Vijayamohanan Pillai N. system of markets

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Macroeconomics:Macroeconomics:IntroductionIntroduction

Vijayamohanan Pillai N.

6 October 2008 Vijayamohan CDS MPhil

The first published use of the term

"macroeconomics" was by the

Norwegian Economist Ragnar Frisch

referring to the Walrasian economy-wide

system of markets

in 1933 in Propagation Problems and

Impulse Problems in Dynamic

Economics. London: Allen & Unwin6 October 2008 Vijayamohan CDS MPhil


For Marx (1867) classical political

economy begins with

Sir William Petty (1623 – 87)

in the 17th century

and ends with

David Ricardo (1772 – 1823)

Classical Economics


for Keynes (1936: 3 fn)

the classical school begins with


and ends with

Arthur Cecil Pigou

(1877 – 1959).

Classical Economics


1. Labour theory of value:Adam Smith (1723 – 90)


andKarl Marx (1818 – 83).

Distinction based onTheories of value:


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2. Marginal Utility theory of value:Hermann Heinrich Gossen (1810 – 58);

William Stanley Jevons(1835 – 82)

Carl Menger (1840 – 1921)

Marie Esprit Leon Walras(1834 – 1910)

Alfred Marshall (1842 – 1924)

Distinction based onTheories of value:


Irving Fisher, Friedrich Hayek,

the Cambridge Marshallians (Pigou,Hawtrey, Robertson and youngKeynes himself)

and the Stockholm School (Myrdal,Lindahl, Ohlin, Lundberg).


Marginal Utility theory of value:‘Marginalist revolution of 1871-4’:

Neo-Classical Economics

No ‘macroeconomy’ for the neoclassicaleconomists, before the 1920s

The Say's Law, the Quantity Theory,business cycle and growth theory were notpart of neoclassical economics.

Neo-Classicalmacroeconomics


1920s, the neoclassical theory cameinto contact with business cycletheory.

They were at a loss to explain thepost-World War I economic crisis inEurope.

And the Great Depression that wasinitiated after 1929 also.

Neo-Classicalmacroeconomics


Neo-Classical macroeconomics

erroneously called

Classical macroeconomics

in text books

thanks to Keynes’ use of the term

‘Classics’

Neo-Classical Macroeconomics ≠ Classical Macroeconomics


DISPUTES INDISPUTES INMACROECONOMICSMACROECONOMICS


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Disputes In MacroeconomicsDisputes In Macroeconomics

NewNew ClassicalsClassicals SupplySupply--siderssiders New KeynesiansNew Keynesians

Edmund PhelpsRonald ReaganRonald ReaganRobert LucasRobert Lucas

Milton FriedmanMilton FriedmanJohn M. KeynesJohn M. KeynesAlfred MarshallAlfred MarshallNeoNeo--ClassicalsClassicals KeynesiansKeynesians MonetaristsMonetarists


Hermann Heinrich Gossen (1810 – 58);

William Stanley Jevons(1835 – 82)

Carl Menger (1840 – 1921)

Marie Esprit Leon Walras(1834 – 1910)

Alfred Marshall (1842 – 1924)

In the NeoIn the Neo--Classical IslandClassical Island


Irving Fisher (1867 – 1947)

Friedrich August von Hayek(1889-1992)

the Cambridge Marshallians

– (Arthur Cecil Pigou,

– Ralph G Hawtrey,

–



the Cambridge Marshallians

– (Dennis S Robertson andyoung Keynes himself) and

the Stockholm School

– (Gunnar Myrdal, Lindahl, BertilOhlin, Lundberg).



• Laissez-faire “Let it be”

• Full employment is the norm.

• Vertical Aggregate Supply Curve

• Stable Aggregate Demand

• Perfect foresight:

No imperfect information



Real Output Depends Upon…

1. Say’s Law (Jean Baptiste Say

(1767-1832)

2. Flexible Prices and Wages =

Continuous market clearing



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Quantity Theory of Money

a la David Hume (1711-1776):

MV = PY

Velocity of circulation constant

Only transaction demand for money

No speculative demand



John Maynard Keynes (1883 – 1946)

Keynes’ Circus:

Joan Violet Robinson (1903 – 83)

Richard F. Kahn

Piero Sraffa (1898 – 1983)

Edwin Austin Gossage Robinson

James E. Meade (1907-1995)

In the Keynesian LandIn the Keynesian Land


Early Post Keynesians

Joan Robinson;

Piero Sraffa;

Nicholas Kaldor (1908 – 86);

Michal Kalecki (1899 – 1970)



Active government policy is needed tostabilize the economy.

