Lucas: In the long run, we’re all prosperous anyway

April 10th, 2008 by isaac

Robert Lucas adds prognostication to his list of accomplishments in “Some Macroeconomics for the 21st Century,” a 2000 article published in the JEP.  This short article describes a fairly simple simulation of growth patterns across countries in a hypothetical alternate universe where, back in 1800, there were absolutely no differences in average income across equally populated (and one assumes equally naturally-endowed) countries.  Such a simulation produces results more or less similar to what we see in the relative growth data across nations over the past 200 years, and furthermore it suggests, says Lucas, that come 2100, income across nations will be high and relatively constant.  Lucas concludes (with tongue in cheek, one hopes) that those people living a century from now will be surprised to see that the conditions of the contemporary world very much agree with the predictions of Lucas’s simple model.  I will elaborate first on Lucas’s model and his discussion of it, and then conclude with my own thoughts.

As previously mentioned, Lucas’s model is based on a simulation wherein at time t = 0, a set of essentially homogeneous countries are standing behind a sort of economical starting gate.  The gate opens, but only such that one or a few countries are allowed to start their industrial revolutions in every time period.  The first to spring into the industrial revolution experiences a constant growth rate of 2% a year.  With each new time period, a new country or set of countries enters the industrial revolution and experiences unconditional convergence (in terms of income) to the first country.  The probability that any country enters into the industrial revolution is increased  over time as average world income increases (per the Solow growth model that we have all come to know and love).  In other words, countries’ incomes converge to that of the first country on the condition that they enter the industrial revolution, which occurs amongst more than 90 percent of all the countries by the year 2000.

There will, of course, be income inequality across countries (Lucas does not touch on income inequality within countries) as the countries enter the industrial revolution and begin the long process of convergence.  In fact, the model predicts that the variance of income distribution is at its peak in the decades from 1960 to about 2000.  Thereafter, inequality tapers off; by 2100, 300 years after the first country industrialized, the distribution of incomes exhibits a log standard deviation of about .5 and is still well on its way down.   

Lucas at least appears fairly convinced of the stylized facts of his model.  He recognizes that war, natural disasters, policy changes, and so forth will occasionally insinuate themselves, but these are not included in the model and in any event appear unimportant (in the long run).  One gets a feeling from Lucas that humans somehow interfere in their own indelible march towards Utopia; he does not rather think that the triumphs and trajectories and stops and starts of history are essential to the human experience.  To put this more concisely, humans don’t mean to get in the way of their own progress, though they sometimes do, and in the end things will work themselves out anyway – no worries.  In the long run, we’re all prosperous anyway.   

It sounds like the policy ineffectiveness hypothesis writ large.  Lucas reminds us that it doesn’t really matter what society you’re talking about – Communist/Socialist, ex-colonial, or run-of-the-mill post-industrial.  There may be ways to slow this process and ways to speed it up but there is no way to stop the march of progress. 

I will have more to say about this article as I develop my thoughts on the Hoover article.  

Posted in e488-puttingitalltogether | No Comments »

Kantor’s “Rational Expectations and Economic Thought”

February 9th, 2008 by isaac

This article by Brian Kantor is probably best understood as a defense of the rational expectations hypothesis by demonstration 1) of its (apparently) common-sense consequences and 2) the empirics that bear it out.  It is divided into a history of the hypothesis’s development and relevant precedents, an account of its movement from hypothesis into a utile theory, and a discussion of its various actual and potential applications.  Kantor’s position is clearly stated in the conclusion: Rational expectations is here to stay and has changed macroeconomics for the better.

The impetus for a rational expectations theory appears to derive, as it seems do most new developments in the economics of the 60s and 70s, from a recognition of the failure of policies informed by the long-run Phillips curve.  Rampant inflation in the 60’s followed by stagflation in the 70s demanded a “new” approach, which, the likes of Kantor thought, demanded a partial return to classical ideas and a critical appraisal of Keynes and the economic policies derived from his General Theory.  In particular, it was suspected that policy changes were broadly anticipated by market participants and that, therefore, prices mostly - if not entirely - reflected these anticipations.  If I am reading Kantor correctly, he seems to be suggesting that a strong version of the idea that economic actors might actually be able to develop expectations of the future based on current trends and events and past experiences was nigh revolutionary.  In other words, it was not broadly suspected that such information was widely accepted and integrated into economic actors’ supply and demand schedules.  It was as if economists considered it implausible that their ilk might be employed by the private sector and use standing theory to make forecasts about the future.  Besides, if economists held the monopoly on knowledge of future market movements, then wouldn’t it stand to reason that all economists would invest and become quite wealthy?

