Advanced Macro

Is Macroeconomics for Real?

In this paper, Hoover brings about the idea that macroeconomics (or the study of broad aggregates) cannot completely be broken down to a microeconomic level. What in the heck does ontology mean anyways? Dictionary.com has a horrible definition. Hoover argues that macroeconomic aggregates are external and objective, refuting the microeconomics base of macroeconomics. This, I disagree with.  While looking at aggregates in general, all aggregates can be broken down to a basic level—if you are studying the universal behavior of humans, its basis is on the individual human. I believe, fundamentally, an economy consists of “individual economic actors” whose decisions are what cause the economy to change or evolve. Hoover quotes Levy that individualism is flawed because these agents (acting sometimes on incomplete information) make decisions for large entities (firms). But does that not still emphasize that the basis for firms are the individuals themselves? Hoover contradicts himself later in the paper by saying “On any interpretation, macroeconomics takes a larger view of the economy and deals with aggregates, which are, in turn, constructed from characteristics of individual economic actors.  It is helpful to distinguish two types of aggregates.”

Hoover breaks down aggregates into two parts: natural and synthetic. Natural is simple sums or averages, however, I do not fully understand what a synthetic aggregate is, however, I believe he talks about aggregates that are related. (Apples, oranges and Volkswagens are not). I believe Hoover’s insight on splitting the hairs between natural and synthetic aggregates is superfluous. He suggests aggregates are not individual existing entities but additions of individual variables (duh). However, Hoover says specifically “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”, but not vice versa. Hoover is an advocate of Macroeconomics over Microeconomics, claiming macro will supervene in reality. One good point Hoover makes is the unpredictability of economic forecasts and its ranking among the sciences—it is not as exact as chemistry or physics, but it is held in higher regard than climatology, geology, and meteorology (this is comforting considering its my major).

What Would Reagan Do?

First and foremost I’d like to point out I’m shocked ANY professor at Mary Washington allows (or encourages) their students to analyze Reaganomics. Although I am not a staunch conservative, it excites me to get the opportunity to study this topic because of its real world application.  The problem is, occasionally, economic theories are so abstract and exist in “magical worlds”, it is important to take time to relate it to actual events or periods.

I am, myself, a modest conservative.  I hold true to the ideals that “the best government is one that governs the least”.  Perhaps it is the true monetarist in me that believes the less government interventions (specifically systematic intervention) is best.  Allow the “invisible hand” of the economy to work and it will. Many of my fellow conservatives (the ones that have any sort of an economics background to be exact) will agree with me. Ronald Reagan believed the same.  What Would Reagan Do? Reaganomics was born from this idea of limiting big government’s involvement in the economy.  Specifically, reduce the growth of government spending, reduce marginal tax rates on income from labor and capital, reduce regulation, control the money supply to reduce inflation. These were the pillars of Reaganomics, which were in dire need after the Stagflation fiasco. In Reagan’s first inaugural address, he promised to limit the size of the federal government, which I believe is key to economic stability. Reagan’s tenure in office was a successful one, with roughly 3.4% growth rate each year. He introduced the idea of the “trickle-down” tax cuts that allowed for more spending. “Only by reducing the growth of government,” said Ronald Reagan, “can we increase the growth of the economy.” However, Reagan’s endorsement of the reduction of the Federal Reserve’s money growth is an odd twist in his actions, which perhaps lead to the 1982 recession. However, the drastic increase in the deficit (fueled by less taxes and increased military spending) has hurt the economy ever since.

The Cambridge Keynesians

 The Cambridge Keynesians were the fundamentalists of the Keynesian school of thought, focusing their efforts on Keynes’s General Theory. Robinson, Kahn, Sraffa, Robinson, and Meade were all the “Cambridge Propers” or “Circus”, or the original bunch who studied and commented on Keynes’s General Theory after its publication.    

Joan Robinson: She contributed much to economics during the 1930-1940s. However, her most revolutionary and lasting idea was her introduction of the theory of imperfect competition into economics. She studied Karl Marx and was one of the first to view Marx as a true, noteworthy economics. In 1965, she published an extension of Keynes’s theory called The Accumulation of Wealth, addressing the issue of capital accumulation, and long run growth and expansion.  She assisted in introducing the Cambridge Growth theory, which covers the holes apparent concerning growth theory in Keynes’s work.

