Sunday, July 11, 2010

Real Business Cycles

Aggressive comments attached to my posts are a sure sign that links elsewhere in the blogosphere are giving me readers that don’t normally come here. That was certainly the case with this piece, which Mark Thoma, and in turn Paul Krugman paid some attention to. This gives me a useful opportunity to address issues related to real business cycle theory and its place in modern macroeconomics.

Milton Friedman and the Old Monetarists seemed to be short-run Keynesians. When pressed to write down his vision of sources of short-run nonneutralities of money, Friedman’s framework was essentially standard IS/LM. In contrast to mainstream Keynesian views at the time, however, Friedman was firmly anti-interventionist. Attempts at stabilization policy, either through monetary or fiscal means, according to Friedman would inevitably make things worse. For Friedman, policy could mess things up because of policy-making lags, imperfect information about the structure and state of the macroeconomy, and the “long and variable lags” associated with the effects of monetary policy (and fiscal policy too).

Then, along came the Phelps volume and Lucas’s pathbreaking 1972 Journal of Economic Theory paper, and macreconomists began to think about the world in an entirely different way. In the Keynesian world, fluctuations in aggregate economic activity are inefficient, and the logic appeared to be consistent with what we observe. We find ourselves in the middle of a recession. In terms of the its basic fundamentals, the economy looks more or less the same as it did before the recession happened. There is roughly the same set of people, with the same skills. The same buildings and machines are in existence, and we know just as much about how to produce stuff as we did before the recession happened. However, we are producing less and more people are out of work. Surely something has gone wrong, and the government can do something about it, by spending more and relaxing monetary policy to put people back to work.

However, the Phelps volume writers and Lucas got us thinking about the following. An unemployed person is someone who answers the labor force survey in a particular way. This person is engaged in a particular activity – search – and we can analyze this process just as we would analyze anything else in economics, as involving choice and incentives. Due to a mismatch between the workers that firms want and the jobs that workers would like to have, separations due to various factors, and people moving in and out of the labor force, there will always be unemployment. Further, fluctuations in these factors determining unemployment will make the unemployment rate fluctuate. Indeed, we might imagine fluctuations in unemployment that are purely efficient – there may be nothing the government should do about this. Also, according to Lucas’s 1972 model, monetary policy could be causing inefficient fluctuations. Indeed, there could be states of the world where GDP is inefficiently high. Thus, the government could be actively screwing things up, in line with Friedman’s thinking.

Next, along come Kydland and Prescott in 1982, with what later became known as real business cycle analysis. In terms of the economics, the Kydland-Prescott framework was not very radical, being an elaboration of received growth theory, stemming from the work of Solow, Cass-Koopmans and Brock-Mirman. However, in a lot of ways Kydland and Prescott were thinking outside the box, and they were very much in the faces of mainstream macroeconomists, in a much more aggressive way than were Lucas, Sargent, and Wallace in the previous decade. Kydland and Prescott offended econometricians, by calibrating rather than estimating, and by using unconventional time series filters (i.e. the Hodrick-Prescott filter) to separate the the business cycle components of time series from the trends. They also gave economists license to contemplate the possibility that business cycles could be bad events that we should do nothing about – government intervention could serve only to make the problem worse, analagous to how Lucas's 1972 model works, but for different reasons.

For some macroeconomists who were brought up on the Keynesian paradigm, and were highly invested in it, this was heresy. Some older prominent economists, including Tobin and Solow, resisted, and some prominent young economists, including Larry Summers, did as well. For young researchers who received their education during the 1970s and 1980s (this includes me of course), the new paradigms were exciting. The economics of Kydland, Prescott, Lucas, Sargent, and Wallace looked more firmly grounded in the solid general equilibrium theory developed by Arrow and Debreu, and these people had good arguments which appeared to match well with empirical observations. Relative to this, mainstream Keynesian economics just looked mushy. Who would want to tie their caboose to that train?

