Advanced Macro Theory I

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I just read Ricardo Caballero and Alp Simsek’s  “A Note on Temporary Supply Shocks with Aggregate Demand Inertia” in the recent issue of AEJ: Insights. It is a good, useful paper. From their abstract: “We study optimal monetary policy during temporary supply contractions when aggregate demand has inertia and the central bank is concerned about future constraints on expansionary policy. In this environment, it is optimal to run the economy hot until supply recovers. However, the policy does not remain loose throughout the low-supply phase. Overall, when the initial aggregate demand is low, the goal is to frontload the rate cuts to raise demand in anticipation of the recovery of supply. If inflation also has inertia, the central bank still overheats the economy during the low-supply phase but gradually cools it down over time.”

The critique. I repeat, a good, useful paper. My objection is it could have been much more. This post argues how it, along with a great deal of New Keynesian research, could been more aligned with available evidence and more powerfully described the problem at hand. better and more usefully. The difficulty to be corrected is general inattention to the fundamental commitment of the New Neoclassical Synthesis. Seeking mainstream status, NK theorists pledged that their macro modeling would be rooted in rational behavior. A long career making sense out of difficult, high stakes macro problems has persuaded me that close, not perfunctory, attention should be paid to rationality. Substituting assumptions of convenience almost always misleads, typically badly. At a minimum, resorting to convenience must be carefully justified.

A recurrent theme of the GEM Blog is the casual scrapping of rationality, particularly in labor pricing, robs macro modeling of powerful guidance. The use of rationality to motivate behavior is arguably the most useful innovation in the development of economics. If carefully pursued, rational behavior has a record of opening up analyses to important, often unanticipated, results.

C&S reject rationality by casually positing irrational labor-pricing. Like a great deal of NK research, the dismissal of rational-behavior wage determination produces an arbitrary, stripped-down context that closes off pathways to usefully enrich their inertial-demand analysis. That enrichment typically turns out to be profound. The contours and particulars of an economy constructed on the  two-venue modeling, featured in the GEM Project and rooted in optimization and general decision-rule equilibrium, powerfully differs from the one erected on single-venue general market equilibrium. 

C&S have joined a long line of NK research illustrating a crucial puzzle in mainstream macroeconomics. Rigorous rational-behavior wage determination consistent with the evidence has already been successfully modeled in this website and elsewhere. C&S could have incorporated  results of that previous work into their article at almost no cost. In so doing, they would have acknowledged that the key to useful labor-pricing modeling after the Second Industrial Revolution is the intuitive addition of a second venue of rational exchange to textbook market-centric modeling. The new venue is comprised of firms in which workplace employer-employee information is inherently asymmetric. That condition is characteristic of a substantial share of the total labor force in any modern, highly specialized economy, making confinement of labor pricing wholly to the marketplace deeply problematic. The exclusion of millions of workers in large, highly specialized firms from market-centric analysis is a problem that macro theorists ignore to their own peril.

Paying attention to the fact of information-challenged workplaces would immediately upgrade the C&S article to the elite status of macro models rooted in neoclassical tenets of optimization and equilibrium. Not even cranky Real Business Cycle theorists, always conscious of the terms of the New Neoclassical Synthesis, could properly reject it.

In summary. Consider the case for and against the general use of the powerful results of the generalized-exchange model. The basic argument for usage is its consistency with Edwin Malinvaud’s (1977) insightful definition of great theoretical achievements: “…the characteristics of great theoretical achievements [are] clear foundations, consistency with many observed facts, unification of theories which previously appeared as fundamentally distinct.”

The two-venue model grounds wage setting in optimization and general decision-rule equilibrium, protecting the theory from being misled by convenient, arbitrary, evidence-inconsistent labor pricing. It provides a rich, evidence-consistent environment for productive analysis. The  cornucopia of consequential new, rational-behavior facts to be built upon features downward nominal wage rigidity over stationary business cycles, chronic wage rent, the existence of involuntary job loss in the millions in response to (inertial) aggregate demand disturbances, the critical distinction between stationary and nonstationary total-spending contractions, the existence of both temporary layoffs and permanent job downsizing, the exclusive location of rational wage rigidities and involuntary job loss in large, highly specialized firms restricted by information-challenged workplaces, and the existence of large human-resources departments that design intra-firm exchange mechanisms and set a substantial share of wages in modern economies.

The generalization of rational exchange from the marketplace to workplaces restricted by information asymmetries furthermore accommodates extreme instability that can transform garden-variety recessions into depression. The 1930s depression, the 1970s stagflation, the 1980s great downsizing, the 1990s virtuous cycle, the 2000s Great Recession, its subsequent slow recovery, and the 2020s rapid recovery from the mass COVID shutdown are provided more evidence-consistent explanations than does market-centric NK theory. In the C&S example, how an economy “runs hot” differs interestingly in two-venue versus one-venue economies. Appropriate monetary policy is more than rate cuts.

What argues against the use of the intuitive workplace generalization of rational exchange? Little objection has been raised about the intra-firm model itself. NK theorists familiar with the generalized-exchange theory accept that it is not wrong. Instead, NK critics argue that it is insufficiently useful to justify the cost of introducing the second (workplace) venue. That cost especially includes investment in human capital needed to understand what actually goes on inside large, highly specialized establishments. Herbert Simon and his colleagues in their close study of rational behavior occurring inside large, complex organizations have alerted economists to the inherently great difference from goings-on in the marketplace. Despite the substantial share of total employment and wage income that occurs in firms with human-resource departments, leading NK theorists still insist on assigning little significance to the necessity of the workplace venue to accommodate the substantial incidence of asymmetric employer-employee workplace information. That assessment is surely something of a conundrum for economists who teach as doctrine Akerlof’s market for lemons.

Blog Type: New Keynesians

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