Aug 29

Layard-Nickell NAIRU model

The Layard-Nickell NAIRU model emerged as a reply from New Keynesian Economics to the natural rate of unemployment, devised by Milton Friedman as a criticism of the Neoclassical Synthesis’ Phillips curve. This NAIRU model comes from an article entitled “Unemployment in Britain”, 1986, by Richard Layard and Stephen Nickell.

Indeed, the Layard-Nickell NAIRU model was able to explain the paradigm shift by moving away from assumptions of a perfectly competitive labour market into a model based on wage determination by means of trade union bargaining. In a perfectly competitive market, salaries and the prices of goods are traditionally determined by considering that the price of a product is fixed via its marginal cost (and, in the case of imperfect competition, a mark-up).

Trade unions will bargain with employers in order to get higher real wages for the workers. In the adjacent figure, it can be seen how the more people is employed and represented by trade unions, the higher real wages will be, thus marking the upward sloping BRW curve (Bargained Real Wages). The explanation is quite simple: from the workers point of view, higher employment rates mean lower opportunity costs derived from job seeking; on the other hand, employers are more likely to pay higher real wages when the economy is in expansion, since they don’t want to lower production (which would happen if workers went on strike.

Once trade unions have bargained an adequate real wages, the employer will fix prices (P) considering both costs of production and mark-ups (μ). If we assume real wages (W) as the only production cost (which is a reasonable assumption, since wages usually make up for a large portion of production costs), and we take into consideration also marginal productivity (MP_L), we can find out what would be the price chosen by the employer:

and assuming the following:

we come up with the real wage:

This real wage (called Price-determined Real Wage, PRW) can be represented graphically as shown in the adjacent figure. Note that it’s a horizontal line, since for any given BRW, and at any employment level, the mark-up would be the same as well as the marginal productivity.

The reciprocal relation between wages and inflation is determined. The distance from the level of employment at equilibrium (L*) and the total labour force (L^T), is the NAIRU. When, for example, the level of employment increases, trade unions will be able to negotiate higher real wages (A). Since the employer won’t be willing to accept a decrease in its profits, the mark-up will be maintained, which will raise prices. Therefore, an increase on employment, which will take the employment level higher than the NAIRU, will end-up increasing aggregate price-levels.

Anything that affects wage formation or unemployment rates is likely to affect inflation. Thus, fixing salaries above what they would be in a competitive labour market leads to higher prices, which increases inflation and reduces real wages. In a similar fashion, an increase in unemployment benefits drives salaries above what would naturally be determined, with similar effects. In this “battle of the mark-ups” between employers and employees, the NAIRU rises. This aims to explain the structural factors between some countries having a higher or lower “natural” unemployment rate than others. Empirically, it is interesting for example to note that only 15% of salaries in the US are fixed by trade unions, whereas in some countries of Europe, such as France, Italy or Spain, famed for having a naturally high NAIRU, almost 75% of employees are covered by a collective agreement.

Aug 29

Lope Gallego

Business cycles

Business cycle, as Joseph Schumpeter saw it, is the economic activity fluctuation that occurs over time, and that comes from the succession of expansionary and contracting seasons. It is analysed comparing real GDP to potential GDP (Y*). There are a few common characteristics, which help differentiate cycles, such as its phases, the way it oscillates, the periodicity and a few stylized facts:

1. Phases:

Four phases can be distinguished, following Richard Lipsey’s classification:

-Trough or depression (A), characterized by a high rate of unemployment and low consumption levels in relation to its real capacity;

-Expansion or recovery (B) of previous employment, income and consumption levels, that usually comes together with a rising in prices;

-Peak (C), distinguished by factors full use, high investment and shortage of labour, particularly for high-skilled jobs;

-Recession (D), demands fall causing unemployment and decreasing production levels.

2. Oscillations:

-Oscillant cycles:

·regular oscillations (cyan);

·irregular, convergent oscillations (red);

·irregular, divergent oscillations (green).

-Non-oscillant cycles:

·convergent (red);

·divergent (green).

3. Periodicity:

Economic cycles have been classified depending in their periodicity. The most common are:

-Very short cycles, with duration of 30-40 months; also known as Kitchin cycles, whose studies saw in stock rotation the origin of these cycles;

-Short cycles, with duration of 7-11 years; also known as Juglar cycles, which origin is based on subsequent inventions;

-Long cycles with duration of 15-25 years; commonly known as Kuznets cycles, whose analysis placed the origin of cycles in demographic factors such as birth rates or migrations;

-Very long or Kondratiev cycle with duration of 50-60 years. This cycles originate with breakthroughs in capital goods, such as the steam engine or the Internet.

