expectations than they should. For
example, there is some evidence that a sequence of positive past returns leads
people to revise expectations of future returns more than they should. This ap-
pears potentially relevant in thinking about phenomena such as fads or bubbles in
asset markets.
For deviations from rationality by some investors to lead to deviations of asset
values from fundamentals, another condition must be satisfied: There must be only
limited arbitrage by the other investors. This is the second front on which re-
search has advanced. The arguments it has made are simple ones. First, the re-
quired arbitrage is typically not riskless: What position do you take if you be-
lieve the stock market is overvalued by x%? Second, professional arbitrageurs do
not have unlimited funds. This opens the same issues as those we discussed ear-
lier when discussing credit. Asymmetric information implies a limit on how much
these arbitrageurs can borrow, and thus on how much they can arbitrage incorrect
asset prices. 35
Empirical research has shown that this line of research can account for a num-
ber of apparent puzzles in asset markets. But other explanations, not based on
such imperfections, may also account for these facts. At this stage, the question
is far from settled. At issue is a central question of macroeconomics, the role of
expectations, of bubbles and fads, as driving forces for at least some macroeco-
nomic fluctuations.
6 MACRO IN THE 共NEAR兲 FUTURE
Let me briefly restate the thread of my argument. Relative to Wicksell and Fisher,
macroeconomics today is solidly grounded in a general equilibrium structure.
Modern models characterize the economy as being in temporary equilibrium,
given the implications of the past, and the anticipations of the future. They pro-
vide an interpretation of fluctuations as the result of shocks working their way
through propagation mechanisms. Much of the current work is focused on the
role of imperfections.
34 For a review, see Shleifer 共2000兲.

35 One of the small victories of this line of research has been the description of an LTCM-type
crisis before it happened. In 1997, Shleifer and Vishny argued that it was precisely at the time when
asset prices deviated most from fundamentals that arbitrageurs might be least able to get the external
funds they needed to arbitrage and may need to liquidate their positions, making things worse. This is
what happened one year later at LTCM.
What happens next? Predicting the evolution of research is very much like
predicting the stock market. Like financial arbitrage, intellectual arbitrage is not
perfect, but it is close. Let me nevertheless raise a number of questions and make
a few guesses.
Which imperfections? Part of the reason current research often feels confusing
comes from the diversity of imperfections invoked in explaining this or that mar-
ket. To caricature, but only slightly: Research on labor markets focuses on de-
centralization and bargaining; research on credit markets focuses on asymmetric
information; research on goods markets on increasing returns; research on finan-
cial markets on psychology.
To some extent, the differences in focus must be right. The problems involved
in spot transactions are different from those involved in intertemporal ones; the
problems involved in one-time transactions are different from those involved in
repeated transactions, and so on. Still, if for no other than aesthetic reasons, one
may hope for an integrated macro model, based on only a few central imperfec-
tions 共say, those which give rise to nominal rigidities, and one or two others兲.
There exists indeed a few attempts to provide such an integrated view. One is
by Phelps in ‘Structural Slumps’ 共1994兲, which is based on implications of asym-
metric information in goods and labor markets. Another is by Caballero and Ham-
mour 共for example 共1996兲兲, based on the idea that most relations, either in credit
or in labor markets, require some relation-specific investment, and therefore open
room for hold ups ex post. These are important contributions, but I see them
more as the prototype cars presented in car shows but never mass-produced later.
They show what can be done, but they are probably not exactly what will be.
Policy and welfare. One striking implication of recent models is how much more
complex the welfare implications of policy are. To take one example, in a model
with monopolistic competition, 共small兲 increases in output due to the interaction
of money and nominal rigidities improve welfare to a first order. This is because
initially marginal cost is below the price and the increase in output reduces the
wedge between the two. Under other distortions, the effects of output fluctuations
on efficiency and welfare can be much more complex. Recent research has revis-
ited for example the question of whether recessions ‘cleanse’ the economy – by
eliminating firms which should have been closed anyway – or weaken it – by
destroying perfectly good firms. The answer so far is: Both, in proportions which
depend on the precise nature of imperfections in labor and credit markets. This
clearly has implications for how one views fluctuations. 36
The medium run. There has been a traditional conceptual division in macroeco-
nomics between the short run – the study of business cycles – and the long run
36 See for example Caballero and Hammour 共1999兲.

