Managerial Economics

Managerial Economics Lecture Seven: The macroeconomy: standard views

Recap & Wrap-up on Microeconomics • Superficially, microeconomics a settled field • Micro-economics = Neoclassical economics • In depth, many possible approaches • Empirical: data contradicts neoclassical assumptions • Theoretical: Schumpeter & evolutionary views of behavior of firms • Analytic: multi-agent modelling of behavior of firms & consumers • A much more complex mosaic than “supply & demand” • Next set of lectures: macroeconomics • Still dominated by neoclassical views • But more avowedly subject to debate

Macroeconomics: the context of business • Manager’s most immediate concern is own market & competition • But macroeconomic performance sets context for own market • Most markets rise & fall with general economic conditions • Some exceptions—e.g., liquidators do well in slumps! • “Boom” or “slump” conditions thus affect profitability • Ability to foresee switch from one extreme to other also extremely important • Hence economists being paid to “forecast” • So can you rely upon economists to predict the behavior of the macroeconomy?

Macroeconomics … Acknowledged debate • No! • Can’t even agree amongst themselves on how it works • Opening sentence of Sloman & Morris “says it all” • “There is no universal agreement among economists as to how the economy functions at a macroeconomic level. Instead there are various schools of thought.” (p. 382) • Dominant areas of dispute: • Whether economy tends towards full employment or unemployment equilibrium • Role of government in economy • “Ignored” area: whether economy inherently stable or cyclical

Macroeconomics … Acknowledged debate • Sloman & Morris summary of debate: 3 issues • Flexibility of wages & prices • Flexibility of aggregate supply • Role of expectations in working of market • Debates shown in context of “aggregate demand & supply analysis” (AD & AS) • Macro-economy summarised by intersection of AD curve & AS • Diagram: prices on vertical axis; GDP on horizontal • Two curves: • Downward-sloping aggregate demand (AD) • Upward-sloping aggregate supply (AS) • Sound familiar?

Macroeconomics … Acknowledged debate Price level • AD: fixed money supply & real income • Lower price level means higher real demand • AS: aggregate production function with diminishing marginal productivity (DMP): If output increases, costs must rise AS AD GDP • AD: movement along requires fall in prices; shift up causes increase in price & increase in GDP • AS: movement along causes rising price level; shift up causes increase in price & fall in GDP

Macroeconomics … Acknowledged debate • Essentially “port” of micro framework to macro economy • Micro: “intersecting demand & supply curves explain everything” • Macro: “intersecting AD & AS curves explain everything” • But as we’ve seen… • Micro analysis has real flaws • Macro… • Similar problems • BUT some debate over “elasticity” of curves… • “Flexibility of wages & prices • Flexibility of aggregate supply • Role of expectations in working of market”

Macroeconomics … Acknowledged debate • Flexibility of wages & prices • “Some economists argue … Markets tend to clear … fairly quickly. Disequilibrium unemployment … fairly small… Any long-term unemployment, therefore, will be equilibrium (or `natural') unemployment. To cure this, they argue, encouragement must be given to the free play of market forces… • Some argue, however, that in the short run wages may not be perfectly flexible… The solution … is to curb … unions so that wage flexibility can be restored and disequilibrium unemployment cured. • Other economists reject the assumption of highly flexible wages and prices… unions will resist cuts in real wages and, certainly, cuts in money wages… • The prices of goods may also be inflexible… firms use cost-plus methods of pricing. If wages are inflexible downwards, … prices will also be inflexible downwards.” (382)

Flexibility of wages & prices • High flexibility: quick adjustment from one equilibrium to another: P AS • “Instantaneous” movement, system always in equilibrium P2 • Low flexibility: slow adjustment from one equilibrium to another: P1 AD2 P,GDP AD1 • Potential for out of equilibrium effects: “disequilibrium unemployment” Y1 Y2 GDP

