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August 27, 2010

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Why Did Economists Reject Flexible Price Models?

Posted: 27 Aug 2010 03:33 AM PDT

I expect that some of you are completely lost in the debate over the relationship between interest rates and inflation that has been going on lately. I'm hoping this will provide some general background on monetary models that will help to sort things out, at least at a very general level.

But the main reason for doing this is to emphasize something that has not been talked about much, how the empirical evidence led economists to move away from flexible price models and consider models featuring wage and price rigidities (and for those of you ready to jump on me about the empirical evidence regarding wage and price rigidities, how the evidence changes with disaggregation and the like, those objections have been presented here, e.g. see this post for one example, or even better, see here, or better yet, scroll down here).

This is an important, too little discussed point. In models with flexible prices, matching the short-run dynamics contained in actual U.S. data with a defensible theoretical model is a challenge, one that can only be overcome with assumptions that are highly unpalatable. We do much better when we add wage inflexibility, but that alone is not enough to get both the size and the sign of all the correlations in the data correct, and it also fails to match the magnitude and duration of the responses to shocks. When price rigidities are tacked onto the model so that both price and wage inflexibilities are present, we get much closer in matching signs of correlations, durations, and magnitudes contained within U.S. data.

Even then, problems remain. One has to do with whether the actual degree of price rigidity in the data is enough to generate the persistence and magnitudes that are needed -- that's the point of the papers linked above. Another is the need to assume unrealistic values for labor supply elasticities in order to get the right degree of labor responsiveness in the model. The values needed do not match the estimated values. In addition, the Calvo pricing assumption is often attacked as ad hoc instead of being derived from first principles, an unrealistic approximation of the true process (e.g. it's not state dependent), and so forth. And this list is by no means exhaustive.

But these models -- New Keynesian models -- are the best we have presently in terms of matching the data empirically. Some proponents of alternatives, e.g. flexible price models, will protest that they can, in fact, do as well or better at matching the data, but they will rely upon assumptions, decompositions, shock characteristics and the like that the larger profession has deemed unsupportable. When the proponents of alternatives to the New Keynesian model produce a model of their own that does a better job of explaining the data without resorting to these assumptions, then it will be time to pay more attention. But for now, for policy analysis in particular, the New Keynesian models are the best we have. I understand that, particularly recently, best does not necessarily imply good -- the models need to be fixed and some people, like Stiglitz don't think they can be fixed at all. But, again, for now they are the best we have, particularly in terms of matching the empirical evidence and for policy analysis.

This is from Carl Walsh's book "Monetary Theory and Policy" (I need to get my hands on his 3rd edition). The sections below provide some background on the evolution of monetary models, as well as more on the point about needing wage and price rigidities to match the empirical evidence:

2 Money-in-the-Utility Function
2.1 Introduction
The neoclassical growth model, due to Ramsey (1928) and Solow (1956), provides the basic framework for much of modern macroeconomics. Solow's growth model has just three key ingredients: a production function allowing for smooth substitutability between labor and capital in the production of output, a capital accumulation process in which a fixed fraction of output is devoted to investment each period, and a labor supply process in which the quantity of labor input grows at an exogenously given rate. Solow showed that such an economy would converge to a steady-state growth path along which output, the capital stock, and the effective supply of labor all grew at the same rate.
When the assumption of a fixed savings rate is replaced by a model of forward-looking households choosing savings and labor supply to maximize lifetime utility, the Solow model becomes the foundation for dynamic stochastic models of the business cycle. Productivity shocks or other real disturbances affect output and savings behavior, with the resultant effect on capital accumulation propagating the effects of the original shock over time in ways that can mimic some features of actual business cycles (see Cooley 1995).
The neoclassical growth model is a model of a nonmonetary economy, and while goods are exchanged and transactions must be taking place, there is no medium of exchange -- that is, no "money" -- that is used to facilitate these transactions. Nor is there an asset, like money, that has a zero nominal rate of return and is therefore dominated in rate of return by other interest-bearing assets. To employ the neoclassical framework to analyze monetary issues, a role for money must be specified so that the agents will wish to hold positive quantities of money. A positive demand for money is necessary if, in equilibrium, money is to have positive value.
A fundamental question in monetary economics is the following: How should we model the demand for money? How do real economies differ from Arrow-Debreu economies in ways that give rise to a positive value for money? Three general approaches to incorporating money into general equilibrium models have been followed: (1) assume that money yields direct utility by incorporating money balances directly into the utility functions of the agents of the model (Sidrauski 1967); (2) impose transactions costs of some form that give rise to a demand for money, either by making asset exchanges costly (Baumol 1952; Tobin 1956), requiring that money be used for certain types of transactions (Clower 1967), assuming that time and money can be combined to produce transaction services that are necessary for obtaining consumption goods, or assuming that direct barter of commodities is costly (Kiyotaki and Wright 1989); or (3) treat money like any other asset used to transfer resources intertemporally (Samuelson 1958). All involve shortcuts in one form or another... An important consideration in evaluating different approaches will be to determine whether conclusions generalize beyond the specific model or are dependent on the exact manner in which a role for money has been introduced. We will see examples of results that are robust, such as the connection between money growth and inflation, and others that are sensitive to the specification of money's role, such as the impact of inflation on the steady-state capital stock. ...
The ... assumption that prices and wages are perfectly flexible will be maintained... Thus, the focus is on flexible price models that emphasize the transactions role of money. The approaches adopted in these models can also be used to incorporate money into models in which prices and/or wages are sticky. The implications of introducing nominal rigidities into general equilibrium models of monetary economies are discussed in [later] chapters...
3.5 Summary
The models we have examined in this and the previous chapter are variants of Walrasian economies in which prices are perfectly flexible and adjust to ensure that market equilibrium is continuously maintained. The ... approaches discussed all represent means of introducing valued money into the Walrasian equilibrium. Each approach captures some aspects of the role that money plays in facilitating transactions. ...
However, the dynamics implied by these flexible-price models fail to capture the short-run behavior that appears to characterize modem economies.
That is perhaps not surprising; most economists believe that sluggish wage and price adjustment, absent from the models of this chapter, play critical roles in determining the short-run real effects of monetary disturbances and monetary policy. Although systematic monetary policy can have real effects with flexible prices, simulations suggest that these effects are small, at least at moderate inflation rates. To understand how the observed short-run behavior of money, interest rates, the price level, and output might be generated in a monetary economy, we need to introduce nominal rigidities, a topic discussed in chapter 5. ...
5 Money, Output, and Inflation in the Short Run
5.1 Introduction
Chapter 1 provided evidence that monetary policy actions have effects on real output that persist for appreciable periods of time. The empirical evidence from the United States is consistent with the notion that positive monetary shocks lead to a hump-shaped positive response of output, and Sims (1992) finds similar patterns for other OECD economies. We have not yet discussed why such a response is produced.
Certainly the models of chapters 2-4 did not seem capable of producing such an effect. So why does money matter? Is it only through the tax effects that arise from inflation? Or are there other channels through which monetary actions have real effects? This question is critical for any normative analysis of monetary policy, since designing good policy requires understanding how monetary policy affects the real economy and how changes in the way policy is conducted might affect economic behavior.
In the models examined in earlier chapters, monetary disturbances did cause output movements, but these movements arose from substitution effects induced by expected inflation. The simulation exercises suggested that these effects were too small to account for the empirical evidence on the output responses to monetary shocks. In addition, the evidence in many countries is that inflation responds only slowly to monetary shocks. If actual inflation responds gradually, so should expectations. Thus, the evidence does not appear supportive of theories that require monetary shocks to affect labor-supply decisions and output by causing shifts in expected inflation.
In this chapter,... we move from the general equilibrium models built on the joint foundations of individual optimization and flexible prices to the class of general equilibrium models built on optimizing behavior and nominal rigidities that are employed in most discussions of monetary policy issues. ...
It is easy to see why nominal price stickiness is important. As we have seen in the previous chapters, the nominal quantity of money affects equilibrium in two ways.
First, its rate of change affects the rate of inflation. Changes in expected inflation affect the opportunity cost of holding money, leading to real effects on labor-leisure choices and the choice between cash and credit goods. However, these substitution effects seem small empirically. Second, money appears in ... the form of real money balances. If prices are perfectly flexible, changes in the nominal quantity of money via monetary policy actions will not necessarily affect the real supply of money. When prices are sticky, however, changing the nominal stock of money does initially alter the real stock of money. These changes then affect the economy's real equilibrium. Short-run price and wage stickiness implies a much more important role for monetary disturbances and monetary policy. ...

Paul Krugman: This Is Not a Recovery

Posted: 27 Aug 2010 12:42 AM PDT

Why aren't monetary and fiscal policymakers doing more to boost the economy?:

