Archive for the ‘e488-newkeynesianevidence’ Category

A Response to Hoover’s “Is Macroeconomics for Real?”

Tuesday, April 8th, 2008

Kevin Hoover’s basis for writing this piece “Is Macroeconomics for Real” comes from comments that have been written anonymously on his class evaluations.  Many of the students side with the commonplace among economists that macroeconomics isn’t “real” because it cannot stand alone.  Rather, it is based off of microfoundations, something that has been seen time and time again through many readings.  Oftentimes, older macro theories are revoked because they don’t incorporate microfoundations, such as utility maximization functions and other maximizing behaviors.  Hoover, however, argues that macroeconomics is a “stand alone” discipline that cannot be reduced to a microeconomics form.  Hoover starts with basic definitions for macroeconomics and microeconomics, defining micro to be the “economics of individual economic actions” and macro to be “the economics of broad aggregates.”  Hoover continues, though, by saying that Keynes didn’t define these two terms as was just mentioned above.  Though he didn’t use the terms macro and micro when making the distinction, to him [Keynes], microeconomics was the “theory of the individual industry or firm” and macroeconomics was the “theory of output and employment as a whole.”  Macroeconomics has expanded beyond Keynes’ definition, but the aggregates that he referenced still refer to GDP, unemployment, interest rates, the flow of financial resources, etc.

I will attempt to answer Hoover’s question by summing up his claims, even with his philosophical undertones.  He references Uskali Maki (1994) to define and answer the “real” in the title of his article.  Maki looks at ontological and semantic realism and says the difference lies with the fact that ontological realism is “what there is” and semantic realism looks at the connection between “language and what there is.”  Remember, Hoover’s claim is to see if macroeconomics can remain independent from microfoundations.  Through his investigation and questioning, he determines that macroenomic aggregates “exist externally”–that is, they don’t rely on microfoundations, which is a huge shakeup from mainstream economic thinking since the 1940s.  Lionel Robbins (1935) makes a blanket statement that “economics is the science which studies human behaviour as a relationship between ends and scarce means which have alternative uses.”  From this statement alone, economics is about the individual, a microeconomic slant.  Keynes, however, developed the modern theory of macroeconomics with three main equations: the consumption function, which looked at aggregate consumption patterns in relationship to national income; investment on the basis of interest rates; and the liquidity preference.  Thus, going solely off of Robbins’ definition, Keynes’ contributions would be invalid because it doesn’t base its models off of the behaviors of the individual.

Hoover continues by looking at Mark Blaug’s (1992) individualism, which makes the claim that explanations of “social, political, or economic phenomena” cannot be explained without the understanding of the decisions of the individual.  Even Augustine Cournot of the 19th century says that “there are too many individuals and too many goods to be handled by direct modeling.”  Blaug, nevertheless, goes on to observe that “few explanations of macroeconomic phenomena have been successfully reduced to their microfoundations.”  Robert Lucas (1987) is a strong supporter of the individualism principle and the idea of microfoundations.  His colleagues and he have worked extensively on new classical economics that assumes that representative economic agents (the individual) make decisions to reach their optimal choices.  Essentially, macro theory must use these fundamental microeconomic elements (i.e. utility maximization, consumption maximization, etc.) in order to have any validity.  A. P. Kirman (1992) criticizes the idea of a “representative agent” because it fails to represent actual individuals.  Individuals inherently seek to maximize their utility and consumption, but without rationally modelling and plotting out their optimal points along a budget constraint.  David Levy (1985) has the same logic because information isn’t perfect.  As previous blogs have alluded to and directly mentioned, assumptions for some of these macro theories, though built upon microfoundations, doesn’t hold water because their assumptions are too “naive” and simplistic.  Though it helps with the model, what good is a model that doesn’t accurately capture actual observed behavior?

Hoover’s next set of arguments is based around the “validity” of the macroeconomic aggregates.  Nobody doubts that GDP, unemployment, and interest rates are interconnected.  People do disagree, however, that these aggregates are the “fundamental units” that constructs this economic reality.  Hayek (1979) says it best that these entitites are secondary because these entities cannot be explained and fully understood without having an understanding of the individual components.  This statement reverberates through all the macro theory that presented criticisms towards other theories for failing to be based upon microfoundations.  Nevertheless, even Hayek doesn’t believe in the pure definition of individualism, citing the Cournot problem.  (CAN SOMEBODY PLEASE TELL ME WHAT IS THE COURNOT PROBLEM?  I think it has to do with being unable to model an entire economy because it’s too complex, but I’m not sure.)

