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American Economic Review
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Number 108 of a series of photographs of past presidents of the Association
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I
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The Missing Motivation in Macroeconomicst
By GEORGE A. AKERLOF*
Macroeconomics changed between the early on the cover of Time.2 Even Milton Friedman
1960s and the late 1970s. The macroeconomics was famously-although perhaps misleadingly-
of the early 1960s was avowedly Keynesian. quoted: "We are all Keynesians now."3 A little
This was manifested in the textbooks of the more than a decade later Robert Lucas and
time, which showed a remarkable unity fromThomas Sargent (1979) had published "After
the introductory through the graduate levels.' Keynesian Macroeconomics." The love-fest was
John Maynard Keynes appeared, posthumously, over.
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6 THE AMERICAN ECONOMIC REVIEW MARCH 2007
cal economics:to
sical economics, objected that constrained
the casual maximization ways
these folks. New Classical critics
of profit and utility functions of Keynes
is the appropriate
economics insisted instead that these relations microfoundation for macroeconomics. They
be derived from fundamentals. They said that also viewed the neutralities as having a certain
macroeconomic relationships should be derived sort of generality. The neutralities do commonly
from profit-maximizing by firms and from utility- describe equilibria of competitive economies
maximizing by consumers with economic argu-with complete information, irrespective of peo-
ments in their utility functions. ple's preferences-as long as those preferences
The new methodology had a profound effect correspond to economists' typical descriptions
on macroeconomics. Five separate neutrality re- of them. The Keynesians then resurrected some-
sults overturned aspects of macroeconomics but not all-of the Keynesian conclusions by add-
that Keynesians had previously considered in- ing a variety of frictions to the New Classical
contestable. These five neutralities are: the in- model. Those frictions include credit constraints,
dependence of consumption and current income market imperfections, information failures, tax
(the life-cycle permanent income hypothesis); distortions, staggered contracts, uncertainty,
the irrelevance of current profits to investmentmenu costs, and bounded rationality. This formu-
spending (the Modigliani-Miller theorem); the lation preserves many (but not all) Keynesian
long-run independence of inflation and unem- conclusions regarding cyclical fluctuations and
ployment (natural rate theory); the inability of macroeconomic policy.
monetary policy to stabilize output (the rational This lecture will suggest a new stance in
expectations hypothesis); and the irrelevance of regard to each of the five neutralities. Like New
taxes and budget deficits to consumption (Ricar- Classical and New Keynesian economics, it will
dian equivalence).6 These results fly in the facederive behavior from utility and profit maximi-
of Keynesian economics. They undermine itszation. That captures the purposefulness of eco-
conclusions about the behavior of the economy nomic decisions. But this lecture will also
and the impact of stabilization policy. question the generality of the preferences that
The discovery of these five neutrality propo- lead to the five neutralities. There is a sense in
sitions surprised macroeconomists. They hadwhich those preferences are very narrowly de-
not suspected that radically anti-Keynesian con- fined. They have important missing motiva-
clusions were the logical outcome of such seem- tion-since they fail to incorporate the norms of
ingly innocuous maximizing assumptions. the decision makers. Those norms reflect how
the respective decision makers think they and
I. Neutralities and Preferences others should or should not behave, even in the
absence of frictions. Preferences reflecting such
How did macroeconomists react to the dis- norms yield a macroeconomics with important
covery of the five neutralities? On the one hand, remnants of the early Keynesian thinking. They
the New Classical economists viewed their neu- also yield a macroeconomics that, in important
trality results as a telltale: that Keynesian econ- details, cannot be obtained only with frictions.
omists of the previous generation had been We shall see that, with such preferences, even
thinking in the wrong way. In their view, sci- in the absence of frictions, each of the five
entific reasoning was producing a new, leaner, neutralities will be systematically violated. Spe-
more precise economics. cifically:
On the other hand, Keynesian economists, for
the most part, reacted differently. In due course * A realistic norm regarding consumption be-
they came to view the neutralities as logically havior will make consumption directly de-
impeccable. These New Keynesians accepted pendent on current income, in violation of the
the methodological dictums of the New Classi- neutrality of consumption given wealth;
* A realistic norm will make investment di-
rectly dependent on cash flow, in violation of
6 Of course, it took some time for the implications ofModigliani-Miller;
these neutrality results to be fully appreciated. For example,
life-cycle consumption and Modigliani-Miller were initially
* A realistic norm will make wages and prices
considered as nothing more than useful codicils to Keyne-dependent on nominal considerations and
sian thinking. thus violate natural rate theory;
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VOL. 97 NO. 1 AKERLOF: THE MISSING MOTIVATION IN MACROECONOMICS 7
* A realistic norm will make income and em- neity may sometimes dampen, but will rarely
ployment dependent on systematic monetary nullify, the conclusions of this lecture.
policy, and thus violate rational expectations
theory; and II. The Five Neutrality Results
* A realistic norm will make current consump-
tion dependent on the current generation's For clarity, this section will now give an
social security receipts, in violation of Ricar- overview of each of the five neutrality results.
dian equivalence.
