Archive for March, 2008

A Response to Mankiw’s “Symposium on Keynesian Economics Today”

Sunday, March 30th, 2008

Keynesian economics assumed that all micreconomic data/markets could be aggregated to come up with a macro-level picture of the economy.  However, the Keynesians were criticized for this very notion, that is, these economists were criticized for not building their theory of aggregate demand off of microfoundations.  As Mankiw stated in the “Symposium,” the Phillips curve phenomenon seemed to disappear with the evidence of stagflation in the 1970s.  As we learned in class early on, Keynesian theory focused on shifts in aggregate demand–either during a recession or a growth period, but never both parts of the business cycle.  That is where the RBC models were able to better explain the paths of the economy.  Though unable to best predict the path, through parameterization, RBC economists were able to constantly tweak the model to come up with the path of the economy where it’s achieving its optimal point.

Nevertheless, the 1970s and early 1980s is when supply-side economics became big with President Reagan behind it.  As we learned in class, the only reason why Reagonomics became prevalent and in the forefront was because it offered something different.  Though Reaganomics and RBC models were at the forefront, few people who became New Keynesians were able to accept the new classical assumptions that firms operate in a perfectly competitive market and all markets clear in time period t.  Rather, firms aren’t assumed to be perfectly competitive and not all markets will clear in one time period.  James Tobin, who argued against markets clearing in one time period, said the reason was because of macro market failures.  This is furthered by the example that the goods market may be in equilibrium, but not the labor market.  Therefore, New Keynesians couldn’t build off the assumptions of Keynesians–that macro is simply aggregated micro–because you really can’t aggregate microeconomic markets since not all markets are clearing in one time period as assumed by the new classicals.  This suggests that there are unforeseen market forces (i.e. externalities) that are multiplied, rather than simply arithmetically added through industries, which is why micro cannot be simply added up.  Mankiw points out that these market failures are felt to the extreme when the economy is going through recessions and depressions.  The 1970s, as mentioned earlier, brought about high levels of unemployment.  The new classicals viewed this unemployment as voluntary whereas the New Keynesians did not.

Bringing this blog back to the beginning statements, New Keynesians had to build a model that was developed from microfoundations–that is, the goods market, labor market, and capital market.  The whole point of a firm is to maximize profit and utility.  From this, they were able to make claims as to why markets didn’t clear in one time period.  Disequilbrium occurs because of sticky prices and wages.  David Romer discusses this price rigidity in which he says that because firms are “imperfectly competitive” they face small barriers that have large macroeconomic effects (once again, this is referring to the unforseen externalities and the spillover effect from one industry into another industry).  James Tobin, however, feels that the New Keynesians aren’t “asking the right questions” and feels that the role of price rigidities have been exaggerated.  As learned in class, though, the business cycle is the reason why we experience sticky prices, all of which come from micreconomic elements.

Mankiw’s “Symposium” ends with some rhetorical questions as to what the New Keynesian line of thinking will do for the field of macroeconomic theory.  Will it be long and arduous or will it be the theory from which other models will build?  Obviously, Mankiw didn’t have the answers, but I still am unclear as to what the differences are between nominal and real rigidity.  It was discussed in the “Symposium” and I was looking through my notes.  I have that nominal rigidity means that nominal prices are sticky (i.e. labor contracts).  Thus, even if we go into a recession and the prices change, the labor contract holds true.  Therefore, the nominal price (i.e. what is spelled out on the contract) will remain unchanged.  However, then my notes discuss real rigidity, which is looking at the rigidity of relative prices.  How does the example of a monopsony condition with one employer fit with relative rigidity?  I understand that nominal prices are increasing at the same rate as the price level, but how does that fit with the issue of rigidity?

Source: Mankiw, N. Gregory.  1993.  Symposium on Keynesian economics today.  The Journal of Economic Perspectives 7, no. 1 (Winter): 3-4.

