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Robert Solow, “Towards a Macroeconomics of the Medium Run.” Journal of Economic Perspectives, Vol. 11, No. 1, Winter 2000.

Solow begins by talking about the progress of macroeconomics even though it is still a rough science that cannot be exact.  He claims that maybe a certain level of inexactness is unavoidable even though macroeconomics is in fact the most important part of the field of economics.  He says that macro is necessary to understand current events and policy implications even if the policy that is required is neglect.  He wants to use this study to talk about some of the leftover questions left in macro but not to go on about them.  He discusses how recently, the general equilibrium model has been the main vehicle for macro theory and he does not believe anything will replace it soon.  He talks about the choices that have to be made within the models and there are obvious flaws that still need to be resolved.  He also discusses the fixed-price models that he supported which did not get a fair trial by American macroeconomists in his eyes.  He talks about how compromising between believable assumptions and assumptions that are able to be modeled is still a very real question in macro theory.  One of the main ones is the distinction between individuals optimizing their benefits in every situation or acting by a rule of thumb.  He also talks about the importance of expectations in macro.  These are the questions still up in the air about the foundations of macro theory which Solow thinks need to be answered in order for macro to progress.

He next discusses growth (fitting considering he came up with the Solow growth model) and how a wider variety of models are available for testing.  He talks about how some growth models such as open economy models are shot down without given much of a chance.  Another factor in growth which Solow discusses is the role of human capital.  He says that it is very important to figure out how developing nations could most effectively work to develop its people’s human capital.  He goes on to talk about how the main focus of most debate today is the fluctuations in the business cycle.  He says the extremists on both sides of the debate have begun to converge a little bit and that the disagreements might be resolved if there were a common framework from which to work from.  His second point is that some of the answers to the questions might change over time as attitudes, theories, and experiences change.  He also points out the importance of not only correcting past errors but also keeping up with the changing reality experienced in the practice of new economic theory.  He also forecasts the open economy models will gain greater importance in the future. 

His next point of discussion is wage and price behavior in the short-medium run.  He uses this as an example of how theory and fact can connect and how the expectations augmented Philips curve was used well in the 70s and 80s because it gave good fits.  Finally Solow begins to discuss “The Medium Run.”  He assumes that in the short run prices are predetermined, not necessarily constant, and that some ad hoc dynamics are also included.  In the long run, he assumes that prices are dealt with in a growth theory manner.  He then postulates that there must be a medium run in which prices play a role but income driven processes may dominate events.  He shows how Keynesians never stop because they are moving from quarter to quarter and Neoclassicals never fix prices because markets do not clear.  He talks about how when he sails he does it as if the world was flat and yet he makes it to his destinations just fine.  He is arguing here for a hybrid model to understand what is occurring in the macroeconomy since a purely Keynesian or neoclassical model does not adequately explain what is going on.

I thought this was a good article by Solow especially after having read that Hoover catastrophe.  Nobody does macro better than Solow and this was much simpler to understand than Hoover’s.  I also think that he makes some very good points about how to look at the macroeconomy with it being completely irrelevant or overwhelming.  It seems like he is preaching a discretionary policy towards which theory to apply.  If you are looking short term, use Keynesian.  If you are looking at the long term, try Neoclassical.  He has a much more uplifting view than Hoover because Solow actually believes that macro exists and is at the heart of what should be studied in economics.

Hoover is attempting to argue that Macro has no real connection to Micro and that the microfoundations program that has been going on in economics for the past 70 years is completely misguided.  He discusses how the changing focus has been on breaking down the macroeconomy into its micro principle parts.  Hoover believes many economists cling to the belief that micro foundations exist because the economy is made up of individual actors and not necessarily because it is plausible or practical to measure.  He wonders if economists merely try to find micro principles which support the macro findings because there are “supposed to be” some there for them to find. 

Finally Hoover starts talking about things I can understand.  He says that eventually the definition of macro always comes back to the aggregate actions of the actors within the economy.  He then distinguishes between natural aggregates, simple sums or averages (employment), and synthetic aggregates, or totals that are constructed in such a way that their composition changes the components of which they are made of (price level).  The discussion of the price level is extensive and he talks about how it can be likened to measuring the temperature in that there is only a relative degree of accuracy.  The price level is “high” or “low” much like it is “hot” or “cold” outside.  He also shows how it is decomposed and the logic that goes into the calculation of the price level.  Also he adds that the weights put on certain components of the price level are chosen quite arbitrarily.  He then briefly discusses the Paasche and Laspeyres indices which are the two most common weighting schemes.  He points out that neither is correct and there are an infinite number of schemes which exist between them.  He shows that the price of money is unlike the price level of any other good and probably has characteristics all its own.  Another synthetic aggregate he discusses is GDP.  He claims that the general price level and real GDP are the two most important aggregates in macro economics.  He states that averages do not translate well in making the conceptual leap from micro to macro and that is why macro often does not capture what is taking place at a micro level. 

