Blog o’ Burns

Laidler, David. “The New-Classical Contribution to Macroeconomics.” Banca Nazionale Del Lavoro Quarterly Review, 1986.

More thoroughly than monetarism, new-classical economics has tried to define macroeconomic principles based on pre-Keynesian classical theory. Laidler argues that this key difference has yielded some overly stringent new-classical assertions, particularly its view that microeconomic behavior should be analyzed under the assumption of continuously clearing markets and strict rational expectations. But aside from these criticisms, he stresses the valuable contribution new-classical theory has made in terms of incorporating expectations into macroeconomic modeling.

Monetarism and New-Classical Macroeconomics

During the 1960s-70s, empirical evidence demonstrated that expansionary demand side policies yielded only temporary gains in output and employment, while inflation tended to rise continuously– a direct contradiction to the Keynesian model as it stood at the time. Monetarists responded by pointing out that: 1) Keynesians underestimated the impact of the quantity of money on aggregate demand and prices; and 2) the notion of a stable inflation-unemployment trade-off as shown by the Phillips curve was based on the assumption that the private sector was constantly fooled by changes in price level. Friedman and Phelps asserted that individuals act based on their expectations of the future, which can be derived from past experience. (Just as an example of this, I’m currently typing this blog on one of the library’s computers, which has a significant lag time between when I type and when the words appear on the screen. At first when I’d hold down the backspace key, I didn’t realize that I was pressing it for too long and would practically erase my whole post. I’m slowly adapting my typing so this doesn’t happen in the future!) They conceptualized the expectations-augmented Phillips curve and argued that any attempt to reduce the unemployment rate below its natural level would lead to higher inflation in the long run. Though these findings provided an alternative to Keynes, they didn’t necessarily challenge the theory and could easily be incorporated into it. Though the expectations-augmented Phillips curve could demonstrate an empirical generalization based on the assumption of expected inflation, monetarists could not explain how this outcome derived from the rational behavior of individuals at the microeconomic level.

Perhaps new-classical economics’ most enduring contribution to macro theory (according to Laidler) has been its version of the aggregate supply curve. Laidler demonstrates this by contrasting it to the Keynesian model. Keynesians assumed that sticky prices cause suppliers to reduce/increase since prices do not change fast enough for markets to clear. So an upward shift in aggregate demand would result in higher output rather than a sudden rise in the general price level. However, this belief in sticky prices could not be reconciled with the Phillips curve, which requires a rise in prices to correspond with an increase in employment. New-classicals provided an alternative explanation, under the assumption of flexible prices: An increase in aggregate demand will translate into higher prices; however, if the shift is unexpected, suppliers will assume that the higher price is unique to themselves, indicating an increase in relative prices. To take advantage of this relative increase, each supplier will produce more, causing aggregate supply to increase beyond its natural level. Thus a rise in general prices fools suppliers into lowering unemployment in order to increase production. However, if the rise in aggregate demand is expected (perhaps due to fiscal or monetary policy) along with a corresponding general rise in prices, suppliers will not hire more workers or increase output. The rise in aggregate demand will merely translate into higher inflation.

The Case for New-Classical Macroeconomics

The new-classical model claims to:

1) Explain past events and forecast future ones more accurately than previous models

Laidler refutes this claim, indicating that the Keynesian model (when modified by monetarism to incorporate expectations and the quantity of money) does a good job of explaining the events of the 1970s, in which prices were sticky and output changed in response to demand side shocks in the short run. This model explains the 1970s at least as well as any new-classical approach.

2) Yield insight into the nature of policy options and state the likely outcome of each choice

3) Have logical coherence and compatibility with other accepted doctrines

Laidler concedes that this third point in the strongest argument in favor of new-classical theory, which has tried to relate macroeconomics to microeconomics more than any prior model. To briefly go over this theory, if we assume that individuals operate in a world of perfect competition and imperfect information with respect to relative prices, supply and demand will depend on expected prices levels. Since people are rational, they will use all available information to form expectations that differ from the actual values only to the extent of a serially uncorrelated random error term. Thus, we can derive the aggregate behavior within an economy based on assumptions of individual behavior– or put the micro in the macro so to speak. New-classicals claim this approach is superior to Keynesian models which emphasize price-stickiness and thus require qualitative empirical laws, the parameters of which are defined by the data itself. Laidler counters this argument in his next section.

