Macroeconomic Coursework - Essay Example

Macroeconomic work Introduction Representative agent models of the economy ranging from those with ical/neo ical underpinnings to Keynesian/Neo-Keneysian theoretical postulates and from monetarist tendencies to supply-side dynamics, have been put forward as some of the most effective models to represent chaotic economic processes during times of economic uncertainties as recessions and downturns. Thus almost all representative agent models including Harrod-Domar Model and Marginal Utility-based models have a theoretical and conceptual framework based on a particular macroeconomic model. In other words what macroeconomic theoretical models seek to accomplish by way of controlling or stimulating variables such as inflation or/and growth are sought to be accomplished in a more articulate manner by these representative agent models. Representative agent models are in fact some efforts of economists to model and represent the macro economy as if it were a single unit. These representative agent models are based on the basic tenets of the original models. On the other hand stimulative fiscal policy measures are adopted by governments in response to recessions or economic downturns. A recession, defined as two consecutive quarters of negative Gross Domestic Product (GDP) growth in a year, can be partially or wholly reversed by using a combination of macroeconomic measures or solutions such as fiscal or/and monetary policy measures. At least this is the belief among economists though there can be a lot of arguments to prove that it cannot be done as easily as it’s proposed. Representative agent models would necessarily require that some very stringent assumptions are satisfied before the model is adopted so that outcomes could be predicted with a degree of certainty. Thus all representative agent models based on classical/neoclassical, Keneysian/neo-Keneysian and monetary theories assume that fiscal stimulus programs could effectively boost economic growth during a recession or an economic downturn. However, those assumptions that they require as essential pre-conditions might be very difficult to fulfill though. Analysis Fiscal policy involves budgetary measures in which the government carries through a deficit budget in order to stimulate the economy by charging lower corporate taxes. In other words fiscal revenue in the given fiscal year will be less than government expenditure on projects. These projects are naturalluy intended to stimulate spending and subsequent economic growth (Ertl, 2008). When the government spends more than what it collects by way of taxes, especially business taxes, more money would be left in the hands of the people and businesses to spend or/and save. When such money comes into circulation the economy gets a boost. Fiscal stimulus programs are intended to solve the problem of persistent unemployment and underemployment in the economy through government spending. However they don’t always produce the desired outcomes. For instance representative agent models in varying degrees point out to the fact that the outcomes of such fiscal stimulus programs might be negated without the slightest warning because some or all the variables in the model go awry due to some reasons which were not foreseen at the time of planning. The government might adopt a deficit budget approach and expect the economy to respond accordingly. However as many representative agent models suggest there can be unforeseen forces that would interfere with the macroeconomic variables and produce unexpected negative results. Harrod-Domar Model, for example, assumes that there is a surplus of labor so that general unemployment acts as a stimulus for the unemployed to accept jobs at the going wage rate. Secondly it assumes that all production is proportional to the capital stock. Given these two assumptions the econmy would be able to absorb the extra spending of the government and the private enterprise to fuel a new cycle of growth. However there is a snag by way of the prevalent real wage rate in the economy. Assuming that the real wage rate is either stagnant or grows at a rate less than the rate of inflation, then there is the crux of the matter. Will those unemployed be prepared to accept jobs at the existing wage rate? It depends on two outcomes. If there are more jobs than what unemployed people would want, then there could be an upward pressure on wages simply through the intervention of the economic law “when demand (for labor) is greater than supply (of labor), the wage rate would rise”. Secondly if there are more unemployed people than the available number of jobs, the reverse of the above law will apply. In the second instance, depressed wages would bring down costs of production and though the aggregate demand in the domestic economy would be lower there would be a greater demand for the country’s exports. In fact this argument has both a Keynesian/Neo-Keynesian and Classical/Neoclassical flavor. However if monetarist theoretical underpinnings were introduced into the argument through inflationary pressures that result from the government’s and private enterprise’s initial spending round, then those outcomes as predicted by the first representative agent models wouldn’t hold but a new set of outcomes would be present. Thus according to the monetarist viewpoint a fiscal stimulus package would be harmful because money supply in the economy would rise and lead to a scenario in which the value of money would deteriorate fast. As a corollary of the above when the stock of money as given by the following formula rises, inflationary pressures would develop in the economy. Money supply = (MV=PT). This is the simplest of the money supply equations where M stands for the stock of money in circulation; V for the velocity: P for the price level; and T for the number of transactions. Assuming that the money supply increases due to the above mentioned fiscal stimulus program of the government, definitely according to the monetary theory there will be a lot of money chasing after too few goods, i.e. demand pull inflation (Callan et al, 2006). In other words aggregate demand in the economy would outstrip aggregate supply. Almost all representative agent models agree that there is a considerable time lag between the government spending programs, including those entailed by its tax cuts to the private enterprise, and the subsequent increase in the