1. Is Keynes Dead? Reviving A Sensible Macroeconomics Joseph E. Stiglitz Columbia University Oxford May 13-15th, 2003

2. 2 Lectures  Lecture 1: Fluctuations in business cycle theories  Lecture 2: Towards a new paradigm for macroeconomics  Lecture 3: Applications to economic policy

3. 3 Towards a new paradigm of macroeconomics I. Premises II. Underlying pillars III. Capital market imperfections a. Theory b. Evidence c. Implications IV. Risk Averse theory of the firm a. Theory b. Consequences a. Portfolio theory of adjustment of the firm b. Specific implications V. Other ways that imperfect information leads to rigidities VI. New monetary paradigm

4. 4 Premises Imperfect information and incomplete markets are at the center of an explanation of economic fluctuations I. Lead to capital, labor, and product markets behaving markedly differently than in standard neoclassical theory II. Focus not just on aggregate demand but also on aggregate supply; two intertwined If aggregate demand were only problem, then small countries in competitive markets should never face a problem— adjustment of exchange rate would imply they face a horizontal demand curve for their products III. Issue is not so much wage and price rigidities, but differences in speeds of adjustment, and distributional consequences of price adjustments IV. Key role played by credit availability—new paradigm of monetary economics in which focus is on credit availability rather than transactions demand for money V. Key role played by imperfect insurance and consequent distributive shocks

5. 5 Underlying pillars (I) I. Labor market —efficiency wage theory a. Generates equilibrium unemployment b. But also affects dynamics of adjustment c. Imperfections of competition mean firms are wage setters II. Product market —imperfect competition a. Implies firms are price setters III. Capital markets —credit and equity rationing a. New theory of the firm i. Risk averse behavior ii. “Portfolio approach to adjustment” Determines wages, prices, inputs, outputs b. New monetary paradigm

6. 6 Underlying pillars (II) IV. Macro-economic behavior a. Based on micro-economic theories b. Particular attention paid to: i. Finance ii. Including financial interlinkages (as important as standard g.e. interlinkages) iii. Cash flow, balance sheet effects iv. Distributive consequences of shocks v. Differences in speeds of price adjustment

7. 7 A closer look at capital imperfections I. Not just a matter of transactions costs (Stigler) II. Lead to credit and equity rationing a. Most firms raise little of the funds required to finance new investment by issuing new equity b. Rejection of “Tobin q” models c. Importance of bank finance—role of banks in gathering and processing information III. Explicable in terms of models of asymmetric information (and costly state verification) IV. Equity rationing implies firms will be risk averse a. Can be modeled in terms of costs of bankruptcy or concave “utility function” b. Can be modeled in terms of behavior of managers—optimal incentive contracts entail managers bearing some risk

8. 8 Simple model (I)

9. 9 Simple model (II)

10. 10 Simple model (III)

11. 11 Implications I. Equity and credit rationing imply cash flow matters II. Equity rationing implies that balance sheet effects matter a. Especially unanticipated price declines (or slower than anticipated price rises) have distributive effects b. Real consequences of distributive effects i. Gains to winners do not offset losses to losers (concavity of relevant functions) ii. Explains why economy may suffer both from a positive oil price shock and a negative oil price shock

12. 12 Evidence –Investment equations I. Earliest studies suggested importance of cash flow effects Neoclassical dogma forced rejection of studies II. Variety of methodologies now confirm role of both cash flow and balance sheet effects III. Especially important in small and medium sized firms IV. Especially important in investments in R&D V. Question role of real interest rates VI. Consistent with evidence of importance of nominal interest rates

13. 13 Other implications, aspects of risk averse behavior of firms, imperfect information (I) I. Portfolio approach to adjustment a. Firm demand,supply decisions based on risk analysis b. Strong interactions among decisions c. Information asymmetries mean that firm knows more about where it is than about where it “might be” with alternative policies i. Risk perceptions depend partly on framing, beliefs about others ii. What does “status quo” mean? iii. Helps explain nominal rigidities iv. Role of coordination, coordination failures, “inflationary psychology”

14. 14 Other implications, aspects of risk averse behavior of firms, imperfect information (II) b. Information asymmetries introduce strong hysteresis effects i. “Used labor” different from new labor ii. “Old loan” different from new loan iii. Weak secondary markets for labor and loans iv. Implications: strong rigidities in adjustment

