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Macroeconomics in The Economy

Pulapre Balakrishnan (pulapre.balakrishnan@gmail.com) teaches at Ashoka University and is senior fellow, Indian Institute of Management Kozhikode.

The Economy is a worthwhile initiative that seeks to teach students about the economy, as opposed to teaching economics. The macroeconomic aspects of the textbook are critically scrutinised to understand what is being taught, and how different the treatment is from extant approaches.

The textbook The Economy1 produced by the Curriculum for Open-access Resources in Economics (CORE) project is an introduction to the economy that according to its authors includes institutions and aims to be evidence-based. Presumably, it is an attempt to interpret the world for students. We are told by its authors that the title has been chosen to distinguish it from texts on “Economics,” the suggestion being that the latter could end up as a discourse on the discipline of economics without much to say about the economy itself. This makes it a welcome initiative. I here comment on the sections that would count as macroeconomics, even though the authors may not have envisaged such a tight distinction. Anyhow, I base this review on the chapters titled “Economic Fluctuations and Unemployment,” “Unemployment and Fiscal Policy” and “Inflation, Unemployment and Monetary Policy.”

The section on fluctuations starts by stating that fluctuations are endemic to capitalism. This is an important point to make at the very beginning, and is markedly different from what may be seen in some standard macro textbooks of the day. It should make students think of capitalism as a “system” that is adopted rather than the inevitable form for an economy. The section starts with a distinction being made between consumption and investment. Consumption smoothening by households as a deliberate choice is introduced to account for the relative stability of consumption. Investment is introduced as volatile and thus accounting for the fluctuations under consideration. I would have preferred a deeper discussion of “animal spirits,” as meant by John Maynard Keynes, to convey the idea that investment is best left exogenous. Some reference to “irreducible uncertainty” would have been appropriate too. But an innovative passage describes how investment can be moved disproportionately by the promise of new and yet untested technologies, leading almost inevitably to a crash. The “tech boom” of the 1990s in the United States (US) is shown to be a case in point. The chapter concludes with a description of investment decisions as a coordination game where anticipation of demand determines investment and thus aggregate demand. It is shown how pessimistic expectations can result in low-level output. The possibility of multiple equilibriums is shown and game theory used to show how this equilibrium would be a Nash equilibrium. In the course of the discussion, national income accounting is introduced and the student is alerted to the shortcomings of gross domestic product (GDP) as a measure of welfare.

Imparting Fiscal Policy

Fiscal policy is dealt with next. Two ideas are presented effectively. First, it is argued that the government through its actions can stabilise the economy (recall that the previous chapter had spoken of the volatility of private investment). Next, it is shown graphically that in the leading economies of the West, fluctuations have been muted as the share of government expenditure has increased. But the authors are quick to caution that the economy cannot be pumped as one can with a bicycle tyre. It is not exactly clear as to what is meant here, but the authors are clearly alerting us to the role of private expectations in determining the outcome of macroeconomic policy. It is when discussing fiscal policy that the authors present their model of macroeconomic equilibrium. This reader would have preferred it to be discussed on its own, with policy options being looked at subsequently. But this to me is less of an issue than the depiction of the full macroeconomic equilibrium itself. It is depicted by combining the goods and labour market equilibria. The former is described as being achieved by “the multiplier model” which turns out to be that old workhorse, the “Keynesian Cross.” It is the labour market model that the authors present at some length. The model itself attempts to capture firm behaviour in the real wage–unemployment space. It consists of a “price-setting curve” which shows the implication for the real wage of profit maximising behaviour by firms under monopolistic competition. This remains flat throughout, as it is assumed to be independent of the cycle. This is contestable given the evidence on the behaviour of the mark-up over the cycle, some of which show it to be countercyclical. The “wage-setting curve,” which makes up the rest of the story, is throughout upward-rising. Note that this is not meant to be your standard neo-classical labour supply curve, but is representative of the labour-hiring decision of the firm, hence, “wage-setting.” This is an innovation alright but is it convincing? It is not intuitive to model the labour market equilibrium without the labour supply decision.

In The Economy, the labour market outcome is based on the behaviour of firms. Worker agency appears in the form of a reservation wage that changes with the level of unemployment and a varying degree of effort based on the real wage offered. But, as said, there is no labour supply decision. This makes it difficult to interpret the “labour market equilibrium” attained at the intersection of the wage-setting and price-setting curves. Quite simply, the question is whether workers supply effort or units of labour. I believe that it is the latter. Finally, the authors argue that in the labour market equilibrium there is always “involuntary unemployment,” or, as they put it, involuntary unemployment is a characteristic of labour market equilibrium. This makes it difficult to interpret the equilibrium in a standard way, that is, as one where workers are supplying all the labour they desire. Also, the implication of the authors’ reasoning that we must tolerate a certain amount of unemployment is disappointing from the point of view of public policy.