A. Dependence of Consumption on Wealth,
Additionally, insofar as the behavior assumed Not Income
by the early Keynesians differed from the be-
havior that produces the neutralities, there is Standard theory tells us that, under only
likely to be a bias in favor of the Keynesians. somewhat special conditions, consumption de-
The Keynesians based their models on their pends on wealth, which is the value of current
observation of motivations, rather than on ab- assets plus the discounted value of future earn-
stract derivations. If there is a difference be- ings.7 Thus there is no tendency for people to
tween real behavior and behavior derived from make their expenditures conform to the pattern
abstract preferences, New Classical economics of their income receipts (as long as their wealth
has no way to pick up those differences. In is given).
contrast, models with norms based on observa- Changes in the pattern of current income that
tion will systematically incorporate such behav- leave overall wealth constant are neutral in their
ior-although, of course, as with any method, effects on current consumption.
there is the possibility for error.
Inclusion of the "missing motivations in mac- B. The Modigliani-Miller Theorem
roeconomics" then combines the observations
of the Keynesians with the intentionality of One version of the Modigliani-Miller Theo-
economic decisions in New Classical econom- rem says that a firm's investment strategy is
ics. Such a synthesis yields the best of the two
totally independent of its liquidity position.8
approaches. Thus, for example, a corporation with an unex-
pected windfall will not spend any additional
Two Disclaimers.--Before beginning in ear- investment dollars. Instead, it will pass the
nest, let me offer two brief disclaimers. First,windfall on to shareholders or seek other finan-
none of the behavior revealing of the norms thatcial investments, since it will make only those
are introduced in this lecture will be new. Oninvestments whose risk-adjusted rate of return
the contrary, I have purposefully chosen phe- exceeds the rate of return on capital.
nomena that have been emphasized since The Changes in the firm's finances will thus be
General Theory by macroeconomists who have neutral in their effect on current investment.
followed Keynes in voicing their continuing
doubts about classical interpretations of macro- C. Natural Rate Theory
economic behavior.
Second, this lecture will discuss different According to Natural Rate Theory, there is
norms that respectively correspond to the fivesome single rate of unemployment that is the
neutralities. I shall assume that these norms are only level that could be permanently maintained
exogenous. Such assumptions of exogeneity are without ever-increasing inflation or ever-
standard in economic analysis. In a given prob- increasing deflation.9 A fiscal/monetary policy
lem in a given time frame, some terms are mix that sought to maintain employment that
assumed constant, while others are allowed to was any higher would result in permanently
vary. I ask you to withhold your doubts regard- increasing inflation. A fiscal/monetary mix that
ing whether such exogeneity is a correct as-
sumption or not. The incorporation of such
7 See Friedman (1957) and Franco Modigliani and Rich-
endogeneity is the next step-not the first ard Brumberg (1954).
step-in the study of the effect of norms on 8 See Modigliani and Merton H. Miller (1958).
macroeconomics, especially since such endoge- 9 See Edmund S. Phelps (1968) and Friedman (1968).
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8 THE AMERICAN ECONOMIC REVIEW MARCH 2007
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VOL. 97 NO. 1 AKERLOF: THE MISSING MOTIVATION IN MACROECONOMICS 9
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10 THE AMERICAN ECONOMIC REVIEW MARCH 2007
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VOL. 97 NO. 1 AKERLOF: THE MISSING MOTIVATION IN MACROECONOMICS 11
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12 THE AMERICAN ECONOMIC REVIEW MARCH 2007
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VOL. 97 NO. 1 AKERLOF: THE MISSING MOTIVATION IN MACROECONOMICS 13
what housewives
derives from her own consumption; nor,should
yetdo, parents who leave
bequests
more tellingly, does it derive from the derive a warm
utility ofglow from bequests
because
her child (as the child's utility that is what
depends on they
its think they should do
own consumption). It enters the forutility
their children. Ricardian equivalence then
function
as a separate term. illustrates how odd neutralities can occur in
What, then, could account formodels that fail glow"?
a "warm to take such norms into account.