A Response to Hoover’s “The New Classical Macroeconomics”

Thursday, March 20th, 2008

Chapter 5: The New Monetary Economics

New classicals have brought about criticisms to monetarism, Keynesian monetary theory, and earlier new classical work for not starting with microfoundations.  Prior to Keynes’ General Theory was written in 1936, the distinction between microeconomics and macroeconomics was unknown.  Rather, there was two economic theories that were prevalent during that time–monetary theory (general price levels) and value theory (relative price levels).  A year earlier than the General Theory, John Hicks discussed monetary theory, which he claimed had its roots in value theory.  The difficult discussion dealt with explaining why people held non-interest bearing money when interest-bearing money opportunities were available.  He concluded that these forms (i.e. non-interest) were held to overcome what he termed as “frictions,” or transaction costs and risk.  The early stages of the quantity theory of money is derived from the Walrasian system where all markets clear because price levels adjust to put supply and demand into equilibrium.  It was eventually discovered that price levels (absolute or general) were ultimately determined by the quantity of money in circulation so as long as the velocity of money in circulation was corrected.  From this stemmed discussions of inflation.  Monetarists, such as Milton Friedman, suggested that in the long run, the growth rate of the money supply only affects the general price level instead of the real output of the economy.  Nevertheless, the inflation phenomenon is one in which there is more money supplied than there is money demanded.

Patinkin took the quantity theory of money a step further by starting to explore real price levels. He noticed that economic activity could be carried on at any absolute price level, but money has a value.  Therefore, its value depends on the aggregate price level, and as a result, Patinkin divides through by the price level to discover the real purchasing power of money and incorporates that data into utility functions.  This allows for the fusion of monetary and value theory because the demand for money is defined to be the same as the demand for any other good because it holds a certain utility value.  In addition, the level of absolute prices is determined in conjunction with all relative prices so as long as there is an “anchor” or standard to set those prices (i.e. gold).  However, the principal criticism for Patinkin’s theory is the absence of a distribution effect.  A distribution effect assumes that if an economic agent had an increase in cash balance then he would increase his supply and demand proportionately and the relative proportions remain unchanged.  This also assumes that every economic agent is alike, which means that it wouldn’t matter who received the increased cash balance.

Gurley and Shaw (1960) look at the finance process.  They define money with two out of the three characteristics as did Patinkin–that is, money is the medium of transactions and its demand is assumed to “arise from uncertainty about the timing of receipts and payments.”  The new definition associated with money under the Gurley-Shaw theory is that money can be termed debt.  Therefore, one person’s assets exactly equals another’s debt.  The two would then cancel out.  Looking at money as a means of exchange, it is useful in transactions given the uncertainty.  This uncertainty is what causes the differences in rates of return of portfolios.  Fama’s paper is important because he claims money exists only because of “government-imposed legal restrictions on other financial assets.”  However, I don’t understand his argument with regard to being able to get rid of fiat money if the government introduces it into the economy and the story regarding ingots and government taxation on spaceships (pages 95-97).

Chapter 5 ends with a discussion of banking and finance and how it relates to the Modigliani-Miller theorem.  According to Hoover, the theorem says that “how a firm finances its real activities has no decisions of other economic agents.”  Fama assumes a few things.  One, there are perfect capital markets (i.e. “no taxes, transactions costs, or danger of bankruptcy).  There is also assumed to be rational expectations.  Third, economic agents are concerned with risk-return ratios as they pertain to changes in wealth.  Fourth, firms ‘investment decisions are made independently of the how the investment is financed.  Lastly, economic agents have the same access to capital markets–that is, if a firm can issue a liability, so, too, can an individual agent.  Debt-equity ratios can be altered by a firm, for example, which will change the real opportunities of return by economic agents.  However, to return the economy to the previous state prior to changes in a firm’s finances, economic agents will have to modify their portfolio composition.  Fama concludes his argument by stating that relative prices are independent of any financial portfolios–that is, relative prices are derived from fiat money or commodities and absolute prices (with inflation built in) are independent of financial assets.  The conflicting idea that I don’t comprehend is that a sophisticated and more developed financial system relies on the presence of money because a financial asset is essentially a claim on something else and the conversion of one asset into another form is done through the transaction of money.  The liquidity of money is of utmost importance because of the “lack of necessary connections between the amount of outstanding claims to goods of conversion.”  That is, money tends to become the good in which “accounts are settled and into which financial assets are ultimately convertible.”  Not following the conclusion, Hoover asserts that, in fact, relative prices are not independent of finance.

Source: Hoover, Kevin D.  1988.  The new classical macroeconomics.  Cambridge, Massachusetts: Basil Blackwell.

