Thursday, April 18, 2013

Aggregate Demand and Modern Macro

Start with a point on language.

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.

This way of thinking is logically incompatible with the way macroeconomics is taught in (almost) all graduate programs today, which is in terms of optimization under an intertemporal budget constraint. I'll avoid semi-pejorative terms like mainstream and neoclassical, and instead follow Robert Gordon and call this approach modern macro.

In the Keynesian income-expenditure vision -- which today survives only, as Leijonhufvud put it, "in the Hades of undergraduate instruction" -- we think of economic actors as making decisions about current spending in terms of current receipts. If I earn $X, I will spend $Y; if I earn one dollar more, I'll spend so many additional cents. We can add detail by breaking these income and expenditure flows in various ways -- income from dividends vs. incomes from wages, income to someone at the top decile vs someone at the bottom, income to urban households vs income to rural ones; and expenditures on services, durable goods, taxes, etc., which generate income in their turn. This is the way macro forecasting models used by business and government were traditionally constructed, and may still be for all I know.

Again, these are relationships; they tell us that for any given level of aggregate money income, there is a corresponding level of aggregate expenditure. The level of income that is actually realized, is the one for which desired expenditure just equals income. And if someone for whatever reason adjusts their desired level of expenditure at that income, the realized level of income will change in the same direction, by a greater or lesser extent. (This is the multiplier.)

I should stress that while this way of thinking may imply or suggest concrete predictions, these are not themselves empirical claims, but logical relationships.

The intertemporal optimization approach followed in modern macro is based on a different set of logical relationships. In this framework, agents know their endowments and tastes (and everyone else's, though usually in these models agents are assumed to be identical) and the available production technology in all future periods. So they know all possible mixes of consumption and leisure available to them over the entire future and the utility each provides. Based on this knowledge they pick, for all periods simultaneously ("on the 8th day of creation" -- that's Leijonhufvud again) the optimal path of labor, output and consumption.

I realize that to non-economists this looks very strange. I want to stress, I'm not giving a dismissive or hostile summary. To anyone who's done economics graduate work in the last 15 or 20 years (a few heterodox enclaves excepted) constructing models like this is just what "doing macroeconomics" means.

(For a concrete example, a first-year grad textbook offers as one of its first exercises in thinking like an economist the question of why countries often run current account deficits in wartime. The answer is entirely in terms of why countries would choose to allocate a greater share of consumption to periods when there is war, and how interest rates adjust to make this happen. The possibility that war leads to higher incomes and expenditure, some of which inevitably falls on imported goods -- the natural answer in the income-expenditure framework -- is not even mentioned. Incidentally, as this example suggests, thinking in terms of intertemporal allocation is not always necessarily wrong.)

In these models, there is no special relationship between income and expenditure flows just because they happen to take place at the same time or in any particular order. The choice between jam today and jam tomorrow is no different from the choice between blackberry and lingonberry jam, and the checks you get from your current job and from the job you'll hold ten years from now are no more different than the checks from two different jobs that you hold right now are. Over one year or 50, the problem is simply the best allocation of your total income over your possible consumption baskets -- subject, of course, to various constraints which may make the optimal allocation unachievable.

My point here is not that modern models are unrealistic. I am perfectly happy to stipulate that the realism of assumptions doesn't matter. Models are tools for logical analysis, not toy train sets -- they don't have to look like real economies to be useful.

(Although I do have to point out that modern macroeconomics models are often defended precisely on the grounds of microfoundations -- i.e. more realistic assumptions. But it is simply not true that modern models are more "microfounded" than income-expenditure ones in any normal English sense. Microfoundations does not mean, as you might imagine, that a model has an explicit story about the individual agents in the economy and how they make choices -- the old Keynesian models do at least as well as the modern ones by that standard. Rather, microfoundations means that the agents' choices consist of optimizing some quantity under true -- i.e. model consistent -- expectations.)

But again, I come not to bury or dispraise modern models. My point is just that they are logically incompatible with the concept of aggregate demand. It's not that modern macroeconomists believe that aggregate demand is unimportant, it's that within their framework those words don't mean anything. Carefully written macro papers don't even footnote it as a minor factor that can be ignored. Even something anodyne like "demand might also play a role" would come across like the guy in that comic who asks the engineers if they've "considered logarithms" to help with cooling.

The atomic units of one vision are flows -- that is, money per time period -- between economic units. The atomic units of the other are prices and quantities of different goods. Any particular empirical question can be addressed within either vision. But they generate very different intuitions, and ideas of what questions are most important. 

Still, it is true that the same concrete phenomena can be described in either language. The IS curve is the obvious example. In the Hades of the undergraduate classroom we get the old Keynesian story of changes in interest rate changing desired aggregate expenditure at each given income. While in the sunlit Arcadia of graduate classes, the same relationship between interest rates and current expenditure is derived explicitly from intertemporal optimization.

So what's the problem, you say. If either language can be used to describe the same phenomena, why not use the same language as the vast majority of other economists?

This is a serious question, and those of us who want to do macro without DSGE models need a real answer for it. My answer is that default assumptions matter. Yes, with the right tweaks the two models can be brought to a middle ground, with roughly the same mix of effects from the current state and expected future states of the world. But even if you can get agreement on certain concrete predictions, you won't agree on what parts of them depend on the hard core of your theory and what on more or less ad hoc auxiliary assumptions. So Occam's Razor will cut in opposite directions -- a change that simplifies the story from one perspective, is adding complexity from the other.

