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October 8, 2011

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Posted: 08 Oct 2011 12:06 AM PDT

Mankiw: The IS-LM model

Posted: 07 Oct 2011 02:43 PM PDT

I haven't bothered with the LM versus MP curve debate because it's all been done before, and because there's really nothing to debate. But I forget that many of you weren't around in 2006 (when the post below was written). For me the bottom line is easy, some questions are easier to answer using the IS-LM model (e.g. see here), some with the IS-MP model (in both cases, coupled with a model of AS), but in general, as noted below, "There is no truly substantive debate here. These two models are alternative presentations of the same set of ideas":

The IS-LM Model, by Greg Mankiw: A reader emails me the following question:

Dear professor Mankiw:

I like your blog a lot. I daily go to it in order to read good economics. Keep up the excellent work!

May I ask you why economists authors of textbooks on intermediate macroeconomics like you keep using the IS-LM model even though we already know that the Central Bank does not set the monetary supply. Instead, it does set the interest rate. Shouldn´t you do like Wendy Carlin and David Soskice in their recent and fantastic book "Macroeconomics: Imperfections, Institutions and Policies" where they replace the LM curve by a monetary rule (for example, a Taylor rule). Wouldn´t that be more representative of what occurs in reality rather than supposing that the institution gets the control of the quantity of money?

Thanks for your attention in advance.

[name withheld]

... My email correspondent wonders whether it would be better just to jettison the traditional IS-LM model in favor of an alternative framework that ignores the money supply altogether and simply takes an interest-rate rule as given. This approach has been advocated by my old friend David Romer. (Economics trivia fact: I was the best man at David Romer's wedding, and he at mine.) You can find David's approach here (figures here). David calls his alternative presentation the IS-MP model, because it combines an IS curve with a monetary policy reaction function.

The first thing to understand about the choice between IS-LM and IS-MP is that it is not about determining which is the better model of short-run fluctuations. There is no truly substantive debate here. These two models are alternative presentations of the same set of ideas. The key issue in deciding which approach to prefer is not theoretical or empirical but pedagogical.

The IS-LM approach has a long history behind it. That is one reason to stick with it, but it is not dispositive. If I were convinced that the IS-MP model was a clear and substantial step forward, I would switch. So far, however, I am not convinced that the new approach is easier to teach or more intuitive for students.

The key difference between the two approaches is what you hold constant when considering various hypothetical policy experiments. The IS-LM model takes the money supply as the exogenous variable, while the IS-MP model takes the monetary policy reaction function as exogenous. In practice, both the money supply and the monetary policy reaction function can and do change in response to events. Exogeneity here is meant to be more of a thought experiment than it is a claim about the world. The two approaches focus the student's attention on different sets of thought experiments.

I like the IS-LM model because it keeps the student focused on the important connections between the money supply, interest rates, and economic activity, whereas the IS-MP model leaves some of that in the background. The IS-MP model also has some quirky features: In this model, for instance, an increase in government purchases causes a permanent increase in the inflation rate. No one really believes that result as an empirical prediction, for the simple reason that the monetary policy reaction function would change if the natural interest rate (that is, the real interest rate consistent with full employment) changed. This observation highlights that neither model's exogeneity assumption should be taken too seriously.

In the end, I remain open-minded, but at this point I prefer the IS-LM model when teaching (at the intermediate level) about the short-run effects of monetary and fiscal policy. If one were to teach IS-MP to undergrads, I would prefer to do it as an supplement, rather than a substitute, for IS-LM.

Related link: Here (and here in published form) is Paul Krugman's cogent defense of teaching the IS-LM model. The article was written quite a while ago, before IS-MP hit the scene, so I don't know what he would say about this alternative framework. But the Krugman piece is interesting, if only vaguely on point, so I wanted to give it some free advertising.

"Notes on a Worldly Philosopher"

Posted: 07 Oct 2011 12:06 PM PDT

Rajiv Sethi:

Notes on a Worldly Philosopher, by Rajiv Sethi: The very first book on economics that I remember reading was Robert Heilbroner's majesterial history of thought The Worldly Philosophers. I'm sure that I'm not the only person who was drawn to the study of economics by that wonderfully lucid work. Heilbroner managed to convey the complexity of the subject matter, the depth of the great ideas, and the enormous social value that the discipline at its best is capable of generating.

I was reminded of Heilbroner's book by Robert Solow's review of Sylvia Nasar's Grand Pursuit: The Story of Economic Genius. Solow begins by arguing that the book does not quite deliver on the promise of its subtitle, and then goes on to fill the gap by providing his own encapsulated history of ideas. Like Heilbroner before him, he manages to convey with great lucidity the essence of some pathbreaking contributions. I was especially struck by the following passages on Keynes:

He was not without antecedents, of course, but he provided the first workable intellectual apparatus for thinking about what determines the level of "output as a whole." A generation of economists found his ideas the only available handle with which to grasp the events of the Great Depression of the time... Back then, serious thinking about the general state of the economy was dominated by the notion that prices moved, market by market, to make supply equal to demand. Every act of production, anywhere, generates income and potential demand somewhere, and the price system would sort it all out so that supply and demand for every good would balance. Make no mistake: this is a very deep and valuable idea. Many excellent minds have worked to refine it. Much of the time it gives a good account of economic life. But Keynes saw that there would be occasions, in a complicated industrial capitalist economy, when this account of how things work would break down.

