Frameworks
The macroeconomic pages of this
site explain six different frameworks that economists
have used to make sense of the world around them. All seem
to have a kernel or two of truth to them, but none seems to
be completely satisfactory all itself.
The framework that dominated introductory economics until
recently has been the simple Keynesian framework of the
income-expenditure
model. This framework suggests that the way to
understand total spending is to divide it into parts and
then study the parts. When one understands the
parts--consumption, investment, government spending, and net
exports--one should understand the whole. This framework has
introduced millions of students to the multiplier process
and the notion of fiscal policy. However, it is poorly
suited to analyze changes in price level well, and it does
not mesh well with the approach taken in microeconomics.
Microeconomics assumes that people's actions are motivated
by a desire to achieve goals, but there is no evidence of
goal seeking in the simple income-expenditure framework.
The quantity-theory
framework is far older than the Keynesian framework and
has undergone a revival since the 1960s. It suggests that we
look at all transactions as involving the purchase or sale
of money. When you go to the store and buy potato chips, you
think of that transaction as the buying of potato chips. The
quantity theory tells you to think of it as a transaction in
which you sell money and the store buys your money (by
giving you potato chips).
Once we start thinking of all transactions as the
purchase and sale of money, it is natural to ask what
happens when the amount of money available to buy and sell
changes. If it decreases, we expect its value to increase,
just as when there are fewer apples to buy and sell, we
expect the price of apples to increase. When the value of
money increases, a fixed amount of money buys more, which
can happen only if prices of goods and services fall. The
quantity theory argues that changes in the amount of money
affect the volume and value of transactions that involve
money.
If changes in the amount of money are important, then we
have to ask what alters the amount of money in circulation.
This question takes us to the banking
system, for in modern economies money is bank debt, and
also to monetary policy, for in modern economies governments
can control the money-creating ability of banks.
A limitation of the simple quantity theory framework is
that it does not explain output fluctuations, which are
obviously very important in modern economies, and money
itself is elusive because what people use for money changes
over time.
A third framework, the ISLM
framework, merges the simple Keynesian framework and the
quantity theory framework allowing us talk about both fiscal
and monetary policy. It has been a very popular framework
among economists, but increasingly economists have begun to
worry about what it leaves out.
The business-cycle
framework asks us to appreciate disequilibrium. It
suggests that we should not always try to analyze the
economy in terms of equilibrium positions. The economy is
like a rocking chair--if either is set rocking, readjusting
to equilibrium takes a long time. In contrast, the ISLM
framework encourages us to analyze in terms of equilibrium
positions.
A fifth framework, that of aggregate-supply
aggregate-demand, attempts to expand ISLM, which is
purely demand driven, to include production-side problems.
If, for example, the supply of a key resource suddenly
drops, what will happen to the economy? ISLM does not tell
us. By including production-side problems, economists can
begin talking about the effects of flexible prices as
opposed to sticky prices, and in turn can discuss a whole
series of questions that are difficult to discuss in other
frameworks.
A final framework, the one that we began with, is the
general equilibrium
framework, which encourages us to see the economy as a
set of interdependent markets. A change in one market can
affect other markets, even those that seems totally
unrelated. This framework has firm roots in microeconomics,
and lets us see why aggregation is necessary. The other five
approaches can be seen as a special cases of the general
equilibrium case, each with a different
emphasis on what is important. We also briefly mentioned
the new-classical or real
business cycle view, which can be seen as a direct use
of the general-equilibrium framework with the assumption
that there are no lags in adjustment.
Because each of these frameworks can give us insights, we
have looked at them all. Perhaps someday a new framework
will be developed that will simplify the study of
macroeconomics by giving us all the important insights of
these six separate but not necessarily contradictory
frameworks. That day does not seem to be near at hand.
Macroeconomic theory is based on people's actions that
make these frameworks work. There are five classes of
behaviors that have been especially emphasized.
First, the decision
to spend or save is important in the income-expenditure
approach and any framework built on it. We argued that
people want both a high standard of living, and one that
does not vary much over time, which leads to the life-cycle
and permanent-income
hypotheses.
Second, two areas of portfolio
choice, or how people structure their balance sheets,
are important in any approach that argues that the amount of
money matters. People make decisions about how large they
want their cash balances, which affects the velocity of
circulation. The better money served as a store
of wealth, the more cash people would want to hold.
Banks also make portfolio choices, and their decisions can
create or destroy
money.
Third, we looked at investment
spending, a form of behavior that is important in
income-expenditure approaches, and has also been a key
ingredient in some business-cycle theories. We argued that
the benefits of additional capital rise when business sales
rise, and therefore the amount of investment should be
sensitive to changes in spending. This idea was called the
accelerator. We
also argued that investment should be sensitive to the real
interest rate. This was a key idea in developing the ISLM
model.
Fourth, we have looked at how policy
makers respond to economic conditions. Just as
businesses and consumers respond in regular and systematic
ways to economic conditions, so do policy makers. When the
economy enters a recession, will policymakers will try to
ease policy, and when inflation is seen as a serious
problem, they will try to tighten policy? By looking at
policy rules, we can talk about the importance of lags
and information, about the role of the exchange
rate on fiscal and monetary policy. We can also look at
the difficulties of measuring
policy and we can ask how people's expectations of
government policy will affect their behavior.
Finally, we have looked at how people adjust prices to
different economic conditions. The size of output
fluctuations seems to depend a great deal on whether prices
are flexible or sticky.
If they are sticky, we need to explain why they are, and we
attempted to do that by arguing that changing price could be
costly, or it could be a result of poor information or of
information that is not shared by all.
Copyright
Robert Schenk
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