Now, though Kydland and Prescott presented an extreme view of business cycles, which could be interpreted as telling us that the government is irrelevant, the general spriit of the approach is something entirely different from that. The key lesson is that we need to impose the same discipline on the evaluation of macroeconomic government policies as we would in any other field of economics. Skepticism about the role of government is healthy, and every government program and intervention should be justified in terms of correcting some externality or market failure. In the language of Pat Kehoe (or maybe this comes from Lucas – I’m not sure), we don’t want to justify government intervention based on a “chicken model.” In a chicken model, we assume that chickens are good, that the private sector cannot produce chickens, and that the government can, and therefore should, produce chickens. A Principles-of-Economics Keynesian-Cross model is basically a chicken model. In it, we assume that more GDP is a good thing, and the government can give us more GDP – essentially for free – by increasing government spending on goods and services. The logical conclusion from such a model is that we could make ourselves infinitely well off with a government of infinite size. Keynesian Cross macroeconomics is basically the macroeconomics of Paul Krugman – what he is peddling to the general public.

What about Prescott’s remarks last Wednesday about the causes of the current recession? What should we make of that? To me, Prescott’s narrative did not make any sense, in terms of what I know about the facts. To be fair, we should wait to see how he spells this out in terms of a rigorous argument with an explicit model he can use to confront the data. However, to make myself clear (to people like Krugman), what I was quarreling about had nothing to do with the competitive paradigm or basic neoclassical growth theory. My only problem was with the shocks that Prescott was evoking to explain events. It could well be that we could ultimately come to an understanding of the financial crisis and the recent recession as an economically efficient macroeconomic response to events. In this context, we might come to think of the policy responses to the crisis – the extreme actions of central banks and the US stimulus bill – as being wrongheaded. In spite of the fact that important factors that gave rise to the recent recession were the result of errors in the design and regulation of the US financial system, it could be that the temporary government intervention in response to the recession was wrong. In my view, some of the US monetary policy intervention was the right thing to do, and maybe some elements of the stimulus bill were appropriate, but I could be wrong.

Now, serious New Keynesian economists do not peddle chicken models in the same sense as the Old Keynesians, like Krugman. These people, including Jordi Gali, Mark Gertler, and Mike Woodford, deal with models where inefficiencies arise for reasons that any economist could understand. The basic sticky price frictions in their models yield relative price distortions that happen to be correctible (subject to the zero lower bound on the nominal interest rate) by monetary policy. These people use conventional theory, developed by Arrow, Debreu, Solow, Cass, Koopman, Brock, Mirman, and Prescott, to derive their conclusions. That has been the great victory of Lucas, Prescott, Sargent, Wallace, and others. Their theoretical methods are now widely-accepted, and in terms of empirical work New Keynesians and others now use a wide array of calibration and estimation techniques. No one would shy away from New Keynesian economics because it is too mushy.

My problem with New Keynesian economics (in addition to its treatment of monetary and financial frictions) lies with the basic sticky price assumption which leads to what I referred to here as “incoherence.” This was a little too harsh a word, but what the heck. One problem with the New Keynesian approach is that there is a chicken model lurking in there. Price flexibility is good, the private sector cannot produce it, but appropriate monetary intervention can produce the equivalent of price flexibility. Another way to look at this is that we do not understand pricing decisions at the level of production, distribution, and retail sales, and the relationship of these pricing decisions to other elements of productive decisions (employment and investment) enough to really say whether there are frictions or externalities arising from those decisions that matter in a serious way for macreoeconomics. No one has a convincing theory (or indeed any theory) to tell us why pricing should matter for macroeconomic activity and policy in the way Old and New Keynesians want it to. That, I think, is the challenge for Keynesian economics. Until that is resolved, I am content to seek explanations for aggregate phenomena and roles for economic policy in financial and monetary frictions.


  1. In other words, that that research line gave us was method, rather than substantial knowledge on the workings of the economy. I would say that's debatable, but a fairly common point of view.

  2. It sounds like you're saying that you'll never accept policy recommendations based on observed macroeconomic correlations between variables, unless given fully realized microfoundations that explain exactly why the given policies should work in the desired way.

    And if I read Nick Rowe right, he's saying that it's OK to use unrealistic microfoundations, on the grounds that there is nothing better available at the moment, and on the assumption that the unrealistic models turn out to approximate the real world closely enough to be useful even if they're technically wrong.

