Is Keynes Dead? Reviving A Sensible Macroeconomics

Joseph E. StiglitzColumbia University

OxfordMay 13-15th, 2003

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LecturesLectures

Lecture 1: Fluctuations in business cycle theories

Lecture 2: Towards a new paradigm for macroeconomics

Lecture 3: Applications to economic policy

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Towards a new paradigm of Towards a new paradigm of macroeconomics macroeconomics

I. PremisesII. Underlying pillarsIII. Capital market imperfections

a. Theoryb. Evidencec. Implications

IV. Risk Averse theory of the firma. Theoryb. Consequences

a. Portfolio theory of adjustment of the firmb. Specific implications

V. Other ways that imperfect information leads to rigiditiesVI. New monetary paradigm

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PremisesPremises

Imperfect information and incomplete markets are at the center of an explanation of economic fluctuations

I. Lead to capital, labor, and product markets behaving markedly differently than in standard neoclassical theory

II. Focus not just on aggregate demand but also on aggregate supply; two intertwined

• If aggregate demand were only problem, then small countries in competitive markets should never face a problem—adjustment of exchange rate would imply they face a horizontal demand curve for their products

III. Issue is not so much wage and price rigidities, but differences in speeds of adjustment, and distributional consequences of price adjustments

IV. Key role played by credit availability—new paradigm of monetary economics in which focus is on credit availability rather than transactions demand for money

V. Key role played by imperfect insurance and consequent distributive shocks

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Underlying pillars (I)Underlying pillars (I)

I. Labor market—efficiency wage theorya. Generates equilibrium unemploymentb. But also affects dynamics of adjustmentc. Imperfections of competition mean firms are wage

setters

II. Product market—imperfect competitiona. Implies firms are price setters

III. Capital markets—credit and equity rationinga. New theory of the firm

i. Risk averse behaviorii. “Portfolio approach to adjustment”

• Determines wages, prices, inputs, outputs

b. New monetary paradigm

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Underlying pillars (II)Underlying pillars (II)

IV. Macro-economic behaviora. Based on micro-economic theoriesb. Particular attention paid to:

i. Financeii. Including financial interlinkages (as important as

standard g.e. interlinkages)iii. Cash flow, balance sheet effectsiv. Distributive consequences of shocksv. Differences in speeds of price adjustment

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A closer look at capital A closer look at capital imperfectionsimperfections

I. Not just a matter of transactions costs (Stigler)II. Lead to credit and equity rationing

a. Most firms raise little of the funds required to finance new investment by issuing new equity

b. Rejection of “Tobin q” modelsc. Importance of bank finance—role of banks in

gathering and processing informationIII. Explicable in terms of models of asymmetric

information (and costly state verification)IV. Equity rationing implies firms will be risk averse

a. Can be modeled in terms of costs of bankruptcy or concave “utility function”

b. Can be modeled in terms of behavior of managers—optimal incentive contracts entail managers bearing some risk

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Simple model (I)Simple model (I)

aversion risk absolute decreasing and 0'U' 0,U'

.a firm, the of worthnet

initial the and borrowed, has firm the amount the B, and ,variables)

ntal(environme parameters exogenous moment) the (for of seta isz

variables decision of seta is x

where

aB,z,x,

a B, z, and x of function

a is turn in whichdebts, repaying after profits , of function a is a

a wealth,terminal of function concave a is U

: whereU(a) E maximize Firms

0

0

0

:

9

U(M(a)) E

maximize and

M(a)

function reward a receive Managers

capitalism Managerial :I nformulatio eAlternativ

Simple model (II)Simple model (II)

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Simple model (III)Simple model (III)

interest. of rate safe"" the and ,a wealthinitial

the x, variables decision the of function a is turn, in pay, must firm the

rate interest The worth.net initial sfirm' the and pay, must firm the of

rate interest the x, variables decision the of function a is turn in which

,bankruptcy ofy probabilit the is P and ,bankruptcy of cost the is c

where

cP-)aB,z,(x,Ea( Firms

0

B

B0max

Costs Bankruptcy Expected Minus Wealth,

Terminal Expected Maximizing :II nformulatio eAlternativ

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ImplicationsImplications

I. Equity and credit rationing imply cash flow matters

II. Equity rationing implies that balance sheet effects matter

a. Especially unanticipated price declines (or slower than anticipated price rises) have distributive effects

b. Real consequences of distributive effectsi. Gains to winners do not offset losses to losers