The general outline of the rational expectations hypothesis is that there are three factors which market participants observe and for which they adjust.  There is the information from the previous period about market movements and responses (especially in relation to policy changes and reactions), anticipation of the market movements of the current and future periods (which are functions of that history as well as current real and nominal factors), and a stochastic disturbance term with a mean at zero.  After the time period is up, actors observe outcomes and adjust accordingly.  The stochastic terms are assumed to not be serially correlated; that is, as Kantor observes by way of the Austrian economist Lachmann, consistent systematic error on the part of particular actors is weeded out by competition applying the available information. 

Throughout the seventies (this paper was published in December 1979), the rational expectations hypothesis was born out by empirical study.  Kantor particularly focuses on studies of the equities markets, since they produced ample if not definitive evidence against Keynes’s notion that changes in investment were, it seemed, entirely explicable by the idea that it was driven by speculation and “animal spirits.”  The efficient markets hypothesis – the idea that prices reflect all the available information about past, present, and future market conditions – garnered a great deal of support from these studies, and would definitely seem to go against Keynes’s implicit preference for a strong role of a more ‘rational’ central authority.  However, critics have suggested that this is all well and good when discussing investment, but other markets – such as those for labor – are less apt to be explicable from a rational expectations perspective.  The answer here for Kantor and others is that both sides of the labor market are liable to make decisions based on the information available, but they may no doubt have some difficult distinguishing whether shocks to the economy are temporary or permanent, positive or negative.  Evidence suggests that this uncertainty leads to a regular deviation about some trend (in terms of employment or economic activity).  The lags in bringing new information into decisions, or delays in the acquisition of relevant information, may be as Robert Lucas suggests, an important source of economic fluctuations which we know as the business cycle.

What does this say for stabilization policy?  Well for one it suggests that it was entirely misguided insofar as it had been conducted up to that point. Unless policy makers can somehow find a way to surprise the market every time they attempt to guide it, it would be very difficult to ’shock’ it in the way that they might hope.  It may be difficult to keep one step ahead of the market at every turn. 

Instead, Kantor suggests that efforts and resources expended in smoothing the business cycle may best be spent in improving the function of existing institutions and in bringing new, helpful institutions into existence.  On this, at least, Kantor remains substantially vague, and I think this is to his credit.  There are, it seems to me, two roads here.  On the one hand, it may provide support for those who believe government has as a tendency to get in the way of and disrupt otherwise well-functioning markets.  To wit, one might suggest that deregulation, lower taxes, etc. etc. are the key.  This will give added incentive for entrepreneurs to find means to improve flows of productive factors and information between markets.  On the other hand, for those more inclined for government-supported solutions, there is the road of policy taking an active role in creating institutions that serve this same purpose.  Nonetheless, we must grant the other side that, even in this, the private sector just might be able to do it better and more efficiently.  The debate is unavoidable, and it continues. 

Good article, fairly intelligible.  I have avoided, despite the voices of my better angels, discussion of some of the philosophical implications here. Suffice it to say that while there is ample evidence and good old-fashioned intuition that rational expectations is the ‘right’ way to go, we may want to question (as I did in my previous and equally long-winded entry) just how far we want to take it without wondering what sort of queer and possibly inefficient or disastrous paths our ‘rational’ expectations, taken in the aggregate over a long period of time, might lead us down.

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Friedman’s “The Role of Monetary Policy”

February 5th, 2008 by isaac

Like many other people in the class, I chose to read Friedman’s (apparently) influential 1967 presidential address before the Eightieth Annual Meeting of the American Economic Association.  I have also perused a couple of the other articles from the reader, so if some of their content seeps into this review, that is why.

 Friedman’s goal is as the title states; he desires to outline what the goals of monetary policy should and should not be, and much of this is based on his work in resurrecting the quantity theory of money over the previous decade.  After an introduction that relates a brief history of the valuation of monetary policy in the decades preceding and following Keyne’s General Theory, Friedman divides his talk into three sections:  What monetary policy cannot do, what monetary policy can do, and how monetary policy should be conducted.