Macroeconomics … Acknowledged debate • Discussion “micro” in nature • IF markets assumed flexible THEN no macro problems • IF markets inflexible THEN problem is micro • Unions if wages inflexible • Monopolies if prices inflexible • No discussion of empirics despite existence of research • Blinder (1998) survey conclusive: prices inflexible; adjustments slow • Therefore disequilibrium unemployment persists • But “debate” continues…

Macroeconomics … Acknowledged debate • Flexibility of aggregate supply • “… flexible … aggregate supply does not respond … to changes in aggregate demand. Aggregate supply … depends on the quantity and productivity of factors of production, not on the level of aggregate demand. An expansion of aggregate demand will merely lead to (demand-pull) inflation… • If the government, therefore, wants to expand aggregate supply and get more rapid economic growth… it should concentrate directly on supply by encouraging enterprise and competition, and generally by encouraging markets to operate more freely…. supply-side economics. • Other … argue that rises in aggregate demand will cause aggregate supply to rise… However, these conditions will not be achieved, they argue, if the government pursues a non-interventionist, laissez-faire policy. The government instead must seek to control aggregate demand, to ensure that it continues to grow, and at a steady, nonfluctuating rate.” (383)

Macroeconomics … Acknowledged debate • Debate shown in terms of slope of AS function • Steep: “neoclassical” • Demand influences only price level • Horizontal: “extreme Keynesian” • Demand influences GDP, price level constant

Macroeconomics … Acknowledged debate • Again, empirical evidence clear but ignored • Blinder finds downward sloping marginal cost the rule • Only possible reason: excess capacity also the rule • “Supply” therefore can expand to match demand • “Aggregate supply” should be horizontal • Main issue—cost pressures on inputs (wages, raw materials) • Rising costs due to rising input prices rather than diminishing marginal productivity… • But “debate” continues…

Macroeconomics … Acknowledged debate • Role of expectations in working of market • “Some economists argue that people's [price change expectations] adjust rapidly … • If aggregate demand expands … people will expect higher prices… all firms will raise their prices in response to the demand increase… price rises will fully choke off the extra demand… no increase in sales, … output and employment. • … increased aggregate demand merely fuels inflation… • Others believe that the formation of expectations is more complex … If there is a lot of slack in the economy—if unemployment is very high and there are many idle resources…—then output and employment may quickly rise…” (384)

Macroeconomics … Acknowledged debate • Blinder’s research again • Very few firms anticipate inflation when setting prices • Empirical research thus rejects “rational expectations” attitude to impact of demand increase • But empirical evidence ignored and “debate” continues… • IF evidence taken into account, then • Disequilibrium output, employment & prices the rule • Supply flexible—excess capacity—so “demand management” policies can affect employment • Prices sluggish & don’t anticipate inflation: cost-push inflation the rule • So in terms of the debate model:

Macroeconomics … Acknowledged debate • Sloman & Morris diagram (c) the rule… • BUT AS slope due to rising input costs, not DMP… • AND… how to model disequilibrium prices? • Can model cope? • Let’s check derivation… • Model an extension of Hicks’s “IS-LM” interpretation of Keynes…

Keynes “general theory”, according to Hicks • Deriving the LM curve: • Fixed Money supply • Exogenously set by Reserve Bank • Money demand • a negative function of interest rate • Money held in case investment expectations not fulfilled • Otherwise no need to hold money except for immediate transactions • But money “barren” [no income from it] so increased interest rate increases opportunity cost of holding money • a positive function of income • “transactions demand for money” • increased income level requires more money for transactions

Keynes “general theory”, according to Hicks • The combination: an upward-sloping LM curve: The LM curve Exogenous Ms i i Md2 (Y2) Md1 (Y1) GDP=Y Y1 Y2 M • LM curve thus shows all combinations of output and interest rate that give equilibrium in money market: demand for money equals supply…

Keynes “general theory”, according to Hicks • Next, the IS curve: • Investment demand a negative function of i [I=I(i)] • Lower interest rate makes more projects NPV positive • Investment rises as interest rate falls • Savings supply a positive function of Income [S=S(Y)] • Savings a residual after consumption • Savings rise as income rise