Hoover next moves on to discussing more philosophical crap that I don’t really understand.  He says that instead of macro theory being based on micro theory economists should understand that macro reality is based on micro reality.  Then he discusses two arguments for macro existing.  The first argument boils down to the fact that it is an observable thing that can cause a marked effect on other things so it must be real.  The second argument is called idealization in which primary factors are determined based on secondary factors set to extremes. 

I think that Hoover makes two convincing arguments in opposite directions.  However, I have difficulty believing that there are no micro foundations for macro theory and occurences.  His argument that economists strive to search for micro foundations simply because they have always assumed they were there does not really convince me that they do not exist.  I think the problem is that the techniques and methodology used to measure macro phenomena cannot accurately depict what is going on on a miro level because of the effect of externalities.  The actions taken by an individual might have an impact on the macro economy, but maybe only under certain conditions since their decisions are considered to be one giant Nash equilibrium.  Without micro foundations, macro would be reduced to data gathering. 

He concludes that yes, maybe, macro is real today.  So, a few things:

1) when did this course take a left down philosophy street?

2) why did I have to look up ontological four times?

3) where in the hell did Hoover come up with this paper?

            a) why in the hell did Hoover come up with this paper?

It was a very difficult paper of which I understood very little and hope Greenlaw plans on clarifying for us tomorrow.     

            Greenwald and Stiglitz are attempting to shed light on the differences between New and Old Keynesians in this article.  They propose that they would both agree on three basic assumptions.  First, during some periods, an excess supply of labor exists at the prevailing level of real wages.  Second, the aggregate level of economic activity fluctuates noticeably no matter how it is measured.  Also, these fluctuations are different in size and magnitude than any that might be accounted for by short-run changes in technology, tastes, or demography.  Finally, even though monetary policy might be ineffective at times, money does in fact matter.  From all of these propositions, they would also agree that government intervention is useful at stabilizing economic activity.  These arguments are what set Keynesians, new and old, apart from other schools of thought such as new classicals and real business cycle theorists which believes markets clear and wages and prices quickly adjust. 

            They say that despite the overarching differences in the two schools, they have also agreed on two methodological premises, that macro has micro foundations and that understanding macro phenomena requires the use of a (simple) general equilibrium model.  They show that leaving out certain factors such as diversity among agents is why other models fail and liken it to “leaving Hamlet out of the play.”  They also say that a good macro model should be able to explain other things like why variations in number of hours work take place in the form of layoffs as opposed to work sharing.  Also, the micro foundations are able to be tested directly.  If the micro could be rejected, the derived macro more than likely could be as well.  They said that figuring out how to incorporate micro foundations is the new principal task ahead of the new Keynesians.

            There are already two different ideologies among new Keynesians about how to explain market imperfection.  The first says that nominal price rigidities are the essential way in which market economies differ from the Walrasian Arrow-Debreu model.  Without the rigidities prices are free to adjust quickly to whatever shocks it experiences.  The second argument is that increased flexibility of wages and prices might exacerbate the economy’s downturn.  This says that even if wages and prices were perfectly flexible, the market would be highly volatile and therefore cause the shocks to be amplified and therefore to persist.  These two approaches have vastly different implications for what would happen.  The first holds that the classical dichotomy breaks down allowing monetary policy to affect things other than the price level.  The second holds that monetary policy has real effects even when wages and prices are flexible.  New Keynesians also suggest a more complex alternative.  First, natural economic forces can magnify shocks that may seem small, and second, existing price rigidities may reduce the magnitude of small fluctuations. 

            The purpose of this chapter is to explain and contrast the second strand of new Keynesian literature with other Keynesian ideas and other schools of thought.  The models contain three basic ingredients: risk averse firms, a credit allocation mechanism in which credit-rationing, risk averse banks play a central role, and new labor market theories including efficiency wages and insider-outsider models.  Risk averse firms have a great deal of importance when it comes to imperfections in the equity market.  New Keynesians put whether finance comes from equity or debt at the heart of their theory.  With equity, the firms share risk with those who provide finance and the firm has no fixed obligation to repay.  With debt, the firm has a fixed obligation and if it fails to meet that obligation, it can be forced into bankruptcy.  They point out that most firms do not use the equity approach because when they do, their market values tend to decline.  The market for equity exists because firms are also operating with imperfect information and are not completely sure of their market value.  They move on to discuss further reasons for firms being risk averse including the fact that production itself is risky because it takes time and there are no future markets for the sale of goods.  The uncertainty firms face increases with the size of change that they are facing.  These this of risk aversion of the firms explains why the aggregate supply curve shifts markedly when the economy enters a recession.  The riskiness of the production increases and therefore their willingness to bear that risk has also increased.  They enumerate the different aspects of the economy which the theory of risk averse firms helps to explain such as how large redistributions affect the economy and how shocks can have large, real and nominal, effects on the economy. 

