In economics, the freshwater school (or sometimes sweetwater school) comprises US-based macroeconomists who, in the early 1970s, challenged the prevailing consensus in macroeconomics research. A key element of their approach was the argument that macroeconomics had to be dynamic and based on how individuals and institutions interact in markets and make decisions under uncertainty.[1]
The terms "freshwater" and "saltwater" were first used in reference to economists by Robert E. Hall in 1976, to contrast the views of these two groups on macroeconomic research.[1] More than anything else it was a methodological disagreement about to what extent researchers should employ the theory of economic decision making and how individuals and firms interact in markets when striving to account for aggregate ("macroeconomic") phenomena.
In many respects, the saltwater-freshwater dichotomy no longer holds true.[1][2][3] In his overview article from 2006, Greg Mankiw writes:
An old adage holds that science progresses funeral by funeral. Today, with the benefits of longer life expectancy, it would be more accurate (if less vivid) to say that science progresses retirement by retirement. In macroeconomics, as the older generation of protagonists has retired or neared retirement, it has been replaced by a younger generation of macroeconomists who have adopted a culture of greater civility. At the same time, a new consensus has emerged about the best way to understand economic fluctuations. [...] Like the neoclassical-Keynesian synthesis of an earlier generation, the new synthesis attempts to merge the strengths of the competing approaches that preceded it.[4]
Differences
The differences in methodological approach to answer aggregate economic questions lead to different policy implications.
Discretionary policies
One of the main differences between so-called "freshwater economics" and "saltwater economics" were in their findings on the effects of and relative importance of structural and discretionary policies.
An implication of saltwater economic theory was that the government has an important role to play in order to actively and discretionarily stabilize the economy over the business cycle through striving to fine-tune "aggregate demand".[5]
Researchers associated with the "saltwater school" found that government economic policies are of utmost importance for both the economy's abilities to respond to shocks and for its long-term potential to provide welfare to its citizens. These economic policies are the rules and structure of the economy. They might be how markets are regulated, what government insurance programs are provided, the tax system, and the degree of redistribution, etc. Most researchers that have been associated with the "freshwater school" have, however, found it hard to identify mechanisms through which it is possible for governments to actively stabilize the economy through discretionary changes in aggregate public spending.[2]
Internal model consistency ("rational expectations")
Another important difference between so-called "freshwater economics" and "saltwater economics" is what is required from an economic model and, in particular, about the internal consistency of the economic model.
In general, "saltwater economists" insist less on internal model consistency than freshwater economists. Typically, they find "examples of irrational behavior interesting and important."[6] Like behavioral psychologists, they tend to be interested in situations where individuals and groups behave in a seemingly boundedly rational way.
In contrast, freshwater economists have in general been interested in accounting for the behaviour of large groups of people interacting in markets, and believe that understanding market failures requires framing problems that way.[7]
"Saltwater Keynesian economists" argue that business cycles represent market failures, and should be counteracted through discretionary changes in aggregate public spending and the short-term nominal interest rate.
"Freshwater economists" often reject the effectiveness of discretionary changes in aggregate public spending as a means to efficiently stabilize business cycles. Economists loosely associated with the "freshwater school" have found that market failures might be important both as a cause of and as amplification and propagation of business cycles. However, it does not follow from these findings that governments can effectively mitigate business cycles fluctuations through discretionary changes in aggregate public spending or the short-term nominal interest rate. Instead they find, in general, that government policies would be more effective if they concentrate on structural reforms that target identified market failures. These economists also emphasize that the government budget constraint is the unavoidable accounting identity and connection between deficits, debt, and inflation.[7]
Economics is a social science that studies the production, distribution, and consumption of goods and services.
Keynesian economics are the various macroeconomic theories and models of how aggregate demand strongly influences economic output and inflation. In the Keynesian view, aggregate demand does not necessarily equal the productive capacity of the economy. It is influenced by a host of factors that sometimes behave erratically and impact production, employment, and inflation.
Macroeconomics is a branch of economics that deals with the performance, structure, behavior, and decision-making of an economy as a whole. This includes national, regional, and global economies. Macroeconomists study topics such as output/GDP and national income, unemployment, price indices and inflation, consumption, saving, investment, energy, international trade, and international finance.
New Keynesian economics is a school of macroeconomics that strives to provide microeconomic foundations for Keynesian economics. It developed partly as a response to criticisms of Keynesian macroeconomics by adherents of new classical macroeconomics.
Robert Emerson Lucas Jr. was an American economist at the University of Chicago. Widely regarded as the central figure in the development of the new classical approach to macroeconomics, he received the Nobel Memorial Prize in Economic Sciences in 1995 "for having developed and applied the hypothesis of rational expectations, and thereby having transformed macroeconomic analysis and deepened our understanding of economic policy". N. Gregory Mankiw characterized him as "the most influential macroeconomist of the last quarter of the 20th century". In 2020, he ranked as the 10th most cited economist in the world.
Business cycles are intervals of general expansion followed by recession in economic performance. The changes in economic activity that characterize business cycles have important implications for the welfare of the general population, government institutions, and private sector firms.
