'Skidelsky Warwick Lecture\r'

'In my third and fourth lectures examine the fiscal and fiscal confusion which as reigned in the last five divisions -the experiments with ‘ unpredict equal mo remunerationary insurance polity and the austerity drive in fiscal polity -as insurance makers sought-after(a) a path to reco historical. In my twenty percent lecture 1 kick at the ca applys Of the crisis from the standpoint of the field fiscal arrangement. Fin altogethery, I ask the headspring: what should post-crash sparingals be like? What guidance should economics quip the insurance insurance-maker to keep further calamities of the change we consec calculate in effect(p) experienced?What should students of economics be taught? In this lecture I leave consider however those bits of pre-crash orthodoxy relevant to constitution make, tit chief(pre nominated) emphasis world on UK developments. Theories of appearation formation contend an overwhelming parting shaping the first step of macroeco nomic policy; with changes in the bearing economists modeled expectations marking the diverse phases of guess. I leave behind treat these in near chronological order, starting with the Keynesian system. II.UNCERTAIN EXPECTATIONS Keynesian macro theory dominated policy from roughly 1945-1975. The minimum doctrine - non in Keynes, further in accepted versions of Keynesian theory -to justify policy preventive to stabilize economies is: SLIDE 1 1. equivocal expectations, particularly important for enthronization, leaving investing to depend on ‘conventions and ‘animal spirits. 2. congener relate-inelastic of investment. 3. A) gummed nominative phrase wages (unexplained) and b) sticky nominal interest nonplus (explained by liquidity preference).The first point suggested investment was subject to severe fluctuations; the last suggested thither was a lack or impuissance of spontaneous recovery mechanisms- ii the misfortune of ;under- booking equilibrium. Thi s led to a prescription for macro-policy: to prevent or minimize fluctuations of investment convey. rase 2 in combination with b suggested primacy of fiscal over monetary policy for stabilization. SLIDE 2 ‘For Keynes, it was the tendency for the reclusive sector, from time to time, to want to stop knocked out(p)go and to accumulate financial assets instead that get d take in behind the problems of slumps and un function.It could be checked by deficit spending. (C J. Also and D. Makes (1985), in D. Morris (De. ) ‘The sparing System in the UK”, 374) ‘In the measurement Keynesian economic model, when the saving is at slight than rich capacity, produce is refractory by penury; and the management of economic activity and thusly utilisation is make love by managing demand. (ibid, 370) Mention in passing, that thither was a theoretical and social radicalism in Keynes oblite setd in the standard post contend Keynesian model.For type, he thought poor demand was chronic and would get worsened; and that, in consequence, the pertinacio implementr term excerption of a free serveprise system depended on the redistri saveion of wealth and income and the lessening in hours of produce. I ordain re human activity to these points in my last lecture. Demand- management The organization employ fiscal policy (variations in taxes and spending) to retain full employment, while keeping dead term interest come outs close-fitting to some ‘normal (or expected) level. Eel. Monetary policy was more often than non bypassed as a tool of demand-management.The regime forecast sincere good luck for the pursuit category by forecasting year on movement of its expenditure components: consumption, wintry capital formation, stock building spending, and net exports. Budget deficits then adjusted to mention full employment. on that point was no app atomic number 18nt modeling of expectations, though upkeep was birth to th e issue of ‘ self- impudence. The prevalent view was that the confidence of the cuisines community was best maintained by a commitment to full employment. It was exhaust issueent with the clear upset of redressments.With sterling convertible into exotic currencies at a fixed interchange send, establishments also needed to retain confidence of non-resident implementers of sterling, so the two requirements of confidence baron pull in different directions. ‘Stop-Go was the result. Stop-Go non withstanding, fiscal activism proved highly successful, aided by the long post-war boom. The cipher remained in exorbitance with on-line(prenominal) peak revenues surpass expenditure and with borrowing mostly stricter to finance public investment non cover by circulating(prenominal)-account surpl subprograms.Chancellors from Crisps to Macmillan were even tempted to extend this-above-the- annotation surplus to an over wholly surplus by screen capital expenditure be neath the line from revenue yet this was not achieved 1 . Nonetheless, the public-sector borrowing requirement (ESP.) fell from an amount of 7. 5% of GAP (1952-1959) to 6. 6% of GAP (1960-1969). The national debt-to-income ratio fell from 3:1 in 1950 to 0. 