After returning from a family vacation in Mexico (aka a week long upset stomach I’m still trying to recover from) I have been trying to catch up on the blogosphere. Tyler Cowen directed me to a series of interesting posts by JW Mason, John Cochrane, (and indirectly) Noah Smith. All these individuals know much more modern macro than I do, but I’ll provide my two cents worth anyway. My basic approach is as follows:
1. Like Milton Friedman, I prefer to use simplest model for the problem at hand.
2. I prefer to use different models for those business cycles that are created by “nominal shocks” (defined below) and everything else, i.e. “real shocks.” Real shocks include factors that change the natural rate of unemployment (or LFPR), savings preferences, technology shocks, terms of trade, taxes, government output, etc. All these things would matter even if wages and prices were completely flexible. Indeed real shocks would be all that matters. Indeed they are (almost) all that matters in the long run.
3. The problem of nominal shocks combined with sticky wages/prices is so radically different from the rest of economics that attempts to capture all of macro in a single model leads to DSGE models that simply cannot do what we ask of them—provide reliable policy advice. Here’s Noah Smith:
Imagine a huge supermarket isle a kilometer long, packed with a million different kinds of peanut butter. And imagine that all the peanut butter brands look very similar, with the differences relegated to the ingredients lists on the back, which are all things like “potassium benzoate”. Now imagine that 85% of the peanut butter brands are actually poisonous, and that only a sophisticated understanding of the chemistry of things like potassium benzoate will allow you to tell which are good and which are poisonous.
This scenario, I think, gives a good general description of the problem facing any policymaker who wants to take DSGE models at face value and use them to inform government policy.
Read the whole thing.
4. My preferred nominal shock model would focus on explaining movements in nominal aggregates, and also explaining the business cycle. More specifically, explaining that part of the business cycle that is due to employment fluctuations attributable to wage and price stickiness. My hunch is that wage stickiness is the key, so I’ll focus on that issue.
5. Because of wage/price stickiness, we need some sort of indicator of “nominal shocks.” We do not have such an indicator, although I often talk as if NGDP is the optimal nominal indicator. Let’s call the optimal nominal indicator “ONI,” and define it as the variable that, if stabilized by the Fed, would leave employment levels closest to their flexible wage equilibrium, i.e. at a level that would obtain if all wages (and prices) were completely flexible. Thus “nominal shocks” can only be defined in terms of wage stickiness, and the ONI will depend on the precise type of wage stickiness. Nominal shocks are not self-evident like “oil price shocks”—you need a model. NGDP is almost certainly not the ONI, as there are presumably monetary policies that would keep employment closer to its flexible wage level than a NGDPLT policy regime.
6. The term ‘demand’ is a rather unfortunate carry-over from the Keynesian revolution. Here’s Mason:
People often talk about aggregate demand as if it were a quantity. But this is not exactly right. There’s no number or set of numbers in the national accounts labeled “aggregate demand”. Rather, aggregate demand is a way of interpreting the numbers in the national accounts. (Admittedly, it’s the way of interpreting them that guided their creation in the first place). It’s a statement about a relationship between economic quantities. Specifically, it’s a statement that we should think about current income and current expenditure as mutually determining each other.
I use the term ‘demand’ in order to talk to Keynesians. However when I use ‘demand’ I have something in mind that is a specific quantity (NGDP, or ONI), and thus I am not really speaking the Keynesian language—I’m talking a close dialect (like Cantonese to Mandarin.) I’d like macroeconomists to stop talking about “demand” and start talking about their preferred ONI.
7. It seems to me that most macro models don’t have a ONI, but rather contain factors that might or might not affect the true ONI (i.e. interest rates, fiscal policy, etc.) And I think that’s part of the problem. Here’s Cochrane:
All current macroeconomic theories start with the same basic story: when interest rates are higher, people consume less today, save, and then consume more in the future.
Why isn’t this an example of the fallacy of “reasoning from a price change?” Cochrane clearly understands this issue because in subsequent paragraphs he talks about the NK view that an outbreak of “thrift” triggered both much lower interest rates and much lower consumption. Aren’t we asking too much of interest rates? They are a key variable for intertemporal allocation decisions, but the NK models also use them to represent monetary policy. That’s just one of the reasons I prefer to use an ONI as an indicator of monetary policy.
8. Later Cochrane discusses the NK view that inflation, even supply-side inflation, can boost real consumption:
Fiscal stimulus, and many of the other seemingly magical properties of new-Keynesian models (see last post) follow from the idea that inflation is good. Fiscal stimulus raises inflation. Broken windows, hurricanes, pointless public works projects, temporarily lowering the economy’s productive capacity, all raise inflation (how is in other equations of the model), which lowers interest rates.
I’m not sold on this story, as you probably guessed, for a variety of reasons.
I’m also skeptical, but for reasons that Cochrane would probably reject even more vehemently than the NK models he criticizes. The view that disasters boost output violates the undergrad AS/AD approach to macro, which predicts that a hurricane will shift AS to the left, reducing output. I believe the textbook AS/AD modelers stumbled on something close to the truth, for essentially accidental reasons. The AD curve is usually drawn with a curvature that looks vaguely like a hyperbola, but not exactly. That means “demand” is assumed to be loosely related to P*Y, or NGDP. In other words, “demand” is a sort of loose proxy for the ONI. There is no actual “ONI” in Keynesian models, but the simple undergrad AD curve is close enough that it produces pretty decent empirical results, indeed better empirical results than NK models featuring weird upward sloping AD curves.
10. If you insist on a formal model, call the natural rate of employment (in terms of hours worked) “En.” Then E – En is negatively related to W/ONI, and hourly wages are very “sticky” in the short run, especially when the aggregate rate of hourly wage rate growth approaches zero. Thus if the central bank can control ONI, it can also influence E in the short run. The musical chairs model. The rest of the economy can be modeled using new classical principles.
PS. It’s probably best to visualize my simple model by using “aggregate wage and salary income” as the ONI, rather than NGDP.
PPS. I’ll read all the old comments, and answer as many (or few) as I have the energy for.
PPPS. Did they really close down Boston when I was gone? If so, why? Or to me more specific, can someone write down a rule that determines when the authorities should close down large cities? I’m not trying to be cute, I actually don’t understand the rationale, although I could imagine several different possible explanations. But I’d be more interested in what you think. I’m inclined to see this as a harbinger of things to come. Welcome to the 21st century.