            The effects that operate through the banking system and credit markets provide yet another piece of the puzzle in new Keynesian economics.  It also provides more justification for monetary policy as a tool for settling the economy.  They take much the same approach as they did with firms as banks being risk averse as well.  They find that risk averse lending behavior will cause economic shocks to be magnified and recessions in turn longer and deeper.  When the economy worsens, lending becomes increasingly risky and bank’s worth, as well as their ability and willingness to bear risk declines.  Monetary policy works at times in this situation.  Lowering interest rates stimulates investment which helps to kick start the economy, but also reserve requirements act as a tax on deposits and therefore banks are willing to lend more to keep their worth up.  They do admit that at times monetary policy can be pretty powerless. 

            Labor markets are aspect of old Keynesian economics that were somehow overlooked even though they focused on unemployment.  New Keynesians introduce the theory that there is involuntary unemployment due to sticky real wages stemming from efficiency wages, insider-outsider theory, imperfect competition and implicit contracts.  They move on to say that other schools of thought are at best incomplete and at worst, flat out wrong.  The next section discussed is price rigidities.  It is shown that price rigidities are not the only source of economic problems such as volatility and unemployment.  For example, some economies facing inflationary pressure still experience unemployment problems.  While these rigidities might not be the whole story, they are still worth looking into and explaining.  They discuss menu costs and how uncertainty magnifies the costs associated with changing procedures. 

            Other Keynesians took on areas of concentration other than that of price rigidities.  Tobin emphasized risk in his studies.  His theories allowed monetary policy to impact the economy through prices and investment.  The theory however, had limited empirical success.  The Real Business Cycle Theories deny that (involuntary) unemployment exists or that money matters.  They focus on the problem of economic volatility.   They are criticized for assuming negative technology shocks when they have difficulty explaining how a loss in technical competence would come about.  New Classical theory is the closest to New Keynesians and they share several methodological similarities.  They go on to tell several of the differences between the two schools such as views on the importance of expectations and changes in price levels effects on the economy. 

            This was a pretty good article for explaining the new Keynesian school of thought.  They were very straightforward with there theory and did not use much notation which made it very easy to follow.  I also like how they not only contrasted themselves with old Keynesians, but with other schools of thought as well.  It makes it much easier to distinguish between there ideas, and the ideas of others. 

Mankiw begins this article by discussing how much easier it was to be a student of macroeconomics 20 years ago because then the answers were much more concrete when it came to what caused fluctuations in output and employment.  Today he says that IS-LM models are rarely cited in scholarly articles because it does not do a very good job at explaining what is actually taking place.  He does say that applied macro has changed little in light of the relatively radical changes in academic macro.  He attributes this disparity between the two fields as the practioners falling behind the state of the art theory that the economists in the academic branch have developed.  He goes on to say that the research that has been done in the past twenty years is the type that cannot be quickly adapted to applied macro.  He uses the story of Copernicus and Ptolemy as a metaphor for what is taking place in macro development today.  His intent in this paper was to highlight some macro developments that can change the paradigm through which people look at the economy much like Copernicus’ heliocentric theory of the universe changed the way in which people viewed the universe. 

He discusses the two reasons for the failure of macro theory in the 70’s.  The first was the failure to explain the rising rates of inflation and the unemployment problems and the second was the inability to convincingly link micro principles with macro practice.  He shows how Friedman and Phelps showed the failures of Phillips curve because of the governments attempt to exploit its foundations.  He also said their studies made way for Lucas’ critique which attempted to broaden the view of macro even further.  He also says that if the old models were accurate at predicting the stagflation of the 70’s, only the “theoretical eccentrics” would have worried about it but for the most part people would consider it as good enough because it did a good job of explaining the data. 

He moves on to talk about the direction of rebuilding macro towards starting from solid micro foundations.  He breaks down macro into three categories.  One area of economic research aims at modeling expectations.  A second area is focused on using new classical models to explain economic phenomena.  The third area uses new Keynesian models to explain the economy.  He goes into discussing expectations and how Sargent and Wallace’s article was among the most important in looking at rational expectations.  He says how monetary policy was first considered irrelevant and incapable of affecting output and employment levels.  Mankiw says it wasn’t the idea of policy irrelevance that was important as much as making economists familiar with rational expectations.  He then goes on to discuss rules versus discretion in monetary policy and the belief that policy rules will allow people to have less uncertainty in their expectations and therefore output should vary less.  He moves on to discuss rational expectations in empirical work and how the change in the view of income theory of consumption changed because a person’s consumption should be unpredictable. 