4. Stylized facts:

Both over time and between countries (a few of numerous reviewed by Robert Lucas in his article “Understanding Business Cycles”, 1977):

-There is positive correlation between variables, which helps smooth fluctuations;

-Co-movement between some variables:

·output fluctuates in the same direction in different sectors (although different amplitudes may apply);

·investment and consumption are clearly pro-cyclical: investment leads and is more volatile, consumption lags and is rather stable;

·income: real wages and profits are pro-cyclical;

·employment and labour force are also pro-cyclical.

-Expansions are usually longer than recessions.

Many papers and works have been written on business cycles and different points of view have taken form. Keynesian economics tries to deal with the economic fluctuation to minimize their impact. Business cycles are seen as a proof of market failure, and justify government intervention in order to assure the correct level of economic activity. Until the optimum level of employment has not been reached, the economy will not be readjusted. Depending on the cycle phase, expansionary or contractionary economic policies may be used.

New Classical Macroeconomics supporters have also dealt with economic cycles, and as a result the Real business cycle theory arises as an alternative view to Keynesian´s. Kydland and Prescott, and in general the Chicago School, are mostly related with the development of this theory. For them, cycles are explained by technological shocks. The fluctuations in the economy are seen to be produced by shifts in the supply curve, as a result of changes in productivity levels. These shocks can be caused by different factors: technology innovation, unusual weather conditions, changes in raw material prices, new policies and regulatory measures, etc. What is basic for these shocks to occur is an alteration in the effectiveness of either capital or labour factors, and therefore changing productivity. As a result in changes in the production quantity, the supply curve shifts, implying a new equilibrium point in the supply and demand model. Thus they believe that economy will reach its new equilibrium point, through the forces of demand and supply in itself, without the need for a government intervention. In fact from their view, government intervention will only worsen the situation.

Aug 28

Lope Gallego

New Keynesian Economics

The New Keynesian Economics seeks to provide Keynesianism with microeconomic foundation support. This contemporary economic doctrine comes as a response to the critiques that Keynesianism received from the New Classical Macroeconomics (NCM) advocates.

New Keynesian Economics can be traced back to late 70s when the first foundations were built by economists such as Stanley Fischer, Edmund Phelps and John Taylor. One of the best economists to characterize the New Keynesian Economics is Gregory Mankiw, as he has made many contributions to this doctrine.

The main issue of this economic doctrine is to explain why changes in the aggregate price level are “sticky”. While in NCM competitive price-taking firms make choices on how much output to produce, and not at what price, in New Keynesian Economics monopolistically competitive firms set their own individual prices and accept the level of sales as a constraint. From a New Keynesian Economics point of view, two main arguments try to answer why aggregate prices fail to imitate the nominal GNP evolution. One of them is used both by NKE and NCM approach to macroeconomics, this is the assumption that economic agents, households and firms have rational expectations. However New Keynesian Economics considers that rational expectations become distorted as market failure arises from asymmetric information and imperfect competition. As economic agents can’t have a full scope of the economic reality their information will be limited, and there will be no reasons to believe that other agents will change their prices, and therefore maintain their expectations unchanged. Expectations are a crucial part for price determination, as they remain unaltered, so will the price, what leads to price rigidity. For firms, price rigidity may also come from what’s known as menu costs, this is, costs that result from price changes.

As a result of this price stickiness, which implies a slow adjustment of the economy and can lead to undesired levels of unemployment, government intervention is justified to stabilize the economy, by using both fiscal and monetary policies. However, this intervention ought to be minimal, much lower than New Keynesian Economics’s predecessors, the Neoclassical Synthesis, would argue for.

Aug 28

Lope Gallego

Gregory Mankiw

Nicholas Gregory Mankiw, born in 1958, is an American economist and professor of Economics at Harvard University.

Mankiw has stood out as a well-known writer, whose best-selling and intermediate-level textbooks of economics, “Principles of Economics” and “Macroeconomics”, 2006, have sold over a million copies and been translated into seventy different languages. Mankiw has written articles in a regular basis at both academic journals and newspapers, such as “The American Economic Review”, “The New York Post” or “The Wall Street Post”. He is also a usual participant in many academic and policy debates.

He is an advocate of New Keynesian Economics, and his most important contributions have been in the fields of both microeconomics and macroeconomics, especially in the latter. Mankiw has dealt with subjects such as consumer’s behaviour, fiscal and monetary policy, financial markets behaviour and the determination of prices. In this last topic he has provided important work regarding menu cost.

Mankiw has also contributed in politics and was a chairman of the national Council of Economic Advisers, from 2003 to 2005, appointed by President George W. Bush.

