The Awesome Adventures of E488! (In written form)

I read the Lucas article for the bottom line section. Lucas shows that the world’s economies are converging and the gap between the largest and most powerful nations and the smallest countries is closer than ever. I guess maybe as a whole this is true, since the developing countries are growing at a faster rate than the developed countries like the US and Western Europe. This does not mean those countries do not have a long way to go. Now I wonder where Lucas put China, which would be considered a developing country up until recently and in some parts, especially in the western part of China, it is still as bad as any third world country. I would think that China’s growth, with it being so big could be skewing the numbers that Lucas has talked about a bit. I would like to see a comparison with just Africa and the Developed countries. Now Lucas is WAY smarter than me, so he may know this to be true, but color me skeptical as I see the gap between rich and poor growing (China being an exception since their middle class has grown exponentially).

I read the article by Mark Wynne. He talks about the phenomenon of sticky prices. He gives an example at first to give us what sticky prices are and why they occur. He says imagine one has a helicopter, which dropped a bunch of money on people. People would spend that money, and if the prices changed at the same time as the increase in money stock changes, all that would happen would be inflation to a new level. However, this does not happen as some companies decide to instead of changing prices to reflect the increase in money, they increase their production since transactions costs of changing their prices outweigh the benefits of new prices or they have a customer base that is very elastic when it comes to higher prices and the change in price could effect their bottom line in that way. Transactions costs do matter. Say if you are a Mom and Pop grocery store. The market tells them they should raise the price of their apple juice by 25 cents. Now they are hesitant to do it since they label everything in the store and that would mean having to go back and relabel every apple juice in the store itself and in their storeroom. The time that take may not be worth the 25 cent change. Also, a Mom and Pop store generally have customers that see a 25 cent change could be the reason they go to a supermarket instead of staying with their store.

Overall sticky prices occur, you see them every time you go out to eat (unless one goes to a place like Bistro Bethem downtown, since they change their menu on a daily basis.)

I love Mankiw.

For one thing, I can understand what he is writing perfectly. This is my favorite article I’ve read thus far. He starts off talking about the changes in macroeconomics in the last 20 years. He talks about what went wrong in the 70s, and compares the differences between academic and applied macro with Copernican and Ptolemaic systems of astronomy. After reading that, I really undertsood that academics can go in one direction to improve the applied which uses the past material in the present and that eventually that academic material of today becomes the applied material of tomorrow. He goes on to say that the 70s was a time where both the applied and the academic works were both wrong.

He then goes into directions of research. He places them into 3 broad categories, modelling of expectations, explaining macroeconomic phenomena using new classical models, and reconstructing macroeconomics using new Keynesian models. First he talks about Expectations research and he talks about Rules rather than discretion and he does a brilliant job of comparing rules vs discretion with the political policy of not negotiating over terrorists. He says that terrorists, if they knew for a fact that the US and other countries would have a rule to not negotiate with terrorists at all, then a rational terrorist would have little to no incentive to take hostages. But since it is discretionary, that means the President and people in charge have an incentive (save face, save lives, gain popularity) to renege on the rule and to negotiate with the terrorists instead of leaving those people SOL. He calls this the time inconsistency of optimal policy.

He talks about New Classicals and their various theories and then jumps into the New Keynesians. He talks about how labor contracts and sticky prices can keep us from being at a general equilibrium. This is because there are transactions costs for changing each of these. For prices, if you are a restaurant, one must change the the menu every night in order to keep up with it. For labor contracts, if the industry has a bad year, the laborers will be like to quote Goodfellas, “F you, pay me!” whether the company can afford it or not and what ends up happening is that instead of keeping the same amount of people at a lower wage they layoff people in order to keep up. Another thing he brings up is the fact that unlike new classicals, which assumed perfect competition, the New Keynesians assumed Monopolistic Competition which I think is a more accurate way of tracking businesses since there are very few industries that are truly in a perfect competition.

Overall as I said, I loved this article.