Lucas begins by discussing the enormous amount of change that has taken place in macroeconomics over the past fifteen years.  He talks about the contesting schools of thought that seem to be a reaction to one another that then build upon the results and improvements.  He goes on to say that these main ideas are not nearly as interesting as the most recent developments in theory.  He moves on to talk about dynamic economic theory and how modern days economists are able to isolate a particular problem and study it much more specificly and intensely than in previous times.  By being able to incorporate probabiliy and dynamic elements into theory, economists can study problems with the same rigor that they would a single decision-maker making a one-time choice at given prices.  He does say that this process of dynamicization is far from completed and it still has not given a satisfactory theoretical account of the events known as the “business cycle.”  He lays out his plan for the rest of the book which is a collection of lectures that he compiled into 7 sections.

He makes a point that if discussions of economics are to yield anything worthwhile, there must be some sort of quantitative assessment of policy impacts and how they affect individual welfare and resource allocation. This means that these discussions must be based upon models.  He clarifies that models do not automate the policy and decision-making process, but they give everyone a uniform way of looking at things and understanding how to get from one point to another.  Models illustrate how certain policies will impact individuals and the consequences that they will have.  He says that the goal ist o make a model that fits historical data and that can be simulated to give reliable estimates of the effects of various policies on future behavior.  He then shows that this data set, the fit, and the reliability are all very relative terms.

To be continued……

Summers uses Prescott’s “Theory Ahead of Business Cycle Measurement,” to examine the state of Business Cycle theory.  He points out that Prescott’s paper is brilliant in highlighting the appeal of real business cycle theories and making clear the assumptions they require.  He does say that Prescott does not make much effort at caution in judging the potential of the real business cycle paradigm.  He does agree that theory is now ahead of business cycle measurement because the measurement techniques do not exist that could adequately test the theories that are now available.  He does use Ptolemaic astronomy and Lamarckian biology to point out that just because a theory can approximately mimic any given set of facts, does not mean that it is anywhere close to being accurate.  He then moves on to four areas which are not persuasive enough in Prescott’s argument.

            The first area in question is if the parameters of Prescott’s theory are correct.  Summers claims that the well-established microeconomic and long-run information the model is based on is not sustainable.  He claims that Prescott’s measurement of household time devoted to market activities is closer to 1/6 than 1/3 and has found no evidence to support Prescott’s claim.  He also found the real interest rate to be closer to 1 percent as opposed to Prescott’s estimation of 4 percent.  He also claims that Prescott’s assumption of intertemporal elasticity of substitution in labor supply, which is central to his model, has no evidence to support it.  He claims that Prescott’s claims to be securely tied down in growth and micro observations are a gross overstatement. 

            His second problem is the lack of evidence to support the “technological shocks” Prescott speaks of.  Summers says this is a critical point because the “technological shocks” in Prescott’s theory are the only thing that fluctuate the business cycle.  Summers claims that Prescott’s measurements of the technological shocks are actually more along the lines of labor hoarding and other behavior not allowed in Prescott’s model.  He says it is hard to find direct evidence of technological shocks.  He also shows that while technological shocks leading to changes in total factor productivity are hard to find, other explanations are easy to support.  He shows one example that “a sizeable portion of swings in productivity over the business cycle is the result of firms’ decisions to hoard labor. 

            Next he moves on to criticize the price-free economic analysis which Prescott seems to practice.  He says by leaving out the price data, Prescott is free to account for other quantities.  However, this makes it impossible to distinguish supply from demand shocks and this type of analysis would be ignored by most hard-headed economists.  He claims that there are no reasons to support any of the findings on price effects predicted by Prescott’s model because they are not endogenous to it.  He makes it clear that without price-levels incorporated into the model, cyclical fluctuations are very difficult to observe and the results are highly suspect.

            His fourth and final fundamental criticism of Prescott’s work is that it ignores the breakdowns in exchanges mechanisms that are most certainly fundamental factors in cyclical fluctuations.  He points out that cyclical fluctuations cannot be limited to movements in intertemporal substitution and productivity shocks especially given that total factor productivity has increased more than twice as rapidly in Europe as in the United States.  He agrees that the Keynesian approach of saying that prices are rigid is not satisfactory but that leaving it out altogether is not the solution. 

