A Response to Kantor’s “Rational Expectations and Economic Thought”

February 7th, 2008

According to Kantor, Keynesian economics began to be undermined following 1945 when the country experienced high levels of employment.  Keynes’ model assumed the rigidity (sticky) of real wages, but Don Patinkin claimed that “the involuntary unemployment and flexible money wages precludes the existence of equilibrium.”  Essentially, he “freed” the once static logic that decreases in employment led to increases in the real wage rate.  Instead, he noted that unemployment was a result of economic dynamics and that the real balance effect was due to flexibility, rather than rigidity, of the wage rate in equilibrium.  (Not knowing what the real balance effect was, I took it upon myself to look it up and this is what I found.  The real balance effect can be defined as an increase in somebody’s real wealth and thus an increase overall consumption due to a decrease in the aggregate price level.)

There is a large contrast between Keynesian economics and monetarists that incorporate expectations into their models.  Keynesians believed that in order to secure full employment, the only thing required would be to adjust real wages and increase the overall price level.  However, this would be proven later not to work because people, in fact, do pay attention to inflation.  Thus, the above-statement would result in only an increase in nominal wages, not real wages.  In the late 1960s, along came Milton Friedman and Edmund Phelps who both said that it is impossible to “fool all the workers all the time.”  That is, laborers are aware of the trade off between inflation and real wages and consequently, the inverse relationship between unemployment and inflation.  With the realization that expectations weren’t factored into the model, economists were soon to escape the “static general equilibrium.”

Early on, expectations, as modeled by Phillip Cagan, were assumed to be weighted averages of previous rates of changes in the aggregate price level.  While this seemed like a feasible model, there was still the understanding that the Phillips curve held true and policymakers could trade inflation for employment levels.  Eventually, the theory failed in the 1970s when the country experienced stagflation–that is, high levels of both unemployment and inflation.  (At this point, people began to abandon the Phillips curve for a short-run Phillips curve that said the relationship held true, but only in the short run.)

Soon, rational expectations came to the forefront of macroeconomic thought.  The inventor…John F. Muth.  He developed these expectations to “make dynamic economic models complete.”  Muth realized that there was great profit to be made by forecasting future expectations, especially if the predictions of economic theory were much better than the predictions developed by the firms.  Because rational expectations are built in to the current models, they can be assumed to be profit-maximizing since that is the goal of every firm.  However, if the past trends prove to be imperfect in forecasting current and future trends, then the practice of rational expectations will be inaccurate.  To guarantee the validity of the model developed, Muth had to assume that random disturbances in the model were normally distributed.  This is a very important assumption because otherwise hypothesis testing to check the statistical significance of variables in the model (i.e. through t-tests) would be useless.  The model in its simplest form says the difference between the actual rate of change of real aggregate output in time period t and the trend rate of the change of supply is equal to the difference between the realized price level in time period t and the expected price level in time period tplus an error term.  The forecasted error term in time period t-1 given the expected price level in time thas to be assumed to be zero because if that forecasted error term isn’t zero, then the actual output Yt will be different than the forecast, which will make it a useless tool for policymakers and firms (Kantor 1979, 1425).

Later on, these rational expectations were tested on other markets, such as the capital market.  It is from the rational expectations breakthrough that the Efficient Market hypothesis is born.  To remind everybody of that hypothesis, it claims that in an efficient market, all information is known and the prices (i.e. stock prices) fully reflect all of that available information.  There are many who believe in the Efficient Market hypothesis, and if their assumptions are valid, then investors can only beat the market in the short run.  That is, in the long run, due to the perfect availability of information, there is no room to make a profit.  However, there are many who refute these beliefs and claim that in fact, there is no such thing as perfect information and it is not readily available to all consumers.

Later in the article, Kantor does say that the major contribution that Keynes makes to economics is the understanding that the “basis of choice lies in vague, uncertain and shifting expectations of future events,” but he neither describes nor attempts to incorporate these expectations into a model.  According to Ludwig Lachmann, the incorporation of expectations by a business man is no different than a scientist attempting to prove a hypothesis.  “Both [business man and scientist] reflect an attempt at cognition and orientation in an imperfectly known world, both embody imperfect knowledge to be tested and improved by later experience.”  This is very true.  Economists are constantly refining models to more accurately reflect observations of trends in the real world.  These lagged models were tested in several situations, including Jacob A. Frenkel’s test for the demand for money during Germany’s hyperinflation era.  He found that people incorporated inflationary expectations into their demand for money.