As for what monetary policy can not do, Friedman claims that it can peg neither a specific interest rate nor a particular unemployment rate for the long run.  Here Friedman is explicitly referring to his natural rate hypothesis.  When interest rates are raised or lowered above the natural level (as through open market operations), individuals will begin to see an unexpectedly larger quantity of money in their pockets.  They will feel their income has increased, and as that money moves through the economy, the price level may rise.  Additionally, greater income means a greater demand for loans and the like, bidding up interest rates.  The only way to prevent this is to increase the rate of money growth at an increasing rate, and this is even more true as expectations adapt, requiring even greater acceleration.  Even when the rate of money growth is slowed to previous levels, interest rates will probably continue to rise and overshoot the natural rate, below which the money infusions were meant to keep interest rates in the first place.  Thus, monetary policy can not peg interest rates in the long run.  

It is not hard to see how this same reasoning may be applied to the unemployment rate, and here we see Friedman’s proposition of the vertical long-run Phillips Curve.  More money means greater income means greater demand for goods and services.  This leads to an increase in the value of the marginal product of labor, increasing labor demand.  But here aggregate demand/supply analysis tells us that the price level will increase, increasing real wages and reducing labor demand.  The only way to keep unemployment below its natural level for more than a short period is, as with the interest rate, to increase the acceleration of money growth, and this leads to inflation and its various and sundry dire effects.

Friedman’s ideas of what monetary policy can do is very much reflective of Friedman’s position on the role the government should play in the economy (not much).  First, monetary authorities shouldn’t screw up.  Monetary policy can have powerful effects on the economy whether it is done well or not, as the Great Depression attests.  Second, monetary policy should be conducted conservatively as often as possible so that, when its powers truly are needed, it can achieve maximum effect.  Essentially, people should not expect the Fed to act except in dire circumstances so that it remains a potent tool.  Finally, monetary policy can indeed act to great effect in times of serious economic disturbance, but should not engage itself in fine-tuning the economy.  This is not so much a third point as it is a necessary conclusion from the first two points.

Finally, Friedman concludes with a note on the conduct of monetary policy, in which he prefers that a rate of monetary growth be the goal rather than an interest rate.  Here, at least, history has not born out Friedman’s thought.  With deregulation of the financial markets and the volatility of the 1970’s and 1980’s, sudden and drastic changes in the money supply became the norm, and it became inadvisable to trust any one measure of money (M1, M2, etc.).  Now, as I understand it, the Fed controls money demand through interest rates, letting the chips of money supply fall where they may.  Edit: The previous sentence is incorrect. The Fed lets money demand fluctuate and targets interest rates by adjusting money supply.

If this article truly is one of the most influential of all works in economics, I think I can see why.  It is clear and concise and represents a powerful rejection of the standing thinking of the time.  One thing bugs me, however, and my guess is that more current theory would bear this out.

Specifically, I simply don’t buy the position that changes in the money supply are neutral in their effect on the economy in the long run.  It strikes me, and Mayer discusses this only in analytical detail in his article “The structure of monetarism,” that the aggregate effects of monetary policy changes depend a great deal on 1) transmission mechanisms and 2) the state of individual sectors of the economy at the time of the change.  I would argue (against a very strict rational expectations assumption) that nominal changes in money supply are registered in the near-term as real changes.  If investment and consumption decisions are based on perceived real changes, this can have long-lasting effects on the structure of the economy.  Investment may be undertaken that has no basis in “real”-ity so that excess money is filtered into the hot sectors of the day.  But if such investments are long-term in nature, such as in real-estate or expensive equipment, a nominal change in the money supply may nonetheless bring about long-run real changes in the economy.  Empirically, I suspect this hypothesis is incredibly difficult to prove.  As Mayer also discusses, monetarists and the schools into which it evolved rely on reduced form equations that perceive the process by which interest rates are changed as black box.  On the other hand, large structural models preferred by Keynsians and those of a similar vein are bound to be criticized, and rightly so, for failing to account for certain vital factors or for violating ceteris paribus constraints. 

