Blog o’ Burns

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.