    And if I read Krugman right, he's saying that this business of microfoundations is fascinating and everything, but I'm trying to use a 600-word op-ed column to get the politicians to adopt those policies I think (based on sharing the same views as Rowe, I guess?) are most likely to put millions of people back to work when they really need it, and so I'm willing to elide these distinctions and stick to a basically obsolete model, because it's easier to explain to lay people.

    Have I got this right?

  3. When the "chickens" being talked about are people's jobs, it becomes difficult to explain why having the government create them might not be the best policy, at least it becomes difficult to explain without sounding like a callous, evil person.

    -- Dave

  4. That's a nice summary of RBC/NK etc.

    However, until there's a DSGE model that features either 'bubbles' or a rational mechanism of extreme amplification of tiny shocks, the current 'modern macro' working model of what happened is essentially the 'we have no idea' model.

    So Krugman's old Keynesian stuff is as good of an approximation of the world as any other, especially seeing how his predictions are mostly fairly accurate lately.


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  6. "So Krugman's old Keynesian stuff is as good of an approximation of the world as any other, especially seeing how his predictions are mostly fairly accurate lately."

    "Mostly fairly accurate" ??!! Paul the Octopus' have been better, surely.

    People can, and apparently do, believe in the tooth fairy, which is as good as an explanation as any other. But when you're talking about spending hundreds of billions rather than trillions of dollars - and taking an enormous risk at the same time that one is making things worse rather than better - it would seem one might want a higher standard than "as good of an approximation of the world as any other".

  7. Here's Paul Krugman in Nov. 2009, "And I’m not sure what to make of it, but casual observation suggests a stronger recovery than anything I see in published numbers."

    It's easy to be right post facto when one makes a large number of vague, essentially inconsistent comments and predictions over a short span of time.

    If you really want to test Krugman's predictive ability, please take his next week's columns and come up with 2-5 predictions of what will happen in the economy over the next 6 months to 2 years. Then the first task is to rate how difficult the predicition is, that is how likely it is to turn out, e.g. a prediction that American unemployment will be higher than 8% 6 months from now will be rated pretty easy, a prediction that it will be higher than 10% will be rated more difficult, and a prediction that it will be higher than 12% very, very difficult.

    Naturally, vaguer predictions ("lost decade") are rated as easy.

  8. "The logical conclusion from such a model is that we could make ourselves infinitely well off with a government of infinite size."

    Only if there is an infinite labour force. I've never seen a Keynesian model which makes that assumption. In the simplest version, the logical conclusion is that we could eliminate all "involuntary" unemployment (and in the simplest version there is no other kind). I'm not saying that the simple Keynesian model is satisfactory, but anyone who accepts your account will have to conclude that Keynes, Hicks, Samuelson and a host of other distinguished economists were complete idiots. Then again, maybe that's what you actually believe?

  9. Politicians, and first year students, do tend to take the Keynesian Cross model somewhat literally. They tend to draw the conclusion that if there is *any* unemployment, the government could make us better off by increasing G or cutting T. Since so many people (politicians, journalists) take only first year econ, if any, that can make it dangerous. "A little learning is a dangerous thing" etc. But the economists who use it also know when *not* to use it. That certainly includes Paul Krugman.

    I think we are *all* doing implicit theorising. Some of us assume unexplained price stickiness; some of us assume there isn't any. I assume only the government can produce chickens; you assume chickens don't exist.

    Evan Harper reads me about right. Except I would add that we are *all* using unrealistic models.

  10. I should just add that I basically agree with your post. But that doesn't stop me continuing to use the assumption of sticky prices.

    It's unexplained. That means it *may* (or *may not*) be logically inconsistent in a way that matters with the rest of the model. Better a possibly incoherent assumption of price stickiness than to ignore the micro and macro evidence of something that looks very much like price stickiness.

    In a recession, it certainly looks a lot easier to buy things, and a lot harder to sell things. That looks like generalised excess supply for goods and labour. The value of money in terms of stocks, bonds, and other monies (stock prices, bond prices, exchange rates), and goods whose prices change minute by minute (commodities) changes a lot and quickly. The value of money in terms of most goods, and labour (CPI and wages) changes very slowly in comparison.

    That all looks to me like an essentially monetary plus sticky prices cause of the business cycle.