Keynes “general theory”, according to Hicks • IS curve thus shows all points where goods market is in equilibrium • Investment = Savings • So consumption = output of consumer goods Y (income) Y (income) S=S(Y) Savings a function of income S Y (income) i Investment a function of interest rate i The IS curve Multiplier I=I(i) Y(output) I (Investment)

Keynes “general theory”, according to Hicks The product: IS-LM analysis • LM curve shows all points for money market equilibrium • Money demand equals money supply • IS curve shows all points for goods market equilibrium • Investment=Savings • Demand for goods equals supply • Intersection shows overall economy equilibrium i LM IS Y (GDP)

i i LM LM IS IS Y Y Macroeconomics … The old debate • Original Keynesian-Neoclassical debate conducted in terms of IS-LM model with • Arguments over whether “free market” IS-LM equilibrium coincided with full employment “Keynesian” “ Neoclassical” FE FE • (Different views of labour market lie behind different positions for [& definitions of!] full employment)

Macroeconomics … The old debate • Arguments over slope of LM curve & effectiveness of monetary & fiscal policy “Keynesian region” • In “Keynesian” region, rightward shift of IS curve (by fiscal policy, etc.) mainly boosts income • In “Classical region”, rightward shift of IS curve (by fiscal policy, etc.) mainly boosts interest rate • “the General Theory of Employment is the Economics of Depression”, Classical is Economics of full employment Monetary policyineffective; Fiscal policy needed to shift IS curve i Monetary policy effective;Fiscal policy just causeshigher interest rates “Classical region” LM IS Yd Yf Y

Macroeconomics … The old debate • IS-LM analysis dominant when price level relatively stable • Legitimised fiscal policy to counter economic slumps • “the General Theory of Employment is the Economics of Depression” (Hicks): increase output & employment by government spending when economy in a slump • Increased price-level volatility led to next development: • Aggregate Demand-Aggregate Supply Analysis • Aggregate Demand curve derived from IS-LM analysis • Assume fixed money supply • Higher price level with fixed Ms means less purchases possible with given Ms level • LM curve “shifts up” as price level rises:

Macroeconomics … The middle-aged debate • IS & LM curves subsumed into one (AD) mapping output against price level… LMP2 i P LMP1 LMP0 P2 P1 P0 IS AD Y0 Y (GDP) Y (GDP) Y2 Y1 Y0 Y2 Y1

Macroeconomics … The middle-aged debate • Aggregate supply graph derived from view of labour market • Neoclassical: real wage is set in labour market • Demand for labour is marginal product of labour curve • Derived from production function with DMP… • Supply of labour assumed upward-sloping • Treated as any other commodity BUT • Even under neoclassical theory labour is not a “commodity” • not produced by factories subject to DMP but offered by workers as part of work-leisure choice • Model can’t definitely derive any shape—upward or downward-sloping…

Income Wage Work Leisure Macroeconomics … The middle-aged debate • Individual worker decides how much labour to supply as trade-off between two “goods”: “income” & “leisure” • Indifference curves show income/leisure combinations that give equal satisfaction • “Budget line” is 24 hours leisure vs 24 hours x wage rate • This worker supplies more labour as real wage rises • At low wage (say 1 banana/hour) has high leisure h1 (say 18 hours/day) w3 Labour supply w2 w2 • Lower leisure (e.g., 16 hours) for higher wage (e.g., 2 bananas/hour… ) w1 w1 24-h3 24 h3 h2 h1 24-h2 24-h1

Wage Income Time (24 hours) Labour Macroeconomics … The middle-aged debate • But analysis can easily derive upward sloping supply of labour curve: worker works less as wage rises: • This worker supplies less labour as real wage rises • At low wage (say 1 banana/hour) has low leisure h1 (say 12 hours/day) w3 Labour supply w3 w2 w2 w1 w1 • Higher leisure (e.g., 16 hours) for higher wage (e.g., 2 bananas/hour… ) h1 h2 h3 24-h2 Leisure Work 24-h3 24-h1 • So neoclassical theory can’t derive upward-sloping labour supply function: shape depends on individual preferences • Nonetheless, assumes upward slope and continues on!