Reference:

Mankiw, N. Gregory. “A Quick Refresher Course in Macroeconomics.” Journal of Economic Literature, Vol. 28, No. 4, (Dec., 1990), pp. 1645-1660

After having read the article by Kydland and Prescott, it seems to me, they are advocating a policy in which we set a target and try to stay at that target rather than ultimately what Greenspan did, which was use his discretion to figure out how to control the economy. K and P feel that since economic agents act in a rational nature, that using discretionary tactics would not work, an in fact it would hurt the economy even more since these tactics lead to instability. Their solution is for the government to have rules. These rules would include setting a target growth rate for the money supply (aka inflation target) and to set a constant rate for taxes.

Do I think that they are right? Well, perhaps, I can see that a rational agent would adjust themselves to whatever the regime is so that they would expect that a certain regime would have their own tax plan and certain FED chairmen have their own policies when it comes to setting the Fed Funds Rate. But I look back at Greenspan and see that he being a person who believed in discretionary practices and the success that the economy had while he was the chairman. Then again he could’ve been lucky. I do not know if we have the answer to that at this point.

Reference:

Kydland, Fynn E. and Edward C. Prescott. “Rules Rather than Discretion: The Inconsistency of Optimal Plans” Journal of Political Economy, Vol. 85 No. 3 (Jun 1977), 473-492

Hoover, Kevin D.  1999.  Is macroeconomics for real?  University of California-Davis (June): 1-22;

“Ontology.” Wikipedia, (accessed 4/9/2008).

Hoover uses this paper to respond to some of his students who doubted that macroeconomics existed. These students said that only they are nothing more than microfoundations added up and thus should just be a form of microeconomics.

Well the first thing I had to find out was what did ontological mean, since I had no clue. I found it on wikipedia, it is the study of the concepts of reality. so now knowing that I could continue. He talks about to types of aggregates, natural which is taking all the individuals and adding them up to come up with the right answer. The second one he comes up with is called synthetic aggregates which involve components but not just added up but manipulated in such a way as to get a figure which works in our macroeconomy. He then goes on to explain these synthetic aggregates with some fancy math that if I looked at it hard or long enough would probably understand.

He then talks about the notion of supervenience, which basically in a nutshell he says, “that even though macroeconomics cannot be reduced to microeconomics, if two parallel worlds possessed exactly the same configuration of microeconomic or individual economic elements, they would also possess exactly the same configuration of macroeconomic elements.  It is not the case, however, that the same configuration of macroeconomic elements implies the same configuration of microeconomic elements.” He then goes on to argue that while individuals can be random in their thoughts and actions, the macroeconomics can pretty accurately predict behavior of these individuals despite their randomness.

So basically macroeconomics does exist and there are uses for it that we see today.

Long, John B. and Charles I. Plosser. Real Business Cycles. The Journal of Political Economy. Vol 91 No. 1. (Feb 1983), pp 39-69.

This article by Long and Plosser goes into talking about the RBC. Their model, like their predecessors, will have the following assumptions:

• Rational Expectations
• Complete Information
• Stable Preferences
• No technological change
• No long-lived commodities
• No frictions or adjustment costs
• No Government
• No Money
• No Serial Dependence on Stochastic elements in the Enviroment

Otherwise known as they have a community in a bubble and are manipulating it so that they can work their data (I’m sorry, but all of those exceptions just make me think that they are talking out everything that could present a problem to their data, but I guess in Economics one is looking for a solution and can just ceteris peribus everything else out.)

So what did they figure out in the end? They saw that maximizing agents in this idyllic world will choose plans of action that are consistent with the business cycle. So in times of good, agents will work more since they are getting more utility by working rather then having that extra leisure and vice versa in times of bad. They also found that relative prices are not constant and are adjusted for consumer preferences and how much production possibility that they have. In this economy, any attempt to stabilize the economy in times of bad will only make this economy worse, not better. So basically they say, let nature take its course and if there is an economic downturn that one should just let it happen and not worry so much about it since eventually the bad times will turn into good times once again.

Lucas, Jr, Robert E. Models of Business Cycles. Basil Blackwell Ltd, London, 1987.

This book was really rough to read. It was full of math that I really could not figure out, If someone would like to look at the math and tell me what it means, that would be lovely, but for now, I’m just going to assume Lucas knows way more than me in that regard and move on. What I am going to discuss is his theory and what he came up with as his conclusion so mostly I will discuss what he talks about in his 7th and 8th chapters. He basically took the Kydland and Prescott model and tweaked it to his standards and voila, his theory on business cycles. He says in the book, that the type of computations that he wants to make are basically technically impossible at the time he wrote this book, but I am sure with the expansion of technology (especially computers), we could probably solve those issues that he addresses. He says that people look at nominal things and misread them as something that is a real issue when in fact they are not and then brings about a problem with real.

