Managerial Economics

1
Managerial Economics

• Lecture Seven
• The macroeconomy standard views

2
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

3
Macroeconomics the context of business

• Managers most immediate concern is own market
  competition
• But macroeconomic performance sets context for
  own market
• Most markets rise fall with general economic
  conditions
• Some exceptionse.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?

4
Macroeconomics Acknowledged debate

• No!
• Cant 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

5
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?

6
Macroeconomics Acknowledged debate

• 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

Price level
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

7
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 weve 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

8
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)

9
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

AD2
P1
P,GDP
AD1

• Potential for out of equilibrium effects
  disequilibrium unemployment

Y1
Y2
GDP
10
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

11
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)

12
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

13
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 issuecost pressures on inputs (wages, raw
  materials)
• Rising costs due to rising input prices rather
  than diminishing marginal productivity
• But debate continues

14
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 economyif unemployment is very high and
  there are many idle resourcesthen output and
  employment may quickly rise (384)

15
Macroeconomics Acknowledged debate

• Blinders 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 flexibleexcess capacityso demand
  management policies can affect employment
• Prices sluggish dont anticipate inflation
  cost-push inflation the rule
• So in terms of the debate model

16
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?
• Lets check derivation
• Model an extension of Hickss IS-LM
  interpretation of Keynes

17
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

18
Keynes general theory, according to Hicks

• The combination an upward-sloping LM curve

The LM curve
Exogenous Ms
i
i
Md2 (Y2)
Md1 (Y1)
GDPY
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

19
Keynes general theory, according to Hicks

• Next, the IS curve
• Investment demand a negative function of i
  II(i)
• Lower interest rate makes more projects NPV
  positive
• Investment rises as interest rate falls
• Savings supply a positive function of Income
  SS(Y)
• Savings a residual after consumption
• Savings rise as income rise

20
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)
SS(Y)
Savings a function of income
S
Y (income)
i
Investment a function of interest rate
i
The IS curve
Multiplier
II(i)
Y(output)
I (Investment)
21
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
• InvestmentSavings
• Demand for goods equals supply
• Intersection shows overall economy equilibrium

i
LM
IS
Y (GDP)
22
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)

23
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 effectiveFiscal policy just
causeshigher interest rates
Classical region
LM
IS
Y
Yd
Yf
24
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

25
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
Y (GDP)
Y0
Y (GDP)
Y1
Y2
Y0
Y1
Y2
26
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 cant definitely derive any shapeupward or
  downward-sloping

27
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
h1
h2
h3
24-h2
24-h1
28
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-h1
24-h3

• So neoclassical theory cant derive
  upward-sloping labour supply function shape
  depends on individual preferences
• Nonetheless, assumes upward slope and continues
  on!

29
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

30
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
31
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

32
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

33
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

34
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
35
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
  unemploymentfull employment)
• Position attacked by neoclassicals as presuming
  non-rational behavior by workers
• Bargaining in money rather than real terms
• Suffering from money illusion

36
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
• Keyness 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

37
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
38
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)

39
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
• Hickss 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).

40
IS-LM An Explanation

• Not unreasonable to hold expectations constant
  for a weekand 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?
• Cant validly derive LM curve, because
  transactions are only reason for holding money
  when expectations constant

41
IS-LM An Explanation

• If expectations constant, then cant be out of
  equilibrium
• if out of equilibrium, expectations must change!
• I accordingly conclude that the only way in
  which IS-LM analysis usefully survivesas
  anything more than a classroom gadget, to be
  superseded, later on, by something betteris 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 expectedif the economy
  is to remain in what (however approximately) may
  be regarded as its existing equilibrium. (Hicks
  1980)

42
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)

43
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)

44
GDP Growth
Keynesian Period
Monetarist/Neoclassical
45
Unemployment
Monetarist/Neoclassical
Keynesian Period
46
Inflation
Monetarist/Neoclassical
Keynesian Period
47
Money Supply
Keynesian Period
Monetarist/Neoclassical
48
Interest Rates
Keynesian Period
Monetarist/Neoclassical
49
Government Budget
Keynesian Period
Monetarist/Neoclassical
50
Balance of Trade
Keynesian Period
Monetarist/Neoclassical
51
Income distribution
Keynesian Period
Monetarist/Neoclassical
52
The Keynesian/Neoclassical Scorecard
Outcomes contradict RE Hypothesis Keynesian
period has Lower Money Growth, Inflation,
Interest Rates, Unemployment Higher Growth
How could this be if policy was
ineffective?Did the economy suddenly
deteriorate? (possibly true)
53
Macroeconomics what the debate ignores

• Empirical record hardly indicates equilibrium

• There is a disequilibrium interpretation too
• Schumpeter and cycles
• Minskys Financial Instability Hypothesis
• But first, empirical investigation of cycles in
  USA data next week