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

This paper takes the form of a playful discussion between two Australian economic students: Bert and Ernie. Bert seems to be arguing for the rational expectations theory, a proposition that boils down to the belief that the average consumer/investor know a lot about future policy, and the effects of that future policy. According to much of Bert’s argumentation, the knowledge and rationality of the average investor will be such that all government policy will be useless. Ernie, however, spends most of his time asking questions and raising objections. Bert begins the article by demonstrating for us graphically the classical monetarist approach; a price and income graph with a vertical supply curve, such that any increase in aggregate demand will translate directly (or in the long run) to a 1:1 increase in the price level.

A note: does the supply curve really have to be vertical, or just extremely inelastic such that prices always increase more than real output, and rather than leaving equilibrium at the point where the supply curve is unit elastic, employers, and consumers would rather stay there. Does this make sense?

Bert contends that the long-run Phillips curve is vertical. That means there is a natural rate of unemployment around which our economy will grow. “Government policy can bring about a departure from that only in the short run and then only by fooling people. But you can’t fool all the people all the time, Therefore, systematic policy is ineffective.” Indeed, later Bert points out that the only way to have any impact on the real output of the economy is by “inducing private agents to have mistaken expectations.” And so in doing this the government can have an impact that supercedes the expectations of the rational agents, however, the impact is likely to be negative and destabilizing

When an employer is deciding whether or not to hire someone, and that person is fully rational and information-imbued, he will need to take into account the future price of labor as well. Therefore, the temporary increase in aggregate demand that our monetary policy has bestowed upon us will not impress our employer. Nor will it impress the laborer, who will also anticipate the increased price level, and hence the later real wage reduction. This argument culminates to its apex on page 300 (of the reader). Why not just use a policy rule? “Any government that relies upon a policy rule—one that has a fixed growth of the money supply—will never cause any deviation from the natural rate. A random policy will affect real output. But any policy rule that is systematically relate4d to economic conditions, for example one designed with stabilization in mind, will be perfectly anticipated, and therefore have no effect on output or employment…to have real effects [it] must be completely unpredictable.”

The significance of this is made clear by Friedman. After WWII, the Phillips curve was god; our government thought that it could systematically exploit the unemployment-inflation dichotomy using aggregate demand. However, rational expectations got in the way, and dissolved the Phillips curve. “If people have rational expectations they wont be fooled by systematic policy even in the short run so there is no scope for short run policy either. This explains why the Phillips curve became unstable the moment policy makers tried to exploit it.

Then Ernie retorts with an argument from the Keynesian model. Monetary expansion leads to an effect on the interest rates that shifts to economy to higher output level. Businesses will expect the increase in aggregate demand and start producing before the demand hits the economy. In this way, monetary policy is actually more effective because of expectations. However, for this to happen, policy makers must take into account the economic effect of the policy, and the expectations effect of the policy, such that their actions are well integrated into both.

Rodney Maddock and Michael Carter.  A Childs Guide to Rational Expectations.  Journal of Economic LIterature (1982) 20, March pp 39-51.

In the article “the Triumph of Monetarism,” the author Brad Long delineates the differences and similarities between monetarism and Keynesianism, arguing essentially that New Keynesianism is an implicit endorsement of monetarism because they both arise from the same foundations/assumptions.  We can understand New Keynesianism as asserting five major propositions.  1) Frictions within the pricing adjustment mechanisms cause business cycle fluctuations.  2) Monetary policy is generally better at stabilizing that is fiscal policy.  3) There is first a general long run trend, and business cycles are variations around that trend, rather than something completely different. 4) We should use policy rules, rather than being so idiosyncratic about decisions.  5) Stabilization policy will always be limited.  Monetarism, in its simplest form, says that the stock of money is most important determinant of interest rates and prices within the course of the business cycle.  However, the author spends the majority of this article explaining the variants of thought within the monetarist tradition, beginning with Irving Fisher. 

This is not simply Hume’s basic quantity of money theory, but rather the application of that basic model to function as a policy tool.  What was most significant about this “first monetarism” is not so much the theory itself, but rather the critiques and ideas that were born from the debate other “subspecies” monetarists like Keynes and Friedman.  In fact, monetarism of this sort was considered “useless” by Keynes, because it was only oriented to long run equilibrium, and “in the long we’re all dead.”

Chicago Monetarism was more sophisticated because it concentrated on the velocity money and the function of banks as multipliers of the money supply.  About the great depression, the Chicago school blamed the monetary and fiscal policies that “had “permitted banks to fail and the quantity of deposits to decline.”  Therefore, their policy prescription was to expand the money supply and run a big deficit.  There are a couple major cannons of Chicago Monetarism.  1) The velocity of money was not constant.  They believed this because inflation and deflation raised and lowered the demand for money (because the returns to investment go down and up).  During booms and busts people would spend or hoard respectively, causing a further variant on the velocity.  2) The control of the money supply was not straightforward or easy.  With a fractional reserve system and no deposit insurance, banks will be unsure about deposit demand and there will be huge swings in the deposit-currency ratio—these two things determine the money multiplier.  This means that aggregate indicators are important to old Chicago types.

Classical Monetarism is classical in the sense that we “classically” understand the world in terms of this school of thought.  Born from the Chicago tradition, this basically asserted that the government has some influence over spending and business cycle stabilization, as we see evidence for in the Volker Chairmanship during the 1970’s, when he ended inflation and facilitated growth using monetary policy (and some psychology).  The author also talks about “political monetarism,” but it’s boring and kind of silly, so I’ll end my post now. 

“The Triumph of Monetarism?” by J. Brad de Long, 1999 from Monetarism Webpage at http://cepa.newschool.edu/het/schools/monetar.htm