Lastly, these lagged models used both autoregressive (lagging one variable)  and moving average parts (incorporating lags of other variables into the model) to better account for consumers’ expectations.  Robert E. Hall is one example.  He looked at the life-cycle and permanent-income hypotheses and found that consumption that is lagged one period can help predict current consumption because it is shown that “expectations of future marginal utility is a function of today’s level of consumption alone.”  Nevertheless, the one shortcoming that needs to be realized, which is apparent in forecasts for employment levels, is the fact that random shocks are real or nominal, as well as temporary or permanent.  Thus, due to the inability for people to determine which category the shock belongs in, forecasts go astray because these effects could not be anticipated.

 Source: Kantor, Brian.  1979.  Rational expectations and economic thought.  Journal of Economic Literature 17, no. 4 (December): 1422-1441.

A Response to Friedman’s “The role of monetary policy”

February 3rd, 2008

Milton Friedman’s article hopes to achieve two things–how can monetary policy contribute to the business cycle and how it should be conducted so that it is the most effective.  Friedman makes the readers aware from the start that Keynes recognized that the monetary policy in place in the 1920s could do little to mitigate the Great Depression because it was a useful tool to stop inflation, but would have done little to curb the recession.  During Keynes time of the Great Depression, he also realized that the liquidity preference for holding money was much higher during times of unemployment, but little could be done in way of monetary policy.  That is where he realized the benefits of government spending to make up for “insufficient private investment” due to the higher interest rates.  It wasn’t until after WWII when monetary policy was realized to be “potent” (as Friedman puts it) because of the inflation sparked by the “cheap money policies.”

In the article, Friedman strongly suggests that the Great Depression, or the Great Contraction as he calls it in this article, was brought on in great part due to the Federal Reserve engaging in deflationary policies, which contracted the money supply by one-third.  Essentially, the Federal Reserve failed to provide liquidity to the banking system.   In Friedman’s era, the role of monetary policy is to promote full employment first and foremost.  Second in the objectives of monetary policy is the prevention of inflation.  However, Friedman feels that the role of the Federal Reserve and monetary policy may be too vast–that is, perhaps the Federal Reserve can’t take on such a big challenge.

Two limitations that monetary policy have a hard time addressing are pegging interest rates for a long period of time as well as pegging unemployment for a long period of time.  Rather than letting the U.S. government pegging war and post-war bonds at a certain price, which turned out to be a mistake, the Fed should engage in open market operations by buying and selling securities.  Of particular concern is a way to keep interest rates low–meaning that the Fed should buy securities to make more money available for banks to loan out.  Friedman recognizes that by allowing the Fed to engage in open market operations, there would be a cyclical adjustment period because as the story goes, if there is more money in the economy, more people will be spending money, which in turn will lead to higher real wages and eventually higher prices.  This would cause spending to decrease and interest rates will have to return to a higher level in perhaps one to two years.  An interesting point that Friedman makes is the country comparison to interest rate levels.  He notes that countries that have higher interest rates have looser monetary policies in place than those countries that have lower interest rates.  This has to do with the fact that outrageous inflation levels have to be curbed by higher interest rates, but in order to achieve those high inflation levels in the first place, the central banking system of that country had to be irresponsible by trying to stimulate growth or “patch up a debt” through the printing of money.  The second limitation that Friedman discusses is the level of pegged unemployment in the long run.  Friedman asks why monetary policy cannot peg the unemployment at a consistent level, say three percent (which is his example).  The reason being is the same reason as pegging interest rates in the long run–in the long run the economy will react to those subsequent policies, but those reactions will be lagged and delayed.  Excess supply or demand will force the real wage rate lower and higher, respectively, than would otherwise be experienced in a state of equilibrium.  (An interesting note about the wage rate is Friedman’s argument regarding minimum wage rates and the strength of labor unions, all of which make the natural rate of unemployment higher than the market would otherwise dictate.)

