Modern Macroeconomics in Practice: How Theory is Shaping Policy

O ver the last three decades, macroeconomic theory and the practice ofmacroeconomics by economists have changed significantly—for thebetter. Macroeconomics is now firmly grounded in the principles of economic theory. These advances have not been restricted to the ivory tower. Over the last several decades, the United States and other countries have undertaken a variety of policy changes that are precisely what macroeconomic theory of the last 30 years suggests. The evidence that these theoretical advances have had a significant effect on the practice of policy is often hard to see for policymakers and advisers who are involved in the hurly-burly of day-to-day policy making, but easy to see if one steps back and takes a longer-term perspective. Examples of the effects of theory on the practice of policy include increased central bank independence; adop-tion of inflation targeting and other rules to guide monetary policy; increased reliance on consumption and labor taxes instead of capital income taxes; and increased awareness of the costs of policies that distort labor markets. Three key developments in academic macroeconomics have shaped mac-roeconomic policy analysis: the Lucas critique of policy evaluation due to Robert Lucas (1976), the time inconsistency critique of discretionary policy due to Finn Kydland and Edward Prescott (1977), and the development of quantitative dynamic stochastic general equilibrium models following Finn Kydlan