In their article, After Keynesian Macroeconomics, Thomas Sargent and Robert Lucas inquire into and critique the fundamental limitations of the Keynesian approach to Macroeconomics.  The approach to economics that arose from Keynes, was one that necessarily relied on historical data, upon which regression equations could be tested and specified.  Any Keynesian macroeconomic equation can be reduced to a regression equation; but to specify the parameters of the equation from observations of the outputs (Ps, Q, and such) requires a great deal of information about the entire system in the first place.  All estimates of these parameters (like rental rates, factor shares, or marginal products) can only be estimated from the historical data; which means that all Keynesian macro models are founded by ex ante information, and cannot adequately take into account the way that people have rational expectations about the future.  

Indeed, there are a number of related reasons why Keynesian structural macro models are not in fact structural, or theoretical, but rather empirically founded and therefore limited.  Keynes implied some very tight restrictions on macro relationships.  By identifying consumption expenditures as a function of income and current consumption only, or the demand for money as a function of interest rates only, Keynes made radical assumptions about that which money demand, and consumption expenditure was not contingent.  But saying what something is not, requires assumptions, in the same way we assume that some variables are truly exogenous, because they are not influenced by the system, but only influence the system.  This way of estimate ‘structural’ macro models must also exclude the individual from the equation.  When the model is based off of historical data and expectations of future values are based off of the previous values, then the individual acts more as a point of convergence of many historically determined macro variables, rather than an agent that makes rational, profit maximizing decisions.  This retrospective way of estimating models lead to the failure of the Keynesian economics in the face of high inflation and unemployment of the 1970’s.  Equations that always assumed a tradeoff between unemployment and inflation were systematically refuted, as both began to grow at faster and faster rates per year. 

But even more than a simple failure of Keynesian macro economics, the general approach to data and modeling was flawed.  Rather than simply adding or subtracting terms, aggregating or disaggregating, Lucas and Sargent argue that new-classical models are more sound in their assumptions, because by starting at the micro level, they can include the self-referential qualities of human agents—because agents are rational and can refer to the model from which they decide how to behave, the model itself should become part of the model, and change dynamically, rather than linearly through time.  Only at the micro level can we get to this lowest common denominator of all macro behavior; or so argues Lucas and Sargent.  

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

In this very brief article, Blinder first argues for what should remain within the established tradition of teaching economics. The IS and LM curves should not be included, for several important reason. The IS curve may be fundamentally flawed because the negative relationship between interest rates and investment may only hold good for homebuilding and consumer durable, rather than business investment. Also, the LM curve fails to make a strong distinction between real and nominal, short and long runs. This was also a serious critique of Keynesianism, and so we can see that the old paradigm has not yet given way to the New Classical and New Keynesian synthesis.

Also, by thinking in terms of demand and supply, we tend to assume that aggregate demand and supply are adjusted rapidly to price changes, while wages remain sticky. But in reality, both prices and wages remain sticky—the supply curve should adjust, not just quantity supplied. In doing so, we would then be assuming that wages and prices should be considered to be largely predetermined in the short run, even though in the long run they will be allowed to adjust. These may be agreed to be core principles of economics, however they are not taught to principles students, nor is there any consensus on the reason for wages being so sticky

Given this brief critique, there are four core things to include in the model for understanding economics. 1) Prices and wages are largely predetermined in the short run because of price stickiness. 2) Output is demand determined in the short run—because of this, 3) Monetary and fiscal policy is effective, via demand changes from fiscal, effect interest sensitivity, effected by monetary policy. 4) Okuns law is legitimate—growth and unemployment rate.

And to summarize the problems with the old model, Blinder offers the following points: 1) The term structure of interest rates say that the rate of interest for long term maturities will be equal to the sum of the expected interest rates per year leading up to the long term rate. Although this may be intuitively appealing, it fails all the empirical tests. We must find something better because this is a major cannon of monetary policy, and we need to know more about its limitations. 2.) Modeling expectations: usually relegated to the Phillips curve on the right side of the equation showing expected inflation, but it should be expanded. A major difficulty is when we see that fiscal stimulus can actually encourage a recession. To get to this understanding, we need to see that fiscal policy works more through intertemporal shifting of demand, and that the term structure of interest rates is essentially wrong.

