Jon’s Blog

The article Real Business Cycles: A New Keynesian Approach, authored by Gregory Mankiw, outlines a new idea regarding economic fluctuations, the real business cycle model. The real business cycle model is one of two stances currently held regarding these fluctuations. The Keynesian centers around general equilibrium and the possibility of market failure. The Classical approach stresses the optimization of private actors, the forces of supply and demand, and efficiency of markets. The real business cycle model is a new break off from the classical school, and credits technological change and an individuals rational response to the change as the source of large fluctuations. Mankiw assesses the theory in the paper, but admits from the intro the he is not an advocate of the idea.

In the article’s first section, Mankiw provides a brief background and set up for the rest of the paper. In Intro Economics courses, students are first exposed to partial equilibrium which eventually builds up to the Walrasian equilibrium and the “invisible hand” theory. The course also explains the classical dichotomy, where real values (employment, output) are determined by the Walrasian system and nominal values (price level, nominal wage) are determined by equilibrium in the money market. Since the nominal values don’t affect the real, the classical view asserts that the money market can be ignored. Both Keynesian and New Classical work attempt to break this dichotamy but in different ways. The theory of real business cycles, however, embraces the dichotomy and the irrelevance of monetary policy.

The disagreement between the two schools can be summed up in the example used in the article. The examples is a temporary increase in government spending. The real business cycle model says that an increase in government spending will increase the demand for goods and thus increase the real interest rate to keep the market in equilibrium. The rise in the interest rate decreases consumption and investment. The key to the real business approach is people will now reallocate their leisure because of the state of the economy. Working today now looks better than in the future, so the labor supply rises , increasing employment and output. In contrast, the Keynesian theory says the rise in the real interest rate does not affect the labor supply but is due to the amount of underutilized labor. The result of the two are the same, but the means to get there are different.

To cement their argument, the real business cycle advocates must explain why it is rational to increase labor during a recession. Their answer is that the price of labor relative to the price of goods falls during a recession, thus wages are PROCYCLICAL. To explain the procyclical nature, there must be substantial fluctuations in the rate of technological change. The reason the economy is in a recession is an inability to produce technological change. This cannot, however, be altered by government response so the “invisible hand” is inefficient. Recessions and other fluctuations, therefore, are natural and efficient.

There have been many arguments formulated against the real business cycle model. First, opponents attack the imperfect information argument of real business cycles. Big fluctuations in technology are very, very broad, well known, and exposed to everyone. There is no way there could be imperfect information in regards to a phenomena so big. The second argument stems from the results of Paul Volcker and his slowing of the economy using monetary policy. Real business cycle advocates argue that government intervention will not affect the outcome of fluctuations, but this was proved wrong in the 80′s. In regards to the procyclical nature of business cycle models, there is an argument for the procyclicalness of money, but not for prices! The last discrepancy comes from the fact that real business cyclists have no addressed and cannot explain the short run Phillips curve.

Mankiw predicts that the advocates of real business cycle models will not be able to provide enough evidence and theory to support their assumptions, while New Keynesians looking into economic fluctuations are on the right track. The article was fairly simple and easy to understand and was an interesting read.

Real Business Cycles: A New Keynesian Perspective (in Symposia: Real Business Cycles)
N. Gregory Mankiw
The Journal of Economic Perspectives, Vol. 3, No. 3. (Summer, 1989), pp. 79-90.

http://links.jstor.org/sici?sici=0895-3309%28198922%293%3A3%3C79%3ARBCANK%3E2.0.CO%3B2-M

The article I read summarizes a study by William A. Niskanen and Stephen Moore which attempted to gauge the success of supply-side Reaganomics during the 1980′s. The study was conducted in response to increased discussion of Reaganomics during Bob Dole’s run at the presidency and his proposed 15% tax cut. The proposed cut was similar to Reagan’s, which was a large part of his economic plan during the 80′s. Reaganomics consisted of four key elements to reverse the high-inflation, slow-growth economic record of the 1970s:
- (1) a restrictive monetary policy designed to stabilize the value of the dollar and end runaway inflation
- (2) a 25 percent across-the-board tax cut enacted (The Economic Recovery Tax Act of 1981) designed to spur savings, investment, work, and economic efficiency
- (3) a promise to balance the budget through domestic spending restraint
- (4) an agenda to roll back government regulation.
There has been a longstanding debate as to the actual success of these policies. Republicans thought the era brought great prosperity, while Democrats thought it widened the income gap, brought about high interest rates, and cause a large budget deficit. This study served to provide an unbiased view based only on the “facts”.