Teaching Inflation

We now come to inflation. When the labour market is in equilibrium, inflation is zero as the real wage implied by the pricing decision is consistent with that implied by workers’ response function in terms of effort given the level of unemployment. As said, graphically, the equilibrium is represented by the intersection of the price and wage-setting curves. At levels of unemployment greater than the equilibrium level, the wage-setting curve is below the price-setting curve and a downward wage–price spiral sets in. The opposite happens when unemployment is below the equilibrium level. Now why does actual unemployment ever move from that implied by the labour market equilibrium? It does so because of fluctuations in aggregate demand, presumably moved by volatile investment. The authors claim that “the economy tends to fluctuate over the business cycle around the unemployment rate … at equilibrium.” In their diagram they show an equilibrium unemployment rate of 5%. This is unsatisfactory. First, why should 5% unemployment be treated as “normal,” implied by the authors’ use of the term for the level of aggregate demand consistent with labour market equilibrium? Not only is this arbitrary, for Western Europe at least, empirical evidence does not suggest fluctuating unemployment so much as an increasing one over the past three decades. The idea of “secular stagnation” may be of relevance here, but I could not find the term in the glossary.

The authors present inflation as a case of the claims of owners (as profits) and of workers (as wages) adding up to more than the size of the pie or output. They are able to reconcile this idea of inflation with their model of the labour market, showing that at the labour market equilibrium when inflation is zero, the claims to output sum to its value. However, it may be said that when the two sets of agents are powerful enough, say in the presence of unions, conflict could arise even in the presence of unemployment. Though they have their own explanation of inflation varying directly with the level of employment and are able to incorporate it into a model of macroeconomic equilibrium, they are yet to bring the Phillips curve into their analysis. Perhaps it is to be able to pinpoint the level of inflation at every level of unemployment. However, the Phillips curve has fared so poorly of late that there have been calls to abandon reliance on it. Most notably, the rapid recovery of employment in the US after the financial crisis has not been accompanied by rising inflation. Actually, inflation has remained quite steady as output fluctuated since 2008, despite expansionary monetary policy and a three-fold rise in the fiscal deficit. As the Phillips curve is purely an empirical discovery to account for which theory has been invented, it may be wise to leave it out of theoretical models altogether. Moreover, the authors claim empirical veracity for their work.

Finally, it is worth remarking that the authors’ approach to Friedman’s (1968) presidential address to the American Economic Association is uncritical. Actually, Friedman’s claim to have shown that you cannot create employment by causing inflation, which the authors refer to, is tendentious as it is unlikely that anyone really claimed this could be done. Solow (2009), in particular, has denied making any such claim in his paper (Samuelson and Solow 1960) which is often used as evidence of it. As for the Phillips curve shifting upwards as expectations of inflation rise, also claimed as the inevitable outcome of trying to keep unemployment below its natural rate, it has been shown that in the US higher average inflation in the decades after the 1970s do not add up over a single unemployment rate (Farmer 2013). This has led to a challenge to the idea of a “natural rate.” The reliance on the idea of a unique long-run equilibrium rate in The Economy is problematic. No concern with stability is shown, that is, what ensures that the labour market will tend to equilibrium given that it can be shaken out of it by fiscal policy? To that extent, the idea of a long-run equilibrium rate of unemployment is merely asserted here as also in Friedman. The authors show a similar reluctance to critically examine the idea of inflation targeting which has received much criticism since the global economic crisis. The main line of argument has been that excessive focus on the inflation rate may have lulled the Federal Reserve into complacency about de-stabilising innovation in the financial sector. It is worth remarking that in the data that they present of the progress made with inflation control in the countries that have adopted inflation targeting there are two prominent cases of failure.

New Zealand, which pioneered inflation targeting, is shown as having an inflation rate higher than what it was when inflation targeting was adopted, while the United Kingdom has an inflation rate more than one and a half times than targeted. Inflation targeting came in at a time when unions had declined considerably in power and episodes of commodity price inflation have been largely muted in comparison with the 1970s. Given that they give it much prominence it is surprising that the authors of The Economy do not present the model underlying inflation targeting, an idea that has dominated practical macroeconomic policymaking for about a quarter century. The “output-gap model” of inflation ought to have been presented to demonstrate how “modern monetary policy” is conducted. Students reading The Economy would be left with no idea. Given that the authors of The Economy have set out to write a book about how the economy actually works, their somewhat uncritical approach to the dominant paradigm is surprising.2 As far as the macroeconomics is concerned, there is little to distinguish the book from others in the market such as Olivier Blanchard’s Macroeconomics.