There are inherent limitations in the IS-LM framework because thinking in terms of aggregate non-dynamic relationships will always, at least implicitly, ignore the way individuals react in accordance with rational, inter-temporal expectations. When Keynes developed his general theory, it was never in anyway general because it failed to incorporate expectations, and the time dimension beyond a single period. The IS LM framework developed by Keynes, however, cannot be made to incorporate rational expectations because the assumptions and foundations are inherently incompatible. The author explains that old economists were asking the wrong questions: it should not be what explains cycles, but rather, what explains differences in cycles—in assuming that cycles are not uniform in time, this latter form of the questions gets at the time dimension of cyclical behavior, and therefore opens up more questions about what are the determinants of this time dimension—indeed, this article deals with the journey to formulating this as a question, and the answers to this question.

Looking closely into the Keynesian system we see that he was generally short run oriented. We need to take his time period into account before we judge him too harshly; he was oriented mostly towards policy prescriptions and short run corrections for shocks for which he could not provide an explanation. By neatly dividing up all the interaction in the economy into three major relationships, Keynes was then able to develop his general theory with a few characteristics that King identifies as trouble spots. 1) liquidity preference responding to nominal prices as largely predetermined 2) expectations were largely exogenous, and onlyn effect to be reckoned with by the model, and not from within the model 3) behavioral rules were essentially fixed, and so public policy had the responsibility of seeing the variability in the exogenous shock; therefore, public policy should be developed on a case by case basis.

Milton Friedman criticized the Phillips curve which is consistent with Keynesian theory, for showing changes between the inflation and unemployment rates, rather than a series of events. The relationship was therefore oversimplified into a tradeoff that appeared static rather than dynamic. Even though Friedman criticized the static nature of the Phillips curve, his own formulation of the curve that incorporates expectations seems to be a static theory in other respects. It implicitly assumed that real wage increases would encourage the same increase of labor supply in the short and long run. The new-classical framework assumes, rather that labor supply is exogenous (population growth rate), so that in the long run labor is fixed and much more inelastic with respect to real wage changes. Also, by incorporating micro-foundations and the permanent income hypothesis, the neoclassical approach was able to account for the dynamic relationship between inflation and unemployment, by looking into the individual consumption function.

Indeed, behind this critique however there is a long literature of economists who have built upon the ISLM framework, curve by curve. On the income side of the IS curve, Friedman and his life cycle theory, Modigliani, and Brumberg, all imply the sensitive relationship between the patterns of income, savings and consumption over the lifetime of a rational agent that implicitly hold a stock of wealth. These variables, assumed to be largely independent of each other in ISLM analysis, are intimately related from the perspective of the individual in time. “The marginal propensity to consume depends in an essential way on the nature of the income profile under consideration: it is low for changes in income that are temporary; high for those that are permanent; and depends in a delicate way on the details of the stochastic process for situations in between.”(pg 76) Therefore, as the neoclassical research and theory continued, it became clear that econometric models should also include some variables that control for expectations about the future conditions of income, production, and cost levels.

The demand for money in the LM portion of the graph, is also complicated by expectations. It was deficient because it boiled down to static models—expectations of future inflation, could only influence cash holdings because inflation effects the nominal interest rate in the future. The choice is not simply between money and bonds, but also between different time-maturity bonds, which requires some inclusion of expectations. For these reasons, we see that Friedman implicitly includes wealth in his permanent income theory, and other economist investigate the influences of inflation directly on money demand by looking into “partial adjustment” phenomena in the money demand market.

These models confirm and build upon the rational expectations augmented neoclassical models that came into the picture around the same time. Rational expectations link the short and long run; money and savings-investment markets that were assumed in the IS LM framework to be mutually exclusive, now became essentially linked by individual agents. The permanent income hypothesis is also derived from the rational expectations framework, and gives a very sensitive account of consumer behavior—empirically its predictions are sounds, and theoretically, it demonstrates that IS curve should be dependent on everything—this is just evidence of how much as Keynes model overlooked. In the end, the author wants to change the direction teaching, policy analysis, and econometrics. Because this framework never even addresses, or recognizes the existence of the long run, asking questions and formulation questions from within this framework is could only tell half the story; which never makes for a good story.

Will the New Keynesian Macroeconomics Resurrect the IS-LM Model?
Robert G. King The Journal of Economic Perspectives, Vol. 7, No. 1. (Winter, 1993), pp. 67-82.

