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Consider a micro-founded model of the Macro-economy where agents are endowed wit...

May 1, 2024

Consider a micro-founded model of the Macro-economy where agents are endowed with Rational Expectations. a) Why are some economists dissatisfied with the answers such a model provides? b) Does Complexity theory fare any better? c) Does Post-Keynesian theory fare any better?

Answer

Some economists are dissatisfied with rational expectations models due to their oversimplification of economic behavior, neglect of real-world frictions, and inability to account for economic crises. Complexity theory and Post-Keynesian theory offer alternative approaches that incorporate more realistic dynamics but have their own limitations.

Solution

Dissatisfaction with Rational Expectations Models: Economists are dissatisfied with rational expectations models because they often fail to predict or explain economic crises, assume perfect information, and overlook the complexity of human behavior

Complexity Theory: Complexity theory provides a more nuanced view of economic dynamics by considering the interactions and feedback loops within the economy. However, it can be criticized for its lack of precise predictions and difficulty in empirical validation

Post-Keynesian Theory: Post-Keynesian theory emphasizes the role of uncertainty, non-neutrality of money, and the influence of effective demand on output. It is considered better at explaining certain macroeconomic phenomena like persistent unemployment, but it may lack the mathematical rigor and predictive clarity of rational expectations models

Key Concept

Rational Expectations vs. Alternative Theories

Explanation

Rational expectations models are critiqued for their unrealistic assumptions, while complexity and Post-Keynesian theories offer more descriptive realism but face challenges in precision and validation.

Repeat this format for each question the student has posed.

Consider a government dynamic budget constraint in debt to GDP terms. a) Why is the stability of this equation a matter of concern? b) How do rating agencies affect the equation and its stability? c) This approach maintains that the government budget constraint is effectively comparable to that of a household. What insight do we gain from such a comparison and what are its limitations?

Answer

The stability of the government's dynamic budget constraint is crucial for assessing fiscal sustainability. Rating agencies influence the perceived risk and thus the cost of borrowing for a government. Comparing the government budget constraint to that of a household provides insights into fiscal discipline but fails to capture the government's unique abilities to tax and issue currency.

Solution

The stability of the government's dynamic budget constraint, often expressed as

\frac{B_t}{Y_t} = \frac{(1+r)B_{t-1} - T_t}{Y_t}

, where

B_t

is the government debt at time t,

Y_t

is the GDP at time t, r is the real interest rate, and

T_t

is the total taxes collected, is a matter of concern because: - It indicates whether the government can maintain its current fiscal policy without defaulting. - It affects the government's ability to finance its operations and investments. - Instability can lead to a loss of investor confidence and higher borrowing costs

Rating agencies affect the equation and its stability by: - Assessing the government's creditworthiness, which influences the interest rate r that the government must pay on its debt. - Changes in ratings can lead to changes in investor perceptions and borrowing costs, potentially making the budget constraint more difficult to stabilize

The comparison of the government budget constraint to that of a household suggests: - Both entities need to balance their budgets over time. - It emphasizes the importance of not perpetually borrowing more than what can be repaid. However, the limitations of this comparison include: - Governments have the power to tax and create money, which households do not. - Governments can influence their own revenue through policy changes, unlike households. - The time horizon over which governments operate and plan is typically much longer than that of households

Key Concept

Fiscal Sustainability

Explanation

Fiscal sustainability refers to the government's ability to sustain its current fiscal policy and debt levels without risking insolvency or default. It is crucial for maintaining economic stability and investor confidence.

Key Concept

Credit Ratings and Borrowing Costs

Explanation

Credit ratings provided by rating agencies affect a government's perceived creditworthiness, influencing the interest rates on government debt and thus the cost of borrowing. Changes in ratings can impact the stability of the government's budget constraint.

Key Concept

Government vs. Household Budget Constraints

Explanation

Comparing government and household budget constraints highlights the importance of fiscal discipline but fails to account for the government's unique financial tools, such as taxation and money creation, which can alter its budgetary outcomes.

Consider a model of an economy with an explicit banking sector as in Howells (2009). a) What problems does the existence of the Zero Lower Bound in the setting of the policy rate create? b) How can we introduce balance sheet liquidity considerations and the effect of securities markets? c) Why would Minsky maintain that such a financial structure inevitably generates cycles?

Answer

The Zero Lower Bound creates liquidity trap conditions, balance sheet considerations and securities markets can be introduced through financial frictions and portfolio choices, and Minsky's financial instability hypothesis suggests that financial structures contribute to economic cycles.

Solution

Zero Lower Bound Problems: The Zero Lower Bound (ZLB) on the policy rate can lead to a liquidity trap where monetary policy becomes ineffective in stimulating the economy

Introducing Balance Sheet and Securities Markets: Balance sheet liquidity considerations can be introduced by modeling banks' assets and liabilities, and the effect of securities markets can be incorporated by considering the portfolio choices of banks and other financial institutions

Minsky's Financial Cycles: Minsky would argue that financial structures are prone to cycles due to the inherent tendencies of businesses and banks to take on more risk during prosperous times, leading to a build-up of financial fragility and eventual crises

Key Concept

Liquidity Trap

Explanation

The Zero Lower Bound can result in a liquidity trap, where traditional monetary policy tools lose their effectiveness, and increasing the money supply does not lead to lower interest rates or increased investment.

Key Concept

Financial Frictions and Portfolio Choices

Explanation

Balance sheet liquidity considerations and the effect of securities markets can be modeled through financial frictions that affect banks' lending decisions and through the portfolio choices that banks and other financial institutions make in response to different economic conditions.

