Econ 488: The Advanced Macro Adventure!

 This article is a reasonably causal yet skeptical assessment of real business cycles. Mankiw briefly describes varying degrees to which real business cycle advocates take their theory, beginning with those who use it as an indicator for the infallibility of hardcore classical economics. These economists believe that nominal variables are completely irrelevant and have no impact on the economy whatsoever; markets will always clear due to real variables alone. Business cycles, therefore, occur as the result of fluctuations in the level of available technology and because of a change in individual production functions between leisure and goods. The leisure-goods trade off is especially problematic as the idea contrasts empirical evidence. For example, in a recession, people consume less and increase their leisure time, and the opposite occurs in a boom. If both of these are normal goods (as real business cycle theory assumes), their reactions should coincide when confronted with the same economic stimulus.  This is where technology steps in to save the day. Real business cyclists argue that recessions occur when technology becomes less productive, which decreases the marginal product of labor and therefore the real wage. As a result, people will both decrease their consumption and increase their leisure. Interesting theory, but Mankiw isn’t having it - as a Keynesian, he believes that unemployment is caused by market inefficiencies, and that individuals are not making a conscious choice to enjoy more leisure by responding to fluctuations in real variables.

More lenient cyclists* treat economic shocks as incidents that are specific to one or a few industries, as opposed to the aggregate economy. The regression of technology in one industry effects aggregate wealth, and leads to a recessing business cycle. Another explanation for this notion states that recessions are caused by adjustment within the labor market as individuals find it less rewarding to work in one industry in relation to another. A recession in this case would be the result of this adjustment in the labor market. The second interpretation works well with Keynesian theory, since the only detail that differs between the two theories is the idea of whether workers are unemployed voluntarily or involuntarily in such situations. Cyclists argue that workers are merely attempting to maximize their utility by switching to a more financially rewarding job. However, in that case recessions would be coupled with a large number of job vacancies, which they are not. Instead, high unemployment coincides with low labor demand, indicating involuntary unemployment that Keynesians believe in. Cyclists also suspect that money has no impact on the real economy, and that instead money reacts to variation in output and never vice versa.

Real Business Cycle Theory provides an interesting way of looking at the short run behavior of the aggregate economy, but severely lacks convincing empirical data. I do like how it challenges generally accepted directions of causality, despite the fact that they lack evidence to support their ideas.  Why does the money supply necessarily have to effect output? They appear to provide logical, inductive reasoning as to why this and other assumptions may not be true as they are understood, but fail to fully support them. They appear to have been stirring things up in economic theory just for the hell of it, ultimately. Mankiw’s final remarks state that real business cycle theory has internal consistency and credibility, but lacks external consistency (which is real evidence). Perhaps I would have a deeper appreciation for the theory if I hadn’t read an article written by a critic, but nonetheless I enjoyed learning about cyclist rationale.

*I’m not brick dumb; I know that cyclists are people riding bicycles. I felt like shortening the term “Real business cycle economists” and “cyclists” was the most amusing alternative that flashed through my mind.

Mankiw, N. Gregory. 1989. “Real Business Cycles: A new Keynesian perspective.” In Journal of Economic Perspectives 3, Summer: 79-90.

Traditional classical thought assumed that price and wage flexibility were such that the economy always managed to move toward the market clearing level. This assumption was questioned by Keynes who argued that firms adjusted quantities because of price and wage stickiness, which decreased the likelihood of full employment. In reality, the traditional classical thought applied to larger items, such as homes and things that could be auctioned off, where price adjustment was a feasible option. The Keynesian way of looking at things applied more to smaller items, where a fixed price was a more pragmatic approach. New Classical economic thought provided a theoretical explanation for why this dichotomy exists.

New Classical thought introduces the profit maximization behavior of firms into their macro model. They assert that an equilibrium will not be achieved without information. In order for markets to clear, there must be perfect information which is only attainable by specialized traders with relatively clear rational expectations. Realistically, these assumptions can only refer to homogeneous products. (Heterogeneous products are a little trickier, and therefore more interesting.)

