We’ve heard it before: Beware of PhD economists. Don’t ask them too many questions; just let them talk. Let them talk about that one thing they spent 6 years writing a dissertation about, and only that thing. Don’t try to argue, don’t try to think. They’ve already done that. They know it. You know it. Just let them do what they’re supposed to do. After all, PhD economists are the people whom we rely on to create macroeconomic policy and teach us about macroeconomics.
Maybe that was a little harsh. But the flaw in macroeconomics comes with the self referential, inward-looking distractions that are the beliefs of macroeconomists, especially those of the New Classical and New Keynesian schools, and especially in reference to the Efficient Markets Hypothesis. The parameters of this hypothesis claim trading that spans all possible outcomes in which budget constraints are always satisfied by assumption, keeping in mind that default, bankruptcy and insolvency are impossible. Because of this, questions of illiquidity and insolvency can’t be asked OR answered. They don’t even exist! Right? Wrong. The hypothesis also includes the assumption that there is some power in the universe that makes sure nothing unexpected happens with long term price expectations. The basis of this hypothesis alone is a major “empirical fatality” of the 2008 financial crisis.
So what does this have to do with DSGE models? Consider the way in which macroeconomists view the EMH—a model that is so doctored to display perfect, unrealistic conditions in an imperfect, realistic world. What do we think they did with DSGE models? In the words of William Buiter: “They took these non-linear stochastic dynamic general equilibrium models into the basement and beat them with a rubber hose until they behaved.”
The problem with macroeconomics is the lack of a powerful desire to understand how the economy works, in good times and in bad. Macroeconomists have a stronger desire to fiddle with their unrealistic models and try to convince people that yes, that really is how the economy works, and no, there is no other way.
To lighten the mood, here’s a picture of my dog in the bathtub:
To fix or to rebuild?
There are plenty of obscure economists who have come up with ways to fix macroeconomics. I think of them like the early 2000s emo bands of Economics. It’s our job to listen to them before they air on the radio. It’s our job to take their theories and pick them apart. What exactly are they fixing? What does the model specifically address?
Is there even a model that fully encapsulates all macroeconomic phenomena?
Can we do that?
I don’t want to say no. But the question is: how do we get there?
I think the biggest mystery is unemployment. I’m still trying to figure it all out. You’re going to have to convince me that involuntary unemployment truly exists. I’m coming up with an argument that it might not. Give me some time. Let me figure it out.
Mankiw throws some New Keynesian perspective into our analysis of RBC models. Good explanation of Walrasian Equilibrium and Classical Dichotomy.
Also, look at how CUTE my dog is. I love her. So fluffy.
The conceptual framework of modern education is misleading and unhelpful to students. It now seems more prominent than ever, the idea of “being good at school”. It has taken over the lives of students since we entered into the system. We’ve been spoon fed by our teachers and professors. Page limits, word counts, exact specifications. We’re taught how to do things “the right way”. We crumble when we are simply told to “do”. The simple task of reading a document and writing a reflection ignites a wave of anxiety among students. Where’s the rubric? How long should it be? What should I write about? What should me thoughts be? We are so used to being provided with the answers to all of these questions, so used to being told exactly what to do and how to do it. We have lost our ability to think, learn and create.
The classes in which I have learned the most are the ones where I am left to my own devices. These types of courses give me the opportunity to think critically, to conquer the moment of panic that accompanies vague assignment descriptions. When I am left to think, I am also given the opportunity to fail, which I think is incredibly important for my formation as a student and as a person. The problem with the conceptual framework of modern education is that students are rarely given an opportunity to fail. Teachers are afraid to let their students fail, and students are afraid to fail. Students don’t work to create or to learn, they work for the A. They work to avoid failure. They study the ins and outs of grading for each professor, memorize their favorite writing styles, and fill their work with fluff. We complete assignments by checking off items on a checklist, not by using our brain power. What kind of learning is that? We aren’t learning from each other, we’re learning through a manual. We sit, absorb, and regurgitate.
So what can be done to fix the conceptual framework of modern education? Let the students fail. Give students the opportunity to think wildly, create fervently, and learn constantly.
While I believe that expectations are important to include in economic analysis, the belief that people and the economy are rational in tandem is fundamentally flawed. The mathematization of people’s decision making processes is flawed. The mathematization of economics is flawed. The equality between the two: flawed. I know what you’re thinking: If we don’t mathematize economics, what are we to do? How can we forecast? Where is the basis of our science? Honestly, I’m not sure. But I do know this: sometimes, people are rational. Take our class for example. All of us (with one exception) made generally rational claims about future inflation. Claims based on past inflation rates, the current economic climate: rational. But what even qualifies as a rational expectation? Is it a prediction that aligns with some complicated, all-assuming, idealistic model? Is it a prediction that matches the actual inflation, even if you just picked your guess out of a hat? How then, are we supposed to be rational agents if the quantifiers for our rationality are flawed? The economy will do as it will. Recessions happen. We will not always see them coming.
New Keynesian Economics
- Founded with an attempt to build microeconomic foundations for Keynesian economics
- Particularly sticky wages and prices
- Why are changes in aggregate price level sticky?
- Why don’t price changes mimic changes in nominal GNP?
- Regards the choices of monopolistically competitive firms that set their individual prices to accept the level of real sales as a constraint.
- Firms do not assume that marginal costs will move in parallel with aggregate demand
- What are sticky wages and prices, exactly?
- Sticky wages are when worker’s earnings don’t adjust quickly to changes in labor market conditions. (ex. Wages won’t go down in a recession and rise in an expansion. Instead we experience unemployment in recessions)
- Sticky prices are when prices do not respond immediately to changing economic conditions. Haircuts have a sticky price, while gas prices do not.
- Believe that many markets are imperfectly competitive and have a degree of monopoly power
- Businesses have the opportunity to be more flexible with pricing
- Believe RIR differ from nominal IR (like the monetarists?)
- Recognize necessity for monetary and fiscal policy
- Heavy reliance on DSGE models
- Taylor rule: optimal interest rates given the given rate of inflation and the output gap
- Hit target inflation and you will have optimum growth and employment (hello Janet Yellen)
- Reasons for sticky prices:
- Staggering of prices. Firms may respond to changing prices slowly. If one firm cuts price of raw materials, it may take a few months for retailers to pass this cost saving onto consumers.
- Demand is inelastic in imperfect competition, there is no incentive to cut prices as revenue falls.
- Reducing prices can increase real incomes for consumers, which might be spent on other goods (firm doesn’t benefit)
- Reasons for sticky wages:
- Trade unions resist wage cuts for their workers.
- Workers are mainly concerned about their wage, and not the overall level of employment
- Cutting wages may reduce worker morale and reduce productivity.