Empirical Evidence and ‘Free Parameters’

In the absence of free parameters, new-classical theory runs into trouble empirically when compared to what we know about microeconomics. For instance, the new-classical model gets rid of the free parameter linking money price changes to “excess demand” by theorizing that the Phillips trade-off reflects the elasticity of the supply of labor to changes in the real wage. However when this theory is tested, the results demonstrate that aggregate employment fluctuations seem systematically too large relative to inflation fluctuations to be treated as movements along a labor supply curve when the labor force confuses nominal wage changes for real changes.

Krugman, Paul. Peddling Prosperity. New York: W.W. Norton & Company, 1994.

I have to say, this post will be a bit out of my comfort zone and have a slightly less formal tone than I’m used to. This is partly because Paul Krugman’s book lays out a thorough but not strictly academic empirical analysis as to the impact of “Reaganomics”– its fallacies, its hypocracy, and some of its *er* sparse virtues. His approach is entirely appropriate considering the un-scholarly advocacy of supply-side economics during the 1980s, primarily instigated through Robert Bartley’s editorial pages of the Wall Street Journal (just for the record, Krugman says their news pages are fine).

Krugman definitely imparts the sense (and even explicitly says at one point) that Reagan supply-siders had sort of a cult mentality, with most of its prominent economists like Arthur Laffer and Robert Mundell falling out of the mainstream. Most other supporters had almost no background in economics and promoted their views through journalism. I don’t want to dwell on the questionable motives and credentials of the supply-siders, but it definitely puts a creepy aura around the whole theory.

Speaking of theory– what exactly was Reaganomics? Well, Krugman clarifies that having conservative views about fiscal and monetary policy and believing in the dominance of the supply-side of the economy does not necessarily classify you as a “supply-sider.” The truth is that Reaganomics was an unclearly defined theory based on two premises: 1) demand-side (particularly monetary) policies are completely ineffective; and 2) productivity is highly responsive to changes in the tax burden.

It is true that high marginal tax rates reduce incentives to produce– this is a point that any economist would find hard to disagree with.  However, supply-siders translated this positive economic fact into an extreme normative policy: tax cuts are always appropriate whether an economy is in recession or not.  Using the Laffer Curve to support such policies, supply-siders predicted that tax cuts might actually increase tax revenues by encouraging people to work, save, and invest.  And even if deficits increased, the increased saving brought on by the tax cuts would easily finance it and still allow for more investment.

Krugman makes it clear that taxes do indeed cause distortions in the economy, particularly with respect to incentives to invest.  Investment reflects people’s willingness to sacrifice current consumption for future consumption.  By taxing gains on investment, there will be less incentive to invest, causing too much present consumption and too little consumption in the future.  However, the supply-siders emphasized the large role that taxation plays in hindering prosperity.  All booms and slumps in the economy were due to changes in tax policy that impacted aggregate supply.  For instance, the Smoot-Hawley tariff allegedly reduced returns to work and investment to such an extent that it caused the Great Depression (during which employment dropped by a third), despite only constituting an effective tax increase of 2.5%.

Attfield, C.L.F., D. Demery and N.W. Duck. Rational Expectations in Macroeconomics. New York: Basil Blackwell Ltd, 1985.

Note: I focused my summary on the first three chapters of this book. I will edit my post sometime this week to include information from Chapter 5, which discusses rational expectations in an open economy.

CHAPTER 1: EXPECTATIONS IN MACROECONOMICS

Attfield et al (1985) begin their analysis of rational expectations with three examples in economic theory in which expectations of one variable or another play a vital role: 1) the IS-LM model; 2) the consumption function; and 3) the natural rate hypothesis.

1) In the Keynesian IS-LM model, the IS curve is volatile due to the instability of the expected profitability of investments, causing it to shift by large amounts as firms change the amount of investment they wish to undertake. However, the frequent shifts in the IS curve would not have much impact if the LM curve were steep, but quite the opposite, it is likely to be horizontal. Why is that? Demand for money depends on expectations of future interest rates. At the critical rate of interest, the interest rate reaches a point so low that people’s demand for money will be very responsive to shifts in it, thereby causing the LM curve to appear flat. If people expect a drop in interest rates, they will sell their bonds and their demand for money will go up.

