Archive for the ‘e488-newkeynesian’ Category

A Response to Greenwald and Stiglitz’s “New and old Keynesians”

Tuesday, April 1st, 2008

 Greenwald and Stiglitz start off by making three claims upon which old and new Keynesians would agree–there will be an excess supply of labor for a given market wage, the aggregate level of output will fluctuate at a greater magnitude than what can be accounted for by short-run changes in technology, and money matters but monetary policy can and has been proven ineffective during certain periods of time (i.e. Great Depression).  Nevertheless, what is different from new classicals is the notion that government intervention via policy decisions can be effective some of the times.  From the start, the two authors make the comparison to new classical and RBC model theorists.  Those schools of thought conclude that all markets clear in one time period; there isn’t the presence of sticky prices or wages; unemployment is voluntary, which is shown by changes of supply and demand shifts in the labor market; and that there aren’t macro market failures, which allows for the efficient responses to changes in externalities (i.e. shocks).  As noted by Greenwald and Stiglitz, the only difference between new classicals and RBC theorists is the shocks that affect the aggregate output of the economy.  For the new classicals, it is shocks to the money supply whereas the RBC focus on technology shocks.  Nevertheless, the two schools of thought, though basing their macroeconomic models on microeconomic foundations or “microfoundations,” assume that firms interact in a perfectly competitive market, there is perfect information, there are no transaction costs, and there is no risk assumed by economic agents since all individuals are homogeneous.  Greenwald and Stiglitz end their introduction with a few questions that look at the “validity” of these earlier macro models.  Some things that cannot be answered by new classicals or RBCs are why there are variations in the number of work hours, why do some industries see higher rates of layoffs, and why are investment and inventories in certain industries so volatile.

The article’s jumping off point is dealing with price rigidities–both nominal and real.  The background behind these observed rigidities in the market is due to the fact that it has been observed that markets don’t clear in one time period.  If they did, this would imply that prices and wages were flexible and resulting from this would be the notion that whenever the market encountered a shock it would adjust instantaneously and maintain full employment and output at its potential.  However, this isn’t the case, which is why there is the discussion regarding these inflexibilities.  According to the authors, the markets benefit from having rigid prices and wages because it lessens the volatility and magnitude of the fluctuations in the economy.  To explain the rigidities of these prices and wages observed in the market, Greenwald and Stiglitz introduce three basic ingredients that are all found in markets that have imperfect information.  These three ingredients are as follows: risk averse firms, a credit allocation mechanism in which risk-averse banks play a central role, and new labor market theories that include “efficiency wages and insider-outsider models.”

Risk averse firms have two options: either issue equity or debt instruments.  There is much less risk with issuing equity because these firms share the risk with those who provide the finance.  Issuing debt, on the other hand, means that the firm issuing this has an obligation to repay and thus can face the risk of going bankrupt.  So it seems obvious that firms would issue equity, but there is a negative side, as pointed out by the authors.  They view the issuance of equity as negative because the market perceives it this way.  The market’s opinion is that the “worst firms” will be the ones most likely to issue equity because those firms may be overvalued and are trying to sell additional shares.  Why are firms risk averse?  The answer is that managers control firms in that manner.  This is because those individuals are more aware of the status quo and less able to predict what will happen if the firms changes its action (which is termed “instrument uncertainty”).  Just as described with modern portfolio theory, firms assess various portfolios to assume the least amount of risk for a given return, or vice verse.  If prices change, so, too, will the actions of the firms and their resultant portfolios–either by changing the price it charges or the quantity it produces to keep customers content.  The example given as to why firms are risk averse deals with a recession.  In a recession, a firm has less cash to operate with and less profits, which reduces both the real worth of the firm and its liquidity.  Therefore, to assume less risk, a firm will decrease output.  Conversely, if firms want to remain at the original output level before recession, firms will be forced to borrow because of their decreased net worth.  This means that with less cash on hand, they will be forced to borrow; in other words, firms will assume more debt.  This all translates into a higher probability that this won’t be paid back and the firm will go into bankruptcy.  Therefore, during recessions, supply curves are shifted to the left and output is reduced to compensate for lower real net worth and less liquidity so that a firm doesn’t take on more risk.  The two authors also mentioned that investments will be volatile in the construction market.  This is because that particular market is made up of numerous small firms, many of whom don’t have easy access to the equity market, and therefore, rely heavily on financing their endeavors through debt instruments.  The two authors also point to one more example in which a decrease in net exports decrease that exporter’s net worth.  This will lead to a decrease in demand of inputs, which will drive down the prices of those inputs in other markets.  A “spillover” effect will be recognized from firm to firm and from market to market.  It’s a result of this “spillover” phenomenon that micro-level industries cannot be aggregated to come up with the macro picture.  Rather, these spillovers, as seen from this simple example, compounds and amplifies as it moves from one firm to another and from one market to another.

