Macroeconomics for the 21st century: Part 2, Policy

Roger Farmer

28 February 2010



Modern Keynesians base their ideas on a version of Keynes’ General Theory that assumes that prices and or wages are sticky (Clarida et al 1999). In the first part of this series (Farmer 2010d), I outlined a theory that reconciles Keynesian economics with Walrasian general equilibrium theory in a new way. The focus of this column is on the implications of these ideas for economic policy.

The key ideas of my theory are that free market economies may support any unemployment rate as an equilibrium and that the equilibrium we observe is selected by confidence. These ideas are worked out fully in two working papers, (Farmer 2009a, 2009b) and in two books, (Farmer 2010a, 2010b) published by Oxford University Press.

Although I recognise that the market system may lead to inefficient outcomes with high unemployment, I do not believe that fiscal policy is the right response to a financial crisis. My reconciliation of Keynes with Walras is different from the orthodox approach and it leads to a different policy proposal.

As an alternative to fiscal policy, I argue for a policy of asset management in which the central bank, in conjunction with the treasury, targets both a short interest rate and a second asset price. Ideally, the second target should be the growth rate of a stock market index, but the price of long-term government debt is a good substitute. I argue that a policy of quantitative easing, of the kind that has recently been implemented by central banks throughout the world, should become a permanent component of aggregate demand management.

Dotting the i’s and crossing the t’s

As Paul Krugman argued recently in the New York Times, we need a formal analysis of a problem before we can be confident about our policy predictions. In Krugman’s words:

“I'm on a continuing quest to develop a tractable model .... Why? you may ask. Why not go with verbal intuition? Well, I'm enough of a conventional economist to think that there's no substitute for a model with dotted i's and crossed t's; it's not the truth, but it really does help clarify your thinking.” (Krugman 2009).

When I began this project, I thought that I would be able to give Krugman what he was looking for. An internally coherent theory based on individual behaviour that would justify Keynesian policies. But as the project developed, I began to realise that in order to save Keynesian economics, I would also need to change it. The model I develop here is explained more fully in Farmer (2009a, 2009b, 2010a, 2010b). Although it is consistent with the key ideas of Keynesian economics, it does not provide a defence of fiscal policy. Instead, I advocate a different approach to restoring full employment.

A summary of the theory

In “Macroeconomics for the 21st Century: Part 1, Theory”, I describe a theory of the labour market based on search equilibrium. This theory explains unemployment as a market failure due to missing markets for the inputs to the search technology and it explains how any steady state unemployment rate can be supported as a zero profit equilibrium. Different equilibrium unemployment rates are consistent with different zero profit equilibria because there are externalities in the labour market. When other firms are recruiting heavily it becomes harder for any individual firm to find a worker. This external effect has the same impact on the firms as a negative productivity shock.

The implications of this idea

Most economists, new-classical and new-Keynesians alike, hold to some variety of the natural rate hypothesis; this is the idea that the economy gravitates towards a natural rate of unemployment. In the words of Milton Friedman, the natural rate of unemployment

“is the level that would be ground out by the Walrasian system of general equilibrium equations, provided there is imbedded in them the actual structural characteristics of the labour and commodity markets, including market imperfections, stochastic variability in demands and supplies, the cost of gathering information about job vacancies and labour availabilities, the costs of mobility, and so on.” (Friedman 1968).

According to the natural rate hypothesis, the natural rate of unemployment is independent of fiscal and monetary policy. I believe that this is false. In the world in which we live, and in the alternative theory of the labour market sketched in my companion piece, fiscal and monetary policy have a permanent effect on the unemployment rate. There are many possible equilibrium unemployment rates and each of them is consistent with any growth rate for the real economy and any inflation rate. The forces that lead towards the social-planning optimum are weak or nonexistent. Instead, any unemployment rate can persist as an equilibrium. Adam Smith’s invisible hand has palsy.

Fiscal policy or quantitative easing?

You might think that the model I have described provides a good way of understanding why we need fiscal policy to move the economy from a high unemployment equilibrium back towards the social optimum. But that’s not necessarily the case. It all depends on the structure of aggregate demand.

In Farmer 2010a, I build a series of general equilibrium models with alternative population demographics. I show there, if the world is well described by a representative household, that fiscal policy is not the answer. In that environment, if households lose confidence in the value of assets, there will be a self-fulfilling drop in the value of the stock market. As households feel less wealthy, they will spend less, firms will cut back on employment and the economy will move to a new equilibrium with a higher unemployment rate and less production. It is nevertheless an equilibrium in which no firm can profit by offering a lower wage and all firms earn zero excess profit.

But the fact that the equilibrium is inefficient does not mean that fiscal policy is the right solution. The Keynesian argument for fiscal policy is based on the theory of the multiplier. According to this theory, consumption is a function of income. Higher expenditure by government causes higher expenditure by the newly employed and a virtuous cycle of employment results in an expansion of the economy that is larger than the original increase in government purchases.