This Is Not a Recovery, by Paul Krugman, Commentary, NY Times: What will Ben Bernanke, the Fed chairman, say in his big speech Friday in Jackson Hole, Wyo.? Will he hint at new steps to boost the economy? Stay tuned. ...
Unfortunately,... this isn't a recovery, in any sense that matters. ... The important question is whether growth is fast enough to bring down sky-high unemployment. We need about 2.5 percent growth just to keep unemployment from rising... Yet growth is currently running somewhere between 1 and 2 percent, with a good chance that it will slow even further in the months ahead. Will the economy actually enter a double dip, with G.D.P. shrinking? Who cares? If unemployment rises for the rest of this year, which seems likely, it won't matter whether the G.D.P. numbers are slightly positive or slightly negative.
All of this is obvious. Yet policy makers are in denial.
After its last monetary policy meeting, the Fed released a statement declaring that it "anticipates a gradual return to higher levels of resource utilization" — Fedspeak for falling unemployment. Nothing in the data supports that kind of optimism. Meanwhile, Tim Geithner, the Treasury secretary, says that "we're on the road to recovery." No, we aren't.
Why are people who know better sugar-coating economic reality? The answer, I'm sorry to say, is that it's all about evading responsibility.
In the case of the Fed, admitting that the economy isn't recovering would put the institution under pressure to do more. And so far, at least, the Fed seems more afraid of the possible loss of face if it tries to help the economy and fails than it is of the costs to the American people if it does nothing, and settles for a recovery that isn't.
In the case of the Obama administration, officials seem loath to admit that the original stimulus was too small. True, it was enough to limit the depth of the slump..., but it wasn't big enough to bring unemployment down significantly.
Now,... officials could, with considerable justification, place the onus for the non-recovery on Republican obstructionism. But they've chosen, instead, to draw smiley faces on a grim picture, convincing nobody. And the likely result in November — big gains for the obstructionists — will paralyze policy for years to come.
So what should officials be doing, aside from telling the truth about the economy?
The Fed has a number of options. ... Nobody can be sure how well these measures would work, but it's better to try something that might not work than to make excuses while workers suffer.
The administration has less freedom of action, since it can't get legislation past the Republican blockade. But it still has options. It can revamp its deeply unsuccessful attempt to aid troubled homeowners. It can use Fannie Mae and Freddie Mac ... to engineer mortgage refinancing that puts money in the hands of American families — yes, Republicans will howl, but they're doing that anyway. It can finally get serious about confronting China over its currency manipulation...
Which of these options should policy makers pursue? If I had my way, all of them.
I know what some players both at the Fed and in the administration will say: they'll warn about the risks of doing anything unconventional. But we've already seen the consequences of playing it safe, and waiting for recovery to happen all by itself: it's landed us in what looks increasingly like a permanent state of stagnation and high unemployment. It's time to admit that what we have now isn't a recovery, and do whatever we can to change that situation.

An Autopsy of Fannie Mae and Freddie Mac

Posted: 27 Aug 2010 12:26 AM PDT

The arguments below concerning Fannie and Freddie's role in the crisis have been made many times here over the last several years, see the second link at the end, but it's worth a reminder given the concerted attempt by anti-government types to make people think that Fannie and Freddie played a large role in causing the crisis. They didn't. That's not to say that Fannie and Freddie are defensible in their present form, see this discussion for example, or this from Dean Baker. But placing the blame for the crisis in the wrong places will lead to ineffective and potentially counterproductive attempts to prevent this from happening again:

An Autopsy of Fannie Mae and Freddie Mac, by Binyamin Applebaum, NY Times: Here's a last-minute option for summer reading material: An autopsy on Fannie Mae and Freddie Mac by their overseer, the Federal Housing Finance Agency.
The report aims to inform the continuing debate in Washington about the future of the government's role in housing finance. ... And it does a good job of making a few key points:
1. Fannie and Freddie did not cause the housing bubble. In fact, you can think of the bubble as all the money that poured into the housing market on top of their regular and continuing contributions. There's a good chart on Page 4 of the report illustrating this...
The market share of the two government-sponsored companies plunged after 2003, and did not recover until 2008. In 2006, at the peak of the mania, the companies subsidized only one-third of the mortgage market.
2. This was not for a lack of trying. The companies bought and guaranteed bad loans with reckless abandon. Their underwriting standards jumped off the same cliff as every other participant in the mortgage market.
3. Importantly, the companies' losses are mostly in their core business of guaranteeing loans, not in their investment portfolios. The guarantee business is the reason the companies were created. ...

More here. And here.

links for 2010-08-26

Posted: 26 Aug 2010 11:02 PM PDT

"The Real Activity Suspension Program"

Posted: 26 Aug 2010 02:59 PM PDT

I know how much some of you will disagree with this, but I have a hard time ascribing bad motives to people at the Fed and using it to explain policy decisions. I think people at the Fed believe in their heart of hearts that they are doing what's best for the economy as a whole as opposed to what's best for a particular party or some small group of people pulling the strings, but they are relying on bad assumptions, questionable models, convenient interpretations, etc. To me, some of the beliefs held by the other side are astoundingly unbelievable, but they would, of course, say the same thing about me. I don't deny that those beliefs can be convenient for the person holding them, but the idea that people at the Fed are consciously holding down the larger economy in order to benefit Republicans or some group of people is hard for me to buy into. There are certainly ideological divides that lead the other side to policies that I think are misdirected, or even counterproductive, but the bad motive explanation is hard to swallow. I'm more inclined to think this goes on in Congress where to some, winning the election is the only thing, but even then it's hard to assert this as a general proposition. But perhaps I have too much belief that people mostly try to do the right thing, and I am hopelessly trusting and naive (though see here). I expect to be told that I am.