The study examined the state of the economy in the Ford/Carter years, the Reagan years, and the Bush/Clinton years up until 1995 using ten different economic indicators. The indicators were; Economic growth, economic growth per working age adult, median household incomes, employment, hours worked, unemployment rate, inflation, interest rates, prosperity, and savings. The data was collected from credible sources such as the Bureau of the Census, the Economic Report of the President, and Historical Tables, Budget of the U.S. Government. There was question as to when to start and end the Reagan years, and the best method proved to be using a one year lag from when he came into office (to allow for his policies to be enacted) until the time he left office. The three eras were; Pre-Reagan (74-81), Reagan (81-89), and Post-Reagan (89-95).

The results of the study showed that 8 out of the 10 variables proved to be better off during the Reagan years, with the exceptions being productivity and savings. Savings was higher both before and after Reagan, while productivity was higher before but lower after Reagan. There are two reasons savings may have been so low in during Reaganomics; the baby boomers were hitting their peak spending years and some of the data does not account for real gain in wealth. However, the fiscal record of Reagan was not nearly as good as his economic record. The budget deficit was higher in real dollars than after World War II. It started at 2.7 percent of GDP and peaked at 6.3 percent. Secondly, the national debt doubled in real dollars from 81 to 89.

The paper also looked at 12 “fables” of the Reagan era. They are summarized as follows:
1. Going in supply siders said the tax cuts would pay for themselves, but during the administration this idea was not held.
2. The fable is that Reaganomics directly caused the huge budget deficit. There were two primary explanations on what else could have caused it: (1) a large and sustained defense build-up; and (2) the unexpected rapid decline in inflation and the recession in the early 1980s.
3.Fable- Reganomics actually helped continue the fall in inflation started by Paul Volcker. There was no massive jump in inflation like some opponents of Reagan said.
4. Reagan actually played a part in ending the energy crisis and OPEC.
5. The article disputes that Clinton did not outperform Reagan using growth rates, which Clinton’s was a half percent lower. This only goes through 95 and predictions for the rest of the decade were the only thing available, so I wonder what the growth rate ended up being throughout the full time of Clinton’s two terms.
6. The 80s weren’t a “classic Keynesian recovery”, as demand should have grown rapidly and it didn’t.
7. Fable- the increase in growth was only because the economy sucked so bad in the first two years of the decade. However, the 92 straight months of expansion (2nd longest in history behind JFKs) hint this isn’t true.
8. Bush and Clinton did’t inherit such a large deficit as people think.
9. Workers had to work more to earn less in 80s. Not necc. true because benefits were becoming a larger part of peoples incomes, and most studies only looked at wages.
10. Fable- rich got richer while poor got poorer. Rich did get a bigger piece of the pie, but not at the expense of the poor. Every quintile benefited, so the pie just grew. Income mobility also supports this.
11. Fable- poor and minorities lost ground in the 80s.
12. Fable- rich saw their tax bills go down, while the poor’s went up.

The article concluded that the 1980′s was an era of prosperity and economic success, outperforming both the eras before and after it. However, I would like to see one thing. The data for the post-Reagan era grouped Bush and Clinton together. Also, the study was conducted in 1995, so not all of Clinton’s data is included. Most of the graphs show an obvious upward slope towards the end of their range showing Clinton’s policies were beginning to take hold and have success. I am interested in seeing a study done on just the Regan era vs. the full Clinton era to try to prove if Reagan did indeed outperform Clinton was the study states.

The 1972 article by Stephen J. Turnovsky and Michael L. Wachter used direct observations of wage and price expectations to test the accuracy of the “expectations hypothesis”. The expectations hypothesis was one of a few ideas developed to better explain the theory behind the Phillips curve. The hypothesis says that the current rate of change in wages is dependent on the rate of change in prices, wages, and unemployment rate in the future. It also implies there is a vertical Phillips curve passing through the “natural” rate of unemployment in the long run.