Aug 27

Lope Gallego

Robert Lucas

Robert Lucas Robert Emerson Lucas, Jr., born in 1937, is an American economist and Professor at the University of Chicago. For many, Lucas is probably one of the most notable economists of all times and one of the most influential economists since the late 1970s. It was in the year 1995 when he won the Nobel Prize of Economic Sciences for his development and utilisation of the rational expectations hypothesis, which has transformed macroeconomic analysis.

Robert Lucas is one of the leading figures of the New Classical Macroeconomics, which defies Keynesian economics approach that previously ruled macroeconomic theory. We can date New Classical Macroeconomics birth from Lucas´s work made in 1973, “Some International Evidence on Output-Inflation Tradeoffs”. He builds macroeconomic models using microeconomic foundations such as market clearing and the optimization by economic agents. He regards the economy as having a dynamic equilibrium with economic cycles.

He has worked with great interest in the implications of rational expectations, and formulated his own supply function in which aggregate output for a given period depends on the expectations of prices based on information available at the end of that period. Indeed, these ideas, shown in Robert Lucas’ 1972 paper “Expectations and the Neutrality of Money”, in which he used Edmund Phelps’ island parable (though applying rational, instead of adaptive, expectations), gave strong significance to the use of rational expectations in macroeconomics analysis.

Robert Lucas´s influential “Econometric Policy Evaluation: A Critique”, 1976, had a deep effect on both policy modelling and econometric practice in general. Lucas stands out the implication that parameters may be subject to change when policy does so, thus, opposing to the previous vision were the parameters were thought as being structural never mind changes in economic policy; this is known as the Lucas Critique.

Aug 27

Lope Gallego

Milton Friedman

Milton Friedman, 1912-2006, was an American economist, Professor at the University of Chicago and main figure of the Chicago School. He was awarded the Nobel Prize of Economic Sciences in the year 1976 for his achievements in the fields of consumption analysis, monetary history and theory, and for his studies about the complexity and difficulty of economic stabilizer policies.

He was a great admirer of von Hayek and became one of the main challengers of Keynesian government policies, especially fiscal policy. He was a strong defender of free market and of monetary policy, having written numerous studies on this last topic.

In “A monetary History of the United States, 1867-1960”, 1963, Friedman together with Anna J. Schwartz, analyse the role of money in the business cycle, and argued about the effects of both monetary expansion and contraction. As Friedman said “inflation is always and everywhere a monetary phenomenon”.

Friedman, in his “The Role of Monetary Policy”, 1968, theorized about the existence of a natural rate of unemployment and stated that policies trying to decrease it would be unbeneficial for the economy and bring inflation with it. He foresighted the instability of the Phillips curve and predicted what was later known as stagflation.

Friedman became an economic adviser at the Ronald Reagan administration, and advocated for minimal government intervention.

Aug 27

Lope Gallego

New Classical Macroeconomics

New Classical Macroeconomics (NCM) arise from the development of the neoclassical economics principles, such as market clearing and optimization behavior by economic agents, which relate this school to monetarism. Its rise as a doctrine can be traced to the work in the early 1970s of its lead economist Robert Lucas (Chicago School).

Indeed, Lucas developed in 1973 what is known as rational expectations, an improvement on the adaptive expectations hypothesis used by monetarists, which changed the way macroeconomic analysis (and econometric analysis) is undertaken. These rational expectations are still used nowadays in macroeconomics.

Regarding policymaking, the NCM believes that no government intervention concerning demand is beneficial for the economy, not even in the short run. They argue that government can promote growth and stabilize the economy only through supply-side policies.

Economists such as Thomas Sargent, Edward Prescott, Neil Wallace and Robert Barro are amongst the most renowned NCM economists, whose theories are usually opposed to those of the followers of New Keynesian Economics.

Aug 25

Lope Gallego

Monetarism

Monetarism, a term first used by Brunner in 1968, can be understood in two ways. The first relates to the economic thought that sees in the quantity of money the major source of economic activity and its disruptions (especially inflation), as well as believing that targeting the growth of money supply is the best monetary policy. Secondly, it refers to a large group of economists adherent to these thoughts, lead by Milton Friedman and the Chicago School of economics.

This paradigm, which gained popularity in the 1960s, relates closely to neoclassical economics, believing that free flow of credit and interest rates, as well as a laissez faire attitude is the best way to go, since limited public intervention and a competitive economic system will grant better results than those resulting from Keynesian economics. However, since monetarists consider monetary policy more effective, government control over money supply is required. Also, since monetarists believed in the importance of the quantity of money, the equation of exchange regained popularity.

Monetarists view fiscal policy less effective than monetary policy because of the low interest elasticity of money demand. Therefore, when using the IS-LM model, monetarists consider the IS curve more elastic than the one used by Keynesians, and a LM curve more inelastic. This is the reason why, when using the monetarist’ IS-LM model, public investment created by fiscal policy creates a crowding out effect over private investment, reducing the effectiveness of public spending. However, even though monetary policy is more reliable, its effects may take a while to be noted in the economy, and therefore its implementation can be difficult.