The second basic ingredient mentioned for price rigidities is credit markets and risk averse banks.  Unlike the goods market, which operates in an auction market where the good is sold to the highest bidder, the credit market doesn’t function in this manner.  Due to risk averse credit institutions who are worried about loans not being repaid, they will not sell to the highest bidder.  Rather, they will use a technique called credit rationing in which “interest rates are chosen to maximize the expected utility of the lender.”  The absence of an auction is observed because of risk averse banks.  Like firms, banks, too, are risk averse and need to be even more so in today’s age with the subprime mortgage meltdown.  Instead of screening customers to see whether they had a high probability of repaying the loan, they seemed to violate the Greenwald-Stiglitz argument by entering into an auction and selling loans to whomever wanted one.  As with firms’ behaviors, banks will respond in similar fashion with a recession.  As the economy worsens, banks perceptions of the relative riskiness of loans will increase.  Since bad economic times equals a higher rate of defaulted loans, banks will experience a decrease in their net worth as debt instruments are being “sold,” but not repaid.  Resulting from these hardships, banks will also engage in portfolio management by shifting their composition to less risky assets (i.e. Treasury bills).  According to Greenwald and Stiglitz, therefore, equilibrium can only be reached at a higher interest rate, which would discourage investment.  However, this isn’t the observed behavior because new Keynesians feel that price rigidities are in place to reduce the magnitude of fluctuations in the market as well as to make customers content.  Therefore, banks will not raise interest rates, which will not discourage investment.  All of this aggregated will lead to the banks assuming greater risks.  Resulting from all of this, the Federal Reserve can be effective in a few ways–changing the reserve requirements and the discount window–rather than the accustomed lowering of the federal funds rate.  (Lowering of the federal funds rate may not decrease the supply of loans enough to make the banks more “sound.”  Using the other two monetary tools will make the bank’s net worth increase because it can borrow from the Fed at a cheaper rate.)

The third ingredient is the labor market.  Old Keynesian economics referred to the unemployment phenomenon, but didn’t discuss the role of the labor market.  New Keynesians suggest an alternative to new classical economists by claiming that even though the employee will work for the going market wage rate, he can’t find work, and as a result, there is the phenomenon known as involuntary unemployment.  This can be caused by efficiency wages, insider-outsider theory, imperfect competition, and implicit contracts.  The efficiency wage says that higher real wages will lead to higher productivity because of the attraction of higher quality labor.  The insider-outsider theory claims that “outside” workers won’t be hired for cheaper wages because the “insiders” are the ones responsible for training them.  Since labor is heterogeneous, the insiders and outsiders are of different quality because the insiders have been trained and the outsiders have not been trained.  Thus, there isn’t a perfect substitute.  As a result, insiders will not want to be replaced by cheaper, outside workers, and since the insiders control the training process, they will refuse to train outside workers for a lower real wage.  The third reason as to why there is a sticky wage has to do with imperfect competition.  The nature of imperfect competition means that each firm sets wages, prices, and employment levels.  As mentioned earlier, firms are risk averse and consequently, don’t know the outcomes on their activities and production with a lower real wage, which is why it won’t be decreased.  Lastly, implicit contracts has been echoed throughout the article.  In a nutshell, firms want to make their employees happy and content and in order to do so, they must provide an incentive for their employees to stay with the firms during “boom periods” when they could easily look for a better job elsewhere.

As learned in class, nominal price rigidities also exist due to the costs of “menu costs.”  That is, the costs may outweigh the benefits from changing prices (i.e. disseminating that information to consumers, physical costs of changing prices, etc.).  In many instances, rather, a firm will exhibit a flat-top profit maximizing curve in which several combinations of output with the constant price will produce very similar profits.  If this is the case, it won’t pay for a firm to change its prices at the risk of losing profits and because these firms have been proven to be risk averse and don’t want to disrupt the status quo of the economy.  Game theory also plays a part in rigidity of prices and wages under the new Keynesian model.  Since the money supply is not perfectly observed by all agents, not all agents will change their prices proportionally.  Because of this uncertainty as to how other economic agents will react to changes in the money supply, it would be sub-optimal to increase your own prices by the same increase in the money supply.  Therefore, it is observed that no agent will increase prices, at least not as much as the increase in the money supply.

 Greenwald and Stiglitz end their discussion by looking at the RBCs and the new classicals.  The two noted that the RBCs focused on economic volatility and said that it resulted from external and unforeseen technology shocks.  According to a new Keynesian, however, how would you explain a recession?  Was there a negative technology shock?  New classicals feel that imperfect information is the reason why there are deviations around potential output and full employment.  While imperfect information and subsequent changes in the demand and supply curves matter (i.e. resulting from a shock), it isn’t the principal reason.  What confused me when looking at the critique of the new classical model was the fact that it didn’t explain in lament terms what was lacking and what was “improved upon” with new Keynesian economics.  I think what Greenwald and Stiglitz hope to have the reader to come away with is that imperfections exist in the macroeconomy and that these imperfections can amplify at the macro-level, which will lead to deviations from potential output and abnormally higher levels of unemployment.

Source: Greenwald, Bruce, and Joseph Stiglitz.  1993.  New and old Keynesians.  Journal of Economic Perspectives 7 no. 1 (Winter): 23-44.  (This can be found in the class Reader.)

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.