596 O. BLANCHARD
– the study of growth. 37 A better division might actually be between the short
run, the medium run, and the long run. Phenomena such as the long period of
high unemployment in Europe in the last 25 years, or the behavior of output
during the transition in Eastern Europe, do not fit easily into either business cycles
or growth. They appear to involve different shocks from those generating busi-
ness cycles – changes in the pace or the nature of technological progress, demo-
graphic evolutions, or in the case of Eastern Europe, dramatic changes in insti-
tutions. They also appear to involve different imperfections – with imperfections
in labor, credit and goods markets rather than nominal rigidities playing the domi-
nant role – than business cycles.
Research on imperfections has allowed us to make substantial progress here.
Our understanding of the evolution of European unemployment for example is
still far from good; but it is much better than it was ten or twenty years ago.
Macroeconomics and institutions. The presence of imperfections typically leads

to the emergence of institutions designed, more or less successfully, to correct
them. Examples range from anti-trust legislation, to rules protecting minority
shareholders, to unemployment insurance. Which institutions emerge is clearly
important in understanding medium run evolutions. Think of the role of labor
market institutions in explaining European unemployment, the role of legal struc-
tures in explaining the evolution of output in transition economies. Institutions
also matter for short run fluctuations, with different institutions leading to differ-
ent shocks and propagation mechanisms across countries. For example, a recent
paper by Johnson et al. 共1999兲 argues that, during the recent Asian crisis, those
Asian countries that had the weakest governance institutions 共such as poor pro-
tection of minority shareholders兲 were also those that suffered the largest ex-
change rate declines. Identifying the role of differences in institutions in gener-
ating differences in macroeconomic short and medium-run evolutions is likely to
be an important topic of research in the future.
Current debates. In the early 1980s, macroeconomic research seemed divided in

two camps, with sharp ideological and methodological differences. Real business
cycle theorists argued that fluctuations could be explained by a fully competitive
model, with technological shocks. New Keynesians argued that imperfections
were of the essence. Real business cycle theorists used fully specified general
equilibrium models based on equilibrium and optimization under uncertainty. New
Keynesians used small models, capturing what they saw as the essence of their
arguments, without the paraphernalia of fully specified models.
Today, the ideological divide is gone. Not in the sense that underlying ideo-
logical differences are gone, but in the sense that trying to organize recent con-
37 More than the rest of this essay, this reflects my views rather than some assessment of the con-
sensus. See for example Blanchard 共1997兲.
tributions along ideological lines would not work well. As I argued earlier, most
macroeconomic research today focuses on the macroeconomic implications of
some imperfection or another. At the frontier of macroeconomic research, the field
is surprisingly a-ideological.
The methodological divide is narrower than it was, but is still present. Can
macroeconomists use small models such as the IS-LM model or the Taylor model
– the model of aggregate demand and supply with wage staggering developed by
John Taylor? Or should they use only fully specified dynamic general equilib-
rium models, now that such models can be solved numerically? 38 Put in these
terms, it is obvious that this is an incorrectly framed debate. Intuition is often
obtained by playing with small models. Large explicit models allow for further
checking and refining. Small models then allow again to convey the essence of
the argument to others. At this stage, I believe that small models are indeed un-
derused and undertaught. 39 Small, back-of-the envelope, models are much too
useful to disappear, and I expect that methodological divide will also fade away.
One way to end is to ask: Of how much use was macroeconomic research in
understanding, for example, and helping resolve the Asian crisis of the late 1990s?
Macroeconomists did not predict either the time, place, or scope of the crisis.
Previous exchange rate crises had involved either fiscal misbehavior 共as in Latin
America兲, or steady real appreciation and large current account deficits 共as in
Mexico兲. Neither fiscal policy, nor, given the very high rate of investment, the
current account position of Asian countries seemed particularly worrisome at the
time. 40
So, when the crisis started, macroeconomic mistakes 共such as fiscal tightening,
the right recommendation in previous crises, but not in this one兲 were made. But,
fairly quickly, the nature of the crisis was better understood, and the mistakes
corrected. And most of the tools needed were there to analyze events and help
the design of policy, from micro-based models of bank runs, to models of finan-
cial intermediation, to variations on the Mundell-Flemming model allowing, for
example, for an effect of foreign currency denominated debt on the balance sheet,
and in turn on the behavior of firms and banks.
Since then, a large amount of further research has taken place, leading to a
better understanding of the role of financial intermediation in exchange rate cri-
ses. Based on this research, proposals for better prudential regulation of financial
institutions, for restrictions on some forms of capital flows, and for a redefinition
38 This debate is about models used in research, not about the applied econometric models used for
forecasting or policy.
39 Paul Krugman recently wondered how many macroeconomists still believe in the IS-LM model.
The answer is probably that most do, but many of them do not know it well enough to tell.
40 A notable exception here is the work of Calvo 共for example Calvo 共1998兲兲, who, before the
crisis took place, emphasized the potential for maturity mismatch 共short term foreign debt, long term
domestic loans兲 to generate an exchange rate crisis, even absent fiscal or current account deficits.
598 O. BLANCHARD
of the role of the IMF are being discussed. A passing grade for macroeconomics?
Given the complexity of the issues, I think so. But it is for the reader to judge.
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DE ECONOMIST 148, NO.