By looking deeply into the differences that exist between Keynes and the New Classical, Shaw contends price flexibility is a major point of divergence.  The new classical assumed that markets would always clear and achieve a Walrasian equilibrium condition, in which there existed a single price vector for all markets that satisfied equilibrium in all markets.  In Walrasian theory, there is an auction type environment where all perfect information prevails, products are homogenous and transaction costs are zero.  This is what Hicks refers to as flexprice markets; because whatever market follows these conditions will likely have flexible prices. 

The characteristics of financial markets most closely resemble these requirements of flexprice markets.  There is extreme competition, well informed specialized traders act as auctioneers, information is equally available amongst all market participants, and there is a large quantity of homogeneous products (from the perspective of the buyer) being sold in near cost-loss conditions.  And indeed, these markets do have extremely flexible prices and wages.   However, not all markets have these pleasant conditions .  Most markets in the world are not financial, but rather have trading in goods and services.  Shaw runs through at least seven different sources of price inflexibility that can arise under conditions where information is not perfect, products are not homogenous, and transaction costs are relatively high.  Hicks refers to these as fixprice market.

The first source Shaw mentioned arises when there is no auctioneer as there was in the Walrasian auction system, such that there would be tremendous costs for all the market participants to have to congregate in one place to bid on prices.  The price tag is cheaper to use from the perspective of the buyer and seller, because fixing a price for a time period would also reduce search costs for buyers (the price wont change by the second, so they wont have to keep checking on it), and this allows time for the buyers to become aware of the price and respond accordingly.  Adjustment are never instantaneous, so it is infact a good thing that prices are fixed because it allows the market time to adjust. Also, this lowers the associated costs of changing price tags, up until it becomes profitable to do so.  Because the cost of a price change will be the same regardless of the extent of a price change, a firm will wait until the benefits of changing the price exceed the cost of the price change; until that point all adjustment will be output adjustments.

Also, in the case of Walrasian equilibrium, perfect information exists because the auctioneer acts to coordinate all market clearing price adjustments.  We see an example for this in the game theory dilemma of private firms in the face of an aggregate money demand shock.  When the supply of money decreases, a firm will experience a drop in the nominal demand for its products.  But at the same time, the cost of its inputs should decrease as well; if the firm decreases its output prices, and input prices fall, then profits should remain unaffected.  But to lower prices means that they will be earning less profit than competitors, so who will be the first one to make the move?  This lack of coordination will delay the impact of nominal changes in demand, and result in price stickiness and changes in real variables.  And of course, these effects are magnified because there is often a lag between intermediate and final goods markets.  The input cost price adjustment will respond more slowly than the nominal demand change, so the firm is not likely to decrease prices because profits would decrease in the short run.

This is a summary of Chapter 7 from Rational Expectations by G. K. Shaw.

New Classical Macroeconomics

The classical foundations of the Monetarist school provide a first point of departure for the New Classical approach to macroeconomics. There are a few important characteristics of monetarism that should be clarified in order to show more clearly the unique qualities of the New Classical tradition. In general, the monetarist critique of Keynesian economics arose out of the period of stagflation during the 1970’s and 80’s. The Phillips curve, adapted into the Keynesian framework, was unable to explain or account for the co-existence of two seemingly inconsistent phenomena; inflation and unemployment should be tradeoff consequences of demand management. In 1968, a few years before stagflation ever became an insue, the monetarist Milton Friedman portended a few serious limitations with the Keynesian framwork and specifically the Phillips curve. Rather than showing a simple inverse relationship between inflation and unemployment, the curve should relate unemployment to real wages rather than nominal prices. Also, in showing changes between the inflation and unmployment rates, the relationship was implicitly oversimplified into a tradoff that appeared static rather than dynamic. Also among his contributions was the natural rate hypothesis, which proposed a stable equilibrium rate of unemployment to which “the stable private economy tends to return once disruptive influences” are removed (Hoover 25).

This theory implies that there is no real tradeoff between unemployment and inflation, but rather any short run tradeoff reflects that economic agents have made a mistake in their expectations of future inflation. In doing so, workers have succumbed to a ‘money illusion’ because they have confused absolute and relative price changes. In the short run the aggregate supply curve is upward sloping because workers have not yet adjusted to real changes in wages. Over time, the incorrect expectations of the workers gradually adapts to coincide with the actual level of prices; the short run aggregate supply curve shifts upward until the wage increase translates entirely into a proportional increase in the price level. We have again reached the classical formula: every increase in spending or wages will translate into an equivalent change in the price level. Even amongst the monetarists there is no clear consensus about how long this corrective period lasts. For monetarists in general, however, we can see that the problem of ‘money illusion’ arises from limited information about relative wages, and expectations that are always retrospective, or ‘adaptive.’