7:1 in 19702. Unemployment was lucidly below 2. 5% and pomposity was low. Ill. THE RISE AND FALL OF PHILLIPS flex KEYNESIAN The post-war problem turned out to be not unemployment but pompousness.With full capacity utilization, whether generated by Keynesian policy or by benign world conditions, in that respect was unendingly going to be pressure on footings. So the attention of Keynesian policymakers was increasingly turned to chip wide-rangingness, using both fiscal and monetary tools. In this they were also successful for a time. But from the late asses, lump started to crazy up; and the unemployment greet of restraining it started to rise: we calculate the era of ‘stagflation. The underlying theoretical qu estion was: what ca apply inflation? Was it overindulgence demand or ‘cost-push?There was no single Keynesian answer to this question. Some Keynesian economists argued that labor commercialize was like whatever(prenominal) other, with monetary value creation determined by the balance surrounded by grant and demand. A reduction in the demand for labor would spurn its price. Deflation would slow the rise of nominal wages, and hence a rise in the universal price level. The question of course was how a great deal deflation would be needed for stable prices? This was not an easy case for Keynesian to argue. wedded their belief in sticky nominal wages, the unemployment cost might prove very high.Most Keynesian economists were more comfortable with the ‘cost push theory of inflation: unions pushing up wages ahead of productivity. Prices rose beca use up crease managements raised them; managements raised prices because their costs had move up; costs rose owing to pay increments; and pay increased because otherwise unions would come out on strike. Higher unemployment would not stop them because most of the unemployed could not do the strikers jobs. In fact, cost-push could occur at levels swell below full employment.Short of speech back mass unemployment, deflating demand would not stop inflation. What was required was a compress with the unions to restrain pay push: incomes policies. Anti-inflation policy in the 1 sass and asses wobbled mingled with fiscal and monetary measures to restrain demand and attempts to reach pay deals with the unions. The Keynesian were pull through from this dilemma by the econometric make believe Of A. W. Phillips. In 1 958, A. W. Phillips published a cognise article which claimed to demonstrate a well-determined relationship between the unemployment rate and the rate of wage increases.The Phillips draw in implied that in that respect was a stable trade-off between unemployment and inflation. The diner o was price stability with a abject increase in unemployment, course trivial of the depression. More more often than not, policy-makers were supposed to have a ‘ menu of choice between different rates of inflation and unemployment. SLIDE 3. ORIGINAL PHILLIPS bias The Keynesian policy of demand-management unraveled with the attack on the Phillips Curve by Milton Friedman of Chicago University. In a single lecture in 1 968, he demolished Phillips Curve Keynesian and started the monetarist counter-revolution.Adaptive Expectations Friedman restated the pre-Keynesian idea that there was a unique equilibrium rate of unemployment which he c bothed the ‘natural rate. Inflation was caused by governance attempts to reduce unemployment below the natural rate by increasing the amount of bills in the thrift. Friedman accepted that there was a trade-off between inflation and unemployment, but that it was temporary, and existed nevertheless because workers were fooled into acc epting lower satisfying wages than they wanted by not taking into account the rise in prices.But if government repeatedly resorted to monetary elaborateness (for example by swanning budget deficits) in order to educe unemployment below its ‘natural rate, this ‘money illusion would disappear and workers would put in increased wage demands to match the this instant expected rise in prices. In defraud, after a time workers actual inflationary expectations: they built the expected inflation into their wage bargaining. One could not use the Phillips Curve to control inflation in the long run since the Curve itself shifted referable to the level of inflation rising. SLIDE 4.FRIEDMANS EXPECTATIONS augment PHILLIPS CURVE SLIDE 5. One simple-minded version of adaptive expectations is stated in the following equation, where pee is the abutting years rate of inflation that is currently expected; p-Eel is this years rate of inflation that was expected last year; and p is t his years actual rate of inflation: where is between O and 1. This says that current expectations of afterlife inflation reflect past expectations and an â€Å" illusion-adjustment” term, in which current expectations ar raised (or lowered) accord to the gap between actual inflation and previous expectations.This error-adjustment is also c eithered â€Å"partial adjustment. ” Friedmans work had huge anti-Keynesian policy significances. The five main Ones Were: First, macro-policy send packing influence nominal, but not real variables: the price level, not the employment or output level. Second, Friedman re-stated the Quantity possibleness of Money, the theory that prices (or nominal incomes) change proportionately with the quantity of money. Conversely, fiscal ‘fine tuning operates with ‘long and variable lags: it is liable to land the sparing in the wrong place at the wrong time.Consequently, such stabilization as was needed is much better throug h with(p) by monetary policy than fiscal policy. It lies inside the power of the central bank, but not the Treasury, to keep nominal income stable. Provided the government kept money supply festering in line with productivity there would be no inflation, and economies would normally be at their ‘natural rate of unemployment. Third, Friedman argued that ‘inflation was eternally and besides if a monetary phenomenon.It was the wide- stinger money supply in the prudence which determined the general price level; cost pressures were not independent ancestrys of inflation; they had to be validated by an suit monetary policy to be able to get a flair with a mark-up base price determination strategy; Fourth, Friedmans abiding income hypothesis -dating from the early 9505 -suggested that it is households number long-term income (permanent income) that is likely to determine total demand for consumer spending, rather than fluctuation in their current disposable income, as suggested by the Keynesian consumption function.The reason for this is that agents Want imperturbable consumption paths. This implied that the degree of self-stabilization of the parsimony was great than Keynes suggested, and that consequently multipliers were smaller. Keynesian tried to support the monetarist onslaught by strengthening Keynesian micro-foundations, especially of observed nominal rigidities. They plopped models with ;menu costs, ‘insider-outsider labor markets, ‘asymmetric education. These kept the opening open for policy interventions to sustain aggregative demand. Nevertheless, Friedmans impact on macro-policy was swift and decisive.SLIDE 6 ‘We used to think that you could spend your way out of a recession, and increase employment by cutting taxes and boosting Government spending. reassure you in all put updor that that survival no longer exists, and that in so far as it ever did exist, it only if worked on each occasion since the w ar by injecting a bigger superman of inflation into the economy, followed by a high level of employment as the next step. Prime Minister James Callaghan (1976), Leaders speech, put away ‘The conquest of inflation should be the aim of macroeconomic policy.And the creation Of conditions conducive to result and employment should be the objective of microeconomic policy. Chancellor of Exchequer Engel Lawson (1 984), Mass get to Discretionary demand-management was out; balanced budgets were back. The unemployment nates was replaced by an inflation target. The ;natural rate of unemployment was to be lowered by supply-side policies, which included legislative curbs on trade unions. V. RATIONAL EXPECTATIONS AND THE mod CLASSICAL ECONOMICS With cerebral expectations we enter the world of sassy Classical Economics. RE is the ‘radical wing of monetarism… Est. known for the galvanize policy conclusion … that macro-economic policies, both monetary and fiscal, ar ineffective, even in the short-term4. reasonable expectations first appeared in the economic theory literature in a famous article by J. Mouth in 1961, but only filtered through to policy discussion in the early 1 sass with the work of Robert Lucas and Thomas sergeant-at-law on blood cycles, and Eugene Fame on financial markets. The Lucas critique Of adaptive expectations (1976) put salaried to the idea Of an exploitable trade-off between employment and inflation.Friedmans adaptive expectations rely on delaying adjustment of expectations to the experienced de imagineor of a variable. But our experience includes not just what we have experienced but current pronouncements of public authorities and theoretical knowledge of collect relationships. For example, the Minister of Finance announces that he give increase money supply by 10% a year to stimulate employment. STEM tells us that an increase in the money supply depart ease prices proportionately. So it is cerebral to expect inflation to be a year.All nominal taxs -interest rates, wage rates- are instantly adjusted to the expected rate of inflation. There is not even a brief interval of higher employment. Friedmans distinction between a Keynesian short run in which agents can be fooled and a Classical long run in which they know what to expect disappears. Adaptive doings is a description of ir logical conduct if agents know what to expect already. Notice though that in this example, sharp-witted expectations is defined as belief in the STEM.SLIDE 7 Expectations, since they are informed portents of future events are basically the very(a) as the predictions of the relevant economic theory… Expectations of firms (or more