Yet my instinct remains – monetary policy can give impetus to actions that bring about economic restructuring, possibly by reinforcing network effects and leading to path dependence.  A neutral monetary policy, it seems to me, would require policy-makers to judge the amount of money needed in each sector (a seemingly impossible task bound to be erroneous in its conclusions) and find ways to bring money into each of those sectors, accordingly. 

A complete theory of monetary policy effects would have to account for this possibility. Anyway, that’s my two cents.  Thoughts? 

Posted in e488-monetarism | 1 Comment »

Lekachman Ch. 4

January 27th, 2008 by isaac

Continuing from the previous post, chapter 4 of Lekachman’s The Age of Keynes is entitled “The General Theory,” and comprises a terse outline of the major ideas and critiques presented in Keynes’s General Theory.  Like Chapter 3, and I can only assume this is true for the rest Lekachman’s book, it is quite accessible and well-written.  I picked up a copy of The General Theorya few days ago for about eight bucks, and after reading about 18 pages over the course of two days, I can attest to Lekachman’s statement that the book is “…a difficult, technical treatise…”  Still, it is manageable with careful reading and a bit of knowledge of Keynes’s intellectual forbears.

The full title of the book is The General Theory of Employment, Interest, and Money, and it tackles in turn each of these matters and seeks a way to tie them together.  Keynes work was motivated by the failures of classical postulates to account for any economic state that did not exhibit full employment; hence his belief that classical economics, rather, was a special case of a more “general theory” which accounted for the possibility of any number of equilibria where employment was less than full.  He first sets out to call Say’s Law (“Supply creates its own demand”) into question; supply was only one part of the story.  It becomes necessary to define an aggregate demand, independent from aggregate supply (at least in the short-run which is all that with which Keynes concerns himself; keep that in mind as you read on).  Aggregate demand for wage-goods – those products demanded for consumption by wage earners – is determined primarily by income.  If a rise in the price of wage-goods relative to wages – which would increase the marginal product of labor, thus giving producers the incentive to hire more labor, and which would increase the level of income desired by both workers and the unemployed – causes both a shift in the aggregate supply of labour and in the aggregate demand for labour, then it can not be said that the economy is currently at full employment.  But then this offers one a way out of an equilibrium of less-than-full employment: increase aggregate demand.  How to do this?  Increase income.  How to increase income?  Public works funded with deficit spending. 

Keynes’s conclusion on this point arises from his observation that classical economics committed a logical fallacy by assuming that if it behooves one firm to lower the wages it must pay, it must thereby behoove all firms to do so. Yet this is incorrect, since lower wages across the board reduce income, thereby reducing aggregate demand, and therefore leading to an equilibrium level of employment below full.  It strikes me that Keynes’s analysis here implicitly assumes that markets are imperfectly competitive, and that wage earners are wage takers, and not on an equal footing with the employer in the wage-bargaining process.  Indeed, I think this becomes fairly clear in the first 18 pages of his book, and it would seem to jive with Keynes’s populist/Labour Party tendencies that Lekachman evokes in chapter 3. 

Another piece of Keynes’s system was his discussion of investment.  Here Keynes seems to reduce investment decisions to a rather unsatisfactory set of notions about investor moroseness or exuberance about the potential or actual marginal efficiency of capital on which investment dollars are spent.  The beneficent state, by taking some control over the investment reins, might stabilize the environment, allowing for more predictable outcomes to investment.  Under the assumption that investment decisions are so loosely and unscientifically determined, then only large interest rate changes will have an appreciable effect in one direction or another on investment.  I’m not a big fan of this point, if it is indeed as unsubstantiated as Lekachman seems to characterize it. 

I’m not perfectly clear on this, but there seems to be an alternative framework for investment.  Keynes apparently rejects the classical idea of a savings/investment equilibrium determined by calculations of time preferences, marginal efficiencies of capital, etc.,  which in turn determine an equilibrium interest rate.  For savings, he seems to think that it is determined not by time preference but by liquidity preference as well as the interest rate.  Money held in stock for a variety of reasons was not by any means saved, and so had nothing to do with determining the interest rate.  Instead, it was speculators, focused solely on the expected rise and fall of securities’ prices, which made predictions of and thereby determined the interest rate; in other words, interest rates are self-fulfilling prophecies.  When equities prices fall then the potential yield (the interest rate) on that equity must rise, since a marginal increase in the equity’s value will be a larger percentage rise at a lower price than at a higher price.  The corollary is also true.  Says Lekachman:  “…the rate of interest is indeed a premium, but a premium paid for surrendering cash, the perfectly liquid asset, for securities, imperfectly liquid assets.”  

