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

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the next phase when CEO’s typically had a sales orientation, mergers were made with an eye to

increase sales; in the third stage, with the increasing importance of finance, mergers have been

rationalized as a way of increasing shareholder value.  In terms of the investment decision, this

means that managers in this final phase were acting like q-theory, Modigliani-Miller investors. 

In contrast, in the earlier phases they were conceiving of their jobs differently: respectively as

maximizing output or as maximizing sales with the funds available to them.  This yields

investment functions in which cash flow and other financial variables play a special role.

This dichotomy between managers with sales and output orientations to their jobs and

those with a finance orientation has been studied by sociologists.  Zorn (2004) characterizes

managerial orientations in these terms and believes that corporate behavior has changed over the

past 40 years—perhaps not coincidentally since the discovery of Modigliani and Miller. He finds

that in the early 1960's large corporations had a treasurer, whose job was to maintain accounts

and produced the budgets.  He was not a party to major decisions.  In contrast, now more than 80

percent of the firms in his sample have, instead, a Chief Financial Officer, who is, typically,

central to corporate decision making.  Zorn characterizes the CFO’s as viewing the firm as “a

system of investment”;  in contrast he characterizes those with sales or production orientations,

as “view[ing] the firm as a production function.”  The investment orientation of the CFO’s, of

course, exactly corresponds to Miller and Modigliani.  The autobiographies of two successful

business leaders brings the distinction to life.  According to Jack Welch’s Straight from the Gut,

under his regime at General Electric, business decisions (including mergers and acquisitions)

were supposed to be made on the basis of cost-benefit analysis.  In contrast according to John

Pepper’s (2005) What Really Matters, under his regime at Proctor and Gamble, business

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decisions were supposed to be made based upon ability to produce brands that would please the

consumer.  Thus, for example, the criterion for a target in a merger and acquisition at P & G was

its possession of assets needed to achieve the sales goals of planned or already- existing Proctor

and Gamble brands.

A test for this theory would be that managers with different conceptions “over-do” what

they think they ought to do relative to strict profit maximization.  A prediction from Zorn’s

theory then is that mergers and acquisitions will be over-done in firms with strictly finance

orientations.  There is also some indication that this has been the case.  Bruner’s (2001) survey

of the returns from mergers finds that acquiring firms exprience on average neither an increase

nor a decrease in the their value.   Such an  average return of zero, suggests that the marginal

returns to the acquirers is negative.  A check whether management orientation affects business

decisions would be to see whether the returns to acquisitions by companies with CFO’s (as

defined by Zorn) was higher or lower than in firms without them.

Summary.  In summary, the investment function reveals another case where

macroeconomic neutrality will hold only under very narrow assumptions regarding motivation. 

Furthermore, the early Keynesian view that investment might be sensitive to firms’ liquidity is in

concert with maximizing behavior.  But this maximization occurs with a broader view of

managerial preferences than in Modigliani-Miller.  On the one hand the dependence of

investment on cash flow may be due to managerial self-interest, as in agency theory.  But it may

also be due to managerial conceptions of how they should or should not behave.

VII.  Natural Rate Theory

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We now turn to natural rate theory.  Once again the debate concerns the behavior of

economic decision-makers.  The early Keynesians viewed wage setters, and possibly also price

setters, as setting nominal wages and prices, respectively, without taking full account of

inflationary expectations.  In contrast, New Classical revisionists have assumed that wage and

price setters care only about relative wages or prices, and therefore wage and price setting will

fully incorporate inflationary expectations.  Such behavior yields a long-run neutrality result

with severe limits on the ability of monetary and fiscal policy to affect unemployment and

output.  

The logic behind these limits is straightforward.  When wage and price setters only care

about relative wages or relative prices, accelerating inflation will occur if unemployment is

below a critical level called the natural rate; accelerating deflation will occur if unemployment is

above it.  

Such inflation dynamics can be explained as follows.  Suppose that unemployment is

below the natural rate.  In that case the demand for goods and for labor will be high.  The

representative firm will then want to charge a price for its own output that exceeds the price

charged by other firms.  Suppose that the firm sets its price for the next period accordingly; its

price will then also include an adjustment for expected inflation.  But then, since the typical firm

is aiming for a price greater than that charged by others, actual inflation will exceed expected

inflation.  Such a gap between actual and expected inflation causes a further reaction.  It will

cause inflationary expectations to be adjusted upwards; and as these expectations are adjusted

upwards inflation will rise higher still.   When unemployment is below the natural rate, inflation

then will then be ever increasing.  Similarly, when unemployment is above the natural rate,

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