Take real business cycle theory – I know it’s a horse I beat a lot, but it’s not dead, and it’s a prime example within economics of what I have in mind. I still want to spend at least some time explaining that theory to my undergrads, so I’ve been looking for a simple, intuitive explanation by an RBC theorist of what’s going on. And I haven’t been able to find one!Krugman could of course look in any of the standard undergrad macro texts, including my favorite. But I'll boil it down and make it really easy for him, and put RBC and NK (New Keynesian economics) in one picture. Full blown RBC, and basic NK (which is just RBC with stickiness) includes intertemporal choice, but for the basic ideas, static analysis works OK.
So that's RBC. What about NK? This is a cashless economy - as in a Woodford world - but we can imagine that prices are quoted in "dollars." P is the dollar price of goods, W is the dollar price of labor, and W/P is the real wage. Suppose further - much in the spirit of Woodford - that the central bank sets P. So, if the nominal wage is flexible, then a negative TFP shock gives us the same thing - the competitive equilibrium goes from A to B. But suppose the central bank does nothing in response to the TFP shock, and W is fixed. Then, after the TFP shock the equilibrium is at D, not B. At D, the real wage is the same as at A, i.e. the slope of the PPF is the same at D as at A. So in the NK world there is an inefficiency when the economy is hit with a shock, and we can see the welfare loss in the picture - the representative agent is on a lower indifference curve at D than at B.
What to do about the efficiency loss? In the NK world, the central bank could increase P, or the fiscal authority could subsidize hiring and pay for that with a lump sum tax. In either case, the appropriate policy will take us to B. Done.
So, that is a simple apparatus, that an intermediate-level undergrad can handle easily, and principles students can do it too. This can be a launching pad for ideas about what TFP is, what a TFP shock is, and what these basic stories leave out. Is it really very useful to think about TFP shocks driving business cycles if we can't measure aggregate TFP well? That NK story about monetary policy seems pretty crude. Shouldn't we elaborate more on what central banks actually do? Shouldn't we include financial factors in both the RBC and NK stories?
And for the really sophisticated stuff, boiled down into words with no mathematics, read Kartik's book.
Can you specify what the adverse TFP shocks were for the last, say, 4 recessions?ReplyDelete
I'm not defending it, I'm just answering Krugman's question.Delete
I don't think this answers Krugman's question. He is asking about TFP shocks that will make sense of what we observe empirically in recessions.Delete
For instance, 'The way I've shown it, leisure rises, hours of work fall, and consumption (equal to outuput) also falls. So it looks like a recession as we know it.'
This is not a recession as we know it (perhaps some but definitely not the majority). People don't reduce their hours in response to decreases in marginal productivity. There is involuntary unemployment.
No, in this instance, he's just asking for someone to give him a simple explanation of how basic RBC works.Delete
"This is not a recession as we know it..."
Relative to the basic observations, it is. As you point out, there are other things to worry about. You have reasons to question the theory. Good for you.
No, there is unemployment. Involuntary unemployment is fundamentally unobservable, unless you stretch it to the meaningless limit as including unemployment caused by search frictions.Delete
Gads, the people who post here when Steve addresses Krugman are worse than those at Noah's dump of a blog.
"People don't reduce their hours in response to decreases in marginal productivity"Delete
You are referring only to the intensive margin of adjustment. If you also consider the extensive margin, like Rogerson (1988) it works way better.
Stephen, I don't think you read Krugman correctly (or possibly I read him differently ). I thought he mentioned the process "it’s the story of a farmer who stays inside when it’s raining and puts in extra hours when the sun is shining."Delete
The problem is relating weather changes or whatever shocks to empirical observations about recessions.
The chart is implying certain things that would suggest that it's not a recession as we know it.
The chart is telling me that productivity should have gone down in the last recession amongst other things (like involuntary emp.)
Would you say that it's a matter of adding more things to the model or thinking of a completely different framework to explain empirical observations.
No, he just asked for a simple exposition of RBC, not a defense.Delete
You just prove Krugman's point of how RBC morons model this recession as a supply shock.Delete
I don't know who those RBC morons might be, but don't put me in that group. I don't do that stuff.Delete
To the various RBC vigilantes:Delete
1) Economic events are hardly monocausal. Most, except perhaps Fama, agree that any explanation of the Great Recession has to involve the financial crisis. But who is to say that technology shocks of various types did not also play a role, however minor? I do remember oil peaking right before the beginning of the recession. Did this contribute to any extent? Who knows? The point is that one cannot a priori exclude from the investigation any possible explanation.
2) I do think that Krugman's question is loaded. What he is really implying is that if you reduce RBC to a simple explanation then that explanation sounds too ridiculous to be taken seriously. But this is only because what Krugman and others often present as a simplified version is a caricature. For example, contrary to what is often claimed, RBC models do not need to assume that people "forget" technology or cut back their hours to produce declines in output. Technology is expressed as deviation from trend, so slower than usual but still positive technological growth can produce a decline in output if as a result enough people choose not to take a job and instead go back to school, stay at home with the kids, take care of the ailing parents, (Campbell, 1994; Campbell and Ludvingson, 2001) or keep looking. Whether this is a plausible scenario is a different story, but it is certainly possible.
3) TFP can also be an approximation for non-technology shocks. For example, much of employment in construction, real estate, and finance was based on fraudulent pricing of the derivatives and underlying assets. Uncovering these practices led to a drop in the value of labor in these sectors. One real estate agent I know decided it was time to take a break and start a family. Despaired, one former student, a finance major, became a cop. My next-door neighbor's kid, with a degree in finance from BU, did find a job but had to look for an unusually long period of time. And a friend, a construction worker, spent more time in-between jobs, looking. Much of this is captured by an RBC model following a negative TFP shock.
Of course, as Steve points out, modelling what happened as the result of an ill-identified negative TFP shock is a crude way of doing business, but no cruder than assuming that a contagious wave of patience reduced demand for consumption (as in NK models) and companies decided to lay off workers rather than adjust their prices downwards.