But if investors expect interest rates to rise and thereby divest themselves, then the government can step in and purchase securities to hold interest rates down.  This is precisely what open market operations, performed by central banks, achieve.  Furthermore, it is well within the purview of public policy to smooth the movement of interest rates and prevent large fluctuations.  Here is yet another entrance for the public sector to perform in various and sundry ways to regulate the private.  The multiplier process discussed in chapter three (see previous post) suggests that small changes in investment will lead in turn to large increases in consumption (aggregate demand) and therefore monetary and fiscal policy both are viable means for the government to intervene and bring an economy out of an equilibrium of less-than-full employment.

I hope have that I have done justice to a single chapter that attempts to do justice to an entire book.  He was a bright guy, this Mr. Keynes, but I see some of those flaws upon which others would fixate in hindsight, and I’m looking forward to reading those critiques and seeing it culminate in a resurrection of classical thought.   

Source:  Lekachman, Robert.  The Age of Keynes.  Chapter 4.  New York:  Random House, 1966.   

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Lekachman Ch. 3

January 24th, 2008 by isaac

I’m going to do this commentary over two entries since this is a fairly large reading. 

Chapter 3 of Lekachmen’s The Age of Keynes is entitled “The Road to The General Theory,” and, as the name suggests, it focuses – somewhat on the material and historical but primarily on the intellectual and theoretical – background upon which Keynes’s General Theory was formulated.

Lekachmen first reminds us of the context, which is always important.  The Treaty of Versailles required massive reparations from the Central Powers and redrew political boundaries, upsetting the status quo of the pre-WWI era and leading to serious social and economic difficulties both domestic and international.  Keynes recognized that this put a serious strain on, among other previously tried and true features of the contemporary economic policy, future primary use of the international gold standard upon which most currencies were based.  This was exacerbated by the fact that in the new economic world order, the United State Federal Reserve had enormous power to affect the ebb and flow of gold-backed currency in and out of the economy, and in general most of the power over the value of gold was more and more concentrated in the hands of a few central banks.  Already a man with a taste for the heretical, Keynes did little to hide his distrust of the gold standard, and advocated that, at best, governments should hold tightly to the reins of the precious metal. 

Over the course of the 1920’s and through to 1933, Keynes published a series of works in which one can observe the birth and adolescence of Keynes iconoclasm and the development of thought that would lead to the General Theory.  In due course, he would come more and more to question the validity of Say’s Law (“Supply creates its own demand”) and the notion that troughs in the business cycle called for more savings and lower real wages.  To the contrary, Keynes’s suspicion grew that there was no automatic mechanism that matched savings to investment, that thrift was by no means the path to success, and that government machinations may be the only means to kick an economy in the direction of full employment.  All of this was flying in the face of most of his colleagues at Cambridge and elsewhere, who like Keynes were students (one way or another) of the neoclassicists like Marshall and Pigou and their intellectual predecessors.  Yet it seems no one, not even Keynes, was fully aware of his work’s implications; he was still carving out a niche for himself in his profession. 

Keynes would adopt the concept of the multiplier from one of his younger colleagues, R.F. Kahn, and he would come to apply it in a way that made deficit spending and other public expenditures very tempting to policy-makers in his 1933 book “Means to Propserity.”  Keynes flirtations with government interference in the market required fair mix of theoretical mastery and political savvy, and the multiplier gave him the means to maintain the latter without leaving the confines of the former.  We all know the idea of the multiplier from intermediate macro, but for Keynes it was something of a selling point.  Yes, you might spend 4.5 million pounds now, but a third of that will be covered by the new tax revenues resulting from new employment as the money trickles through economy, and who knows how much more of a tax receipt windfall will result from a sustained increase in economic prosperity?

I have provided here only a gloss but I really do recommend this reading; Lekachman is quite the lucid writer and one can only benefit from knowing the foundations from which Keyne’s built his General Theory.  I don’t have any substantive commentary on the content of this chapter except that I am extremely curious to see how, with the advent of neoclassical growth, economists of either persuasion begin to reconcile the Keynesian with the neoclassical.  It almost seem to me as if the two are well-nigh incompatible, at least with regards to bridging the gap between short-run economic fluctuations and long-term growth.