Lucas says that private agents choose what they are going to do presently and in the future based on expectations of what other economic agents are going to do. He basically considers government as nothing more than another agent, albeit a public one rather than a private one. What the provate agents will do is look at the public agent (government) and make the necessary inferences as to what kind of fiscal and monetary policy that it will conduct. He talks about making an ‘economic constitution’ which basically means a set of rules to which the government should adhere to.

He also says that post-war business cycles are not very important as far as individual welfare is concerned. He says that welfare and social security are things that should be designed with total ignorance of the business cycle. Now I really did not get what he meant by that. I am guessing is that if we are in a trough or recession let it not effect the amount of welfare and social security that is distributed since the unemployment will always be around even when times are good.

He also states that fiscal and monetary policy really is only there to attain an average rate of inflation and that is all. He says that rates below 10% are fine but anything above that and we get a significant deadweight loss. He also says that stability is the one of the only “Free lunches” economics has found and can be had easily.

So basically, my main question is, that has there been any further conclusion that Kydland and Prescott’s model was right or not. If so, what are those results and where are places I can find them? My final question is, if Fiscal and monetary policy, according to people like Lucas and other New Classicals, is really nothing more than an inflation guard, then why do we continue to use it and why does it continue to change day in and day out?

You can access this article right here.

This article gives a basic rundowns of the differences between Keynesian and New Classical Macroeconomics (NCM).  First the article talks about the general differences between the two. First, that NCM assumes that market decisions are made by rational agents. And because of this, if  government should intervene in the economy, it requires two key steps: Identifying the “Market Failure” and showing that the government can actually follow policies that can lead to social improvements. Second, that they stress the supply side in the very short run, than just the long run like the Keynesians. Third, they question whether policy instruments can be manipulated to accomplish anything specific objectives.

Then Mr King looked at three different issues from the 1992 election campaign from each of these opposing viewpoints. First, he looked at a temporary cut for the middle class. Keynesians would see this as people have more money and thus spend more and create more demand for domestic goods, and this would lead to more jobs and more income. NCM would say that this temporary cut would do little to nothing. The reason for this would be that since it is temporary and not permanent, people would me more apt to take that money and save most of it instead spending like the Keynesians believe. Another reason NCM feel this will not work is that they know that the borrowing that the government has to do must be paid back with higher taxes in the future. The second issue he took at look at was the temporary revival of investment tax credits. The Keynesians look at them as a way to stimulate investment spending but do not see that these credits can make companies wait for the credit to go into effect to further invest and thus in a recession, lower spending even more. Third he looks at monetary policy. While Keynesians feel that monetary policy can make a difference in the economy, the NCM feel that while the expansionary policy will work in the short run, it will not work in the long run. They also claim that expansionary monetary policy could ignite higher inflation.

The NCM seem to make some sense. They talk about how instead of focusing on the short run economy, government should look at the long haul. I liked this article since it explained things and that I understood what things meant in here.

King, Robert. New Classical Economics, The Concise Encyclopedia of Economics.

So the report talks about the stagflation problem of the 70s, with rising unemployment, rising inflation, and how the administrations of those years were perfectly okay with giving up a little inflation to reduce unemployment. It then says that the real output per hour rose at a slower pace in the 70s than it did in the 60s, going from 3.0% to 1.4%. They said the reason for this was the sharp price increase in the cost of oil, the increase of unskilled laborers, and for all you sexists out there, more women joining the workforce. Another curb to productivity was increases in government regulations, which reduced labor productivity and diverted capital investment from the improvement of productivity to making sure regulations were met. Well, for me, if that was for safety reasons, or some other positive reason to divert that capital, I am all for it. They proposed that the tax changes that were put into place in 1981 and 1982 would stimulate savings, investment, and effort and thus lead the country into being more productive.