A Response to Summers’ “Some skeptical observations on real business cycle theory”

Thursday, March 13th, 2008

Lawrence Summers starts out by comparing the foundations of Keynesian macroeconomic theory to that of astrological science.  That is, both are “premised on the relevance of variables that are in fact irrelevant.”  According to real business cycle economists, Keynesian economics didn’t explain the macro economy because it wasn’t based on microfoundations.  As we have learned in class, RBC models are based off of utility maximization and profit maximization principles, which evolve at the microeconomic level.  Summers brings Prescott’s “Theory Ahead of Business Cycle Measurement” into his critique of RBC models.  Prescott’s article is essentially asserting the claim that the theory cannot be currently tested because there does not yet exist measurement tools capable of testing the theory.  Nevertheless, Summers critiques Prescott’s article on four levels–the parameter estimation, the shocks present in the model, price levels, and exchange failures.  Summers goes on to say that throughout history theories have been developed that seemed plausible (or at least a good starting point) because they “mimic” or approximate reality well enough for that period in time.  However, as measurement tools improve and people are made more aware of their surroundings, theories will change (i.e. the Earth was at one point considered the center).  This is what this critique attempts to accomplish–that is, to determine whether or not Prescott’s theory mimics the economy in its current state coincidentally or if it captures the observed business cycle trends.

With respect to the parameter estimates, Summer can find no evidence to support Prescott’s claim that the one-third of all household time is devoted to market activities.  Most other studies, such as Martin Eichenbaum, Lars Hansen, and Kenneth Singleton (1986) have estimated that to be only one-sixth since 1956.  In addition, Prescott’s model assumes the average real interest rate to be four percent.  Over his thirty year study, however, the real interest rate only averaged out to one percent.  Summers’ last critique with regards to parameter estimates is Prescott’s inability to display evidence that supports his claim on the elasticity measurements of labor supply.  According to Summers’ reading of many studies, labor supply is only minimally effected by changes to the real wage.

Like many RBC models, the observed cyclical behavior is caused by external/exogenous shocks, known as technological shocks.  However, the critique makes the claim that he doesn’t have nay evidence to support the business cycle movements.  Even the oil shocks of the early 1970s haven’t contributed to “large movements in measured total factor productivity.”  In small sectors of the economy, however, such as in the mining and construction sectors, negative productivity growth has been observed.  In addition, technology shocks may not be as large as originally thought.  Studies have shown, especially in Jon Fay and James Medoff (1985) that the reason for cyclical behavior is due to firms holding more labor than necessary during troughs.  Known as “labor hoarding,” firms may hold labor in excess of regular production requirements during recessions because it is deemed more costly than the wage rate to hire or fire employees.  Therefore, when the economy is experiencing a peak, the labor force is being fully utilized and shown as productive.  However, when a recession occurs, those excess laborers are kept on rather than fired, which makes it appear as each labor unit is now less productive and factor productivity will decrease.  While Summers doesn’t think of “labor hoarding” as a technological shock, many RBC economists do think of any deviation from the long-run potential output as a technological shock.

The third argument that Summers makes is the absence of price data in his model.  I don’t understand this paragraph because I do not comprehend what Summers means when he argues that Prescott’s model was tested without price data.  To me, it is unfathomable as to how any economics can be empirically tested without paying attention to price.  I will have to do some exploration as to what a “price-free economic analysis” means in the eyes of Summers.  The last objection to the Prescott model is the inattention to exchange breakdowns.  From the critique, it is mentioned that studies that analyzed the Great Depression made it clear that firms had output to sell and workers wanted to exhange their labor for those products, but there was a breakdown in the exchange mechanism of labor for products and the exchange never transpired.  This “breakdown” caused U.S. GNP to decline fifty percent over the years 1929 to 1933.  The best explanation for these exchange mechanism failures is due to the credit market breakdown during the same time period.

Summers sums up the critique to say that economists will continue to be better at explaining behaviors of individual economic agents than explaining the equilibrium in markets when many economic agents interact.  With that being said, Summers stresses that the importance of being able to explain why exchange markets breakdown, and if that can be accomplished, then these macroeconomic models will be able to help forecast economic fluctuations.  What I was hoping for the critique to address was the parameterization issue that was discussed in class on 3/12.  If models are constantly changing to fit the data, how can we be sure that it’s the best model out there and not one that simply “mimics” the available data–which is something that Summers starts out discussing?

Source: Summers, Lawrence H.  1986.  Some skeptical observations on real business cycle theory.  Federal Reserve Bank of Minneapolis Quarterly Review (Fall): 23-27.  (This can be found in the Reader.)