Post war research on the consumption function, (see for example, Friedman 1957), found that consumption depends not on income, but on wealth. Friedman called this “permanent income”. This finding has important implications for the efficacy of fiscal policy since it implies that increased government deficits will crowd out private expenditure. In my view, we have seen crowding out the past six months as private savings rates increased in response to large fiscal deficits. Fiscal policy may not be completely crowded out; but even partial crowding out will offset the benefits of a fiscal expansion by transferring the costs of the recession to our children and grandchildren who must repay the debts that are incurred by large fiscal programs.

If fiscal policy did not prevent us from sliding into a great depression, what did? It is my view that the purchase of private assets and long bonds, by the Fed in the US, and gilts, by the Bank of England in the UK, was responsible for increasing the value of private wealth. Lower mortgage rates helped stem the collapse in house prices. The purchase of gilts restored the value of stocks, through substitution effects in the asset markets. In my view, policies like this should become an alternative pillar of monetary policy. Policies that restore private wealth and private expenditure are superior to fiscal expansions that increase the size of government and place our children and our grandchildren further into debt to overseas investors.

A new employment policy

If fiscal policy is not the answer, what should we do collectively to restore full employment?

Confidence can affect asset prices. Sustained plunges in asset prices can have long-term permanent effects on the unemployment rate. Intervention by the central bank can also affect asset prices and when the markets become destabilised, governments can and should intervene to restore confidence.

Consider the US case. Before the creation of the Fed in 1913, short-term interest rates were much more volatile than they are now. They were allowed to move around, not just in response to fundamentals, but also in response to market sentiment. After 1913, the Fed began to directly target a single asset price; the interest rate on overnight loans. In my view, the government should engage in a more extensive asset management policy by targeting a second asset price. In 2010b I argue that this should be an index of stocks; but the yield on government bonds would be a feasible alternative.

One might be sceptical of the possibility of moving the interest rate on long bonds independently of the short-rate, since orthodox theory of the term structure of interest rates argues that this cannot be done. The US experimented with a policy to move long and short rates independently in the early 1960s and according to conventional wisdom this exercise, “operation twist”, was a failure. In fact operation twist was not unsuccessful. It was never tried.

In a 2006 NBER working paper, Kenneth Kuttner has shown that bond purchases by the Fed in the 1960s were tiny and he presents convincing evidence to show that at other times, the Fed and the Treasury did have a significant impact on the yield curve by varying the quantities of bonds of different maturities in the hands of the public. Recent experience with quantitative easing suggests that Kuttner is right. The Fed can move short rates independently of long-rates and, by moving long-rates, the Fed can, and has, influenced the value of the stock market.


Although my theory of aggregate supply sounds superficially like the Hicks-Hansen description of Keynesian theory that was taught to generations of economists in the post-war period, it is very different. Unlike the Hicks-Hansen model, the equilibrium concept that I develop in my work does not rest on some prices being away from their Walrasian levels and there are no forces in the model that cause some agents to want to charge different prices.

I have argued that it is time to drop the natural rate hypothesis and return to the Keynes of the General Theory. This is not just empty rhetoric. It has implications for the policies to be used to stabilise the real economy in the 21st century.

This piece is part of a published article in the National Institute Economic Review (2010c). I thank the National Institute for permission to reprint it here. I also thank the National Science Foundation for their support of this research under grant SBR 0720839.


Clarida, Richard, Jordi Galí, and Mark Gertler (1999), “The Science of Monetary Policy: A New Keynesian Perspective”, Journal of Economic Literature, 37:1661-1707.

Farmer, Roger E A (2009a), “Confidence, Crashes and Animal Spirits”, NBER WP,14846.

Farmer, Roger E A (2009b), “Fiscal Policy Can Reduce Unemployment: But There is a Better Alternative”, CEPR Discussion paper 7526.

Farmer, Roger E A (2010a), Expectations Employment and Prices, Oxford University Press, Oxford, March.

Farmer, Roger E A (2010b), How the Economy Works: Confidence, Crashes and Self-Fulfilling Prophecies, Oxford University Press, Oxford, April.

Farmer, Roger E A (2010c), “Macroeconomics for the 21st Century: Full Employment as a Policy Goal", National Institute Economic Review, 211: R45-2R50, January.

Farmer, Roger E A (2010d), “Macroeconomics for the 21st Century: Part 1, Theory”,, 27 February.

Friedman, Milton (1957), A Theory of the Consumption Function, Princeton University Press.

Friedman, Milton (1968), “The Role of Monetary Policy”, American Economic Review, 58:1-17.

Keynes, John Maynard (1936), The General Theory of Employment Interest and Money, MacMillan, London.

Krugman, Paul, (2009), “Economists, ideology and stimulus,” The Conscience of a Liberal:, 19 January.

Kuttner, Kenneth N (2006), “Can Central Banks Target Bond Prices?”, NBER Working Paper 12454.



Topics:  Frontiers of economic research

Tags:  Keynesian economics, Walrasian general equilibrium

Distinguished Professor of Economics at UCLA and Senior Houblon Norman Fellow at the Bank of England