For example, from the income-expenditure perspective, saying that future interest rates will have a similar effect on current activity as current interest rates do, is a strong additional assumption. Whereas from the modern perspective, it's saying that they don't have similar effects that is the additional assumption that needs to be explained. Or again, taking an example with concrete applications to teaching, the most natural way to think about interest rates and exchange rates in the income-expenditure vision is in terms of how the the flow of foreign investment responds to interest rates differentials. Whereas in the modern perspective -- which is now infiltrating even the underworld -- the most natural way is in terms of rational agents' optimal asset mix, taking into account the true expected values of future exchange rates and interest rates.

Or, what got me thinking about this in the first place. I've been reading a lot of empirical work on credit constraints and business investment in the Great Recession -- I might do a post on it in the next week or so, though an academic style literature review seems a bit dull even for this blog -- and three things have become clear.

First, the commitment to intertemporal optimization means that New Keynesians really need financial frictions. In a world where current output is an important factor in investment, where investment spending is linked to profit income, and where expectations are an independently adjusting variable, it's no problem to have a slowdown in investment triggered by fall in demand in some other sector, by a fall in the profit share, or by beliefs about the future becoming more pessimistic. But in the modern consensus, the optimal capital stock is determined by the fundamental parameters of the model and known to all agents, so you need a more or less permanent fall in the return on investment, due presumably to some negative technological shock or bad government policy. Liberal economists hate this stuff, but in an important sense it's just a logical application of the models they all teach. If in all your graduate classes you talk about investment and growth in terms of the technologically-determined marginal product of capital, you can hardly blame people when, faced with a slowdown in investment and growth, they figure that's the first place to look. The alternative is some constraint that prevents firms from moving toward their desired capital stock, which really has to be a financial friction of some kind. For the older Keynesian perspective credit constraints are one possible reason among others for a non-supply-side determined fall in investment; for the modern perspective they're the only game in town.

Second, the persistence of slumps is a problem for them in a way that it's not in the income-expenditure approach. Like the previous point, this follows from the fundamental fact that in the modern approach, while there can be constraints that prevent desired expenditure from being achieved, there's never causation from actual expenditure to desired expenditure. Businesses know, based on fundamentals, their optimal capital stock, and choose an investment path that gets them there while minimizing adjustment costs. Similarly, households know their lifetime income and utility-maximizing consumption path. Credit constraints may hold down investment or consumption in one period, but once they're relaxed, desired expenditure will be as high or higher than before. So you need persistent constraints to explain persistently depressed spending. Whereas in the income-expenditure model there is no puzzle. Depressed investment in one period directly reduces investment demand in the next period, both by reducing capacity utilization and by reducing the flow of profit income. If your core vision of the economy is a market, optimizing the allocation of scare resources, then if that optimal allocation isn't being achieved there must be some ongoing obstacle to trade. Whereas if you think of the economy in terms of income and expenditure flows, it seems perfectly natural that an interruption to some flow will will disrupt the pattern, and once the obstacle is removed the pattern will return to its only form only slowly if at all.

And third: Only conservative economists acknowledge this theoretical divide. You can find John Cochrane writing very clearly about alternative perspectives in macro. But saltwater economists -- and the best ones are often the worst in this respect -- are scrupulously atheoretical. I suspect this is because they know that if they wanted to describe their material in a more general way, they'd have to use the language of intertemporal optimization, and they are smart enough to know what a tar baby that is. So they become pure empiricists.

In Leon Fink's wonderful history of the New York health care workers' union 1199, Upheaval in the Quiet Zone, he talks about how the union's early leaders and activists were disproportionately drawn from Communist Party members and sympathizers, and other leftists. Like other communist-led unions, 1199 was kicked out of the CIO in the 1940s, but unlike most of the others, it didn't fade into obscurity. Originally a drugstore-employees union, it led the new wave of organizing of health care and public employees in the 1960s. Fink attributes a large part of its unusual commitment to organizing non-white and female workers, in an explicitly civil-rights framework, and its unusual lack of corruption and venality, to the continued solidarity of the generation of the 1930s. Their shared political commitments were a powerful source of coordination and discipline. But, says Fink, it was impossible for them to pass these commitments on to the next generation. Yes, in 1199, unlike most other unions, individual leftists were not purged; but there was still no organized left, either within the union or in connection to a broader movement. So there was no way for the first generation to reproduce themselves, and as they retired 1199 became exposed to the same pressures that produced conservative, self-serving leadership in so many other unions.

I feel there's something similar going on in economics. There are plenty of people at mainstream departments with a basically Keynesian vision of the economy. But they write and, especially, teach in a language that is basically alien to that vision. They're not reproducing the capacity for their own thought. They're running a kind of intellectual extractive industry, mining older traditions for insights but doing nothing to maintain them.

I had this conversation with a friend at a top department the other day:

  what do you think? is this kind of critique valid/useful?
11:17 AM him: its totally true
11:18 AM and you wouldn't know what was getting baked into the cake unless you were trained in the literature
  I only started understanding the New Keynsian models a little while ago
  and just had the lazy "they are too complicated" criticism
11:19 AM now I understand that they are stupidly too complicated (as Noah's post points out)
11:20 AM me: so what is one supposed to do?
  if this is the state of macro
 him: i dunno. I think participating in this literature is a fucking horror show
 me: but you don't like heterodox people either, so....?
11:21 AM him: maybe become a historian
  or figure out some simple variant of the DSGEmodels that you can make your point and publish empirical stuff

This is where so many smart people I know end up. You have to use mainstream models -- you can't move the profession or help shape policy (or get a good job) otherwise. But on many questions, using those models means, at best, contorting your argument into a forced and unnatural framework, with arbitrary-seeming assumptions doing a lot of the work; at worst it means wading head-deep into an intellectual swamp. So you do some mix of what my friend suggests here: find a version of the modern framework that is loose enough to cram your ideas into without too much buckling; or give up on telling a coherent story about the world and become a pure empiricist. (Or give up on economics.) But either way, your insights about the world have to come from somewhere else. And that's the problem, because insight isn't cheap. The line I hear so often -- let's master mainstream methods so we can better promote our ideas -- assumes you've already got all your ideas, so the only work left is publicity.