The price for information on expectations in the heterogeneous product market is greater than its homogeneous counterpart, and therefore specialized traders have no place in this marketplace. Therefore prices are more likely to be fixed. Heterogeneous products refer to anything where there is variation among specific choices of the same thing. Think of going to the grocery store and picking out fruit: you don’t want to just send a person to pick up a piece of fruit at random, because there’s a chance that it will be of a lower quality than what you expect. Choosing your piece of fruit requires deliberation, and therefore you need to cut out the middleman and set standard prices so the quality of the fruit isn’t up for debate. The labor market is the same way - an employer will want to assess the quality of a worker because of the abundance of variables involved in the labor market, and therefore is not likely to delegate the task to an arbitrary specialized labor trader (at least not in countries that respect human rights, more or less).

Price fixing allows firms to make a good available at a variety of locations with minimal transactions costs, and also avoids adjustment costs that he would need to accrue if he were interested in adjusting his prices to be market clearing. Therefore, price setters establish their prices to match their expected long run economic trends. This requires less coordination since the final price is created with enough leeway to account for short run price variation. Firms’ efforts to maximize their profits relative to competing firms also will inhibit them from adjusting their prices, as no firm wants to be the first to lower prices and thereby lose profits for the sake of being in equilibrium. They are more likely to adjust their quantities to account for a decrease in aggregate prices.

I don’t remember what it was about exactly, but the term “fixpricety” was somewhere in this chapter.

Shaw, G.K. 1984. Rational Expectations and Price Flexibility. in Rational Expectations: An Elementary Exposition, 73-82. New York, NY: St. Martin’s Press.

It’s half past one in the morning. This blog post requires a disclaimer. Since those weaken arguments, I’m not putting one on here - just imagine that I included a really killer one that COMPLETELY makes up for any inconsistencies or grammatical errors.

As Greenlaw said in class today, it is difficult to disentangle Reagan’s economics from his politics. I have thus far read two of his speeches: one from 1964 when he’s advocating presidential candidate Goldwater, one from 1983 when he was addressing the Heritage Foundation.  I also skimmed through an address he made to the national Evangelical church association, or some organization like that. My favorite line from that one was: Girls termed “sexually active” — and that has replaced the word “promiscuous” — are given this help in order to prevent illegitimate birth or abortion. This statement was in his argument of how planned parenthood-type organizations should be required to inform parents of girls who they were providing birth control to, and how the morality of the issue is greater than the respect for these girls privacy (this is how he phrases it, by the way, not me this time!). Granted, I’m sure that to some extent he had adjusted his language to appeal to his audience. Regardless, I find it a bit inconsiderate to assume that minors who are sexually active are necessarily promiscuous. This isn’t an economic argument, but I feel it is still important.

The article from 1983 was the first I read, and was intended as an address to the members of the Heritage Foundation but felt more like Reagan advocating his own policies. Apparently the economy was doing well at this point, having emerged from the recession of ‘82 (possibly ‘81, I’m not sure). He boasted that no one was using the term “Reagonomics” anymore because his policies were working. By cutting the federal budget by 40%, most of which was from welfare, he was able to give tax breaks of 25%. On the bright side, his administration did decide to work inflation indices into the tax system to ensure that people were not being taxed too much for their salary. He switches to discussing the Cold War, and the threat from the Soviets. It’s easy to see how his demonization of  socialist policies fueled his economic policy seeking less government involvement and fewer welfare programs. The Soviet Union was clearly not upholding the ideals it had been founded upon, and instead of acknowledging this inconsistency Reagan decided to not only identify the reality of the Soviet Union as the enemy, but also the sham ideals they were supposed to represent. He closes by discussing how America has become a city on a hill; given his audience, this is acceptable… but may not make for the best international policy of all time. Another oddity was that he glorified conservative thought and the possibilities it presents for our nation, but never really clarifies what exactly conservative thought is. He even at one point just says “I know it when I see it.” It seems that a general school of thought that is supposedly the beacon of success for our nation should be more identifiable than that.

The second real article I read was from 1964. Reagan didn’t discuss supply-side economics as much in this one, however he seems to already be teasing out the details of that theory, despite his goal being to advocate Barry Goldwater. He describes America as, more or less, the Mecca of freedom and the ONLY source of hope for those living in injustice. He attacks recent regimes for failing to balance the budget in 28 of the previous 34 years, and for allowing inflation to get out of hand. Most of all, he attacks government welfare, taxes, and subsidizing. When discussing agriculture, he is distraught that farmers have been put out of business while more government officials in the agriculture department are being appointed. He considers subsidies a waste of money, as the government is effectively paying people to not grow things on their land. It reminds me rather of a part in Catch-22 where one character specializes in not growing alfalfa and exploits the government  by using his subsidy money to purchase more and more land to not grow alfalfa on. From this I gather that he would prefer a free market for agricultural produce, which may drive prices down because of an increase in the surplus of goods. The subsidy is more or less an insurance mechanism for the farmers from what I understand, and saves them from their own profit-maximizing behavior.