Referring back to the aggregates that consumes macroeconomics, Hoover states that there are two aggregates: natural and synthetic.  Natural aggregates are those that are simple sums or averages, such as total employment or an average interest rate on commercial paper/Treasury security for a certain period of time.  Hoover says that he terms them natural because they are calculated in the same units in which the individual units are also calculated.  The other aggregate is synthetic.  Synthetic aggregates are those that are “fabricated out of components” and therefore have a different structure.  The main example here is the aggregate/general price level.  An average of all prices will not work because apples and oranges cannot be added together.  The ultimate goal is to find out the price of money to see what something is worth in real terms.  Again, this is difficult to accomplish because the overall economy is complex and there would have to be thousands of equations to capture all of the movements in the economy, which is next to impossible and very, very time consuming.  The story goes on to discuss the indexes that have to be constructed.  Indexes give insight into general price levels because once again, percent changes of certain goods and services will weigh more heavily on the overall economy and “price of money” than other goods and services.  For instance, Hoover says a change in the price of gasoline will have a larger impact than the change in the price of caviar.  Thus, indexes reflect weights that have to be applied to certain industries and sectors of the economy.  (As a side note, PPIs and CPIs are calculated with and without food and energy because these two areas of the economy are the most volatile and will have a large impact on what is the perceived rate of inflation.)  This same thought process holds true for the need to calculate real GDP.  Price changes are bound to occur.  Therefore, nominal GDP will always increase, even if quantity does not change.  Therefore, real GDP is needed to see whether prices changed and the level of output did not change, or whether the economy experienced an increase in output due to more efficient methods.  If the latter is true, then real GDP will go up.  If the former is true, then it can be expected that only nominal GDP will increase due to the rise in prices.

The following section discusses supervenience, which I don’t understand.  I will quote the passage, but cannot provide insight only because it does not make sense to me.  On page 12, Hoover says “Macroeconomic aggregates I believe supervene upon microeconomic reality.  What this means is that even though macroeconomics cannot be reduced to microeconomics, if two parallel worlds possessed exactly the same configuration of microeconomic or individual economic elements, they would also possess exactly the same configuration of macroeconomic elements.”  The reverse doesn’t necessarily hold true.  On a different note, Hoover discusses irreducible aggregates and their ability to be manipulated.  Some macroeconomic aggregates cannot only be controlled, but “can be used to manipulate other macroeconomic aggregates (i.e. real interest rates and price levels and their effect on yield curves).  He ends the paper by stating that this paper only attempted to show the current behavior and interplay between macroeconomics and microeconomics.  Hoover does go on to mention that there are macroeconomic aggregates that are irreducible, and consequently, cannot be built upon microfoundations.  Therefore, these entities are indeed “real.” 

Source: Hoover, Kevin D.  1999.  Is macroeconomics for real?  University of California-Davis (June): 1-22, (accessed April 8, 2008).

A Response to Wynne’s “Sticky Prices: What is the Evidence?”

Thursday, April 3rd, 2008

Mark Wynne attempts to look at the evidence behind changes of the stock of money and whether this has implications for the overall economy (i.e. employment, growth rates) in the short run.  This has obvious implications for effectiveness of monetary policy because through open market operations, the Federal Reserve controls the money supply.  For over two hundred years, this issue has been “debated” and the only conclusions that seem to be able to be drawn from this is that “prices are ‘sticky’ at nonmarket-clearing levels.”  This will directly effect the real factors of the economy.  Suppose that people were magically inundated with more money than they had before.  Also, suppose that this increase in the money supply was a one-time, unexpected policy.  Since it can be assumed that each person was holding the optimal amount of cash previous to the increase in the money supply, this excess cash would be spent on stuff.  However, if everybody spent their excess cash holdings to return to their optimal holding of cash (which existed before the increase in the money supply), nothing will motivate the producers to put out more output.  Thus, the long-run result would be an increase to the price level by the same proportion that the money supply was increased.  New Keynesians, however, are interested in the “transition stage” that occurs between the event that got the economy out of disequilibrium until the time that the economy has restored equilibrium.  This transition stage, according to Wynne, could see one of two scenarios–either an instantaneous increase in the price level, which would end the story, or a rigidity of prices.  The rigidity of prices is the more interesting situation.  If some producers are slow to raising their prices, due to the menu costs and other situations that were discussed in class (even though nominal demand has increased with this excess amount of money in the economy), then output in the short run may increase without an increase to prices.  This increased output would show up as a real increase in the short run until all firms had a chance to raise prices equal to the growth rate of the initial increase in the money supply.  Wynne mentions in the introduction that his article will focus on sticky prices rather than wages because many analysts view the failure of wages to adjust to changes in the economy as wage stickiness.  Rather, this “rigidity” is due to labor contracts that are spelled out, which requires the wage to be paid out in installments in the form of paychecks.  Therefore, it is because of this locked-in labor contract that wages don’t adjust as often as prices.