2) One post-Keynes development in the consumption function has been the concept of permanent income, indicating that people consume based on expectations of future income rather than just current income. This has significant implications on government policy, because if policymakers attempt to stimulate the economy by increasing expenditure, the multiplier may not be as strong if people do not expect their future income to change.

3) In the natural rate hypothesis, it is assumed that workers are primarily concerned with real wages and will form expectations with respect to inflation when determining whether to supply more labor. If aggregate spending rises, prices will rise, and employers will offer higher nominal wages to attract more labor. Workers will see that higher nominal wages do not translate into higher real wages and will stop supplying labor. In this case, an increase in aggregate spending would have little effect on employment. However, the opposite would occur if workers did not expect prices to rise.

As demonstrated in the three examples above, incorporating expectations into economic models has changed how economists view potential outcomes. However, little data exists to measure this phenomenon. Attfield, Demery, and Duck ask whether it is possible to have a general theory explaining how expectations are formed that can be easily tested and can demonstrate the relationships proposed in macroeconomic theory. The theory of rational expectations attempts to serve such a purpose.

CHAPTER 2: THE THEORY OF RATIONAL EXPECTATIONS

The theory of rational expectations assumes that people base their expectations on all available information, which is used to formulate a “process” (often represented by an algebraic equation) that reflects the pattern of a variable’s behavior. If the variable follows the exact pattern described by the process, people’s expectations will be perfectly accurate with zero forecasting error. However this would most likely not be the case since most processes are not completely deterministic — most have a stochastic (or random) element. The best expectation a rational person can make is that this error term will equal its mean of zero.

One criticism of the theory is the plausibility that people actually use complex processes when forming their expectations. Many people are unaware that certain economic variables exist let alone understand how they may determine the value of other variables. In addition, it may not be efficient to try to obtain all of the information necessary to form accurate forecasts. A rational person will only acquire information as long as the marginal return from doing so exceeds the marginal cost. Attfield et al argue that though people probably do not consciously calculate the expected values of variables, collectively they act as if they do. Futhermore it is costless to recognize when your expectations turn out to be wrong, so it is costless to use this information until the marginal return from doing so equals zero. A second criticism is in the fact that the actual values of determinant variables may not be known. In such a case, the authors argue, people will form rational expectations with respect to those values as well. As a final criticism, there may be limits to the applicability of the theory of rational expections. On occasion, events occur that appear unique or unusal. The authors believe that such events are often a function of some greater underlying pattern that has not been recognized yet. People are capable of making intelligent appraisals of current circumstances to for expectations.

CHAPTER 3: RATIONAL EXPECTATIONS AND A FLEXIBLE PRICE MACROECONOMIC MODEL

The authors derive the following model under the assumption that prices move freely to equate supply and demand.

To review a bit, to derive the aggregate demand curve, we must look at equilibrium aggregate demand determined by the IS and LM curves at different price levels. The IS curve shows combinations of real income and nominal interest rates for which aggegate demand for output equals actual output. The LM curve shows combinations of real income and nominal interest rates for which the quatity of money dmanded equals the quantity supplies. Where the two curves intersect indicates the equilibrium interest rate and level of aggregate demand. From this diagram, a downward-sloping aggregate demand curve can be derived.

Now let us assume that suppliers are primarily influenced by relative prices. If the relative price of goods in one region is higher than in another, suppliers in that region will respond to the higher prices by supplying more output. A higher relative price in one region translates into a lower relative price in another, causing that supplier to decrease its output. Thus, aggegate supply stays the same with an adjustment in relative prices. However, what if suppliers are unsure as to the value of relative prices? They will have to form rational expectations of the average, economy-wide price of the good and compare this expectation with the actual prices in their own market. If the exonomy-wide expectation of relative prices turns out to be above actual relative prices, aggregate output will be above its natural rate. The natural rate reflects the relationship between output and price level if the price level is accurately forecasted. The primary implication of this hypothesis is that changes in the price level which are expected have no effect on real output.

