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  Macroeconomics for a Modern Economy †  By E DMUND S. P HELPS * Expressionism was rooted in the new ex-perience of metropolitan life that trans-formed Europe between 1860 and 1930. It[is] a visionary expression of what it feelslike to be adrift, exhilarated, terrified in afast-paced, incomprehensible world.—Jackie Wullschlager, “The OriginalSensationalists,” Financial Times The modern economy began to supplant the tra-ditional economy in several nations in the latter half of the nineteenth century—and in many more in thelatter half of the twentieth. A system where self-employment and self-finance was typical gave wayto a system of companies having various businessfreedoms and enabling institutions. This was the“great transformation” on which historians and soci-ologists, as well as business commentators, were towrite volumes. The modern economy, where fullyadopted, has indeed been transformative for na-tions 1 —but much less so for economics. If there is a thread running through my pub-lications, particularly the work discussed here,it is that I have tried in that work to bear in mindthe distinctive nature of the modern economy. 2 What is its nature? I. Modern Economies and Modern Economics Many of the early contrasts between the twokinds of economy were drawn by sociologists.The traditional economy was said to rest on acommunity of persons known to one other andengaged in mutual support—on Gemeinschaft—  while the modern economy was said to be basedon business, where people competed with oneanother—on Gesellschaft  (Ferdinand To¨nnies1887). 3 Social rank was said to count in a tra-ditional economy but not in a modern economy(Weber, 1921–22). True or not, these sociolog-ical contrasts did not obviously call for a fun-damental revision of standard economicmodels.  Economic contrasts between the two systemswere drawn by economic historians. A tradi-tional economy is one of routine. In the para-digm case, rural folk periodically exchangetheir produce for goods of the town. Distur-bances, if any, are not of their doing and arebeyond their control—temperature, rainfall, andother exogenous shocks. A modern economy ismarked by the feasibility of endogenouschange: modernization brings myriad arrange-ments from expanded property rights to com-pany law and financial institutions. That opensthe door for individuals to engage in novelactivity in the financing, developing, and mar-keting of new products and methods—commer-cial innovations. The emergence of this“capitalism,” as Marx called it, in Europe andAmerica ushered in a long era of stepped-upinnovation from about 1860 to 1940; further * McVickar Professor of Political Economy and Director,Center on Capitalism and Society, Earth Institute, ColumbiaUniversity. For discussions related to this lecture, some of them stretching back decades, I am grateful to PhilippeAghion, Max Amarante, Amar Bhide, Jean-Paul Fitoussi, Ro-man Frydman, Pentti Kouri, Richard Nelson, and RichardRobb. Raicho Bojilov and Luminita Stevens gave creativeresearch assistance. † This article is a revised version of the lecture EdmundS. Phelps delivered in Stockholm, Sweden, on December10, 2006, when he received the Bank of Sweden Prize inEconomic Sciences in Memory of Alfred Nobel. The articleis copyright © The Nobel Foundation 2006 and is publishedhere with the permission of the Nobel Foundation. 1 Several European nations saw rising opposition tomodernism in the nineteenth century and proceeded in theinterwar period to hamstring their modern economies withthe institutions of a twentieth century “corporatist” systemof permissions, consultations, and vetoes, making businesssubservient to community and state. 2 This recollection focuses on the main works of minerelating to imperfect information and incomplete knowl-edge. That leaves out several papers, including ones onrisky wealth accumulation, and factor-saving bias in tech-nical change. 