Macroeconomics … The middle-aged debate • Neoclassical demand for labour derived from production function • GDP produced under conditions of diminishing marginal productivity • Labour market competitive so economy(!) can purchase as much labour as it likes at the going real wage… • Product market competitive so economy(!) can sell as much as it likes without affecting the price level… • Employers therefore hire workers until marginal benefit (increased profit) equals marginal cost (increased wage bill). • Marginal benefit is increase in output • Marginal cost is (constant???) going real wage • Equilibrium wage is thus equal to marginal product of labour

GDP Labour Marginal Product/Real Wage Labour Macroeconomics … The middle-aged debate • GDP assumed produced under conditions of diminishing marginal productivity • Higher output needs more labour (capital fixed) • Additional labour less productive because of DMP • Employers willing to pay lower (real) wage to hire • Marginal physical product curve thus traces out demand for labour • Real wage thus equals the marginal product of labour Physical Marginal RW1 Product RW2 E1 E2

Macroeconomics … The middle-aged debate • Sounds “meritocratic”: “you get what you contribute” • “the real wage equals the marginal product of labour” • BUT… • Absurd to apply “firm level” micro assumptions at economy level • Firm might have little impact on employment but “Economy” must have large impact • Firm might not depress its price too much by increasing output but “Economy” has to reduce price to increase sales… • When these factors added, outcome not so meritocratic: neoclassical theory shows workers ‘ripped off’…

Macroeconomics … The middle-aged debate • With acknowledgement of • Wage rises as function of aggregate employment • Price falls as function of aggregate output… • Two factors mean real wage much less than marginal product of labour… • But ignoring this and assuming perfect competition everywhere, neoclassical aggregate supply function is…

Macroeconomics … The middle-aged debate • A vertical line! • Intersection of labour supply & demand determines real wage and equilibrium (“full employment”) supply of labour • Equilibrium labour supply determines output via production function [Source: Levacic & Rebmann Macroeconomics: an Introduction to Keynesian-Neoclassical Controversies (1982); still probably best advanced macro text around] • Equilibrium output & employment independent of prices • Fiscal policy ineffective; • Economy tends to full employment anyway…

Macroeconomics … The middle-aged debate • Neoclassical AD/AS: • Manipulating aggregate demand (fiscal policy) simply causes inflation… • Any impact of AD on employment a “temporary disequilibrium effect”… • Increase in price level causes apparent drop in real wage • Drop in real wage encourages greater demand for labour • Increased demand absorbed by rise in wages AS P AD2 AD1 Y

Macroeconomics … The middle-aged debate • Keynesian AS/AD demand differs only in model of labour market. Argues: • workers bargain over money wage, not real • Can employ any number of workers at going money wage up to full employment; • From that point on, wage must rise to employ more people • “Full employment” defined not as equilibrium condition (as in neoclassical version) but as percentage of workforce (e.g., “3% unemployment=full employment”) • Position attacked by neoclassicals as presuming “non-rational behavior” by workers • Bargaining in money rather than real terms • Suffering from “money illusion”

Macroeconomics … The middle-aged debate • But Keynesian position easily derivable from neoclassical analysis of labour supply • Since individual labour supply curves can have any shape, no aggregate relation can be presumed between (real or nominal) wages and labour supply • Keynes’s “hire as many workers as wish at the going wage” at least as valid as Neoclassicals unjustified assumption of upward-sloping aggregate labour supply • Given Keynesian money-wage supply function: • Increasing price level lowers real wage • Lower real wage encourages employers to hire more workers • Aggregate supply therefore slopes upwards…

