Economic models: Which ones do economists prefer?

Ezra Klein asked Krugman that what model he and Delong used? Also point the differences between the models other economists use?

Krugman responded via this post.  First what other models say:

It’s a good request, although the truth is that the other side in this debate doesn’t necessarily agree on a single model, or even use models at all. Still, I think it is possible to describe the general views of the other guys — and to see how off their predictions have been.

So: first of all, the other side in this debate generally adheres, more or less, to something like what Keynes called the “classical theory” of employment, in which employment and output are basically determined by the supply side. Casey Mulligan has been most explicit here, coming up with increasingly, um, creative stories about how what we’re seeing is a choice by workers to work less; but the whole Kocherlakota structural unemployment thing is similar in its implications.

Oh, and the Cochrane-Fama thing about how a dollar of government spending necessarily displaces a dollar of private spending is basically a classical view, although there doesn’t seem to be a model behind it, just a misunderstanding of what accounting identities mean.

Once you have a more or less classical view of unemployment, you naturally have the classical theory of the interest rate, in which it’s all about supply and demand for funds, and something like a quantity theory of money, in which increases in the monetary base lead, in a fairly short time, to equal proportional rises in the price level. This led to the prediction that large fiscal deficits would lead to soaring interest rates, and that the large rise in the monetary base due to Fed expansion would lead to high inflation.

You can see the classical theory of interest and the soaring-rate prediction clearly in Niall Ferguson’s remarks:

After all, $1.75 trillion is an awful lot of freshly minted treasuries to land on the bond market at a time of recession, and I still don’t quite know who is going to buy them … I predict, in the weeks and months ahead, a very painful tug-of-war between our monetary policy and our fiscal policy as the markets realize just what a vast quantity of bonds are going to have to be absorbed by the financial system this year. That will tend to drive the price of the bonds down, and drive up interest rates

and, of course, in many WSJ op-eds, in analyses from Morgan Stanley, and so on.

Meanwhile, you can see the high-inflation prediction in pieces by Meltzer and Laffer — with the latter helpfully titled, “Get Ready for Inflation and Higher Interest Rates”.

Then, what he and Delong say:

While the other side was making these predictions, people like me were saying that classical economics was all wrong in a liquidity trap. Government borrowing did not confront a fixed supply of funds: we were in a paradox of thrift world, where desired savings (at full employment) exceeded desired investment, and hence savings would expand to meet the demand, and interest rates need not rise. As for inflation, increases in the monetary base would have no effect in a liquidity trap; deflation, not inflation, was the risk.

So, how has it turned out? The 10-year bond rate is about 2.5 percent, lower than it was when Ferguson made that prediction. Inflation keeps falling. The attacks on Keynesianism now come down to “but unemployment has stayed high!” which proves nothing — especially because if you took a Keynesian view seriously, it suggested even given what we knew in early 2009 that the stimulus was much too small to restore full employment.

The point is that recent events have actually amounted to a fairly clear test of Keynesian versus classical economics — and Keynesian economics won, hands down.

Boy how well and simply he writes on economics. It is crazy for people to respond saying Krugman does not know economics et al.

In another post, Karl Smith of modelbehavior.com summarises the key macro models. He also points to key papers which help understand these models/thoughts.

Real business cycle  – For these guys recessions represent people for various reasons deciding not to work. It might be a productivity shock. It might be government disincentives. If you want a nice little nerd rundown you can check this out:  http://www.kellogg.northwestern.edu/faculty/rebelo/htm/rbc.pdf

Recalculation: In summary, for these guys recessions are caused by mistakes which take time to be corrected. There is no treatise as such but you can try:  http://bit.ly/93uTMM

Mismatch: For them a recession is basically a giant shift in priorities. What makes them different from recalculationist is that there need be no “mistake.” For the super nerd version check out  http://home.uchicago.edu/~shimer/wp/mismatch-print.pdf

New Keynesians: For these guys recessions are about an excess demand for some type of financial instrument.  http://www.economics.harvard.edu/files/faculty/40_Small_Menu_Costs.pdf

Hmm. Superb summary this. He adds:

By and large most economists are working with some type of New Keynesian model. The difference is the focus or the details. In terms of policy, however, I think political economy concerns dominate.

My thoughts tend this way: look this all about money (or bonds or credit) and so the focus of everything is the Fed. I was a stimulus skeptic. I could see the reasoning but I thought it better to focus all of our attention on monetary policy. I also suggested then and now that if fiscal stimulus must be done, that it should consist entirely of tax cuts or increases in direct assistance to the poor.

However, this was for political economy reasons. Not model reasons. If someone asked whether I thought GDP was higher or lower as a result of the Obama stimulus, I would answer: higher. On the other hand, Brad and Paul like to focus on spending. I suspect this is in no small part because they think government spending is too low anyway. Why not kill two birds with one stone: build some roads and get some jobs.

At the end of the day, your choice of New Keynesian instruments: monetary policy, government spending or tax cuts depends mostly on political economy concerns. That is, your view of the fundamental relationship between the government and the economy.

Krugman responds:

I plead innocent on that one. I wanted and still want fiscal expansion because it’s relatively certain in its effect: if the government goes and buys a trillion dollars’ worth of stuff, that will create a lot of jobs. On the other hand, if the Fed goes out and buys a trillions dollars’ worth of long-term bonds, the effect is quite uncertain, with many possible slips between the cup and the lip.

Great insights from both Karl Smith and Krugman. THis is what makes blogs so useful..

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