  11. Greg Hill

    Arrow draws a different conclusion from his work on competitive equilibrium than you do, namely that requirements for GE are so stringent that the main application of the GE model is show where real world markets fall short.

    Everyone is familiar with Arrow's arguments regarding health care and learning by doing (increasing returns), but Arrow even made a case for "the socialization of investment" based on the lack of complete markets in contingent claims.

  12. I have documented Prescott's views from 1 year ago, as I understood them (which means, I might be missing the entire point).

  13. I think I can provide some defense for chicken models.

    the issue is that most modern macromodels actually deal with representative agents hypothesis. When you think really hard about you are actually with when you use a representative agent model, what you actually get to is that it is a really sophisticated "chicken model".

    As I see it, a representative agent does not have any counterpart in the real world; it is a theoretical construct that is usefull to reach interesting conclusions because, usually, economies or groups of agents act as if they were single agents, or for other reasons. The behaviour of the entire economy is an "emerging pattern" (that is, not an aggregation of identical behaviours) which similar from a epistemological point of view to the consumption and investment function you get in your ISLM.

    But it is one thing to think that microfoundations are useful to grap emerging patterns, and it is a very different one to think that you can apply welfare economics and th eeconomics of market failures in the same way you do it in micro. I mean, the utility function of a representative agent does not have any clear normative value in terms of individual preferences, you have to take an enormous logical step if you want to argue that since representative agents optimize intertemporally, fluctuations resulting from that optimization are in some sense optimal.

  14. Evan,

    "It sounds like you're saying that you'll never accept policy recommendations based on observed macroeconomic correlations between variables, unless given fully realized microfoundations that explain exactly why the given policies should work in the desired way."

    Yes, we want our models to be consistent with the observed correlations, but you can't do policy without firmly grounded theory.

    "And if I read Krugman right, he's saying that this business of microfoundations is fascinating and everything, but I'm trying to use a 600-word op-ed column to get the politicians to adopt those policies I think (based on sharing the same views as Rowe, I guess?) are most likely to put millions of people back to work when they really need it, and so I'm willing to elide these distinctions and stick to a basically obsolete model, because it's easier to explain to lay people."

    I can't read Krugman's mind, but if this is what he thinks, I think he is wrong. If the idea is good, that's in part because it is simple, and you should be able to explain it to anyone. My wife has a PhD in English literature and no knowledge of economics, but she seems to understand me.


    "When the "chickens" being talked about are people's jobs, it becomes difficult to explain why having the government create them might not be the best policy, at least it becomes difficult to explain without sounding like a callous, evil person."

    This is a problem we have as economists. We're willing to evaluate tradeoffs which involve life and death and events like unemployment that are a very big deal in the lives of individuals. That does not make us callous or evil. We're just doing our jobs. Personally, I am insuring more than my share of the unemployed within my own household.


    Representative agent is a useful starting point, but most cutting edge research goes for some heterogeneity. My models have lots of heterogeneity, private information, and other frictions, and I still do the welfare analysis.

  15. My background is that of a professional investment manager who has spent over thirty years trading in real capital markets, analyzing real companies and investments and utilizing the tools of modern financial economics to do so. Having said that, it amazes me that economists still cling to Arrow-Debreu etc. when it is so obviously clear that modern capitalist economies behaving nothing like an
    Arrow-Debreu world. And it is a matter of public policy for this to be so. Start with the a basic public policy deviation such as the granting of patents, allowing for at least temporary monopoly rents. This illuminates the real failure of neo-classical foundation models to really get what happens out there in real world markets. The most important to understand, I think, is that in reality most prices do not equal marginal cost, but are in fact much higher in both the manufacturing and service sectors of the economy. Every CEO in the world spends his day trying to figure out how to extract monopoly rent over the next planning time frame and in general, is fired when she and her staff fail to do so. Therefore, the entire foundation of Real Business Cycle theory is bogus, and of course has to therefore rely on the exogenous tooth fairy of technological progression and regression. And in the real world, technological progression and regression is endogenous to the functioning of real capitalism, which is characterized primarily by monopolist competition. In the real world of monopolistic competition technological progress is rewarded with the capture of monopoly profits, and is the focus of most value-added business activity. I would suggest a re-reading of Paul Romer on this point, which again, as somebody who paid his rent and accumulated some serious wealth by having to make real investment decisions with real money, is a model that much more accurately describes the business world I have been in for the past four decades.

