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No Such Thing as a Free Lunch: Principles of Economics (Part 173)

Trickle-down economics - it didn't work. The whole idea was supply-side economics: give rich people a lot of money; they'll spend it, it'll go into the economy. Here's what we found out - rich people, really good at keeping all the money. That's how they got rich. If you want it in the economy, give it to the poor people. You know what they're really good at? Spending all their money.

Greg Fitzsimmons

Debates in Macroeconomics (Part H)

by

Charles Lamson

Testing Alternative Macroeconomic Models

You may wonder why there is so much disagreement in macroeconomics. Why cannot macroeconomists test their models against one another and see which performs best?

One problem is that macroeconomic models differ in ways that are hard to standardize. If one model takes the price level to be given, or not explained within the model, and another one does not, the model with the given price level may do better in, for instance, predicting output not because it is a better model but simply because the errors in predicting prices have not been allowed to affect the predictions of output. The model that takes prices as given has a head start, so to speak.

Another problem arises in the testing of the rational-expectations assumption. Remember that, if people have rational expectations, they are using the true model to form their expectations. Therefore, to test the assumption we need the true model. There is no way to be sure that whatever model is taken to be the true model is in fact the true one. Any test of the rational-expectations hypothesis is therefore a joint test (1) that expectations are formed rationally, and (2) that the model being used is the true one. If the test rejects the hypothesis, it may be that the model is wrong instead of expectations not being rational.

Another problem for macroeconomists is the small amount of data available. Most empirical work uses data beginning about 1950, which in 2021 is about 72 years (288 quarters) worth of data. While this may seem like a lot of data, it is not. Macroeconomic data are fairly "smooth," which means a typical variable does not vary much from quarter to quarter or year to year.

To give an example of the problem of a small number of observations, consider trying to test the hypothesis that import prices affect domestic prices. Import prices changed very little in the 1950s and 1960s. Therefore, it would have been very difficult at the end of the 1960s to estimate the effect of import prices on domestic prices. The variation in important prices was not great enough to show any effects. We cannot demonstrate that changes in import prices help explain changes in domestic prices if import prices do not change. The situation was different by the end of the 1970s, because by then import prices had varied considerably. By the end of the 1970s, there were good estimates of the import price effect, but not before. This kind of problem is encountered again and again in empirical macroeconomics. In many cases there are not enough observations for much to be said, hence considerable room for disagreement.

It is difficult in economics to perform controlled experiments. Economists are for the most part at the mercy of the historical data. If we were able to perform experiments, we could probably learn more about the economy in a shorter time. Alas, we must wait. In time, the current range of disagreements in macroeconomics should be considerably narrowed. 

*CASE & FAIR, 2004, PRINCIPLES OF ECONOMICS, 7TH ED., PP. 660-661*

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Muladhara Chakra Meditation

No Such Thing as a Free Lunch: Principle of Economics (Part 172)

Some people continue to defend trickle-down theories which assume that economic growth, encouraged by a free market, will inevitably succeed in bringing about greater justice and inclusiveness in the world. This opinion, which has never been confirmed by the facts, expresses a crude and naive trust in the goodness of those wielding economic power and in the sacralized workings of the prevailing economic system.

Pope Francis

Debates in Macroeconomics

(Part G)

by

Charles Lamson

Supply-Side Economics

From our discussion of equilibrium in the goods market, beginning with the simple multiplier in part 130 and continuing through parts 148-169, we have focused primarily on demand. Supply increases and decreases in response to changes in aggregate expenditure (which is closely linked to aggregate demand). Fiscal policy works by influencing aggregate expenditure through tax policy and government spending. Monetary policy works by influencing investment and consumption spending through increases and decreases in the interest rate. The theories we have been discussing are "demand-oriented."

The 1970s were difficult times for the U.S. economy. The United States found itself in 1974 to 1975 with stagflation---high unemployment and inflation. In the late 1970s, inflation returned to the high levels of 1974 to 1975. It seemed as if policymakers were incapable of controlling the business cycle.