Parent-to-child bequests are a form A of comment
gift. Ifby David Romer (2001,
there 539)
tells us where
is any type of economic transaction that we is
should
gov-venture next. He has
remarked
erned by norms, it is the giving of that Parent-
gifts.33 "quantitatively important" viola-
to-child bequests also occur tions
within families.
of Ricardian equivalence and of the per-
Therefore, they should also bemanent
affected
income/life-cycle
by the hypothesis occur for
norms of family life. We havethe same reasons.
already seen Ricardian
one equivalence is not
important
example of such norms (Friedan's for us of
portrait as anthe
empirical aspect of mac-
roeconomics.
proper place of women in the early There are so many reasons other
1960s).
than constant.
The norms of family life are not the role of norms for its violation. But it
They
vary by culture. They also changedoes give
overus antime.
initial window
As on the type of
motivation
the nature of the ideal family has missingso
shifted, in has
classical macroeconom-
ics.have
the ideal bequest. Actual bequests Inclusion of such motivation
changed in will give us a
tandem. For example, the ideal new perspective century
sixteenth on the consumption function. It
Anglo-Saxon family was dynastic. allows usThe lineage
to return to a view in which consump-
tion willFathers
passed from father to oldest son.34 depend on current
then income, just as its
left the bulk of their estates to their
inclusion
oldest
makes it
sons.
naturalIn
to believe that social
the twenty-first century, in thesecurity
ideal transfers
family,will affect savings and con-
sib-
lings are equal. Most bequests are now
sumption, evenly
even in a world without frictions.
divided between them.35
V. Consumption and Current Income
Summary.-Economic outcomes, such as the
Thisutility
consumption of the parent and the takes us to
ofthe second neutrality. Ac-
the
child, are one determinant of cording bequests. But other
to this result, an- than its contribution
other possible determinant is parents' to a consumer's
viewswealth,re-current income has no
garding how they should behave independent
toward effect
their on the consumption of a
children. Just as Friedan's suburban housewives utility-maximizing consumer.
waxed their floors, because they thought that is Milton Friedman (1957) derived such
consumption-income neutrality in the two-
period model of Irving Fisher. In this model, the
consumer chooses her consumption between
33 The literature on gift-giving is of course replete with
two periods. She maximizes her intertemporal
the notion that gift-giving will be determined by what assets
people consider to be theirs and how much of those assets utility function, given by the function U(cl, C2):
should be given to others (Ruth Benedict 1946), rather than c, denotes her current consumption in the first
by the final utility outcomes for the gift-giver and for the period; c2 denotes consumption in the second
gift-receiver. Theodore Caplow (1984) describes the im-
period.36 If she maximizes U(c1, c2), a dollar of
plicit rules for Christmas gift-giving in "Middletown." Peo-
ple believe that the gifts they should give, and receive, should
income earned today will have the same effect
be given according to these rules. Caplow suggests that one on her current consumption as a discounted
might consider these "rules" as norms for gift-giving. dollar earned in the next period. Thus, her con-
34 For the history of the Anglo-Saxon family and the sumption will depend only on the discounted
change of its conception from dynastic to nuclear, see value of her current and future income and the
Lawrence Stone (1977).
35 Using tax data, Mark D. Wilhelm (1996) found that only rate of interest. This proposition is easy to
10 percent of estates differed by more than 5 percent from prove. It generalizes to many different com-
equality between bequests to siblings. His data are only for modities and to many different time periods,
bequests from estates larger than the federal minimum for
taxation. For a more general population, Jere R. Behrman and
Mark R. Rosenzweig (2004) have examined the difference in
bequests to twins. Once measurement error is taken into ac- 36 She receives income of Y, in period 1, income Y2 in
count, they find no significant differences in the bequests. period 2, and she can borrow and lend at the rate of interest r.
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14 THE AMERICAN ECONOMIC REVIEW MARCH 2007
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VOL. 97 NO. 1 AKERLOF: THE MISSING MOTIVATION IN MACROECONOMICS 15
think for
future wages; David W. Wilcox (1989), they should consume. Second,
social
ple think
security recipients who had been earlier they
notified of should consume can
viewedJonathan
changes in cost-of-living adjustments; either as entitlements or as o
Finally,
Parker (1999), for payers of social in taxes
security turn, current income is o
major
with predictable inter-year changes; determinants
Nicholes S. of these entitlem
obligations.
Souleles (1999), for changes in disposable income
net of tax refunds; and James Banks, Richard
Blundell, and Sarah Tanner (1998), and Bern-
Sociology of Consumption.-The m
heim, Jonathan Skinner, and Steven
emphasized
Weinberg
by sociologists for consu
(2001), for retirees. very different from that in the life-c
Textbooks explain such excess Sociologists
sensitivity by describe consumption
a variety of frictions, particularly borrowing
determined by the norms regarding w
constraints. For example, Rudiger should consume. These norms, in tur
Dornbusch
and Stanley Fischer (1987) say: "Given
pendent thatupon the the individual's situati
permanent income hypothesis is who she thinks she
correct [sic],is.