If we want to take questions of aggregate demand and everything that goes with it -- booms, crises, slumps -- seriously, then we need a theoretical framework in which those questions arise naturally.


[*] Keynes' original term was "effective demand." The two are interchangeable today. But it's interesting to read the original passages in the GT. While they are confusingly written, there's no question that Keynes' meant "effective" in the sense of "being in effect." That is, of many possible levels of demand possible in an economy, which do we actually see? This is different from the way the term is usually understood, as "having effect," that is, backed with money. Demand backed with money is, of course, simply demand.  


UPDATE: The Cochrane post linked above is really good, very worth reading. It gives more of the specific flavor of these models than I do. He writes: In Old Keynesian models,
consumption depends on today's income through the "marginal propensity to consume" mpc. 
Modern new-Keynesian models are utterly different from this traditional view. Lots of people, especially in policy, commentary, and blogging circles, like to wave their hands over the equations of new Keynesian models and claim they provide formal cover for traditional old-Keynesian intuition, with all the optimization, budget constraints, and market clearing conditions that the old-Keynesian analysis never really got right taken care of. A quick look at our equations and the underlying logic shows that this is absolutely not the case.  
Consider how lowering interest rates is supposed to help. In the old Keynesian model, investment I = I(r) responds to lower interest rates, output and income Y = C + I + G, so rising investment raises income, which raises consumption in (4), which raises income some more, and so on. By contrast, the simple new-Keynesian model needs no investment, and interest rates simply rearrange consumption demand over time. 
Similarly, consider how raising government spending is supposed to help. In the old Keynesian model,  raising G in Y = C + I + G raises Y, which raises consumption C by (4), which raises Y some more, and so on. In the new-Keynesian model, the big multiplier comes because raising government spending raises inflation, which lowers interest rates, and once again brings consumption forward in time.
Note, for example, that in a standard New Keynesian model, expected future interest rates enter into current consumption exactly as the present interest rate does. This will obviously shape people's intuitions about things like the effectiveness of forward guidance by the Fed.


UPDATE 2: As usual, this blog is just an updated, but otherwise much inferior, version of What Leijonhufvud Said. From his 2006 essay The Uses of the Past:
We should expect to find an ahistorical attitude among a group of scientists busily soling puzzles within an agreed-upon paradigm... Preoccupation with the past is then a diversion or a luxury. When things are going well it is full steam ahead! .... As long as "normal" progress continues to be made in the established directions, there is no need to reexamine the past... 
Things begin to look different if and when the workable vein runs out or, to change the metaphor, when the road that took you to the "frontier of the field" ends in a swamp or in a blind alley. A lot of them do. Our fads run out and we get stuck. Reactions to finding yourself in a cul-de-sac differ. Tenured professors might be content to accommodate themselves to it, spend their time tidying up the place, putting in modern conveniences... Braver souls will want out and see a tremendous leap of the creative imagination as the only way out -- a prescription, however, that will leave ordinary mortals just climbing the walls. Another way to go is to backtrack. Back there, in the past, there were forks in the road and it is possible, even probable, that some roads were more promising than the one that looked most promising at the time...
This is exactly the spirit in which I'm trying to rehabilitate postwar income-expenditure Keynesianism. The whole essay is very worth reading, if you're interest at all in the history of economic thought.


57 comments:

  1. i prefer the way in which nick rowe explains it. in short: the concept of aggregate demand only meake sense in a moentary exchange economy.

    http://worthwhile.typepad.com/worthwhile_canadian_initi/2011/01/understanding-the-keynesian-cross.html

    http://worthwhile.typepad.com/worthwhile_canadian_initi/2011/02/but-where-will-the-demand-come-from-in-praise-of-older-keynesians.html

    ReplyDelete
    Replies
    1. JCE-

      Nick Rowe's stuff is great. I wish I could write half as clearly as he does. But "aggregate demand" when he says it, means something different from when Keynesians say it.

      For us, a "demand problem" means that someone has chosen to reduce their expenditure relative to their income, and because in modern economies there is a strong causal link from expenditure --> output --> income --> expenditure, the effect of this is to reduce total activity in a self-perpetuating way.

      Whereas for Nick, it means there is excess demand for means of payment, and excess supply of currently produced goods, which will last until the supply of money increases, or the price of currently produced goods falls.

      Two ways of looking at the same phenomenon, but two ways with different implications for policy and that invite a different set of natural next questions.

      Delete
    2. JW: Thanks! And good post that raises many issues that should be raised.

      "But "aggregate demand" when he says it, means something different from when Keynesians say it."

      I'm not sure that's right.