15. 15 Model (I)

16. 16 Model (II)

17. 17 Model (III)

18. 18 I. Production is risky a. Most goods are not sold forward b. Implying that firms must bear risk of shifts in demand curves, prices c. Implying that increases in risk will have adverse effect on supply d. And weakening of balance sheet will have adverse effect on supply e. Implying that a demand shock in one period will have adverse effects on supply in subsequent periods But that in turn will have implications for aggregate demand in those periods Model (IV)

19. 19 Model (V)

20. 20 Implications (I) I. Most firms are price setters, not price takers a. With imperfect information, firms face downward sloping demand curve for their products b. Especially important when there is product differentiation II. In setting prices, production worry about risk a. Strategic risk—response of rivals b. Risk of excess production c. For commodities that can be put into inventory at moderate cost, risks associated with price adjustment greater than risks associated with excess production—implying slow adjustment of prices (and wages)

21. 21 Implications (II) III. But adjustments of different prices, wages proceed at different rates a. Different balances of costs and benefits Asset prices determined in competitive market places may adjust much more rapidly than commodity prices b. Asymmetric price adjustments mean that there can be large real distributive, balance sheet effects

22. 22 Other implications I. Procyclical inventory policy a. High “shadow” interest rate in economic downturn b. Means that firms need to readjust portfolio c. Including “liquifying” assets d. Inventory reduction relatively easy, least costly way of obtaining liquidity II. Procyclical markups a. Again associated with high shadow interest rate in downturn b. Discouraging investments in recruiting customers c. Implying higher markups in downturn d. Consistent with declining real product wages in recessions

23. 23 Other ways that imperfect information leads to rigidities I. Search models a. Downward sloping demand curves b. By asymmetries between consequences of lowering price (takes time for those at other stores to discover) and raising prices (customers immediately know), can lead to kinked demand curve II. Adverse selection models—efficiency wages and lending markets a. Quality of those attracted depends on wages, prices offered by others b. Coordination failures—given beliefs that others are not adjusting much, optimal adjustment may be low III. Rigidities in contract forms a. Suspicion that those proposing new contract form have differential information, near “zero sum” world IV. Because of costs of hiring and firing, doing nothing may have “option value” a. Greater uncertainty, greater the rigidities

24. 24 Non-monetary paradigm What is wrong with old theory Principles of new theory

25. 25 What is wrong with old theory Monetary theory based on transactions demand for money especially problematic I. Money not needed for most transactions (credit used for most) II. Most money is interest bearing Opportunity cost if “money” (difference between interest rate on CMA accounts and T-bills) simply determined by transactions cost, unrelated to economic activity III. Most transactions trades in assets and not directly related to income generation Relationship between two not stable over business cycle Seeming instability of velocity—led to end of monetarism in most countries

26. 26 Differences between average annual T-bill rate and CMA rate

27. 27 Non constancy of velocity

28. 28 Empirical puzzles and problems Standard theory focuses on ‘interest rate’ channel I. Relative stability of real interest rates II. Little evidence of effect of real interest rates on investment (US) III. Considerable evidence of effects on nominal interest rates IV. Investment equations in which cash flow and net worth effects appear significant

29. 29 Relative stability of real interest rates

30. 30 Principles of new theory (I) I. Based on supply of credit (loanable funds) II. Based on bank (and other) intermediation a. Information problem b. Ascertaining credit worthiness c. Monitoring and enforcing loan contracts III. Banks are “firms” that engage in these credit services a. Entails risk bearing b. Willingness and ability to perform service depends on balance sheet

31. 31 Principles of new theory (II) IV. Theory focuses on how a) shocks to economy and b) policy (both macro-policy and regulatory policy) affect banks’ (and others’, including firms’) ability and willingness to provide credit a. Regulatory policy has macro-economic effects b. T-bill rate should not be center of policy analysis—what matters is availability and terms of credit to private sector; marked changes in spread V. Theory pays special attention to bankruptcy, credit interlinkages among firms (as important as standard general equilibrium product and factor interlinkages)

32. 32 New paradigm provides a framework for thinking about deflation and alternative policy responses Deflation, particularly unexpected deflation, leads to real balance sheet effects which can adversely affect aggregate demand This is in addition to traditional real interest rate effects