Macroeconomics in the Small and the Large
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Macroeconomics in the Small and the Large

Essays on Microfoundations, Macroeconomic Applications and Economic History in Honor of Axel Leijonhufvud

Edited by Roger E.A. Farmer

This book honors the work of Axel Leijonhufvud. The topics range from Keynesian economics and the economics of high inflation to the micro-foundations of macroeconomics and economic history. The authors comprise some of the very best economists active today.
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Chapter 3:  Interest Rate Setting in the Presence of Investment Prospects and Knightian Uncertainty

Edmund S. Phelps

Extract

3. Interest rate setting in the presence of investment prospects and Knightian uncertainty Edmund S. Phelps* The subject of this chapter is monetary policy. Wicksell around 1900 and Keynes in the 1930s were seminal figures. Wicksell argued that a central bank setting the interest rate below the ‘natural’ interest rate would cause rising inflation; Keynes that setting it above the natural rate would drive employment below what today we would call the ‘natural’ level. The splendid 1968 book of our honoree, Axel Leijonhufvud, was devoted to bringing out and supporting Keynes’s penetrating insights on the challenges the Bank of England and the Federal Reserve face in seeking to prevent or combat depression. The book showed that Keynes had in mind a twosector model, which ‘Keynesians’ drew back from. Keynes also had in mind a capitalist economy, thus one whose structure and future were not completely known – owing in part to drift in the structure and novelty in the future. My work too, as in Structural Slumps (1994), has given a central role to the varying real price of the business asset in its models. The 1970 conference volume Microeconomic Foundations (Phelps et al., 1970) was tacitly about an economy with an evolving and thus imperfectly known structure. So I have long had an affinity for Keynes and Leijonhufvud, even if in some ways I have departed from them. And the two main points of the present chapter take up in the context of policy rules these same two...

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