Senior Moments

Chari and Kehoe argue in this article that macro is grounded in the principles in economic theory and that these theories are now being used in practice.  They cite examples of increased central bank independence, and adoption of inflation targeting as monetary developments based on macroeconomic theory.  They credit several economic initiatives with these developments.  These include the Lucas critique and the time inconsistency critique by Kydland and Prescott.  Essentially rules are better than discretionary policy because of the time inconsistency problem.  Furthermore in order to conduct policy analysis the way that a current choice of policy will effect expectations of future policies MUST be considered

In retrospect - Chari and Kehoe do an excellent job of explaining the necessity of future economic research.  They demonstrate how current policy initiatives are results of this previous research and argue that future policy initiatives can only benefit from increased reasearch in the field.  This paper lacks argument but essentially demonstrates necessity - something I haven’t seen in the previous readings this semester

Hoover raises some interesting points regarding microfoundations in this article.  The idea that there are different types of microfoundations was new to me and his explanation of natural versus synthetic aggregates actually makes a lot of sense.  All to often in class we have mentioned that you can’t just add up a whole bunch of average consumers and assume them to act as the economy would (natural aggregates) but rather we must take into consideration variances associated with these consumers. 

Personally I think that there has to be some kind of microfoundations but there is no precise way to measure the microeconomy as of yet.  The advances we have made in macroeconomics in recent history are dramatic - we haven’t seen these advances in micro and maybe the focus needs to shift back to the basic assumptions - and whether they are legitimate. 

This article argues that optimal control theory is not good economic policy, and that rather, there should be a fixed rule for determining the money supply.  Control theory is a policy in which monetary adjustments are made in an effort to target a set rate of inflation.  Kydland and Prescott’s argument is very similar to Friedman’s monetarist ideas, however they argue for a more complex rule that takes into account timing and magnitude of policy effects.  This more complex rule allows for entire futures to be taken into account when formulating this monetary rule rather than just current decisions.  Rational agents could prosper from such a rule as long as policy makers do not take advantage of expectations.  In the event that policy makers manipulate policy based on rational expectations, economic agents would lose trust in the system and it would no longer work.

While I appreciate the ideas that Kydland and Prescott raise - I don’t see this method working for an extended period of time.  Governments would not allow monetary policy to be deemed completely ineffective or allow for set monetary rules because it takes away one facet of control.  I do agree with them that inflation targeting is not particularly effective either - as Friedman said monetary policy takes time to cause fluctuations and all too often over corrections are made in order to spur economic prosperity.  There is no efficient policy in todays mindset where there is such a focus on we have to be prosperous and there is no allowance for economic slow down.  I don’t think consumers realize - no matter how rational they are - that these slowdowns are natural parts of the economy and will eventually go away - this jumping to conclusions tends to just make things worse and media involvement can cause catastrophe.

Bruce Greenwald and Joseph Stiglitz, “New and Old Keynesians,” Journal of Economic Perspectives, Winter 1993, Vol. 7, pp 23-44. In the READER.

Greenwald and Stiglitz do a good job of touching on the similarities and differences between not only Keynesianism and New Keynesianism but also how these theories differ from RBC.  The authors state that the ingredients necessary for an acceptable model are risk averse firms, a credit allocation mechanism (credit rationing from risk averse banks), and new labor market theories (including efficiency wages and insider-outsider models).  New Keynesians argue that these models can not be established as such that they always clear and note that the imperfections in the economy arise from price rigidities.  They also note however that flexible prices might only exacerbate fluctuations away from equilibrium.  These observations move away from the traditional argument that everything must balance and that a constant equilibrium is necessary to function efficiently.  This is an interesting notion as non-equilibrium situations are much more often observed than actual periods of equilibrium (I would argue that there has never been pure equilibrium) so this theory is a movement in the right direction.

Having read Some skeptical observations on real business cycle theory by Lawerence Summers has only added to my curiosity about adding money to the model. I think that taking all of these theories that we have studied to analyze current situations could prove to be quite interesting. In regards to Summers’ piece the problems that he addresses out of the model were nothing new as we have been discussing them in class but he takes these issues and proves that they are valid through the use of real world examples which helped to make the models more “real” for me. One thing that Summers addresses that I don’t think we have in class is exchange failures. While this may be linked to the exclusion of money from the model Summers raises an extremely valid point. Until you can incorporate these monetary adjustments the business cycle models lose their validity and are just another simulation…

Edward C. Prescott, “Theory Ahead of Business Cycle Measurement” Federal Reserve Bank of Minneapolis Quarterly Review, 1986 Fall. In the READER.

I have to admit the first time I read through this article the concepts that I did grasp were few and far between. There is a focus on the development of the business cycle models throughout the center of the article. The beginning and end of the article however were especially helpful. Prescott highlights the necessity for the business cycle by saying that, “given peoples ability and willingness to intertemporally and intratemporally substitute consumption and leisure and given the nature of the changing production possibility set, it would be puzzling if the economy did not display these large fluctuations in output and employment with little associated fluctuations in the marginal product of labor”. Furthermore, rather than describing business cycles, Prescott focuses on the business cycle phenomena because he believes that the expression business cycle is misleading. He claims that the use of the term cycle leads people to think in terms of a time series rather than a growth component - this I have to agree with. The business cycle fluctuations, while seemingly occurring withing a specific time period can not be predicted by the use of time alone. Prescott argues that the business cycle phenomena is a certain set of statistical properties that occurs within a time series which makes sense.