  16. Price stickiness is often called unexplained by some economists, but I think it's in large part that they just don't like the explanations because they go against the unrealistic assumptions that they want to make, like people are completely logical and only care about maximizing a super simple utility function whose only input is current consumption (no behavioral factors), people have perfect public information, perfect expertise and education regarding everything that make decisions on, analysis is instant and costless, etc.

    In reality, business are reluctant to change prices, and especially to cut nominal wages, for behavioral and practical reasons.

    Unlike most economists I have a lot of experience and training in business, MBA from one of the top schools and successful entrepreneur (in addition to having most of the econ PhD coursework from completing all but dissertation for a finance PhD, and a great deal of independent study). I often think of business as micro-microeconomics, because you study individual businesses, managers, workers, and consumers in depth rather than whole industries and markets, or in macro the aggregation of industries and markets. This business knowledge can be valuable sometimes in thinking about economics.

    I find the existence of sticky prices compelling because as a business person I know consumers hate price increases and jumpy prices. You don't want to cut prices if you're going to have to raise them again quickly and anger customers (and my experience is that business people tend to be overly resistant to cutting prices). It does work this way for commodities like oranges and tomatoes, but there's no brand to tarnish there, for consumers to become angry at, plus a culture of jumpy prices has been established for things like produce, but not for other products.

    In addition, the empirical research is clear that workers will resist a nominal wage cut far more than a wage freeze that equates to a real cut. They won't adjust their required wage down very quickly or easily at all, and if a business hurts morale and loyalty that can be very costly in the real world.

    Models that assume people only care about real consumption, with no context or emotion attached, won't include this, but the real world certainly does.

  17. Keynesian macroeconomists should be the last to throw stones as Ed Prescott.

    Keynesian macroeconomics postulated that the economy slips into recessions for all sorts of reasons such as shifts and turns in the animal spirits and a loss of consumer confidence leading to a fall in autonomous investment and autonomous consumption. A collapse in autonomous investment and autonomous consumption is the Keynesian explanation for the great depression.

    At least Prescott and other RBC theorists accepted that they must eventually unpack productivity drops and name causes that can be explored further and perhaps found persuasive or perhaps wanting.

    By the time Keynesian macroeconomics fixed all the flaws mighty exposed by the 1970s stagflation, it rebranded itself New Keynesian macroeconomics. This is no more than becoming monetarist macroeconomists without having to admit all of your previous criticisms of Friedman were wrong. Admitting that error of judgment would put jobs and tenure track at risk!

  18. "One problem with the New Keynesian approach is that there is a chicken model lurking in there. Price flexibility is good, the private sector cannot produce it, but appropriate monetary intervention can produce the equivalent of price flexibility."

    But this may make sense.

    It's really hard, and hazardous, to cut an employee's real wage when there's no inflation, but if the government creates inflation, it then becomes a whole lot easier; just keep the nominal wage the same, or even raise it, just less than the inflation level. I know if you are unwilling to not assume that people are not super calculators who only care about maximizing a simple utility function that only includes current dollar consumption with no context, then you will think this is not an explanation. But just cause a group of economists doesn't like it doesn't mean it not true and supported far better by the evidence from reality than their assumptions.

    Likewise, if there's inflation, and the public understands that, that gives cover, a good excuse so as to not anger customers, to raise prices. And, a business can feel more comfortable about cutting the real price, knowing that if it doesn't work out they can more easily raise it back up again under cover of inflation. I know, again, this assumes that all people, or the vast majority, aren't super calculators, but while we're on a post about Prescott, let me give you this quote from Jodi Beggs (Harvard econ Ph.D. student) of the "Economists do it with Models" blog on Ricardian equivalence:

    "Given that many people seem barely able to even say what country the U.S. declared its independence from, I am not so concerned with such sophisticated and forward-looking behavior occurring on a large scale."


  19. This argument, which is of course standard in macroeconomics, is completely ideological. What makes general equilibrium so "solid"? It's incredible empirical triumphs? The observed fact that market prices clear all markets simultaneously? Where does the conviction that Arrow-Debreu is the only possible starting point come from, if not ideology?