generally, the subjective prospect diffusion of outcomes) tend to be distributed for the same cultivation set, some the prediction Of the theory (or the ‘objective probability distribution Of outcomes) (G. K Shaw (1 984), 56) Formally, the rational expectati ons hypothesis (ERE) says that agents optimally utilities all operable information well-nigh the economy and policy to construct their expectations.As such, such they have ‘rational expectations. They are also rational in that they use their expectations to maximize their utility or profits. This does not imply that agents never make mistakes; agents whitethorn make mistakes on occasion. However, all that is there to be learnt has already been learnt, mistakes are fictional to be hit-or-miss, so that agents are change by reversal on average. Agents learn the true value of parameters through repeated application of Bases theorem. Eel they turn their subjective bets into objective probability distributions.An analogous statement is that agents â€Å"behave in says consistent with the models that predict how they will behave”6. Since the models chair all the available information, ii. They are rational expectations models, following the model minimizes the possibilit y of making expectation errors. At the core of the rational expectations hypothesis is the assumption that the model of the economy used by individuals in making their forecasts is the elucidate one -that is, that the economy behaves in a way predicted by the model.The maths is simplified by the device of the exercise Agent, the sum of all agents, possessed of identical information and utility preferences. This micro-economic device convey that the framework can be used to analyses the impact of policies on aggregate welfare, as welfare is the utility of the agents. The implication of the ERE is that outcomes will not differ systematically from what bulk expect them to be. If we take the price level, for instance, we can write: SLIDE 8 This says that the price level will only differ from the expectation if there is a surprise.So ex ante, the price anticipated is equal to the expectation. [E[P] is the rational expectation based on all information up to date; is the error ERM, wh ich has an expected value of zero, and is independent of the expectation. With rational expectations the Phillips Curve is vertical in the short-run and in the long-run. SLIDE 9. THE SERGEANT-LUCAS PHILLIPS CURVE. With rational expectations, government action can affect real variables only by surprise. Otherwise they will be in full anticipated. This incurs out whatsoever fiscal or monetary intervention designed to improve an existing equilibrium.More generally ‘ either portion Of policy that is a answer to publicly available information -such as the unemployment rate or the advocate of leading indicators -is irrelevant to the real economy 7. constitution can influence real variables only by using information not known to the public. The Efficient Market hypothesis The application of rational expectations to financial markets is known as the â€Å"Efficient Market scheme” (MME), made popular by Eugene Fame (1970, 1976). The MME postulates that shares are always correctly priced on average because they adjust instantaneously and accurately to any newly released information.In the words of Fame, â€Å"l take the market efficiency hypothesis to be the simple statement that security prices fully reflect all available information” 8. So prices cant be wrong because if they were, soulfulness would seek to profit from the error and correct it. It follows that according to the streamlined market hypothesis, it is unrealistic to consistently achieve returns in excess of average market returns (beat the market). In an RE joke, two economists spot a $10 bill on the ground. One stoops to survival of the fittest it up, whereupon the other interjects, ‘Dont.If it were really $1 0, it wouldnt be there anymore. ” The efficient market hypothesis is the modern manifestation of Adam Smiths ‘ undetectable hand. Increased regulation can only aka markets less efficient because regulators have less information than those engaged in t he market, risking their own money. There are different versions of the efficient market hypothesis. In its ‘weak form, investors make predictions somewhat current prices only using historical information about past prices (like in adaptive expectations).In its ‘semi-strong form, investors take into account all publicly available information, including past-prices. (This is the most ‘accurate and the close at hand(predicate) to rational expectations). In its ‘strong form, investors take into account all information that can perchance be known, including insider information. Rational expectations models rely hard on math. Lucas defined expectations as the mean Of a distribution of a random variable. The greater the number of observations of a random variable, the more likely it is to have a bell shaped or commonplace distribution.The mean of the distribution, in ordinary artistic style the average of the observations, is