Macroeconomic Problems, Microeconomic Solutions Peter J. Boettke Econ 881/Spring 2005 February 28

Main Points to Stress Macroeconomic problems are coordination problems  Production plans must mesh with consumption demands Capital and Labor Incentives must be aligned and capabilities must be exploited  Incentive problems are knowledge problems and knowledge problems are incentive problems Changing circumstances result in disturbances, but the crucial question is one of adjustment  Feedback and learning through time

Macroeconomic Problems Errors of Over optimism  Produce products which nobody wants Errors of Over pessimism  Don’t product products which people want  Capital goods are allocated incorrectly; capital investments are inappropriate; labor is misallocated; and as a result the economy underperformed from the point of view of realizing the mutual gains from exchange, employing resources efficiently, and satisfying the demands of consumer sovereignty.

What is the solution to these problems? Classical  Market discipline Keynesian  Government correctives Fiscal policy Mix of fiscal and monetary policy After Keynes  Market equilibrium

Fiscal Policy Versus Monetary Policy as a Corrective Keynesian World ViewMonetarist World View LM IS LM YY r r Liquidity trap makes monetary policy ineffective Crowding out makes fiscal policy ineffective

Neo-Keynesian Synthesis r Y IS LM r Y Goods Market equilibrium; Money Market equilibrium

What is Wrong With this Picture? Unconnected to the Choices of Individuals  Labor Market Money Illusion  Capital Market Fiscal Illusion Autonomous Investment  Capital Goods Market Time and the Process of Production Complementarity and Substitutability in the chain of production

Labor Market Response Workers do not persistently suffer from money illusion N W/P W/P 0 W/P 1 N0N0 N1N1

Short Run Phillips Curve U I Long Run at Natural Rate Short Run Trade Off as Workers Suffer Money Illusion

Lucas Critique of Keynesian System Adaptive Expectations → Rational Expectations  Bayesian Learning Expectations on underlying distribution  Methodological Rule --- economist cannot assume a level of knowledge greater than the participants in the economy Equilibrium Theory of the Business Cycle  Monetary Neutrality and Market clearing Noise and disturbances to the system (signal extraction)  Invariance proposition

Upshot of Lucas Critique Short Run and Long Run Phillips Curve are the same Microfoundations of Macroeconomics provides coherence to the discipline General Competitive Equilibrium  Optimizing behavior  Continuous Market Clearing

Is New Classical Economics Austrian Economics? Microfoundations  Aggregate economics unconnected to choice Compositive Method, Rationality  Hypothesis or axiom Choice under uncertainty Expectations and the Equilibrium Construct  Logical coherence Process theory and adjustment, 236, fn. 25

The Classic Austrian Theory of the Cycle r Q D SoSo S1S1 r QS/C Higher Order Goods Lower Order Goods

Main Tenets of the ABTC Non-neutrality of Money  Injection effects through Relative price adjustments Capital Structure  Heterogeneous and multi-specific goods Capital maintenance and entrepreneurial decision making Intertemporal Coordination and Monetary mechanism  Interest rates as signals between present and future Complimentarity of Capital and Labor  Employment of scarce resources

Critique of ABCT Theory  Bias error and bias toward particularly costly errors  Incoherence of grafting a disequilibrium story on an equilibrium theory Empirical  Co-movement of investment and consumption  Limited applicability of interest rate mechanism as trigger