Prescott’s article begins by saying that for a long time, economists have not really known what to make of large fluctuations in output and employment over relatively short periods of time.  Movements as much as ten percent are observed while movements in labor’s marginal product are small.  He says that these observations should not be puzzling and they are in fact what should be predicted by economic theory.  He said given the conditions in the United States, it would be puzzling if these fluctuations did not take place.  He also points out that standard theory also correctly predicts the amplitude of these fluctuations as well as the fact that the investment component is about six times as volatile as the consumption component.  Prescott, with the aid of several others, looked at the American economy since the Korean War to see if it displayed fluctuations with developments in technology.  Sure enough, it did.  He found that when the rate of technological change was uncertain, the business cycle phenomena was both dramatic and unanticipated.  The models are highly abstract and therefore hypothesis testing will reject them but they are viewed more as the promising beginning of a larger research program than the definite end and correct answer.

            He criticizes the use of the term “business cycle” because it tags on the time series components and also because the term does not accurately represent the cycle aspect of the idea.  He therefore classifies it as business cycle phenomena.  He uses Lucas’ definition for the business cycle as being the “recurrent fluctuations of output about trend and the co-movements among other aggregate time series.  The trend is neither a measure nor an estimate of the unconditional mean of some stochastic process and it would actually be problematic if it was.  It is the computational process of fitting a smooth curve to the data set.  He then gets into the technical aspects of fitting a line using logarithms which I do not completely understand.  He does speak about using the same points on the two different data sets in order for the findings to be meaningful. 

            He next moves on to every macro student’s favorite model: the Solow-Swan Growth Model.  He breaks down the different aspects of the growth model and explains some of the math behind it.  *Since I am fairly sure all of us have had either macro or development I will not bore you with a recap.  If you need to see it again it is on pages 370-373.  He does criticize that this model should not be used to look at the business cycle because one of the restrictions is that neither employment nor savings vary.  He moves on to show that one approach used to look at this problem is the Pareto optima approach.  “Given a single agent and the convexity, there is a unique optimum and that optimum is the unique competitive equilibrium allocation.  He next introduces expectations into the growth model by making uncertainty the household’s expected discounted utility. 

            He next shows how data can be used to restrict the growth model and two of the most important parameters are intertemporal and intratemporal elasticities of substitution.  One thing that must be looked at is the Cobb-Douglas function and if it supports the fact that the American real wage has increased more than 100 times since the Korean War.  Again he gets into math and equations I don’t quite understand but I think the main point is that traditionally the elasticity of substitution between consumption and leisure has been close to 1.  Also that the real wage has increased steadily in the US. 

            The nature of technological change is the next thing Prescott explores.  He cites how it can be calculated in the Solow model by the changes in output minus the sum of the changes in labor’s input times labor share and the changes in capital’s input times capital share.  Measuring variables in logs, this is the percentage change in the technology parameter of the Cobb-Douglas production function.  He points out that Solow’s model overestimates the standard deviation of technological change and therefore the variability of that parameter.  He says there are non-negligible errors in measuring the inputs especially with regards to labor.  He summarizes this section by saying that technological shocks are highly persistent and that tying down the standard deviation of the technology change shocks is very difficult. 

            Next Prescott goes on to describe the statistical behavior of the growth models and how theory provides an equilibrium stochastic process for the growth economy studied.  Again, he gets technical and I get lost.  The basic growth model has a standard deviation of the technology shock equal to 0.763.  Theory implies that the standard deviation should be 1.48 percent; in fact it is 1.76 for the post-Korean War American economy.  The difference appears to be due to errors in measuring aggregate hours and output. 

            The Kyland-Prescott economy modified the growth model in two ways. First, they assumed that a distributed lag of leisure and the market-produced good combine to produce the composite commodity good valued by the household.  The second modification is to permit the workweek of capital to vary proportionally to the workweek of the household.  The Hansen indivisible labor economy shows that when movements between employment and nonemployment are considered and secondary workers are included, elasticities of labor supply are much larger.  He also finds that most of the variation in aggregate hours arises from variation in the number employed rather than in the hours worked per employed person.  He finds that if the technology shock standard deviation is 0.71, then fluctuations in output for his economy are as large as those for the US economy.  Also, variability in hours is 77 percent as large as variability in output.  Empirical labor elasticity is found to larger than the true elasticity.  One reason this model does not accurately display the numbers observed is because of cyclical measurement errors in output. 

            This is a very difficult article I think.  There is a lot of very technical information with regards to models and that makes it kind of tough to follow.  I understand what he means about errors in measurement affecting the results and the discrepancies between their models and the observed values however, I do not quite follow some of the logic he uses within the article. 