real output. What matters here is the real output of the economy and not the nominal output. Next the government would be forced to initiate anti-inflationary measures such as spending cuts, increases in corporate taxes and increases in expenditure taxes. This is not going to help the economy because already there is a problem of recession. In the first place the fiscal stimulus program was adopted to solve this problem. Thus representative agent models which are trying to represent the whole economy as a single entity cannot successfully factor in every variable. This is where they are lacking most. As and when the government seeks to solve the problem of unemployment, especially demand-deficiency or Keynesian unemployment which according Keynes occurs when the aggregated demand is lower, there would be a number of corresponding shortcomings taking place. For example an increase in government expenditure to stimulate spending by private enterprise can be regarded as a misdirected policy thrust because a number of other factors known as heterogeneous elements would not have been adequately taken into consideration by planners. Technology for instance doesn’t remain static. The basic assumption that a representative agent model must necessarily be homogeneous cannot be accepted here. Indeed these assumptions are made in order to facilitate the smooth flow of the argument and to ensure the predictable outcomes in mathematical formulas. Such outcomes don’t stand up to rigorous analysis. Technology keeps on changing from one period to another in such a manner that there is very little else that can be factored into the equation of a representative agent model to bring about a logical conclusion. The aggregate demand and supply function as given by the above graph shows how the government fiscal stimulus program would impact on the economy in the short run irrespective of the classical-Keneysian dichotomy on the long run variations. Even the structural constraints would have to be ignored conveniently to produce such smooth outcomes. In fact it’s the structural constraints that distort the outcomes of the representative agent model. In turn structural constraints are caused by inadequate ethnological developments to match the government’s fiscal stimulaus program. The diagram illustrates the fact that given the government’s stimulus program there would be a subsequent shift in the aggregate demand curve to the right. This means that the increased government expenditure coupled with decreased corporate taxes (which enable the private enterprise to increase their investment expenditure) would cause an expansionary cycle of economic activity. Though this is what’s assumed to be logically feasible, there can be many snags to this theoretical posture. Representative agent models irrespective of their origin just agree with this initial assumption. However as the diagram illustrates, the price level increases with the initial rightward shift in the AD curve. This is why that representative agent models are deemed to have only limited practical value. While the macroeconomic models outlined above would proceed from here to explain each outcome by using their own methodologies and assumptions, representative agent models would use a set of variables and constants along with any assumptions to justify their progressive path of analysis form here onwards. For example the dichotomy between the Keneysian/neo-Keynesain and classical/neo-classical long run perceptions of the aggregates would show that their disagreement is based on just a technical point of explanation to the concept of ‘full employment’. Mainstream economists are opposed to such economists like Tobin here. The former argue that full employment occurs even when there are some people unemployed not necessarily due to cyclical unemployment. So the full employment can occur when unemployment is above 0. Another related concept is the Non Accelerating Inflation Rate of Unemployment (or NAIRU). NAIRU is more acceptiable to governments’ policy makers due to its flexibility in defining what long run full employment in the economy is. Some economists agree on an unemployment rate equal to 4% to 5% while others support even a greater percentage like 10%. However what matters here is the representative agent models’ attempts at predicting each model’s behavior given the government’s policy on interest rates. For instance such models try to track how on the aftermath of the government’s policy the interest rates would be influenced. If the government through its central bank seeks to decrease the interest rate with a view to further encouraging businesses to borrow and invest in new ventures, there would be less unemployment. However governments tend to follow the opposite principle, i.e. increase interest rates and discourage both private enterprise and people from borrowing from the banking sector. Though as is known, the real cause of inflation is not attributed to full employment but to the banks’ ability to create paper money by just writing checks. Representative agent models just try to capture this outcome and show how best the government could initiate economic policies that would guarantee a satisfactory full employment rate simultaneously with lower levels of inflation. Despite these efforts it must be said here that almost all of these representative agent models have failed to build an all encompassing working model of the free market macro economy so far. Above all they don’t explain outcomes related to recessions adequately. Unemployment accompanies recessions and unemployment is not adequately explained by them (Hemming, Mahfouz, Schmmelpfenning and IMF, 2002). Frictional and structural unemployment are inevitable in an economy because in the first place always there would be some people looking for jobs and always there would be some industries that might experience a fall in demand thus causing structural unemployment. However representative agent models have failed to factor these unpredictable variables into them adequately. In fact, it’s not possible to say how much of the NAIRU consists of frictional unemployment and how much of structural unemployment etc. Recent developments show that full employment equilibrium of the economy can be explained by any theoretical model but none of them can explain many intricacies adequately. Representative agent models factor in the marginal propensities to consume and