One thing that Friedman stresses is that monetary policy, though it sounds negative, may prevent money from being a “source of economic disturbance.”  Essentially, the Great Contraction may have occurred on a lesser scale or not at all if deflationary measures weren’t used by the Federal Reserve System.  The second thing that monetary policy can do that will help the economy is to keep it running, to keep it “well oiled.”  That is to say, monetary policy can ensure price stability, which is important for consumers and businesses alike because they will consume more rationally and predictably if the economy is presumed to be stable.  Lastly, monetary policy works as a countermeasure.  For example, if there are presumed federal budget deficits–which means an increased spending–then monetary policy could work to offset the expected increases in inflation.

 When looking at how monetary policy should be conducted, there are two responsibilities: controlling factors in the environment that it can more easily control (i.e. price level) and stay away from those that it has a harder time controlling (i.e. unemployment levels) and avoiding “sharp swings” in policy (i.e. over correcting the market by being too expansionary and too contractionary).  All in all, short of publicly stating a fixed monetary growth, stable monetary policy is needed to promote economic stability.  However, Friedman does recognize the shortcoming, which is sometimes unavoidable–that is, there are other exogenous factors that will influence the domestic economy (i.e. exchange rates, currency markets, and foreign economic trends).

Source: Friedman, Milton.  1968.  The role of monetary policy.  American Economic Review 58 (March): 1-17.  (This can be found in Snowdon’s Macroeconomic Reader.)

A Response to Lansing’s “Can the Phillips Curve Help Forecast Inflation?”

January 28th, 2008

Rather than look at articles that delve into the time line behind the development of the theory, I thought that it would be useful to explore a practical application of the Phillips curve.  To me, the application of a theory and/or model (once you understand its background and assumptions about the world) is more interesting and useful than a simple discussion of the evolution of a particular way of thought.  Thus, I began exploring websites that looked at practical uses for the Phillips Curve and came across Kevin J. Lansing’s FRBSF Economic Letter“Can the Phillips Cure Help Forecast Inflation?”  Lansing starts the brief by giving the reader a basis for the question as to whether the Phillips Curve is a good forecasting tool for future inflation measures.  He notes that in the 1960s many economists and policymakers believed there to be a “stable trade-off” between inflation levels and levels of the unemployment.

 The substance for the forecasting application of this model really comes into play during the 1970s when Edmund Phelps (1967) and Milton Friedman (1968) refuted those earlier claims–as well as A. W. Phillips (1958) findings that policymakers could lower the unemployment rate by creating higher inflation–and stated that this “stable trade-off” could only be realized in the short run.  Phelps and Friedman’s comments led to a short-run Phillips curve, that is, the inflation and unemployment levels tend to move in opposite directions in the short run.  Interesting enough, the short-run unemployment that the Phelps-Friedman argument refers to is more commonly known as the Non-Accelerating Inflation Rate of Unemployment (NAIRU), which is the level of unemployment that holds the inflation rate at a particular level.

This short-run Phillips curve model became an interesting topic for Atkeson and Ohanian (2001) and Fisher, Liu, and Zhou (2002) in which those papers looked at the model as a useful tool for forecasting inflation rates.  Atkeson and Ohanian (2001) divide their sample into two periods: 1960-1983 and post-1983.  The relationship in the first period is negative, but in the second period, the relationship produces a line that is much flatter, indicating even less of a relationship between inflation and unemployment.  Fisher, Liu, and Zhou (2002) follow-up the 2001 study and examine closely the post-1983 period.  The paper concludes that the Phillips curve model can correctly predict the direction of the rate of inflation 60-70% of the time.

The final reason for Lansing discussing the application for the Phillips curve as a useful forecasting tool is because of the relationship between unemployment and inflation in the 1990s.  As the traditional model shows, there is a trade-off, or inverse relationship, between inflation and unemployment.  Nevertheless, during this decade, inflation and unemployment both moved in the same direction–downward.  Lansing gives reasons for this observed trend–inflation and unemployment remained low due to the increase in the growth rate of worker productivity due to the creation of new technologies.  Thus, due to the fact that multiple regression lines could fit the wide dispersion of data–suggesting that the inflation-unemployment relationship isn’t precisely shown with the short-run Phillips curve–there is evidence indicating that the short-run Phillips curve isn’t useful in forecasting the magnitude of future inflation, but perhaps is better at forecasting the direction of the change of future inflation.

