Attacks on the Traditional Approaches to Macroeconomics

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Attacks on the Traditional Approaches to
Macroeconomics

• Lecture 14

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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

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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

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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!

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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

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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
• UE - E\1 f ( RW\1 - RPexpected)
• Unemployment is an error in expectations due to
  static expectations about future wages and price
  levels

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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 DemandSupply
• All Those Wanting to Work at the Current Real
  Wage Can Find Work after a Reasonable Period of
  Search

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

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

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Past and Modern Expectations Modeling

• Static or Naive, expecting no change
  RPexpected RPeRP\1
• Adaptive or Koyck RPe - RPe\1 k ( RPe\1 -
  RP\1)
• where 0 lt k lt 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

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