Although involuntary unemployment is something that comes about in disequilibrium, Friedmans theory of unemployment was an equilibrium approach. How is this when unemployment is a disequilibrium phenomenon? The money illusion can only have an impact on unemployment, insofar as workers have been mistaken in their expectations about the future rate of inflation. When there is an unexpected fall in aggregated demand, the price level and price of output will also fall. Employers will higher more workers as the marginal cost per worker increases, and as the real wage is perceived to decrease, so will the aggregate supply of labor. In the end, unemployment falls. Frictional unemployment comes about as workers move between jobs and adjust to nominal price changes. Therefore, unemployment happens in the economy when workers have mistaken expectations even while they are struggling to maximize their utility. This is not an ideal situation because under different circumstances the aggregate income could be higher—but it is the best situation given the set of constraints.

In what Kevin Hoover calls the “first paper to deserve to be called ‘new classical,’” Lucas and Rapping manage to unite this “equilibrium” approach to unemployment with a labor supply curve that is elastic in the short run but inelastic in the long run. Although Friedman critisized the static nature of the Phillips curve, his own formulation of the curve that incoroporates expectaions, seems to be a static theory in other respects. It implicitly assumed that real wage increases would encourage the same increase of labor supply in the short and long run. The new-classical framework assumes rather that labor supply is exogenous (population growth rate), so that in the long run labor is fixed and much more inelastic with respect to real wage changes. As a note to the reader, be careful not to confuse nominal and real price changes; Friedman and the new classicals agree that the Phillips curve is vertical in the long run only when graphed against nominal price changes. Lucas and Rapping integrate this distinction into the their model as they begin from an individual agent’s consumption function in which future and current leisure are close substitutes. When real wage rises temporarily above its ‘normal’ level, more labor is supplied because the relative cost of leisure has increased. When the real wage rises permanently, there should be no long run change in the level of employment. The relative prices of working and leisure would remain constant, such that an agent would not substitute future for current leisure. This model is representative of the new classical approach in several ways. 1) It begins from microfoundation and a consumers utility function. 2) From within this micro-framework, the profit/utility maximizing agents behave in a way that is consistent with a general equilibrium. 3) The intertemporal substitution of leisure is the most relevant factor that determines fluctuations in output and employment.

But how can rational maximizers continue with adaptive expectations when their expectations are consistently wrong? To do so would be irrational, and therefore inconsistent with equilibrium. In this critique we are able to introduce “rational expectations” as an important element of new-classical thought. Friedman and Lucas noted that adaptive expectations are not compatible with natural rate hypothesis, because expectations would never fully adapt to real prices. If an exogenous supply shock increases the real wage rate, maximizing agents would always have expectations that lagged behind the real wage and price level. As relative prices and wages corrected over the short run from lower values in the past, workers would continue to perceive incorrectly that their real wage was higher than ‘normal.’ Labor supply would never adjust to its initial level, and a natural rate of unemployment would be unreachable. (29 Hoover) Adaptive expectations are systematically wrong. The new-classical economists therefore adopted the “rational expectations hypothesis” developed by John Muth. There are at least three defining features of rational expectations. 1) Information is always a limited resource that is never wasted. 2) There is no “inside” information because all information is public. As long as it remains public, no one is able to profit more than anyone else is. (15 Hoover) 3) Expectations are always developed from within a ‘relevant system’ that explains the economy, that is, people act as if they know the predictions of the model for the economy that incorporates all the relevant variables.

The second of these characteristics poses the biggest challenge for Keynesian and Monetarist theory. Agents with rational expectations do not suffer from the money illusion, but rather from incorrect expectations. When workers confuse a nominal increase with a real increase, they will work more because their rewards for working have seemingly increased. An agent with rational expectations, however, will always have perceptions that are consistent with the actual values of the variable in question, differing only by an amount that averages out to a serially uncorrelated random event. In any given situation “expectations may be incorrect,” but never “systematically incorrect” or else the expectations should grow to integrate whatever information is missing. All errors are random and not the result of any missing information, even though perfect information is never required. (347 Laidler) Using this random component, new classical economists were able to develop upon the supply side monetarist approach, without assuming adaptive expectations or perfect information into their models.