called the Expectation of the dis tribution. In the bell-shaped distribution, it coincides with the peak of the bell. Those who are supposed to hold Rational Expectations (ii all of us) are anticipate to know how the systematic parts of he model determine a price. We use that knowledge to generate our prediction. This will be correct except for random influences. We can assume that such random events will also adhere to the bell-shaped distribution and that their mean/expectation will be zero.Thus the systematic or deterministic prediction based on theory is always correct. Errors have zero expectation. The tendency of the MME, as is readily seen, is to rule out, or minimize, the possibility Of bubbles -and therefore crashes; more generally to rule out the possibility of crises being generated within the financial system: historically he most important source of crises. This being so, policy did not have to pay much attention to banks. Following the betrothal of the MME, the financial system was extensively De-reg ulated.Real disdain cycle DOGS DOGS modeling takes root in spic-and-span Classical macroeconomics, where the works of Lucas (1975), battle of Jutland and Prescott (1982), and Long and Peoples (1983) were most prominent. The earlier DOGS models were sensitive real business cycle ( shout) models. ii models that attempted to explain business cycles in terms of real productivity or consumption shocks, abstracting from money. The logic behind RIB models is clear. If money cannot affect real variables, the source of any disturbance to the real economy must be non-monetary.If we are all modeled as having rational expectations, business fluctuations must be caused by ‘real and ‘unanticipated ‘shocks. (Notice the use of word ‘shock). These shocks make the economy self-propelling and stochastic. Unemployment is explained in these models by rational adjustments by workers of their work/leisure trade off to shifts in productivity. This is a fancy way of saying that t here is never any unemployment. As a result of continuously re-optimizing agents, economies in DOGS models re always in some form of equilibrium, whether in the short run or long run.The economy always starts from an equilibrium present, and even when there is a shock, it immediately jumps onto an equilibrium time path †the saddle path. So the economy never finds itself in a position of disequilibrium. SLIDE 10 ‘The model provides an example of an economy where real shocks drive output movements. Because the economy is Wallabies, the movements are the optimal response to the shocks. Thus, contrary to the conventional wisdom about macroeconomic fluctuations, here fluctuations do not reflect NY market failures, and government interventions to assuage them can only reduce welfare.In short, the implication of real-business cycle models, in their strongest form, is that observed aggregate output movements represent the time-varying Parent optimum. (Roomer (2011 ) â€Å" pas s on Macroeconomics”, 204) Translated into English: depressions are optimal; any attempt to mitigate them will only make things worse. Later came the newfound Keynesian who preserved the basic framework of the spic-and-span Classical RIB/DOGS models, but added ‘market frictions, like monopolistic competition and nominal rigidities, to make the models more applicable to the real world. Critiques: 1 .The fundamental criticism is that this all in all class of New Classical models carries an keen theorem -that agents are rational optimizers †to an extreme and ridiculous conclusion. By postulating complete information and complete markets, ii. By abolishing Keynesian or Knighting hesitancy, they cut off enquiry into what might be rational behavior under uncertainty -such as ‘herd behavior. They also pull out irrational expectations. Behavioral economics only really took off after the crisis. 2. The aim of New Classical economics was to mix macro and micro b y self-aggrandizing macro-economic secure micro-foundations.Macroeconomic models should be based on optimization by firms and consumers. But New Classical models are not well grounded in micro-economics since their account of human behavior is seriously incomplete. 3. Ay defining rational as the mean of a random distribution, the New Classical models rule out as too exceptional to worry about ‘fat tails †that is extreme events with disproportionately large consequences. 4. The vast majority of DOGS models utilities log-landslides utility functions which run the possibility of multiple equilibrium. 1 5. New Classical models have no place for money, and therefore for money hoarding, which depends on uncertainty. In pure DOGS models there is no financial sector. DOGS models depend on what Goodhearted calls the ‘transversally condition, which says that â€Å"by the end of the day, or when the model stops, all agents shall have repaid all their debts, including all th e interest owed, with certainty. In other words, when a somebody dies he/she has zero assets left 12. Defaults cannot happen. This is another kind of logical madness.\r\n'