      I see Keynesian "demand problem" and excess demand for money as being two sides of the same, errr, coin. And we have to look at both sides (I think). You can't talk about the hot potato without talking about getting money from selling stuff and spending money by buying stuff, and how those two are interdependent in aggregate. Which is like the Keynesian income-expenditure-income thingy. Except: Keynesians make this big deal about the distinction between newly-produced goods and all other goods, which is an important part, but only a part, of what happens in the trade cycle. Because buying and selling old stuff matters too. See: http://worthwhile.typepad.com/worthwhile_canadian_initi/2011/12/the-trade-cycle-vs-is.html

      I tried to clarify that in this old post: http://worthwhile.typepad.com/worthwhile_canadian_initi/2012/08/the-very-short-run.html

      Delete
  2. You paint a grim picture of the stagnation of the economic thought and economic education. How did you become a heterodox macroeconomist then, if I may ask?

    I was taught macroeconomics by the enthusiastic and inspiring Neo-Keynesian teacher - she was kinda illiterate and knew little beyond the 1970's translated textbooks and Keynes's 'General Theory' - and she managed to get me interested in how the world (and its economy) works. She understood the importance of income flows and the aggregate demand and was able to engage difficult questions in a thoughtful manner, but her macroeconomics was very much a thing of the padt. The newer generation of Russian economists knows little beyond New Keynesian DSGE-slapdashing, I believe. Guess there is not much hope for the state of macroeconomics, East, West or worldwide.

    ReplyDelete
  3. Pardon my asking a question from far left field. :)

    As I read this post, an analogy from physics came to mind. Newtonian physics is built upon conservation laws, such as conservation of energy and conservation of momentum. The statement that in any time period, total income equals total expenditure is similar to a conservation law, although a term for what is being conserved does not immediately come to mind. To apply conservation laws to dynamics relies upon differentials. The future is unknown, if determined. You discover the future step by step from the present. That sounds like the Keynesian perspective.

    OTOH, there is another law of dynamics, the Law of Minimum Action. A good example is that light travels in a "straight line" (geodesic). Suppose that a photon goes from point A to point B. It takes a straight line, but since it cannot "see" B, how does it know which path to take? Nonetheless, if you are given that a photon went from A to B, you can find the path by minimizing action. (Quantum mechanics introduces complications, but we are talking classical mechanics here.) To apply the law of minimum action you use integrals. That seems to me like the modern economics paradigm, which involves maximization, and people act as though they could see the future.

    The nice thing in physics is that there are some problems that are easier to solve by the law of minimum action, so, even though using Newtonian dynamics is the norm, you can switch frameworks as desired. It has been proven that the two approaches are equivalent.

    But it seems that in economics the two approaches may not be equivalent, and may yield different answers. Which is better is an empirical question, and that provides an incentive to be an empiricist.

    Make sense? Thanks. :)

    BTW, this post helped me to see why some economists react to identities with scorn. Knowing an identity does not help much to solve a maximization problem.

    ReplyDelete
  4. In this framework, agents know their endowments and tastes (and everyone else's, though usually in these models agents are assumed to be identical) and the available production technology in all future periods. So they know all possible mixes of consumption and leisure available to them over the entire future and the utility each provides. Based on this knowledge they pick, for all periods simultaneously ("on the 8th day of creation" -- that's Leijonhufvud again) the optimal path of labor, output and consumption.

    This seems to rule out the possibility of economic crises.
    In fact, this seems to rule out the possibility of frictions too.

    O_O

    ReplyDelete
    Replies
    1. Not necessarily. Let's say, for instance, that everyone is on their optimal consumption path, but then we impose a limit on the maximum ratio of debt to current income. For some people whose current income is low relative to their lifetime income, this will force them to consume less in the current period than would be optimal. If you postulate this is a change that happens suddenly then, hey, there's your crisis.

      This is the basic framework of Krugman and Eggertson.

      Delete
  5. Thomas Palley writes a lot of articles that keep the Keynesian/Kalecki flame burning bright. Like his paper "simple debt analytics"


    pe

    ReplyDelete
  6. Very clear and trenchant post. Seems to me that the income-expenditure vision imposes itself naturally on those, like Keynes, who have a historically informed perspective, while that of intertemporal optimisation appeals easily to people who, understanding history less well, get trapped in teleological ways of thinking.

    ReplyDelete
  7. my problem with this kind of theory is that IMHO it implies that everyone acts in order to maximize his/her consumption (utility ) and thus rules out the idea that many people act in order to accumulate wealth, not to consume it. This lead to theories where every crisis is due to some form of miscalculation, while in reality a lot of actors try to accumulate wealth for the sake of it (let's call it Calvinist mindset) .

    ReplyDelete
  8. "Demand backed with money is, of course, simply demand."

    Or depending on how determined the backing is, simply "spending."

    ReplyDelete
    Replies
    1. Nope. Excess demand *is* possible. I might go to the store wanting to buy an apple, with money in my hand intending to spend it, but I don't actually spend it, because the store has run out of apples. Don't forget the supply-side!

      Delete
    2. >Don't forget the supply side!

      Right. But I think we're agreeing here, that demand backed by money is not a useful definition of aggregate demand. My comment was pointing that out. Desired spending/demand (which you'll be happy to hear I'm finally wrapping my brain around) works much better. That desire (and changes to it) is where the multiplier resides.

      Delete
  9. A great work on income/expenditure models is that of Wynne Godley and Marc Lavoie. I don't think any other income/expenditure model comes close to what they do. In their work, aggregate demand is defined as consumption plus fixed capital formation plus exports minus imports and this differs from aggregate supply by "change in inventories". So for any given period, one can be greater than the other.

    "Specifically, it's a statement that we should think about current income and current expenditure as mutually determining each other."