Later Prescott acknowledges that the beauty of the business cycle model is that micro or macro observations can be used and it is easily adapted as such. This allows business cycles to be analyzed throughout the economy as a whole as well as individual sectors and even firms - a major strength. Prescott concludes that “costly efforts at stabilization are likely to be counterproductive. Economic fluctuations are optimal responses to uncertainty in the rate of technological change. However, this does not imply that the amount of technological change is optimal or invariant to policy.” I feel like the conclusions that these economists seem to be reaching these last few subject areas all say the same thing - monetary and fiscal policy is bad - so why do we continue to do it? Would expectations change if we adopted a monetary role or is half the fun in the fact that expectations vary so widely because of unexpected monetary and fiscal policy shocks? Does the average consumer even understand these policy implications or do they hear the rates/taxes are cut and think that automatically signals good…might be something worth investigating.

Robert Lucas and Thomas Sargent, “After Keynesian Macroeconomics,” After the Phillips Curve: Persistence of High Inflation and High Unemployment, 1978. In the READER.

Lucas and Sargent argue a variety of things in “After Keynesian Macroeconomics”, most notably that Keynesian macroeconometricmodels can’t be used to formulate monetary or fiscal policy.  They claim that these models have no solid basis on economic principles and work randomly at best.  Second Lucas and Sargent argue that there is no hope that these models can be revised to be more reliable.  They believe that the equilibrium models proposed by the classicals can be revised and will be much more effective in identifying structural econometric models.  They cite the rationality associated with these models for these conclusions.  They also claim that expectations must be included in such models in order for them to be reliable.  The inclusion of the business cycle in equilibrium models that are criticized are “simply misunderstandings” according to Lucas and Sargeant.  They argue that the inclusion of the business cycle in the neoclassical models will help to determine which economic policy will be most effective at what time.

The ideas proposed by Lucas and Sargeant seem rather extreme - it makes me wonder if theres some king of “happy medium” for all this or if we’re studying all of these contradictory theories just to study them.  I understand that everyone has their own opinion and will enforce policy changes from a seat of power based on these opinions but none of them seems completely right.  I think Lucas and Sargeant are quick to criticize without proposing an actual fix for the models and the inclusion of the business cycle may be a good recommendation but they do not present any way to feasibly do this.  Its as if they’re saying, “hey heres this good idea, you go do the work and we’ll take the credit”

“What Would Reagan Do?” The Heritage Foundation.

Throughout speeches given to members of the british parliament (1982). campaign addresses for Goldwater (1964), remarks to evangelicals (1983), and to the heritage foundation (1983) Reagan proposes some extreme economic beliefs. most notably that, “even in [times] of severe economic strain, free peoples can work together freely and voluntarily to address problems as serious as inflation, unemployment, trade, and economic development in a spirit of cooperation and solidarity.” Reagan is a strong supporter of a laissez-faire type economy with the exception of the military. He proposes that everything can be solved with tax incentives/rebates and that the deficit will work itself out if the government just stays out of businesses business. He claims that his ideas date back to the founding fathers who sought to “minimize centralized government” and touts the inefficiencies of governmental aid programs. While I agree that occasionally the government does become over involved, and I agree that once a government program exists it will hardly ever cease to exist I don’t know that I agree with the idea that people should be left completely to their own devices because they know whats best for themselves. These speeches do not go into specific economic policy during the Reagan administration (in fact some of these speeches weren’t even during his time in office), however they do offer insight into the ideas that were bouncing around in his head and where they came from.

The first two chapters of Sheffrin’s book explain the conceptual basis behind rational expectations as well as the relationship between inflation and unemployment. Sheffrin details what expectations are using a group of farmers as an example. He says that farmers’ planting decisions depend on the prices they EXPECT to receive when the crop is marketed. This makes the actual price for the crop change because farmers plant more when they expect prices to be high leading to over supply (this concept can be attributed to Nerlove - 1958). He also describes the Muth’s work in trying to incorporate expectations into economic models. Muth argued that “expecations, since they are informed predictions of future events, are essentially the same as predictions of relevant economic theory” These rational expectations that Muth references are the centerpiece of Sheffrin’s work.

In the second chapter Sheffrin actually treis to describe the impact of expectations on the Phillip’s curve. He cites Cagan 1956 when he says “If inflationary expectations only gradually adjust to actual experience as would be the case with the adaptive expectations concept, policymakers could weigh the temporary employment gain against the losses from permanently higher inflation rates”. After discussing this trade off without the implications of expectations last week I find this statement particularly interesting because while in the short run it may be true we discussed the possibility of sacrificing a great deal of employment to decrease inflation. Sheffrin seems to be rejecting this idea entirely.