Source: Lansing, Kevin J.  2002.  Can the Phillips curve help forecast inflation?  FRBSF Economic Letter 02-29 (October 4): 1-4, http://www.frbsf.org/publications/economics/letter/2002/el2002-29.html (accessed January 28, 2008).

A Response to Coddington’s “Keynesian economics: The search for first principles”

January 23rd, 2008

This was probably not the most appropriate starting point for me when trying to read an article pertaining to Keynesian economics.  I understand the skeletal basics–that is, Keynesian economics is sometimes given the name of modern macroeconomics which emphasizes the need for government spending to stimulate aggregate demand, which in turn will lead to a higher level of output.  Alan Coddington starts out by stating that original economists analyzed markets on the basis of the choices made by individual traders, all of whom made decisions based on predictable, stable, and clearly specified objectives.  However, after reading the introduction, I felt very lost and lacking the basic background on this economic viewpoint to really comprehend the nuances of Coddington’s article because his article presented more of a social commentary on Keynesian economics from three coined perspectives than a substantial background on the theory.  The authors three categories within Keynesian economics is fundamentalists, hydraulics, and reconstituted reductionists.

 Fundamentalists attack the traditional reductionists who insist that individuals exhibit “stable and clearly specified objectives” when making decisions on consuming products.  Rather, Keynes (1937) insists that choices were vague, uncertain, and expectations of future events were constantly shifting due to the strong influence of decision-making that one person could have on another consumer.  (This is where reductionists differed–they felt that consumers weren’t swayed by other people’s decisions.)  Lastly, fundamentalists believe that “self-interest will determine what in particular is produced, in what proper proportions the factors of production will be combined to produce it, and how the value of the final product will be distributed between them” (Keynes 1936).  This aggregate demand, as Keynes suggests, is what ultimately dictates both the level of employment and the level of output for the given economy.

Hydraulic Keynesianism was a popular way of thinking following the post-war era in the 1950s and 1960s.  This is where the government’s role became pronounced.  Here, Keynes makes it known that a large decentralized economy may be subject to broad central control or influence through the instrument of the budget–“fiscalism.”  Coddington refers to this form of Keynesian economics as “hydraulic” because of the homogeneous flows and interconnectedness of the stable relationship among three factors: expenditures, income, and output.  Thus, with the assumption that those three factors are indeed stable, then the government, which directly controls those factors, will ultimately dictate the economy’s level of output; thus, overall employment will be directly tied to aggregate demand rather than real wages.

 The third Keynesian breakdown, the reconstituted reductionist, makes little sense to me.  Coddington referred to two individuals who were at the forefront of this approach–Robert Clower and Axel Leijonhufvud, both of whom did work describing and modeling the disequilibrium status.  However, I couldn’t pick up on the author’s nuances in this section, so I will have to defer to either Dr. Greenlaw or someone else in the class who may have some understanding on the work that these two individuals contributed to macroeconomics.

 I regret ending my entry with the last paragraph the way I did, but I think I chose the wrong selection when trying to better comprehend Keynesian economics.  If I had understood the work of the individuals who associated themselves with this thought, then I think I would have gotten a lot more out of the reading, but unfortunately, I have to be honest in saying that the technicality of the piece was well over my head.

Source: Coddington, Alan. 1976.  Keynesian economics: The search for first principles.  Journal of Economic Literature 14 (December): 1258-73.  (This can be found in Snowdon’s Macroeconomic Reader.)

A Response to Blaug’s “The Neoclassical Theory of Money, Interest, and Prices”

January 17th, 2008

This chapter in Blaug’s book closely examines the origins, but more importantly the observable market forces that made for the strength and validity of the quantity theory of money.  Milton Freidman commented on the quantity theory of money as one that had strong observable correlations as the “uniformities that form the basis of the physical sciences.”  That is to say, the relationship between the quantity of money and changes in the price level both in the short-run and long-run occurred almost uniformly and over a wide spectrum of circumstances.  Blaug then goes onto to discuss Say’s Law of Markets that essentially states that there can be no demand without supply.  In a barter economy, production increases not only the supply of goods, but also creates demand for these goods.  The important point to note in a barter economy is that supply cannot exceed demand because supply creates demand and “products are paid for with products.”  A distinction is made, however, that in a monetary economy there is the possibility for an excess supply of commodities (i.e. money), meaning that the increased supply of money will strictly lead to inflation and not more demand because it is important to keep in mind that with inflation, there is more money demanding the same amount of goods.