    This isn't so. An example would be the government increasing its expenditure. Current income needn't determine current expenditure. a more accurate statement is by Lance Taylor:

    "Formally, prescribing a closure boils down to stating which variables are endogenous or exogenous in an equation system largely based upon macroeconomic accounting identities, and figuring out how they influence one another."

    ReplyDelete
    Replies
    1. Like to add that perhaps the definition is from Kaldor and Hicks.

      Delete
    2. I like Godley and Lavoie too. They are definitely important contributors to the tradition I am counterposing to modern macro here.

      The question of how to treat inventories is certainly legitimate; my teacher David Kotz (for instance) agrees with Godley and Lavoie that it's better not to treat them as final expenditure, but instead as a margin on which aggregate income and expenditure can diverge. I don't have a strong settled view on this myself, but nothing in the argument I'm making here depends on it.

      On the question of the dependence of expenditure on income. Of course not ALL expenditure depends on income. The category of autonomous expenditure -- including much of government spending -- has always been central. But it must be the case that a large fraction of current expenditure depends on current income, or concepts like "the multiplier" don't work.

      "Formally, prescribing a closure boils down to stating which variables are endogenous or exogenous in an equation system largely based upon macroeconomic accounting identities, and figuring out how they influence one another."

      I'm a huge fan of Lance Taylor -- if I ever taught graduate macro, which I never will, I'd seriously consider Reconstructing Macroeconomics as the core text. I've discussed model closure on this blog here. But I don't see any contradiction between this post and the quoted lines.

      Delete
    3. JWM,

      Great point about the multiplier. Perhaps our points were just matters of stressing.

      About your post on "what adjusts" - always feel like writing something along those lines. Nice post.

      Delete
    4. Ramanan: "In their work, aggregate demand is defined as consumption plus fixed capital formation plus exports minus imports and this differs from aggregate supply by "change in inventories"."

      I don't *think* Marc would say that. And if he did say that, I think he would be being a little sloppy, or else wrong. Aggregate demand is not identical to *actual* expenditure on newly-produced goods. It is *desired* expenditure. And Aggregate supply is not actual sales. It is desired sales.

      If I go with money in my pocket to buy a new car, and they don't have a car in inventory, and they can't or don't want to build me one quickly enough, I may return home with the money still in my pocket. AD is greater than actual expenditure.

      Delete
    5. Plus, if "aggregate demand" means exactly the same as "actual sales", it doesn't make logical sense to say that changes in aggregate demand *cause* changes in actual sales.

      Delete
    6. I think I agree with Nick here. Defining aggregate demand using a backward-looking, retrospective accounting view doesn't work. Not sure what Lavoie would say, but I think Nick's probably right here to.

      Delete
    7. Nick,

      Okay I will have to come back with a self-consistent system of defining things and also about how G&L use it - accepting that I may have not represented them right.

      "Plus, if "aggregate demand" means exactly the same as "actual sales", it doesn't make logical sense to say that changes in aggregate demand *cause* changes in actual sales."

      It can be said differently to convey the same thing you may want to convey by saying changes in aggregate demand causes changes in output because the latter is different from the former and in a recursive manner where sales higher than expected lead firms to produce more to bring inventories/sales level to a desired level.

      Delete
  10. Josh, an aside spurred by your nice encapsulation of Nick's view vis a vis I->E->I->E:

    It may be ignorance, but the "demand for money" (means of payment) notion has always seemed wrong to me, intuitively. But I can't articulate why, cogently. Having to do with:

    For real goods, increased demand can increase production and/or price. For money, all the burden falls on "price." (Except with long, incentive-driven Nth-order "production" effects through treasury/fed/banks.) Have you written about this asymmetry? Have others? I don't recall Nick speaking in these terms. Thx.

    ReplyDelete
    Replies
    1. Steve,

      1. The point I'm trying to make here isn't that thinking of aggregate demand in terms of excess demand for money is wrong. It's just that it's only one way of thinking about it, it's not the way of thinking that the concept of aggregate demand was originally framed in, and the choice of paradigm makes a difference. But the excess-demand-for-money framing is genuinely useful for some questions. (And also, it's genuinely present in Keynes -- the famous passage about how "people want the moon," etc.)

      2. I think the distinction you're drawing doesn't really come up because we are normally implicitly thinking of Marshall's "market day" where quantities are fixed. There is a difference between money and other goods in that we think it's easier for the relative price of some goods to rise, than for there to be general deflation. But it's not (directly) related to output adjustment.

      3. Obviously, in the longer term, the fact that the private sector cannot produce "money" is critical. The problem is that for most naive definitions of money the private sector has no problem producing it, indeed the supply is more or less infinitely elastic. (This is the whole "endogenous money" thing.) There are at least two possible solutions. One is to focus on currency specifically -- the one kind of money that the private sector cannot produce. Both Nick and Paul Krugman (who is basically a monetarist -- Friedman would have loved the babysitting coop) have taken this route. Not going to dig up links now but if you're interested I'll find them. The second solution is to shift the focus from money to some other class of assets. This is DeLong's approach -- it's not excess demand for money per se as for safe assets. The best systematic development of this idea is probably by Jean Tirole. But he takes the fact that only the state can produce safe assets as a premise, and works from there.

      Delete
    2. Just to say: while the private sector can produce "money" in a real/useful sense, the real sector (households and nonfinancial businesses) can't, really. They can issue IOUs among themselves, but those never attain the exchangeability value (JP Konig would call it liquidity value) that "money" has. Medium of exchange.

