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Bookblogging: Implications of micro-based macro

October 21st, 2009

Another section from my book-in-progress. The book-so-far can be viewed here.

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Implications

The implications of the micro-foundations approach to macroeconomics can be assessed in the light of the introduction to Paul Krugman’s essay ‘How Did Economists Get it So Wrong’. 

It’s hard to believe now, but not long ago economists were congratulating themselves over the success of their field. Those successes — or so they believed — were both theoretical and practical, leading to a golden era for the profession. On the theoretical side, they thought that they had resolved their internal disputes. Thus, in a 2008 paper titled “The State of Macro” (that is, macroeconomics, the study of big-picture issues like recessions), Olivier Blanchard of M.I.T., now the chief economist at the International Monetary Fund, declared that “the state of macro is good.” The battles of yesteryear, he said, were over, and there had been a “broad convergence of vision.” And in the real world, economists believed they had things under control: the “central problem of depression-prevention has been solved,” declared Robert Lucas of the University of Chicago in his 2003 presidential address to the American Economic Association.

These conclusions did not emerge as specific implications of any particular model. Rather, the micro-foundations approach, at least in its current form, can only work well under specific assumptions and conditions. The crucial assumptions are that the standard microeconomic model in which market outcomes are driven by the optimizing decisions of rational individuals (in typical macroeconomic models, those of a single rational individual).

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Rationality everywhere

The incorporation of rational expectations into micro-based macroeconomic models went hand in hand with the acceptance of increasingly strong forms of the efficient markets hypothesis, and both fitted naturally with the rise of market liberalism. In competitive markets where participants are perfectly rational and display high levels of foresight, it is very hard to see any beneficial role for governments. Even if governments happen to better informed than market participants, they should not, in a world of perfect rationality, act on that information. Rather, they should release the information to the public, allowing market participants to combine this public information with their own private information, and secure better outcomes than would be possible from government action.

Of course, many macroeconomists, and particularly those of the New Keynesian school, explicitly rejected the ultra-rational assumptions that produced such implausible conclusions as Barro’s Ricardian equivalence. One of the standard moves in the construction of Blanchard’s haikus was to allow the ‘representative individual’ to deviate in some small way from perfect rationality. 

A common example is the assumption of ‘hyperbolic’ discounting. The idea is that in assessing a choice between getting some benefit immediately, or at some point in the relatively near future, say, in a month’s time, people display a lot of impatience. They are willing to offer a big discount to get the benefit now rather than wait to get something better. But, if they are asked about two points in the future that are a month apart, they will offer only a small benefit. Such preferences, if maintained over time, are not consistent with standard rationality. The choices people make now regarding choices in the medium future are not the same as they would make if they waited until the opportunity for immediate consumption was actually available. A paper by Liam Graham and Dennis Snower showed that the combination of staggered nominal contracts with hyperbolic discounting leads to inflation having significant long-run effects on real variables, that is, to the existence of a Phillips curve relationship that might persist into the long term.

Papers in this tradition showed that small deviations from rationality can sometimes have big effects on economic outcomes. But they rarely have big implications for public policy. Rather, they point in the direction of the idea set out by Cass Sunstein and Richard Thaler in their recent book Nudge. Sunstein and Thaler argue that governments can sometimes exploit deviations from rationality by framing choices that will ‘nudge’ people’s decisions in a socially desirable direction. George Lakoff in Don’t Think of An Elephant makes the same argument in a political context, suggesting that the Republican Party has had more success than would be expected based on underlying support for its policies, because it has done a better job of ‘framing’ political issues. Rather than seeking a more rational debate, Lakoff, argues, Democrats should respond in kind.

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Fiscal and monetary policy

The theoretical complacency with which the DGSE school viewed the state of macroeconomic theory was matched by a similar complacency regarding macroeconomic policy. From the early 1990s to the panic of 2008, macroeconomic policy was, for all practical purposes, monetary policy, or, more precisely interest rate policy. The standard approach involved what is called a Taylor rule, after … economist John Taylor, later the Under Secretary of the US Treasury for International Affairs under the George W. Bush|Bush Administration, who proposed in 1993. Taylor presented his rule as a way of describing the actual behavior of central banks, but it soon came to be used as a normative guide to policy. 