    Your formula that every government intervention must be justified in terms of externality or market failure is also ideological, in that it supposes that markets are innocent until proven guilty, and governments are guilty until proven innocent. If we are to be practitioners of healthy skepticism, then we must be skeptical of both governments and markets.

  20. Ideology:

    the body of doctrine, myth, belief, etc., that guides an individual, social movement, institution, class, or large group.
    such a body of doctrine, myth, etc., with reference to some political and social plan, as that of fascism, along with the devices for putting it into operation.
    Philosophy .
    the study of the nature and origin of ideas.
    a system that derives ideas exclusively from sensation.
    theorizing of a visionary or impractical nature.

    So what ideology is at play here? Did Arrow and Debreu have an ideology? If so, it didn't find its way into their theory, which in its most general form has absolutely no predictive content. You have to put more structure on it to make it useful. You said: "If we are to be practitioners of healthy skepticism, then we must be skeptical of both governments and markets." But that is exactly what I am saying.

  21. You don't see how #1 exactly fits macro? I'm sure that Arrow and Debreu were motivated by the intellectual challenge, but in the hands of Lucas and his successors, how is general equilibrium is not a body of doctrine that guides a large group?

    You're saying the default model of economic interaction is a perfectly-functioning market were prices cannot be manipulated by participants, and not are prices such that markets clear today, but everyone agrees what prices will be in every future state of the world in such a way that markets will always clear forevermore. That this model is so intuitively plausible that it defines good scientific practice in the way that old Keynesian models do not. How is that not a doctrinal belief?

  22. The model is useful, particularly as a starting point for good science. If you think this body of work is driven by belief, you should read it and think about it. You might change your mind.

  23. Given some of the comments here and similar ones else where on the blogosphere, I think more would have to be said about the basic anatomy of popular criticism of economic theory and methodology that seems to have mushroomed after the crisis. Karthik Athreya's piece was actually a good start. It is mind boggling the way in which various media have fed into each other to create a remarkably homogeneous criticism of way the macro-economists have conducted themselves for the past 25-30 years. Occasional sensational statements by otherwise sensible economists have only made things worse.

    Many ideas of economists sound bizarre to the layman, probably because its something like the blind-men and the elephant story. The point is that no body really understands the elephant and it is so easy to pick on someone who makes it his business to construct at times unreal [surreal ;)] models to infer something about the elephant. Put together all the elegant apparatus that economists have build over the years we at least have a somewhat accurate picture on how this extremely erratic beast called the economy should behave under certain conditions. This is an immense progress according to me as we at least can now have some careful if-then statements that can be evaluated using careful analysis.

    I sometimes think that it was actually good that people like Krugman said something sensational and sparked a useful public debate. But at times I am not sure. I firmly believe that he definitely knows how economics works. One can see that from his popular textbook on international economics. He starts with a perfect benchmark model of trade and slowly goes towards models dealing with more complicated issues. There is a multiplicity of models in international trade and each has its own utility depending on what issue you want to analyze. Why should Krugman expect any different from macroeconomics? And if he did not why would he embark upon a simple minded criticism of macroeconomics which probably was single most driving force in creating the popular criticism of economics in the wake of the crisis. Does he really believe that international economics has been more successful in dealing with policy issues than macroeconomics. If that was indeed the case why do trade talks fail so often than they succeed?

    In the past history and now economics seems to have become those branches of social sciences where many non experts believe they can do a better job than people who spend substantial part of their life tinkering with small details to come up with a tiny winy building block that contributes to the grand edifice of theoretical understanding.

    Also more importantly the internet has added its own flavor to the whole debate. In this regard I have come to firmly believe in Nicholas Carr's arguement in how internet is shaping the way we approach construction of knowledge. The facility of skimming through information and writeups without even resting for a bit to introspect and engage into deep thought is turning out be a bane for us as a knowledge seeking society. And I think no where this has been so evident than the way popular criticism of crisis has developed and spread across the internet. I think we will need a lot more efforts like yours to cut through this superficial semblance of understanding that has come to plague the popular consciousness.

  24. Parag,

    Excellent. I think we more or less understand each other.