      I'd like to see a lot more thinking that incorporates that distinction -- private vs. real (aka "main street"). The real sector being 1. the primary producer, and producer of surplus, and 2. also the implicit sector hovering in many people's (economists') minds when they're in less-than-formal, not-carefully-defined discussion.

      Delete
    3. Oh and thanks for the Tirole paper. Read the abstract and have it queued up. Just what I was after.

      Delete
    4. Steve I think that's a great point. Further in that direction, households or firms can choose to seek debt or not.

      Delete
  11. JW

    I'm not sure if you intended to, but this post comes off as implying that the 'Old Keynesian' model is fundamentally about near-atemporal exchange, in which case the Nick Rowe-ian take on it is entirely valid.

    Leijonhufvud's case has always been the Old Keynesian model makes most sense in an inter-temporal framework - this was a big difference in the notion of disequilibrium that he proposed vs that proposed by Robert Clower. Of course, ex-ante optimization is given up, equilibrium is retained only in the sense of a 'stationary' state rather than a state where all plans are fulfilled. So Leijonhufvud-ian macro can still be traversed to from the Saltwater orthodoxy, through some rigorous theoretical bolstering.

    But income/expenditure macro, without explicit expectations, is arguably the old monetarist's preserve.

    ReplyDelete
  12. JW: "My point is just that they are logically incompatible with the concept of aggregate demand."

    I disagree.

    First, I can *imagine* a world in which aggregate demand for goods is a meaningful concept and totally unrelated to income from sales of goods. (E.g. a 2 period OLG model in which only the young sell goods and only the old buy goods, and the old use their existing stocks of M to buy goods, so AD=M/P. Actually, just like Lucas 72).

    Second. Start with a model in which the current planned time-path of expenditure (AD) depends on current expected time path of income and interest rates. (Intertemporal version of Old Keynesian consumption function.) Now wave your hands, and assume away the coordination problem (it's easier if you assume identical agents) so that expected time path of income = planned time path of expenditure. Et voila! A New Keynesian IS curve, which the economy is always on.

    It's not that AD isn't in the NK model. It's just that they skip a step, and jump straight to the semi-equilibrium condition.

    ReplyDelete
  13. I went to grad school to be a macroeconomist, and gave up after sensing out how intractable the problems were: given the number of business cycles, etc., and the popular models, it seemed really improbable one could generate an interesting result. Thus I find it interesting to see so much discussion of macro policy in terms of the old Keynesianism as if nothing empirically or theoretically happened after the 60's. I mean, if you want to be at the center of macro policy debates in the NYTimes and such, you would be better prepared if you simply didn't know anything subsequent to 1969.

    ReplyDelete
    Replies
    1. Hey Eric, just wanted to let you know that you inspired me to become an anti-macro blogger in the first place. Now I am trying to adapt some of your finance models. So thanks for existing!

      Delete
    2. I find it interesting to see so much discussion of macro policy in terms of the old Keynesianism as if nothing empirically or theoretically happened after the 60's. I mean, if you want to be at the center of macro policy debates in the NYTimes and such, you would be better prepared if you simply didn't know anything subsequent to 1969.

      As a description of the state of (non-academic) debates, this is certainly accurate. But I'm curious what you take from it. Is the failure on the side of policymakers and the press to draw on more recent macro work, or is the failure on the side of modern macro to provide anything useful for policy?

      (I'm sure if I knew you I could guess your answer, but I don't and genuinely can't tell.)

      Delete
  14. Noah: heh. Well, I hope you have the patience of Job as the "anti" mob has been getting the short end of the stick since antidisestablishmentarianism. I guess there's a benefit to smacking back bad ideas, but that idea bag is endless, if not a loop. As per getting anything I've discussed modeled I'd love to see it...

    ReplyDelete
    Replies
    1. About the "anti" mob, I need no patience since for me it's a labor of love...I exist to troll pseudoscience. ;-)

      As for the models, I may be getting back to you soon...

      Delete
    2. Speaking of "pseudoscience" Noah, is it:

      A) Actually coming up with ideas, formalizing them, systematically testing them, and having the results peer-reviewed by active scholars in the field.

      OR

      B) Waking up at noon, cranking out a blog post about what Krugman ate for breakfast, then hitting all of the blog comment sections like a medical intern running rounds?

      I have a feeling you're not on the side you think.

      Delete
  15. Noah and Eric-

    I've been thing a lot lately about how macroeconomics can be useful even where there is not enough data to make causal claims with the degree of confidence required in an exact science.

    I think you may exaggerate the data limits a little. I think there are some relationships between aggregates that have been strong enough, and stable enough, for us to use them to make predictions about the near future with a reasonable degree of confidence. One problem with modern macro is that the emphasis on microfoundations leads to a focus on supposed "structural" relationships, ignoring other perhaps more robust aggregate relationships.

    But grant the point that for many interesting questions, we just don't have the data to make macro an exact science. I still think it's worth doing, for three reasons.

    1. Negative conclusions are still interesting. The impossibility of establishing any definite relationship between public debt and growth (to take an obvious example) isn't a failure of science, it's a real scientific finding. True, it gives us no guidance about government borrowing as a tool to boost growth. But knowing we don't know the answer to that question is useful -- it frees us to focus on the more direct effects of government tax and spending decisions, which we do know something about.

    2. Not all questions are causal. There are a great many non-causal questions in macroeconomics that can be answered exactly. And establishing the basic desriptive facts about the economy is important. As Montaigne famously said, "Men are too quick to ask why is this so, when they should first ask if it is so." This is one reason I like accounting decompositions so much.

