Blog o’ Burns

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!

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.