Two examples
there are two possible explanations."40 They illustrate
are such dependence on
norms.and
liquidity constraints for consumers Following
myopia Pierre Bourdieu (1984), peo-
in their projections of future income.
ple's consumption of cultural goods-the liter-
Thus, we see the realignment ature
that occurred
they read, the music they hear, and the art
they buy-reflects
because of the life-cycle permanent income hy- not just their individual
pothesis: excess sensitivity may tastes.
occur, The but
upperonlyclass should not make lower-
class choices.
in the presence of credit constraints Correspondingly, the lower class
or myopia.
should avoid
Such a view cannot have been adopted appearing above their station.42
because
of its empirical support. Few studies have
The epithet tested
"lace curtain Irish" illustrates. To
this proposition, but those that the
dousers
have rejected
of this phrase, those lace curtains were
it. For example, credit constraints cannot
indicative of thoseex- violating their social place.
plain the reduction in consumption Weber's analysis of the relation between re-
of retirees.
And, neither myopia nor creditligion
constraint can
and savings further reflects the role of
people's views regarding
explain the reduction in union members' con- who they should be.
sumption at the time of wage declines scheduled
In The Protestant Ethic and the Spirit of Capi-
in their union contracts (Shea 1995,
talism,43 996).
Weber describes Calvinists as aspiring
The adoption of the permanent income/
to be "worldly ascetics." He concludes that
life-cycle hypothesis then must "economic
rest on acquisition
theoret-is no longer subordi-
ical, not empirical, reasons. But nated
the to man as thefails
theory means for satisfaction of his
to take into account norms regarding what peo-
material needs.""44 Here the purpose of saving is
ple think they should, or should not,
to live consume.
up to an ideal. The Calvinists are thrifty
Such a norm-based theory will nest
because Keynes's
they think they should not be consum-
psychological law. Consumption-income
ing. That turns theneu-
motivation of the life-cycle
trality will occur only in a singular special case.
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16 THE AMERICAN ECONOMIC REVIEW MARCH 2007
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VOL. 97 NO. 1 AKERLOF: THE MISSING MOTIVATION IN MACROECONOMICS 17
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18 THE AMERICAN ECONOMIC REVIEW MARCH 2007
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VOL. 97 NO. 1 AKERLOF: THE MISSING MOTIVATION IN MACROECONOMICS 19
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20 THE AMERICAN ECONOMIC REVIEW MARCH 2007
maximize shareholder value. In the now-standard many instances of lax corporate oversight in favor
theory of the firm, the interests of the shareholders of management interests. For example, he has
and the interests of the managers are viewed as cited the excess exploration and drilling opera-
different. The managers are only the agents of the tions of oil companies when retained earnings
owners, and accordingly they maximize their own were high, from 1975 to 1981,62 and the mainte-
interests instead. Such incentives are said to turn nance of low-return operations in many US indus-
the managers into "empire-builders,"61 who will tries, as in the investments of General Motors
use the resources they control to increase their throughout the 1980s.63 In Jensen's views, share-
own domains. holders would have fared better if profits had been
Empire-building can result from two types of returned to them, giving them the option of invest-
motivations. On the one hand, managers may ing at a higher rate of return, or perhaps if profits
have only strict economic interests in mind: had been used for takeovers outside the industry.
they care only about their take-home pay, and To cure what he calls the "failure of corporate
their effort on the job. Such managers, for ex- internal control," Jensen has also suggested that
ample, will be biased in favor of investments firms should issue large amounts of debt, perhaps
whose operation or construction enhances their even by going private. In that case, the added debt
firm-specific human capital, and thereby in- obligations act as a brake on excess investment.
creases their bargaining power. Regarding investment behavior, Jensen is then on
On the other hand, empire-building may be the same page as Keynesian economists such as
pursued as a goal of its own, for its own sake. Klein and Goldberger. They refer to "the prefer-
We saw earlier that most workers have views ence of many businessmen for internal as opposed
regarding how they should or should not per-to external financing" (1955, 12-13) and also con-
form their jobs. Accompanying such views,sider it the major reason for the dependence of
most managers and workers will have the fur-investment on cash flow.
