Attacks on the Traditional Approaches to Macroeconomics

1. Attacks on the Traditional Approaches to Macroeconomics Lecture 14

2. Alternative Theories to Define Alternative Policies • Monetarism is an argument against discretionary monetary policy to counter the business cycle • Other theories have also been proposed in recent decades to evaluate (and minimize) the theoretical potency of monetary and/or fiscal policy. At least two have added lasting value, although they extend rather than replace traditional theory: • “New Classical or ‘neoclassical’ inflation and unemployment theory” • “rational expectations”

3. Neoclassical Inflation and Unemployment Theory • Classical (i.e. pre-Keynesian) theory thought of markets as always being in equilibrium • But how could unemployment, particularly of the magnitude and duration experienced in the Depression, be considered an equilibrium? Keynesian thinking evolved to understand unemployment in the terms we have learned with IS-LM analysis and an accelerationist Phillips Curve • Other theorists proposed alternative explanations for unemployment that treat it a voluntary and hence equilibrium or market clearing. This return to a contention that markets cleared--everyone who wanted a job at the prevailing wage had a job--was termed “neoclassical” because it was a new version of classical conclusions • To be an accurate explanation of cycles, neoclassical labor theory fundamentally requires people to be fooled and uninformed about the wages being offered so that they mistakenly, voluntarily turn down job offers and stay unemployed

4. Rational Expectations • Another theoretical approach, sometimes even considered to be allied with the neoclassical unemployment and inflation theory, argued that fiscal and monetary policy would be impotent if people understood and anticipated its consequences.. i.e. if they were “rational” in their decisions. • In a “rational expectations” world, consumers and businesses see the full IS-LM reactions work out in advance and thus cut off the real output macroeconomic responses. • For rational expectations to be an effective denial of the potency of policy and business cycles in the real world, you might say that people must not be fooled. • This, of course, is the exact opposite of the neoclassical model but some theorists think they can simultaneously defend both!

5. Neoclassical Inflation and Unemployment Theory • Phelps, a leading proponent, treats unemployment as a decision under the control of the employee • Four types: speculative, precautionary, search, queue--but the differences are not crisp (note historical link to “money theory”) • spec.: withhold work because wages are low • precaut./wait: individual “between jobs” waiting for the random arrival of the next contract • search: active rejection of offers while actively looking for better offer • queue: like wait unemployment, by worker who believes offering a lower wage will do no good because the employer will only assume he must be worth less if offering to work for less • “These are...essentially informational in origin” • “the typical unemployed worker..is acting on an erroneous estimate of the demand for his services” • “...lead to the Monetary Phillips Curve”

6. The Role of Expectations in Neoclassical Unemployment Models • “...Unexpected inflation (of wages and prices) brings with it above-equilibrium employment and the process of unexpected deflation brings with it below-equilibrium unemployment” • The hypothesized sequence: • surge of demand from tax or monetary policy brings higher wages (recognized).. • .. and higher prices (not recognized at first) and... • .. lures more workers to accept jobs; • then price increase is recognized.. • ..and jobs are quit, and the process reverses. • The model thus explains the correlation of unemployment and inflation in reverse flow and timing versus traditional theory. Here: • U=E - E\1 = f ( RW\1 - RPexpected) • Unemployment is an error in expectations due to “static expectations about future wages and price levels”

7. Review the Traditional Alternative--Simple Micro in the Labor Market : Prices, Demand and Supply • Demand: More Workers/Hours Will Be Demanded by Employers the Lower the Real Wage, Other Things Equal • Supply: More Hours Will Be Supplied by Individuals the Higher the Real Wage • Equilibrium: Demand=Supply • All Those Wanting to Work at the Current Real Wage Can Find Work after a Reasonable Period of Search

8. Simple Micro in the Labor Market : Prices, Demand and Supply DEMAND REAL WAGE EQUILIBRIUM SUPPLY WORKERS or HOURS DEMANDED AND SUPPLIED

9. Simple Dynamics: Disequilibrium Means Change in the Labor Market • Unemployed Workers: • Voluntary, as in searching for a job at a wage higher than they or their peers are being offered: not a sign of Disequilibrium • Involuntary: Would accept the prevailing wage but no offer forthcoming. • By definition, Supply greater than Demand...at the prevailing wage • Involuntary Unemployment Creates Pressure for (Real) Wages to Fall • In the Traditional Model, knowledge of prices, wages, and offers is reasonably complete on the part of both workers and firms but prices and wages simply take time to adjust to gaps that have opened between demand and supply. Note sequence timing and logic of the flow is the reverse of the Neoclassical • RW or RP = f (U or U\1) • In the 1970s, the very important improvement in the traditional model was the inclusion of a full response of RW to RPexpected so that there would be only one equilibrium level of unemployment

10. Simple Dynamics: Disequilibrium Means Change in the Labor Market DEMAND REAL WAGE DISEQUILIBRIUM INVOLUNTARY UNEMPLOYMENT SUPPLY WORKERS / HOURS DEMANDED AND SUPPLIED

11. Fluctuations in Unemployment Reveal Job Loss to be the Primary Source of Changes in Unemployment--i.e. action by the employer and not the employee

12. Fluctuations in Unemployment

13. Rational Expectations • Argues that fiscal and monetary policy would be impotent if people understood and anticipated its consequences.. i.e. if they were “rational” in their decisions. • In a “rational expectations” world, consumers and businesses see the full IS-LM reactions work out in advance and thus cut off the real output macroeconomic responses. • For rational expectations to be an effective denial of the potency of policy and business cycles in the real world: people must not be fooled, or other sources of wage and price stickiness must be substantial. • The value of the rational expectations critique is that expectations must be modeled more carefully, more richly than in the past; in particular, they should reflect any linkage individuals associate with current policy actions

14. Past and Modern Expectations Modeling • Static or Naive, expecting no change: RPexpected= RPe=RP\1 • Adaptive or “Koyck”: RPe - RPe\1 = k * ( RPe\1 - RP\1) • where 0 < k < 1 is the partial adaptation parameter • thus RPe = ( 1- k) * RPe \1 + k * RP\1, • and substituting repeatedly, RPe = exponentially decaying sum of k raised to the ith power times RP\i • Polynomial variations on the Koyck lag structure • Expanding to include current and prospective policy variables along with lagged inflation variables in regression analyses • for example, the size of the structural government deficit (expected to prevail in the future) in the expectations terms of interest rate equations • another example, including consumer surveys of expected future conditions in consumer spending equations and then trying to model these survey answers