As a result of these seeming failures, orthodox economics came under fire. One assault was from a group of economists who expounded supply-side economics. The argument of the supply-siders was simple. Basically, they said, all the attention to demand in orthodox macroeconomic theory distracted our attention from the real problem with the U.S. economy. The real problem, said supply-siders, was that high rates of taxation and heavy regulation had reduced the incentive to work, to save, and to invest. What was needed was not a demand stimulus but better incentives to stimulate supply.

If we cut taxes so people take home more of their paychecks, the argument continued, they will work harder and save more. If businesses get to keep more of their profits and can get away from government regulations, they will invest more. This added labor supply and investment, or capital supply, will lead to an expansion of the supply of goods and services, which will reduce inflation and unemployment at the same time. The ultimate solution to the economy's woes, the supply-siders concluded, was on the supply side of the economy.

At their most extreme, supply-siders argue that the incentive effects of supply-side policies were likely to be so great that a major cut in tax rates would actually increase tax revenues. Even though tax rates would be lower, more people would be working and earning income and firms would earn more profits, so that the increases in the tax bases (profits, sales, and income) would outweigh the decreases in rates, resulting in increased government revenues.

The Laffer Curve Figure 2 represents a key diagram of supply-side economics. The tax rate is measured on the vertical axis, and tax revenue is measured on the horizontal axis. The assumption behind this curve is that there is some tax rate beyond which the supply response is large enough to lead to a decrease in tax revenue for further increases in the tax rate. There is obviously some tax rate between 0 and 100 percent at which tax revenue is at a maximum. At a tax rate of 0, work effort is high, but there is no tax revenue. At a tax rate of 100, the labor supply is presumably 0, because people are not allowed to keep any of their income. Somewhere in between 0 and 100 is the maximum revenue rate.

FIGURE 2

The big debate in the 1980s was whether tax rates in the United States put the country on the upper or lower part of the curve in Figure 2. The supply-side school claimed that the United States was around A and taxes should be cut. Others argued that the United States was nearer B and tax cuts could lead to lower tax revenue.

The diagram in Figure 2 is the Laffer Curve, after Arthur Laffer, who, as legend has it, first drew it on the back of a napkin at a cocktail party. The Laffer Curve had some influence on the passage of the Economic Recovery Tax Act of 1981, the tax package put forward by the Reagan Administration that brought with it substantial cuts in both personal and business taxes.The individual income tax was to be cut 25 percent over three years. Corporate taxes were cut sharply in a way designed to stimulate capital investment. The new law allowed firms to depreciate their capital at a rapid rate for tax purposes, and the bigger deductions lead to taxes that were significantly lower than before.

Evaluating Supply-Side Economics

Among the criticisms of supply-side economics is that it is unlikely a tax cut would substantially increase the supply of labor.

Supporters of supply-side economics claim that Reagan's tax policies were successful in stimulating the economy. They point to the fact that almost immediately after the tax cuts of 1981 were put into place, the economy expanded and the recession of 1980 to 1982 came to an end. In addition, inflation rates fell sharply from the high rates of 1980 and 1981. Except for one year, federal receipts continued to rise throughout the 1980s despite the cut in tax rates.

Critics of supply-side policies do not dispute these facts but offer an alternative explanation of how the economy recovered. The Reagan tax cuts were enacted just as the U.S. economy was in the middle of its deepest recession since the Great Depression. The unemployment rate stood at 10.8 percent in the fourth quarter of 1982. It was the recession, critics argue, that was responsible for the reduction in inflation---not the supply-side policies. In addition, in theory, a tax cut could even lead to a reduction in labor supply. Recall our discussion of income and substitution effects in parts 27 and 29. Although it is true a higher after-tax wage rate provides a higher reward for each hour of work and thus more incentive to work, a tax cut also means households receive a higher income for a given number of hours of work. Because they can earn the same amount of money working fewer hours, households might actually choose to work less. They might spend some of their added income on leisure. Research done during the 1980s suggest tax cuts seemed to increase the supply of labor somewhat but the increases are very modest.

