Power of Generalized-Exchange Modeling in 470 Words

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Generalized-exchange theory is rooted in optimization and equilibrium, aligns with the relevant evidence, and is consistent the detailed descriptions provided by practitioners. It is a vastly more useful treatment of modern, highly specialized economies than market-centric New Keynesian (NK) modeling:

>The model intuitively generalizes rational exchange from the labor market (with its full slate of NK frictions) to workplaces restricted by inherent employer-employee information asymmetries. Such workplaces have accounted for much of the total labor force since  the Second Industrial Revolution.

>Information-challenged workplace equilibrium produces two classes of rational wage rigidity (WR), downward nominal inflexibility over stationary business cycles and chronic wage rent.

>Generalized-exchange WR combines with adverse disturbances in nominal demand to produce two classes of involuntary job loss: temporary layoffs that occur in the millions in recessions (consistent with stationary spending disturbances) and permanent job downsizing that occurs in the millions in depression (consistent with nonstationary spending collapse).

>Generalized-exchange labor pricing is motivated by optimizing employer-employee interaction organized by general decision-rule equilibrium. It is consistent with perfectly competitive labor markets. It is critically consistent with the 1990s New Neoclassical Synthesis, which provides standards for macro modeling accepted by New Keynesian, New Classical, and Real Business Cycle theorists.

>That grand compromise paid particular attention to rational behavior. Indeed, if faced with a choice between rationality and the evidence, the jump ball goes to the former. While that always being the correct selection is debatable, a long career making sense out of difficult, high-stakes macro problems has persuaded me that close, not perfunctory, attention should be paid to rational behavior. Substituting assumptions of convenience, especially in wage analysis, almost always misleads, typically badly. At a minimum, such convenience – frequently used in NK modeling – must be carefully justified.

The fundamental NK problem is that rational marketplace exchange is, by itself, inadequate to the task of usefully modeling macro instability. Market-centric theory must be cojoined with rational workplace exchange restricted by information asymmetries. It is crucial to understand that the second venue is not some kind of elaborate market friction. What goes on in large-establishment (LE) workplaces differs greatly from small-establishment (SE) activity. Preferences that motivate worker conduct are especially unique to each sector. Detailed workplace rules and systems of jurisprudence always constructed by profit-seeking LE firms exist only in their most rudimentary forms in SE businesses.

Furthermore, LE labor pricing dominates SE wages, forcing small-firm workers into chronic market disequilibrium and creating virtual queues of SE workers wanting rationed LE jobs. It makes no sense to try to understand information-challenged workplace equilibrium and the role it plays in macroeconomics by thinking of it as a market friction. The hard fact is that stabilization-relevant theory requires two distinct venues of rational price-mediated exchange, and any attempt to advise policymakers using analysis rooted in only one (always the marketplace) is akin to malpractice.

Blog Type: New Keynesian  

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