Archive for February, 2008

Chari’s Review of Lucas and the New Classical School of Thought

Thursday, February 21st, 2008

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.        

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Sargent’s NFL Analogy for Reaganomics

Tuesday, February 19th, 2008

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. 

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Sargent’s Expectations

Monday, February 11th, 2008

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. 

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Friedman on the Role of Monetary Policy

Monday, February 4th, 2008

Friedman attempted to illustrate how the instrument of monetary policy helps to achieve the economic goals of high employment, stable prices, and rapid growth.  He explains how monetary policy was viewed as a string that could be pulled to stop inflation but that did not have the power to halt recession.  Many believed that money did not matter, it was merely something to keep interest low, hold down interest payments in the government budget, contribute to the “euthanasia of the rentier,” and maybe stimulate investment a bit.  This view was challenged when other countries around the world proved that interest rates could not be kept at a permanent low level.  From this came a revival in monetary theory.

            It was shown that changes in the quantity of money produced in other ways could affect total spending even under such circumstances.  The revival also undermined Keynes’ key theory that even in a world of flexible prices, a position of equilibrium at full employment might not exist.  The revival of monetary policy stemmed largely from a re-evaluation of the role money played from 1929-1933.  They discovered that the Federal Reserve System did do what it could to curb the Great Depression and that the Great Contraction was a testament to the power of monetary policy, not the evidence of its impotence.  Another factor which aided the revival of monetary policy was the state of unhappiness with fiscal policy.  Friedman also points of how drastically different the frame of mind with monetary policy had become in a few short decades.  He states that while monetary policy is important, he fears that too much emphasis might be placed on it now. 

            Friedman goes on to say what monetary policy cannot do.  He says that it cannot peg interest rates for more than a short period of time and it cannot peg unemployment rates for more than a short period of time either.  He argues that increasing the money supply will lower interest rates but that effect is the initial response and will ultimately raise prices and therefore reduce the real quantity of money.  This will return interest rates to the level they were once at and possibly higher than they were before the increasing of the money supply.  He finally argues that interest rates are a misleading indicator of whether monetary policy is tight or easy and that it is much better to look at the rate of change of the quantity of money.  Next he looks at employment and what monetary policy cannot accomplish with it.  He argues that monetary policy cannot peg employment levels for the same reasons as the interest rate, because of the difference between the immediate and the delayed consequences of the policy.  He talks about how expectations make it very difficult to use monetary policy to curb inflation and unemployment in most cases because people are acting off of past experiences instead of what should be happening.  To summarize, Friedman says that monetary policy can peg nominal rates and quantities but it cannot control the real rates of interest, rate of unemployment, level of real national income and so on. 

            He next talks about what monetary policy can do.  He says while it cannot peg these real rates and levels, monetary policy does have a strong influence on them.  Friedman speaks of money as merely a machine, but one that has allowed for tremendous growth in output and the level of living which people experience.  He says that while it is only a machine, when it gets out of order, it sends shocks through all of the other machines in the economy.  He uses the Great Contraction as his prime example of this.  He claims that every major inflation has been produced by monetary expansion.  He says one thing monetary policy can do is prevent money itself from being a major source of economic disturbance.  It is also the monetary authority’s duty to suggest improvements to the machine that will make the likelihood that it will go out of order smaller.  A second thing monetary policy can do is provide a stable background for the economy.  If things are kept in good shape, people’s expectations will be the most conducive to economic growth and confidence.  The third thing monetary policy can do is to help offset major economic disturbances arising from other sources.  He says that this role is one that is not as easy to do as the first two because it is not well known when action should be taken and how people will react to it. 

            Friedman finally tries to answer the question of how monetary policy should be conducted.  He says that the monetary authority should guide itself by the magnitudes it can control, not by the ones it cannot control.  He says that if they take interest rates or the unemployment percentage as its guide, they will most definitely go astray.  He says they should stick to exchange rates, price levels, and the quantity of money total.  He says for the United States, the exchange rate is not as desirable to target but that price levels is the most important.  He says that this is difficult to do because of the time lag and the variability with the magnitudes of the effects.  He says that due to the ignorance of what effects monetary policy will have on the economy, it is better to not make any large movements because they might be the source of disturbance.  He also says to avoid sharp swings in policy and to keep things moving gradually.  He argues for a publicly announced policy of a steady rate of growth.  He finally claims that a favorable climate for growth is the most we can ask for from monetary policy given our current understanding of it, but that much is within our grasp. 

            This is a good article on what monetary policy can and cannot do and why people believe what they believe about it.  Friedman is one of the leading monetarists and it is good to hear him speaking about the shortcomings and limitations of monetary policy.  I think this is a good article and definitely helpful when it comes to understanding monetarism. 

 Friedman, “The Role of Monetary Policy,” American Economic Review, 1968

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