This article is about Robert E. Lucas, Jr. and his contributions to the field of economics.  He wrote several papers in the 60’s and 70’s that are now referred to as modern classics.  Chari wrote this article in an attempt to place Lucas’ contributions to economics in a historical context.  Lucas is sometimes credited with bringing about the beginning of the end of Keynesian economics and the rise of rational expectation economics.  Chari cites Lucas’ work as not actually revolutionary, but as part of the natural progression of the developments of economic theory.  He then goes into showing how models and theories develop and how when problems or inadequacies are found in certain models, they are reformed or altogether new models are made to accurately represent what is occurring.  He claimed that Lucas’ greatest contribution was to develop and apply economic theory to specific questions in macroeconomics and to make obsolete one class of models.  He credited Lucas with showing how to construct dynamic stochastic general equilibrium models and also to show how to develop and analyze a specific mechanism by which monetary instability leads to fluctuations in output and inflation. 

            Chari describes the shortcomings of the models used in macroeconomics up until the 60s and how they were thought to come from deeper foundations in individual or firm decision making.  While it was generally accepted that these models were alright, it was also widely known that there needed to be microeconomic foundations for macroeconomics.  The main difficulty was that macro questions deal with uncertainty and dynamics and they could not figure out how to incorporate this into foundations.  There were two fundamental postulates that theory was based off of.  Firstly, individuals act purposefully to achieve the ends they seek.  Secondly, outcomes are based off of the actions of others as well so individuals must form expectations.  The equilibrium postulate captured this concept of expectations and presented it in a consistent manner.  However, this was not very useful in a world rife with shocks and unforeseeable events.  The breakthrough was found in the game theory work of John Nash and the work of Kenneth Arrow and Gerard Debreu in the theory of competitive equilibrium.  Chari contrasts the models of the past with modern models and shows how the former were static-equilibrium in nature and showed slow movements in the economy.  The new models that were developed were able to reproduce observations that were thought to be out of equilibrium with surprising accuracy. 

            Next, Chari discusses Expectations and the Neutrality of Money.  He sets the stage by explaining the theory behind the Phillips curve and then the arguments of Friedman and Phelps against its policy recommendations.  They argued people do not care about nominal qualities, just real ones and that is why inflation cannot really affect any real variables in the economy.  Lucas’ paper set out to answer how monetary policy can affect inflation, output, and unemployment.  He argues that monetary instability causes people to confuse monetary disturbances with relative price movements and that is why fluctuations in aggregate output are seen.  Lucas set up a model in which people only lived for two periods and there were the young and the old.  At the end of every period the old die, the young become old, and a new generation is born.  Only the young can produce, but both the young and old consume goods.  Goods cannot be stored due to changing tastes and preferences.  He points out that social security is one such way that part of production is transferred to the old.  He cites the institution of money as useless pieces of paper which provide the old a claim to the goods produced by the young.  He shows how in this equilibrium example, peoples decisions to consume and save are based upon their expectations of future generations.  Zero degree homogeneity is said to exist when if all values were expressed in another unit, there is no effect on outcome.  Neutrality is thought to exist when a proportional change in all nominal quantities at all dates is associated with proportionate change in all prices and no change in real quantities.  Monetary injections into this economy can have inflationary effects if the money injected is independent of the amount of money a person had.  The effects are much the same as a tax.  However, if the amount of money injected is in a direct proportion to the amount of money people carried in the past, the negative effect of inflation is offset by the higher return associated with the proportionate transfer.  He uses another lengthy example to contrast anticipated and unanticipated monetary fluctuations.  If a person has accurate information and is aware of the fluctuation, their expectations can be forecasted and accounted for.  The same cannot be said for unanticipated monetary fluctuations.  Lucas also calls for the monetary authority to follow the “k percent rule” in which the money supply increases at a constant rate. 

            It took some time for the rational expectations approach to catch on but once it did, it was very popular for three reasons.  It adds no free parameters but instead imposes restrictions across equations, it is consistent with maximization theory, and the equilibrium point of view practically forces one to use rational expectations.  Chari then goes on to say how Lucas’ work was a vast improvement over the Keynesian ideas and even those ideas held by Friedman which they were based up.  He then goes on to discuss some of the things that have spawned from the work of Lucas.  He goes through Lucas’ critique of the Fed and how his input was incredibly useful and showed other economists that his systems and theories could accurately explain what was being observed in the economy.

            I thought this was a good article although some of the examples were long and somewhat difficult to follow.  I also thought that his review of Lucas took on great admiration and he had definitely bought into Lucas’ methodologies and theories.  This did a very good job of explaining how New Classicals changed the way that the macroeconomy was seen and the tools and models used to analyze it.               

V.V.Chari, “Nobel Laureate Robert E. Lucas, Jr.: Architect of Modern Macroeconomics,” Journal of Economic Perspectives, Winter 1998, Vol.12, No. 1, pp. 171-186.        

