Blog o’ Burns

Mankiw, Gregory N. “A Quick Refresher Course in Macroeconomics.” Journal of Economic Literature 28 (December 1990): 1645-1660.

In this article, Mankiw attempts to reconcile why developments in economic theory had not yet been translated into changes in applied macroeconomics. Until the 1970s, John Hicks’ interpretation of John Maynard Keynes’ vision of the economy through the IS-LM model was deemed the general consensus among economists at the time. Such theory became embodied in more practical, large-scale macroeconometric models such as the MIT-Penn-Social Science Research Council model. However, support for the IS-LM model dwindled in the early 1970s due to its inability to explain stagflation and its lack of adequate micro foundations. Friedman and Phelps’ prediction that the empirical relationship between inflation and unemployment would break down if exploited came true. Lucas also scored a blow on Keynesian thought with his critique arguing that many key macroeconomic variables depend on expectations. If a model cannot account for changes in expectations then it cannot evaluate alternative policies.

This breakdown in consensus caused economists to branch out in three directions of research to build macro models on firm micro foundations; these directions included: 1) modeling expectations (particularly rational expectations); 2) explaining macro phenomena using new classical models; and 3) resurrecting Keynesian theory with new Keynesian models.

New Keynesian Macroeconomics

While new classical models attempted to explain economic fluctuations within the Walrasian market-clearing framework, new Keynesians took another look at the possibility for market failure on a grand scale. They needed to explain why wages and prices failed to adjust instantly to equilibrate supply and demand. Lack of a theoretical justification for price and wages stickiness had helped bring down the original Keynesian model. Such an explanation would need firm mico reasoning as well.

Fixed Prices and General Disequilibrium

During the 1970s, Keynesians spent much time and energy trying to determine how markets interact when prices are fixed at nonmarket-clearing levels, primarily demonstrating economic policy’s influence on output and unemployment under such a regime. These models showed that the behavior of the economy depends greatly on which markets have excess supply and which have excess demand. The excess supply of labor (unemployment) can occur under two regimes: 1) classical unemployment in which real wages are too high all workers to be profitably employed; and 2) Keynesian unemployment in which unemployment occurs because firms cannot sell all they want to at the market price. In the classical case, unemployment occurs due to disequilbrium in the labor market, while the Keynesian case implies a disequilibrium in the goods market. Where is the problem? If imperfections exist in both markets, how do they interact? What keeps prices from adjusting to clear markets?

After the new classical revolution, American Keynesians switched focus to modeling the price adjustment process. Economists typically work under the assumption of perfect competition in which all firms are price-takers. However to model price adjustments, new Keynesians acknowledged that some economic actors have the power to be price-setters.

Labor Contracts and Sticky Wages

To explain sticky wages, a popular line of research was to model labor market failure as caused by labor contracts that specify nominal wages in advance. Such models were appealing because they reflected obseved institutions and implied that policy does have relevant effects on employment. Since nominal wages cannot adjust to economic disturbances, monetary policy can systematically determine real wages and thus employment.

Such models faced criticism on three grounds: 1) what micro foundation is there for firms and employees to enter into potentially harmful contracts?; 2) why should nominal wages play such an important role in determining employment?; and 3) shouldn’t real wages be countercyclical if this theory were true?

Monopolistic Competition and Sticky Prices

In the 1980s, Keynesians shifted focus from the labor market to the goods market. In particular, they looked at monopolistically competitive firms who face small “menu costs” when changing prices. Such costs include the time it takes to inform customers, the risk of making customers angry, and the effort to determine whether prices should change or not. If these costs exceed the benefit of changing prices, they will maintain socially sub-optimal prices.

“Menu costs” reflect nominal rigidities in the goods market. However, real rigidities may exist in the labor market in the form of efficiency wages. In such models, a cut in wage corresponds with a drop in productivity, since it causes the best workers to quit. Since firms monitor effort imperfectly, workers sometimes shirk their responsibilities and risk getting fired. Lower wages imply lower opportunity costs for losing one’s job, thus increasing the likelihood of shirking. If the cost of lost productivity outweighs the benefit of cutting wages, firms will not reduce wages in response to an excess supply of labor. Such real rigidities alone only cause classical unemployment; however when coupled with nominal rigidities, they provide a powerful explanation for Keynesian disequilibrium.

Stockman, Alan. “Real Business Cycle Theory: a Guide, an Evaluation, and New Directions,” Federal Reserve Bank of Cleveland Economic Review, 1988 Quarter 4, Vol. 24, No. 4, pp. 24-47.