RBC is appropriate for recessions which are caused by supply side shocks. The obvious one is the oil crisis and as fossil fuels will run out in this century the next large nasty recession will probably be caused by a supply side shock. RBC and variations of it will be an important tool to explain it.Delete
But right now we are in a recession which is caused by a demand-side shock so we gotta used different models. Good ol' IS-LM has been e.g. doing fine at predicting that inflation will not rise.
The problem is that one side of the debate is acknowledging that there are recessions which are caused by supply-side shocks and that we have to use different models for different situations whereas the other side is in demand denial:
"Companies decided to lay off workers rather than adjust their prices downwards."
This is precisely what happened. Just because you cannot imagine that not reducing wages can make sense for a company (you never read the efficient wage literature) doesn't mean that it does not exist. Suggesting that tens of millions of people are unemployed worldwide right now for search model reasons is ridiculous.
"But right now we are in a recession which is caused by a demand-side shock..."Delete
Be precise. What do you mean by that?
If I may add to the question, a drop in TFP reduces the demand for labor. Is this, then, a supply shock or a demand shock?Delete
Aside from Fama, Scott Sumner also believes the problems in finance were the result rather than cause of the recession.Delete
And he thinks the cause was what?Delete
Monetary policy. The Fed got spooked by oil prices and feared rising inflation at just the wrong time. When participants in the market noticed things starting to head south and the Fed surprised them by not "leaning against the wind" like Greenspan would have, they freaked out. It's also Sumner's view that the Great Depression was in large part the result of the Fed mistakenly trying to counter-act a perceived bubble (though this leaves out the large role played by central banks in other countries).Delete
"Be precise. What do you mean by that?"Delete
Dealing with details instead of the broad picture makes little sense while you are in demand denial, assuming the typical neoclassical "all recessions are caused by supply-side issues" position (as opposed to my moderate position that supply-side recession will probably be the biggest problem in this century but right now we have a demand-side recessions). Once you abandon this radical position we can talk about the details.
Of course I know very well that the distinction between supply- and demand-side shock is often pointless in macro models with asymmetric information in financial markets (my favourite papers being Stiglitz and Greenwald's work from the late eighties and early nineties).
But we do not talk about deep theory but rather the broad picture and policy implications. Your laissez-faire position is the usual medicine when a supply-side shock hits the economy whereas my QE plus massive deficit spending position is the usual medicine when we are in a balance sheet recession and at the zero lower bound.
Dear troll, no need to copy and paste the same mumbo jumbo you write in every post. You have already adequately proven that you have no idea what you are talking about, and that you are incapable of defining the difference between a supply and demand shock.Delete
Anonymous troll, you must not be aware of Williamson's recent model in which QE + deficit spending is the recommended course of action. Of course, he's still contrarian in that he expects this to produce deflation and higher real interest rates (which is why even people who support those policy recommendations think he has strange ideas). Williamson's actual theory for the cause of the recession (as far as I can tell) is that a lot of collateral, which the economy had been heavily depending on, suddenly declined in value. Sounds more similar to demand-stories than the cartoonish versions of RBC typically contrasted with it. Given that diagnosis, I would have expected him to endorse something exotic like Miles Kimball's FLOC or Roger Farmer's "qualitative" easing.Delete
Switching from trying to accurately describe Williamson's views (which are not my own) to mocking others, which may be your preference, the balance-sheet recession diagnosis isn't looking too good. According to IMF measures, the U.S has been engaged in more austerity recently than the Eurozone, but we had a stronger recovery.
"One real estate agent I know decided it was time to take a break and start a family. Despaired, one former student, a finance major, became a cop. My next-door neighbor's kid, with a degree in finance from BU, did find a job but had to look for an unusually long period of time. And a friend, a construction worker, spent more time in-between jobs, looking."
Are not all those examples much easier to understand as responses to a lack of demand? Just how do you see them as responses to a supply shock? What are people responding to - a fall in the real interest rate? And why would they respond like this?
Paul, not really.Delete
If you think the problem is lack of demand in general then a bubble and the underlying fraud were good things; the real problem is that they burst. Are we willing to argue this? Moreover, any policy that increases demand for anything is good. Is this true? I don't think so.
Regarding the second question, I am pretty sure that any attempt to increase the so-called aggregate demand that ends up increasing demand for services like health care or college education will mostly inflate the prices of these services (which is good for me personally) but will have little effect on overall employment. Regarding the first question, I think that if the salary of certain jobs in finance far exceeded their social value because of fraud, their destruction is a good thing and I wish they never come back.
But once we start thinking in less aggregate terms, and recognize that the economy is a complex mechanism, a collection of different markets some of which may be operating efficiently while at the same time others are not, then the concept of a demand shock or supply shock becomes less useful because a supply shock in one sector (i.e. a decrease in the supply of sub-prime mortgages) translates to a demand shock in a different sector (i.e. construction). And the AD-AS framework becomes a very crude guide for policy action, as what is needed is policies that address the inefficiencies of the specific sectors that are under-performing. Saying that the answer is to stimulate AD is like using a hatchet instead of a scapel to perform heart surgery.
Of course, this is not to say that the AS-AD framework may not be useful as a stripped-down explanation of some recessions, but I do not think this is one of them. Moreover, even the AS-AD model is not that simple to derive (as many of my students can attest), so if it is that crude why bother? I think people go by it because this is what they have been taught. But to me that is not a good enough reason.
I don't think (and Krugman doesn't think) that stimulus is always needed. If the economy is already at potential, further stimulus by increasing the money supply will just result in inflation, which is the economy's way of getting back to supply=demand, because the real value of the money supply falls. The economy adjusts well in that direction. But you get problems if demand is below potential, because now you are asking wages and prices to fall, which does not go well. That's why you need stimulus if the economy is below potential, while if it is above potential, it will just take care of itself.
