July 5, 2007 

People who make these types of arguments seem to lack an understanding of how theories are developed.  Theories are not just “ideas” of how the world works.  As we all learned somewhere in our education, the scientific method ensures that theories once developed are tested to make sure they are consistent, in a statistically significant way, with what actually happens.  Thus, the theory of evolution is not some pie-in-the-sky concept Darwin dreamt up one night while aboard the Beagle.  Similarly, economic theory is robustly tested and economists fiercely debate the implication and application of various theoretical economic models.

Sometimes economic theory is so powerful, and so insightful, that it offers policymakers and businesspeople a better way to think about the challenges they face.  Recently two widely respected macroeconomists, V. V. Chari and Patrick Kehoe, both the University of Minnesota and Federal Reserve Bank of Minneapolis, set out to demonstrate how macroeconomic theory has influenced economic policymaking. 

Macroeconomic Theory and Monetary Policy

Their work “Modern Macroeconomics in Practice:  How Theory Is Shaping Policy” appears in the Fall 2006 edition of the Journal of Economic Perspectives, while an abbreviated version of that paper appears this month in the 2006 Annual Report of the Federal Reserve Bank of Minneapolis.

Chari and Kehoe skillfully explain how the Robert Lucas’ Lucas Critique, Kydland and Prescott’s time inconsistency critique, and dynamic stochastic general equilibrium models have resulted in politically independent central banks that place an emphasis on rule-based price level stability. 

The most dramatic example of this the European Central Bank.  The Maastricht Treaty which established the ECB, lays its independence from short sighted politicians and it states that “the primary objective” of ECB is to “maintain price stability.”  This is an excellent example of how economic theory played a direct hand in shaping policy.

But the reach of macroeconomic theory and model building goes well beyond the creation of ECB.  We see similar actions with the UK inflation targeting regime and the Bank of England being granted political independence.    Inflation targeting has also been adopted in New Zealand, Chile, Canada, Israel, Australia, Finland (before Euro), Sweden, Mexico, the Czech Republic, Poland, Korea, Brazil, Colombia, Thailand, South Africa, Hungary, Iceland and Norway.  All of this is directly traceable back to the developments in macroeconomic theory.

We see debates taking place today within the Federal Reserve and financial markets over the desirability of the Fed to have an explicit inflation target.  We also see the Fed attempting be more clear in its communication with financial markets in regards to the Fed’s future interest rate movements.  Why are these things being done?  How should financial market participants and business leaders respond to such changes?  One gets a much better understanding of these developments if one understands things like the Lucas Critique, time inconsistency, and stochastic GE models.

Macroeconomic Theory, Fiscal Policy, and Businesspeople

These models also offer us a clear insight into how fiscal policy should be conducted.  Essentially these models suggest:   tax rates on labor and consumption should be roughly constant over time; income taxes on capital should be zero; and finally returns on debt and taxes on assets should fluctuate to allow for responses to negative shocks that could hit the economic system. 

Unfortunately, as Chari and Kehoe point out, macroeconomists have not been as successful in changing fiscal policy to be more efficient as they have been in positively impacting monetary policy.  The same could also be said for economic theory’s impact on managerial decision making.  Hopefully, things will change in the future.

However, this much needed application of economic theory to business decision making and policymaking will not happen as long as economic models and economic theory continue to be disregarded by many in our business schools.  Theory does have an important role to play in the training of the next generation of business leaders.  Those business leaders who do not understand nor comprehend the application of economic theory to their firms will be left in dust by those leaders who do.

Regards,

M. Brandl