The Neoclassical-Keynesian Synthesis


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J. Hicks' 1937 drawing of IS-LM from Econometrica

The "Neoclassical-Keynesian Synthesis" refers to the Keynesian Revolution as interpreted and formalized by a largely American group of economists in the early post-war period. The centrepiece of the Neoclassical-Keynesian Synthesis (or the "Neo-Keynesian" system) was the infamous IS-LM Model first introduced by John Hicks (1937) and then expanded upon by Franco Modigliani (1944). The IS-LM model purported to represent the gist of John Maynard Keynes's General Theory (1936) in the form of a system of simultaneous equations.

One of the startling results of the IS-LM model was that it was unable to obtain the Keynesian result of an "unemployment equilibrium". The model tended to yield the Neoclassical result of "full employment". As a result, in order to generate an "unemployment equilibrium" as a solution to this system of equations, the Neo-Keynesians appealed to rigid money wages, interest-inelastic investment demand, income-inelastic money demand or some other imperfection to this system. Thus it is referred to as a "synthesis" of Neoclassical and Keynesian theory in that the conclusions of the model in the "long run" or in a "perfectly working" IS-LM system were Neoclassical, but in the "short-run" or "imperfectly working" IS-LM system, Keynesian conclusions held.

Later on, the Neo-Keynesians added the infamous Phillips Curve (Phillips, 1958; Lipsey, 1960) to the system in order to enable them to account for inflation. The international sector was incorporated into an extended IS-LM system known as the Mundell-Fleming model (Mundell, 1962). Much work also went into providing "microfoundations" for the basic Keynesian relationships: the consumption function was formalized as a utility-maximizing problem by Franco Modigliani and Richard Brumberg (1953), the investment function was derived from profit-maximization by Dale W. Jorgenson (1963) and Robet Eisner and Robert H. Strotz (1963); the money demand function derived from utility-maximization by William J. Baumol (1952) and James Tobin (1956, 1958); the transmission mechanism (i.e. the impact of LM on IS) was expanded and given more detailed analysis by Lloyd Metzler (1951), James Tobin (1961, 1969) and many others.

The Neoclassical-Keynesian Synthesis was wildly successful and dominated macroeconomics in the post-war period. For a long time, the Neo-Keynesian system was synonymous with the "Keynesian Revolution" and was highly influential in both theoretical, applied and policy work. Abba Lerner (1944, 1951) was among the first to recognize the implications of the Keynesian system for government macroeconomic policy: by appropriate fiscal and monetary policies, a government could "steer" the economy away from extremes and thus smooth out the business cycle. This policy-effectiveness was given an enormous boost by the new econometric model-building techniques and optimal policy design criteria developed by Jan Tinbergen (1952), James E. Meade (1951), Lawrence Klein (1950), Robert Mundell (1962), Henri Theil (1964), William Poole (1970), Alan Blinder and Robert Solow (1973) which helped governments design and estimate the impact of various fiscal and monetary policies on employment and inflation.

The Neo-Keynesian system came under sustained attack in the late 1960s and early 1970s. In a famous tome, Axel Leijonhufvud (1968) argued that the Neo-Keynesians had completely thwarted the meaning of J.M. Keynes's General Theory. Following Clower (1965), Leijonhufvud suggested that instead of pursuing "unemployment equilibrium" in an imperfect system, they should be analyzing "prolonged disequilibrium" in a system without ad hoc rigidities. Their proposed "Walrasian-Keynesian" synthesis had long been suggested by earlier commentators such as Don Patinkin and Frank H. Hahn.

The Cambridge Keynesians -- Joan Robinson, Nicholas Kaldor, etc., to which one could add the Oxford economists Roy Harrod and John Hicks -- had taken their version of the Keynesian Revolution in a direction very much different from the Neo-Keynesians. They did not employ the IS-LM system but rather worked on extending the principal propositions of Keynes's General Theory to dynamic growth and business cycle models. (it is perhaps not surprising to note that the Neo-Keynesians, who believed that Keynesian results were only "short-run", did not really venture in this direction, but simply borrowed entirely from Neoclassical theory to build their own growth models). The Cambridge Keynesians and their counterparts in the United States (the American Post Keynesians), considered the Neo-Keynesian construction as a horrendous betrayal of the Keynesian Revolution.

However, the Neo-Keynesian system only came into serious trouble in the early 1970s, when a sudden, sustained bout of inflation and unemployment in the OECD countries did not seem to be compatible with the predictions of the Neo-Keynesian system -- and the traditional Keynesian policy-responses undertaken by various Western governments did not seem to alleviate the problem at all. Milton Friedman (1968), the leader of the rival Monetarist School, proposed a "natural rate of unemployment hypothesis" that did seem consistent with the OECD experience. This natural rate hypothesis was formalized by Edmund Phelps, Robert E. Lucas, Thomas Sargent and used as the basis of a "New Classical" macroeconomic theory, which has risen since the 1970s to replace Neo-Keynesianism as the new macroeconomic orthodoxy.

For more details, consult our survey of the "Neo-Keynesian World" and the other cross-references below.

The Builders of Neo-Keynesian Theory

Developers of Keynesian Policy

Critical Associates and Contributors to the Keynesian Theory and Policy

Resources on the Neo-Keynesians

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