But you didn't answer my questions about how the examples you gave could result from a supply shock. What is your idea of the mechanism?
Paul, what I am saying is that, exactly, the phrase "the economy is already at potential" does not make much sense. Even in today's world, some markets ARE at potential. The academic market is one. The health care market is another. Stimulating demand for these services will simply cause universities and hospitals to raise their prices, regardless of the fact that there are many unemployed construction workers. You have to stop thinking about the economy as a single entity to see this. Also, I did answer your question. The disruption in the supply of credit, particularly for subprime lenders, is, well, a supply shock, which in turn affects the demand for labor in construction. In this case the supply disruption was the result of uncovering the fraudulent practices, but if it had been a decrease in the productivity of the subprime sector the effect would be exactly the same. The question, is this a supply or a demand shock is therefore ill-defined. Let's talk about specifics. What is the problem? Which sector does the problem lie in, and how does it spill-over to the other sectors? What is the best way to fix it? You cannot answer this by using a simple AS-AD model. I am embarrassed to admit that we bullshit students when we teach it. Steve has convinced me to stop.Delete
So take the Krugman-Eggertsson story. According to that story impatient consumers were forced (why and by whom we are not told) to pay off a huge amount of debt. In order for patient consumers to make up for this by raising their consumption, the interest rate must be negative. However, because of sticky prices and the zero-lower-bound, what we have instead is a decrease in output. But if this is the case then there is a simple answer to the problem that does not involve fiscal stimulus: We can have the Fed extend a line of credit to these credit-constraint households. But then this generates a whole new discussion as to whether these households will be able to pay back their debt, etc. And, as far as price stickiness is concerned, the microeconomic evidence is that prices do not stay sticky for that long. Roger Farmer, who considers himself as Keynesian as it gets, shows here:
that both nominal wages and nominal prices were quite flexible even in the great depression.
In any case, once we engage in this discussion and try to identify the source and location of the inefficiency we are already past the capabilities of the AD-AS model.
"Anonymous troll, you must not be aware of Williamson's recent model in which QE + deficit spending is the recommended course of action."Delete
Anonymous wanker, I couldn't care less about a counterfactual model, not to mention that Williamson has neither advocated deficit spending nor QE. He has actually predicted that QE will lead to 4-5% inflation.
I rather stick with demand-side models that match the facts better (right now, as I already pointed out the most nasty recessions in this century will most likely be supply-side driven).
It becomes more and more boring to argue with people who prefer ideology over facts.
"The disruption in the supply of credit, particularly for subprime lenders, is, well, a supply shock, which in turn affects the demand for labour in construction."
I guess we are getting into semantics here. I wouldn't call that a supply shock. The ability to build houses did not decline. I would see the collapse of the credit market as a reduction of the money supply, which reduced the demand for housing. Sure, you can call it a supply shock if you call a fall in the supply of money a supply shock. But what I mean by a supply shock, and what I think most people mean, is a change in the rate of growth of technology, or an environmental disaster, or a new regulation, any of which could mean that less output can be produced with the same input. I would see a change in the money supply as being one of the two things that can cause a demand shock. The other one would be a change in the level of demand that a given money supply produces, due, for example, to a change in confidence. I don't think this needs to be ill-defined if we define a supply shock as a change in the rate of growth of productivity in one or more sectors. But a change in the money supply is fundamentally very different. The central bank can create more of that with the stroke of a pen.
As for your point about some sectors being at potential and others not, sure. Then, we expect prices to rise in those sectors and attract people into them from ones that are below potential, which might take time and cause inflation. But as long as many sectors are below potential, I would suggest that the economy as a whole should be considered below potential. I am certainly not suggesting that there is a sharp line here, but rather a very fuzzy one. But I think we can do pretty well if we think in terms of aggregate supply and aggregate demand within a single country. If we think internationally, I absolutely agree that single-output-good models do not work at all.
"there is a simple answer to the problem that does not involve fiscal stimulus: We can have the Fed extend a line of credit to these credit-constraint households." I agree absolutely with that (and with your qualification which follows) and I am sure Krugman would agree too. The fundamental problem in a liquidity trap is that, while the CB can create any amount of money it likes, the normal way in which it gets that money out into the real economy is blocked. Normally, the interest rate falls when money is created, inducing more people to borrow and spend and put money into the bank accounts of real people. But if we are at the lower bound, that doesn't work. Money created just piles up as excess bank reserves. Your solution would be one way around the block. Another would be for the CB to print thousand dollar bills and drop them by helicopter. But the most accepted and legally workable solution is for the CB to print money which the government borrows and spends. That's fiscal stimulus.
it IS a productivity shock if you think about it, i just takes place in the financial sector! As in Steve's paper, the problem is similar to an increase in the cost of monitoring creditors, or in liquidating the collateral. Yes, this shock may affect the supply of credit and through it the demand for houses etc. Which is why, I agree, the sematics are not important, and why Steve, rightly so, asks anyone using these terms to be specific in what they mean.
Regarding the second point, are you sure that this is possible? If you look at unemployment statistics by category you will see that the real problem lies with workers under 24, males more than females, with no college education, and black. Can these workers become doctors or professors? Or will they simply end up paying more for health insurance, higher property taxes, etc while at the same time struggling to get a job, while I get a raise because finding competent faculty members in economics is so difficult? I have been vocal even before the recession about the paradox of immigrants, like myself, filling easily good paying jobs in colleges, hospitals, Silicon Valley, while so many Americans are mourning the loss of low-skill manufacturing jobs. Something is broken, and I do not think that it is fixable with simply stimulating aggregate demand, whatever that means. By the way, many liberals feel the same way and disagree with Krugman on this. For example read this piece by Jeffrey Sachs:
Regarding the final point, I agree with Steve's recommendation of increasing the supply of T-Bills, by running higher short-run deficits, until their interest rises. So there is no disagreement in policy there. But these recommendations do not come out of a simple AD-AS model, and I think this is where the disagreement lies. You may ask, why does it matter? It may not matter now, but at some point it will.