• purpose of real business cycle (RBC) models explain aggregate fluctuations in business cycles without reference to monetary policy
• explain fluctuations without discussion of market failures, fiscal policies, or disturbances to preferences or demographics
• concentration on technology shocks not a defining feature of RBC analysis
• Real business cycle analysis important and interesting:
  • evidence that monetary policy affects real output is weaker than economists had thought
  • even if monetary policy affect real output, evidence shows that it isn’t as dominant an influence on business cycles as previously thought
  • even if monetary disturbances play a major role in real-world business cycles, most economists believe that supply shocks and other nonmonetary disturbances (like oil price change, technological progress) also play an important role
    • designed to determine how real shocks affect output, employment, hours, consumption, investment, productivity, etc.
    • also try to show how disturbances in one sector of the economy at one time affect other sectors at later times
  • can determine how any disturbance (even monetary) spreads through different sectors of the economy over time
    • though monetary disturbances frequently set business cycles in motion, possible that the subsequent dynamics and characteristics of cycles would not be much different if caused by disturbances in tastes or technology
• characteristics include:
  • consumption varies less than output, which varies less than investment; consumer purchases of durables vary as much as investment while consumption of nondurables and services vary less and are positively correlated with output
  • hours worked are positively correlated with output and vary about as much
  • average product of labor is positively correlated with output and varies about half as much; correlation between productivity and output smaller than correlation between hours and output
• features of business cycles that this theory does not address
  • nominal money and real output are highly correlated
  • prices vary less than quantities
  • nominal prices are negatively correlated with output
  • real wages are acyclical or mildly procyclical
  • real exports, imports, and net exports are all correlated with output
• Stockman argues that quantitative differences across countries in business-cycle phenomenon and the cyclical behavior of international trade variables can provide support and evidence on RBC models
• Description of a Prototype RBC Model
• assume that: 1) households maximize the expected discounted value of a utility function defined over consumption and leisure; 2) constant-returns technology transforms labor and capital into output, which may be consumed or invested
• production function subject to random disturbances
• firms are perfectly competitive and there are no taxes, public goods, externalities, or restriction on the existence of markets
• maximization decisions involve tradeoffs: consumption vs. investment; labor vs. leisure
• given some particular production and utility functions, an initial stock of capital, and random disturbances, the model can be solved for decision rules and thereby probability rules for all of the endogenous variables –> probability rules yield variances, covariances, and other indicators that can be compared against real world data
• criticized over arbitrary choices of utility and production parameters and exogenous stochastic processes
• Some Variation on the Prototype Model
• Kydland and Prescott included time to build (non-instantaneous investment), variable utilization of capital, lagged effects of leisure on utility, and imperfect information about productivity
• Hansen added lotteries on employment and assumed people either worked full time or not at all; optimal outcome may be to have some people working full time and others not; who works and who doesn’t is completely random and exogenous to the system
• Restrictions on Parameters and Functional Forms
• fraction of total time spent working
• psychological discount rate
• rate of capital depreciation
• marginal rate of substitution over time in consumption, which corresponds to the the relative risk aversion for intertemporally separable utility functions
• marginal rate of substitution over time in leisure
• labor’s share of total GNP
• variance and autocovariances of productivity shocks
• Business Cycles and Long-Run Growth
• some economists have recently argued that the traditional distinction between issues of long-run secular growth and short-term GNP fluctuations should be altered to show that business cycles and long-run growth are intertwined
• given assumption that monetary disturbances only have temporary effects on real output, real disturbances more important source of output fluctuations
• dynamics of GNP during recessions much different than during nonrecession periods

Is it usual for the chairman of the Federal Reserve and the Secretary of Treasury to take such a direct action in bailing out a specific investment firm?

Prescott, Edward C. “Theory ahead of business cycle measurement.” Federal Reserve Bank of Minneapolis Quarterly Review (1986) Fall, pp9-11.

Just as a disclaimer (I know this is lame!): Since Prescott spends a great portion of his paper testing theoretical predictions of statistical properties, it was a bit difficult to follow how (and why) the statistical methodology played a major role in his theory. I apologize in advance if I interpreted anything incorrectly.