WHAT DO WE KNOW ABOUT MACROECONOMICS THAT FISHER AND

Key words: macroeconomics, business cycles, fluctuations, history of thought

* MIT and NBER.

De Economist 148, 571–601, 2000.

Ê From 1940 to 1980. A period of consolidation. A period during which an in-

Let me develop these themes in turn.

To somebody who reads it today, the pre-1940 literature on macroeconomics feels

A quote from Pigou’s Marshall lectures, ‘Keynes’s General Theory, A Retrospec-

3.1 Establishing a Basic Framework

price level. This systematic, general equilibrium approach to the characterization

3.2 Back to Dynamics

Key to these developments was the notion of ‘temporary equilibrium,’ devel-

Ê The introduction of costs of adjustment for capital, leading to a well defined

3.3 From Models to Data

Starting in the 1940s, in macroeconomics as in the rest of economics, research

3.4 The Casual Treatment of Imperfections

16 A semantic clarification: Following tradition, I shall refer to ‘imperfections’ as deviations from

4 POST 1980. I. WORKING OUT THE QUANTITY THEORY.

In discussing the role of imperfections in macroeconomics, it is useful to divide

4.1 Staggering, and the Adjustment of the Price Level

A tempting analogy to the proposition that staggered adjustment of individual

4.2 Real and Nominal Rigidities

4.3 Demand versus Output

4.4 Money as Numeraire and Medium of Exchange

The argument underlying non-neutrality relies on two properties of money, money

5 POST 1980. II. THE ROLE OF OTHER IMPERFECTIONS

23 See in particular Mankiw 共1985兲 and Akerlof and Yellen 共1985兲.

5.1 Unemployment and the Labor Market

leads to an increase in vacancies and a decrease in unemployment. Given these

One way of assessing progress is to go back to a famous quote by Friedman

27 For a more detailed assessment, see Blanchard and Katz 共1997兲.

5.2 Saving, Investment, and Credit

Issues of financial intermediation, from ‘credit crunches’ to ‘liquidity scrambles,’

28 See for example Espinosa and Rhee 共1989兲.

In such a world, the importance of having marketable assets leads in turn to a

5.3 Increasing Returns

The potential relevance of increasing returns to fluctuations is another old theme

32 See for example Holström and Tirole 共1998兲.

aggregate demand on output 共a version of the interaction between nominal and

5.4 Expectations as Driving Forces

This last theme, movements in expectations as an important source of fluctua-

6 MACRO IN THE 共NEAR兲 FUTURE

34 For a review, see Shleifer 共2000兲.

36 See for example Caballero and Hammour 共1999兲.

Macroeconomics and institutions. The presence of imperfections typically leads

Current debates. In the early 1980s, macroeconomic research seemed divided in

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