For RBC theory to be meaningful, it has to induce a nontrivial decline in employment in response to a TFP shock -- both because we need to match the large swings in employment in the data (the most visible characteristic of recessions) and because we need some endogenous response to amplify the TFP shock and produce large fluctuations in output.ReplyDelete
But a consumption/leisure diagram is incapable of doing this, at least in a way that isn't immediately rejected by the data. If the substitution effect dominates the income effect, so that a decline in TFP causes an increase in leisure in the static consumption/leisure tradeoff, then an increase in TFP must cause a decrease in leisure. And this is obviously a nonstarter, because historically we've seen a massive secular upward trend in TFP without any kind of comparable downward trend in leisure.
So this simple "substitution bigger than income effect" illustration for RBC, if it was really the core intuition in the theory, would be easily refuted.
(Indeed, for precisely this reason, the usual RBC model is calibrated such that in the static consumption/leisure tradeoff, income and substitution effects cancel!)
The real mechanism in RBC is all about capital adjustment. Indeed, for permanent TFP shocks, RBC is just the stochastic neoclassical growth model, and the impulse response to a TFP shock is all about convergence to the new capital steady state. Capital breaks the simple consumption/leisure tradeoff in the static model, making it possible for leisure to decline in the short run in response to a TFP shock even if there is no long run effect.Delete
But once we realize that RBC is fundamentally a model of capital adjustment, we can ask how reasonable its specification of capital adjustment is. And that's where it does very poorly. The RBC model only obtains strong effects through a simple specification that ignores all capital adjustment costs -- even though those costs are a mainstay of the neoclassical approach to investment.
It is easy to see that the no adjustment costs assumption is far too extreme -- in that world, the simple equilibrium condition MPK = r+delta must hold at all times, which is absurd given how much more 'r' moves at high frequencies compared to any plausible value for 'MPK'. But once we specify realistic adjustment costs, the RBC mechanism weakens dramatically, and we no longer obtain an employment response of respectable size.
Maybe it's hard to capture RBC in a blog post because once you meet Krugman's challenge and lay out a "simple, intuitive explanation" of what's going on in the model, you realize that it doesn't really work.
If you read anything published in the last 30 years, you'd know that all of those considerations have been addressed. See, for example, Julia Thomas's paper on microadjustment costs for investment; guess what, they don't matter in the aggregate.Delete
And who says TFP shocks have to be permanent? Just because you want them to be, so that you can point out an anomaly that Mike Woodford spotted twenty years ago? Congratulations, you've reinvented a wheel, your mom must be so proud.
The problem with the frictionless model of capital adjustment, and the Khan and Thomas model that exhibits frictions at the micro level without changing the frictionless macro implications very much, is that it has wildly counterfactual implications for the behavior of investment in response to shocks.Delete
For instance, the model implies that investment is hypersensitive to short-run fluctuations in the real interest rate. Indeed, this hypersensitivity is essential to the behavior of the RBC model under transitory TFP shocks. (A version of the model you implore me to consider!)
Yet clearly this hypersensitivity does not hold in practice, or else the Fed would have already provoked the largest investment boom in American history. 'r' moves around a lot at high frequencies without 'K' fluctuating in a comparable way (which would imply insane fluctuations in the flow of investment to keep up). Usually people writing macro models include (classical, often quadratic) adjustment costs as a way to render their models at least minimally consistent with this data.
Since the RBC model does not include any such adjustment frictions, it only achieves large impulse responses at the cost of glaring inconsistency with the joint time series of capital, investment, and real interest rates.
Williamson got owned! And gives no reply!Delete
I think you mean pwned! Not sure what you're talking about.Delete
I think the anon above refers to the series of comments about how counterfactual RBC's predictions are, and your lack of a response to these comments.Delete
Anonymous @ February 18, 2014 at 9:42 AM tries to make 2 points, I think:Delete
1) You can't really explain RBC without going into production and capital, you can't do it with an endowment economy -- point on which he's probably right;
2) RBC requires questionable calibrations or other knife-edge stuff, and thus it is a very bad model of business cycles. He's probably right but nobody claimed otherwise and thus this point is off-topic, literally.
"endowment economy" above should read "labor-only economy". Mistype/brainfart.Delete
Oh yes very intuitive, sir.ReplyDelete
"indifference curves of the representative agent"
Your are the bad student. Read Kenneth Arrow.
Your understanding of economics is quite poor, apparently. Please just go away.Delete
RBC theory starts by making very strong assumptions which are arcane enough to to the layman to understand and plain wrong to the mathematician or microeconomist to take seriously. Krugman argues that there is really no way to explain those assumptions in an intuitive manner and I don't see how Williamson succeeds by starting his rebuttal with "indifference curves of the representative agent". Please elaborate on what makes you think that this reflects the quality of my understanding of economics.Delete
I'm wondering why you're not complaining about the NK part.Delete
Sure, NK models are also subject to that critique. That does not entitle you to call a Nobel prize winner a bad student and try to convince the public that RBC makes perfect sense.Delete
I guess we disagree. I don't think Nobel prize winners, the Queen of England, me, or you deserve any special treatment, other than the normal respect we pay to all human beings. I feel entitled to poke fun at anyone.Delete
The idea that unemployment (or a fall in hours work, as you like to put it) is a voluntary response to a fall in real wages induced by a TFP shock because the substitution effect dominates the income effect, is the most retarded idea macroeconomics has ever produced. It is an embarrassment to the entire profession that these are ideas are still around and taken seriously (by the way, that moment condition that relates wages to hours is wholeheartedly rejected in the data ... still people like Prescott cannot shut up about it. Instead he rejects econometrics. You cannot make this stuff up!).ReplyDelete
But as they say, science progresses funeral by funeral. So I suppose we need to wait a bit longer until the journal gatekeepers retire and more relevant macroeconomics will be allowed in.