Macroeconomics … The middle-aged debate • Fiscal policy (shifting AD) can increase output & employment at expense of increased price level… Price level AS • Subsequent theoretical developments dominated by neoclassicals • Effectively application of micro to macro: • Economy modelled as either single rational agent or general equilibrium system… AD GDP

Macroeconomics … The middle-aged debate • So two perspectives: • Neoclassical: Economy tends to full employment equilibrium on its own • Fiscal policy just causes inflation • Keynesian: Economy can fall into unemployment equilibrium • Fiscal policy causes inflation which can move economy to full employment… Reality check time! • (A) Which perspective is closer to the empirical truth? • (B) What about what both perspectives ignore: disequilibrium dynamics (Schumpeter again…)

“IS-LM: An Explanation” • In 1979/80, Hicks commented that • “The IS-LM diagram, which is widely, though not universally, accepted as a convenient synopsis of Keynesian theory, is a thing for which I cannot deny that I have some responsibility.” • saw two key problems with IS-LM as an interpretation of Keynes • 2nd problem was time-period of model: • Hicks’s used a week, • Keynes used “a ‘short-period’, a term with connotations derived from Marshall; we shall not go far wrong if we think of it as a year” (Hicks 1980).

“IS-LM: An Explanation” • Not unreasonable to hold expectations constant for a week–and therefore ignore them. • But keeping expectations constant over a year in an IS-LM model does not make sense, because • “for the purpose of generating an LM curve, which is to represent liquidity preference, it will not do without amendment. For there is no sense in liquidity, unless expectations are uncertain.” (Hicks OREF) • I.e., why hold money for precautions/speculation, if expectations were constant? • Can’t validly derive LM curve, because transactions are only reason for holding money when expectations constant

“IS-LM: An Explanation” • If expectations constant, then can’t be out of equilibrium • if out of equilibrium, expectations must change!: • “I accordingly conclude that the only way in which IS-LM analysis usefully survives–as anything more than a classroom gadget, to be superseded, later on, by something better–is in application to a particular kind of causal analysis, where the use of equilibrium methods, even a drastic use of equilibrium methods, is not inappropriate…” • “When one turns to questions of policy, looking towards the future instead of the past, the use of equilibrium methods is still more suspect. For one cannot prescribe policy without considering at least the possibility that policy may be changed. There can be no change of policy if everything is to go on as expected–if the economy is to remain in what (however approximately) may be regarded as its existing equilibrium.” (Hicks 1980)

Macroeconomics … Some empirical data • “Rational Expectations” version of Neoclassical theory eventually developed the “Policy Ineffectiveness Proposition” (PIP): • Expressed in terms of “Phillips curve” trade-off between unemployment and inflation… • “by virtue of the assumption that expectations are rational, there is no feedback rule that the authority can employ and expect to be able systematically to fool the public. This means that the authority cannot expect to exploit the Phillips curve even for one period.” (Thomas J. Sargent & Neil Wallace 1976, “Rational Expectations and the Theory of Economic Policy”, Journal of Monetary Economics Vol. 2, pp. 169-83)

Macroeconomics … Some empirical data • PIP asserts economic policy could never have been effective • Keynesians dominated 1950-1973 economic policy • Neoclassicals dominated 1973-now • By PIP, should be no difference between two except: • Inflation & money supply growth higher under Keynesian • Budget deficit greater under Keynesian • Interest rates higher under Keynesian • All real variables (unemployment, growth) the same… • Some causal empiricism: compare economic growth, unemployment, inflation, money growth, interest rates, government deficit (USA Data)

GDP Growth Keynesian Period Monetarist/Neoclassical

Unemployment Monetarist/Neoclassical Keynesian Period

Inflation Monetarist/Neoclassical Keynesian Period

Money Supply Keynesian Period Monetarist/Neoclassical

Interest Rates Keynesian Period Monetarist/Neoclassical

Government Budget Keynesian Period Monetarist/Neoclassical

Balance of Trade Keynesian Period Monetarist/Neoclassical

Managerial Economics