3 To¨nnies writes of the “anonymity” of transactors in Gesellschaft, that is, capitalism. That is a fair observation of classical perfect competition. But in my work on moderneconomies the entrepreneur, financier, manager, employee,and customer are not exactly anonymous. Firms acquireemployees who are identifiable and nonsubstitutable; firmsknow their customers; customers know their supplier; andso on. 543  waves of innovation have since occurred. Theinnovations undertaken were successful oftenenough that rapid cumulative economic changefollowed.A few pioneering theorists, mostly from theinterwar years, saw the commercial innovative-ness and the ongoing economic change as hav-ing systemic effects that altered people’sexperience in the economy. ● Innovativeness raises uncertainties. The fu-ture outcome of an innovative action poses ambiguity: 4 the law of “unanticipated conse-quences” applies (Robert K. Merton 1936);entrepreneurs have to act on their “animalspirits,” as John Maynard Keynes (1936) putit; in the view of Friedrich Hayek (1968),innovations are launched first, the benefit andthe cost are “discovered” afterward. The in-novating itself and the changes it causes makethe future full of  Knightian uncertainty (Frank H. Knight 1921) for noninnovators, too. Finally, since innovation and change oc-cur unevenly from place to place and industryto industry, there is also uncertainty about the  present: what is going on elsewhere, much of which is unobserved and some of it unobserv-able without one’s being there. Thus, even if every actor in the modern economy had thesame understanding (“model”) of how theeconomy works, one would not suppose that others’ understanding is like one’s own. Withmodernization, then, another feature of a tra-ditional economy—common knowledge thata common understanding prevailed—waslost. 5 ● Innovativeness also transforms jobs. AsHayek (1948) saw, even the lowest-rankingemployees come to possess unique knowl-edge yet difficult to transmit to others, sopeople had to work collaboratively. Managersand workers, too, were stimulated by thechanges and challenged to solve the newproblems arising. Alfred Marshall (1892)wrote that the job was for many people themain object of their thoughts and source of theirintellectual development. Gunnar Myrdal(1932) wrote that “most people who are rea-sonably well off derive more satisfaction asproducers than as consumers.”Far into the twentieth century, though, eco-nomics had not  made a transition to the modern.Formal microfounded economic theory re-mained neoclassical, founded on the pastoralidylls of Ricardo, Wicksteed, Wicksell, Bo¨hm-Bawerk and Walras, right through the 1950s.Samuelson’s project to correct, clarify, andbroaden the theory brought into focus itsstrengths; 6 but also its limitations: it abstracted  from the distinctive character  of the moderneconomy—the endemic uncertainty, ambiguity,diversity of beliefs, specialization of knowl-edge, and problem solving. As a result it couldnot capture, or endogenize, the observable phe-nomena that are endemic to the moderneconomy—innovation, waves of rapid growth,big swings in business activity, disequilibria,intense employee engagement, and workers’ in-tellectual development. The best and brightestof the neoclassicals saw these defects but lackeda microtheory to address them. To have ananswer to how monetary forces or policy had animpact on employment, they resorted to make-shift constructions having either no microeco-nomics behind it, such as the Phillips curve andeven fixed prices, or  to models in which allfluctuations are merely random disturbancesaround a fixed mean.After some neoclassical years at the start of my career, I began building models that addressthose modern phenomena. So did several otheryoung economists during that decade of fer-ment, the 1960s. 7 At Yale and at RAND, in part 4 Ambiguity and vagueness come into use with papers byDaniel Ellsberg (1961) and William J. Fellner (1961). 5 I do not mean to suggest that the modern economy hasled to a net increase in total risk, measurable and unmea-surable. My sense is that much of the huge gain in produc-tivity was brought by modernization rather than scientificadvance and this gain has in turn permitted more and moreparticipants to take jobs that offer reduced physical dangersand moral hazards. Financial innovations have helped toreduce the risks created by modernization. It is plausiblethat the wide swings in business activity that finance capi-talism imposes are no worse than the waves of famine andpestilence that afflicted traditional economies. 6 One could argue that his textbook (1948) and Founda-tions (1947) began a Restoration that saved the economicsheritage from the radical Keynesians, institutionalists, andbehavioralists of that time. 7 Kindred spirits tilling the field or adjacent fields in the1960s include Robert Clower, Robert Aumann, Brian 544 THE AMERICAN ECONOMIC REVIEW JUNE 2007   through my teachers William Fellner andThomas Schelling, I gained some familiaritywith the modernist concepts of Knightian un-certainty, Keynesian probabilities, Hayek’s pri-vate know-how and M. Polanyı´’s personalknowledge. Having to a degree assimilated thismodernist perspective, I could view the econ-omy at angles different from neoclassicaltheory. 8 I could try to incorporate or reflect inmy models what it is that an employee, man-ager, or entrepreneur does: to recognize thatmost are engaged in their work, form expecta-tions and evolve beliefs, solve problems andhave ideas. Trying to put these people intoeconomic models became my project. II. Expectations in Models of Activity Unemployment determination in a moderneconomy was the main subject area of my re-search from the mid-1960s to the end of the1970s, and again from the mid-1980s to theearly 1990s. The primary question driving myearly research was basic: Why does a surge of “effective demand,” that is, the flow of moneybuying goods, cause an increase in output andemployment, as supposed in the great book byKeynes (1936)? Why not just a jump in pricesand money wages? Another question arose immediately: Howcould there be positive involuntary unemploy-ment in equilibrium conditions—more pre-cisely, along any equilibrium path? The answerimplied by my model was that if there were notpositive unemployment, employee quittingwould, in general, be so rampant that every firmwould be trying to out-pay one another in orderto cut the high training outlay that comes withhigh turnover. To my mind, the argument didnot rest on the “asymmetric information”premise that a worker could conceal his or herpropensity to quit from an employer. (Employ-ers might know better what quit rates to expectthan the employees themselves.) It rested on theimpossibility of a contract protecting the em-ployer from all the excuses for quitting theemployee might be able to claim. There are alsothe abuses the employer could inflict on em-ployees to force them to quit. In a moderneconomy, therefore, agreements are unwritten,thus informal, or, where written, not entirelyunambiguous.My approach to the relation between “(ef-fective) demand” and activity started from theobservation that, faced with all sorts of inno-vations and change, the market place of themodern economy was not just “decentralized,”as neoclassical economists liked to say. Thebeliefs and responses of each actor in the econ-omy are uncoordinated: Walras’s deus exmachina, the economy-wide auctioneer, is inap-plicable to a modern economy in which muchactivity is driven by innovation and past inno-vation has left a vast differentiation of goods.This led to the point that the expectations of individuals and thus their plans may be incon-sistent. Then, some or all persons’ expectationsare incorrect—  a situation Marshall and Myrdalcalled disequilibrium. 9 Thus the economy—say,a closed economy, for simplicity—might oftenbe in situations where every firm (or a prepon-derance of firms) currently expects that the other  firms are paying employees at a rate lessthan, or perchance greater than, its own payrate. In the former example, every firm believesthat, with its chosen pay scale, it is out-paying the others.In my first model, having a labor marketcapable of disequilibrium (Phelps 1968a), theeffect of such an under  estimate of the wagerates being set elsewhere is to damp the wagerate that every such firm calculates it needs topay in order to contain employee quitting byenough to minimize its total cost (at presentoutput)—the sum of its payroll costs plus turn-over costs. In terms of a later construct, the Loasby, Armen Alchian, Axel Leijonhufvud, Richard Nel-son, Sidney Winter, Arthur Okun, and William Brainard.They were joined in the 1970s and 1980s by Roman Fryd-man, Steven Salop, Brian Arthur, Mordecai Kurz, and Mar-tin Shubik. In the 1990s and 2000s, Amar Bhide´ and AlanKirman joined in and both Thomas Sargent and MichaelWoodford tested the waters. 8 I did not explicitly put in these modernist concepts intomodels so much as I took out  some neoclassical properties so that the models might be more consonant with modernthinking. 9 Imaginably, random forces might come to the rescue,but the expectations would still be incorrect ex ante. In mymodeling, I always excluded such random forces for thesake of clarity—forces that are the essence of the NewClassical model. 545VOL. 97 NO. 3 PHELPS: MACROECONOMICS FOR A MODERN ECONOMY   “wage curve” is lowered by firms’ underesti-mating what will be the going wage at theircompetitors. 