Now let us assume that aggregate demand shifts upward, but people expect price levels to remain the same. Suppliers will see the unexpected rise in their prices and assume that a shift in relative demand for their goods has occurred. Responding to these higher prices, they will supply more output. However, if people are rational, why couldn’t they predict the shift in aggregate demand? And if they could predict that it would rise, why didn’t they forecast the rise in average price level? At the heart of these questions is how rational people handle the “signal extraction problem.” A rational supplier wants to know the precise impacts of changes in aggregate demand and relative demand on his/her prices. However, he/she can only see the combined influence of these two factors on his/her prices. Thus, expectations will vary somewhere between the old price level and the actual price level.

The key conclusion to draw from the theory of rational expectations is the fact that only random shifts in aggregate demand will affect real output. Predictable shifts will only affect prices.

Laidler, David. “Monetarism: An Interpretation and an Assessment,” Economic Journal, 1981.

Laidler begins by defining four key characteristics of monetarism: 1) it employs the quantity theory to macroeconomic analysis in two senses– Friedman’s theory of the demand for money and the traditional theory of money supply and price level; 2) it rules out any long-run trade-off between price level and real income, using the expectations augmented Phillips Curve; 3) it presents a monetary approach to balance of payments and exchange rate theory; and 4) it discourages activist stabilization policy and price controls, while favoring monetary policy aimed at long term price stability.

The Quantity Theory of Money

Often viewed a “development” of Keynes’s capital theoretic approach to monetary theory, Friedman’s theory of the demand for money highlighted some key differences between the two schools of thought. While Keynes had treated money as simply a financial asset, Friedman conceptualized money as a durable good to which the permanent income hypothesis of consumption could be applied. He also recognized inflation as a distinct rate of return on money and proposed a well-determined functional relationship between expected inflation and the demand for money– a relationship which Keynes had denied. Finally, perhaps the most widely debated element of Friedman’s argument was his assertion that the demand for money and the velocity of money were relatively stable. This assertion is one of the differentiating arguments separating monetarists from classical and neoclassical economists. Though debate continues, empirical evidence has shown that demand for money function has shifted as institutional frameworks have evolved.

Another factor that distinguishes monetarists from their classical predecessors is their strong emphasis on the role of the quantity of money in determining prices. Employing quantity theory, monetarists have more clearly declared the money supply to be the main cause of income fluctuations, partly due to their strong belief in a stable velocity of money. Classical economists had often questioned the constancy of this variable.

With respect to the IS-LM model, there are two ways this model can demonstrate monetarist results. In the underemployment form, if the demand for money is insensitive to interest rates then the quantity of money is the key determinant of real income. In the full employment form, the quantity of money must be the key determinant of money wages because the economy is at maximum output and the velocity of money is held constant.

The Expectations Augmented Phillips Curve

Monetarists have long doubted the trade-off between inflation and unemployment, believing instead in the stability of the private sector which tends to operate near full employment. For a while the Phillips Curve was seen as providing an alternative explanation of inflation, but in actuality, the expectations-augmented Phillips Curve was declared the missing equation in the monetarist model.

In the early 1970s, two extreme views of this expectations-augmented curve existed. At one extreme, it was believed that monetary policies only impacted real income and prices were determined by external factors. At the other extreme, most monetarists believed that inflation was low in a depressed economy and high in an expanded one. However, this trade-off between inflation and deviations of output from that of full employment were only temporary and vanished in the long-run. Keynesians criticized the equation for failing to explicitly define other factors that impact inflation, all of which were represented by the variable v.

Since then, there has been general agreement that no significant trade-off exists between output and inflation in the long-run. However, how long it takes for an economy to converge at long-run equilibrium is still highly disputed. In addition, greater consensus has been reached on the importance of external factors on inflation in the short-run, while Keynesians now recognize long-run inflation as a monetary phenomenon. However, debate continues over the theoretical basis for the Phillips Curve.