“Laissez-Faire” is subject to recessionsand widespread unemployment

AD is Unstable (Investment fluctuates)

Significance of speculative demand formoney

Fiscal policy effective; monetary policynot.



..

Free gifts to every kid inFree gifts to every kid inthe world? Are you athe world? Are you aKeynesian or something?Keynesian or something?


Neo-Classical – KeynesianSynthesis

Neo-Keynesians

IS – LM Model

John R Hicks (1904 – 1989) at LSE

with

Paul Samuelson (1915 -)

and

Alvin Hansen in America

Hicks (1937) "Mr Keynes and the Classics: A

suggested interpretation", Econometrica6 October 2008 Vijayamohan CDS MPhil

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Neo-Keynesians

Franco Modigliani (1918–2003);

James Tobin (1918–2002);

Robert Solow (1924 -)

In the 1950s and 1960s virtually all

macroeconomists except

Milton Friedman (1912 – 2006)6 October 2008 Vijayamohan CDS MPhil

Sticky wages : Modigliani (1940)

Startling result of the IS-LM model:

unable to obtain the Keynesian result of

an "unemployment equilibrium".

Yield the Neoclassical result of "full

employment", with the real balances or

Pigou effect (Don Patinkin 1956).

Neo-Keynesians


So, in order to generate an

"unemployment equilibrium" as a

solution,

rigid money wages, interest-inelastic

investment demand, income-inelastic

money demand or some other

imperfection added to this system.

Neo-Keynesians


Hence a "synthesis" of Neoclassicaland Keynesian theory:

Neoclassical conclusions in the "longrun" or in a "perfectly working" IS-LMsystem, but Keynesian conclusions inthe "short-run" or "imperfectlyworking" IS-LM system.

Interpretation of the General Theory asthe economics of disequilibrium.

Neo-Keynesians


the Phillips Curve (a la Alban W.Phillips 1958; Lipsey, 1960) addedto account for inflation.

The international sectorincorporated into an extended IS-LMsystem known as the Mundell-Fleming model (Robert A Mundell,1962).

Neo-Keynesians


providing "microfoundations" for thebasic Keynesian relationships:

the consumption function wasformalized as a utility-maximizingproblem by Franco Modigliani

and Richard Brumberg (1953)

Neo-Keynesians


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"microfoundations"

the investment function was derivedfrom profit-maximization by Dale W.Jorgensen (1963) and Robet Eisnerand Robert H. Strotz (1963);

the money demand function derivedfrom utility-maximization by WilliamJ. Baumol (1952) and James Tobin(1956; 1958);

Neo-Keynesians


"microfoundations"

the transmission mechanism(i.e. the impact of LM on IS) wasexpanded and given more detailedanalysis by Lloyd Metzler(1951), James Tobin (1961 1969) andmany others.

Neo-Keynesians


For a long time, the Neo-Keynesiansystem was synonymous with the‘Keynesian Revolution’ and washighly influential in both theoretical,applied and policy work.

The post Keynesians were deadopposed to it – ‘KeynesianFundamentalists’

Neo-Keynesians


Paul Davidson

created the term Post-Keynesian

To separate

the economics of Keynes

From NeoKeynesian economics

Post KeynesiansPost Keynesians



The Cambridge Keynesians –Joan Robinson,

Nicholas Kaldor,

Michal Kalecki,

George L.S. Shackle,

Roy Harrod from Oxford


and their American counterparts –Evsey Domar,

Abba Lerner,

Sidney Weintraub, Paul Davidson,Alfred S. Eichner, Hyman P. Minsky,Alain Barrère, Josef Steindl,Athanasios Asimakopulos,Edward J. Nell



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They did not employ the IS-LM system

but continued on what they perceived to

be the next logical step:

extension of the General Theory into the

longer run, the "dynamic" economy –

dynamic growth and business cycle

models



The neo-Keynesian interpretation of theGeneral Theory as the economics ofdisequilibrium in a short-run generalequilibrium model : illegitimate

Joan Robinson called it

‘the bastard Keynesianism’

in 1962 in her review ofHarry Johnson’s Money, Trade andEconomic Growth (1962).



The MonetaristsThe Monetarists

Milton Friedman (1912–2006)and Co.

‘Second Chicago School’Nobel prize: 1976


MonetarismMonetarism

"Monetarism“ coined in 1968 byKarl Brunner

became a powerful intellectual forcein the late 1960s and early 1970s,

In the late 1970s and early 1980schanneled into economic policy.



Monetarism has since given way tothe more mathematically rigorousand "Walrasian"New Classical economics of

Robert E. Lucasin the 1970s and 1980s –the ‘Third Chicago School’.