save but nevertheless many of them again don’t adequately account for divergences in agents’ behavior due to exogenous factors. For instance MPC and MPS can vary in keeping with the interest rates changes but how much of a percentage change in the real interest rates in the economy would be needed to bring about how much of a change in these propensities cannot be predicted by any model with accuracy. Therefore the government’s fiscal stimulus program will take a series of unpredictable turns and twists in the process. However there are near approximations like the famous Harrod-Domar Model which have been able to identify and isolate many of those chaotic variables in the macroeconomic equation and convincingly predict their probable behavioral patterns. Monetary theory perhaps has come closest to this near approximation model. Its theoretical postulates have been developed with emphasis on the money supply theory and therefore it excludes some other very important features in the macroeconomic model. Apart from this shortcoming it doesn’t have any other known limit though its inadequacy in addressing structural constraints in the economy is considerable. For instance the Lucas critique points out that it’s impractical to place emphasis on historical data to predict the behavior of government policy outcomes. In this sense the outcomes of the government’s fiscal stimulus program couldn’t be accurately unpredicted by relying on these representative agent models many of which depend on historical data for analysis. Lucas critique has attracted much attention due to the fact that equations which use systemic estimates in them for modeling the behavioral outcomes of government policy such as the fiscal stimulation of the macro economy aren’t reliable and therefore results can be distorted. In other words parameters of those models are not structurally determined. Assuming that the government’s fiscal stimulus program is imbedded to create more jobs and reduce inflation simultaneously, then as the subsequent developments illustrated above would show there would be no predictable outcome that can be directly attributed to this policy. Therefore these parameters aren’t policy invariant, i.e. they would change when the government changes its policy. When policy outcomes based on such models are taken for granted there would be more trouble because conclusions based on them would be misleading. On other hand general equilibrium models as those suggested by Walrus and his followers necessarily focus on the macro economy with a general approach. Their hypothetical approach is exclusively determined by the static variables in a general equilibrium framework as against a competitive model. In fact classical representative agent modules are intended to produce some theoretically appropriate constraints on empirical evidence so that subsequent outcomes can be predicted with some accuracy. When these models are applied to study the policy outcomes related to the government’s fiscal stimulus program there is much less of an agreement among economists on the outcomes (Hemming, Kell, Mahfouz and IMF, 2002). As the Lucas critique points out policy variables don’t necessarily follow from either a competitive equilibrium model or a general equilibrium model but from the very foundations of the government policy being changed followed by changes in parameters of the model. Thus it’s not difficult to see where the fallacy of these representative agent models lie. Naturally the government’s fiscal stimulus policy works to produce the predictable outcomes in a vacuum-like situation where a lot of variables are removed. However such scenarios don’t exist in the real world. Therefore the inadequacies associated with representative agent models in explaining the outcomes of a governments’ policy change cannot be ignored in this instance. They are real and many in number though some models serve as near approximations to critical understanding of the real economy’s behavior. Conclusion The purpose of a hypothetical evaluation of the macro economy by using a representative agent model is to adequately predict and capture the essence of a government policy change with all implications of the policy being explained and understood. Thus the primary and immediate task of the representative agent model is to enable the analyst to represent the entire economy in a manageable hypothetical model as single entity. Some representative agent models that vary from classical to neoclassical, from Keynesian to neo-Keynesian and from monetary theory related models to supply-side theory related ones, have been articulated by many economists though their degree of success varies to such a greater extent that majority of them have simply been ignored and discarded. However it must be said that models like that of Harrod-Domar and some monetary theory based ones have captured the imagination of many critics. All in all it’s the Lucas critique that has invariably attracted much attention when it comes to how best representative agent models describe fiscal stimulus programs and policies of governments. Therefore it’s the Lucas critique that has convincingly pointed out why these models have failed. They have failed according to the Lucas critique because the very parameters in these models vary with the government’s policy. In other words they are not policy invariant. As such it’s almost impossible to predict outcomes related to the government’s fiscal stimulus policy. REFERENCES 1. Callan, T., Barrett, A., Barry, F., Horst, A. V. D., Kearney, I., Lane, P., Nolan, B., OBrien, M., Walsh, J. R., Economic and Social Research Institute & Foundation for Fiscal Studies, 2006, Budget Perspectives 2008, ESRI, Dublin. 2. Ertl, A. W. 2008, Toward an Understanding of Europe: A Political Economic Précis of Continental Integration, Universal-Publishers, Florida. 3. Garrett, E, Graddy, E. & Jackson, H. E. 2008, Fiscal Challenges: An Interdisciplinary Approach to Budget Policy, Cambridge University Press, New York. 4. Hemming, R, Mahfouz, S., Schimmelpfennig, A & International Monetary Fund, 2002, Fiscal Policy and Economic Activity During Recessions in Advanced Economies, International Monetary Fund. Washington. 5. Hemming, R., Kell, M., Mahfouz, S. & International Monetary Fund, 2002, The Effectiveness of Fiscal Policy in Stimulating Economic Activity: A Review of the Literature. International Monetary Fund, Washington. Read More