Richard Kahn: One of the first economists to focus on bringing new-classical economics and new-Keynesian economics together. Specifically the IS-LM model.  The IS-LM model, when properly applied, yielded results that favored the Neo-classical full employment conclusion.  However, New-Keynesians response was to include rigid money wages, as well as other imperfections naturally seen in an economy. “Thus it is referred to as a “synthesis” of Neoclassical and Keynesian theory in that the conclusions of the model in the “long run” or in a “perfectly working” IS-LM system were Neoclassical, but in the “short-run” or “imperfectly working” IS-LM system,  Keynesian conclusions held”. During his earlier years, Kahn introduced the idea of the “multiplier” which Keynes was rumored to have “stole” for his General Theory.

Piero Sraffa: Aided in Joan Robinson’s work on imperfect competition. He spent 20 years reviewing and editing David Ricardo’s work.

Roy Harrod—Responsible for laying the analytical groundwork for imperfect competition. Also, introduced the multiplier-accelerator model, as well as the profit-maximizing behavior. However, Harrod’s work was continuously stolen from him or he did not receive the credit deserved.

Old and New Keynesians, By Bruce Greenwald and Joseph Stiglitz

Although old and new Keynesian theory differs, there are a few things that both hold to be true. 1) An excess supply of labor exists at the prevailing level of real wages, 2) Long-run aggregate level of economic activity fluctuates variables, not including shocks like technology, tastes, or demography, 3) money (kinda) matters, 4) government intervention is sometimes necessary to stabilize the economy (inflation targeting), 5) that wages and prices are quick adjusting beasts when the labor markets clear, and 6) microeconomics should be the basis for macroeconomic theory (I agree).

New Keynesian economics was a sort of response to the monetarist movement after the 1970s.  While New Keynesian economics mostly is an evolution from old Keynesian economics, there are still some significant differences. First, the flexibility of wages and prices in an economy might affect the economy’s volatility, and cause more damage than good. Secondly, there exist natural economic forces in any economy can cause any changes to be extreme. Thirdly, more ridged prices may stabilize the economic fluctuations.

Furthermore, new Keynesian economics introduces three ideas that play may explain basic macroeconomic uncertainties. Risk averse firms—in the credit and equity market, those who are more likely to default (or most overvalued firms) will likely issue on a line of equity, where as those more stable companies will use credit. In this case, the issuance of new stock has a negative effect on the economy. Rightly put, “A risk adverse firm will be sensitive to the risk associated with any action (including inaction). Production itself is risky”. They introduce ‘Portfolio Theory’ where a firm takes into account risk, and expected returns when making decisions about prices, wages, employment and production. The company will naturally change their decision as the economy changes. Three things affect a company’s willingness to take on risks: 1) the overall state of the economy, 2) the firm’s cash position, and 3) the overall changes in the price level.

However, the game changes with the cost of bankruptcy. It causes the aggregate supply curve to shift left because the amount firms are willing to produce is reduces. The cost of bankruptcy is an incentive NOT to produce.

New Keynesians continue by claiming banks who are inherently risk averse will exacerbate the effects of a negative economic downturn. Monetary policy is most effective at this point by changing the reserve requirement, and raising or lowering the discount rate may be more effective than manipulating the interest rates.

New Keynesians touch on the subject of ‘involuntary unemployment’ where people are willing to work at the real wage rate but cannot find jobs. “Efficiency wage theories can be used to explain why firms do not lower wages even in the presence of an excess supply of workers, and also why they avoid two-tier wage systems, under which new workers are hired at lower wages than existing workers”. This finally explains “sticky wages” to me.

Furthermore, New Keynesians emphasize the idea of price rigidity and price stickiness “menu prices” where firms only change their prices periodically (because the cost is high to do so)

Some Skeptical Observations on Real Business Cycle Theory

Lawrence Summers

 First and foremost, I enjoyed reading Lauren Summers “Some Skeptical Observations on Real Business Cycle Theory”. Unlike his fellow garrulous peers, Summers presents a reasonably “easy-to-read” rebuttal of Edward Prescotts “Theory Ahead of Business Cycle Measurement”—an economic breath of fresh air, so to speak.  Summers believes that economic variables are pulling ahead of economic theory.  Business Cycle Measurement is not in sync with the theories. In addition, Prescott’s paper does not address nor explain the Business Cycle issues in modern capitalist societies.  Is this not why theories exist? To apply to the real world? A point made by Summers is that “extremely bad theories can predict remarkably well”.  The business cycles maybe be caused by random fluctuations in productivity but is this another example of a lucky bad theory? Summers dissects Prescott’s theory down to four areas: parameters, shocks, prices, and exchange failures. Parameters: Summers suggests that the parameters used in Prescotts argument are incorrect, and that Prescot relies on “selective reading” in order to represent his case. The parameters in economics are not so cut and dry. Shocks: Prescott’s primary shock to the economy is based on technology.  Summers believes he omits labor hoarding, etc. Evidence of such technological shocks are lacking. The majority of these shocks can be attributed to labor related issues.  Prices: Prescott’s analysis of the Business Cycle Theory does not include prices, which Summers finds absurd.  Exchange Failures: Prescotts claims that the cyclical variation in business cycles are due to exchange mechanism failures. However, he does not conclude what those failures are, however Summers suggest it is the breakdown of the credit environment.