The idea of the Taylor rule was to set interest rates in such a way as to keep two variables, the inflation rate and the rate of growth of Gross Domestic Product, as close as possible to their target values. Typical targets might be an inflation rate of 2 to 3 per cent, and a real GDP growth rate in line with long-term growth in the labour force and labour productivity, say 3 per cent for a developed country like the US.  Given 

Within this framework, the essential functions of macroeconomic theory are relatively simple. Complex macroeconomic models can be reduced to simple relationships between one policy instrument (interest rates) and two targets (inflation and growth). Since there are two target variables, it’s impossible to hit each target exactly, so the models give rise to a trade-off. Using the single representative agent who typically inhabits a DGSE model, it’s possible to calculate the optimal trade-off, which can be expressed as the range of acceptable variation in inflation rates.

During the Great Moderation, all this seemed to work very well, to the extent that commentators spoke of a ‘Goldilocks economy’, neither too hot, nor too cold but just right. Even with a tight target range for inflation, between 2 and 3 per cent per year, it seemed possible to stabilise growth and avoid all but the mildest recessions. In these circumstances, the comment of Robert Lucas that   the “central problem of depression-prevention has been solved,”  seemed only reasonable.

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  1. gerard
    October 21st, 2009 at 08:47 | #1

    Typical targets might be an inflation rate of 2 to 3 per cent, and a real GDP growth rate in line with long-term growth in the labour force and labour productivity, say 3 per cent for a developed country like the US.

    So one variable – interest rates, targets two variables, growth and inflation. Is it not significant that private debt was not considered as an important variable, considering how much it grew during this period? This is why Fisher and Minsky are now making a comeback.

    All the cheap imports from Asia over this time had such a deflationary effect on prices that they must have given the impression that rates should be set very low, which expanded debt and real estate inflation – two things that the central banks didn’t care about.

    Then also the government had decided that to stimulate the economy it could just rely on the central bank to drop rates instead of using fiscal stimulus. I guess they didn’t want to ‘crowd out’ private investment. But surely it would be a good thing if productive investment in things like infrastructure crowded out private investment in stupid real estate bubbles!

  2. James
    October 21st, 2009 at 08:59 | #2

    I find it interesting that the Taylor rule makes no mention of unemployment, one of the statutory targets of the RBA in Australia. Is unemployment explicitly targeted (in some sense) by any other central banks?
    Gerard, with your last sentence you have summarised most of Henry George.
    Prof Q, are any of these comments useful? Can’t help noticing that the text as posted in the Wiki seems unchanged from that in the blog, despite the noise we all generate in a vague effort to be helpful.

  3. jquiggin
    October 21st, 2009 at 10:13 | #3

    @James The comments are useful, and I am making changes in response. However, I’m working with a variety of versions, and I don’t always update the Wiki version when I change to take account of comments. It’s good to see you are following closely enough to notice this, and that will spur me on to keep the wiki up to date.

    On your substantive point, the Taylor rule advocates would say, I think, that any effects of monetary policy on unemployment work through changes in GDP, so that unemployment is targeted, just not directly.

  4. Uncle Milton
    October 21st, 2009 at 22:29 | #4

    Isn’t Lucas half right in that the policy response to the GFC, and the subsequent non-depression, shows that the problem of depression prevention has been solved? Admittedly, it’s been done using an analytical framework and policies that Lucas has spent the last 40 years arguing against, but still, 12 months ago a depression was in the offing.

    Recessions, on the other hand, like the poor, will always be with us.

  5. TerjeP (say tay-a)
    October 22nd, 2009 at 02:57 | #5

    The idea of the Taylor rule was to set interest rates in such a way as to keep two variables, the inflation rate and the rate of growth of Gross Domestic Product, as close as possible to their target values. Typical targets might be an inflation rate of 2 to 3 per cent, and a real GDP growth rate in line with long-term growth in the labour force and labour productivity, say 3 per cent for a developed country like the US.