    3. The standards of exact science aren't the only way to evaluate causal claims. Noah, you talk about science and pseudo science as if those were exhaustive categories, but there are lots of fields of human knowledge that are not either. When you post about George R. R. Martin, you aren't doing science, but you are making arguments backed up with evidence and reason, that may be more or less valid. Or if historians ask, "was slavery the cause of the Civil War," let's say, this is a question that is never going to be answered statistically. (Though statistics might be part of a larger non-quantitative argument.) But that doesn't mean it is a question that can't be answered at all, or that all answers are equally valid. Saying that macroeconomists should use of standards of evidence more like historians' is not the same as giving up on the whole project, I don't think.

    ReplyDelete
  16. • What do you mean by "logical relationships"?

    • Don't you mean "when I reduce my expenditure someone else's income goes down?

    • How about making heterodox models that don't suck?

    ReplyDelete
  17. How about making heterodox models that don't suck?

    We're working on it.

    ReplyDelete
  18. while the private sector can produce "money" in a real/useful sense, the real sector (households and nonfinancial businesses) can't, really. They can issue IOUs among themselves, but those never attain the exchangeability value (JP Konig would call it liquidity value) that "money" has.

    True. But I think the pure IOU economy, where all transactions take the form of a new liability issued by the buyer is an interesting simplification, even though it is not realistic. Just like the money-toekn economy can be a useful simplification. The thing is, the latter gets tons of attention, while the former gets almost none. Among other things, it helps us see how there can be changes in aggregate demand for goods without any change in the supply or demand for money.

    ReplyDelete
  19. > two languages express the same thing...why does it matter?

    Suppose I'm modelling a 1-D function. I have the choice of either sinusoidal or polynomial basis elements. With enough parameters I can fit any elephant under either approach. But let's say, following Schrodt/Achen I limit myself to three.

    I fit both models to equal accuracy on past data. Although the sinusoidal basis fits the data better in some places wereas the poly fits better in others.

    Now someone asks me what would happen if things were different. Clearly my extrapolations will differ depending which basis I adjust. Either "Everything goes in cycles" or "The past is the best predictor of the future".

    Model realism_does matter, even if continuum fluid mechanics does fine despite the noncontinuity of the substrate.

    ReplyDelete
  20. I find it striking how discussion of multipliers omits individuals and geography. Isn't it simpleto look at flows within Arizona (or Brooklyn) andget the timing and dispersal of a helicopter drop from that? Imagine you could subpoena major credit card companies' transaction data (for the good of the nation!).

    ReplyDelete
  21. Nick:

    I see Keynesian "demand problem" and excess demand for money as being two sides of the same, errr, coin. And we have to look at both sides (I think). You can't talk about the hot potato without talking about getting money from selling stuff and spending money by buying stuff

    Yes, that is how you see it. And I'm not saying you're wrong to see it that way! I'm just saying there are other ways to see it. There is a perfectly consistent way of conceptualizing aggregate demand without any monetary hot potato at all.

    ReplyDelete
  22. ITT JW Mason didn't read Lucas (1976).

    You can't do macro in the way you're thinking, if all of your parameters are totally pulled out of a hat, and can't be trusted with robustness to regime change.

    Well-- unless you're saying economics should all be the type of hands-off, conceptual armchair economics done by bloggers, in which case the profession really is heading straight to the toilet faster than the bloggers whose hands sit on the flush seem to think...

    Point being, no, if you know what the problems with "Old Keynesianism" are you can't just wander back into that world. For example, old-Keynesian Philips Curves are what got that style of Macro in so much trouble-- speaking of the ad hoc assumptions. It makes zero sense to practically just eyeball regression coefficients that aren't actually reliable or properly-estimated whatsoever. Your model will be bunk.

    ReplyDelete
  23. There are many important fields where one can't rigorously prove results but there's wisdom to be had, so I don't think that you can't know things you can't prove.

    Economics as a science is basically about modeling, and if all you knew about the economy was what can be modeled you would know very little. I hate the way models are accepted because in principle they can capture some phenomenon, as invariably these models don't explain anything as shown by their inability to predict (eg, Lucas island model, Romer growth model, Krugman's New Trade Theory, Stiglitz's impossibility of efficient markets, the CAPM, Solow's growth accounting, Turnpike models, the Transactions demand for Money, etc.). One spends a lot of time understanding these models, and then what? Does that make you a valued counsel for a large company or government? Only insofar as you can argue better, generating a spread argument that others can't easily dismiss. See the way vulgar Keynesians (Jared Bernstein) apply their models, such tools are used are often used to obfuscate and deflect common sense criticisms as being nonscientific, when such people are speaking about constructs and relationships with more rigor than is empirically warranted. I think it's pointless to get into such debates, modern day augurs or oracles. That's not a search for truth, just a way to more easily convince yourself you were right all along.

    I'm glad blogging has revealed that macro debates are fundamentally as partisan as they were 100 years ago, because 20 years ago there was this conceit that it was all a technical debate. Perhaps we simply need more granular data than is available, so like the germ theory before the magnifying glass, we simply can know what's driving things. Clearly national income accounting has failed spectacularly relative to original expectations as to what it would show, like measuring one's health via a thermometer: correct at extremes, but pretty useless in between.

    Maybe things like the good life or happiness or an optimal fiscal policy will forever remain things that are achievable, just not in any rigorous way. Or maybe someday we will discover the equivalence of an economic magnifying glass.

    ReplyDelete
    Replies
    1. Fantastic Eric.

      > magnifying glass

      I have hopes for electronically recorded transaction data. For example the billion prices project.