The data on price and wage expectations was used to accomplish to things. First, itwas used as explanatory variables to test the “expectations hypothesis”. Second, the data was used to explain the actual expectations in wage equations. Below is the basic wage equation used to determine expectations:
- Equation: wt= ao + a1 Ut -1 +a2 p*
Where,
– wt = average percentage change in the money wage rate in period t
– Ut = average rate of unemployment in period t
– p* = average expectations of the future rate of inflation, held during period t
However, this is only the most basic equation used, as several other values can be added to it. A “profit rate” can be used to represent informational input. Also, there could be a “catch-up” term or lagged variables to reflect adjustment effects.

The data used in the paper was collected from past issues of the Philadelphia Bulletin. The editor of the paper surveyed between 40 and 60 business economists in different professions, asking them their estimation of various economic indicators. The indicators included the Consumer Price Index (CPI) and average weekly wages in manufacturing. The survey was conducted every two years from 1949 until 1969, and asked for expectations both six and twelve months in the future. The data is not perfect, as the economists may not reflect the expectations of decision makers. However, it is the best available data on expectations.

Numerous regressions were run using ordinary least squares but only the “best fitting” results were discussed in the paper. Two major findings came from the results. The first was that price and wage expectation series are significant in explaining actual wage changes. Second, the coefficients for price and wage expectational variables are consistent for the different equations. While the results were positive, there was a possibility of error in variables or equation bias. As for the actual wage expectations, the sum of the coefficients were near zero. This suggests that in the short run money wage expectations are likely to be influenced by current conditions in the labor market.

“A Test of the “Expectations Hypothesis” Using Directly Observed Wage and Price Expectations”
Stephen J. Turnovsky; Michael L. Wachter. The Review of Economics and Statistics, Vol. 54, No. 1. (Feb., 1972), pp. 47-54.

Milton Friedman’s 1968 article “The Role of Monetary Policy” from the American Economic Review shows why he is one of the leading economists of all time. The article would be very easy to read and understand even if the one doing so was not too sharp on his or her economics. At the same time, however, it does an excellent job in providing information it intends to and it is very convincing throughout. Even if I was a direct opponent to Monetarism, I would have to stop and re-think my own opinions for a second after reading the article. I can see now why Friedman was a leader in the revival of monetary policy.

Friedman starts the article off with a brief summary of economic viewpoints in the United States during the 20th century. He provided various reasons why monetary policy had been abandoned for years because of Keynesian ideas. Keynes did a good job at exploiting the weaknesses of monetary policy, as there are many, and ignored the positive effects which it could have. Therefore, the general thought about the economy shyed away from monetary policy. However, studies performed decades after the Great Depression showed that monetary policy during that time did not fail, and that the opposite was actually true.

The US economy had a very Keynesian view up until the 1950′s, when people realized that it too had many flaws. One of those flaws, inflation, was a huge issue following World War II. Around this time there was a resurgence of monetary policy. However, the new monetary policy was slightly different than in the 1920′s. Before, its goals were to promoted price stability and the gold standard, along with analyzing the “state of the money market”. Friedman’s monetary policy tried to promote full employment and prevent inflation (although a secondary measure). Friedman also notes that the “pendulum” of beliefs cannot swing too far, as any extreme in monetary policy many put too much stress on monetary policy and its chance at success.

The rest of the article served one purpose; to seperate what monetary policy can and cannot do. This to me was the most convincing point in the article. Rather than look past the flaws or limits of monetary policy, Friedman confronted the issues. His theories were not perfect, but if used correctly could be very efficient. The first thing that Friedman said monetary poiicy cannot accomplish was to peg interest rates a specific level. At first, increasing the rate of monetary policy will indeed lower interest rates in the short term. However, as interest rates lower, people will start to spend and invest more. This could raise prices across the board thus lowering the real supply of money. Within a year or two interest rates would be right back to their higher levels. Even worse, if consumers expect prices to continue to rise they would want to borrow more and more money. The increased levels of borrowing would cause the lenders to demand even high interest rates. Basically, it is impossible to hold IR’s at one level. Friedman also goes into the fact that monetary policy cannot peg unemployment level. Many of his first reasons are very similar to the interest rate case. The effects of a change in monetary policy could lower unemployment in the short run, but the results would be different on a longer term. The second point Friedman gets into has to deal with real and nominal rates. He states that monetary policy can control nominal rates of unemployment, interest rates, etc., but cannot control real rates.

