Revival of Economic Liberalism Flashcards
Lucas’ policy ineffectiveness proposition
Rational expectations: agents only make random errors in their forecasts
+
Flexible prices: prices adjust quickly too clear markets
= monetary and fiscal policies can’t affect aggregate demand
this is Ricardian equivalence as David Ricardo suggested it and is said that running deficit and borrowing was no more expansionary than balancing the gov budget
Ricardian Equivalence
Barro: rational expectations include the expectation that more borrowing now means more tax later
hence you can save up in advance of the tax
therefore you take as much demand out of the economy as the gov puts in
which nullifies the expansionary effect of the deficit
Critics of Ricardian Equivalence
it attributed too much knowledge to taxpayers
eg in 2000 only 1/3 of Danish voters knew whether the gov was in surplus or in deficit - far fewer knew deficits size
New Keynesian economics
- Not convinced by rational expectations
but went along with it because
a) nothing convincing to put in its place
b) wanted to show that with RE, new classical policies still wrong because
2. prices not perfectly flexible
so even if expectations rational, prices lag behind money and aggregate demand does rise
Why are prices inflexible?
New Keynesians tried to find micrcofoundations ie ground inflexible prices in optimising behaviour by firms
charge had been that Keynesians had been throwing
in arbitrary rigidities to justify government action
large number of reasons put forward why optimising individuals might not want to change prices to clear market
Why don’t you change prices all the time?
1988 Alan Blinder asked businesses this:
a) ‘we only change our prices when our costs change’
b) ‘implicit contracts’ customers trust us not to change prices to make a quick profit
- workers trust us not to cut wages whenever we can get away with it
- goodwill of customers and workers makes us more profit in the long run
c) coordination failure: firms don’t change prices because they don’t want to be the first to do it
- prices rise: what if no one follows suit
- price cuts: looks like starting a price war
Rational expectation hypothesis
expectations aren’t systematically biased and agents only make random errors
How?
- Correct for their own bias once they see it:
- if you forecast inflation 5% too high year after year you will adjust for this
- but how long would this take? Meantime the process governing inflation might have changed - They might know the economic theory which correctly explains the variable they’re trying to forecast
- but which is the correct one when the professional economists disagree?
Keynes, Risk and uncertainty - Neoclassical counterattack
Unemployment does cure itself
unemployment leads to wages down which leads to prices down so real balance (quantity of money/price level) rises
this means aggregate demand rises so unemployment goes down (the real balance effect - Pigou)
Not the pre-Keynesian argument which relied on (w/p) falling
Mainstream Keynesians agreed with this as a theory so that is became known as the neoclassical Keynesian synthesis
neoclassical because unemployment does cure itself
Keynesian because aggregate demand is central
Post-Keynesians
- real balance effect misses the point:
what happens to expectations while:
- prices falling
- wages falling
- firms going bankrupt - debts unchanged but revenues down
- unemployment rising
answer: agents don’t know how to form expectations
this kind of uncertainty is the heart of Keynes and was thrown away in the neoclassical synthesis
Risk and uncertainty
Frank knight, ‘Risk, uncertainty and profit’
risk is where you can quantify the odds (will you throw a 6?)
uncertainty is where you can’t
2008-9 financial crisis is an example of uncertainty
Untrue that almost no one thought it could happen
but true that almost no economists gave guidance on how likely and when it would happen
Neoclassical position was that quantifiable risk is the norm - major crises are qualitatively different from normal life
Robert Lucas: orthodox economists had been forecasting events conditional on ‘no catastrophe’
Keynesian position: uncertainty is persuasive and doesn’t just concern major crises
What did Keynes say about the crisis
- General theory: compared stock market to beauty contest
but one where you don’t rank the candidates in order of beauty, but in the order you think the largest number of other people will rank them
you buy shares you think others will buy (and push the price of)
this is used by fundamentalist Keynesians to argue the futility of rational expectations
Keynes: because future is uncertain, people fall back on assuming present conditions will continue
- unless there’s some striking and unambiguous reason why they shouldn’t
In normal times: “it would be foolish, in forming out expectations, to attach great weight to matter which are very uncertain” - General theory
“In abnormal times…the market will be subject to waves of optimistic and pessimistic sentiment, which are unreasoning and yet in a sense legitimate where no solid basis exists for reasonable calculation”
Post-Keynesian policies
- Uncertainty is persuasive and destabilising
- Gov control of the money supply doesn’t work because quantity of money is endogenous
because banks can create money out of nothing
How? - Banks don’t need money to lend money
- credits my account with £1000, buy your car with it, you Put it in the bank: total deposits = £1000
Is there a limit to banks doing this?
Yes:
- More loans means more risks of default
- more bank deposits means greater risk that too many depositors want them back at the same time
But (post-keynesians) commercial banks don’t think about their reserves when they’re making loans
because they know central banks will create reserves to prevent/remedy a shortage
shortage of reserves pushes up interbank lending rate
central bank creates reserves to bring it back on target
Therefore quantity of money is endogenous
- central bank dragged along by commercial banks
- US evidence: changes in MO (bank reserves at central bank) follow changes in M2 (publics holding of bank deposits plus currency) - Kydland and Prescott
therefore if central banks ‘create money out of nothing’, central bank doesn’t put a brake on them