Here's Andy Harless:

The Real Activity Suspension Program, by Andy Harless: (Think of this as a guest post by the Cynic in me. I'm not sure my Cynic is entirely right on either the facts or the economics, but he has a provocative point. And I apologize for the fact that he misuses the word "recession" to include the period since our inadequate recovery began.)
Americans got angry when the federal government tried to bail out banks by buying assets or taking capital positions. Whatever you may think of those bailout programs, they at least had the advantage that taxpayers were getting something in return for their money. There is another bank bailout program going on now – one that allows the federal government to recapitalize banks with public money, receive nothing at all in return, and somehow escape criticism for doing so. That bailout program is called the Recession.
How does the Recession allow the government to bail out banks? With the recession going on, people are afraid to do anything risky with their assets, so they keep them deposited in banks, earning no interest. Banks can then invest these deposits in Treasury notes and credit the interest on those Treasury notes to their bottom line, thus improving their balance sheets. So the government pays to recapitalize banks while receiving nothing in return.
Now this bailout program is not without its risks. The biggest risk is that the economy will recover, which would be a disaster for the program. Suddenly, not only would banks be holding losses on their Treasury notes, but their cost of funds would go up, as depositors realized that there were more attractive investments available than zero-interest bank deposits.
Another risk, with similar implications, is an increase in the expected inflation rate. That would also lead to capital losses on the banks' Treasury note holdings and an increase in their cost of funds.
Finally, there is reinvestment risk. Treasury notes mature and need to be rolled over, the coupon payments need to be reinvested, and banks have new inflows of funds that need to be invested. A substantial decline in the yields on Treasury notes (perhaps a continuation of what we are seeing now) would benefit banks in the short run because of the capital gains involved, but ultimately it would effectively terminate the bailout program, since banks would no longer be able to earn a large spread on their safe investments.
So the success of this bailout program depends on avoiding recovery, avoiding increases in inflation expectations, and avoiding major declines in Treasury note yields. Now do you understand why the Federal Reserve Bank presidents – representatives of the banking sector – are the most hawkish voices at the FOMC's policy meetings?

"Find the Unemployed and Hire Them"

Posted: 26 Aug 2010 11:02 AM PDT

It's my understanding that the editors at Bloomberg will not let their columnists say certain things, and that's one of the reasons I stopped, for the most part, sending any traffic in their direction. If the columnist persists and tries to say it anyway, the column is spiked.

I don't know the extent to which Kevin Hassett is constrained by these puppet strings, but it's interesting to hear the change in tone when he is not writing for Bloomberg.

Let's start this with a recent Hassett opinion piece at Bloomberg entitled "Bury Keynesian Voodoo Before It Can Bury Us":

Bury Keynesian Voodoo Before It Can Bury Us All, by Kevin Hassett: Initial claims for unemployment benefits surged to 500,000 in mid-August, a level more typical of a recession than a recovery. ...
In all likelihood, the data will soon be so convincingly bad that we'll again debate the need for an economic stimulus. Let's hope that when that begins, all will finally concede that the ideas of John Maynard Keynes are as dead as the man himself, and that Keynesianism is the real voodoo economics.

And here's Kevin Hassett when he's not writing for Bloomberg:

Conservative Economist: 'Find the Unemployed and Hire Them', by Derek Thompson: Let's put this gently: economist Kevin Hassett is no Keynesian.
Hassett, the director of economic-policy studies at the American Enterprise Institute and an economic adviser to Sen. John McCain, recent attacked President Obama's economic plan as "voodoo economics"...
But when I got him on the phone to talk about the unemployment crisis, he struck a different tone. ... The problem, he said, was that Obama's stimulus was not direct enough.
With the Recovery Act, the White House eschewed direct hiring and aimed instead to raise overall economic output in the hope that more activity would lead to more demand...
"My idea is simpler. Find the unemployed and hire them."
If the government had spent the stimulus hiring people directly, we could have supported 23 million jobs, Hassett claimed. Hiring millions of unemployed workers directly into government organizations that already exist -- such as the military and the Army Corps of Engineers -- would be a much more efficient use of government funds.
Hassett defended direct government hiring, which the federal government used en masse during the Great Depression...
"Employers don't want to take a chance on some guy without a job for two years," he said. "The cycle is so long and deep that the cyclical becomes the structural." The easiest way for the government to end somebody's jobless spell is, very simply, to end it by straight-up hiring the worker.
"Since the economy has created this class of long-term jobless, the arguments for government hiring becomes stronger," he said. "If you give the person a job for a while, it helps them get a job later. You remove the stigma."

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