Wynne’s earlier study with Sigalla in 1993 concluded that raw data that are used to compile the producer price index and the consumer price index are often list prices instead of transaction prices.  There are two answers for this practice.  One is so firms protect themselves against potential antitrust litigation and the other reason is so these spelled out prices don’t fall into the hands of competitors.  In order to get around this dilemma, the BLS will take the average sticker price of various stores and the average discount or coupons associated with the purchase of this product.  This averaging of raw price data makes for a difficult time in assessing the flexibility of the prices.  Since some average prices fluctuate more than their “constituent price series,” this, too, will make for an unreliable estimate as to the flexibility of prices.  Wynne points to the earliest studies of the frequency of price changes, which was conducted by Mills (1927).  He developed a wholesale price index (WPI) in which he recorded 206 commodities.  The WPI ranged from 0 to 1 with an index value equal to zero if the price never changed over the period monitored and a value of one if the price changed every period recorded.  The shapes of these graphs were U-shaped, that is, there were a lot of commodities that didn’t exhibit price changes over the recorded time frame and a lot of commodities that exhibited price changes almost every period.  There were fewer commodities that fell in the middle range.  The products that exhibited the most price changes were farm products.  (An interesting note is that during WWI, the WPI graph didn’t show a U-shaped distribution, but rather an even distribution of commodities exhibiting ratios in the middle of the graph and a lot of commodities at the right-hand side of the graph.  The two criticisms of Mills’ work are that he used averages and used list prices rather than transaction prices.

Cecchetti’s (1986) study of magazines is a good example of price stickiness.  He was able to get away from the criticisms that plagued Mills (1927) because magazine prices are transaction costs and there are few discounts associated with magazines.  His sample period from 1953-1979 suggested high price stickiness because real costs were decreasing as nominal prices were increasing during high periods of inflation in the 1970s.  Therefore, he concluded that menu costs–that is, these fixed costs–were very high.  Nevertheless, his study had other shortcomings that Mill didn’t experience.  He looked at newsstand prices of magazines, but it is recognized that many people buy a subscription for a magazine, which is similar to the criticism of labor contracts.  That is, these individuals enter into a contract with the magazine company for a year and many times, subscriptions allow for customers to receive discounts.  This commonality, unfortunately, isn’t reflected in Cecchetti’s 1986 study.

Koelln and Rush (1993) look at whether controlling for quality of a product affects price rigidity, something for which Cecchetti couldn’t control.  Looking at magazine data from 1950-1989, the two conclude that Cecchetti’s study of price rigidity was overstated.  Looking at the number of pages of text, they were able to conclude that as inflation “erodes the real price of the magazine,” the number of pages of text will decline.  Therefore, this “price rigidity” can be confused with the declining quality of the product.  Carlton (1986) revisits Stigler and Kindahl (1970) in which the two looked at transaction costs rather than list prices of various industrial commodities.  Stigler and Kindahl (1970) collected data from buyers and not from sellers because buyers have less of an incentive to report list prices.  Thus, Carlton concludes that industrial commodities, especially industries dealing with steel, chemicals, and cement kept prices unchanged for a period of at least one year.  Other studies that have been conducted were those in the retail business.  Kashyap (1991) looked at retail catalogues and concluded that nominal prices remain unchanged for periods of at least one year and when prices do change, both the magnitude and number of changes is irregular.  Blinder (1991) conducted interviews with firms and found out that fifty-five percent of the firms interviewed claimed to have changed their prices no more than once a year, with only ten percent claiming to change prices monthly.  An interesting note from Blinder’s study is that three-fourths of the firms will change something other than price (i.e. delivery lags, quality of products) when demand is tight.

There have been some overall assessments of price stickiness.  Many studies mentioned by Wynne only have to do with a small fraction of the country’s GDP (i.e. magazines).  Other studies deal with intermediate products rather than finished products (i.e. industrial companies).  Lastly, of most importance is the price rigidity studies that actually deal with transactions involving money.  Since many products are bought via credit, it doesn’t represent the demand for money, and consequently, these studies will not determine whether money plays an important role in price rigidities.  Wynne also brings it to the attention of the reader that studies, such as Cecchetti and Stigler-Kindahl reaffirmed their theories of price rigidities rather than looking for price rigidities.  What I mean by this is that these two studies picked areas of the economy where it was already hinted at that prices were already inflexible and thus, the studies produced biased results that reaffirmed, rather than proved, that prices in these markets were rigid.  Carlton (1983) also criticizes the studies done on price rigidities.  For instance, it was known that there were price controls during WWII that held nominal prices at a constant level.  However, to get around this, the quality of the products being offered were decreased.  Thus, in a sense, the products were no longer homogeneous because of the varying qualities of the products being assessed.

Wynne concludes that there is little evidence to suggest that prices are sticky in the overall economy.  With all the thinking and assumptions of price stickiness, he was shocked that only three studies were able to be produced that showed actual price stickiness.  There are ways to deceive the idea of price stickiness by either withholding delivery during a heightened demand or by lowering the quality of the product.  In essence, just because markets take longer to clear than in a Walrasian auction, doesn’t mean that the evidence points to price rigidities.  To go back to the original question regarding the effectiveness of monetary policy and its effects on the real side of the economy–only a small degree of price rigidity needs to be in place for those external, monetary shocks to be able to trace out the observed business cycle.  Even if all prices were deemed flexible, monetary policy could still affect the real side of the economy–the shocks would simply then come from macro market failures or market incompleteness.

Source: Wynne, Mark A.  1995.  Sticky prices: What is the evidence?  Federal Reserve Bank of Dallas Economic Review (1st Quarter): 1-12.