What about the recovery from the recession? Why did real output begin to grow rapidly in late 1982, precisely when the supply-side tax cuts were taking effect? Two reasons have been suggested. First, the supply-side tax cuts had large demand-side effects that stimulated the economy. Second, the Fed pumped up the money supply and drove interest rates down at the same time that the tax cuts were being put into effect. The money supply expanded about 20 percent between 1981 and 1983, and interest rates succumbed. In 1981, the average 3-month U.S. Treasury bill paid 14 percent interest. In 1983, the figure had dropped to 8.6 percent.

Certainly, traditional theory suggests that a huge tax cut will lead to an increase in disposable income and, in turn, an increase in consumption spending (a component of aggregate expenditure). In addition, although an increase in planned investment (brought about by a lower interest rate) leads to added productive capacity and added supply in the long run, it also increases expenditures on capital goods (new plant and equipment investment) in the short run.

Whether the recovery from the 1981 to 1982 recession was the result of supply-side expansion or supply-side policies that had demand-side effects, one thing is clear: The extreme promises of the supply-siders did not materialize. President Reagan argued that because of the effect depicted in the Laffer Curve, the government could maintain expenditures (and even increase defense expenditures sharply), cut tax rates, and balance the budget. This was not the case. Government revenues fell sharply from levels that would have been realized without the tax cuts. After 1982, the federal government ran huge deficits, with nearly 2 trillion dollars added to the national debt between 1983 and 1982. 

*CASE & FAIR, 2004, PRINCIPLES OF ECONOMICS, 7TH ED., PP. 658-66*

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No Such Thing as a Free Lunch: Principles of Economics (Part 171)

No single piece of macroeconomic advice given by the experts to their government has ever had the results predicted.

Peter Drucker

Debates in Macroeconomics

(Part F)

by

Charles Lamson

Evaluating Rational-Expectations Theory

From the last few posts, it should be clear that the key assumption concerning the new classical macroeconomics is how realistic is the assumption of rational expectations. If it approximates the way expectations are actually formed, then it calls into question any theory that relies at least in part on expectation errors for the existence of disequilibrium. The arguments in favor of the rational-expectations assumption sound persuasive from the perspective of microeconomic theory. If expectations are not rational, there are likely to be unexploited profit opportunities---most economists believe such opportunities are rare and short-lived.

The argument against rational expectations is that it requires households and firms to know too much. This argument says it is unrealistic to think these basic decision-making units know as much as they need to know to form rational expectations. People must know the true model (or at least a good approximation of the true model) to form rational expectations, and this is a lot to expect. Even if firms and households are capable of learning the true model, it may be costly to take the time and gather the relevant information to learn it. The gain from learning the true model (or a good approximation of it) may not be worth the cost. In this sense, there may not be unexploited profit opportunities around. Gathering information and learning economic models may be too costly to bother with, given the expected gain from improving forecasts.

Although the assumption that expectations are rational seems consistent with the satisfaction-maximizing and profit-maximizing postulates of microeconomics, the rational-expectations assumption is more extreme and demanding because it requires more information on the part of households and firms. Consider a firm engaged in maximizing profits. In some way or other, it forms expectations of the relevant future variables, and given these expectations, it figures out the best thing to do from the point of view of maximizing profits. Given a set of experiences, the problem of maximizing profits may not be too hard. What may be hard is forming accurate expectations in the first place. This requires firms to know much more about the overall economy than they are likely to, so the assumption that their expectations are rational is not necessarily realistic. Firms, like the rest of us---so the argument goes---grope around in a world that is difficult to understand, trying to do their best but not always understanding enough to avoid mistakes.

In the final analysis, the issue is empirical. Does the assumption of rational expectations stand up well against empirical tests? This is difficult to answer. Much work is currently being done to answer it. There are no conclusive results yet, but it is one of the questions that makes macroeconomics an exciting area of research. 

Real Business Cycle Theory

Recent work in new classical macroeconomics has been concerned with whether the existence of business cycles can be explained under the assumptions of complete price and wage flexibility (market clearing) and rational expectations. This work is called real business cycle theory. As we discussed in earlier posts, if prices and wages are completely flexible---that is not fixed and open for negotiation, then the aggregate supply (AS) curve is vertical, even in the short run. If the AS curve is vertical, then events or phenomena that shift the aggregate demand (AD) curve (such as changes in the money supply, changes in government spending, and shocks to consumer and investor behavior) have no effect on real output. Real output does fluctuate over time, so the puzzle is how these fluctuations can be explained if they are not due to policy changes or other shocks that shift the AD curve. Solving this puzzle is one of the main missions of real business cycle theory.

It is clear that if shifts of the AD curve cannot account for real output fluctuations (because the AS curve is vertical), then shifts of the AS curve must be responsible. However, the task is to come up with convincing explanations as to what causes the shifts and why they persist over a number of periods. The problem is particularly difficult when it comes to the labor market. If prices and wages are completely flexible, then there is never any unemployment aside from frictional unemployment (the result of voluntary employment transitions within an economy). For example, because the measured U.S. unemployment rate was 9.7 percent in 1982 and 4.2 percent in 1999, the puzzle is to explain why so many more people chose not to work in 1982 than in 1999.

Early real business cycle theories emphasized shocks to the production technology. Suppose there is a negative shock in a given year that causes the marginal product of labor to decline. This leads to a fall in the real wage, which leads to a decrease in labor supply. People have been led to work less because the negative technology shock has led to a lower return from working.The opposite happens when there is a positive shock: The marginal product of labor rises, the real wage rises, and people choose to work more. This early work was not as successful as some had hoped because it required what seemed to be unrealistically large shocks to explain the observed movements in labor supply over time.

Since this initial work, different types of shocks have been introduced, and work is actively continuing in this area. To date, fluctuations of some variables, but not all, have been explained fairly well. Some argue that this work is doomed to failure because it is based on the unrealistic assumption of complete price and wage flexibility, while others hold more hope. Real business cycle theory is another example of the current state of flux in macroeconomics. 

*CASE & FAIR, 2004, PRINCIPLES OF ECONOMICS, 7TH ED., PP. 657-658*

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Katy Trail

No Such Thing as a Free Lunch: Principles of Economics (Part 170)

We have the most flexible and adaptive economy. Making sure we sustain the ability of the American economy to perform well is really the priority of economic policy.

John W. Snow

Debates in Macroeconomics

(Part E)

by

Charles Lamson

 The Lucas Supply Function

Lucas begins by assuming people and firms are specialists in production but generalists in consumption. If someone you know is a manual laborer, the chances are she sells only one thing---labor. If she is a lawyer she sells only legal services. In contrast, people buy a large bundle of goods---ranging from gasoline to ice cream and pretzels---on a regular basis. The same is true for firms. Most companies tend to concentrate on producing a small range of products, but they typically buy a larger range of inputs---raw materials, labor, energy, and capital. According to Lucas, this divergence between buying and selling creates an asymmetry. People know much more about the prices of the things they sell than they do about the prices of the things they buy.

At the beginning of each period, a firm has some expectation of the average price level for that period. If the actual price level turns out to be different, there is a price surprise. Suppose the average price level is higher than expected. Because the firm learns about the actual price levels slowly, some time goes by before it realizes all the prices have gone up. The firm does learn quickly that the price of its output has gone up. The firm perceives---incorrectly, it turns out---that its price has risen relative to other prices, and this leads it to produce more output.

A similar argument holds for workers. When there is a positive price surprise, workers at first believe their "price"---their wage rate---has increased relative to other prices. Workers believe their real wage rate has risen. We know from theory that an increase in the real wage is likely to encourage workers to work more hours. The real wage has not actually risen, but it takes workers a while to figure this out. In the meantime, they supply more hours of work than they would have. This means the economy will produce more output when prices are unexpectedly higher than when prices are at their expected level.

This is the rationale for the Lucas supply function. Unexpected increases in the price level can fool workers and firms into thinking relative prices have changed, causing them to alter the amount of labor or goods they choose to supply.

Policy Implications of the Lucas Supply Function The Lucas supply function in combination with the assumption that expectations are rational (The rational-expectations theory posits that individuals base their decisions on three primary factors: their human rationality, the information available to them, and their past experiences.) implies that anticipated policy changes have no effect on real output. Consider a change in monetary policy. In general, the change will have some effect on the average price level. If the policy change is announced to the public, then people know what the effect on the price level will be, because they have rational expectations and know the way changes in monetary policy affect the price level. This means the change in monetary policy affects both the actual price level and the expected price level in the same way. The new price level minus the new expected price level is zero---no price surprise. In such a case, there will be no change in real output, because the Lucas supply function states that real output can change from its fixed level only if there is a price surprise.

The general conclusion is that any announced policy change in fiscal policy or any other policy has no effect on real output, because the policy change affects both actual and expected price levels in the same way. If people have rational expectations, known policy changes can produce no price surprises---and no increases in real output. The only way any change in government policy can affect real output is if it is kept in the dark so it is not generally known. Government policy can affect real output only if it surprises people; otherwise, it cannot. Rational-expectations theory combined with the Lucas supply function proposes a very small role for government policy in the economy.

*CASE & FAIR, 2004, PRINCIPLES OF ECONOMICS, 7TH ED., PP. 656-657*

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No Such Thing as a Free Lunch: Principles of Economics (Part 169)

Economic policy is like business - it's all about compromise.

John Delaney

Debates in Macroeconomics

(Part D)

by

Charles Lamson

New Classical Macroeconomics

The challenge to Keynesian and related theories has come from a school sometimes referred to as the new classical macroeconomics (used because of the assumptions and conclusions of this group of economists resemble those of the classical economists---that is those who wrote before Keynes). Like monetarism and the Keynesianism, this term is vague. and no single model completely represents the school. The following discussion, however, conveys the flavor of the new classical views.

The Development of New Classical Macroeconomics

New classical macroeconomics has developed from two different, though related, sources. These sources are the theoretical and the empirical critiques of existing, or traditional, macroeconomics.

On the theoretical level, there has been growing dissatisfaction with the way traditional models treat expectations. Keynes himself recognized that expectations (in the form of "animal spirits") play a big part in economic behavior. The problem is, traditional models have assumed that expectations are formed in naive ways. A common assumption, for example, is that people form their expectations of future inflation by assuming present inflation will continue. If they turn out to be wrong, they adjust their expectations by some fraction of the difference between their original forecast and the actual inflation rate. Suppose I expect 10 percent inflation next year. When next year comes, the inflation rate turns out to be only 5 percent, so I have made an error of 5 percent. I might then predict an inflation rate for the following year of 7.5 percent, halfway between my earlier expectation (10 percent) and actual inflation last year (5 percent).

The problem with this treatment of expectations is that it is not consistent with the assumptions of microeconomics. It implies people systematically overlook information that would allow them to make better forecasts, even though there are costs to being wrong. If, as microeconomic theory assumes, people are out to maximize their satisfaction and firms are out to maximize their profits, they should form their expectations in a smarter way. Instead of naively assuming the future will be like the past, they should actively seek to forecast the future. Any other behavior is not in keeping with the microeconomic view of the forward-looking, rational people who compose households and firms.

On the empirical level, there was stagflation in the U.S. economy during the 1970s. Remember, stagflation is simultaneous high unemployment and rising prices. The Phillips Curve theory of the 1960s predicted that demand pressure pushes up prices, so that when demand is weak---in times of high unemployment, for example---prices should be stable (or perhaps even falling). The new classical theories were an attempt to explain the apparent breakdown in the 1970s of the simple inflation unemployment trade-off predicted by the Phillips Curve. Just as the Great Depression of the 1930s motivated the development of Keynesian economics, so the stagflation of the 1970s helped motivate the formulation of new classical economics.

Rational Expectations

In previous posts, we stressed households' and firms' expectations about the future. A firm's decision to build a new plant depends on its expectations of future sales. The amount of saving a household undertakes today depends on its expectations about future interest rates, wages, and prices.

How are expectations formed? Do people assume things will continue as they are at present (like predicting rain tomorrow because it is raining today)? What information do people use to make their guesses about the future? Questions like these have become central to current macroeconomic thinking and research. One theory, the rational-expectations hypothesis, offers a powerful way of thinking about expectations.

Suppose we want to forecast inflation. What does it mean to say that my expectations of inflation are "rational"? The rational expectations hypothesis assumes people know the "true model" that generates inflation---they know how inflation is determined in the economy and they use this model to forecast future inflation rates. If there were no random, unpredictable events in the economy, and if people knew the true model generating inflation, their forecasts of future inflation rates would be perfect. Because it is true, the model would not permit mistakes, and thus the people using it would not make mistakes.

However, many events that affect the inflation rate are not predictable---they are random. By "true" model, we mean a model that is on average correct in forecasting inflation. Sometimes the random events have a positive effect on inflation, which means the model underestimates the inflation rate, and sometimes they have a negative effect, which means the model overestimates the inflation rate. On average, the model is correct. Therefore, rational expectations are correct on average, even though their predictions are not exactly right all the time.

To see this, suppose you have to forecast how many times a fair coin will come up heads out of 100 tosses. The true model in this case is that the coin has a 50-50 chance of coming up heads on any one toss. Because the outcome of the 100 tosses is random, you cannot be sure of guessing correctly. If you know the true model---that the coin is fair---your rational expectations of the outcome of 100 tosses is 50 heads. You are not likely to be exactly right---the actual number of heads is likely to be slightly higher or slightly lower than 50 but on average you will be correct.

Sometimes people are said to have rational expectations if they use "all available information" informing their expectations. This definition is vague, because it is not always clear what "all available information" means. the definition is precise, if by "all available information" we mean that people know and use the true model. We cannot have more or better information than the true model.

If information can be obtained at no cost, then people are not behaving rationally if they fail to use all available information. Because there are almost always costs to making a wrong forecast, it is not rational to overlook information that could help improve the accuracy of a forecast as long as the costs of acquiring that information do not outweigh the benefits of improving its accuracy.

Rational Expectations and Market Clearing If firms have rational expectations and if they set prices and wages on this basis, then, on average, prices and wages will be set at levels that ensure equilibrium in the goods and labor markets. When a firm has rational expectations, it knows the demand curve for its output and the supply curve of labor that it faces, except when random shocks disrupt those curves. Therefore, on average the firm will set the market clearing prices and wages. The firm knows the true model, and it will not set wages different from those it expects will attract the number of workers it wants. If all firms behave this way, then wages will be set in such a way that the total amount of labor supplied will, on average, be equal to the total amount of labor that firms demand. In other words, on average there will be no unemployment.

There might be disequilibrium in the labor market (either in the form of unemployment or in excess demand for workers) because firms may make mistakes in their wage-setting behavior due to expectation errors. If, on average, firms do not make errors, then, on average, there is equilibrium. When expectations are rational, disequilibrium exists only temporarily as a result of random, unpredictable shocks---obviously an important conclusion. If true, it means disequilibrium in any market is only temporary, because firms, on average, set market-clearing wages and prices.

The assumption that expectations are rational radically changes the way we can view the economy. We go from a world in which unemployment can exist for substantial periods and the multiplier can operate to a world in which (on average) all markets clear and there is full employment. In this world there is no need for government stabilization policies. Unemployment is not a problem that governments need to worry about; if it exists at all, it is because of unpredictable shocks that, on average, amount to zero. There is no more reason for the government to try to change the outcome in the labor market than there is for it to change the outcome in the banana market. On average, prices and wages are set at market-clearing levels. 

*CASE & FAIR, 2004, PRINCIPLES OF ECONOMIC, 7TH ED., PP. 654-656*

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