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.

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.

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.

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.

• 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

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!

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.

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%.

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.