The Hypothetical World of Econs

One of my readings for my class ‘Macroeconomics in the Global Environment’ is George A. Akerlof’s The Missing Motivation in Macroeconomics (2007). It is a reading for the lecture on Business Cycles, however, it is much more intended to give us an idea about the state of the Macroeconomics profession today. The reading is also somehow a justification for why the class is dominated by New Keynesian thinking rather than New Classical thinking.

What I want to look at today is the consequences of New Classical Thinking for the field of Macroeconomics. It is inspired by Akerlof’s paper which gives an overview on the five neutrality results that derive from New Classical Thinking. First I am going to define the New Classical school of thought. Thereafter I am going to look at the implications of this view for the macro-economy before discussing the evidence in favour and against the five neutrality results in today’s economy.

New Classical Macroeconomics evolved in the 1970s and 1980s. It is the revival of the belief that shifts in the aggregate demand curve only change the aggregate price level, but not total output. Krugman and Wells (2009) point out that the return to the Classical view was triggered by two new concepts, namely (1) rational expectations theory and (2) real business cycle theory. The concept of rational expectations came into play in the 1970s and was first formulated by John Muth in 1961. Rational expectations theory argues that individuals and firms are utility maximisers, meaning that economic actors always make optimal decisions and take into account all available information. Rational expectations theory is based on the notion of rationality and the assumption that people are forward-looking creatures, thriving for optimal decisions. Richard Thaler and Cass Sunstein like to call these hypothetical individuals ‘Econs’. Their name stems from the idea of homo economicus. They describe these individuals as creatures that can “think like Albert Einstein, store as much memory as IBM’s Big Blue, and exercise the willpower of Mahatma Gandhi” (2009, p.6). Akerlof explains the revival of the Classical View with the belief that macroeconomic relationships should be built on microeconomic fundamentals, meaning that in order to develop proper macroeconomic theory, one has to take utility-maximising individuals and profit-maximising firms and create a truly rational economic system.

Having defined what New Classical Macroeconomics is (in a rather crude manner) and how it views individuals as Econs and firms as profit-maximisers, let’s take a look at the implications for such an economy. Akerlof points out that there are five separate neutrality results following from the New Classical school of thought. It should be noted, though, that these neutralities are also embraced by many New Keynesians while adding a range of frictions (credit constraint, market imperfections, information failures, tax distortions, staggered, contracts, uncertainty, menu costs or bounded rationality). These five neutrality results of the New Classical school of thought are:

  1. Independence of consumption on current income
  2. Irrelevance of current profits to investment spending
  3. Long-run independence of inflation and unemployment
  4. Inability of monetary policy to stabilise output
  5. Irrelevance of taxes and budget deficits to consumption (Akerlof, 2007)

The first neutrality result is the Life-Cycle Permanent Income Hypothesis, i.e. the concept that consumption depends on wealth and not on current income. Wealth is an individual’s permanent income, i.e. current income and the present value of future income (Akerlof, 2007). In the world of Econs there is no correlation between the consumption and current income, because individuals allocate their expenditures based on the present value of all their life-time earnings. This also implies that these individuals engage in what is called consumption smoothing and proper saving for retirement. Econs save enough of their current income for later and they also do not increase consumption in case of a pay rise or decrease their consumption in case of a pay cut.

The second neutrality result is similar to the first one but in the context of profit-maximising firms. The Modigliani-Miller Theorem states that a firm’s investment strategy does not depend on its current financial position (Akerlof, 2007). This is because a profit-maximising firm will only make profitable investments and therefore Modigliani and Miller (1958) argue that a firm’s liquidity position will not have any effect on current investment.

The third neutrality result is the Natural Rate Theory in Macroeconomics, a theory which is embraced by the majority of Economists today. It is based on the notion that there is an unobserved non-accelerating inflation rate of unemployment (NAIRU) in the economy. The National Rate Theory evolved as a response to the break-down of the perceived trade-off between unemployment and the inflation rate, also known as the Philips curve. In particular, the New Classical school of thought showed that this trade-off is at most a short-run phenomenon. In the long-run, there is a natural unemployment level which occurs when the economy is at its long-run equilibrium, i.e. at its potential output level. In this long-run unemployment trends back to its natural rate no matter what the inflation rate is.

The fourth neutrality result is Rational Expectations Theory which renders monetary policy ineffective for taming the business cycle. This is because wage and price setters will respond systematically to any changes in the money supply (Akerlof, 2007). Robert Lucas contributed a great deal to this neutrality result which is commonly known as the Lucas critique. Lucas argued that:

“Given that the structure of an econometric model consists of optimal decision rules of economic agents, and that optimal decision rules vary systematically with changes in the structure of series relevant to the decision maker, it follows that any change in policy will systematically alter the structure of econometric models.” (Lucas, 1976, p. 41)

In sum, wage and price setters will adjust their expectations in anticipation of monetary policy and will therefore adjust wages and prices accordingly offsetting the effects of an increase or reduction in the money supply.

The fifth neutrality result is the concept of Ricardian Equivalence and Akerlof (2007) points out that this is chronologically the last neutrality result embraced by modern Eonomists. According to this concept lump-sum inter-generational transfers do not impact current consumption. Akerlof (2007) explains this concept with the use of an example. Imagine that there are only two people, a parent and a child and that there are only two periods, period one and two. Furthermore the parent derives not only utility from her own consumption in period 1 but also utility from her child’s consumption in period 2. Then it can be shown that any inter-generational transfer does not change current consumption. In essence, this is because the present value of parents’ and children’s consumption is limited by the present value of the complete family’s earnings and the family’s initial wealth. Lump-sum inter-generational transfers, such as social security payments, do not change the family’s budget constraint. The lump-sum transfer merely redistributes earnings from one generation to another, leaving the aggregate pie unchanged and the parent will take into account that, in order to receive social security payments, her child will be taxed by government later.

Having looked at all five neutrality results in the world of Econs in detail, let’s take a short look at how plausible they are. Do individuals not alter their consumption if their current income changes? Do firms not change their investment strategy if their cash flows and therefore their liquidity position changes? First, there is evidence for a positive relationship between current income and current consumption in today’s economy. Second, there is clear evidence that managers maximise their own interests instead of the interests of their shareholders and that they often engage in so-called empire building because they only care about their own compensation or because of the prestige that comes with it (Akerlof, 2007). There is also an on-going debate about the third neutrality result and some Economists argue that the Philips curve, i.e. the trade-off between unemployment and inflation, might still exist. Especially when Central Banks target very low levels of inflation of 0 to 2 percent, this (almost perfect) price stability might come at a cost of higher long-run rates of unemployment. Assuming that economic actors form rational expectations (the fourth result) is crucial for the world of Econs; however, it does not resemble reality and in recent years fields like behavioural economics have evolved in response. There is compelling evidence that Humans are not Econs and good examples questioning the assumption of rational expectations are herd behaviour or risk aversion. Lastly, there are many reasons for why Ricardian Equivalence does not hold in today’s economy as opposed to the world of Econs. Akerlof (2007) points out that there are for example childless families, there is uncertainty induced by uncertainty about one’s age of death, tax distortions or a mere lack of foresight on the effect of inter generational transfer payments on future taxes. One can easily argue that pensioners are unlikely to take into account that their social security payments will increase the debt burden for future generations to come.

In sum, the New Classical school of thought has created a hypothetical economic system in which utility-maximising individuals and profit-maximising firms are well-behaved and always make optimal decisions leading to the five neutrality results described above. In practice, this is far from reality and one of the reasons for the revival of Keynesian thinking, the New Keynesian school of thought, which has evolved as a response. In addition, the failure of New Classical Macroeconomics has opened the door for new ideas, such as behavioural economics and other unconventional schools of thought. Also the failure of many Economists and Macroeconomic models in predicting the global financial crisis proved the need for such fresh ideas. What is more, it showed that we do not live in a world of Econs but in a world of Humans as Richard Thaler and Cass Sunstein put it aptly.

Thanks for reading!

Jasse


References

Akerlof, G.A. (2007). The Missing Motivation in Macroeconomics. American Economic Review, 97(1), 5-36. DOI: 10.1257/aer.97.1.5

Krugman, P., and Wells, R. (2009). Macroeconomics. New York, NY: Worth Publishers.

Lucas, R. (1976). Econometric policy evaluation: A critique. Carnegie-Rochester Conference Series on Public Policy, Elsevier, 1(1), 19-46.

Modigliani, F., and Miller, M.H., 1958. The Cost of Capital, Corporation Finance and the Theory of Investment. American Economic Review, 48(3), 261–97.

Thaler, R.H., and Sunstein, C.R. (2009). Nudge: Improving Decisions About Health, Wealth, and Happiness. New York, NY: Penguin Books.

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