Allowing for imperfect or a non-zero cost of information; the new classicals were indeed new and something other than older classical economists. In the classical framework, as we have seen, all agents are blessed with perfect information, price flexibility, and clearing markets. While the last two conditions still hold true for new classicals, non-perfect information means that while the economy will always be in equilibrium, that growth path will not necessarily be constant. What brings the new classical in line with classical thought, also separates the new classicals from monetarist theory. Of course, we have already seen many differences, 1) Monetarists are more comfortable with high levels of aggregation, while New classicals always begin from micro-foundations. 2) Rational expectations are an integral element in all new classical models, while this is not the case for monetarists. And to assume perfect price and wage flexibility is to go even further. 3) As we have said, among the monetarists the aggregate supply curve is upward sloping because workers have not yet adjusted to real changes in wages. Over time the incorrect expectations of the workers gradually adapts to coincide with the actual level of prices; the short run aggregate supply curve gradually shifts upward until the wage increase translates entirely into a proportional increase in the price level. This process is always temporary, however in the new classical approach, it is almost instantaneous. Prices and wages are assumed to be perfectly flexible, so any increase in the money supply translates immediately into a price increase that is perceived and anticipated. What matters most for the aggregate labor supply, is rather real wages and expected real wages in the future.

So then, in summary, what are the major characteristics of new classical economics? There are at least three necessary concitions. 1) Real factors determine the economic decisions of rational agents. Consumption saving, and investment decisions are not based on nominal or monetary factors. 2) In accordance with the microfoundations of new classical, economic agents will always optimize and are always in equilibrium. 3) There can be no systematic errors in they ways they observe and behave in their economic environment; that is, they must have rational expectations. Of course, while a new-classical economist necessarily believes in rational expectations, all of those whom subscribe to rational expectations are not new-classical economist

There are a number of theoretical and empirical weaknesses within the new-classical approach. First of all, with respect to New Classical models, Laidler points out that the “truthfulness” of a model should not be contingent upon whether or not it can explain the data on which it was designed; “this is just testing the logical ability of the economist.” Rather a model should be able to anticipate those events that the economist did not know about first, or define the model to address beforehand. The desperate attachment to maximization, deduceability, and the apriori non-empirical model, has hobbled the predictive abilities of neo-classical thought. Empirically and historically, there are some demonstrations of these weaknesses. Because the neo-classicals propose that the Phillips curve reflects the elasticity of the supply of labor with respect to real wages, we are able to test the hypothesis. Aggregate employment fluctuates too strongly relative to inflation; changes in employment are only supposed to be the result of real wage changes. Secondly, in accordance with new classical theory, output follows changes in the real price; prices should always move prior to output changes. The data show, however, that quantity changes seem to precede associated changes in price.

Works Cited

Hoover, Kevin D. The New Classical Macroeconomics: A Skeptical Inquiry. New York, NY, Basil Blackwell: 1988

Laidler, David. 1986. The New Classical Contribution to Macroeconomics. Banca Nazionale Del Lavoro Quarterly Review, (March), pp 27-55. In A Macroeconomics Reader. Ed. Brian Snowdon and Howard R. Vane. London, Routledge Press: 1997.

Shaw, G K. Rational Expectations: An Elementary Exposition. New York, NY. St. Martin’s Press.

Methods and Problems in Business Cycle Theory

Robert E. Lucas, Jr.

Journal of Money, Credit and Banking, Vol. 12, No. 4, Part 2: Rational Expectations. (Nov.,1980), pp. 696-715.

Robert Lucas begins his critique with an observation; the intention behind Business Cycle Theory is to create “models” of reality, rather than actually model reality to mimic it. It is the purposes behind each pursuit that distinguish the usefulness of RBC models, from any discussion derived from actual economic behavior. The purpose of models is to help us understand the mechanism that exist in reality; to confuse this with a purposed aimed at “realism” is to denigrate or ignore the inherent usefulness of RBC models. Lucas complains that “the theory is not being effectively used to help us to see which opinions about the behavior of actual economies are accurate and which are not.” Its not so important to be a “real” interpretation, as it is to be a “better imitation.” The question arises: “what makes a better imitation than mimicking what is real?” and this is the question that Lucas is setting out to answer.