Phelps presented one theoretical approach, defining the expectations augmented Phillips Curve as an aggregate supply curve. To say this implies that the voluntary choices of individuals determine fluctuations in output and employment in response to prices. As we all know, choices are based on inaccurate expectations, indicating that unemployment is caused by incomplete information. Thus, the way that expectations are formed play an important role in economic well-being. If we apply the “rational expectations” hypothesis to supplement the aggregate supply curve interpretation, a person will obtain information until the marginal cost of doing so equals the marginal benefit. Over time, expectations will not be wrong systematically, thus causing their distribution to reflect the correct expectations model.

The Monetary Approach to Balance of Payment and Exchange Rate Analysis

Until 1971, the world operated on a fixed exchange rate regime against the U.S. dollar. The monetary approach to the balance of payments suggest two reasons why an inverse relationship existed between inflation and unemployment in Britain. Firstly, as long as fixed exchange rates were maintained, prices of tradeable goods sold domestically were determined by world markets, thus the long run behavior of prices depended on that of world prices. When this gets incorporated into inflation expectations, if world prices are stable, so will expectations. Secondly, high levels of demand are associated with high rates of domestic credit expansion, which generate balance of payments problems. If exchange rates were allowed to float, the country’s balance of payments deficit would likely be replaced with inflationary pressure. This second point became less valid after most of the world switched to floating exchange rates after 1971. However even before the switch to floating exchange rates, monetarists agreed that flexible exchange rate regimes were a pre-requisite for achieving monetarist goals of price stability.

Policy Issues

Just like the monetarists of the 1950s, contemporary monetarists seek monetary policy that adheres to some simple rule under which monetary aggregates do not react to short-run fluctuations. They also feel that fiscal policy should focus on resource allocation and distribution of income rather than on activist stabilization. Many argue that it is one thing to say that policy can systematically influence output and employment in the short-run, but it is another to say that policymakers know how to use their tools to do this. While we can always count on markets to clear and expectations to be rational, we cannot count on our own knowledge of the economy to make safe stabilization policy.

Monetarists also fervently oppose wage and price controls which have failed to be an effective alternative to monetary policy in curbing inflation. In an open economy, such controls cannot have a long term impact on the price level under either fixed or floating exchange rates. Under fixed exchange rates, prices cannot be controlled by domestic policy, while under floating rates, exchange rates and world prices cannot be regulated separately.

Questions

What are the determinants of the velocity of money? (The article mentioned inflation as one, but what are the others?)

Can someone explain how the Phillips Curve can act as an aggregate supply function?

The article implied that one big difference between monetarists and the classicals was the belief that the velocity of money was constant. Aren’t their viewpoints the same? Or did the classicals believe that velocity is constant, while monetarists believe that it is stable? If so, what exactly is the difference between “constant” and “stable”? (I know this is kind of a weird question, but it confused me a ton!)

Gonçalo L. Fonseca, “Inflation and the Phillips Curve,”The History of Economic Thought Website.

Demand-Pull and Cost-Push Inflation

The Keynesian model as it stood could not explain falling money wages in the 1950s. It was not until Alban W. Phillips demonstrated the relationship between wage growth and unemployment that Neo-Keynesians (Lipsey, Samuelson, and Solow) had the empirical foundation to integrate an explanation of inflation in the model. Two competing theories existed to explain rising price levels: 1) demand-pull inflation; and 2) cost-push inflation.

According to demand-pull theory, inflation was generated by excess demand as an economy approaches or exceeds potential output at full employment. If demand rises beyond this point, supply cannot follow and conduct the multiplier effect. As a result, equilibrium prices rise. However, prices only need to rise once in order for equilibrium to be established, so what explains continuous inflation? Keynes argued that this phenomenon occurred due to wages lagging behind rising prices. When this occurs, the distribution of income shifts away from workers and goes to profit-earners. Since workers have a higher marginal propensity to consume, a fall in real income flattens the aggregate demand curve and causes it to fall, thereby lowering prices and curbing inflation. But since wages will eventually rise to catch up with prices, the inflation gap returns, starting the cycle all over again and causing inflation to recur.