Concerning the Phillips curve, monetarists criticise the money illusion implied in it, which is the basis for the relationship between inflation and unemployment. They believe that, given an unanticipated higher inflation and the subsequent decrease in unemployment, the trade-off shown in the Phillips curve will hold. However this will not be the case when monetary policies are anticipated, implying that the trade-off between inflation and unemployment does not apply in the long run. This is a clear example of the learning process introduced in the Adaptive Expectations hypothesis, firstly formulated (though not under its widely known name) by Irving Fisher in his article “The Purchasing Power of Money”, 1911, and popularized by Phillip Cagan in 1956 and by Friedman, in his paper “The Role of Monetary Policy”, 1968, where he also introduced the concept of natural rate of unemployment, which is the rate that the economy will reach after each movement along the Phillips curve. It must be highlighted that, contrary to New Classical Macroeconomics studies and its Rational expectations hypothesis, monetarists believe that the trade off can be systematically exploited in the short run, as long as each policy is unanticipated.

Given the low effectiveness of fiscal policy as well as the risks of high inflation caused by systematic monetary policies, monetarists defend a commitment by the monetary authorities to steady monetary growth, and reject discretionary and politically driven monetary policies, because of the uncertainty they create.

Aug 24

Lope Gallego

Monetarism

From the conciliatory mood of the 1940s and 1950s, where we saw how Keynesianism and Neoclassicism could fit together, we move away from the Neoclassical Synthesis and back to a determinedly ‘laissez faire’ attitude with Monetarism. This current popularises government intervention as firmly limited to guaranteeing market safeguards and intervening in the financial markets, abandoning fiscal policy. We move, therefore, into an era concerned with financial stability, where inflation becomes a firm target.

Monetarism became popular amongst, famously, US and UK politicians in the 1980s, coinciding with a period of severe stagflation, and is, to this day, a controversial school of Economics, paradoxically known because of its affinity to various legislatures despite being a firm advocate of the separation between politics and economics.

Monetarism:

Monetarism, a doctrine opposed to Keynesianism, from which we must highlight

Milton Friedman, the clear leader of the

Chicago school, specially during the 50s and 60s.

Importance of expectations:

Adaptive expectations, as opposed to money illusion, which was implemented into the

Expectations-augmented Phillips curve, that demonstrated the inefficiency of monetary policies aimed at reducing unemployment. Therefore, in the long run, the

Natural rate of unemployment will persist.

Aug 22

Lope Gallego

Revealed preference theory

Revealed preference theory is attributable to Paul Samuelson in his article “Consumption Theory in Terms of Revealed Preference”, 1948. Consumer theory depends on the existence of preferences which materialise into utility functions. These utility functions are maximised by consumers subject to a budget restraint. The issue is that it is difficult to accept that individuals really have a definite mathematical formula in mind when choosing between different options. What revealed preference theory does is work backwards to assume that we can deduce these utility functions from consumer behaviour. Analysing these choices leads us backwards to a set of preferences that influences the choices they make. It therefore allows economists to study consumer behaviour empirically.

There are two main axioms to the theory, both based on completeness and transitivity:

WARP (Weak Axiom of Revealed Preference): If A is revealed preferred to B (A RP B), then it must be so in every case. That is, if a consumer ever chooses B, then we must assume that A was previously chosen and that the budget constraint had enough ‘left over’ to allow a consumer to choose B as well.

SARP (Strong Axiom of Revealed Preference): This adds transitivity. If there are only two goods, then it is clear that WARP already defines a consumer’s choice: A over B. However, the SARP adds the idea of indirectly revealing preferences: if A is chosen over B and B over C, SARP and transitivity dictate that A is also preferred to C, so A is indirectly revealed to be preferable to C (A R* C). This drastically reduces the amount of empirical evidence necessary to define consumer preferences.

In the case shown in the figure below, we know that C is indirectly preferred to B (C R* B) because it allows us to reach a higher utility curve. Because C and B define a space (R*), and we know that C, B and A are contained within R*(R*{(C,B)}), then we can say that C RP A RP B, that is, by knowing from observation that C is indirectly preferred to B, we can tell that C is revealed as preferable to A (C RP A) and that A is revealed as preferable to B (A RP B).

If we think of A, B and C as infinitely complex bundles of goods, we can map out all a consumer’s choices. In theory, we can track this backwards to actually build utility functions if we have access to unlimited data. Without actually having to do this, we can aggregate consumer data to reveal general truths about a certain population’s preferences.

Video – Revealed preference: