Category Archives: macroeconomics

Game Thoery and Macroeconomics

The increasing emphasis on micro-foundations in macroeconomics seems to have lead to modeling efforts incorporating strategic decision making at the individual level in a general equilibrium setting yielding interesting insights on important questions.  A couple of days at a workshop organized by the Center for Game Theory at the scenic Stony Brook university on the use of game theory in macroeconomics was indeed an enjoyable experience in this regard. Here is a peek at a few interesting papers from the workshop.

1. B Ravikumar et al, Unemployment Insurance Fraud and Optimal Monitoring:

How do you address the problem that the unemployment benefits overpaid because of fraud are more than ten times the overpayments due to insufficient search?  Ravikumar and his coauthors  study optimal monitoring of fraudulent behavior in a model of unemployment insurance and suggest an interesting optimal monitoring mechanism to avoid the overpayment .

2. Harold Cole, Why does technology not flow to developing countries?

A very interesting approach to answering the question asked originally by Robert Lucas in his 1990 AER paper.  Cole and his coauthors concentrate on efficiency of financial system of a country as the factor determining technology adoption. They conduct a comparative analysis of technology adoption in the US, Mexico and India to help shed light on the question. They propose that “the ability of an intermediary to monitor and control the cash ‡flows of a fi…rm plays an important role in a fi…rm’s decision to adopt a technology“. This is where the efficiency of the financial system comes into play.  Based on this hypothesis, they develop a costly state verification model of venture capital where the position of a firm wishing to adopt a particular technology on the technology ladder is private information. An intermediary financing the adoption of technology for  such a firm has to incur positive costs for monitoring and where it cannot monitor, it has to develop incentive schemes to ensure successful running of the venture.  The model is then embedded in a general equilibrium framework and calibrated to the US, Mexico and Indian data for applied analysis.

3. Perri Fabrizio and Vincenzo Quadrini, International Recessions.

The recession following the recent financial crisis in the US is different than the ones before in many respects. One of them is that this recession seems to be internationally synchronized at least for the developed countries. How do we explain this synchronization? Perri develops a two-country model with financial market frictions where a credit tightening can emerge as a self-fulling equilibrium caused by pessimistic but fully rational expectations. As a result of the credit tightening, countries experience large and endogenously synchronized declines in asset prices and economic activity (international recessions). The model suggests that these recessions are more severe if they happen after a prolonged period of credit expansion.

4. Xavier Mateos-Planas and Victor Rios Rull, Credit Lines.

An interesting analysis of unsecured credit arising out of use of credit cards:

This paper develops a new quantitative theory of long-term unsecured credit contracts. Households can default and can switch credit lines. Banks can change the credit limit at any time, but must commit to the interest rate or not depending on the regulatory setting. Without commitment, the distribution of households over interest rates, credit limits and wealth matches observed patterns. We study the new regulatory rules in the card market which require a stronger commitment from banks not to raise interest rates discretionally. This results in tighter limits but lower interest rates, reduced indebtedness and lower default.

Overall it was a good food for thought and a much needed intellectual refreshment!

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Factor shares in India’s National Income

The business cycle properties of data in the US says that consumption is much less volatile than the GDP. This suggests that households do engage into consumption smoothing and hence looking at consumption distribution is not a good gauge for what is happening to income distribution. A similar argument can also be made for India and hence the debate on effects of liberalization policies would do better if based on income distribution than just on consumption distribution. C.P. Chandrashekhar and Jayati Ghosh make this point quite well in their recent column in The Hindu Business Line.

According to their analysis the share of wages and salaries in the national income of India has shown a decline since 1991. This decline is evident both as a share of total NDP as well as of Organized sector NDP. It was roughly around 70% for a decade preceding the economic reforms and has declined since to 50% in the year 2009. This might seem surprising given that in the US (and probably most of the developed world ) the share of compensation of employees in national income has remained between 60-70% for last 50 years or so.

The authors suggest this as an evidence for rising income inequality after the economic reforms and I don’t necessarily disagree with that interpretation.This issue is certainly important to look into and might suggests a role for policy intervention.

However, the contrast with the US suggests that there might be some other factors at play causing the shares to settle at different values in both these countries. One reason for this contrast is that the factor shares could reflect the relative factor scarcity. Capital being relatively scarce in developing countries compared to the developed ones, higher overall returns for it might be expected. The other reason might be the declining importance and presence of unions in the Indian organized sector after reforms than before. If one admits that most of the growth of the organized sector has been because of the rising service sector, then this does makes sense. In addition, the continuing rigidity of labor laws might also mean a lower opportunity cost for ones time further reducing the bargaining power of the workers.

Overall, these empirical regularities and differences in factor shares across countries are definitely worth investigating more.

Update- January 24, 2014: The recent issue of QJE has a paper on this issue. Looks like declining labor share is not just an Indian phenomenon. The authors surmise that the relative decline in price of investment goods explains this trend. You can read it here.

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Filed under current economic issues, India-US: Some Conundrums, indian economy, macroeconomics

Modeling the economist modeling the economy!

Saint-Paul Gilles of Toulouse School in Paris is one of those economists whom, you cannot afford not to read. If he writes it, you read it period. He has come up with a very interesting paper on the political economy of macroeconomic thinking- again a must read! you can find it here.

A few months back, I came across an interesting presentation by him titled “Endogenous Indoctrination“. He uses interesting techniques to see how indoctrination can evolve in a society and influence voter attitudes where teachers have a certain attitude towards the market system.


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Networks and Macroeconomics

No other field challenges your beliefs like macroeconomics. It will just not allow you to rest unless you decide to give up and fall into the trap of what Ricardo Cabellaro calls ‘the pretense of knowledge’. In a very convincingly argued case against the pitfalls of reading too much into the precision and addictiveness of the Dynamic Stochastic General Equilibrium Modelling framework, he introduces us to some interesting, alternative ways of looking at the macroeconomy.

These models try to capture the nature of economic complexity that is easily eschewed by the DSGE framework in favor of precision and neat quantitative results. According to Caballero, “ the nodes of such economic models are special for they contain agents with frontal lobes who can both strategize and panic”. Networks are important and such agents introduce much of unpredictability in the linkages.

Do agents always understand the complete networks and linkages? Apparently not. In fact  “the importance of this lack of understanding is at its most extreme level during financial crises when seemingly irrelevant and distant linkages are perceived to be relevant”.  Novelty and uncertainty play an important role in determining the size of reaction as well.

He also introduces us to literature that deals with developing a policy framework which is robust to small mistakes from the policy maker. Hansen and Sargent’s extremely readable “Robustness” is an important contribution to this literature.

I don’t really have the expertise to comment on what this means for the fate of the whole DSGE world and whether grad students can get away with not learning it. However, I am definitely convinced that the research cited by Cabellaro certainly offers a fresh perspective of linking individual behavior to macro behavior. Randomly browsing the net for his cited references, I came across a course on networks offered by Daron Acemoglu of MIT. The introduction in his course syllabus is worth reproducing here:

Networks are ubiquitous in our modern society. The World Wide Web that links us to and enables information flows with the rest of the world is the most visible example. But it is only one of many networks within which we are situated. Our social life is organized around networks of friends and colleagues. These networks determine our information, influence our opinions, and shape our political attitudes. They also link us, often through important but weak ties, to everybody else in the United States and in the world. Economic and financial markets also look much more like networks than anonymous marketplaces. Firms interact with the same suppliers and customers and use web-like supply chains. Financial linkages, both among banks and between consumers, companies and banks, also form a network over which funds flow and risks are shared. Systemic risk in financial markets often results from the counterparty risks created within this financial network. Food chains, interacting biological systems and the spread and containment of epidemics are some of the other natural and social phenomena that exhibit a marked networked structure.

So, while working on the dissertation, when I was just starting to think that I finally might have made it at least somewhat near the frontier, here comes a group of very intelligent economists pushing it even further!

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Filed under current economic issues, macroeconomics, Macroeconomics and the crisis, social perspectives

Thinking about price stickiness

In a previous post I jotted down what I think about the issue of price stickiness and its implications for the issue of relevant macroeconomic framework.  In an interesting blog post, David Andolfatto takes the thinking way further than I can imagine right now.

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Notes on Workshop on Financial Crisis, Montreal PQ

I was quite excited about this workshop. It had all the right speakers and almost everyone was eager to listen to what they have to say about the crisis. The workshop was didvided into two parts. In the first part, Timothy Lane from Bank of Canada, Robert Hall from Stanford and the Hoover institution and Narayana Kocherlakota from the Fed Minneapolis presented their thoughts on the crisis.

Timothy Lane’s talk was a good survey of lessons learnt so far from the crisis with a bit of central banker’s perspective. Robert Hall’s speech promised a lot. It was kind of a precursor to what he was suppose to talk the next at the SED plenary session (the plenary talk did not turn out be that interesting though!). One of the important points that he made based on the data was that the zero lower bound on the interest rate may not mean much if the rates faced by consumers are positive and sticky. The second arguement was that because consumption expenditure has been pretty resilient and productivity infact surged during the crisis the real business cycle explainations of the crisis are completely useless.

Narayana’s speech turned out to be the attraction of the evening.  Based on the idea that finanical investments by banks pose a negative externality and hence need to be internalized by taxing risk taking, in his speech he carefully laid out the arguement and some thoughts on how to approach its implentation.  When Kocherlakota was appointed as the Fed Chief, lot of people had doubts about his effectiveness as a policy maker. But he has time and again proved that clear and disciplined thinking can save the day anywhere. I am sure in the coming days this first rate theoretician will have many interesting things to say and I will be all ears!

The second half of the workshop was a round-table discussion by two Nobel prize winners- Bob Lucas and Ed Prescott and John Murray from Bank of Canada. It contained much of off hand talk by Bob Lucas and a no nonsense presentation by Ed Prescott. In spite of the argument by Bob Hall above,  Prescott continued with his RBC story of the crisis. He argued that Hall is wrong because data can be revised any time and mostly contrary to what Hall is saying. Hall argued that Prescott is wrong because his RBC story requires completely unrealistic estimates of Frisch elasticity. The most notable feature of the evening, however, was that in spite of the clash of titans, all the questions after the presentations and the round table were for Kocherlakota and his idea of risk tax. He kind of completely stole the show.

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Did Keynes get it wrong?

In an earlier post, I argued that the newclassical framework may be the right one for macroeconomic analysis. This was because recent microeconomic evidence suggests that prices are actually quite flexible. It means that market responds to clear the shelves! Were markets responsive even during the Great Depression? Obviously not- otherwise we would not have had a severe and prolonged depression in the first place. In fact Lord Keynes famously argued that prices and wages were rigid downwards and hence markets could not clear causing the great depression. An important question is was this rigidity a result of optimizing decisions or was caused because of something else?

If we decide  to believe Prof. Ohanian of UCLA, then this rigidity was not because markets did not respond but it was more of a case where they were not allowed respond. To support this claim, he develops a theory of labor market failure for the Depression based on Herbert Hoover’s industrial labor program that provided industry with protection from unions in return for keeping nominal wages fixed. He finds that the theory accounts for much of the depth of the Depression and for the asymmetry of the depression across sectors. The theory also can reconcile why deflation/low nominal spending apparently had such large real effects during the 1930s, but not during other periods of significant deflation.

You can watch this video in case you don’t want to read the paper.

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New keynesian or New classical?

For quite some time now I have been struggling with the question of what is the appropriate theoretical framework for macroeconomic analysis. The new Keynesian framework assumes that prices are rigid, whereas the new classical framework assumes that prices are flexible and hence markets always clear. Which one is the right assumption?

There has been significant amount of research done about price flexibility in reality starting with the seminal paper by Bills and Klenow (2005). In a more recent paper by Klenow and Malin(2010), the authors summarize this research and try to give us a clear picture on the evidence concerning frequency of price changes. One of their important conclusions is that the prices change at least once a year with temporary price changes and discounts taking up most of this change.  After excluding these short term changes, they conclude that prices change close to once a year. Of course there is significant variation in frequency of price changes across goods with prices of more cyclical goods changing with a higher frequency than others. But more importantly,  there exist strong linkages between price changes and wage changes.

How does this evidence bear on the question of relevant macroeconomic framework? It certainly seems that prices are actually much more flexible than what we would like to believe.  Given the lagged effect of any policy change, be it fiscal of monetary, it would certainly be true that on an average prices would have changed at least once before the effect materializes.  If this holds then prices have to be treated as flexible for policy analysis purposes and hence the appropriate macroeconomic framework would definitely be the new classical one! At least that is how I would like to think about the issue. Any thoughts on it?

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Why are we in recession?

The spread of the current financial crisis from the US to countries across the globe just showed how interlinked today’s national economies are. The importance of trade and financial flows in such interlinking cannot be overemphasized.  However, what about the linkages emanating from from a global labor market? Does it have anything to do with the current crisis? Ravi Jagannathan and folks have something interesting to say on this.

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More on Government Spending Multipliers

How large is the government spending multiplier? A more recent paper by Christiano et. al. sheds some new light. This paper is more centered on the US. Here is a link for how large is the government multiplier internationally.

A new paper by Cogan et al. finds that the effect of fiscal stimulus is 1/6 th of those estimated by Christina Romer and Bernstein.

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