Repeat After Me: The Quantity of Labor Demanded is Not Always Equal to the Quantity Supplied

I've been teaching a class on intermediate macroeconomics this quarter. Increasingly, over the past twenty years or more, intermediate macro classes at UCLA (and in many other top schools), have focused almost exclusively on economic growth. That reflected a bias in the profession, initiated by Finn Kydland and Ed Prescott, who persuaded macroeconomists to use the Ramsey growth model as a paradigm for business cycle theory. According to this Real Business Cycle view of the world, we should think about consumption, investment and employment 'as if' they were the optimal choices of a single representative agent with super human perception of the probabilities of future events. 

Although there were benefits to thinking more rigorously about inter-temporal choice, the RBC program as a whole led several generations of the brightest minds in the profession to stop thinking about the problem of economic fluctuations and to focus instead on economic growth. Kydland and Prescott assumed that labor is a commodity like any other and that any worker can quickly find a job at the market wage. In my view, the introduction of the shared belief that the labor market clears in every period, was a huge misstep for the science of macroeconomics that will take a long time to correct.

In my intermediate macroeconomics class, I am teaching business cycle theory from the perspective of Keynesian macroeconomics but I am grounding old Keynesian concepts in the theory of labor market search, based on my recent books (2010a, 2010b) and articles (2011, 2012, 2013a, 2013b).  I am going to use this blog to explain some insights that undergraduates can easily absorb that are adapted from my understanding of Keynes' General Theory. Today's post is about measuring employment.  In later posts, I will take up the challenge of constructing a theory to explain unemployment.

Ever since Robert Lucas introduced the idea of continuous labor market clearing, the idea that it may be useful to talk of something called 'involuntary unemployment' has been scoffed at by the academic chattering classes. It's time to fight back. The concept of 'involuntary unemployment' does not describe a loose notion that characterizes the sloppy work of heterodox economists from the dark side. It is a useful category that describes a group of workers who have difficulty finding jobs at existing market prices. 

The Impact of Financial Market Volatility on Emerging Market Economies

Early in the New Year, economists from all over the world will congregate in Boston for the 2015 annual meetings of the American Economics Association. The main purpose of these meetings is to interview new Ph.D. candidates for potential jobs as academics and in the public and private sectors as research and/or policy economists.  

Sangyup Choi

As an academic economist at UCLA, my job includes teaching undergraduates, carrying out economic research for publication in books and journals and, (my favorite part), training new Ph.D. economists. Teaching graduate students is a rewarding experience for an academic as we get to watch our students progress from undergraduates to colleagues. What begins as a teaching experience in year 1 ends up as a learning experience in year 5. 

Today's blog features my student, Sangyup (Sam) Choi, who is working on  the impact of financial market volatility on emerging market economies.  My colleague Aaron Tornell and I are Sam's principal advisors.

Sam is studying the VIX and its impact on economic activity. This is a hot topic amongst macroeconomists ever since Nick Bloom showed, in a paper published in Econometrica,  that shocks to uncertainty are a causal factor in US. recessions. What, you ask is the VIX?


The VIX is an index of volatility that goes up when traders are less certain about the future. In his Econometrica paper, Nick showed that shocks to the VIX are an independent causal factor that helps to predict future U.S. output. Here is a graph of the VIX for the period 2000 to 2014.

Figure 1: The VIX from 2000 to 2014

In a paper published last year in Economics Letters, Sam showed that Nick’s results are sensitive to the period of study. The VIX does predict future output in data from 1950 through 1982, but that result goes away after 1983. The largest recession in post war history in which the VIX jumped by a factor of four, (see Figure 1), did not have a significant independent impact on the U.S. economy, once other explanatory variables have been accounted for. That in itself is surprising. But it gets better.

Will Americans Ever Vote for a Far-Reaching Wealth Tax?

 Here is a link to my piece on inequality that was published today on the Guardian Economics Blog

What Thomas Piketty has shown us, is that since 1980, it is only the rich and the very rich who have benefited from growth, writes Roger Farmer

But there will come a time when the average American realises that the dream that his parents aspired to is no longer within his reach. Photograph: Peter Hundert/ Peter Hundert/cultura/Corbis

Don't Panic --- Yet!

Volatility has returned to the stock market and most of the gains of 2014 were wiped out in the last week. Is it time to panic? Not yet!