ther view that the firm should be investing in
those jobs. For this reason, the agents making B. Sociology of the Corporation
the investment decision are likely to engage in
empire-building. We can represent such moti- Once again, we have seen a neutrality result
that depends on the goals of the respective de-
vation by adding a term to the utility function of
the agent-decision maker. Her utility functioncision makers. Accordingly, the norms of cor-
will not only depend on her own pecuniaryporate decision makers are central to the
returns and her expenditure of effort. It will alsosociology of the corporation. For example, Dirk
include an additional term reflective of her M. Zorn (2004) has examined how the locus of
control has changed in large US firms over the
norms. She will lose utility insofar as the firm's
investment fails to live up to her ideal of whatpast 40 years. He has shown how this control
has shifted away from those with a production
she thinks it should be. In this case, the typical
norm is that she thinks that the firm should or a sales orientation to those with a financial
engage in investment that will enhance her job orientation.64 Empirically, this is seen in the rise
performance. of the chief financial officer. Prior to the 1960s,
Following the logic of Michael Jensen (1986,corporate finances were handled by corporate
1993), empire-building, accompanied by thetreasurers, whose duties were mainly restricted
abdication of corporate oversight in favor of to keeping the accounts and producing the bud-
management interests, explains a correlation be- gets. Now, most large corporations have re-
tween investment and cash flow. Furthermore, placed them by a CFO. With the change in title
this correlation will occur regardless of the moti-has come a change in function. CFOs are typi-
vation for the empire-building, whether for purely cally central to major decisions. Such a change
economic reasons as in the principal-agent model, affects investment decisions. If they are com-
or, instead, because of managers' norms for how mitted to their missions, managers with sales or
they think they should behave. Jensen has given
62 Jensen (1986, 327).
63 See Jensen (1993, 853).
61 Empire-building is especially emphasized by Jeremy 64 That distinction was emphasized earlier, for example,
C. Stein (2003), following Jensen (1986, 1993). by Neil Fligstein (1990).
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VOL. 97 NO. 1 AKERLOF: THE MISSING MOTIVATION IN MACROECONOMICS 21
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22 THE AMERICAN ECONOMIC REVIEW MARCH 2007
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VOL. 97 NO. 1 AKERLOF: THE MISSING MOTIVATION IN MACROECONOMICS 23
takes the form that nominal considerations af- shows such a spiral.71 For example, the United
fect real wage or price setting in some way or States experienced rapid deflation from 1929 to
other. 1933, but inflation systematically neither rose nor
Evidence of one form of violation of the fell for the next decade. The predictions of natural
assumptions of natural rate theory is especially rate theory are thus grossly violated. But sticky
stark. That evidence concerns downward wage wages offer a good explanation for such behavior.
rigidity. Such wage behavior can easily be per- For example, a dynamic simulation of the US
ceived statistically by examining distributions economy with money wage rigidity and with
of wage-changes. These distributions are char- Depression-level unemployment fits the data all
acterized by a bunching of wage changes but at exactly (Akerlof, Dickens, and Perry 1996).72
exactly zero; there are some wage changes justNominal wage rigidity may not only be sta-
above zero in these distributions, but almost tistically
no perceptible; it can also be macroeco-
wage changes just below.68 Careful studies have nomically important, even outside of Great
documented such wage stickiness in Australia, Depressions. Nominal wage rigidity imparts a
Canada, Germany, Japan, Mexico, New Zea- long-run trade-off between unemployment and
land, Switzerland, the United States, and the long-run inflation. This trade-off is of sufficient
United Kingdom.69,70 There seems to be no way size that it should deter central banks from
to account for such nominal wage rigidity with targeting very low levels of inflation. For exam-
the basic assumptions underlying natural rate ple, simulations of the US economy (Akerlof,
theory: that participants in the economy care Dickens, and Perry 1996) show that an increase
only about real prices and real wages. of the inflation target from 0 to 2 percent will
Wage stickiness also explains a macroeco- permanently reduce unemployment by 1.5 per-
nomic observation that is an anomaly for natural centage points.73
rate theory. Unemployment was so massive in
the Great Depression that inflation should have Norms as Explanation for Sticky Money
been below inflationary expectations throughout Wages.-It seems to be impossible, or all but
this long period. With any natural-rate adaptive- impossible, to explain the existence of sticky
expectations Phillips curve, such high unemploy- money wages, without relaxation of the basic
ment would have caused a deflationary spiral. assumption that the utility functions of employ-
Data on inflation are available for 12 countries for ees or of employers contain real arguments. A
the Great Depression. Not a single one of them simple and natural amendment to the standard
model explains such sticky money wages: that
employees have a norm for what wages should
68 These distributions have accumulations at zero, and According to that norm, they will lose utility
be.
from
they are also asymmetric: there are more wage changes a money wage decline. Sticky money
above zero than below zero. This suggests that the accumu- wages then result, as the bargains between em-
lations at zero do not occur just because there is a menu cost
ployers and employees reflect the presence of
for changing wages.
this ideal in the utility function.