Two points seemed to be missed in the previous, invariably angry, comments above:Delete
First, Steve is simply answering Krugman's question about exposition of an idea. One's belief in the mechanism has no bearing on the explanation. Think about how you'd answer someone asking for a simple explanation Ptolemaic views of the earth and the sun. Explaining it doesn't mean endorsing it as a good model for all questions.
Second, on the issue of what question you're trying answer: the model is not MEANT to talk about "employment"--it's target is data on aggregate HOURS worked. Of course, this makes you want to be careful about concluding how bad a recession is for people from such a model, but the model is just telling you how productivity and aggregate hours might move together.
Mind you, the representative agent may not reflect in any way the "true" income and substitution effects experienced by individuals--just that aggregate data may look like it's generated by a single type of person.
No need to get so emotional about the whole thing.
As for a more relevant macro: read a journal sometime before talking authoritatively about what is in them. Only Paul Krugman, and those who get their economics from him, think that macro ignores the concerns of the unfortunate. Look at the leading macro textbook: Ljungqvist and Sargent (2013)--chock full of models of unemployment, etc. The sheer counterfactual nonsense that comes from the horde of Krugman is something to behold.
So if Krugman could explain it that easily, why didn't he?Delete
No, Krugman's critique is that you cannot really explain RBC models in an intuitive - for the layman- way, and he has a point. A point that Williamson is unable to refute by starting the whole discussion with "a representative agent" and "TFP shock". PK's critique is valid regardless of whether RBC matches unemployment or not. S&L (a book which I love, by authors I really respect) is full of Bellman equations and no intuition, which is fine since it is an advanced textbook, but the more basic textbooks fail to convey intuition.Delete
To anonymous 10:42 AM,Delete
So as the RBC model is "is not MEANT to talk about "employment"--it's target is data on aggregate HOURS worked" we can safely use it for policy experiments? Obviously not. If you are so damn interested in "how productivity and aggregate hours might move together" I suggest you calculate a correlation. If you want to understand through which mechanism they move together, you need to think harder than a voluntary tradeoff between labor and leisure.
As for L&S, I'm pretty familiar with their book.
Not so fast. He gave you a story, with people making decisions, that yields the outcome. You can dislike it, and just provide what you think is a better account--fixing all of what you regard as bad with his story--even if it's only for corr(hours, output).Delete
And I did agree with you, too: " Of course, this makes you want to be careful about concluding how bad a recession is for people from such a model"
Why the all the anger? Especially if you're familiar with L&S?
What does your description of RBC capture that Krugman's description in the next paragraph did not?ReplyDelete
"I mean, I could do it myself. Strip the story down to basics – make it a steady-state model, not a growth model, and drop the capital accumulation; what you’re left with is fluctuations in the marginal productivity of labor, which have a magnified impact on output because workers choose to work less when the technology is bad and more when the technology is good. As I’ve written before someplace, it’s the story of a farmer who stays inside when it’s raining and puts in extra hours when the sun is shining."
Seems you agree.
So, you see, PK's gambit is to act like's posing a question, just to get on with the business of complaining about it. He does get the simplest kernel of the idea very well.Delete
The other stuff, which he apparently thinks is not worth communicating to broad audiences is that by including capital accumulation and other things that even the most quantitative versions of the RBC models do, you get the right ordering of consumption, investment, and output volatility. Notice that IS/LM for all its vauntedness, has exactly nothing to say about the comovements of the most important macro variables. It's not even wrong. It's just, well, not even anything.
Best of all, notice that the conversation in this thread has become undeniably productive: people are complaining about some elasticities, about the plausibility of what's happening at the level of firms that could generate aggregate declines in factor productivity, about what adjustments costs of capital really look like etc. IS/LM neither requires, nor permits, any such conversation about the characteristics of decisions makers in the economy. If that level of sterility doesn't bother you, go ahead at stick to IS/LM.
And this is what Prescott, love him or not, forced us all (except for Paul Krugman) to start talking about.
Not really. Krugman has talked about this before. He seems to want to argue that RBC is perhaps complicated, perhaps silly on the face of it. Here I argued that one can tell stories that would make almost anything in economics look silly, including things Krugman cares about:Delete
Then your argument is ad hominemDelete
The only difference I see is that he makes it clear that the fall in employment is a choice, whereas you write, "employment falls." But isn't his description more accurate?Delete
"The only difference I see..."Delete
Between what and what?
What is the difference between your description of the RBC model and Krugman's?Delete
Yours has a little more jargon, but the intuition is exactly the same. TFP shocks cause people to choose to work more or less.
Well, you can see what it is. I don't know how Krugman would flesh out the words he wrote down. It's true that if someone stopped me on the street, and asked me what RBC is, I might say something similar. In terms of what I wrote above, that's more than "jargon" and "intuition" wouldn't you say?Delete
"In terms of what I wrote above, that's more than "jargon" and "intuition" wouldn't you say?"Delete
Really? No, I wouldn't say so.
What do you think needs to be fleshed out?
No, I fleshed it out, the way I imagined Krugman wanted it. I can write the formal model behind the picture if you want. Production possibilities are given byDelete
C = zF(K,h-l)
and the preferences of the rep. agent are given by the utility function U(C,l).
C is consumption, l is leisure, z is TFP, K is the capital stock (fixed), h is time available to the rep. agent.
So, when we teach undergrads, we tell them exactly what those things mean. So it's fleshed out in terms of what an undergrad knows. That's not jargon for them. Krugman says specifically that he wants something for his undergrads. If you don't get it, then you know much less than an econ undergrad.