There is a close relationship between changes in the value of the stock market and changes in the unemployment rate one quarter later. My research here, and here shows that a persistent 10% drop in the real value of the stock market is followed by a persistent 3% increase in the unemployment rate. The important word here is persistent. If the market drops 10% on Tuesday and recovers again a week later, (not an unusual movement in a volatile market), there will be no impact on the real economy. For a market panic to have real effects on Main Street it must be sustained for at least three months.  And there is no sign that that is happening: Yet.

Figure 1: Wall Street and Main Street (c) Roger E. A. Farmer

Figure 1 plots a simple transformation of the value of the unemployment rate, measured on the left axis, and the real value of the S&P, measured on the right axis, in log units. This graph shows a clear correlation between these series and a more careful investigation reveals that this correlation is causal in the sense in which Clive Granger defined that term: there is information in the stock market that helps to predict the future unemployment rate.

It is of course, possible, that movements in the stock market are only apparently causal. In reality, the clever people who trade in the markets are prescient in their ability to foresee the very bad fundamentals that are driving the real economy. It is also possible that sometimes, market participants panic and that panic has real consequences when the rest of us find that our houses and pension plans are suddenly worthless. My own theoretical work supports the latter hypothesis but reasonable people can disagree.

So: should you be worried that we are about to enter a double dip recession? In my view, not yet, because, as of right now, the market shows no signs of a persistent drop when measured in real terms.    When (and if) the Yellen Fed follows through with its withdrawal of QE; we may be looking at a very different situation. Hang on to your hats!

Thought for the Day

 On the eve of the Nobel Prize in Economics, here is a thought for the day:

No great improvements in the lot of mankind are possible, until a great change takes place in the fundamental constitution of their modes of thought.  John Stuart Mill (Autobiography, 1824 Chapter 7)

Quoted from "How the Economy Works: Confidence Crashes and Self-Fulfilling Prophecies". Chapter 7.

Inequality and the Fourth Estate

I have been slow to chime in on Thomas Piketty’s book, Capital in the 21st Century, but it is hard to ignore the chatter that the book has generated from those on all sides of the political spectrum. The book sheds welcome light on the topic of income and wealth inequality and it has rekindled a debate in the United States and Europe on an age-old question: Should we care if some individuals earn much more than others?

As individuals in a modern democracy we make social decisions about how much of each good to produce and consume through free trade in a market economy. The rules by which we trade with others are determined through democratic elections in which we give power to our representatives to transfer resources from one human being to another. And we interact with each other through conversations, free association and social media or through more organized forms of persuasion such as newspapers and television stations. 

As economists, we are sometimes justly accused by other social scientists of taking a narrow view of human nature. A human being, to the neoclassical economist, is a preference ordering over all possible actions that he or she may take over the course of a lifetime. That preference ordering is fixed at birth and swings into action at the age of consent, at which time each of us exercises our endowed ability to choose among competing alternatives to maximize our happiness. 

That, of course, is poppycock. The view of homo-economicus as a utility seeking machine is not to be found in Smith, who had a much richer view of human nature as evidenced by his “other book” on The Theory of Moral Sentiments. Nor is it to be found in John Stuart Mill’s eloquent defense of free speech in his essay On Liberty. Both of those eminent social scientists would, I am certain, have been open to the idea that our opinions are formed through rational argument with other human beings. Our preference orderings do determine our actions; but they are not preordained. Nature and nurture are equally important determinants of human action.

Financial Policy

John Cochrane supports the case (forcefully made by Anat Admati) for higher capital requirements, citing excellent pieces by Pat Regnier at Time and Peter Coy at Business Week who explain exactly what this does and does not,  mean. I agree: we need banks to hold more capital.  But is that enough?

The following passages are extracts from my recent paper in the Manchester School on the role of the Financial Policy Committee as a guardian of financial stability.  I make the case that financial markets are inefficient because we cannot trade in markets that open before we are born. That fact is an important source of market incompleteness that I call the "absence of prenatal financial markets".

We all agree that financial crises occur. We disagree as to their cause. Some economists argue that markets are not only informationally efficient; they are also Pareto efficient. The boom and the bust are a consequence of the natural flow of knowledge acquisition in a capitalist economy. They are the price of progress. I disagree.