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
Post Keynesian principle - Inflation isn’t caused by excess demand
- Neoclassical theory: high demand pushes firms into output range where marginal cost is rising so prices go up
- Post Keynesians falls Sratta: there’s no range
But won’t firms out up prices any way to cash in on demand?
Post-keynesians say not as profit margins move with the business cycle - Godley, Coutts and Nordhaus
Therefore cutting demand wont cure inflation
- government spending cuts
- tax rises
- interest rate rises
all create unemployment for no purpose
So what does cause inflation?
post-keynesians struggle over distribution (wage-price spiral)
starting point:
- price = cost + profit markup
- workers push up labour cost
- firms raise prices to restore markup
- workers push up wages to restore real wage
Friedman said quantity of money determines prices
Post-Keynesians:
- prices up
- more demand for credit
- more lending
- quantity of money up
Then what happens to the Phillips curve?
wage inflation determined by unemployment rate
original post-keynesian position: it doesn’t exist, inflation determined by class struggle
more recent: state of class struggle determines when Phillips curve exists and when it doesn’t
full employment gives workers more bargaining power if they’re in strong enough position to start with
Phillips curve a sign of strong working class
theory: when workers have more bargaining power, or use it more aggressively, unemployment needed to hold wage inflation down i.e there’s a Phillips curve
so when workers are weak, bosses can hold wages down anyway i.e no curve
Decline of TU’s and rise of self-employment and gig economy in countries like UK might suggest they’ve got weaker
Post-Keynesian principles - Restricting demand damages the sully side (Hysteresis)
Hysteresis: equilibrium value of a variable depends on its actual past values
thus rise in unemployment and so a rise in natural rate of unemployment
Why hysteresis?
long-term unemployed drop out of Labour market reducing the supply of labour
and/or lose skills, motivation and good working habits (reducing demand for them)
- Institute of Fiscal Studies (2014): UK’s potential (full-capacity) output was 10% lower than it would’ve been without the post-2008 recessions
- Bristol university study (2012) found that hysteresis had a 30-year reach:
- children of parents who lost their jobs in the 1980s had fewer educational qualifications and were less likely to be employed today
Post-Keynesian principles - workers spend more of their wages than capitalists do on their profits
therefore shift from profits to wages pushes up aggregate demand and is good for employment
(compare neoclassical view that lower real wage will cure unemployment)
Is this theory right?
Vogel and Hein - 2008 looked at 6 countries growth rates from 1960-2005
- conclusion: higher share of wages raised growth in France, Germany, UK and USA
But lowered in Austria and Netherlands
possible interpretations: last 2 are very open economies whose exports likely to suffer from high labour costs
If high wages help growth, are there policy implications?
How can you have a policy of high/low wages if gov doesn’t control wages?
Implications for policy towards TU’s who push up both nominal and real wages
Neoclassical: restrict TU’s as job destroyers
Post-Keynesian: encourage them as job creators
Post-Keynesian Principles - Flexible wages and prices don’t destabilise the real economy but DESTABILISE it
ie wage rigidity a hedge against depression
better for prices to fall and profits to take a one-off hit than a downward wage-price spiral
Post-Keynesian position overall
Post-Keynesians intensify the Keynes message that aggregate demand is at the centre of macroeconomics:
- It doesn’t affect prices and so has all the more effect on output
- It’s sensitive to income distribution
- Temporary changes have permanent effects via hysteresis