Source:  Lekachman, Robert.  The Age of Keynes.  Chapter 3:  New York:  Random House, 1966.   

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Neoclassical Economics

January 18th, 2008 by isaac

What is valued and how do we value it?  This is a question humans asked and attempted to answer long before the classical school of economics was born with Smith’s Wealth of Nations. Aristotle believed that value was intrinsic to an object, a property of its underlying substance.  While David Hume would reject this claim to powerful effect in the mid-1700’s, the field of economics would not fully shake itself free of this conception until the late-19th century.  The labor theory of value, elaborated and utilized tenaciously by Karl Marx in his attacks against capitalism, was not merely some communist delusion; it was the basis of the classical economists’ explanation of prices, which were thought merely to fluctuate around a commodity’s “real” value – the amount of labor accumulated in the commodity.  This came from the immediate physical labor of the worker, but also from the machinery (itself built by labor) that was used in the production process.  The money fetched by the commodity, then, was thought to be distributed according to the labor each member of the production process could mobilize.  Thus did the capitalists, mobilizing labor through their tools and machines, get their piece in the form of profits, the workers get their piece in the form of wages, and so forth. 

This conception of value was problematic, in that it consistently failed to predict the buyer’s willingness to pay for an item given what it was worth.  A paradigm shift took place, its intellectual roots in David Hume’s work in which he argued that their was nothing intrinsic to any object (including humans); rather, knowledge was based on the juxtaposition of things and their qualities, and thus so was value.  This in mind either explicitly or implicitly, late-19th century economists became less interested in the real “worth” of an object and more in how buyers and sellers seemed to value items in relation to one another.  This was the groundwork of the so-called marginal revolution, which suggested that people were not interested in the “real” value of a commodity – that is, it’s value in terms of labor – but rather in the extra utility (revenue) that purchasing (producing and selling) one more unit of the commodity would provide to the buyer (producer), relative to the costs of acquiring (making) it.  When theses costs and benefits are in equilibrium, no more units will be bought or sold.  Value becomes linked to notions of scarcity and unlimited wants, and the tensions between the two is worked out in markets.  This is the basis for supply and demand analysis, and it also clarifies market entrance and exit on both sides of the exchange.  Along with the help of a few simplifying assumptions, it comprises the foundations of what we now call neoclassical economics.

These assumptions, as discussed in the article, are threefold:
1) People have rational preferences among outcomes.
2) Individuals maximize utility and firms maximize profits.
3) People act independently on the basis of full and relevant information.

Neoclassical economics atomizes the individual so that her decisions come down to the solutions to one or two simple equations, and when economists aggregate those decisions they can develop workable theories of markets for just about anything one can conceive – from Playstation 3’s and the labor used to build them to marriage partners.  It was the mathematization of economics, as the author of this article discusses, that gained it acceptance as something on par with physics as a science.  The insatiable appetite for that which satisfied notions of modernism – the idea that the world can only benefit from progress and development technologically, intellectually, morally, and so on (and that the ‘modern’ society embodies those ideas) – encouraged these developments and made them concrete.  Once neoclassical, mainstream economics gained recognition as a science, it became extremely difficult to challenge in the countries that most esteem this label, such as the UK and USA. In these bastions of economic thought, it is the neoclassical conception of economics that students are taught, to the exclusion of alternative approaches, such as Marxian, Austrian, neo-institutional, and so on.  For the most part, neoclassical economics does not abdicate authority to these heterodox groups when it fails to explain certain phenomena, but rather borrows from them and implements their ideas as necessary and in such a way as satisfies the neoclassical notions of optimization.  