Sargent, the avid football fan, begins his analysis of Reaganomics by explaining how team goals are accomplished through coordination and strategy.  He likens the economy to a football team in which each of the players must act together with the others in order to achieve their goal of scoring a touchdown.  He points out how this type of situation is one in which a “laissez-faire” approach is not the most effective.  He shows how actors within an economy must work together to accomplish a goal and how sometimes within the US economy it is more like two teams playing against each other than two teammates working together to achieve an outcome. 

            He next goes into discussing dynamic games which he defines as a collection of players and a set of rules which dictate the rewards and penalties.  It requires time to complete and the current score depends on past actions of the various players.  Each player has a goal which may be idiosyncratic, such as personal glory or profit, or altruistic, such as the success of their team or country.  A team game is one in which there a two or more players attempting to achieve a common objective.  The goal is achieved by choosing a strategy which is what dictates the players’ actions throughout the course of the game.  The contingency plan is what the players resort to when the strategy begins to alter from the path they originally had decided upon.  The players make their moves based on the actions of the other players.  If one player’s decision has an influence on the strategy of another, that player is said to be in a dominant position.  In order to maximize the rewards for the team, all of the players must share the same perceptions of the structure of dominance and agree that their strategies are mutually feasible.  When the structures of dominance differ, the game changes or a whole new game is created.  In Nash equilibrium, players act as if the other players’ actions are outside of their control.  In a “Stackelberg,” or dominant-player equilibrium, one player takes into account the influence of his strategy and how it affects the strategies of the remaining players.  The remaining players are thought to be followers and weak compared to the dominant player.  If there are two dominant players, there is the potential for power struggle and what is called “Stackelberg warfare.”  He says that recent American monetary and fiscal policies have been an example of “Stackelberg warfare.”  The most fundamental principle of these dynamic games is that strategies are interdependent. 

            He next explains how the economy can be viewed as a dynamic game comprised of three players: the public, the monetary authority, and the fiscal authority.  The public determines consumption, investment, and private employment and pays taxes levied by the fiscal authority.  The fiscal authority makes decisions about public expenditures and tax rates.  By doing this, the fiscal authority determines the government deficit.  The monetary policy controls the composition of the debt which the government issues by engaging in open market operations.  Therefore, the fiscal authority influences the rate of addition to public debt and the monetary authority determines its composition.  This action by the monetary authority is known as debt management.  All three of these players share the same goal which makes it a team situation and the fact that their strategies and decisions affect each other make it a dynamic game.  So to recap, the public chooses investment rates and the terms on which it is willing to accumulate government debt, the fiscal authority determines the current and total state of government indebtedness, and the monetary authority determines the composition of the debt. 

            Now he moves on to discussing the inflationary consequences of government deficits and other ways to finance them.  Government expenditures can be financed in a number of ways such as levying taxes, borrowing in interest-bearing form, and printing high-powered money.  The strategies of the three actors can all affect how the price level path moves.  The public can only take on so much debt as their limit of wealth will allow.  The actual upper bound for that level of debt is below the total wealth of the country.  He compares the demand function for money which says that the demand for real base money is a decreasing function of the expected gross rate of inflation.  This is the model used to study hyperinflation during the WWII era.  He contrasts this model with another that states that the price level is a function of the supply of base money and with the expected price level in the future.  This shows that if government debts are to influence the price level, it can only be through their effects on the expected path of high-powered money.  He comes to the conclusion that the inflationary effects of government deficits depend greatly on their strategy for servicing the debt it issues.  He considers a Ricardian regime in which additional base money is never issued to finance a deficit because they are either financed with a surplus or by issuing or retiring interest-bearing bonds.  In this regime there is no inflationary effect because the government is not allowed to affect the path of base money.  They expect the deficit to be offset by a future surplus.  He then shows the opposite in which deficits are inflationary because the government influences the time path of both base money and the price level in an immediate way.  They plan to finance their deficit by an “inflation tax” on the holders of the base money.  In the non-Ricardian regime which we see much more often in the real world, deficits definitely have more potential to be inflationary if they are not financed in a certain way. 

            Finally Sargent gets to Reaganomics and credibility.  He claims that the Reagan administration came into office attempting to mix and match between the Ricardian and Bryant-Wallace plans for fiscal and monetary policy.  They wanted the tight monetary policy found with the Ricardian plan and the plans for taxes and expenditures which were contained in the Bryant-Wallace scheme.  They attempted to use tight monetary policy to keep inflation under wraps while trying to use fiscal policy to cut taxes and therefore have large deficits.  This brought the two policies into direct contradiction and essentially into a game of chicken where one side would have to cave in to the other.  This type of game of chicken makes the public uncertain of the future tax rates, rates of inflation, and rates of interest on government securities.  The uncertainty this causes, he claims, is completely unnecessary and avoidable.  With a better outlook and more certainty as to future rates, the economy will most assuredly run more smoothly.  He claimed Reaganomics was not credible because it was in fact not possible.  The stress placed on the “announcement effects” was intended to give people good expectations and give the plans of the administration more credibility. 