After reading Prescotts’s “Theory Ahead of Business Cycle Measurement” I concluded he presented his argument in a concise and clear manner. I especially enjoyed his simplistic definition of Business Cycle phenomena, but I too thought that the technological shocks were not the only shocks needed to be discussed. Summer’s makes very valid points to which I did not even notice after reading Prescott.

The New-Classical Contribution to Macroeconomics

By David Laidler

After the “destruction” of the Keynesian following during the 1970s, new-classical economics was born as a response. A few of the foundations of New-Classical Macroeconomics is as follows: 1) agents are rational, utility-maximizing individuals who practice the rational expectations theory, 2) the economy as a whole is assumed to have equilibrium and full employment and potential output, 3) this equilibrium is always set at the market clearing price and wage adjustment, and 4) that no systematic economic policy is effective.

Laidler states the Neo-Classical response to the stagflation of the 1970’s was such: “First, that Keynesian orthodoxy had underestimated the role of the quantity of money as an influence on aggregate demand in general and the behavior of prices in particular, and second that the idea of a stable inflation—unemployment trade-off—the Phillips curve—was based on an implicit assumption that the private sector of the economy suffered from perpetual money issues. The author, new-classical economics is a forceful alternative to the Keynesian school of thought, but can claim no theoretical challenge.

One of the largest contributions to macroeconomics, I believe, is the neo-classical theory of Rational Expectations, by Robert E. Lucas Jr.  However, I do not fully grasp the economic definition of “sticky” wages or prices, so I will not dare venture any further. He claims “it is possible to derive predictions about the aggregate behavior of the economy directly from premises concerning individual behavior, but the rational expectations theory gives no prediction to human behavior. The neo-classical rational expectations theory suggest agents postulate expectations “as if” they were fully informed with complete knowledge, and make no mistakes outside of random exogenous shocks. These shocks include ‘policy surprise’ and technological ‘real shocks’. Thus, knowing the importance of information in this economy, when information changes, the economy’s behavior naturally follows suite.  Laidler also believes, not only are the agents utility maximizing, but the policy-makers as well.

The author does not hid the fact he believes New-Classical Economics has given little of substance to the economics community, and denies the “inherent superiority” of the school of thought claiming it “makes false predictions about the very phenomena with which it purports to deal”.

A Child’s Guide to Rational Expectations

I found this discussion between “Bert and Ernie” interesting. Bert (as in the Sesame Street character) seems to have a better grasp of Expectations than Ernie, or at least have read more Expectations material.  However, first and foremost, they both agree that “Rational expectations is the application of the principle of rational behavior to the acquisition and processing of information and to the formation of expectations”. 

Although it is apparent to me that the majority of economic material is more cumbersome to read than Thoreau’s Walden—economists have a tendency to use gratuitously big words and be relatively long-winded in their points—Bert summarizes expectations by simply saying “If you expect the real wage to be $10 per hour this week, and $1 next week, then it makes sense to work as much as possible this week, and have some time off next week. Therefore, the number of hours worked in any period, that is, the labor supply, will depend not only on the current real wage but on the expected future real wages”. This is a fantastic, simple snippet of expectations.

However, this the definition out of the way, the meat of Rational Expectations is more complex. Bert points out the idea that government policies designed to change the level of aggregate demand are not likely to be effective because the aggregate supply curve is vertical, thus output cannot deviate. He suggests that in order of policy to be effective, the government must fool fully-informed agents about their expectations—i.e. the government will attempt to enact an opposite policy to make the agents react in the correct way. The argument is against systematic policy changes and the “monetary policy must be completely unpredictable”.

Bert points out Friedman’s idea that in the long run, a government who tries to fool their constituents will not be effective in the long run, thus government policy can only be effective in the short run.  However, if individual agents have rational expectations, they cannot even be fooled by systematic policies in the short run. Bert, the obvious “hands-off monetarist” believes this is why the Philips curve continues to be unstable. Ernie, the Keynesian voice, claims that business can actually aid in making the policy more effective because, using rational expectations, they will try to exploit the interest rates to expand their output.

