Blog o’ Burns

Hoover, Kevin D. “Is Macroeconomics for Real?” (June 1999)

How sad would it be if the big punchline to this course was the fact that macroeconomics wasn’t real? I’d ask for a refund. Thankfully, that was not the conclusion of this article and hasn’t necessarily been the conclusion of most economists. In general, economists don’t doubt that stable and observable relationships exist at the aggregate level; however, can these relationships be explained in the context of an individual’s rational microeconomic behavior? I won’t pretend to completely (or even mostly… or even partly…) understand Hoover’s argument against the necessity of microfoundations, but I believe he is saying that macroeconomics is not just a construct of measurement or of theory– economic aggregates aren’t just derived from micro behavior; they also affect behavior in ways that alter economic “reality.”

The quest to base macro theory on microfoundations is founded in methodological individualism, which argues that explanations of social, political, and economic phenomena can only be adequate if they are based on the beliefs, attitudes, and decisions of individuals. Lucas and his fellow new classicals have tried to achieve this by using representative-agent models in which a single individual takes on national income as his/her budget constraint and makes microeconomic optimal choices which are supposed to represent the choices of the aggregate economy. However, few macro phenomena have been successfully reduced to their microfoundations.

Hoover distinguishes between two types of economic aggregates: natural aggregates are simple sums or averages, while synthetic aggregates are derived from their components in a way that makes them “dimensionally distinct” from those components. For example, changes in the general price level entail more than just looking at the price of one good or even just averaging the prices of many goods. Everyone has the sense that inflation exists and recognizes that a dollar doesn’t buy as much as it used to, but looking at prices alone won’t tell you much about changes in purchasing power. Economists have multiple ways of measuring inflation, but none will perfectly capture what the everyday person experiences– this just shows how aggregates can exist independent of how they are measured and how they affect the behavior of economic agents.

Though I’m typically the kind of person who likes tearing apart an argument, I have to say that I applaud Hoover’s questioning of the need for microfoundations. To me, new classical pretensions of finding economic truth by incorporating microfoundations seems like just a veneer covering up an over-simplified theory that assumes away any of the messiness that characterizes a real economy. Besides that, I never saw any evidence that these models were truly based on micro behavior. As far as I could tell, microfoundations were just used to explain why the economy is always operating at potential– since people/firms attempt to maximize utility/profits, they always react rationally to shocks in the economy, and thus output is always at its optimal level given people’s preferences for leisure and consumption. Such conclusions seem terribly convenient and don’t take into account possibilities for externalities, prisoner dilemma situations, and any number of occasions for market failure. Of course, all of these issues occur at the micro level, but I don’t feel like it’s necessary (or even possible) to model such problems at the aggregate level.

The point is that details matter. I consider myself a rational person, but my utility function probably changes on a daily basis based on my mood. If I’m having a bad day, I might buy some ice cream even though I wouldn’t consider it worthwhile on any other day. Let’s say that I’m a representative human being, and every person on earth increases his/her marginal propensity to consume ice cream on a bad day. Now imagine that there’s a shock to the economy, and suddenly everyone on earth is having an incredibly terrible day. A new classical would say: “And then all of the rational Stephanie’s went out to buy ice cream instead of doing homework, and ice cream prices rose due to higher demand, causing some of the Stephanie’s to drop out of line and equilibrating supply and demand.” However in the real world, it goes something more like this: “And then all of the Stephanie’s lined up at all of the Carl’s in the world and got way annoyed that the line was so long. The line was so long that the opportunity cost of getting ice cream (better grades from doing homework) exceeded the pleasure of eating it. However, if the line got shorter because other Stephanie’s dropped out, the net benefit of sticking around would make it worthwhile. As such, all of the Stephanie’s waited for each other to drop out of line. Meanwhile, the employees at Carl’s didn’t want to raise their prices, because they were afraid that all of their business would go to Coldstone instead. Besides, they knew that tomorrow would be a good day, so it didn’t make sense to change their prices for just one day. In the end, a suboptimal amount of homework got done and Carl’s didn’t make as much profit as it could have.” As you can see, all of these decisions were made at the micro level, but they were all based on perceptions of the larger economy. I hope that’s at least part of what Hoover is talking about.

King, Robert G. “Will the New Keynesian Macroeconomics Resurrect the IS-LM Model?” Journal of Economic Perspectives 7, no. 1 (Winter 1993): 67-82.

Part of the downfall of the original Keynesian model was its inability to explain the theoretical foundations for the existence of sticky prices. The past two decades has seen the emergence of new Keynesian economists using micro foundations to explain why both real and nominal rigidities might exist in the market. These exciting findings have led to the temptation to accept old Keynesian assumption as valid; however, King argues that new Keynesian work will never be able to reconcile the IS-LM model with rational expectations. As such, the IS-LM model may still be a useful way to present results, but it simplifies reality too greatly to be a reliable way to derive those results.

As all of us have learned in previous macro courses, the IS curve, which basically serves as the aggregate demand curve, is downward sloping under the assumption that savings is a positive function of income and investment is a negative function of interest rates. The LM curve is upward sloping since money demand depends positively on real income and negatively on nominal interest rates (which reflect the opportunity cost of holding money). A typical classroom analysis would go like this: an increase in the money supply (represented by shifting the LM curve out) leads to an increase in aggregate demand (which shifts the IS curve out) and leads to lower real and nominal interest rates. However, in the real world is it possible for expectations to shift the IS curve to such an extent that both real and nominal interest rates actually rise. This may happen because: 1) an increase in the money supply may signal higher future prices and lower the cost of investment at any nominal interest rate; and 2) investors recognize that an increase in the money supply will increase aggregate demand and will therefore invest more to capture the expected gains from additional consumption. These dynamic real world possibilities are difficult to account for using typical IS-LM analysis, which considers expectations as exogenous to the model.