69 The following studies have all found significant signs
of nominal wage rigidity: Truman Bewley (1999), David Indeed, the study by Bewley (1999) gives
Card and Dean Hyslop (1997), Shulamit Kahn (1997),
David E. Lebow, Raven E. Saks, and Beth Anne Wilson
(1999), and Joseph G. Altonji and Paul J. Devereux (1999)71 See Janet L. Yellen and Akerlof (2006, 12).
for the United States; Pierre Fortin (1996) for Canada; 72 There are other possible reasons for this failure of the
Vincenzo Cassino (1995) and Simon Chapple (1996) for standard predictions from natural rate theory. Inflationary
New Zealand; Jacqueline Dwyer and Kenneth Leong (2000) expectations may not have been adaptive; the failure of
for Australia; Sara G. Castellanos, Rodrigo Garcia-Verdii,
deflation to accelerate could be due to expectations that the
and David Kaplan (2004) for Mexico; Sachiko Kuroda and price level would return to some normal level. In the United
Isamu Yamamoto (2003a, b, c) and Takeshi Kimura and States, the National Recovery Act, which encouraged firms
Kazuo Ueda (2001) for Japan; Ernst Fehr and Lorenz Goette
to increase prices, and unionization, which gave a fillip to
(2003) for Switzerland; Thomas Bauer, Holger Bonin, andwages, could also have affected the trade-off between in-
Uwe Sunde (2003) and Christoph Knoppik and Thomas flation and unemployment. But since unemployment was so
Beissinger (2003) for Germany; Stephen Nickell and very high for so very long, and since the absence of accel-
Glenda Quintini (2001) for the United Kingdom; and Jonas
erating deflation was so universal across countries, this still
Agell and Per Lundborg (2003) for Sweden. seems to be a dog that did not bark. It seems to point to a
70 See, for example, Anthony P. O'Brien (1989) and
problem with natural rate theory.
Christopher Hanes (2000). 73 See Akerlof, Dickens, and Perry (1996, table 4).
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24 THE AMERICAN ECONOMIC REVIEW MARCH 2007
direct evidence that such a norm exists and is siderations in mind, but desired wage changes
responsible for wage stickiness. His extensive will be truncated insofar as they entail money
open-ended interviews sought to elicit why em- wage decreases. To my mind, such a view en-
ployers failed to cut money wages in the Con- tails a theoretical error. As we have seen, the
necticut recession of 1991-1992. Bewley existence of money wage rigidity occurs be-
concludes that, even though substitute labor wascause workers have a norm, which affects their
easily available, employers were reluctant to cututility function, that their employers should not
wages because of the negative effects of such make such cuts. The message of this finding is
cuts on morale. He says that managers werethat norms in the utility function yield at least
afraid that cuts in money wages would causeone clear violation of natural rate theory. That
workers no longer to "identify" with their com-suggests the further empirical possibility that
panies.74 There might be no immediate conse- workers (and also employers and customers)
quences during the recession. But employersmay also have other norms regarding what nom-
thought that such cuts would cause workers to inal wages (and prices) should be. All such
shirk after the recession had ended. They also violations are exceptions to natural rate theory,
feared that their best workers would be more and yield reasons for long-run trade-offs be-
likely to quit. These stories indicate that work- tween inflation and unemployment.
ers are not thinking about their wages only in Money wage rigidity is then potentially only
real terms, relative to the price level or the the tip of an iceberg. If there is one way in
wages received by others. They also have a which nominal wages enter utility functions,
special aversion to cuts in wages below their because of employees' norms regarding what
current nominal levels.75 their employers should or should not do, there
could also be many other ways.
Norms about Wage Increases.-The motiva- There is another natural way whereby such
tion underlying resistance to money wage cuts norms could enter utility functions: employees
is so obvious, and the facts are so unexception- may not only have a norm that they should not
able, that most macroeconomists accept the pos- take wage cuts. They may also have norms
sibility that money wages are sticky. Even so, regarding the nominal rate of increase of their
they rarely appreciate the broader implications wages or salaries. For example, employees may
of such violation of the assumptions of naturalbelieve that their employer should give them a
rate theory. Their adjusted model is that price nominal raise.