In the end, I believe, Bert was the victor. However, rational expectations is the best guess of the future, assuming all those decision makers have good available information. However, this theory does not predict human behavior. The theory of rational expectations claims that any deviation from the expected price from the actual price is caused by faulty information or random chance. Thus, pricing in rational expectations can be concluded to be P = P* + e, where price equals rational expectation price and e is the random error term. This is an important point in studying rational expectations.

Monetarist and Contributions

Jean Bodin- Put forth the first statement in the Quantity Theory of Money.John Locke- Introduced the concept of the “velocity” of money, as well as the “natural labor theory of property”. This suggested that, “whoever works the land, owns the land”. Simon Newcomb- One of the main developers of the “Quantity Theory of Money” using mathematics formals and laid the ground work for the theory of loanable funds through his distinction between stocks and flows. Newcomb was also an avid proponent of laissez-faire.Irving Fisher-  The gentleman who bought economics the “indifference curve”, the “Phillips curve”, and expounded on Newcomb’s distinction between “stocks and flows”  James Laughlin- An avid supporter of the Federal Reserve System and an outspoken “Apologist”.Henry Simons- A vicious proponent of laizze-faire, Simons vehemently opposed the New Deal policies, but did urge the government to pursue Anti-Trust policy. He called for “active monetary expansion via deficit spending Milton Friedman- Friedman led the charge against the Keynesian school of though. He introduced the Permanent Income Hypothesis. He believed “money matters” and rejected the IS-LM dichotomy. After reevaluating the Phillips Curve, Milton introduced the Natural Rate of Unemployment theory. Robert Lucas- Introduced the concept of “Rational Expectations”, and “buried” the New-Keynesdian orthodox. He advocated the supply-side economics in the “Real Business Cycle” theory and introduced the  idea of human capit

Whilst the Phillips Curve has always been one of those elusive economic topics that I have never quite grasped, my reading of the “The Phillips Curve” was slow and deliberate but gave me a clearer understanding. These are the key points I concluded and/or questions I have:

1)     As unemployment increases, then wage inflation declines—price inflation was negatively correlated with unemployment

2)     Lipsey’s theory was based on studying micro-level industry: the larger the excess demand for labor in a particular industry, the faster the rate of adjustment of the money wage.

3)     Is positive unemployment eventually eliminated?

4)     Aggregating the Lipsey’s theory was the solution to the Neo-Keynesian problem, however, the aggregate Phillips curve is shifted to the right of the industry Phillips curve

5)     Why is the zero-inflation unemployment rate for the aggregate is greater than  the zero-inflation unemployment rate for the industry?

6)     Are we above full employment because “positive unemployment” exists?

7)     Excess labor demand exists in the aggregate

     Aggregate wage inflation increases because industries will raise wages to attract new workers.  However, in order for their current industries to retain the workers, those industries will also increase wages to keep their employees. This explains why even without a rise in demand, wage inflation persists.

9)     The Phillips curve can be used to manipulate levels of inflation and employment in an economy. It is now an impressive economic tool.

This article does an excellent job of explaining the inflation-and-unemployment tradeoff. However, the issue with aggregating an industry model and getting different results intrigues me.  The article’s explanation of the difference between the industry and aggregate Phillips curves is a little lacking.

Arthur Cecil Pigou-

Educated in Cambridge, Pigou was an individual who enjoyed great success during his studies in Economics. Pigou’s 3 main interests were 1) the history of the labour movemovement, 2) tariff reform, and 3) wealth and welfare. 

Pigou also wrote a number of economics books or articles.  Pigou’s The Theory of Unemployment evolved into what is known as classical marginal productivity theory.  In A Retrospective View and Employment and Equilibrium, he squashed a friendly fued with Keynes, acknowledging that “short run equilibrium with a high level of unemployment was indeed a possibility”.  He also introduced the idea of the “real balance effect” or that “lower wages lead to lower prices which in turn lead to an increase in the real value of cash balances held by the private sector.

Most importantly, however, Pigou differentiated between goodness and satisfaction, introducing the term “utility” into the economic mix.

However, as dry as the previous paragraphs describing Pigou’s studies were, his life was redeemed significantly with two small sentences about Pigou’s past-times:

“In the Alps, which he started visiting in 1907, Pigou climbed with

the best of his day (including George Mallory, lost with Irvine near

the summit of Everest in the 1924 expedition) without himself

claiming to be among the really great. It was a passion that did not

wane…”

Pigou’s perpetual vertical tendencies (and trust me, they are strong tendencies), as well as his devotion to economics, leads me to conclude one thing about this individual: he is a man after my own heart.