To be fair, the IS-LM model was not initially designed to capture all of the nuances of real world behavior. It was primarily a short cut to demonstrate the impact of short run shocks in aggregate demand to help formulate policy responses. During the 1950s and 60s, intertemporal models of consumption and investment began emerging to reconcile short-run and long-run behavioral observations. These included Friedman’s permanent income hypothesis and Jorgenson neoclassical theory of investment, both of which placed importance on expectations of the future: future income, future production, and future costs.

It wasn’t until the Lucas critique that expectations began being thought of as endogenous to macro models. This critique directly assaulted two distinctions made by Keynes: the distinction between the short and long run and the separation of the saving/investment and monetary sectors. The incorporation of rational expectations blurred these distinctions since: 1) expectations about the future means that people’s behavior are based on intertemporal factors; and 2) expectations link conditions in the savings sector to conditions in the monetary sector. In general, rational expectations imply that all relevant variables useful for forecasting income and interest rates should be included in the consumption function– not just current income.

Apart from the theoretical weaknesses of the IS-LM model, it also does a poor job explaining variation in empirical studies. The model predicts that a positive IS shock will raise output and temporarily raise nominal interest rates. However, empirical studies have shown that such positive shocks tend to rates the rate of inflation for the first few quarters and permanently raises inflation across all time horizons. Thus, real interest rates decline. King argues that without any justification of being a reliable policy tool, the IS-LM model should be abandoned and only used to simplify the presentation of more complex findings.

Alan S. Blinder, “Is There a Core of Practical Macro That We Should All Believe?” American Economic Review, Vol. 87, No. 2, May, 1997.

Asking the question (in the title, by the way) “Is There a Core of Practical Macro That We Should All Believe,” Alan Blinder argues that economists should form a consensus around certain practical design elements without worrying about their theoretical underpinnings. He then identifies two critical failings of the standard macro model which need both theoretical and empirical repair.

A negatively sloped IS curve has been a central premise on which the Federal Reserve has viewed monetary policy. Part of Hicks’ interpretation of Keynes’ General Theory, the IS curve reflects the functional relationship between real output and the real rate of interest. Both historical observation and some empirical research suggest that higher real interest rates lead to lower spending, which validates the use of this curve for framing analysis. However, there are still questions about the sensitivity of investment to interest rates, while a clear relationship between aggregate demand and real interest rates appears to exist. Blinder calls for a further investigation of this paradox.

Hicks’ counterpart to the IS curve, the LM curve, demonstrates the functional relationship between real output and nominal interest rates. Since both money demand and money supply have proven unstable, the LM curve no longer plays a serious role in policy analysis and has been replaced with the assumption that a central bank controls short-term nominal interest rates. However, Blinder proposes that economists shift their focus from short-term interest rates to long-term interest rates which most impact spending.

When economics is taught through textbooks, the IS curve tends to represent aggregate demand and is graphed against an aggregate supply curve to portray short-run equilibrium where they intersect. In this scenario, prices appear to adjust quickly; however in the real work, both prices and wages are very sticky. Practical analytical models do not include an upward-sloping supply curve and do not solve for a market-clearing price level. They tend to view wages and prices as predetermined in the short run, which are then altered using dynamic adjustment equations to describe the evolution of wages and prices over time. These short run models typically solve for output instead of price level.

Blinder next discusses two not-so-well-respected empirical observations that are atheoretical, which include the Phillips curve and Okun’s Law. As opposed to new classical economists who have all but shunned the Phillips curve, Blinder argues that it still works well as an empirical tool and deserves a place in the core macro model. An even more simple relationship was shown by Okun’s Lw, which demonstrates the linear relationship between the percentage change in output and the absolute change in the unemployment rate.

How do all of these pieces fit together? Blinder argues that for four main components in a core macro model: 1) prices and wages are largely predetermined in the short run and evolve according to Phillips type equations; 2) output is demand-determined in the short run; 3) aggregate demand responds directly to fiscal and monetary policy; and 4) Okun’s Law links output growth to changes in the unemployment rate.

Certainly these elements are strikingly imperfect and incomplete. Blinder recognizes this and calls for the development of two components needed to bridge the gap between our economic understanding of short term interest rates and long term interest rates. These missing components include a reliable theory on the term structure of interest rates and a practical way to model expectations. With respect to the former, the current expectations theory of term structure describes any long-term interest rate as a weighted average of current and expected future short-term interest rates plus a premium. However, this model consistently fails empirical tests and is in need of repair. With respect to modeling expectations, evidence that people form rational expectations has also been limited. Some empirical relationships have found that assuming adaptive expectations fits better. Blinder emphasizes the need to include some practical application of expectations into a core macro model.

Finally, Blinder conducts a brief discussion of a growing belief among policymakers that contractionary fiscal policy actually stimulates growth, which contradicts the Keynesian fiscal multiplier. There are two arguments in favor of this view: 1) promises of future fiscal contraction cause expectations of lower real short-term rates which lead to lower long-term rates today; and 2) expectations of lower future public debt lead to lower long-term rates today. Blinder proposes that economists determine whether these arguments have theoretical or empirical validity.