The breakdown might come merely because prices in some important markets are too inflexible to do their job adequately; that thought had already occurred to others. It seemed a little implausible that the Great Depression of the 1930s should be explicable along those lines. Or the reason might be more fundamental, and apparently less fixable. To take the most important example: we all know that families (and other institutions) set aside part of their incomes as saving. They do not buy any currently produced goods or services with that part. Something, then, has to replace that missing demand. There is in fact a natural counterpart: saving today presumably implies some intention to spend in the future, so the "missing" demand should come from real capital investment, the building of new productive capacity to satisfy that future spending. But Keynes pointed out that there is no market or other mechanism to express when that future spending will come or what form it will take... The prospect of uncertain demand at some unknown time may not be an adequately powerful incentive for businesses to make risky investments today. It is asking too much of the skittery capital market. Keynes was quite aware that occasionally a wave of unbridled optimism might actually be too powerful an incentive, but anyone in 1936 would take the opposite case to be more likely.

So a modern economy can find itself in a situation in which it is held back from full employment and prosperity not by its limited capacity to produce, but by a lack of willing buyers for what it could in fact produce. The result is unemployment and idle factories. Falling prices may not help, because falling prices mean falling incomes and still weaker demand, which is not an atmosphere likely to revive private investment. There are some forces tending to push the economy back to full utilization, but they may sometimes be too weak to do the job in a tolerable interval of time. But if the shortfall of aggregate private demand persists, the government can replace it through direct public spending, or can try to stimulate additional private spending through tax reduction or lower interest rates. (The recipe can be reversed if private demand is excessive, as in wartime.) This was Keynes's case for conscious corrective fiscal and monetary policy. Its relevance for today should be obvious. It is a vulgar error to characterize Keynes as an advocate of "big government" and a chronic budget deficit. His goal was to stabilize the private economy at a generally prosperous level of activity.

This is as clear and concise a description of the fundamental contribution of the General Theory that I have ever read. And it reveals just how far from the original vision of Keynes the so-called Keynesian economics of our textbooks has come. The downward inflexibility of wages and prices is viewed in many quarters today to be the hallmark of the Keynesian theory, and yet the opposite is closer to the truth. The key problem for Keynes is the mutual inconsistency of individual plans: the inability of those who defer consumption to communicate their demand for future goods and services to those who would invest in the means to produce them.

The place where this idea gets buried in modern models is in the hypothesis of "rational expectations." A generation of graduate students has come to equate this hypothesis with the much more innocent claim that individual behavior is "forward looking." But the rational expectations hypothesis is considerably more stringent than that: it requires that the subjective probability distributions on the basis of which individual decisions are made correspond to the objective distributions that these decisions then give rise to. It is an equilibrium hypothesis, and not a behavioral one. And it amounts to assuming that the plans made by millions of individuals in a decentralized economy are mutually consistent. As Duncan Foley recognized a long time ago, this is nothing more than "a disguised form of the assumption of the existence of complete futures and contingencies markets."

It is gratifying, therefore, to see increasing attention being focused on developing models that take expectation revision and calculation seriously. A conference at Columbia earlier this year was devoted entirely to such lines of work. And here is Mike Woodford on the INET blog, making a case for this research agenda:

This postulate of "rational expectations," as it is commonly though rather misleadingly known... is often presented as if it were a simple consequence of an aspiration to internal consistency in one's model and/or explanation of people's choices in terms of individual rationality, but in fact it is not a necessary implication of these methodological commitments. It does not follow from the fact that one believes in the validity of one's own model and that one believes that people can be assumed to make rational choices that they must be assumed to make the choices that would be seen to be correct by someone who (like the economist) believes in the validity of the predictions of that model. Still less would it follow, if the economist herself accepts the necessity of entertaining the possibility of a variety of possible models, that the only models that she should consider are ones in each of which everyone in the economy is assumed to understand the correctness of that particular model, rather than entertaining beliefs that might (for example) be consistent with one of the other models in the set that she herself regards as possibly correct...

The macroeconomics of the future, I believe, will still make use of general-equilibrium models in which the behavior of households and firms is derived from considerations of intertemporal optimality, but in which the optimization is relative to the evolving beliefs of those actors about the future, which need not perfectly coincide with the predictions of the economist's model. It will therefore build upon the modeling advances of the past several decades, rather than declaring them to have been a mistaken detour. But it will have to go beyond conventional late-twentieth-century methodology as well, by making the formation and revision of expectations an object of analysis in its own right, rather than treating this as something that should already be uniquely determined once the other elements of an economic model (specifications of preferences, technology, market structure, and government policies) have been settled.

I think that the vigorous pursuit of this research agenda could lead to a revival of interest in theories of economic fluctuations that have long been neglected because they could not be reformulated in ways that were methodologically acceptable to the professional mainstream. I am thinking, in particular, of nonlinear models of business cycles such as those of Kaldor, Goodwin, Tobin and Foley, which do not depend on exogenous shocks to account for departures from steady growth. This would be an interesting, ironic, and welcome twist in the tangled history of the worldly philosophy.

The Employment Report: Still Moving Sideways

Posted: 07 Oct 2011 09:18 AM PDT

A few comments on the employment report:

The Employment Report: Still Moving Sideways

No comments: