Aug 28

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

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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

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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

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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

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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

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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 22

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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:

Aug 22

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Characteristics demand theory

Characteristics demand theory states that consumers derive utility not from the actual contents of the basket but from the characteristics of the goods in it. This theory was developed by Kelvin Lancaster in 1966 in his working paper “A New Approach to Consumer Theory”.

This approach allows us to predict how preferences will change when we change the options or baskets presented to consumers by studying how these vary according to the change in the characteristics that make them up. With conventional theory, the introduction of a new option meant that we could not reliably predict how this would slot into the consumer’s preference map. However, by relying on a study of the characteristics rather than the goods or service involved, we can predict how changes will affect a consumer’s behaviour without needing to start once again empirically.

This allows us to calculate ‘shadow prices’ for different attributes without having a price for the good itself by associating utility to the characteristics that make up the good rather than the good itself. With these ‘shadow prices’, we can solve utility maximisation problems for baskets or options for which we do not have empirical evidence, as Lancaster demand also lends itself to building utility functions (based on the amount of each type of characteristic rather than the amount of each type of good in a particular basket).

Characteristic demand theory also helps justify the existence of brands. Luxury brands are able to charge a surprice for their products by differentiating themselves from competitors that sell similar goods. In the first diagram, if we suppose that both brands have the same characteristics and are perfect competitors, then we will choose the basket that maximises our total consumption. This means will tend to opt for the cheaper brand, which allows us to reach the highest utility curve: for a given amount of money, we are able to buy either a certain amount of brand 1 (point B) or a certain amount of brand 2 (point A). We choose A since it’s on a higher indifference curve. Point C represents a higher utility curve achieved by a drop in the price of brand 1. However, even though brand 1 got cheaper, we’ll still consume A, since it remains on a higher indifference curve.

In the second diagram, if we look at Lancaster demand, our utility functions will be based on the characteristics that each basket contains rather than on the amount of each type of good. Here, it is no longer ‘all or nothing’- we can allow for convex demand curves that represent our preference for variety in consumption: point C. This time, if the price of one brand drops, we will change our outcome: we can opt for point D.

Video – Characteristics demand:

Aug 22

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Neoclassical synthesis

Neoclassical synthesis (NCS) refers to an economic doctrine that appeared in the U.S. in the early 1940s, and would remain the dominant paradigm until the late 1960s, when monetarism took over. It was Paul Samuelson, in his book “Economics”, 1955, who gave this doctrine its sense of synthesis, since it can be described as Keynesian in the short run and neoclassical in the long run. This is, policy makers will be able to adjust the economy (especially using fiscal policies, seen by NCS’ economists as far more effective than monetary policy) in the short run, but considering also that equilibrium will be reached in the long run without the need for public intervention. Theoretical and empirical studies by NCS’ economists are mainly based on the IS-LM model and the Phillips curve.

The IS-LM model was first developed by John Hicks in 1937 and Hansen expanded and popularized it in 1949. It is built on the premises put forward by J. M. Keynes in his “General theory”, 1936, and gives fiscal policy a higher degree of efectiveness (IS-LM policies effects, NCS view).

The Phillips curve, derived from an empirical study, gave a relationship between unemployment and inflation, which was not explicit in Keynes’ analysis. The validity of this relationship has been highly criticized by different schools of economic thought, such as monetarism, the New Classical Macroeconomics and the New Keynesian Economics.

Other renowned NCS’ economists are Modigliani, for his analysis of consumption under an intertemporal utility maximization frame, known as the life-cycle hypothesis; Jorgenson, for his work on the investment function; and Tobin and Baumol, for their studies on the demand and supply of money.

The NCS as a macroeconomic mainstream started struggling in the late 1960s, following a high inflation episode in the U.S., which could not be explained using the theoretical framework of this doctrine. Not long after, in the mid-1970s, stagflation in the U.S. meant the rise of monetarism and the subsequent fall of the NCS.

Aug 21

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Goods

Goods are something that provides its holder some kind of satisfaction, and therefore has a utility. There are different kinds of goods, and different classifications can be arranged and identified. We can differentiate between consumption goods (durable or perishable) and capital goods. Classification depending in responsiveness to incomes changes (normal goods and inferior goods) and to price changes (ordinary goods and Giffen goods) can also be made.

-Normal goods are those whose demand increases due to a rise in income levels, having therefore a positive correlation, which implies that the elasticity of this kind of goods is always higher than 0. Normal goods are divided in two categories, Superior goods and Necessary goods.

·Superior goods, also known as luxury goods, are those goods that displace the demand of inferior goods after a rise in consumers’ income. They are a kind of normal goods as their demand increases when income does as well, however, the difference is that they occupy the share of inferior goods. The elasticity of this kind of goods is, for this, always higher than 1.

·Necessary goods are those whose demand increases when income does, however the increase in demand is less than proportional to the rise in income. Elasticity of this goods is always between 0 and 1.

-Inferior goods are those whose demand moves in opposite direction to the income variation of consumers. This occurs because consumers’ preferences change to other goods that are more highly regarded.

-Ordinary goods are those goods whose demands move in opposite direction to the price variation. This means an increase in the price of the good will mean a decrease of its demand and the other way around.

-Giffen goods are those goods whose demand moves in the same direction as the price variation, this meaning, raising the price of the good will increase its demand, and the other way around. The explanation to this kind of goods comes from the “Snob Effect”, the more expensive a good is, the less people can afford it, and therefore becoming more precious and highly valued.