Lucas points to a few key developments that have allowed RBC models to make a contribution. First, is what Lucas calls a “purely technical” development that enlarges our “abilities to construct analogue economies.” He is of course, talking about formalized mathematical models that allow us to investigate situations or cause-effect relations that would otherwise be to costly to observe in “real economies.” Second, Lucas points us to the fact that RBC models are built in response to different question. Unlike the journalist for whom every new story is a phenomenon based on a new theory, RBC models approach the world with unbending, unchanging formalism. This is probably an overstatement, but it illuminates the need and use of formal models in RBC theory. Third, as more economist and mathematicians specialize in the field, it is no wonder that the field requires more specialization to understand and utilize it in itself. This has caused a misunderstanding amongst outside observers, such that historians have attempted to “understand developments of monetary economics in terms entirely internal to the sub-discipline.”

The author spends some time criticizing Keynes, only in the end to show how much “Keynesianism” in all its advancements are indebted to the neo-classical formalized approach to economics. In this context, Lucas continues with the history of RBC theory in the context of general equilibrium theory, a mode of thought that begins, so he contends, with Alfred Marshall. Paul Samuelson advanced the course of finding a neo-classical synthesis with Keynesianism, by supplying the “main ingredients” for a mathematically explicitly theory of general equilibrium; “an artificial system in which households and firms jointly solve explicit ‘static’ maximum problems.” But, as Lucas points out, business cycles are not static. To correct for this, Samuelson included additional “free” parameters that still had an “equilibrium” point to appease the neo-classicals, while maintaining enough parameters to show a wide variety of possible paths coming as a result of an exogenous shock. There was equilibrium with dis-equilibrium; a synthesis.

Real business cycle theory developed out of the new classical tradition and attempts to explain economic activity fluctuations in a world without coordination failures, “price stickiness, waves of optimism or pessimism, monetary policy, or government policy in general.” Therefore, in contrast to the Keynesian approach, RBC theory describes all fluctuations as real fluctuations in supply, and hence every fluctuation is a new equilibrium rather than a point of dis-equilibrium.

An important historical moment for RBC models came with the publications of Ragmar Frisch (1933) and Eugen Slutzky (1937), who distinguished between impulse and propogation mechanisms. Impulse mechanisms are what initially cause a “variable to deviate from its steady state value, whereas propagation mechanisms: “causes deviations from the steady state to persist for some time.” All deviations from the steady state arise from exogenous productivity shocks, in contrast to the Keynesian theory in which demand-side fluctuations account for output fluctuations. This is why RBC theory designates little importance to other impulse mechanisms like tax rates, monetary policy, and preferences, all of which are very important in Keynesian theory.

The growth of output in Robert Solow’s model (1956, 1957) is dependent upon the capital labor ratio and the “solow residual”, which embodies the “technical possibilities” that augment the productivity of labor. This residual is stochastic, exogenously determined, and accounts for almost half of the growth in output. RBC theory is then founded in a neo-classical growth model augmented by stochastic shocks to productivity. Stadler points out that “once one incorporates stochastic fluctuations in the rate of technical progress into the neoclassical growth model, it is capable of displaying business cycle phenomena that match reasonably closely those historically observed in the USA.” (pg 1753).

Stadler then points out a few common features of RBC models. 1) they have their foundations in micro-economic behavior. The behaviors of representative agents are aggregated to determine the overall impact on the economy. Furthermore, all agents have rational expectations and all markets are instantly clearing with no information asymmetries. For this reason, all RBC theories are built within the framework of competitive general equilibrium models. 2) All firms and households are maximizing agents. 3) Cycles are dependent upon the shocks to technology that impact the production function—therefore, rather than deviations, these productions functions have been redefined so that all cyclical behavior is still an equilibrium condition. 4) There are propagation mechanisms that magnify or mitigate the exogenous shocks to labor-augmenting technology.

Kydland and Prescott (1982) present a classic example of an RBC model in which all volatility in output can be accounted for by stochastic changes in productivity. Like most RBC models, it has the problem that it overpredicts the correlation between productivity and output. Because these models are developed and tested around the same data, the standard deviation of output predicted in the model is identical with the data.

Billy Swanson

I didn’t go hunting for an article, because honestly, I was a little afraid of getting something bad/irrelevant off the web. So instead, I read “the new classical contribution to macroeconomics” by David Laidler, pp 334-358. I tried reading the Lucas-Sergant article entitled “After Keynsian Economics,” but couldn’t make too much sense of it. In this article, Laidler is arguing for the New-Keynsian/monetarist approach to macroeconomics. While recognizing that new classical had its contributions, it also had more than its share of false predictions and missteps. Therefore, Laidler argues that even though the Keynsian model failed to explain stagflation, there are other alternatives to the new-classical model; even if the contributions of new classical are inherently important to that alternative.

First, Laidler shows the reconcilability of monetarism and Keynsianism; a hybrid that is stronger than either model separately. The Keysnian “test” failed in the 1970’s when the gains in output and expenditure only corresponded to a short-term change in output, and Inflation rose at higher and higher rates, rather than shifting to a higher stable level. The monetarist contributions to the Phillips curve (such as the expectations augmentation) “pose no radical theoretical challenge to” Keynsian theories, but in fact resemble extensions of the ISLM model. From an analytic point of view, the new rendition of the Phillips curve–compliments of Friedman and Phellps—did not provide the deep explanation that Luca and the new-classical economists attempted.

There are a few major characteristics that distinguish new classical, from new-keynsian. In Keysnina macroeconomics, prices are inflexible (sticky). Therefore the supply of labor, inventories and capital must accommodate the sticky prices, causing aggregate demand shifts and more pressure on price changes. This system in one “in which prices are sticky, in which quantities change to absorb demand side shocks in the short run, and in which inflation expectations though mainly backward looking are endogenous.”(Pg. 338) In knew classical however, prices are assumed to be flexible and always the mechanism by which markets equilibrate. The individual is likely to misinterpret a money price change for a relative price change, therefore altering the quantity of goods s/he produces. Therefore, output and employment fluctuations occur because the individual is reacting to price changes. Prices have the effect on output; the opposite of the Keynsian approach. Furthermore, if prices are flexible and the market agents are not tied down by contracts and stick prices, in order for the rational maximizers to avoid unnecessary loses to income, s/he must form expectations consistent with the model. The “demand and supply schedules which determine the equilibrium structure of market prices” do not depend on “full and accurate information,” but rather the “agents perceptions of that structure.” (Pg. 339)

There are a few fundamental drawbacks to the approach of Neo-classical economics. First of all, Laidler points out that the “truthfulness” of a model should not be contingent upon weather or not it can explain the data on which it was designed; “this is just testing the logical ability of the economist.” Rather a model should be able to anticipate those events that the economist did not know about first, or define the model to address beforehand. The desperate attachment to maximization, deducibility, and the a priori non-empirical model, has hobbled the predictive abilities of neo-classical thought.

Empirically and historically, there are some demonstrations of these weaknesses. 1) Because the neo-classicals propose that the Phillips curve reflect the elasticity of the supply of labor with respect to real wages, we are able to test the hypothesis. Aggregate employment fluctuates too strongly relative to inflation, given that the changes in employment are only supposed to be a result of “is perceived nominal wage changes as reflecting real wage changes.” 2) Prices fluctuate and then output changes. The data show, however, that quantity changes seem to precede associate changes in price. 3) Because prices automatically adjust, the “economy should always be on its long-run demand for money function,” although empirically this is untenable. (Pg. 342)

Unfortunately, I could not find the Klamer article in the library. “HB 172.5, yup. C66 nope. Guess I’ll have to go Google Scholar, hope the article isn’t crap…” No, it wasn’t bad at all, I just hope that I didn’t miss anything too fundamental. This weekend I’ll try to find the book and read it.

The Laffer Curve is the defining feature of Reagonomics; a simple bell shaped curve showing the quadratic relationship between tax rates and total government revenues, such that higher tax rates do not always result in higher tax revenues for the government. While the Keynesian approach considers only the absolute amount of income available, Reagonomics considers the opportunity cost of leisure.

There are a few effects that taxation causes, according to supply side economics.

1) Because taxes are imposed on work effort, the relative cost of leisure in terms of work hours declines, such that leisure is now less expensive, and working is less profitable. The person would now work less, and relax more.

2) Of course, there are also taxes on the future income and savings, so that under the US tax structure, people will decide to save less in the future. Knowing that the rate of return must at least equal the cost of investing, as the pre-tax rate of return must now rise “sufficiently such that after paying the tax, the net return will be that required to induce people to hold the same amount of capital.” Since this is not likely to happen, the amount of capital will decrease.

3) As the amount of capital decreases, from what we know about the inverse relationship between capital labor ratios and the marginal products, wages and rents paid to labor and capital, workers are now likely to get paid less because there is less equipment to work with.

So taxes are bad for the economy; a supply-shock that causes a downturn in savings and production function. Therefore, if we make a few basic assumptions about human behavior, it is possible to maximize government tax revenues while decreasing tax rates. “As the tax rate increases, the quantity of work demanded declines. At first, the higher tax rate applied to the fewer units results in greater total revenue. However, before too long, quantity falls in greater proportion than the rise in tax rate.” The tax rate has entered into the elastic region of the labor supply curve; or the argument assumes that income effect cannot dominate the substitution effect. Any decrease in wages per hour must result in an increase in leisure consumed.

Of course, this theory is a biased republican tool for world domination. Criticisms of the Laffer Curve are severe. 1) the curve is an “imaginary” aggregate of the individual choice between work vs. leisure. There is no honest way to measure or exploit the proposed benefits, because there is no way to locate ourselves on it. 2) It lacks any discussion of the economic processes that undergirds the macro-behavior. Sure, the individual is accounted for, but what about the macro economy? “It is simply assumed that the economy shifts from one point on the curve to another. There is no discussion of how the shift occurs, how long the shift takes, or what relative price effects are engendered by the shift.” We could just as easily be below the region of maximized revenues, so that we should raise taxes.

The author then elaborates a little on the distinction between risk and uncertainty, to show how time preference can give rise to government officials making bad policy decisions with respect to taxes and expenditure (although this connection is not clear). Risk and uncertainty can be related to class and case probability, respectively. Risk is a randomness that can be expressed in terms of a “specific numerical probability,” deriving the likelihood of an unknown even with class characteristics—hence this is class probability. Uncertainty however, cannot be neatly summarized in a numerical value, but must be decided upon following a case by case basis; in this, we know something about the event and the events surrounding it, but nothing about the class of events to which it belongs such that we have no context in which to find its probability.

Ludwig Van Den Hauwe. The Case for Supply-Side Economics Revisited: The Effect of Time Preference. European Journal of Law and Economics, 10, 139 160, 2000. http://64.233.179.104/scholar?hl=en&lr=&q=cache:3jveIKB56kJ:ftp://wueconb.wustl.edu/econ-wp/mic/papers/0508/0508007.pdf

How have I not posted in 8 days? I’ll just post on this topic again, becuase Im sure there is something I’m supposed to be doing.  In the article, Thomas Sargent proposes a method to empirically test Irving Fishers hypothesis about real and nominal interest rates in the face of inflation.  This hypothesis has two formulations:

1) An increase in the rate of inflation will produce an equivalent jump in the nominal yield of bonds over the given time of maturity.   In the long run, a jump in expected inflation will leave the real rate of interest unaltered.  However, in accordance with the Keynesian critique of classical economics, the long run may be too long in the future.  For this hypothesis to work in the short run, “the LM curve is vertical, the IS curve is horizontal, or the Phillips curve is vertical (as it would be in long run).  These assumptions are very monetarist and classicist, along with the conclusion.

2) The more widely accepted Fisher hypothesis is founded on more likely assumptions.  First we must assume that by “rational expectations,” we mean that the public will expect whatever the economic model is able to confirm.  Thus, expectations are exogenous to the model.  Secondly, that the natural rate of unemployment hypothesis is true, and therefore no fiscal or monetary efforts can lower the unemployment rate in the long run.  If we assume these, then the real interest rate is independent from the systematic (M1, I think) part of the money supply and nominal rates are influenced only through expected inflation as influenced by the money supply.  The difference between 1 and 2 lies in the fact that in 2, we make no assumptions about the slopes of the IS LM curves in the short run.   The two assumptions are enough to separate real from nominal rates of interest. 

Sargent, Thomas J.  “Rational Expectations, the Real Rate of Interest, and the Natural Rate of Unemployment.”  Brooking Paper on Economic Activity, Vol 1973, No. 2 (1973), pp 429-480.   

The Address is: http://www.jstor.org/cgibin/jstor/printpage/00072303/di009424/00p0166r/0.pdf?backcontext=page&dowhat=Acrobat&config=jstor&userID=c76f587e@mwc.edu/01c0a8487500507fe6d&0.pdf