Modern macroeconomics – a crash course
from Lars Syll
Not long ago, in an interview that Robert Lucas gave for the Wall Street Journal, one could read the following statement on rational expectations:
If you’re going to write down a mathematical model, you have to address that issue. Where are you supposed to get these expectations? If you just make them up, then you can get any result you want.
Rather gobsmacking, isn’t it? The really interesting thing to ask is, of course, if people do have rational expectations. And most of the time they don’t. Anyone can assume anything he wants when constructing deductive-axiomatic models. If these models are supposed to have anything interesting to say about real people in real worlds, they, however, have to build on knowledge of how people really behave when it comes to expectation formation processes.
Most of the interview with Lucas turns out to be nothing more than a rather revolting piece of self-righteous history revisionism. To get a more fair picture of what Lucas and the other freshwater titans of neoclassical economics accomplished with their rational expectations hypothesis – and in what context it happened – Paul Krugman‘s version of the development of modern macroeconomics is definitely more recommendable:
1. In the beginning was Keynesian economics, which was ad hoc in the sense that on some important issues it relied on observed stylized facts rather than trying to deduce everything from first principles. Notably, it just assumed that nominal wages are sticky, because they evidently are.
2. In the 1960s a number of economists started trying to provide “microfoundations”, deriving wage and price stickiness from some kind of maximizing behavior. This early work had a big payoff: the Friedman/Phelps prediction that sustained inflation would get “built in”, and that the historical tradeoff between inflation and unemployment would vanish.
3. In the 1970s, Lucas and disciples take it up a notch, arguing that we should assume rational expectations: people make the best predictions possible given the available information. But in that case, how can we explain the observed stickiness of wages and prices? Lucas argued for a “signal processing” approach, in which individuals can’t immediately distinguish between changes in their wage or price relative to others — changes to which they should respond by altering supply — and overall changes in the price level.
4. In the 1980s, the Lucas project failed — pure and simple. It became obvious that recessions last too long, and there are too many sources of information, for rational confusion to explain business cycles. Nice try, with a lot of clever modeling, but it just didn’t work.
5. One response to the failure of the Lucas project was the rise of New Keynesian economics. This basically went back to ad hoc assumptions about wages and prices, with a bit of hand-waving about menu costs and bounded rationality. The difference from old Keynesian economics was the effort to use as much maximizing logic as possible to interpret spending decisions. I find NK economics useful, if only as a way to check my logic, although it’s not really clear if it’s any better than old-fashioned Keynesianism.
6. The other response, by those who had already invested vast effort and their careers in the Lucas project, was to drop the whole original purpose of the project, which was to explain why demand shocks matter. They turned instead to real business cycle models, which asserted that the ups and downs of the economy are caused by technological shocks magnified by rational labor supply responses. Full disclosure: this has always seemed absurd to me; as many have pointed out, the idea that the unemployed during a recession are voluntarily choosing to take time off is something only a professor could believe. But the math was impressive, and RBC became a self-contained, self-replicating intellectual world.
7. The Lesser Depression arrives. It’s clearly not a technological shock; clearly, also, nobody is confused about whether we’re in a slump, as the old Lucas model required.
In fact, it looks a lot like what Keynes described, and old-Keynesian models work very well, thank you, both at explaining it and in making predictions about such things as interest rates and the effects of fiscal austerity. But the descendants of the Lucas project know that Keynes was wrong — it’s what their teachers and their teachers’ teachers have been saying all these years. They cannot accept anything resembling a Keynesian explanation without devaluing everything they’ve done with their intellectual lives.
And, moreover, prices and wages never were really sticky, as the present recession/stagnation shows. Keynes was not so keen on the stickiness, otherwise he would not have spent such a long time on effective demand: the general Theory ha both stickiness and failure of demand.
I had actually written a post about that very post by Krugman in which I suggested “So it is peculiar that Krugman thinks that “NK economics [is] useful, if only as a way to check my logic, although it’s not really clear if it’s any better than old-fashioned Keynesianism.” What logic? New Keynesian models assume a natural rate, and that the economy (without rigidities) moves to full employment! The problem with the NC/RBC/Lucas’ type of theory is not that it failed to predict the 1980s recession or that they think that most crises are caused by real shocks (although both propositions are obviously wrong), as Krugman seems to believe, but that they do maintain the fiction of an efficient market that clears (in their case too fast for Krugman’s taste) and that produces a natural rate. If he wants to move in the right direction Krugman should follow Galbraith and announce that it is time to ditch the natural rate hypothesis.” Full link here http://nakedkeynesianism.blogspot.com/2011/09/lucas-in-context-keynes-out-of-context.html
As I hsve been arguing for decades — Keynes never assumed stickiness in wages. In fact chapter 19 of the GENERAL THEORY is entitled “Changes in Money wages”. In this chapter Keynes demonstrates that even if money wages (and prices) are perfectly flexible, the system will not provide an automatic mechanism to restore full employment after any short fall in aggregate demand.
Thr cause of unemployment is savings in the form of liquid assets -=- where these liquid assets are money and any financial assets traded on a well organized and orderly markets. As Chapter 17 of the GENERAL THEORY proclaims , the “essential properties” of money and all liquid asssets are : (1) The elasticity of production is zero — and therefore any increase in demand for liquidity will not produce any increase in demand for labor to produce this liquidity , and (2) the elasticity of substitution between liquid assets and producible goods is zero and therefore even if producible goods prices fall relative to the price of liquidi assets,, producible goods will not be substituted for liquid assets and therefore the relative demand for producible assets will not increase.
Only Samelson was stupid enough to ignore Keynes’s message and insert the sticky wage and pice assumption to explain unemployment!!
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With regard to (1): this might not be totally true. Take the Swiss example: somebody has to produce the keystrokes to ‘print’ the billions and billions of Swiss Franks which are at the moment created out of thin air as a lot of people are at the moment investing their Euro’s in this particular kind of ‘liquidity’:). ‘Swiss frank collectors’, instead of ‘stamp collectors’ – stamps are a kind of printed money, too, of course. But indeed (2): people investing in these franks already had the option to buy Bulgarian stuff (Bulgaria has the lowest wages of the EU, wages which are about as low as German ones of 1910, according to a very rough calculation, while the Bulgarian truck drivers which I see on the Dutch roads are surely not less productive than the Dutch drivers. Same might hold (but I’m not an expert on that one) about the Bulgarian women who are supposed to be main inhabitants of certain districts in larger towns). Lower Eurozone wages might increase the purchasing power of these Swiss franks – but these lower wages also increase real wealth of the owner of the franks, possibly leading to even higher purchases of these franks. Steve Randy Waldman has some philosophical thoughts about this.
Paul, sometimes things go wrong when you are in a hurry. The response I posted earlier today on KEYNESIAN MACROECONOMICS and on which you then commented should of course have been placed here. Sorry for the confusion!