Challenging the Supply-side Vision of the Long Run
Edited by Mark Setterfield
Chapter 2: Keynesian Macroeconomics and the Theory of Economic Growth: Putting Aggregate Demand Back in the Picture
Thomas I. Palley INTRODUCTION Keynesian macroeconomics, which dominated the economics profession from World War II through to the mid-1970s, emphasized the significance of the level of aggregate demand for the determination of the level of economic activity. Yet, when it came to constructing a theory of growth, the effect of aggregate demand was visibly absent. This absence created a significant internal inconsistency that likely contributed to the decline of the Keynesian paradigm. In stark contrast, new classical macroeconomics, which came to supersede Keynesian macroeconomics as the dominant paradigm in the mid1970s, was consistent with growth theory. This consistency promoted its rise. Over the last decade, there has emerged a new ÔendogenousÕ growth theory that breaks with the earlier ÔoldÕ growth theory by making the steady-state growth rate endogenous to the system. This chapter uses a simple analytical framework predicated on the familiar distinction between potential and actual output to frame the relation between growth theory and macroeconomics. The framework is then used to explore the relation between growth theory, new classical macroeconomics, neo-Keynesian macroeconomics and Keynesian macroeconomics. Whereas old growth theory was deeply inconsistent with Keynesian macroeconomics and its emphasis on aggregate demand, new endogenous growth theory is not. Growth theory can therefore now be rendered consistent with Keynesian macroeconomics. This is a significant advance in the reconstruction of a consistent Keynesian paradigm. OLD GROWTH THEORY The Solow (1956) neoclassical growth model represents the paradigmatic model of old growth theory. The most important feature of the model is that 19...
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