The last couple pages dealt with what monetary policy can do. Monetary policy can prevent money itself from being a major disturnbance in the economy. Unlike John Stuart Mill’s belief, money is a very powerful tool. Better monetary policy can reduce the errors that would allow money to have a negative effect. Monetary policy can also provide a stable background for the economy. Friedman compares it to the gold standard. The gold standard used to provide a stable backing for the United States economy, but is no longer in use. He states that monetary policy could provide the same effects. Lastly, Friedman says that monetary policy can help to deflect distubances from other sources. One example is if the government spends way to much and puts itself into a large deficit. Monetarism could slow the growth of money by temporarily raising interest rates. The long run effect, however, would be to lower inflation, prices, and interest rates in the long run.

Friedman, “The Role of Monetary Policy,” American Economic Review, 1968, IN THE READER

During the 1950′s, economists struggled to produce ideas that filled the various gaps in theory left by Keynes’ General Theory. One model, first developed by Alban W. Phillips and later cemented by Richard Lipsey, served to fix two problems associated with the model. The most obvious success of the Phillips Curve, as it would become known, was relating monetary wage growth and unemployment. Secondly, it allowed for Keynes’ theories to be adapted for inflationary situations, as Keynes’ original work focused mostly on recessionary examples. The Neo-Keynesians (namely Lipsey, Paul Samuelson, and Robert Solow) quickly adapted the Phillips Curve into their school of thought.

Around the time of the introduction of the Phillips Curve, there were two theories that attempted to explain inflation. These were demand-pull and cost-push inflation. Although both theories could be correlated to the Phillips Curve empirical data, the demand-pull perspective was taken up by the Neo-Keynesians. In short, demand-pull inflation sets up a continuous cycle of an “inflationary gap” that allows for sustained price increases. The inflationary gap decreases as the distribution of income is shifted from wage to profit earners, then appears again when incomes shift once more, this time from profit earners to wage earners because of lagging money wages (a process which repeats itself). Using this as a stepping stone, the Neo-Keynesians then linked this correlation into the IS-LM model.

The basic relationship in the Phillip’s curve was that price inflation is negatively correlated with unemployment. Therefore, there is a trade off between two evils. As unemployment increases, inflation decreaes, but as unemployment decreases inflation will go up. Richard Lipsey followed up on Phillips empirical work with his theoretical argument in 1960. Lipsey used basic microeconomic principles and forumlated them onto a macro scale. Therefore, if a particular labor market is not in equilibrium, the speed at which wages will adjust depends on the difference between labor supply and labor demand. Questions also arose as to how constant demand and therefore constant inflation takes place. If there is excess demand in one industry, wages must go up to attract workers. As workers enter the industry, the excess demand in that industry is eliminated. However, there is still excess demand in the economy as a whole. Even though this is true, there is still incentive for individual firms to raise wages, and thus achieve persistent inflation in the aggregate, because they would want to keep their employees from leaving their industry.

This was another solid article by the Economic Thought Website. It was a little more detailed than previous articles, but it was still simplified enough to understand and catch the drift even without being an econ genius.

Gonçalo L. Fonseca, “Inflation and the Phillips Curve,”The History of Economic Thought Website.

When using the term “Keynesian”, most people strictly associate the principles and theories formulated by John Maynard Keynes. However, Keynesian economic thought is much broader due to the expansion of Keynes’ theories by many of his contemporaries. One notable group, the “Cambridge Keynesians” was begun by a group of young economists studying under Keynes at Cambridge named the “Circus”. This group, made up of Richard Kahn, Joan Robinson, Austin Robinson, James Meade and Piero Sraffa, read and discussed Keynes’ General Theory , formulating their own opinions and passing them along to Keynes for revision. Not only did the group help revise Keynes’ work but many produced significant theories themselves. Richard Kahn provided the “income-expenditure multiplier” which helped to explain the determination of output and unemployment. Joan Robinson, along with fellow Cambridge economist Nicholas Kaldor, formulated the “Cambridge Growth Theory”.