In neoclassical economics, outcomes are considered best in the Pareto-efficient sense when “any other allocation of goods and services would leave someone better off,” meaning that if someone were to take an equilibrium defined by a well-functioning market and redistribute the resultant allocation, the total utility experienced at equilibrium would be less than the one produced by the unfettered machinations of the “invisible hand.”  Much of the frustration that spawns alternative schools of economic thought arises from disagreement with the mainstream’s fundamental assumptions as outlined above.  In my opinion, the resilience of the mainstream seems to arise from two factors.  First, it aligns quite readily with how westerners buy and large tend to think of themselves and others.  We often see ourselves as rational, autonomous individuals that make the decisions that are most satisfying to us given the outcomes we expect, and as we are the ones most often under study in economics, we are prone to impute such assumptions into our analyses.  Second, evidence that goes against the assumptions is often and easily construed in a way that it is made to fit the framework.  Notions of “incomplete information”, “bounded rationality”, and cultural peculiarities can be modeled or otherwise understood with a fair degree of accuracy using probability distributions, cognitive neuroscience, or careful study of the subject and subsequent retooling of the fundamental decision equations.  Neoclassical economics is notoriously flexible as an analytical framework, is able to maintain an acceptable level of clarity even after some relaxation of its assumptions, and on these facts turns its continued support and utility as the main school of thought in economics.

This article is short and easily understood, but some may question the author’s objectivity as a commentator on such important information (though certainly not as an economist); his judgment in calling detractors from the mainstream “kooks” or “antiscientific” is not only a gloss – it is outright wrong.  Except to the extent that adherents often downplay these alternative views, however, there is nothing “wrong” with neoclassical economics.  In any event, the idea of value in economics has some very deep and fascinating roots that one can learn in any class or book on the history of economic thought. 

Reference:  Weintraub, E. Roy, “Neoclassical Economics”, The Concise Encyclopedia of Economics. Liberty Fund, Inc. Ed. David R. Henderson. Library of Economics and Liberty. 18 January 2008. <http://www.econlib.org/library/Enc/NeoclassicalEconomics.html>.

Posted in e488-classical | 2 Comments »

Irving Fisher

January 18th, 2008 by isaac

Irving Fisher was one of the most prolific economists of the 20th century, both because of the magnitude of his contribution and his ability to relate his ideas to readers with a comprehensible and pithy writing style.  Says the author of the article “…graduate economics students, who to this day still study [Fisher’s Theory of Interest, one of his most important works], often find that they can read – and understand – half the book in one sitting.” 

According to the article, Fisher’s contributions to economics lie in his work on money and interest, and also in his sensible use of mathematics to sharpen his analysis.  In the book just mentioned, Fisher’s Theory of Interest, he fleshed out what continues to be the mainstream conception of interest rates – that they are indexes “‘of a community’s preference for a dollar of present [income] over a dollar of future income.’”  Furthermore, the value of capital is the income it produces – net of initial costs and depreciation – vis a vis the interest rate.  Finally, with respect to interest rates, Fisher was the first to make a clear distinction between the real and nominal interest rates and to show that the former was equal to the latter less inflation.  All of these notions are central to how economists conceptualize interest and the relationship between capital and income.

Fisher was also one of the first to construct and utilize price indices, and no doubt this was empirically useful in his work on the quantity theory of money, laying the groundwork that allowed the monetarists like Friedman and his ilk to interrogate Keynesianism to near-revolutionary effect in the 1960s.  The equation of exchange is a very useful identity, formulated by Fisher, that can be used to ‘check the math’ on a variety of statements about economic policy effects.  It states that MV = PT, where M is the stock of money, V the velocity (or circulation rate) of money, P is the price level, and T is the total volume of transactions (we now use y instead of T, where y is stands for real income).  If any one variable is changed, at least one of the others must change to maintain the equality. 

From the author’s description, Fisher was something of a jack-of-all-trades and a man of many firsts.  He earned the first PhD in economics from Yale before the ivy league school even had an economics program.  He had a somewhat dubious social agenda, being a supporter of eugenics, Prohibition, and “peace.”  He also lost some face when, during the Great Depression, he insisted that recovery was imminent for several years.  (Incidentally, Fisher himself lost a great deal of wealth in the crash of 1929). 

Overall, the article was interesting but too much of a gloss to glean too much information.  I was, however, intrigued by the suggestion that he was a good writer, and since Fisher’s work is older, it is generally available for free on the internet.  For instance, you may find Fisher’s Theory of Interest here.

 Source:  “Biography of Irving Fisher.”  The Concise Enyclopedia of Economics.  Liberty Fund, Inc. Ed.  David R. Henderson.  Library of Economics and Liberty. 18 January, 2008.  http://www.econlib.org/library/Enc/bios/Fisher.html

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