You misunderstood my objection. I understand RBC, and I understand both your explanation and PK's for the intuition. I think his explanation captures all of the intuition that yours captures and a little more. As it is less clear in your explanation that the decline in hours/employment is a choice.Delete
Actually, I think Cowen and Tabarrok use the same example as PK in their macro textbook
I wonder if RBC proponents don't like explaining it simply and straightforwardly, because it doesn't sound very good. I wonder if that's why it seems more natural to you to write, "employment falls," which is really a passive construction.
"As it is less clear in your explanation that the decline in hours/employment is a choice."Delete
No, that's totally obvious. We could add the words "because the representative agent chooses, if you want it to be clear to the students.
"I wonder if RBC proponents don't like explaining it simply and straightforwardly, because it doesn't sound very good."
Bullshit. People have been explaining this for 30 years now. The story is in early editions of Barro's textbook, for example. The model is so simple. It's totally obvious what's going on. No one is hiding anything.
You write, “C = zF(K,h-l). C is consumption, l is leisure, z is TFP, K is the capital stock (fixed), h is time available to the rep. agent. So, when we teach undergrads, we tell them exactly what those things mean.”
I imagine a young Joan Robinson raising her hand to ask, “In what units is K expressed?” And, without giving her professor a chance to answer, she presses on, “Doesn’t TFP assume an aggregations of stuff that can only be meaningfully aggregated under very stringent conditions?” “Have you read Franklin Fisher’s work on aggregation?" You can find links to it here: http://economics.mit.edu/faculty/ffisher/cv.
So, Joan Robinson asks the question. I ask her: So why is heterogeneity in capital important to the question at hand? How might things change if I relaxed that assumption? What would I learn?Delete
Here’s the problem: in your equation, you aggregate labor in terms of hours, but you don’t specify the units in which capital, K, is measured. Since capital can’t be aggregated in terms of physical units (as far as I know), a lot of economists try to aggregate capital using price values. And while you can fit a production function using the price data, the underlying accounting identity, Y = Wages + Profits, is really doing all the work. An hour or two with Franklin Fisher’s papers on the subject will give you the gist of the problems.Delete
Nice post. The Krugman apologists are out in medium force today. But, he won a Nobel!ReplyDelete
Krugman is employed principally as a political advocate for social democracy--Nobel (on trade) notwithstanding.
Yeah, there world is so simple, all those evil liberal hack economists on the one side and politically neutral economists on the other side. You got any other fairy tale for us?Delete
"Our health systemn was great until the federal government got involved. Mc Cain has made a serious proposal to improve the system. Obama’s proposal is to make a bad system worse.
Edward C. Prescott
P.S. With people like you I understand why Ruyssians can not governed themselves."
I accidentally deleted someone else's comment here. He/she was thinking I wasn't showing enough respect to Krugman, given his Nobel. So, my reply is:Delete
No one is complaining about his Nobel prize. You want genuflection every time his name is mentioned or what? I've made fun of other Nobel winners in person. It's clear that Krugman himself doesn't think the prize is sacred. His willing to dish it out to Lucas and Prescott, for example.
You folks are hilarious.Delete
Barack Obama won a Nobel. Yasser Arafat won a Nobel. I'm sure Krugman did some fine work on trade theory 25 yrs ago. Super.
But today he is employed as a political advocate; not a truth-seeker. To think otherwise demonstrates a strong confirmation bias.
And oh yeah--there are plenty of hack econos on the political right. Same applies to them. Not. Truth. Seekers.
You are sure that Krugman did some fine work on trade theory because he won the Nobel ... but then you dismiss the Nobel at the same time?Delete
You cannot argue from authority and dismiss this authority at the same time. You might wanna actually read the papers he wrote in order to know what you are talking about
16 years ago Krugman wrote a paper about the liquidity trap which kicked off the literature (similarly to New Trade theory he wrote a simple papers which captures the key insight while ensuing literature reaffirmed the main insight in more general models): Woodford, Eggertson and so on to write similar papers in the 00s. So much about Krugman not having done serious work besides explaining intra-industrial trading.
I assume you are referring to his paper about Japan. Have you actually read it? He presents some interesting facts and hypotheses but nothing path-breaking. Even his intra-industry trade work is based on ideas introduced by Dixit and Stiglitz. But I must give him credit for being so good at selling himself.Delete
By the way, let me quote from that paper:Delete
"one might identify three strands of modern thought that are missing from the classic IS-LM analysis. First is the intertemporal nature of decisions. Economists now understand, perhaps better than fifty years ago, that how one formulates expectations is a crucial matter in macroeconomic analysis, and that a good first pass assumption is that these expectations are rational... Finally, traditional IS-LM analysis neglects the role of financial intermediaries. But how one interprets the experience of the 1930s hinges crucially on how broad a monetary aggregate one chooses; and the same has turned out to be true in recent arguments over Japan. Furthermore, one school of thought about the Depression argues that a troubled banking system lay at the heart of the problem; a similar view has become near orthodoxy about contemporary Japan. So one needs
at least a basic sense of how financial intermediation fits into the picture of the liquidity trap."
Need for dynamics? Rational expectations? Need to model intermediation? No, this is not Steve Williamson writing, it is Paul Krugman. Check it out!
By the way, New Trade Theory failed empirically. Krugman conveniently forgets to mention that his central insight turned out to be false.Delete
Well, to be fair, Krugman opposed the policy recommendations of free traders. This was in the pre-G.W.Bush era, when his economics mattered more than his politics.Delete
Oops, I meant he opposed "strategic traders".Delete
"Even his intra-industry trade work is based on ideas introduced by Dixit and Stiglitz. But I must give him credit for being so good at selling himself."Delete
That's like saying that "RBC is just Arrow Debreu but Prescott and Kydland were pretty good at selling it" which is a ridiculous statement.
Although I am highly critical of the macro of the last 30 years I would never make such a statement; I might view it critically but iit was still very important technical work.
You on the other hand seem to have issues acknowledging technical work by Krugman. The only reason for this can be a political one.