According to cost-push theory, firms set the price of output. As the economy reaches full employment, workers have more clout in negotiating higher wages due to lack of competition from unemployed labor. To maintain the same level of profits, firms respond to the increase in wages by increasing the price of their products. This in turn causes real wages to stay the same, which workers eventually recognize and thus continue to demand higher wages. As such, inflation recurs. Lerner recognized that spiraling inflation need not be the fault of labor—he argued that employers have much clout during times of high unemployment, and their quest for higher profits could cause them to raise prices. Thus, the possibility of stagflation exists.

Adopting the demand-pull theory, Neo-Keynesians incorporated the findings of the Phillips Curve into their model by graphing a capacity constraint to the left of the IS-LM equilibrium point, calling the difference the “inflationary gap.” Thus, inflation was caused by excess demand. Keynes had argued that this gap would be closed by shifting income distribution; however, Neo-Keynesians thought that inflation itself would close the gap by lowering the money supply and thus increasing interest rates, ultimately reducing investment and demand. Once again, this model could not account for recurring inflation and lacked an understanding of the relationship between the market for labor and the market for goods.

The Phillips Curve

The Phillips Curve demonstrates the non-linear relationship between inflation and unemployment. A trade-off appears as low unemployment is associated with high inflation and vice versa. Neo-Keynesian economist Richard Lipsey argued if labor markets for a particular industry were in disequilibrium, then how quickly wages adjusted depended on the how big the gap between labor supply and labor demand was relative to labor supply. The more excess demand for labor existed, the faster wages would rise.

The non-linear shape of the Phillips Curve is attributed to frictional unemployment and institutional constraints. To derive the aggregate Phillips Curve, the Neo-Keynesians averaged the industry Phillips Curves described by Lipsey. Due to the non-linearity of the curve, even if each industry curve were identical, the aggregate Phillips Curve would appear to the right of the industry curves. So economy-wide, unemployment at zero inflation would be higher than in any particular industry, implying that inflation is not only a function of unemployment but also of the distribution of that unemployment across industries. This helps explain why wages rise when an economy is at full employment. Though in the aggregate it is impossible for firms to attract additional workers with higher wages, individual industries may try to attract workers from other industries by raising their wages. Thus, to prevent workers from being lured away, each industry will raise its wages.

Inflation and Interest Rates

What impact does inflation have on the rest of the Keynesian model? Keynes’s theory of liquidity preference had indicated that money demand is inversely related to the return on other types of assets. Mundell argued that the nominal interest rate is a function of inflation expectations and the real interest rate. If inflationary expectations rise, then for any amount of money supply the real interest rate will fall since holders of money will expect a negative return on their holdings in the future. They will attempt to get rid of their money by purchasing equity, causing demand for money to fall and the price of equity to rise.

However, nominal interest rates do not rise in exact proportion to inflationary expectations due to the fact that shifting away from holdings of money to holdings of equity decreases the return on equity (due to the now higher price). Unlike money, the supply of capital cannot increase, forcing its price to rise.

Through this reasoning, Mundell demonstrated that inflation or even the anticipation of inflation could have a real effect on the economy by shifting holdings of money to holdings of capital.

The Expectations-Augmented Phillips Curve

The stagflation of the 1970s - presence of both high unemployment and high inflation- caused doubt over the reasoning of the Phillips Curve. Many Keynesians argued that the curve was simply shifting up and to the right, as unemployment gradually became associated with higher and higher levels of inflation. However, this “migration” indicated that the relationship between unemployment and inflation was not truly negative. More importantly, if the curve could shift, policymakers could no longer rely on it to make manipulate unemployment or inflation.

Milton Friedman and Edmund Phelps proposed an expectations-augmented Phillips Curve to explain the phenomenon of stagflation. They essentially demonstrated that inflationary expectations not only shifted asset holdings but they also could shift the entire Phillips Curve outward. Since not all expectations occur, there is a specific short-run Phillips Curve, with each curve representing a certain level of inflationary expectations—higher inflationary expectations yield higher curves. So in the short run, a fall in unemployment due to an increase in nominal demand will be accompanied by increased inflation like previously understood. However, long run inflation is trickier. In the long run, expected inflation equals current inflation. Like in the short-run, a drop in unemployment in the long run will also see a rise in inflation, but this inflation is augmented by expected inflation, making the tradeoff much steeper.