“inflation is always and everywhere amonetary phenomenon”

“money is all that matters for changesin nominal income and for short-runchanges in real income”

(Friedman, 1970)

"Quantity Theory" relationship betweenthe money supply and prices


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(1) monetarist transmission mechanism:agents dispose of excess money supplyby purchasing goods rather than bonds.

(2) stability of money demand:in practice, the demand for money is astable function of wealth, prices, pricechanges and interest.

Central features of Friedman'sMonetarism


(3) money-to-income causality:movements in the money supply have beenthe primary cause of business fluctuations;movements in aggregate demand for goodshave relatively little impact.

(4) natural rate of unemployment hypothesis:there exists a unique rate of unemploymentthat is associated with non-acceleratinginflation and that, in the long run, theeconomy will settle at such an unemploymentrate.



(5) superiority of monetary policy rules:monetary policy is much more effective thanfiscal policy;

So Central Banks target money aggregatesrather than interest rates;

Following a ‘Constant money growth rule’ is,at least in the long run, better than adiscretionary, counter-cyclical monetarypolicy.



Business cycle theory:

Imperfect information:

Adaptive expectation hypothesis

“Fooling Model”



From 1960 to 1973, US-Europeaneconomic history well explained byKeynesian economics.

But the 1973 oil shock, by contrast,baffled it;

and the Keynesian economists began torecognize the same basic microeconomictool : the supply/demand diagram.

NewNew ClassicalsClassicals::


NewNew ClassicalsClassicals

Thus entered the AD – ASdiagram,introduced in the late 1970s (intextbooks)by (Neo/New-)Keynesianeconomists (like Robert Gordon,Edmund Phelps and Alan Blinder).

Could explain 1973 upward supplyshock, causing Stagflation6 October 2008 Vijayamohan CDS MPhil

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But no policy solution

Keynesian failure

"Monetarist experiments" ofdisinflation in the late 1970s andearly 1980s in several Westerncountries, the US and the UK.

Further disaster



Thus the advent of New Classicals

A dramatic attack by Robert Lucasand Thomas Sargent at the annualconference of the Federal ReserveBank of Boston in June 1978, onthe very foundation of Keynesianeconomics

"After Keynesian Macroeconomics"6 October 2008 Vijayamohan CDS MPhil

The three basic features of the NewClassical school:

the adoption of the competitivemicrofoundations and imperfectinformation

and the use of rational expectationhypothesis.



Robert Lucas Wins 1995 Nobel Prize inRobert Lucas Wins 1995 Nobel Prize inEconomicsEconomics

RATIONAL EXPECTATIONS

'For having developedand applied the

hypothesis ofrational expectations,

and thereby havingtransformed

macroeconomicanalysis and

deepened ourunderstanding ofeconomic policy.'6 October 2008 Vijayamohan CDS MPhil

PrizePrize--Winning ForesightWinning Foresightby an Exby an Ex--WifeWifeRobert LucasRobert Lucas, the Nobel prize winner

of $1.1 million dollars$1.1 million dollars, HAD to splitsplit

his money with his exhis money with his ex--wifewife, who sevenseven

years agoyears ago had her divorce lawyer insert

a clause to cover just such a possibility.

The clauseclause in the settlement reads: “Wife shall receive 50%“Wife shall receive 50%of any Nobel Prize if it occurs within seven years.”of any Nobel Prize if it occurs within seven years.”

Lucas said, “A deal is a deal. It’s hard to be unpleasant after“A deal is a deal. It’s hard to be unpleasant aftera prize like that.”a prize like that.”

Rita LucasRita Lucas had more than just foresightforesight; she had luckluck.If the announcement, which came on Oct. 10Oct. 10, had comeafterafter Oct. 31Oct. 31, she would have gotten nothinggotten nothing.

**Rita LucasRita Lucas knew who had won in the pastwon in the past and she was thinkingthinking

in a rational mannerin a rational manner on who she expectedexpected to winto win in the futurefuture.

8 University of Chicago professors have won8 University of Chicago professors have won and he was the55thth in the last 6 yearsin the last 6 years.6 October 2008 Vijayamohan CDS MPhil


2004 Nobel Memorial Prize:Finn Kydland and Edward Prescott:

“For their contributions to dynamicmacroeconomics:

the time consistency of economicpolicy, and

the driving forces behind businesscycles.” Real business cycle theory6 October 2008 Vijayamohan CDS MPhil

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NewNew ClassicalsClassicals::the ‘Third Chicago School’the ‘Third Chicago School’

Robert Lucas ()

Thomas Sargent

Robert Barro

Edward Prescott

Finn Kydland


developed during the 1980s as aresponse to New Classical theory

New Keynesians investigate whatthey believe to be the essentialaspect of Keynes’s theory:

the existence of price and wagerigidities.