The key difference between liberal and conservative economists is that the former can do independent technical work (Krugman recently criticized Stiglitz for claiming that less income inequality would have positive effects upon agg.demand) whereas the latter are more often influenced by the ideology.
You pull things out of your ass. Stiglitz is a liberal economist, so I fail to see how giving him some credit for Krugman's work is politically motivated. Also, many people other than myself feel that Dixit and Stiglitz deserved more credit for their contribution. They basically invented the monopolistic competition model; Krugman simply applied it to international trade. Still an important contribution, but clearly the value added is much smaller than that added by Kydland and Prescott to Arrow Debreu.Delete
Finally, just to be clear, I am not at all implying that Krugman did not deserve the Nobel, I think mostly because of his work on economic geography. I was about to begin my undergraduate studies in econ when the first edition of "Economic Geography" came out, and it inspired me to pursue graduate studies in econ with focus on international trade. Later, Paul Romer's work made me switch to endogenous growth. So I think that the pre G.W.Bush Krugman was a great economist, and in many respects a brilliant thinker. This made up for the fact that he is arrogant, self-centered, and quite nasty to people he disagrees with (ask fellow liberal Robert Reich). As Deidre McCloskey argued, who cares if someone is smart or a nice guy, the relevant question is if they are a good economist, and PK was. These days, I am not so sure. And it is precisely because I was a fan that I am being so critical.
Bullshit, Krugman has been for Old (baby sitting co-op story) and New Keynesian (the liquidity trap paper) analysis back in the nineties so his economics has not changed.Delete
But the world around him has. Given the war crimes and economic foolery of the Bush government being polite and moderate was hardly paramount. And when intelligent economist like Fama and Cochrane repeat fallacies that have been debunked 80 years ago you also have to be blunt.
Of course you do not have a problem with the treasury view or the Iraq war which is why you have a problem with a centrist like Krugman who doesn't shut up about war crimes or economic bullshit that hurts millions. Yes, this isn't just an intellectual game, on this side of the big pond austerity has wreaked havoc in Greece. But despite the overwhelming amount of evidence economists like you or Williamson still deny that expansionary fiscal policy is expansionary (and especially while we are at the ZLB).
You know nothing about me dude. I didn't favor the Iraq war. You also know nothing about economics. Old Keynesian and new Keynesian models are completely different animals. Same troll different day!Delete
By the way, I am Greek, grew up in Greece, and left in the late 1990s cause I saw this coming. So don't talk to me about Greece. You know nothing about it.Delete
Looks I hit a nerve and somebody ran out of arguments.Delete
First, reading skills are essential. I did not say that Old and New Keynesian models are identical but that Krugman favoured them in the nineties as well as right now
Second, if you know so much you can surely tell us why unemployment is so high right now in Greece. My explanation as well as the IMF's is that out of the textbook, contractionary fiscal policy turned out to be, big surprise, indeed contractionary, demand turned out, big surprise, to matter indeed in the short run.
So either embrace the Keynesian demand-side story or tell us your alternative story.
Given that your were able to predict the current crisis in the nineties I assume that you were able to predict that the ECB will not play lender of last resort when there will come a speculative attack on the Euro and that the stupid fiscal rules of the stability and growth pact make fiscal demand management harder.Delete
But somehow I doubt that you are Nostradamus and I guess that your explanation will be something like Casey Mulligan's "food stamps caused the Great Depression" nonsense.
Don't get me wrong, supply-side factors matter and your predictable rant about Greek socialism will actually not be without merit. But neither can explain why unemployment skyrockets.
There are some things about the prevailing culture and institutions of a country that someone sitting at an IMF or Princeton office cannot understand. I can explain to you why I knew Greece was heading that way but this is not the place. All I can say was that I had a disagreement about this with George Mario's Angeletos (now at MIT) over pizza when we were both graduate students back in 1999. The problem with your story regarding Greece is that prices and wages have declined drastically, including the legally established minimum wage. Moreover, farmers still complain that they cannot Greeks to help harvest and are still forced to rely on illegal immigrants, even though out of a sense of duty they agreed to pay minimum wage.Delete
P.S. Hit a nerve? You are giving way too much credit to yourself.
" I can explain to you why I knew Greece was heading that way but this is not the place."Delete
In other words you cannot really explain it (well). Furthermore you make the typical error (typical for neoclassical demand deniers) of trying to explain a short-run crisis with structural issues.
I am not a New Keynesian (a misnomer as this was precisely the position Keynes argues against in the GT), wage and price stickiness are one but hardly the key market failure that can explain why an underemployment equilibrium exists and persists. Wages and prices fell massively during the Great Depression (the issue is not clear cut though as they fell more or less in snyc so that real wages remained roughly equal). I am rather with Williamson, it is most likely financial market imperfections that are the key cause for existence and persistence.
It is the massive drop of government spending, simple as that. Other European countries which unlike Greece had no structural problems and low levels of public debt, Ireland and Spain, also experienced a sharp increase of unemployment due to austerity.
I am afraid I lack the competence to address your issues. A medical professional is required.Delete
Looks like you can only troll after I took apart your nonsense argument about Greece. Pathetic but usual freshwater crowd behaviour.Delete
Can't you get some boric acid to get rid of Krugman, Quiggin and the other cockroaches?