I have reviewed only the sections that strictly correspond to “short run” macroeconomics here but have noticed that The Economy has a discussion of growth and a chapter devoted to three important macroeconomic phases, namely the Depression, the Golden Age of Capitalism, and the Global Financial Crisis of 2008, in the history of the West. Detailed data-based expositions are relatively rare in macroeconomic textbooks and therefore are a welcome presence here. After decades of teaching macroeconomics I am convinced that it is necessary to weave in evidence along with theory.

A Worthwhile Effort

Lastly, how suited is The Economy for understanding the Indian economy? A significant feature of India is the presence of an agricultural sector, which is no longer very large but houses the largest share of the working population. Here many of the assumptions and the reasoning adopted in The Economy are unlikely to be applicable even if they would be for the rest of India’s economy. The presence of agriculture requires a departure from the one-good model of standard macroeconomics. Both growth and inflation mechanisms are likely to be different in India. Here there are fluctuations that arise not only from aggregate demand shocks but also from supply shocks. Of course, supply shocks are modelled in The Economy, arising from oil price shocks but in India there is often persistent excess demand in the agricultural goods market. The tendency for the relative price of agriculture to rise is both inflationary, setting off a wage–price spiral as in The Economy, and also causes slower industrial growth as food becomes more expensive for households. All this has been extensively modelled by Indian authors and a substantial body of evidence on macroeconomic outcomes here exists (Balakrishnan 1991, 2014; Rakshit 2011; Goyal 2013; Chattopadhyay 2017). Hopefully, India-specific features will be incorporated in the Indian version of The Economy, which I am told is on its way.

The Economy commences with the following note to instructors:

The text focuses throughout on evidence on the economy, from around the world, and from history. It is motivated by questions—how can we explain what we see? The method is to ask interesting questions first and then to introduce models that help to answer them. Standard tools such as constrained optimization are taught by showing how they give insight into real-world problems. Economics as a discipline is set in a social, political, and ethical context in which institutions matter.

As I have stated at the outset, the authors of The Economy are embarked on a worthwhile exercise. The book succeeds considerably in providing evidence on the functioning of the economy. But it cannot be said to have broken new ground in macroeconomics.

Notes

1 View at: http://www.core-econ.org/the-economy/book/text.

2 It would be disastrous to imagine that our students are credulous. An undergraduate at Ashoka University recently sent me an email with a link to an article in the Economist politely enquiring why she should be listening to lectures on the Phillips curve when evidence of its existence was missing. The Concerned Article was titled “The Phillips Curve May Be Broken for Good: Central Bankers Insist That the underlying Theory Remains Valid” (https://www.economist.com/blogs/graphicdetail/2017/11/daily-chart). I had to mumble something about having to expose my students to the entire literature!

References

Balakrishnan, P (1991): Pricing and Inflation in India, Delhi: OUP India.

— (2014): “Macroeconomic Reversal in India: A Structuralist View,” The Malcolm Adiseshiah Lecture, The Elizabeth and Malcolm Adiseshiah Trust, Chennai.

Chattopadhyay, S (2017): “Inflation Targeting Amidst Structural Change: Some Analytics for Developing Economies,” Economic & Political Weekly, 14 January.

Goyal, A (2013): “Propagation Mechanisms in Inflation: Governance as Key,” India Development Report 2012–13, S Mahendra Dev (ed), OUP India and Indira Gandhi Institute of Development Research, Mumbai.

Friedman, M (1968): “The Role of Monetary Policy,” American Economic Review, Vol 58, No 1, pp 1–17.

Rakshit, M (2011): “Inflation and Relative Prices in India 2006–10: Some Analytical and Policy Issues,” Economic & Political Weekly, Vol 46, No 16, pp 41–54.

Farmer, R E A (2013): “The Natural Rate Hypothesis: An Idea Past Its Sell-by Date,” Working Paper 19267 NBER.

Samuelson, P A and R M Solow (1960): “Analytical Aspects of Anti-inflation Policy,” American Economic Review, Vol 50, No 2, pp 177–94.

Solow, R (2009): “Text of a Panel Discussion,” Understanding Inflation and the Implications for Monetary Policy: A Phillips Curve Retrospective, J Y Fuhrer Kodrzycki, J S Little and G P Olivei (eds), Cambridge, Massachusetts: MIT Press.

Updated On : 15th Jun, 2018

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