    Mundell says that in regards to monetary policy you can’t hit two targets with one arrow. One of the problems with US monetary policy is that unlike Australian monetary policy it isn’t as single minded about inflation targeting.

  6. James
    October 22nd, 2009 at 09:22 | #6

    @Uncle Milton
    I think we have to suspend judgement on that until all the stimuli packages around the world wind down; As Roubini, Keen, and the other minority economists point out, there is still a mountain of dubious private debt out there.

  7. Ernestine Gross
    October 22nd, 2009 at 21:08 | #7

    “One of the standard moves in the construction of Blanchard’s haikus was to allow the ‘representative individual’ to deviate in some small way from perfect rationality.

    A common example is the assumption of ‘hyperbolic’ discounting. The idea is that in assessing a choice between getting some benefit immediately, or at some point in the relatively near future, say, in a month’s time, people display a lot of impatience. They are willing to offer a big discount to get the benefit now rather than wait to get something better. But, if they are asked about two points in the future that are a month apart, they will offer only a small benefit. Such preferences, if maintained over time, are not consistent with standard rationality. The choices people make now regarding choices in the medium future are not the same as they would make if they waited until the opportunity for immediate consumption was actually available. A paper by Liam Graham and Dennis Snower showed that the combination of staggered nominal contracts with hyperbolic discounting leads to inflation having significant long-run effects on real variables, that is, to the existence of a Phillips curve relationship that might persist into the long term.”

    I have some questions.

    1. What is ‘standard rationality’? It seems to me this notion should be defined, at least in a footnote.

    2. I find it extraordinarily difficult to accept the idea that one can draw any conclusion about ‘inflation’ from a model of an economy populated by 1 individual. Surely, if there is only 1 individual in an economy, this person will do what he or she wants and this person is the only judge of what is ‘rational’ and what is not. I find it very difficult to imagine that this single individual would be so bored as to see a need to entertain him or herself by means of recording the total resources in his or her economy, invent money, in which he or she records transactions with him or herself, invent a bank for him or herself only to discover that he or she is fooling him or herself by writing down the borrowings as ‘assets’. Since I do not presume people build deliberately silly models, my question is: What is the meaning of the adjective ‘representative’?

    3. Why is it ‘irrational’ for a single individual to have ‘hyperbolic discounting’, assuming the individual knows his or her life is finite and there will be no next generation because he or she has failed to clone him or herself. Moreover, what explains the jump from the ‘representative individual’ to ‘people’?

  8. Jim Birch
    October 23rd, 2009 at 12:50 | #8

    Ernestine,

    Wouldn’t it be rational to have ZERO time preference provided the benefit was in the time one could rationaly expect to be alive? What’s so special about current consumption? Obviously, the proviso is significant in the long term, but for a healthy individual below (say) fifty the chance of death is so low as to barely affect time preference at all.

    The problem with rationality is biology. Selection pressure will create wired-in time preferences that are optimised for a much less predictable world, basically a strategy that says Eat It Now, before it runs away, goes rotten, or some alpha male whacks you and steals it. Hyperbolic discounting is actually a superpositioning conflation of the wired in, aka lower brain biological, approach and a genuinely rational strategy. In choosing between now or next month the biological impulse will likely overpower the rational but when choosing between a benefit in either two or three years, the wired in preference is already out of it’s depth and has more or less given up.

    What’s interesting to me is the way that the individual can be change – or be changed – in the relative weights given to these modes. Things like environment and education have big effects. If you compare the individuals in a pokie bar with members an accountants convention, you can measure pronounced differences with simple tests. It’s a surprisingly trivial matter to shift an individual’s weights too, especially in the “downwards” direction where anything even mildly stressful will do. In a study I read recently, they simply began by asking participants a question on some immaterial subject and then randomly telling them they were right or wrong before assessing their time preferences. Those who got it wrong went more hyperbolic. People who have higher residual stress – eg, measured by cortisol levels – also have more hyperbolic time preferences. This would be a significant factor in the weaker economic decision making of poor people.