Key Concept

Financial Instability Hypothesis

Explanation

Minsky's view is that economic cycles are driven by the financial structure of the economy, where periods of economic stability lead to increased borrowing and risk-taking, eventually resulting in financial instability and economic downturns.

Consider a Real Business Cycles model of the economy. a) What are its defining assumptions? b) How does it fare in terms of internal and external consistency? c) Why do some economists consider it implausible as an explanation of observed cycles?

Answer

The Real Business Cycles (RBC) model is based on the idea that economic fluctuations are primarily driven by real (not monetary) shocks, such as technology changes. It is consistent internally but has faced criticism for external consistency and plausibility.

Solution

Defining Assumptions of RBC Model: - Economic agents are rational and have perfect foresight. - Markets are always in equilibrium (clear). - Fluctuations in the economy are driven by real shocks, particularly technological innovations. - The model ignores monetary and nominal rigidities. - Labor and goods markets are perfectly competitive

Internal and External Consistency: - Internally, the RBC model is consistent as it is based on microeconomic foundations and general equilibrium theory. - Externally, the model struggles with consistency when compared to empirical evidence, as it cannot easily explain certain observed phenomena like the persistence of business cycles or the volatility of employment

Criticisms of Plausibility: - Economists find the RBC model implausible because it attributes fluctuations mainly to technology shocks, which seem insufficient to explain the frequency and depth of observed economic cycles. - The assumption of perfect foresight and the neglect of monetary policy are also seen as unrealistic

Key Concept

Real Business Cycles (RBC) Model

Explanation

The RBC model is a framework in macroeconomics that explains economic cycles through real shocks, particularly technological changes, assuming rational agents and market equilibrium.

Key Concept

Internal and External Consistency

Explanation

Internal consistency refers to the logical coherence of the model's assumptions and conclusions, while external consistency pertains to the model's ability to match empirical data and observed economic behavior.

Key Concept

Plausibility of RBC Model

Explanation

The plausibility of the RBC model is questioned due to its reliance on real shocks to explain complex economic cycles and its assumptions of perfect foresight and market clearing, which are often at odds with empirical observations.

Consider the economy described in part A section d. a) The agent described is now embedded in an Overlapping Generations model. Solve the representative agent’s problem. Describe how agents “overlap” within this framework. b) Solve the firm’s problem by finding the factor remunerations of capital and labour. c) Find the competitive equilibrium of this model.

Answer

The representative agent's problem in an Overlapping Generations model is solved by maximizing utility subject to a budget constraint, agents "overlap" by living for two periods, firms determine factor remunerations by maximizing profits, and the competitive equilibrium is found when supply equals demand for both capital and labor markets.

Solution

Representative Agent's Problem: The representative agent maximizes utility subject to their budget constraint over two periods of life

Overlapping Generations: Agents are born, live for two periods (young and old), and overlap with one generation entering the workforce while the previous one is retiring

Firm's Problem: The firm maximizes profit by choosing the optimal amount of capital and labor, leading to factor remunerations determined by their marginal products

Competitive Equilibrium: The competitive equilibrium occurs when the supply and demand for capital and labor are equal, resulting in market-clearing wages and rental rates of capital

Key Concept

Overlapping Generations Model

Explanation

This model captures the economic interactions between different generations, with agents living for two periods and making consumption and savings decisions that affect both their own utility and the economy's capital accumulation.

Key Concept

Firm's Profit Maximization

Explanation

Firms maximize profits by hiring labor and capital up to the point where the marginal product of each factor equals its price, which determines the factor remunerations in the economy.

Key Concept

Competitive Equilibrium

Explanation

A competitive equilibrium in this context is achieved when the markets for capital and labor clear, meaning that the amount supplied equals the amount demanded at the equilibrium prices.

Answer

Some economists are dissatisfied with rational expectations models due to their assumptions of perfect information and optimization, which may not reflect real-world behavior. Complexity theory and Post-Keynesian theory offer different perspectives that may better capture the dynamic and uncertain nature of the macroeconomy.

Solution

Dissatisfaction with Rational Expectations Models:

Economists are dissatisfied with rational expectations models for several reasons, including the assumption of perfect information, the neglect of real-world frictions and complexities, and the inability to account for economic crises and persistent unemployment.

Complexity Theory:

Complexity theory may fare better as it incorporates heterogeneous agents, non-linear dynamics, and network effects, which can lead to emergent macroeconomic phenomena not captured by rational expectations models.

Post-Keynesian Theory:

Post-Keynesian theory may also fare better by emphasizing the role of uncertainty, the non-neutrality of money, and the importance of effective demand, which challenge the rational expectations assumption of market clearing and equilibrium.

Key Concept

Rational Expectations Models

Explanation

Rational expectations models assume that agents have perfect foresight and use all available information to make optimal decisions, leading to a tendency to underestimate the complexity of economic behavior and overstate the stability of the economy.

Key Concept

Complexity Theory

Explanation

Complexity theory in macroeconomics takes into account the interactions between agents and the resulting non-linear dynamics, which can lead to more realistic models of economic fluctuations and financial crises.

Key Concept

Post-Keynesian Theory

Explanation

Post-Keynesian theory focuses on the role of uncertainty, the endogeneity of money, and the principle of effective demand, which can lead to persistent disequilibrium and the importance of fiscal and monetary policies in stabilizing the economy.