Another interesting point that Sheffrin references comes from Lucas - he says that the tradeoff between leisure time and work is not an accurate measure of employees desire because theoretically this leisure time or vacation would be taken when it is of least cost to the employee, however, it is very easy for employers to manipulate this vacation time which means that it is typically taken when it is of least cost to the employer as opposed to the employee. While this is beneficial it does not tend to indicate that employees are not working because leisure time is of greater reward to them than being employed, but rather that it is of little consequence when that leisure time occurs as long as it happens at some point.

I felt like Sheffrin does an excellent job of presenting different theories in this book, but doesn’t come up with many theories of his own (at least in the first two chapters…that could come later). He cites studies and produces formulas but none of them are his unique thinking. It provides a broad understanding of the concepts associated with rational expectations and is a good read (thus far) for understanding the theories, however sometimes the reader gets lost in the details and loses the “big picture” (at least this was my experience)

Friedman, “The Role of Monetary Policy,” American Economic Review, 1968

RESPONSE:

Friedman does an excellent job of describing his perceptions of monetary policy in this speech.  It is however obviously biased - he includes his predictions for the future of the economy (many of which seem to be coming true) as well as seemingly contradicting himself.  I especially noticed this in the section on how monetary policy should be conducted - he indicates that the best way to conduct monetary policy was to use it to control exchange rates, price level and quantity of total currency and then goes on to say that using exchange rates or the price level would cause an implosion of the policy itself.  He also indicates that much of what he discusses is immeasurable and therefore monetary policy is still quite a guessing game.  I did find it interesting that he referenced the lag time between policy changes and their effects however and that helped to explain why the fed seems to over correct (by doing things like cutting interest rates 1.25% within a week).

NOTES:

• Major goals of economic policy – high employment, stable prices, rapid growth
• Keynes offered explanation for inability of monetary policy to stem depression
  • Liquidity preference is absolute (or nearly so) interest rates cannot be controlled by monetary measures – investment and consumption are little affected by interest rates
  • Fiscal policy offered alternative solution to great depression
    • Government spending makes up for insufficient private investment and tax reductions undermine stubborn thriftiness
  • Only role of monetary policy at time was believed to be keeping interest rates low in order to hold down interest payments in government budget and stimulate investment and maintain high AD
  • Produced a shock when these beliefs crumbled after the war – inflation was stimulated by fiscal policy
    • Changes in wealth affect aggregate demand even if they don’t alter interest rates
    • Undermined Keynes’ theory that in world of flexible prices equilibrium at full employment may not exist – unemployment had to be explained by rigidities or imperfections not as natural outcome
• Idea that great depression occurred despite aggressive expansionary policies is untrue
  • Monetary authorities followed highly deflationary policies and quantity of money in US fell by 1/3 in course of depression – not because there were no willing borrowers but because there were no lenders
    • Federal reserve failed to provide liquidity to banking system
• In 1920’s chief role of monetary policy was to promote price stability and preserve gold standard – evaluated  by state of money market, extent of speculation and movement of gold
• Today monetary policy promotes full employment while preventing inflation
• What can’t monetary policy do?
  • Peg interest rates for more than short period of time\
    • If fed tries to keep interest rates low it buys securities – raises their prices – and lowers their yields
    • Increases quantity of reserves to banks and ultimately total quantity of money
      • This is only initial impact – increasing the quantity of money only makes interest rates lower for a time tan they otherwise would have been
      • More rapid rate of monetary policy stimulates spending and thereby increase relative price of higher cash balances than desired
        • One mans spending is another mans income – increasing income will raise liquidity preference and demand for loans – reverses the downward pressure on interest rates
    • Cyclical adjustment process
  • Peg rate of unemployment for more than limited periods
    • Monetary authority can’t adopt target for unemployment because of the “natural” rate of unemployment and the “market” rate of unemployment
      • At any given time there is some level of unemployment which is consistent with equilibrium and real wage rates
      • Natural rage of unemployment is level that would be ground out by general equilibrium equations provided they take into account actual structure of labor and commodity markets including market imperfections, stochastic variability in supply and demand, cost of gathering info about job vacancies and job availabilities, cost of mobility etc.
      • Problem with the Phillips curve is its failure to distinguish between real and nominal wages
• What monetary policy CAN do
  • Prevent money from being major source of economic disturbance
  • Provide stable background for economy
    • Economic system works best when producers and consumers, employers and employees, know that average price level will behave in known way in future – preferably that it will be highly stable
  • Contribute to offsetting major disturbances to economic system
    • Monetary policy can hold inflationary dangers in check temporarily and can ease transitions through changes in rate of monetary growth
    • Should only be used when present “clear and present danger”
• How monetary policy should be conducted
  • Monetary authority should guide itself by things it can control rather than things it cannot
    • Interest rates and current unemployment percentage poor policy criterion
    • Most appealing policy guides exchange rates, price level and quantity of total currency
      • Price level most important
        • Monetary action takes longer time to affect price level than monetary totals and therefore effect of price level hard to predict
      • Monetary total best currently available guide
  • Avoid sharp swings in policy
    • Tendency to wait too long and then over correct is source of economic disturbance itself
      • Failure to account for delay between action and effect