Next they talked about the inflation problem. They said a variety of factors influenced this sharp rise in inflation (3.0% rate in 1970 to 10.2% in 1980). One was supply determined changes in the commodities market and the disruptions in the supply of oil (Thanks to the unethical cartel known as OPEC). Then expectations of the continuing inflation crept into the picture and even when demand was declining, reducing inflation was still not happening. They then said that money growth was the true culprit in the long run as a percentage of growth rate in the money supply will mean a percentage of increase in nominal GNP (sounds familiar, eh?)

They then talk about the  recessions of 1980 and 1982 and what the effects of both of those were on the economy. Basically, they said the recessions were not bad things as it slowed down the rate of inflation and got it back to a 3.3% rate in 1982. They said one of the causes of the 1982 recession included a slowdown in the velocity of money, though they said that this is impossible to anticipate and only in hindsight would one be able to see such a thing happening.

They then project that recovery from the recession is coming (which it did huzzah!), and that the only way we can continue growth without inflation is with good monetary and fiscal policies (which would pretty much sound intuitively obvious to even the most casual of observers, I would think).  Monetary policies should include controlling the growth of the money stock but not specifically targeting a specific rate.

They also talk about the Federal Deficit which is a huge problem and continues to be today. They blamed the recession and the cutting of taxes to curb that recession as the main reasons for this deficit problem. They then talk about the federal debt “crowding out” businesses by competing directly with private enterprise for lending dollars. They also say that the large budget deficit will artificially inflate the value of the dollar and will hurt businesses that export and companies with competition that import goods from other parts of the world.

Interesting seeing a glimpse into the minds of these economists that Reagan assembled. Btw, all of that information was only in the first chapter. there are 6 chapters in all and it is an interesting read. Also you can read any of the reports of the president going back to 1947 by going here.

Source:

Economic Report to the President, 1983. Council of Economic Advisors, 1983.

Every time I think of the term expectations it reminds me of an old Mad TV skit called “Lowered Expectations”. Basically, the premise is that ugly, demented, or mentally challenged people would have a place to go and try to get dates. Here is an examples via my favorite website youtube.

 http://www.youtube.com/watch?v=VRcj9WbHL…

 http://www.youtube.com/watch?v=GxL1uXwSr…

Anywho, this is not about those expectations, but the fun loving economic meaning for expecations. I read Rational Expectations by G. K. Shaw. The reason for my tardiness on this post was because I wanted to finish the book before I posted. Now that I’ve completed it here is the finished product.

Shaw first talks about how rational expectations theory is needed. He says prior to the advent of adaptive and rational expectations, theories like static expectations and non-rational expectations were too simplistic and not very good way to predict the future.

He starts off with talking about static expectations. This is basically the prevailing theory that what happens today will continue to happen into perpetuity. This thinking of course does not make sense since things change all the time but this was the way that early economists thought and made their models. The problem with this is that people do not think that way and thus the prediction for the future could be grossly inaccurate, unless it is something that historically never changes or only rarely changes.

Next he talks about adaptive expectations. These are when one takes his expectations from prior periods and uses those previous expectations to predict what is going to happen. Now that is all well and good and all, but that does not factor in current conditions into the equation, it just looks at the past to predict the future.

Finally (and for the last half of the book,) he talks about Rational Expectations.  This is when economic agents takes not just prior information, but also current information and make a best guess using this data. The main problem with this is that in order to make a perfect prediction of the future, one must have perfect information which is near impossible to get. Shaw defends this by saying with the media and lirbaries available to the public at large, people can look up what they need to make a smart, rational prediction of the future (if this book were not written 24 years ago, Shaw would certainly included the internet and the wealth of knowedge as a HUGE way to stay informed.) I mean these days one is a few clicks away from looking at any report one wants to see. Need unemployment numbers, look at the BLS website, need Consumer Confidence, go to the University of Michigan.

These days, it actually takes a bit of effort to not be informed enough to make a rational expectation  of the future. Now the hard part (as we saw in class a few days ago), is to include this into a macroeconomic set, that predicts what everyone else is thinking and predicting. Shaw says that by and large, people do think relatively the same way and react to information and such the same way. How true that is, that is left up to individual speculation.

Overall, it is used in models today and until someone figures out a new and better way to predict the future, rational expecations will continue to be the standard.

Reference:

Shaw, G. K. Rational Expectations. St. Martin’s Press, New York, 1984.