(concavity of relevant functions)ii. Explains why economy may suffer both from a

positive oil price shock and a negative oil price shock

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Evidence –Investment equationsEvidence –Investment equations

I. Earliest studies suggested importance of cash flow effects

• Neoclassical dogma forced rejection of studies

II. Variety of methodologies now confirm role of both cash flow and balance sheet effects

III. Especially important in small and medium sized firms

IV. Especially important in investments in R&DV. Question role of real interest ratesVI. Consistent with evidence of importance of

nominal interest rates

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Other implications, aspects of risk Other implications, aspects of risk averse behavior of firms, averse behavior of firms, imperfect information (I)imperfect information (I)

I. Portfolio approach to adjustmenta. Firm demand,supply decisions based on risk

analysis

b. Strong interactions among decisions

c. Information asymmetries mean that firm knows more about where it is than about where it “might be” with alternative policies

i. Risk perceptions depend partly on framing, beliefs about others

ii. What does “status quo” mean?iii. Helps explain nominal rigiditiesiv. Role of coordination, coordination failures,

“inflationary psychology”

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Other implications, aspects of risk Other implications, aspects of risk averse behavior of firms, averse behavior of firms, imperfect information (II)imperfect information (II)

b. Information asymmetries introduce strong hysteresis effects

i. “Used labor” different from new laborii. “Old loan” different from new loaniii. Weak secondary markets for labor and loansiv. Implications: strong rigidities in adjustment

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Model (I) Model (I)

tttttt

tttttt

tttt

ttIttt

ttttt

lLhlwqL

pQheLGNN

KIKK

aIpLwB

where

drBpQpa

,,1

,,,

:

1,

1

1131

21

1111

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Model (II)Model (II)

investmentI

pricep

employmentL

wagew

rate interest nominalr

debtB

casha

whereand

:

policies employment sfirm'

the of function a rate, quit q

employee per hoursh

salesQ

dividendsd

function productionG

sinventorieN

stockcapitalK

t

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Model (III)Model (III)

111 ,,Max

:

tttt

32

1

i

NKaJdu

problem gprogrammin dynamic a with(2)

or (1) function objective the replace weframework general more

this Within ).production and rate, ondepreciati the demand;

affecting variable random a is ( variables random of vector a

is and policies, employment sfirm' the of function a also

force), labor the of hour perty productivi (average efforte

whereand

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I. Production is riskya. Most goods are not sold forwardb. Implying that firms must bear risk of shifts in

demand curves, pricesc. Implying that increases in risk will have adverse

effect on supplyd. And weakening of balance sheet will have adverse

effect on supplye. Implying that a demand shock in one period will

have adverse effects on supply in subsequent periods

• But that in turn will have implications for aggregate demand in those periods

Model (IV)Model (IV)

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Model (V)Model (V)

curve supply the into enter all "expections" and workers,trained and stock,

capital cash, free including assets, specificfirms the describing vector

a K, worth,net firm in dispersion worth,net average firm, facing

risks ,B ty,availabili capital on nsrestrictio capital, of cost Where

KaBwQQ

curve supply aggregate to Leading

x. in increase

an from costy banckruptc (expected) marginal the is where

CpF

:known is price output before spentbe

must (x) input single wherecase to model general ngSpecializi

*

a*

x

xxx

;;,;,, *

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Implications (I)Implications (I)

I. Most firms are price setters, not price takersa. With imperfect information, firms face downward

sloping demand curve for their productsb. Especially important when there is product

differentiation

II. In setting prices, production worry about riska. Strategic risk—response of rivalsb. Risk of excess productionc. For commodities that can be put into inventory at

moderate cost, risks associated with price adjustment greater than risks associated with excess production—implying slow adjustment of prices (and wages)

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Implications (II)Implications (II)

III. But adjustments of different prices, wages proceed at different rates

a. Different balances of costs and benefits• Asset prices determined in competitive

market places may adjust much more rapidly than commodity prices

b. Asymmetric price adjustments mean that there can be large real distributive, balance sheet effects