and wage decisions are made only with real con- There is little research on the existence of
such norms. The two questionnaire studies that
have investigated it obtain strong and mutually
reinforcing
74 In more detail, Bewley (1999, 1-2) summarizes his results. Eldar Shafir, Peter Dia-
findings: "Other theories fail in part because they are based
mond, and Tversky (1997) asked respondents to
on unrealistic psychological assumptions that people's abil-
comment on a vignette about two young women
ities do not depend on their state of mind and that they are
who take their first jobs with the same initial
rational in the simplistic sense that they maximize a utility
that depends only on their consumption and working con- income. Specifically they asked respondents
who will be better off: Barbara, who receives a
ditions, not on the welfare of others. Wage rigidity is the
product of more complicated employee behavior, in the face
5-percent raise in the presence of 4-percent in-
of which manager reluctance to cut pay is rational. Worker
behavior, however, is not always rational and completely
flation; or Ann, who receives a 2-percent raise
when inflation is zero; 79 percent of respon-
understandable. A model that captures the essence of wage
rigidity must take into account the capacity of employeesdents
to correctly said that Barbara would be
identify with their firm and to internalize its objectives. This
worse
off than Ann economically. Nevertheless,
internalization and workers' mood have a strong impact on
64 percent of respondents also said that Barbara
job performance and call for material, moral, and symbolic
reciprocation from company leadership." would be happier.76 Such responses are con-
75 Following the argument by Raj Chetty and Adamtrary to the natural rate hypothesis that em-
ployees only care about real returns. But an
Szeidl (2006), some employers may have been concerned
with the fact that their employees had fixed mortgages that
easy explanation for this phenomenon occurs if
they would find difficult to pay with cuts in nominal wages.
This puts the violation of natural rate theory in another
place: why were these financial contracts in nominal rather
than in real terms? 76 Shafir, Diamond, and Tversky (1997, 351-52).
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VOL. 97 NO. 1 AKERLOF: THE MISSING MOTIVATION IN MACROECONOMICS 25
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26 THE AMERICAN ECONOMIC REVIEW MARCH 2007
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VOL. 97 NO. 1 AKERLOF: THE MISSING MOTIVATION IN MACROECONOMICS 27
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28 THE AMERICAN ECONOMIC REVIEW MARCH 2007
generally, models by
can be explained based only on
economists'
herence to positivevariables
economics.86 Friedm
verified only
(1953) essay on positive economics
testing-has severedescri
bias
the methodological implications
economic phenomena of such be w
In particular, he saysSummers
that economic (1986) illus
theori
this bias. The conventional test modeling.
should strive for parsimonious of the efficient A
cording to Friedman, marketstheyhypothesis-that
should stock prices are the for
even
realistic assumptionsexpected
invalue pursuit
of future returns-looks
of such for au- par
mony. tocorrelations
Maximization models of the excesswith
returns on stocks
only ob
tive arguments of utility
relative to bonds. have
Followingbeen
Summers, it define
would
more parsimonious than take approximately
models 5,000 years of data with
where peop
such a test
additionally, lose utility to obtain as much
insofar as as 50 percentor
they,
ers, fail to live up to rejection
their of anstandards.
alternative model where As stock
a res
whatever the empirical prices are validity
more than 30 percent oraway relevanc
from their
such norms, positive economics
fundamentals 35 percent of the has a meth
time. With such
ological bias against lack
their of power, nulls are important. When they
consideration. It p
ileges models without are not rejected, alternative theories, such as
norms.
The prescriptions of those positive
with norms, are noteconomics
even considered. This re
garding the conduct lecture
of has empirical
illustrated such reversion investiga
to norm-
compound the biasless against
nulls. Consumption norms. Fried
behavior, investment
says that economists behavior,
should and wage andnot price pay
behavior-the
heedthree to
stated intentions of most decision
important componentsmakers,of most macro mod- wh
would include their els-all
norms display excessas to how
sensitivity relative tothey
re-
others should behave. spectiveInstead,
neutralities. All ofempirical
these violations could wo
should test only hypotheses
be easily explained by norms. that econom
Yet in each case
consider to be basedeconomists have sought to explain such viola-
on parsimonious mode
If economic tests tionshad great
of classical theory bypower,
norm-less models. then
would be easy, of course, In contrast to toreliance on statistical Friedm
follow testing,
dictum of making more disciplines and
other than economics typically
more refined put t
of hypotheses much
with greater weight on a naturalistic
decreasing parsimon ap-
proach. This
norms really do affect approach involves this
behavior, detailed case
meth
would reject modelsstudies.
withoutSuch observation of the small often
norms and in
course would arrive at the
has been models where
key to the understanding of peo
the
views regarding howlarge.
they To me,should
the most dramatic
behave example aff
of
decision such a relation
But making. between the small tests
economic and the lac
power. All economiclarge occurs in the
models are structure
very of life itself
impre
Francis
in their specification ofCrick the andindependent
James D. Watson87 conjec v
able, the nature of tured correctly
the dependentthat if theyvariables,
could describe th
nature of
and lags, leads
crystalline andofthe
structure a singlenatur
DNA mole-
cule,
residuals. Yet worse, they would
most have unlocked the
economic secret o
proble
involve simultaneitylife.
