Regime Switching at the Lower Bound: A Research Topic for Students

I just returned from a conference at the San Franciso Fed on Monetary Policy and Financial Markets HERE where I discussed a paper by Fumio Hayashi and Junko Koeda. They use a novel way of identifying the effects of policy during periods of Quantitative Easing which recognizes that policy is different when interest rates are at the lower bound. An interesting take away from their paper is that QE is effective at reducing the output gap.

The Hayashi-Koeda paper suggests the following research topic for Ph.D. Students. H-K use an SVAR, i.e. a vector autoregression that is identified by making assumptions about the covariances of the variables. See Stock and Watson here for a summary of what that means.

The novelty in Hayashi Koeda is to allow for different coefficients of the VAR when the interest rate is at the lower bound. The pitfall here, is that although SVAR stands for "structural vector autoregression", there really isn't anything structural about it. An SVAR is just the reduced form of a DSGE model. And that means that the coefficients of the equations cannot be relied upon to remain constant if the policy rule changes.

Nothing new there -- we've known that for a long time. I was asked to discuss the paper because I've worked here (with Dan Waggoner and Tao Zha) on DSGE models where the parameters switch occasionally from one regime to another. Here is the interesting research topic. How are Regime switching SVARs of the kind estimated by Hayashi and Koeda, related to the Markov switching DSGE models that I studied with Dan and Tao?

Labor Markets Don't Clear: Let's Stop Pretending They Do

Beginning with the work of  Robert Lucas and Leonard Rapping in 1969, macroeconomists have modeled the labor market as if the wage always adjusts to equate the demand and supply of labor.

I don't think thats a very good approach. It's time to drop the assumption that the demand equals the supply of labor. 

Why would you want to delete the labor market clearing equation from an otherwise standard model?  Because setting the demand equal to the supply of labor is a terrible way of understanding business cycles.

Thought for the Day

"In economics, the majority is always wrong." — John Kenneth Galbraith

Asset Prices in a Lifecycle Economy

I have just completed a new paper on asset prices, "Asset Prices in a Lifecycle Economy".  The paper is available here from the NBER or here from my website.  This is a good time to comment on asset price volatility and the apparently contradictory findings of two of the 2013 Nobel Laureates because my paper sheds light on this issue. 

In 2013, Gene Fama, Lars Hansen and Robert Shiller, shared the Nobel Prize for their empirical analysis of asset prices.1 

Fama won the Nobel Prize for showing that financial markets are efficient. He meant, that it is not possible to make money by trading financial assets because markets already incorporate all available information. 

Shiller won the Nobel Prize for showing that financial markets are inefficient. He meant that the ratio of the price of a stock to the dividends it earns, returns to a long run average value; hence, an investor can profit by holding undervalued stocks for very long periods. 

These apparently contradictory results are consistent  because Fama and Shiller are referring to different concepts of efficiency.

When Fama says that financial markets are efficient, he means informational efficiency. There is a second concept that economists call Pareto efficiency. This means that there is no possible intervention by government that can improve the welfare of one person without making someone else worse off. The fact that markets are informationally efficient does not necessarily mean that they are Pareto efficient and that fact helps to explain why financial markets appear to do such crazy things over short periods of time.

Doing Economics: A Thought for the Day for Grad Students

A common mistake amongst Ph.D. students is to place too much weight on the ability of mathematics to solve an economic problem.  They take a model off the shelf and add a new twist. A model that began as an elegant piece of machinery designed to illustrate a particular economic issue,  goes through five or six amendments from one paper to the next. By the time it reaches the n'th iteration it looks like a dog designed by committee.

Mathematics doesn't solve economic problems. Economists solve economic problems. My advice: never formalize a problem with mathematics until you have already figured out the probable answer. Then write a model that formalizes your intuition and beat the mathematics into submission. That last part is where the fun begins because the language of mathematics forces you to make your intuition clear. Sometimes it turns out to be right. Sometimes you will realize your initial guess was mistaken. Always, it is a learning process.

Did Keynes have a Theory of Aggregate Supply?

My old classmate Nick Rowe has a new post on Chapter 3 of The General Theory.  In Nick's words,

Start with three equations.

1. The production function: Y=F(L). Output (Y) is a function of employment (L). 

2. A "classical" labour demand curve: W/P=MPL(L). The real wage (W/P) equals the Marginal Product of Labour, which is a decreasing function of employment. This is Keynes' "first classical postulate", which he agreed with. 

3. A "classical" labour supply curve: W/P=MRS(L,Y). The real wage equals the Marginal Rate of Substitution between labour (or leisure) and output (or consumption). This is Keynes' "second classical postulate", which he disagreed with (except at "full employment"). 

From 1 and 2, plus some tedious math, we can derive what Keynes calls "the aggregate supply function": PY/W = S(L). It shows the value of output, measured in wage units, as a function of employment. It is substantively identical to the Short Run Aggregate Supply Curve in intermediate macro textbooks that assume sticky nominal wages: Y=H(P/W), which uses the exact same equations 1 and 2, but presents the same solution differently. 

From 1 and 3, plus some tedious math, we can derive a second "aggregate supply function", that is not in the General Theory: PY/W = Z(L). It is substantively identical to the short run aggregate supply curve implicit in New Keynesian models, which assume sticky P and perfectly flexible W, so the economy is always on the labour supply curve and always on the production function.

From 1 and 2 and 3, plus some tedious math, we can solve for Y, L, and W/P, and derive a third aggregate supply function: Y=Y*. This is the textbook Long Run Aggregate Supply curve. It is identical to the solution we could get if we solved for the levels of Y, L, and W/P that satisfied both the first and second "aggregate supply functions".

Nick's first supply curve is the only supply curve in The General Theory. All else is due to misinterpretations by later economists who tried to make sense of what Keynes really meant (ineffectively in my view).  We don't need sticky prices (supply curve number 2) and we don't need to reintroduce the second classical postulate through the back door (supply curve number 3).  That is 1950s MIT talking and it led us down the wrong path.