  25. I now realize my comment is really long. sorry for spamming your blog!

  26. Why would you assume that I haven't read much about macroeconomics? I have read a very great deal. I have no problem with the idea that Arrow-Debreu is a useful model. But if models are going to be judged on usefulness, then they should be judged on usefulness. IS/LM is a useful model, too. You want to say that old Keynesianism is a bad model because it's assumptions are unrealistic, but then when you want to defend a model whose assumptions are patently unrealistic, you fall back on the fact that it's useful. Maybe in fact it's not that useful. Maybe it's time to rethink its usefulness, the same way that economists rethought the usefulness of IS/LM in the wake of stagflation. Maybe if we applied the usefulness criterion fairly, rather than first excluding some models because they failed to satisfy patently unrealistic assumptions, we would discover that lots of other models with fundamentally different assumptions were even more useful.

  27. I assume you haven't read much, because your misconceptions are like those of my undergraduates during the first week of class. All models are wrong or unrealistic in some fashion, and they all make assumptions that are "patently unrealistic." We construct the models with particular issues in mind, to address particular problems we are interested in. Keynesian models are not the only game in town, and there are plenty of other ways to think about policy that don't involve sticky wages and prices. We have models in wide use that go beyond Arrow-Debreu to think about private information, limited commitment, incomplete markets, search frictions, etc. All of these models are useful in some fashion for dealing with particular problems. IS/LM is not useful - that's why the New Keynesians abandoned it.

  28. Ah, the "you're like an undergraduate" card, the go-to trump card of academics who've decided not to listen. I have read plenty, thank you, including the New Keynesians you mentioned. Now you can insult my reading comprehension instead.

    So all models are patently unrealistic, but you seem to like some unrealisms more than others. The idea that we are continuously in an equilibrium of prices, plans, and expectations, a la Radner, is A-OK with you, but the idea that prices don't instantly adjust to these new equilibria is an unrealistic chicken model.

    There are 2700 stocks listed on the New York Stock Exchange. God knows how many products Amazon and Walmart sell. How do prices in an economy of the size and complexity of the US economy get set into this equilibrium of prices, plans, and expectations? You assume that prices get set perfectly, except for some small deviation from perfection, such as search frictions, without ever explaining how this miraculous level of coordination happens. Walras' chicken auctioneer?

  29. Sorry to offend you, but as Bullwinkle said, "I paint what I see." Another common line used in Minneapolis is: "It takes a model to beat a model." What's yours?

  30. Another point related to this:

    "There are 2700 stocks listed on the New York Stock Exchange. God knows how many products Amazon and Walmart sell. How do prices in an economy of the size and complexity of the US economy get set into this equilibrium of prices, plans, and expectations?"

    That's what so amazing about a market economy. That's a hard problem to solve. You wouldn't want a central planner doing it.

  31. A model is only as good as its interpretation.

    The problem we too often see is models interpreted straight out literally, like reality behaves exactly the same. Or qualitatively literally, or just overly literally.

    Models usually describe some force, or forces, at work, but not all. You have to use high level intelligence, not mechanical thinking, to consider how strong those forces are in the real world, and to consider other forces not in the model that are substantial, and how strong they are, and what direction they go in (considering any substantial interactions and feedback effects), to determine how things work in sum over the short, medium, long, and/or very long run.

    The models are an aid, and often a very valuable one, but when interpreted intelligently, not literally. And when combined with other important information from reality, emperical and just logic that's solidly linked to very reasonable, mild assumptions (often far milder than those common statistical tests are based on).

  32. Richard H. Serlin

    -The problem we too often see is models -interpreted straight out literally, like -reality behaves exactly the same. Or -qualitatively literally, or just overly -literally.

    Agreed, but I would say that economist should interpret the model literally and use it to say "if ..., then ..". And not set up a model and pretend that it is the model that says something about the real world when it is the economist's gut/experience/what ever.

  33. So no answer? There's no mechanism? It's just some miracle of markets that they instantly clear now and into the future? And this is so clearly true that we should make it a requirement of a good economic model?

    I mean, what's your argument here? The US economy works better than Stalin's Five Year Plans, therefore we must conclude that the economy is always in equilibrium at all times? There's no middle ground?

  34. Middle ground between what and what? What is your model?

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