  9. jquiggin
    October 23rd, 2009 at 12:54 | #9

    @Ernestine Gross
    I’ve written something about the representative individual, which I will post.

  10. sdfc
    October 23rd, 2009 at 13:19 | #10

    I couldn’t agree more James, particularly when many of the primary drivers of the problems which led us to the GFC are still in place. Namely easy money in the developed world, currency manipulation in the developing (China, Saudi Arabia), and yes mountains of household debt.

    Terje, in my opinion slavish adherence to the inflation targeting framework led the RBA hold rates too low for far too long.

  11. Ernestine Gross
    October 23rd, 2009 at 13:39 | #11

    JQ, I take it you understood my tounge-in-cheek comment in the way I had intended.

  12. Ernestine Gross
    October 23rd, 2009 at 13:59 | #12

    Jim @8,

    I am not convinced that “the problem with rationality is bioloy” because a) the term ‘rationality’ would need to be defined’, b) I understand that game theory, which has well defined notions of rationality, seems to work quite well for describing the behaviour of schools of fish.

    I can’t see that observations of preferences being influenced by social circumstances necessarily destroys the assumption of rational behaviour in agent models (as distinct from macro-models)in economics. It is one thing to study how preferences come about (biology, sociology, neuroscience) and another to study what happens in a model of an economy, given preferences, one for each ‘agent’ and rational behaviour (ie agents act in a manner that is logically consistent with his or her preferences).

  13. Alice
    October 23rd, 2009 at 17:53 | #13

    @sdfc
    agree sdfc – slavish being the opertaive word plus the idea that unemployment is a secondary objective (take care of GDP and you automatically take care of unemployment…this is **** trickle down).

  14. SJ
    October 23rd, 2009 at 23:24 | #14

    Ernestine Says:

    I understand that game theory, which has well defined notions of rationality, seems to work quite well for describing the behaviour of schools of fish.

    Unless this is to be regarded as another of your hyperbolic comments that should be regarded as “tongue-in-cheek”, i.e., absolute nonsense, I’m going to have to ask for some citations here on the applicability of game theory on the behaviour of schools of fish.

  15. Ernestine Gross
    October 24th, 2009 at 04:42 | #15

    SJ @14,

    The earliest reference I know of is in Dutta, P. K. (1999) Strategies and Games – Theory and Practice, The MIT Press.

  16. Alice
    October 24th, 2009 at 09:54 | #16

    @SJ
    SJ and Ernestine – it may not be game theory based but in this link I can see how some finance boffs think modelling fish school behaviour is useful. You see some fish herd others smaller fish into a tight swirling ball and then eat them, like hedge fund managers! So in modelling fish behavior you get to help the predators in the financial markets know which way the smaller fish will go!

    http://74.125.155.132/search?q=cache:AvHHI-OEMMEJ:capital-flow-analysis.com/capital-flow-watch/fish-schools-covariance-and-dyor.html+game+theory+and+the+behaviour+of+schools+of+fish&cd=5&hl=en&ct=clnk&gl=au

  17. Alice
    October 24th, 2009 at 10:07 | #17

    @Ernestine Gross
    Ernestine, SJ ?? Dugatin and Reeve (1998) “game theory and animal behaviour” Oxford uni press.
    Any animal that swarms or herds seems to have some use in financial markets analysis it would appear. Really, what on earth was so wrong with Keynes animal spirits?

    A rose by any other name…..

  18. SJ
    October 24th, 2009 at 21:17 | #18

    OK, I see that it’s just ordinary run-of-the-mill payoff for cooperation stuff. The fish play a “safety in numbers” strategy. It’s not a learned behaviour, it’s something they’re hard-wired to do. So it’s not really a rebuttal to Jim Birch’s post @8.

  19. Ernestine Gross
    October 29th, 2009 at 15:43 | #19

    Alice, I take it that SJ @18 has made a tongue-in-cheek statement as defined in SJ’s earlier post.

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