In the neoclassical period (1870-1930), many individuals were concerned with the short-run implications of the quantity theory of money MV = PT; where M = money supply, V = velocity of money, P = aggregate price level, and T = level of output or real value of the aggregate transactions.  In particular, the individuals were concerned with how to model V and T.  While many believed these to be somewhat constant, Fisher’s Purchasing Power of Money discusses the problems of “transition periods” during which both V and Tare changing.  Nevertheless, criticisms arose during the early twentieth century because the model to show the relationship between the money stock and aggregate price level was deemed too oversimplified.  Out of these criticisms that the demand function for money wasn’t explicitly written, a new model was developed where it was believed that the reason people held cash was out of embarrassment for defaulting on investments.  As a result, V became a constant because it didn’t seem to be a function of either real income or the rate of interest.

The next section in Blaug’s book looks at Wicksell’s linkage between money and prices via the interest rate.  In this portion of the chapter, Blaug discusses Wicksell’s cumulative process.  Wicksell looks at the cumulative process from two extremes–the pure cash system and the pure credit system.  In the pure cash system, money is defined as coins and paper currency, whereas increases in checking deposits are treated simply as increases in the velocity of the banking reserves and the ability for the bank to loan out funds.  Here it is defined that a decrease in the bank rate (the market’s interest rate) will lead to an increase in investment because the marginal product of capital is greater than the marginal cost of borrowing.  This will result in a disequilibrium, causing the demand of capital goods to increase (due to a lower interest rate), consumer goods to rise, and the wages demanded from workers to also rise.  All of this increased demand will lead to a price rise that is considered cumulative in nature.  Nevertheless, this disequilibrium will be corrected by the market because an increase in the price level (i.e. inflation) will be corrected as inflationary pressures deplete reserves (since it is now more expensive to buy the same basket of goods).  This decrease in bank reserves will lead to a higher bank interest rate and the above-mentioned steps will be reversed and equilibrium will be achieved once again.  In the other extreme–the pure credit system (which is supposedly similar to our banking system today), all money is in the form of demand deposits and bank notes.  However, what I don’t understand and would like help with is the distinction between the pure cash system and pure credit system and also what it means for the elasticity of the bank to be infinite (in a pure cash system) and for the elasticity of a bank to be zero (in a pure credit system).

The last large theme of this chapter examined market equilibrium.  According to Blaug, market equilibrium is achieved when three conditions are met: (1) the loan rate of interest is equal to the expected yield of newly created capital (the rate of return); (2) the demand for loanable funds and the supply of savings is equal; and (3) the level of the commodity prices has no tendency to move.  After going through the derivation of a mathematical equations that linked planned and realized investment and saving with planned and realized income, two relationships were realized.  One is that if investment exceeds saving, then earned income is rising.  The other one makes mathematical sense, but not economic sense.  It states that an excess of planned savings or planned investment implies a deficiency of realized income as compared with planned income.

The chapter ended with a look at both expectations as well as a quick glance at both Wicksell and Keynesian models.  With regard to expectations, Wicksell assumed that the “elasticity of expectations of unity”–which meant that a change in current prices is expected to change the future prices in both the same direction and same proportion.  Right away, it can be observed that this upward spiral would be unending and an equilibrium point between supply and demand would never be achieved without the help either anticipated expectations to curb those expectations or outside intervention.  Keynes felt that the economic system could be out of equilibrium even if the market interest rate and the natural rate were at the same levels.  This could occur if the interest rate mechanism didn’t match the demand and consumption plans of households and business firms.   According to Keynes, the way to deal with this disequilibrium is through outside intervention, also known as “automatic stabilizers,” via fiscal policy.

Source: Blaug, Mark.  1978.  Economic theory in retrospect.  3d ed.  Cambridge: Cambridge University Press