10 Such a lowering of the wagecurve serves to lower firms’ cost curves, thus tolower the prices and, through the monetaryblock of the 1968 model, to increase output(achieved at first by moving employees fromtraining to producing); employment graduallyexpands thanks to reduced quitting caused byemployee expectations that wages are lower atother firms than at their own. Later, firms maystep up hiring (from the initially reduced level)in response to the reduced costs and thus higherprofit margins. What seemed to be a simplemodel was quickly revealed to be full of sub-tleties, so that very few students fully master it.However, the point that expectations matter forwages, prices, and activity has been grasped.The economy is boosted  by underestimation of competitors’ wages and by firms’ underestima-tion in customer markets of their competitors’prices (Phelps and Sidney G. Winter, Jr. 1970).Similarly, the economy is dragged down by over  estimation.What would happen in this economy, with itspotential for disequilibrium and, say, increaseddisequilibrium, if aggregate demand shiftedonto a higher path? 11 I often studied an uniden-tified spending shock in the private sector thatoperated to increase the velocity of money and,if the central bank were slow to respond, woulddrive both the price level and money-wage leveltoward correspondingly higher paths—whetherpromptly or in a drawn-out process. I supposedthat this velocity shock would be neutral forquantities and relative prices if and when firmsand workers formed correct  expectations of themoney-wage and price responses to the upwardshift in the demand price. 12 Yet firms and work-ers have no way of perceiving such neutrality atthe start.What ensues? My models implied the follow-ing: 13 every firm mistakenly infers that, as oftenhappens, all or much of the increase in demandit observes is unique to it; so in deciding howmuch to raise its wage it is led to underestimate the rise of wage rates at the other  firms. Simi-larly, every customer-market firm, in decidinghow much to raise its price, is led to underes-timate the extent to which the other firms aregoing to raise their price. As a result, the firmraises its price relative to what it believes theothers are going to do but by little—  by less thanit would do if it did not underestimate the riseelsewhere and less than the increase in its de-mand price; similarly it raises its wage but by little—  by less than it would do if it did notunderestimate the rise elsewhere. I added that“uncertainty” might induce a “cautious, gradualresponse in the firm’s wage decision” (Phelps1968a, 688). 14 Regarding quantities: the increase at eachfirm in customers’ demand sparked by the ve-locity shock causes the firm to recognize that, atthe initial price and output, it can now sell morewithout having to lower its price. The firm,which was indifferent about a small increase of output before, sees the profitability of an in-crease, so it steps up its output. 15 Hence, there isan increase in the maximum stock of job-readyemployees that the firm would retain in their en-tirety, thus an immediate jump in its vacancies.Accordingly, the decreased quitting broughtabout by perceptions of an improved relative 10 See Carl Shapiro and Joseph E. Stiglitz (1984). Guill-ermo Calvo and Phelps (1983) derived a wage curve in acontract setting. 11 I was always aware that, in the version of the model inwhich all firms are ready at the drop of a hat to jump theirmoney wages and prices, there being no setup costs of doingso, a demand shock in a few cases might theoretically haveno effect on quantities and relative prices. Take a suddenannouncement by the central bank that it is immediatelydoubling the money supply. If that shock is very public (itcould not be missed by anyone) and its consequences arecommon knowledge, and if it is neutral for equilibriumvalues, there would result in the models I was studying animmediate doubling of money wages and prices; both out-put and employment would be undisturbed. Keynes (1936)also implicitly noted such exceptions. 12 This means that whatever the equilibrium employmentpath leading from the economy’s initial state, the velocityshock is neutral for that equilibrium path and every otherequilibrium path, whether attained or not. 13 I am referring here to a fusion of my 1968 paper withPhelps-Winter (1970) and I am drawing on analyses andcommentary in Phelps et al. (1970), Phelps (1972a), andPhelps (1979). 14 It would be incorrect to infer that the quantity effectsof effective demand shifts are present because a sort of wage “rigidity” is imposed in the end. There would bequantity effects anyway, though smaller and maybe lessprolonged. 15 If, as in my 1968 paper, every firm raised its pricefully so as to clear the market for its initial output, theincreased profit margin would have the same effect. 546 THE AMERICAN ECONOMIC REVIEW JUNE 2007 
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