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Other implicationsOther implications

I. Procyclical inventory policya. High “shadow” interest rate in economic downturnb. Means that firms need to readjust portfolioc. Including “liquifying” assetsd. Inventory reduction relatively easy, least costly way of

obtaining liquidity

II. Procyclical markupsa. Again associated with high shadow interest rate in

downturnb. Discouraging investments in recruiting customersc. Implying higher markups in downturnd. Consistent with declining real product wages in

recessions

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Other ways that imperfect Other ways that imperfect information leads to rigiditiesinformation leads to rigidities

I. Search modelsa. Downward sloping demand curvesb. By asymmetries between consequences of lowering price (takes

time for those at other stores to discover) and raising prices (customers immediately know), can lead to kinked demand curve

II. Adverse selection models—efficiency wages and lending marketsa. Quality of those attracted depends on wages, prices offered by

othersb. Coordination failures—given beliefs that others are not adjusting

much, optimal adjustment may be lowIII. Rigidities in contract forms

a. Suspicion that those proposing new contract form have differential information, near “zero sum” world

IV. Because of costs of hiring and firing, doing nothing may have “option value”

a. Greater uncertainty, greater the rigidities

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Non-monetary paradigmNon-monetary paradigm

• What is wrong with old theory

• Principles of new theory

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What is wrong with old What is wrong with old theorytheoryMonetary theory based on transactions demand for money

especially problematicI. Money not needed for most transactions (credit used

for most)II. Most money is interest bearing

• Opportunity cost if “money” (difference between interest rate on CMA accounts and T-bills) simply determined by transactions cost, unrelated to economic activity

III. Most transactions trades in assets and not directly related to income generation

• Relationship between two not stable over business cycle

• Seeming instability of velocity—led to end of monetarism in most countries

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Differences between average annual T-bill rate and CMA rate

0%

1%

2%

3%

4%

5%

6%

7%

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

US Treasury Bills(3m)

Merrill Lynch U.S.Treasury Money Fund

Merrill Lynch ReadyAssets Trust

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Non constancy of velocity

Velocity

0

5

10

15

20

25 United States

India

Japan

Korea

Mexico

Venezuela

Money (current LCU) (mill) from World Development Indicators, World Bank, 2000.Definition - Money is the sum of currency outside banks and demand deposits other than those of central government. This series, frequently referred to as M1 is a narrower definition of money than M2. GDP at market prices (current LCU) (mill) from World Development Indicators, World Bank, 2000.

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Empirical puzzles and problemsEmpirical puzzles and problems

Standard theory focuses on ‘interest rate’ channel

I. Relative stability of real interest rates II. Little evidence of effect of real interest

rates on investment (US)III. Considerable evidence of effects on

nominal interest ratesIV. Investment equations in which cash flow

and net worth effects appear significant

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Relative stability of real interest rates

Source: International Financial Statistics (IFS) , Washington, DC: IMF, 2002.

United States

-15%

-10%

-5%

0%

5%

10%

1952

1956

1960

1964

1968

1972

1976

1980

1984

1988

1992

1996

2000

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Principles of new theory (I)Principles of new theory (I)

I. Based on supply of credit (loanable funds)II. Based on bank (and other) intermediation

a. Information problemb. Ascertaining credit worthinessc. Monitoring and enforcing loan contracts

III. Banks are “firms” that engage in these credit services

a. Entails risk bearingb. Willingness and ability to perform service

depends on balance sheet

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Principles of new theory (II)Principles of new theory (II)

IV. Theory focuses on how a) shocks to economy and b) policy (both macro-policy and regulatory policy) affect banks’ (and others’, including firms’) ability and willingness to provide credit

a. Regulatory policy has macro-economic effectsb. T-bill rate should not be center of policy analysis

—what matters is availability and terms of credit to private sector; marked changes in spread

V. Theory pays special attention to bankruptcy, credit interlinkages among firms (as important as standard general equilibrium product and factor interlinkages)

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New paradigm provides a framework New paradigm provides a framework for thinking about deflation and for thinking about deflation and alternative policy responsesalternative policy responses

• Deflation, particularly unexpected deflation, leads to real balance sheet effects which can adversely affect aggregate demand

• This is in addition to traditional real interest rate effects