Introduction

By deriving aggregate models from micro observations of behavior, new-classical economists argue that fluctuations in output and employment despite small changes in the marginal product of labor should not be surprising. Given people’s ability to substitute consumption for leisure in a world of changing production possibilities, it would be odd for fluctuations not to occur. By using standard theory, Prescott argues that the new-classical real business cycle model has the power to predict the amplitude, serial correlation properties, and volatility of investment relative to consumption with respect to these fluctuations. He argues that the growth model should serve as the basic model describing macroeconomics just as the theory of supply and demand describes price theory. By incorporating uncertainty in the rate of technological change into the growth model, Prescott seeks to demonstrate that it displays the business cycle phenomenon. As the title of his work implies, he emphasizes the importance of theory guiding empirical analysis rather than the reverse. However, he presents a very abstract framework and acknowledges that it should only serve as a foundation for future research that must incorporate elements such as public finance, the foreign sector, and monetary factors. I can’t help but feel that Prescott is proposing a “Theory of Everything” for economics, at least more so than any prior model we have looked at. (For those who are interested, the “Theory of Everything” is kind of the Holy Grail of physics– I saw a documentary on PBS… crazy stuff!)

The Business Cycle Phenomenon

Prescott’s inquiry begins with the question: Do the the stochastic difference equations that are the equilibrium laws of motion for the stochastic growth display the business cycle phenomenon? He uses Lucas’ definition of a business cycle phenomenon as consisting of recurrent fluctuations of output about trend and the co-movements of among other aggregate time series. Prescott shows that when you plot the percentage deviation from trend of output and hours of market employment, output and hours move together at nearly the same amplitude. From this analysis, you can also see that consumption appears less variable and investment more variable relative to output. In addition, the average product of labor is procyclical but does not vary as much as output or hours.

The Growth Model

Prescott builds on the growth models of Solow and Swan, which assumes an aggregate production function with constant returns to scale, two inputs (labor and capital), constant supply of labor, and output that can be used for consumption or investment. He argues that this structure is not adequate to study business cycles because neither the employment or savings rate varies. To derive the determinants of employment level and the savings rate, Prescott looks at the household. In a world of uncertainty, the household attempts to maximize its expected discounted utility. The social optimum will be at the competitive equilibrium, assuming no externalities. Both the wage and the rental price of capital that households receive for their factors of production are a function of technology and the stock of capital.

On the other hand, firms seek profit maximization. To produce, firms try to rent labor and capital at low prices and sell their goods at higher prices. Knowing that household decisions depend on expectations of future prices with relation to the economy’s state (in terms of capital and technology) and that firms depend on the state of the economy as well, for equilibrium to occur: 1) the firm’s policy functions must be optimal given the pricing functions; 2) the household’s policy functions must be optimal given the pricing functions and level of future capital per capita; 3) all markets clear; and 4) expectations are rational. Leisure, and thus the number of hours of employment, will vary in equilibrium depending on expectations of future prices and wages.

As a last modification to his model. Prescott relaxes the assumption that technology shocks are identically and independently distributed random variables. This is necessary is technology shocks demonstrate high serial correlation.

Using Data to Restrict the Growth Model

The strength of this model rests in the fact that it uses both growth and micro observations to determine production and utility functions. Its key parameters are the intertemporal and intratemporal elasticities of substitution, with the thesis that measures from aggregate series are consistent with those from panel data. One constraint on the growth model with respect to the production function is the fact that capital and labor shares of U.S. output have been relatively constant since the Korean War. An observation that restricts the the utility function is the fact that leisure per capita displays no trend despite real wages increasing steadily. With respect to technology, it has been found that developing countries experiencing strong technological shocks have also experienced similar fluctuations in their economies to those with no technological shocks.

The Nature of Technological Change

Solow defined technological change as changes in output minus the sum of changes in labor’s input times labor share plus the change in capital input times capital share. Prescott supplements this approach by accounting for measurement error.

Some Thoughts…

Not to fudge the rest of Prescott’s article, but he spends most of the remainder of his article comparing computer generated statistical results to the actual values of the post-Korean War U.S. economy. The predicted values of the simulations were found to be surprisingly close to the actual values.

I feel like I missed a major point in this article, but I don’t think I’m smart enough to make the connection. Something seems really unsatisfying about this article, because despite all of the claims that new-classical theory incorporates micro observations, I am still not sure what Prescott is saying about how rational actors react to technology shocks. What is a technology shock? Prescott doesn’t provide any examples of what this would look like. It seems too convenient to have all fluctuations in output be caused by changes in technology, a variable that cannot reliably be measured by any current data available (correct me if I’m wrong). Maybe I misunderstood the definition of technological change, but it seems like the definition itself seems to indicate that it reflect fluctuations in the economy. Is it so surprising for x to cause y, when by definition it does so? I know I have to be wrong. Correct me please!