      Delete
  24. Economics as a science is basically about modeling

    Ain't that the truth! The opening words of the abstracts of the most recent three papers open on my computer (all on business cycles and credit constraints) are "We develop a model...", "We build a variation of the neoclassical growth model...", and "We study models..."

    But while we're evidently in agreement here, I'm a bit more sanguine about the possibilities for non-model-based macro. My paper with Arjun Jayadev, an accounting decomposition of historical changes in household debt-income ratios, recently got an R&R from AEJ: Macro. Not one model in it.

    ReplyDelete
  25. JW Mason

    I'm a bit confused by this - the fault is my very shaky understanding of modern macro. Can you help me?

    I thought in modern macro models households have income - rK+wL - and in aggregate that equals expenditure - consumption +gross investment. Or I guess just wL and C.

    And I'm sure I've seen simple dsge models that contain something called a "demand shock" - which affects the chosen level of output (via the labor supply decision, I suppose)

    as I had understood it, the main gulf between modern macro and Keynesianism was that such demand shocks are rather silly, they just entail a simply choice of working and consuming less. Whereas Keynesianism has the idea the everybody might wish to keep working, maintain their expected income, yet for some reason desire to spend more spend more (or less) and when they do so, actual income will change (the multiplier) rendering their previously expected incomes wrong. So there's a departure from Rat Ex. Further, it makes sense for individuals to want to maintain their incomes whilst decreasing their spending because of we have money (not barter) and similarly they might decide to maintain their incomes whilst increase their spending because of credit expansion (or money creation) or maybe monetary velocity increase.

    where am I going wrong?

    ReplyDelete
  26. I came to this thread too late - not sure if you'll pick this up, but you might like this paper on demand driven business cycles

    http://www.nber.org/chapters/c12929.pdf?new_window=1

    ReplyDelete
  27. Luis-

    Thanks for the paper, looks interesting.

    I'm sorry the post isn't clear to you -- I'm not sure I can do better in comments, but hopefully I'll write more, and more clearly, about this stuff in the future. But again, in my mind the key difference between older Keynsian macro and modern macro is that the older vision had units making decisions about expenditure in each period based on income in that period (or in recent periods), while in modern macro decisions are made once and for all for a path of expenditure over all time.

    ReplyDelete
  28. Completely OT but, how is this that in this blog posts disappear in limbo?
    I was waiting for the return of the post following this one to write this but, since it seems that it won't come back:
    Congratulations for your job.

    ReplyDelete
  29. JW,

    oh the fault is mine - I'd wrongly interpreted you as saying modern macro doesn't impose aggregate income=expenditure.

    You can do modern macro with myopic consumers, but I'm not sure that would heal the gulf between old and new Keynesian. But I'm writing that simply because I have stuck in my head the idea that the real issue is coordination and complementarity amongst heterogeneous agents. If I had the technical chops, I'd like to do work like Russell Cooper

    http://ebooks.cambridge.org/ebook.jsf?bid=CBO9780511609428

    ReplyDelete
  30. @JW: "in modern macro decisions are made once and for all for a path of expenditure over all time."

    Just to confirm (because I really have no idea and I want to): does this straightforward sentence accurately describe modern macro? None of the models incorporate units' updating of expectations over time, in a dynamic model? (Would this require agent-based simulation modeling?)

    ReplyDelete
  31. SR, I know you didn't ask me but ... I think that sentence is really only literally true in deterministic models with no uncertainty - in basic stochastic models the representative agent updates consumption decisions dynamically as "things happen" (shocks arrive, policy responds) but how it will update those decisions in response to things happening is planned in advance (once and for all) and E(X_t+1) is a function of X_t, where X is whatever, so expectations of tomorrow are updated as things happen today. That is assuming the processes which deliver shocks are known and fixed once and for all.

    I think modern macro models in which the processes are not known, so the agent has to learn about them (and update expectations/beliefs concerning the process itself) are common enough, and there are also some models (fewer?) in which the stochastic processes themselves changes. There's also an interesting subfield about rare disasters - a nice paper is Variable Rare Disasters by X Gabaix - which revolves around agent learning, I think.

    ReplyDelete
  32. Thanks LE. I knew it couldn't be that simple, dammitall... The Gabaix work in general looks fascinating.

    ReplyDelete
  33. Luis, Steve,

    I stand by my contention that, on the most basic level, the distinction really is that simple, if we are talking about the analytic core of modern macro -- the stuff that is taught in graduate school, and the default assumption for work in other areas that needs macro background assumptions.

    Just to pick one example that's handy, this widely cited paper by Toni Whited is about credit constraints and business investment. But as you'll see (page 1449 and following) the baseline model of investment is explicitly derived from rational optimization in which the shareholders know the true expected return on capital for the firm over infinite future time.

    I'm not saying that all mainstream macroeconomics assumes this is literally true. For instance, this particular paper is specifically about how credit constraints cause firms to depart from the optimal investment path. What I am saying is that this is the starting point for all modern macroeconomics, from which departures have to be explicitly justified.

    ReplyDelete
  34. JW

    I am making the great mistake of writing about something I have little direct experience with, aside from having used the neoclassical growth model in context of growth research, only patchy recollections of classes ... but I think we are talking about the same thing in slightly different terms, aren't we? It's just that I think the analytical core of modern macro is stochastic, and in a stochastic environment the equivalent of choosing your path of expenditure once and for all is choosing your policy rule once and for all, which says how your expenditure will respond to shocks.

    ReplyDelete