He considers welfare a source of government expenditure that has gotten WAY out of hand, and highlights the difference between the sum of money that is being put into welfare programs and the sum of money that ends up making its way to the hands of those stricken with the burden of poverty. Given the number of impoverished people (defined as anyone making less than $3,000 per annum) and the amount of money that is going toward welfare programs, these individuals should be receiving an extra $4,600 on top of their $3,000 maximum, making them no longer impoverished. Instead they are receiving about $600, because the government has again assigned itself the task of saving people from themselves and establishing PROGRAMS instead of unregulated hand outs. While I agree that people take welfare for granted, it’s more responsible to spend the extra money to establish programs as opposed to giving potentially financially irresponsible people income they haven’t had to work for without any restrictions as to its use. This goes along with his rather exhausted theme of wanting to reduce the influence of government in all aspects of society. I say exhausted because he discusses this point ad nauseam in the remainder of the speech.

All of that sounds a little snide. Reagan’s speeches rub me the wrong way, but I don’t mean to attack him as a person. Also these are just my reactions to what I’ve read. Maybe I’ll appreciate his policies more as I continue to read, but it doesn’t look promising right now. I think I just dislike how politicians speak in general… so that might also do it. Anyway, I’m just making sure no one thinks I’m attacking Reagan personally, because sometimes people get really combative about that.

I demanded that my probably VERY inebriated, artist best friend draw me a picture of what comes to mind when she hears the term “stagflation.” I think she did a pretty good job:

I haven’t done expectations yet, but it’s on the way. I think this makes it kind of ok, though.

It’s my boyfriend’s 21st as of midnight, so I’m sharing my feelings to keep myself sane while providing moral support to him as he regurgitates the shots that his bastard, drunkard friends so eagerly shoved down his throat…. I’m pretty sure that’s not how it worked exactly, but that’s the picture he painted for me after his roommate deposited him in my care and wished me luck.

So I haven’t yet started on my expectations reading because I’m still trying to get a better understanding of monetarism. I’m reading the “Conversations with Economists” chapter on monetarism, and so far it’s making enough sense to me. I’m at the part where Brunner is discussing how monetarist thought reassesses the assumptions Keynes makes about politicians. What I get from it so far is that he disagrees with Keynes’ implication that individuals in the government are only concerned with social costs and benefits and have no personal ambitions. Instead he seems to adhere to the method of thought we developed in Humphrey’s comparative class last semester, where politicians are rational and self interested, and seeking to maximize their profits even if it’s at the expense of the public sector.

This logic makes sense to me, and it kind of creates issues with how I perceive my identity. Monetarists advocate limited government intervention in the private sector and therefore laissez fair policies, which are associated with conservativeness. I have, and still do consider myself a politically liberal-minded person, but my agreement with aspects of monetarist thought seems contrary to this fact. I think the issue has to do largely with the strict dichotomy between liberal and conservative. Politicians have as great a likelihood for exploitation of the public sector as corporations do in the private sector, and therefore both need to be limited. I guess that thought in and of itself is both liberal and conservative and at the same time neither. I don’t really know what that perspective gives me aside from non-idealistic. But there you have it. I’m going to go hunt down some former frat boys now.

    Friedman describes the origin of monetary policy and its strengths and weaknesses in “The Role of Monetary Policy”. Monetarism gained momentum in reaction to Keynes’ assessment of the Great Depression (referred to as the “Great Contraction” by Friedman), as Keynes’ followers believed that monetary policy had a minimal effect on monetary policy. This led to inefficient policies that adopted low interest rates regardless of the cost and thereby allowed for rampant inflation; this in turn stimulated the rise of monetarism. Monetarists reassessed major economic activity of the previous years in terms of flow variables, such as rates of inflation and unemployment, as opposed to stock variables, such as aggregate demand and price levels that assume a specific point in time.