New Keynesian TheoryNew Keynesian Theory


New KeynesiansNew Keynesians

the New Classicalrational expectations +the natural rate hypothesis +the assumption of continuous marketclearing

Policy Ineffectiveness proposition (PIP):

anticipated monetary policy changeshave no effect on output andemployment even in the short run.


Stanley Fischer (1977) and EdmundPhelps and John Taylor (1977):

nominal demand disturbances arecapable of producing real effects inmodels incorporating rationalexpectations,

if the New Classical assumption ofcontinuous market clearing isabandoned;

And in such models systematicmonetary policy can help stabilize theeconomy.



Non-market clearing model:

Market imperfections: Imperfectcompetition; coordination failures;credit restrictions

Nominal wage and price rigidity

Rational Expectation Hypothesis

Microfoundations

Optimization: Firms – profits;workers – utility



In explaining business cyclefluctuations new Keynesians emphasizenominal price rigidities over nominalwage rigidity.

This is in sharp contrast to

Keynes,

the Neo-Keynesianism of Modigliani

and the neoclassical synthesis,

which emphasize nominal wagerigidities.



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The economy is stable butstable butpotentially unstablepotentially unstable

[supply shockssupply shocks or booms andbusts impact investmentinvestment].

Many prices/wages are inflexibleprices/wages are inflexibledownwarddownward,

particularly wages

[contractscontracts and efficiencyefficiencywageswages].



Velocity is unstableVelocity is unstable

[directdirect with the interest rateinterest rate andiinnvveerrssee with the mmoonneey sy suuppppllyy]

InflationInflation can be caused by excess MSexcess MS,

but it may also be caused by

“investment booms”“investment booms”, or

“adverse supply shocks.”“adverse supply shocks.”

The Fed targets the interest ratetargets the interest rate ininthe SRthe SR

but monitors the MSmonitors the MS in the LRin the LR.




Edmund Phelps

Nobel prize in 2006:

"for his analysis of intertemporal

tradeoffs in macroeconomic policy


SupplySupply--SideSide EconomicsEconomics


MundellMundell

Robert Mundell created modernsupply-side economics in a singleparagraph at the end of a monographpublished in 1971, then neverpursued his idea in print.

1999 Nobel prize “for his analysis of monetary andfiscal policy under different exchange rate regimes

and his analysis of optimum currency areas”.


Arthur LafferArthur Laffer

works with Mundell from 1969.

Calls Mundell “a genius.”

Whereas Mundell deliberately avoids thelimelight, Laffer wants fame. Uses his contacts atChicago and Stanford to become PresidentNixon’s Chief Economist.

Mundell visits Laffer in Washington. Lafferintroduces Mundell to George Schultz who playsa key role in the Reagan Administration.

The stage is set for ReagonomicsReagonomics.

1974, Laffer draws a curve on a napkin.


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Laffer CurveLaffer Curve

TaxRevenue

Marginal Tax Rate0%

100%tmax thigh

45


Wall Street JournalWall Street Journal ConnectionConnection

Jude Wanniski (WSJ reporter) reportson the ideas of Mundell and Laffer in aseries of articles beginning in 1974.

Coins ‘Laffer curve’.

March 1976, conference in Virginia:

Herb Stein refers to “supply-side fiscalism”.

Later this becomes “supply-side economics.

1978, Wanniski writes a book called

The Way the World Works.


ReagonomicsReagonomics in practicein practice

When Ronald Reagan ran forpresident in 1980, he promised to cuttaxes in what seemed, at the time, amagical way.

Tax revenue would go up, not down,he said, as the economy boomed inresponse to lower rates.


Since then supply-side economics hasbecome a central tenet of Republicanpolitical and economic thinking.

That’s despite the fact that the bigsupply-side tax cuts of the 1980s andthe 2000s did not work out asadvertised, as even most supportersacknowledge



In the 1980s, during the initial era ofsupply-side tax cuts, per capitarevenue from personal income taxes,adjusted for inflation, rose anaverage of just 0.7 percent annuallythroughout the Reagan presidency,according to the White House Officeof Management and Budget.



That was far below what turned outto be an average annual increase of6.5 percent in the eight years of theClinton administration, when taxrates at the high end of the incomeladder were raised.



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Since 2001, the annual per capitarevenue from income taxes fell1 percent under President Bush eventhough tax collections picked upsharply starting in 2005.

The budget surplus Mr. Bushinherited turned into a deficit.


6 October 2008 Vijayamohan CDS MPhil 6 October 2008 Vijayamohan CDS MPhil

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