Nicholas Gregory Mankiw is an American macroeconomist who is currently the Robert M. Beren Professor of Economics at Harvard University. Mankiw is best known in academia for his work on New Keynesian economics.
John Brian Taylor is the Mary and Robert Raymond Professor of Economics at Stanford University, and the George P. Shultz Senior Fellow in Economics at Stanford University's Hoover Institution.
The permanent income hypothesis (PIH) is a model in the field of economics to explain the formation of consumption patterns. It suggests consumption patterns are formed from future expectations and consumption smoothing. The theory was developed by Milton Friedman and published in his A Theory of the Consumption Function, published in 1957 and subsequently formalized by Robert Hall in a rational expectations model. Originally applied to consumption and income, the process of future expectations is thought to influence other phenomena. In its simplest form, the hypothesis states changes in permanent income, rather than changes in temporary income, are what drive changes in consumption.
Mainstream economics is the body of knowledge, theories, and models of economics, as taught by universities worldwide, that are generally accepted by economists as a basis for discussion. Also known as orthodox economics, it can be contrasted to heterodox economics, which encompasses various schools or approaches that are only accepted by a small minority of economists.
In the history of economic thought, a school of economic thought is a group of economic thinkers who share or shared a mutual perspective on the way economies function. While economists do not always fit within particular schools, particularly in the modern era, classifying economists into schools of thought is common. Economic thought may be roughly divided into three phases: premodern, early modern and modern. Systematic economic theory has been developed primarily since the beginning of what is termed the modern era.
Dynamic stochastic general equilibrium modeling is a macroeconomic method which is often employed by monetary and fiscal authorities for policy analysis, explaining historical time-series data, as well as future forecasting purposes. DSGE econometric modelling applies general equilibrium theory and microeconomic principles in a tractable manner to postulate economic phenomena, such as economic growth and business cycles, as well as policy effects and market shocks.
Microfoundations are an effort to understand macroeconomic phenomena in terms of economic agents' behaviors and their interactions. Research in microfoundations explores the link between macroeconomic and microeconomic principles in order to explore the aggregate relationships in macroeconomic models.
The neoclassical synthesis (NCS), or neoclassical–Keynesian synthesis is an academic movement and paradigm in economics that worked towards reconciling the macroeconomic thought of John Maynard Keynes in his book The General Theory of Employment, Interest and Money (1936) with neoclassical economics.
New classical macroeconomics, sometimes simply called new classical economics, is a school of thought in macroeconomics that builds its analysis entirely on a neoclassical framework. Specifically, it emphasizes the importance of rigorous foundations based on microeconomics, especially rational expectations.
Jordi Galí is a catalan macroeconomist who is regarded as one of the main figures in New Keynesian macroeconomics today. He is a Senior Researcher at the Centre de Recerca en Economia Internacional (CREI), a Professor at Universitat Pompeu Fabra and a Research Professor at the Barcelona School of Economics. After obtaining his doctorate from MIT in 1989 under the supervision of Olivier Blanchard, he held faculty positions at Columbia University and New York University before moving to Barcelona.
In macroeconomics, particularly in the history of economic thought, the Treasury view is the assertion that fiscal policy has no effect on the total amount of economic activity and unemployment, even during times of economic recession. This view was most famously advanced in the 1930s by the staff of the British Chancellor of the Exchequer. The position can be characterized as:
Any increase in government spending necessarily crowds out an equal amount of private spending or investment, and thus has no net impact on economic activity.
Macroeconomic theory has its origins in the study of business cycles and monetary theory. In general, early theorists believed monetary factors could not affect real factors such as real output. John Maynard Keynes attacked some of these "classical" theories and produced a general theory that described the whole economy in terms of aggregates rather than individual, microeconomic parts. Attempting to explain unemployment and recessions, he noticed the tendency for people and businesses to hoard cash and avoid investment during a recession. He argued that this invalidated the assumptions of classical economists who thought that markets always clear, leaving no surplus of goods and no willing labor left idle.
In macroeconomic theory, general disequilibrium is a situation in which some or all of the aggregated markets, such as the money market, the goods market, and the labor market, fail to clear because of price rigidities. In the 1960s and 1970s, economists such as Edmond Malinvaud, Robert Barro and Herschel Grossman, Axel Leijonhufvud, Robert Clower, and Jean-Pascal Benassy investigated how economic policy would impact an economy where prices did not adjust quickly to changes in supply and demand. The most notable case occurs when some external factor causes high levels of unemployment in an economy, leading to households consuming less and firms providing less employment, leading to a rationing of both goods and work hours. Studies of general disequilibrium have been considered the "height of the neoclassical synthesis" and an immediate precursor to the new Keynesian economics that followed the decline of the synthesis.
The new neoclassical synthesis (NNS), which is occasionally referred as the New Consensus, is the fusion of the major, modern macroeconomic schools of thought – new classical macroeconomics/real business cycle theory and early New Keynesian economics – into a consensus view on the best way to explain short-run fluctuations in the economy. This new synthesis is analogous to the neoclassical synthesis that combined neoclassical economics with Keynesian macroeconomics. The new synthesis provides the theoretical foundation for much of contemporary mainstream macroeconomics. It is an important part of the theoretical foundation for the work done by the Federal Reserve and many other central banks.
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