            This was another good read from Sargent.  He has a way of explaining his models and equations verbally that make good sense of them and allows you to see the variables more clearly.  He also writes in a way that makes him accessible without having to be constantly wondering what his terminology means.  I think this explained Reaganomics well and succinctly put why it failed as a strategy for economic prosperity. 

The first chapter of Sargent’s book, “Rational Expectations and Inflation,” discusses the reconstruction of macroeconomics in order to incorporate people’s changing expectations into the picture.  He starts by illustrating how under the same set of rules, it is relatively simple to extrapolate a past behavior pattern into the future.  He shows how the Houston Oilers would punt nearly 100% of the time on fourth down within their own territory during a given season.  From this it would be fairly simple to assume that if they were in their own territory on fourth down, they would punt no matter what stadium they were in or what team they were playing. He then assumes that the rules were changed to allow for six downs in the NFL.  If this were the case, the Oilers would never punt on fourth down.  This explains his idea that people’s expectations and behaviors change when the rules of the game they are playing also change.

He asserts that models should be dynamic with regards to people’s behavior and allow it to change as the rules change.  He says that models tend to do a good job of predicting future behavior as long as the rules remain constant.  However, once the rules of the game change, models lose their forecasting ability.  His first example is the investment decision. It shows how government imposed taxes affect the amount invested on capital.  He shows that the demand for capital responds negatively to current and future tax rates.  However, how much people will invest depends on their expectations about the future.  If they believe it is a short term tax increase, they will stop investing in the short term and wait until the tax has been relaxed to make more investments.  If they believe it is the first of a series of tax increases, they might investment more in the short term before the taxes grow even further. 

His next point is the inflationary effect of government deficits.  He shows that the effects on inflation are due mostly to how the government plans to service the debt that it issues.  First he assumes that all deficits will be offset by a future surplus and therefore there would be no inflation.  He contrasts this with the more applicable model illustrated by Friedman in which the government funds their deficit by issuing additional base money.  This shows that issuing interest-bearing government  debt has an inflationary effect if for no other reason that it signals a possible increase in base money. 

These examples show how the behavior patterns change when the constraints people face are changed.  He says new models and econometric methods are needed in which this principle is adhered to in order to make more accurate predicitions about future actions.  Sargent claims that if dynamic econometric models were formulated explicitly in terms of the parameters of preferences, technologies, and constraints, in principle they could be used to predict the effects on observed behavior of changes in policy rules.  He talks about the new research efforts taking place to develop theoretical and econometric methods capable of isolating parameters that are invariant under government interventions in the form of changes in the rules of the game.  New methods and models such as h=T(f), where h is a collection of decision rules of private agents, f is a collection of elements that form the “environment” facing private agents, and T is a “cross-equation restriction” since each element of h and f is itself a decision rule or eqution determining the choice of some variable under an agent’s control, utilize time series observations on an economy that was operating for some period under the a single set of government rules or strategies.  The crux of these new equations is the concept of cross-equation restrictions which allow the dependence of the private agents’ strategies on the government strategies to be viewed.  However, these methods and models are still in the developmental stages and need much refining. 

Cross-country analysis has also been used in an attempt to see how policies have affected the private agents’ decisions over time.  It allows economists to have distinct pairs of obvervations h1, f1: h2,f2:……. and so on however, these data points are often fragmented and therefore incapable of formal time-series econometric analysis that is typically used. 

He goes on to discuss some on the implications for policy makers.  He discusses how the shift of the policy makers view can go to how they are setting up the rules of the game.  They must think about how they are doing such things as setting the tax rate and the different approaches they can take.  Sargent also says that the peoples’ views on the law of motion is necessary to make relatively accurate decisions about how they will react to certain changes in the rules.  He preaches that the government should attempt to look at the bigger picture and think about how they will continually adjust the tax rate in response to the state of the economy and not isolate on how it will move the tax rate in response to a single recession.

I thought this was a very good read for expectations.  The mathematical formulas and notation is fairly difficult however, Sargent does a good job of explaining what is actually meant by the symbols.  I tend to agree with the fact that how people react to a certain action has a great deal to do with their thoughts on how that action has affected things in the past and what it will do in the future.  I also feel like Sargent was correct in saying that in order to have more accurate and dependable models, there must be some measure of what people feel like will happen in the future.  Without some measure of peoples expectations, it is nearly impossible to forecast what they will do in response to a tax increase or interest rate cut.