(asThein
duality between the
supply structure
and demaof the
making establishmentDNA molecule and the way in
of causality which organ-
difficul
almost any isms are
instance, suchgenerated and reproduced
a large numbeis one o
models can be thestatistically
fitted most beautiful findingsthat
of humanit
knowl-
is
tremely hard-and perhaps impossible-to
edge. It indicates the sense in which Crick and
tistically reject allWatson
the variants
were, of
indeed, profoundly mod
correct.
without norms. As What a result, thefor
are the implications program
social science?
positive economics-with its
Positive economics, initial
with its emphasis nulls
on statis-
tical analysis of populations, would suggest tha
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VOL. 97 NO. I AKERLOF: THE MISSING MOTIVATION IN MACROECONOMICS 29
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30 THE AMERICAN ECONOMIC REVIEW MARCH 2007
powerful evidence
sophisticated calculation. Ourinearlier
favor of normsdiscussi
comes
did discuss at least from
one employees'
change resistance in
to money
the wage nor
cuts and
regarding bequests, but thatcustomers' resistance to from
resulted nominal a ve
price increases.
large change in people's As long as inflation
orientation. It is low, it
result
from changes in theiris conception
doubtful that small changes
of the in inflation
family will
of their own place within affect suchitnorms.
and People
ofseemthe to find
placeit
their heirs. That alsoeasier to think in nominal,
occurred over rather
a than
very in real,
lo
run-over the course of centuries. terms. Indeed the facilitation of such thinking
is one of the benefits of money according to
B. Life-Cycle Hypothesis the textbook mantra on its three uses: for
transactions, as a store of value, and as a unit
Regarding the life-cycle hypothesis, we ar- of account. Money is useful as a unit of
gued that consumption depends upon current account especially if people think in nominal,
income because norms regarding how much rather than in real, terms. As a result, as long
people think they should spend are linked toas inflation is low, people are unlikely to
it. But such a norm Wyould be highly unlikelyforsake making calculations in nominal terms,
to change as a result'of the use of fiscal andespecially regarding the norms of what wages
monetary policy for stabilization. In the first or prices should be. Of course, if inflation
place, such stabilization will make the adher-increases to high levels, the norms for wages
ence to the norm less costly, not more costly, and prices and the method of calculating
in purely economic terms. Furthermore, mac- those norms will change. Exactly how they
roeconomic sources are responsible for only a change-with the possibility that they under-
small fraction of the variation in individual adjust to increases in inflation when it is low
and overadjust when it is high-should be
incomes. As a result, there is further reason
why the role of current income in norms empirically
is investigated.
unlikely to change as a result of macroeco-
nomic stabilization. E. Where Do the Norms Come From?
C. Cash Flow and Investment We do not know the general answer to the
question where norms come from. This lecture
The rise of the CFO suggests that norms has tried to make the case that norms, such as
regarding investment have changed in large US they are, could potentially play an important
role in macroeconomics. Hopefully, then, it has
firms. Quite possibly, this change occurred be-
cause firms realized the need for financial con- added to the motivation for research on their
trols that compared the returns on inside and microfoundations.88
outside options. Such an endogenous response
would make Modigliani-Miller correct. But, XI. Conclusion
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VOL. 97 NO. 1 AKERLOF: THE MISSING MOTIVATION IN MACROECONOMICS 31
Akerlof,reason
should behave. There is systematic George A.,
whyed. 2005. Explorations in
such knowledge and experiencePragmatic
are likelyEconomics:
to be Selected Papers of
George
accurate: by their nature, norms areA.generated
Akerlof (and Co-Authors). Oxford
and known by a whole community. They
and New York: are
Oxford University Press.
known to those who abide byAkerlof,
them, George
and A.,those
William T. Dickens, and
who observe them as well. George L. Perry. 1996. "The Macroeconom-
We have shown ways in which macroeconomic ics of Low Inflation." Brookings Papers on
variables will be affected by norms. The neutral- Economic Activity, 1: 1-59.
ities say that consumption should have no special Akerlof, George A., William T. Dickens, and
dependence on current income; investment should George L. Perry. 2000. "Near-Rational Wage
be independent of current cash flow; wages and and Price Setting and the Long-Run Phillips
prices should not depend on nominal consider- Curve." Brookings Papers on Economic Ac-
ations. The very construction of those neutralities tivity, 1: 1-60.
denies the possibility that peoples' decisions Akerlof, George A., and Rachel E. Kranton. 2000.
might be influenced by their views regarding how "Economics and Identity." Quarterly Journal
they, and how others, should behave. In practice, of Economics, 115(3): 715-53.
however, the neutralities are systematically vio- Akerlof, George A., and Rachel E. Kranton. 2002.
lated. Insofar as economists have felt it necessary "Identity and Schooling: Some Lessons for
to explain these violations, they have appealed to the Economics of Education." Journal of
a variety of different frictions, such as myopia and Economic Literature, 40(4): 1167-1201.
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