Archive for March, 2008

NKE

Sunday, March 30th, 2008

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. 

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Lucas’ Models of Business Cycles

Thursday, March 20th, 2008

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……

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Summer’s Skeptical Observations: real business cycles

Tuesday, March 18th, 2008

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. 

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Prescott’s View on the Business Cycle

Saturday, March 8th, 2008

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. 

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