Another member of the Circus that had a significant impact of economic theory was Piero Sraffa. Sraffa’s early works on returns to scale and perfect competition pointed out many flaws in Marshallian economics, which is one reason for the creation of imperfect competition. Sraffa was a very shy man often having trouble lecturing his students, and this shyness led him to one of his greatest contributions. To avoid the lecturing, Keynes appointed Sraffa to librarian of King’s College where he was able to spend ample time revising the works of David Ricardo. The twenty year project outlined Classical and Neoclassical economic thought and sturred many extentsions to those ideas.

The effect of Keynes theory was felt far outside of this inner circle. Economists at institutions such as Oxford and the London School of Economics also helped the expansion. Led by Roy F. Harrod, they looked even deeper into the effect of the theory of long-run growth and cyclical functions. Harrod concentrated on growth, and his work was later expanded by Evsey Domar to construct the Harrod-Domar model of “steady-state growth”. The model adds demand determined equilibrium to Keynes theories, with steady-state growth occuring when aggregate demand grows at the same rate as output. The Harrod-Domar model is an essential theory in modern economics as it is used to explain growth in developing nations.

In summary, Keynesian economics extends far beyond the General Theory. Many of John Maynard Keynes peers and pupils expanded this work to produce what we know today as modern economics. This economic “think tank” circulated ideas around England and proved to be one of the most influential eras in the field. This article, as well as the links to other related topics, is a great source for general economic knowledge. The Economic Thought website seems to provide a vast encyclopedia of economics that could prove very useful throuhgout the semester.

Summary- Arthur Pigou

Arthur Pigou enjoyed a very decorated academic career, studying alongside great minds such as Winston Churchill. As a student he received awards in many fields including the Chancellor’s medal for English and the Cobden Prize for his study of agricultural prices over time. Once he began teaching in 1901, however, he stuck mostly to the field of economics. While his knowledge of the subject was vast, his main interests were in the history of the labor movement, tariff reform, and Marshallian economics (which he called advanced economic theory). His works in these fields included The Principles and Methods of Industrial Peace and The Riddle of the Tariff. In his advanced economic theory lectures, Pigou offered a very structured presentation of Alfred Marshall’s ideas which he did not change or alter to his preference throughout the years in respect to his mentor.

When Marshall resigned as the Professor of Political Economy at Cambridge in 1908, Pigou was not very high up on the list of potential predecessors. However, with the help of Marshall’s personal recommendation Pigou was offered the job, which he held for thirty-five years thereafter. It was around this time that Pigou was finishing up his most notable work. Originally titled Wealth and Welfare, it was later named The Economics of Welfare (1920) after he re-wrote it following the war. The book as so big two sections, Industrial Fluctuations (1927) and A Study in Public Finance (1928), were taken off and published as separate titles.

Pigou also developed a semi-feud with economist John Maynard Keynes, sparked by differing views of unemployment. The feud was not bitter, however, as the two were both colleagues and friends for over twenty-five years, sharing a great mutual respect. In 1913, Pigou produced The Theory of Unemployment which setup the classical marginal productivity theory and attributed unemployment to trade union intransigence and minimum wage laws. At the same time, Keynes was developing his work, General Theory, and needed a theory to dispute while establishing his new ideas of what really caused unemployment. The Theory of Unemployment served that purpose. In two later works, Employment and Equilibrium and A Retrospective View, Pigou admitted his judgment of Keyes may have been harsh, and conceded that short run equilibrium with a high level of unemployment was a possibility.

In the grand scheme of things, Arthur Pigou did not create or discover anything revolutionary. He did not change a school of thought or provide a great fundamental theory. However, he did provide solid work in field of economics for over fifty years. He presented ideas in a more systematic way than ever before, and shifted people to this more orderly thinking. The article was a decent read, but added a little too much fluff about his personal life that could have been omitted. It does, however, provide a nice overview of Pigou for anyone who needs a quick, condensed summary of the economist or his works.

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