Several other bloggers have recently described how they visualize macro, so I’ll play copycat. I see three types of macro, each radically different from the other two:

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Long run nominal is the easiest to explain, then business cycles, and long run real growth is the most complex.

1. Long run nominal trends. Central banks determine the long run trend NGDP growth rate, or long run inflation rate, by adjusting long run growth in the monetary base, relative to money demand/velocity, which is mostly determined by non-monetary factors in the long run. The only exception is that when the long run trend rate of nominal growth is slow enough to push interest rates to zero, then money demand shocks become relatively more important. Changes in the long run trend rate of inflation/NGDP growth have fairly small second order effects on real variables unless the changes are extreme. Money is roughly, but not precisely, neutral and super-neutral in the long run.

2. Business cycles. There are two types of business cycles—with or without big swings in the unemployment rate. Throughout most of history, real output volatility was primarily due to real shocks such as wars, droughts and plagues. These did not necessarily impact the unemployment rate.

In large modern economies, real shocks such as the 2011 Japanese earthquake have at most a very modest short-term impact on output, and almost no impact on unemployment. Some public polices can impact the unemployment rate, such as FDR’s NIRA rule that mandated a 20% across the board wage rate increase in July 1933. European style labor market policies can lead to a higher natural rate of unemployment. But even in Europe, fluctuations in the unemployment rate are primarily due to nominal shocks.

Like Keynes, I believe that modern business cycles reflect the interaction of sticky wages and nominal GDP shocks leading to employment fluctuations. Unlike Keynes, I believe wage flexibility would help, although I don’t think there’s much the government can do to make wages more flexible. And unlike Keynes, I believe monetary policy drives NGDP shocks. Recessions are caused by the failure of central banks to stabilize one or two year forward NGDP expectations. Wage flexibility at the individual level doesn’t solve the problem for that individual; it’s aggregate wage stickiness that matters.

When the central bank has a bad target, such as an inflation target, then fiscal policy can help. But fiscal policy should always involve tax changes, never spending changes. (See this, for example.) Spending should be determined according to classical cost/benefit considerations. And the low interest rates typically seen during a recession do not imply a need for more government spending—that’s reasoning from a price change.

3. Long run economic growth. This reflects many factors. It’s useful to contrast per capita growth near the frontier (US/Switzerland/Singapore) and catch up growth (China/India/Ethiopia.) Trend real GDP growth at the frontier reflects technological progress at the global level, and good governance at the country level.

Catch-up growth occurs when there is some sort of public policy change that makes a country’s position in the pecking order change. Thus under Mao’s policies, China’s natural position might have been 5% of the frontier, and the switch to a 1950s European-style mixed economy might move China’s natural position to 55% of the frontier. They are currently transitioning to that 55% position. Further gains beyond the 55% point would require further market reforms.

Both human resources and good governance determine the natural position of a country. In some cases, such as the two Koreas, governance explains most of the divergence, although human resources may change as a result. Most low-income countries suffer from both low human resources and bad governance, and indeed the low human resources may partly cause the bad governance.

Human resources relate to cultural factors such as utilitarianism (i.e. sympathy for strangers), trust, patience, and also average IQ. In the modern world, human resources matter much more than natural resources, except in small oil-rich countries. Human resources can be increased more easily than natural resources, although we are not certain which methods are most effective.

Good governance consists of deregulation, privatization and fairly low marginal tax rates. But government can play a constructive role in areas such as the environment and (consumption) redistribution. If all countries had the same governance, there would still be lots of inequality in the world, but far less than we currently see.