This paper is based on a long-term research program with Rachel Kranton on the implications of identity

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correspond to economists’ typical descriptions of them.   Such generality makes them useful as

null hypotheses for statistical testing.  Furthermore the mind’s eye can often roughly extrapolate

how different departures from the pure model will affect the equilibrium outcomes.  Indeed in

some cases the neutralities will still continue to hold, even though the economy is no longer

perfectly competitive or information no longer perfect.

But the usefulness of the neutralities as benchmarks in all of these cases depends upon

their independence of preferences.  If, on the contrary, economists’ view of people’s motivation

is not realistic, then the neutralities may no longer hold.   In that case they no longer serve as a

good null for the behavior of real people in real macroeconomies. 

In addition, insofar as the behavior assumed by the Keynesians differs from the behavior

that produces the neutralities there is likely to be a bias.  This bias favors the Keynesians, who

based their models on their observation of motivations, rather than on abstract derivations.  If

there is a difference between real behavior and behavior derived from abstract preferences, the

neoclassical methodology has no way to pick up those differences.  In contrast, models based on

observations of such behavior, will systematically incorporate it, even though, as with any

method, there is the possibility for error.  It would be no coincidence then if the deviation

between Keynesian macro behavior and the behavior derived from the neutralities is due

precisely to components of preferences that had been observed by the Keynesians, but were by

assumption excluded from neoclassical models.  

The innovation of this lecture is to interpret such behavior through preferences that

include norms, which are people’s views regarding how they, and others, should or should not

behave.  Such preferences are a central feature of sociological theory, but they have been all but

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5

See Friedman (1957) and Modigliani and Brumberg (1954).  

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totally ignored by economists.  Inclusion of such norms in utility functions makes Keynesian

views of the macroeconomy consistent with maximizing behavior—the maximizing behavior of

real people.  It simultaneously invalidates each of the five neutralities.  

That is the subject of this lecture.  

None of the behavior revealing of such norms will be new.  On the contrary, I have

purposefully chosen phenomena that have been emphasized since The General Theory by

macroeconomists (including Keynes himself) who have voiced their continuing doubts about

classical interpretations of macroeconomic behavior.  Others—especially including those

approaching economics through psychology rather than through sociology—have given different

interpretations to the exact same behavior.  In most cases there is no inconsistency.  We are

seeing the same phenomena—just through a different lens.   

II. The Five Neutrality Results 

This section will now describe in turn each of the five neutrality results.  

1. Dependence of consumption on wealth, not income:

Standard theory tells us that under only somewhat special conditions, consumption

depends on wealth, which is the value of current assets plus the discounted value of future

earnings.

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  Thus there is no tendency for people to make their expenditures conform to the

pattern of their income receipts (as long as their wealth is given).  

Changes in the pattern of current income that leave overall wealth constant are neutral in

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6

See Modigliani and Miller (1958).

7

See Phelps (1968) and Friedman (1968).

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their effects on current consumption.  

2. The Modigliani-Miller Theorem:

One version of the Modigliani-Miller theorem says that a firm’s investment strategy is

totally independent of its liquidity position.

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  Thus, for example, a corporation with an

unexpected windfall will not spend any additional investment dollars.  Instead it will pass the

windfall on to shareholders or seek other financial investments, since it will only make

investments whose risk-adjusted rate of return exceeds the rate of return on capital.

Changes in the firm’s finances will thus be neutral in their effect on current investment.

3. Natural Rate Theory: 

According to Natural Rate Theory there is some single rate of unemployment that is the

only level that could be permanently maintained without ever-increasing inflation or ever-

increasing deflation.

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  A fiscal/monetary policy mix that sought to maintain employment that was

any higher would result in permanently increasing inflation.  A fiscal/monetary mix that sought

to maintain employment that was any lower would result in permanently decreasing inflation.   

Changes in the fiscal/monetary mix that affect long-term inflation will thus be neutral in

their effects on long-term unemployment.  

4. Rational Expectations:

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See Lucas (1972), Sargent (1973) and Lucas and Sargent (1979).

1

See Barro (1974) for the modern reincarnation of these ideas, first discovered by Ricardo.    

 

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According to Rational Expectations Theory a systematic response of monetary policy to

the business cycle will have no effect on the stability of the macroeconomy.

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  Wage and price

setters will foresee the systematic component of monetary policy; they will raise or lower prices

and wages exactly proportionally, and thereby neutralize its effect on demand.  

 

The stability of the economy is thus neutral with respect to the systematic reaction of

monetary policy to the business cycle.

5. Ricardian equivalence:

According to Ricardian equivalence, under somewhat special conditions, a representative

consumer who receives a lump sum intergenerational transfer (for example, in the form of a

social security payment) will not spend a single dime extra.

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  Instead she will pass on the whole

extra income, dollar for dollar to her heirs, who will have to pay the higher tax bills necessary to

retire the increased debt incurred in funding the transfer to the previous generation.  

The transfer is neutral in its effect on current consumption.

 

III. The Missing Motivation: Norms

Each of the neutralities is based on the assumption that the respective decision makers are

utility maximizers, but their utility functions have been very narrowly described.   The utility

functions of the decision-makers depend only on real outcomes.  For example in the

consumption-neutrality models, utility depends on consumption and leisure; in Modigliani-

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