It might be boring without these characters, don't you think?Delete
I'm staying out of this argument. But I love drawing pictures. Especially for teaching. Here are my (two) pictures of the NK model:ReplyDelete
RBC is simple -- it is microeconomic theory at its core. ISLM, on the other hand, is voodoo and hand-waving at best.ReplyDelete
There is a high quality response to your post viewable here: http://www.econjobrumors.com/topic/steve-williamson-cant-explain-rbc-very-well . Would you be interested in commenting on/replying to it in any way?ReplyDelete
I guess quality is in the eye of the beholder. I read some of that earlier. One comment certainly was not correct, which is that capital accumulation is important for RBC dynamics. The intertemporal aspect of the full-blown modle allows some flexibility in matching the data. With what I did here, C=Y, and obviously that's not going to tell you why consumption is smoother than output. So you need to add investment. Then, with the standard intertemporal model, the consumption smoothing motive works to get you what you want. The representative agent is a permanent-income consumer, and the increase in savings as a result of the current TFP shock shows up in investment, and a higher future capital stock. But the effect on the capital stock is small potatoes. The dynamics in output is driven mostly by the exogenous TFP shock, and what you get from the endogenous behavior of the labor input in response to TFP. In the full-blown model, sufficient volatility in the labor input is obtained through sufficient intetemporal substitution of leisure.Delete
The claim is that if you want labor to fluctuate in response to short-run tech shocks, but NOT to respond to long-run tech progress, you need capital.Delete
Without capital, you get a simple decision rule N(Z), and then either you don't get fluctuations in N from fluctuations in Z, or else get a long-run upward trend in N.
Sure. I gave you a little undergraduate example of the basic idea. If we want to get serious about it, we're going to have to worry about what you're discussing - e.g. short run vs. long run elasticities of labor supply. That's part of having a complete dynamic model that's going to look after all these issues - relative variability in C, I, and Y, and employment fluctuations that look like the data. I'm not sure what you're trying to tell me. This discussion on econjobmarket rumors seems to be about whether or not I know some stuff outside of the topic under discussion. How pointless can you get?Delete
I did not read through all the comments so I apologize if someone has already brought this up.
However, let me assure that Paul Krugman is most definitely not just asking for someone to give him a simple explanation of how RBC works.
He is saying that are at least two different types of explanations. A technical one - such as you presented in this post. And, an intuitive one - such as the classic characterization of an RBC recession as a rainy day.
He is then suggesting that he can do both, but that many RBC's, yourself perhaps included, are *incapable* of doing the second.
Make no mistake, Paul Krugman is suggesting that he has measured your feasible set and found it wanting.
The only practical retort to this accusation. Is to offer a proof by construction. Produce in what Paul has labeled your infeasible reason. Present an original explanation of RBC that is NON-technical.Again, not merely elementary in its technicality.
Produce a model that depends on intuition and common sense, without the add of stepwise logic, mathematics ,diagrams, compass or edge.
And because Karl needs to be capable of understanding, please use a crayon and nothing more sophisticated than addition of single digit numbers. Subtraction is too hard.Delete
Be assured, no one brought up your concerns.Delete
You have a very odd notion of how we should evaluate a scientific theory. Boil it down to a few soundbites, try it out on a random person on the street, and see if he/she buys it. You know, gravity seems like a bizarre idea - the earth is so big that it holds me down? And bacteria? I'm supposed to think that things I can't see make me sick?Delete
We know what Krugman's game is. There are ideas he doesn't like, and he wants to discredit them by making them appear ridiculous. Here's what I had to say about that:
You can make the ideas Krugman loves look pretty silly. The typical Keynesian stories are told in a way that seem plausible to your average layperson because they cover up all the things that make it work.
Stephen your above is all McClosky and Maki and Lawson and Hoover stuff:Delete
And? Yes, McCloskey was once my colleague. That was a very interesting time.Delete
Also, you mustn't use a pencil, or your thumbs, or not even your mouth. It must be in a format that makes no demands on the reader whatsoever. Please submit your explanation at your earliest convenience, in triplicate. He will then relay your submission, by the 4:30 Autogyro, connecting through Siam, to Professor Krugman. If you explanation is deemed worthy, you will receive a signet and years supply of wax with which to seal letters on behalf of Professor Krugman. Godspeed.ReplyDelete
Steve, it's true that if you work with a utility function that satisfies the fact that we haven't seen a major increase in work effort over 200 years of technological progress, then a representative household RBC model without capital will imply that hours/labour input does not change in response to technology shocks. You need the ability to adjust capital significnatly (which should not be that controversial given the volatility of business investment and durables consumption) for the substitution effect to dominate the income effect. For households who aren't saving you need some other source of income than labour for substitution effects to dominate, e.g positive transfers from richer households.ReplyDelete
Also, substitution effects dominate in RBC models with indivisible 0/1 employment choices and incomplete financial markets (look up papers by Chang at U. Rochester).
We can debate the meaning of aggregate capital, aggregate consumption forever. These concepts are useful approximations for dealing with macro phenomena though no one actually uses aggregate capital anymore than anyone is actually confronted with the CPI inflation basket. Or at least many people think they're useful approximations, let Cambridge UK disagree if they want.
I think people get hung over on an original simple RBC model in which TFP shocks were the only source of business cycles and the aggregate dynamics were always Pareto optimal. The original model no doubt reflected the political biases of Prescott, and unfortunately it seems very hard these days to separate politics from economic analysis at least in the blogosphere or the news media.
A more general definition of Real Business Cycle models, is as a class of models where only relative prices of things matter (the use of money as a medium of account does not by itself cause mispricing of products or labour services). Within this class of models you can have an RBC economy with incomplete financial markets, default, efficiency wage frictions that increase the responsiveness of employment to shocks etc...
TFP shocks themselves are just a catch all for a reduction in the efficiency of converting production inputs into actual sales to consumer. So lower TFP can just mean that it's harder to find customers for your product, i.e a demand shock.
Recent papers by Rios Rull and co-authors have shown that once you start thinking of economies with search frictions in product markets, demand shocks are isomorphic to productivity shocks. So the difference between demand and supply shocks becomes blurred, at least if you're thinking in terms of a Phillips curve and the Keynesian output gap.
I expect that readers here will be very interested in an important conference taking place next week in the UK. Topic is diversity in macroeconomics:ReplyDelete
With the exception of Gilboa-Schmeidler, that conference looks horrendous.Delete
I guess you're not interested in learning anything new. Too bad for you!ReplyDelete