Friedman clearly states misconceptions about monetary policy and explains the realities that give rise to these concepts. Specifically, monetary policy cannot “peg” interest rates or unemployment rates. The economy’s reaction to a change in the money supply as induced by a change in the interest rate is often lagged. First the change will impact spending, then income and prices, then the demand for funds. Ultimately these changes will force the interest rate to be driven in the opposite direction to regulate the money supply. The response of the economy to variation in the money supply results in the cyclical behavior of monetary policy.

Monetary policy’s behavior in relation to unemployment is a bit more tricky. Friedman uses the Phillips Curve as a starting point for his analysis, stating that the general idea is accurate but the implications are oversimplified. Indeed, there does appear to be a relationship between inflation and unemployment, but the trade off is not that simple and does not refer to clear-cut stock variables. An expansionary policy would lead to both an increase in aggregate demand and therefore an increase in employment at the same nominal wages. However, this policy would also cause prices to rise and therefore real wages would fall. Once the workers catch on to the fact that their real wages have fallen, the will either refuse to work at their current wage rate or will be laid off as a result of the fall in consumption, driving unemployment upward. Like the previous issue with pegging the interest rate, any alteration targeted toward moving unemployment in one direction will eventually lead to a reaction in the opposite direction. The major difference between this argument and the Phillips Curve argument is their treatment of inflation and unemployment. Monetarist theory treats these items as flow items, stating that a general increase in the rate of inflation will cause the unemployment rate to decrease.

While monetary policy is often assaulted by individuals with these misconceptions, its tools can be useful in minimizing the shocks to the economy. Borrowing an analogy from Mill, Friedman describes money as a machine, or the means to exchange. The purpose of monetary policy is to make sure that the money machine is working properly and smoothly. Therefore, its task should be to address external shocks and internal cycles by carefully adjusting the money supply. These changes should not be dramatic, as a substantial change of direction in policy would cause more harm than good : basically it would be an internal shock. Historically, changes such as these have made the economy unstable because consumers and firms become unsure of their expectations in regard to prices and real wages.

I’ll probably either come back to make this more reader-friendly later or just try to read something else. I read Greenlaw’s post about not choosing the same one as other people too late, unfortunately. In my defense, I start reading two of the other articles in the Reader, but realized that I have too limited a background in monetarist theory to fully absorb the content of those articles. I’ll do my best to get through one that no one else wants to read later. Promise.

Friedman, Milton. 1968. The role of monetary policy. American Economic Review 58 (March): 1-17.

     This article explains the origin of the Phillips Curve and subsequent theoretical reactions to it. The Phillips Curve represents the negative relationship between unemployment and inflation. This concept was further supported by Lipsey’s discovery of a negative relationship between wage inflation and the demand for labor and Hansen’s definition of frictional unemployment. The Phillips Curve refuted the Keynsian assumption that inflation only occurred after full employment has been reached. This was largely because when unemployment rose, there was no observable decrease in consumer prices. However, commodity prices are less sticky and are more reactive to demand changes. This assumption was also challenged during the 50’s and 60’s, when there was considerable inflation before full employment was reached.

During the 70’s, both unemployment and inflation increased. The Philips curve was seemingly refuted. Some argued that this was rather an indication of a rightward shift in the Philips curve due to external shocks (namely the increase in the labor supply due to women and teenagers and increases in the cost of resources). Monetarist theory, on the other hand, argued that the Philips curve would not explain long run trends. Instead, monetarists believed that real wages are the driving force behind all variation in the labor market. Changes in the equilibrium come from lags in information. (E.g., when the real wage declines, firms are more likely to realize it first. They will offer workers higher nominal wages, which the new workers will later refuse when they realize that the purchasing power of their wages is actually not to their liking and equilibrium will be restored.) Another argument popularized by “new classicist” theory states that inflation has no role whatsoever on unemployment as its trends are predictable, and rational economic actors will therefore adjust their behavior accordingly. Instead of variation in unemployment coming from judgment errors on the part of workers, instead these errors are made on the part of firms when they believe that the price of their good alone is rising independent of the prices of other goods, and attempt to maximize their profits accordingly.

If you’re looking to learn about the Phillips Curve, this article is not the way to do it. I have an understanding of how the Phillips Curve operates, but I don’t understand how it was created or the micro nuances of its behavior (aside from what I can logically work out on my own). The article is very useful in describing the debate over the credibility of the Phillips Curve.

Greenwald, Encyclopedia of Economics, pp. 778-782 (expect a more complete citation later)