Modeling Issues in Macroeconomics Articles by Bell, Hahn, and HausmanModels and RealityModels and Reality (Continued)Slide 4Slide 5Slide 6Slide 7Slide 8What is Equilibrium?General Equilibrium Theory AssumptionsGE Cannot AddressInconsistencies in GENeoclassical Model AssumptionsMethodology Daniel M. Hausman (1989)DeductivismDeductivism (2)Positivism or Popperian ViewsPredictionismPredictionism (2)OperationalismRhetoricOther theories of methodologyModeling Issues in MacroeconomicsModeling Issues in MacroeconomicsArticles by Bell, Hahn, and HausmanArticles by Bell, Hahn, and HausmanMacroeconomics I – ECON 309 S. Cunningham2Models and RealityModels and RealityUnder liberalism, human beings are regarded as individuals detached from family, clan, class, or nation, as independent, self-determining beings. This leads to methodological individualism. If we regard the economic system as an enormous composition of independent, specialized agents, then the central problem of economic inquiry is the explanation of the exchange process. If the exchange is made through free markets, then the explanation of exchange is coincident with the explanation of prices.Note: the market process does not require that all people be selfish, but rather that they have a self-interest and act purposefully.3Models and Reality Models and Reality (Continued)(Continued)Marginalists. The neoclassicals make relative prices and relative scarcity the fulcrums of economic analysis. –Methodological individualism–Focus on the margin–Diminishing marginal utility–Price theory vs. value theory: the measure of something is its utility, not its value–General Equilibrium–Utility maximization“The individual is imagined in a constant process of delicately balancing his marginal expenditures and marginal utilities.” –here we have the idea of the “economic man”, a term introduced by Pareto.4Models and Reality Models and Reality (Continued)(Continued)Say’s Law–“Supply creates its own demand.”–One never sells without an intention to buy.–Critical Assumptions:•All agents optimize•Wages are equal to the marginal product of labor:–A producer would never offer a wage greater than the value of the added output his labor would produce, so that the number of workers hired by a firm would be set at the point where the cost of the marginal worker would equal the value of his output.•No leakages (barter economy?)–Best of all possible worlds5Models and Reality Models and Reality (Continued)(Continued)Equilibrium–Marshall’s neoclassical economics:•Relates to the determination of price in one market (price theory)•Equilibrium is a state that persists, and usually occurs when the forces of supply and demand are in balance (equal)–Walras’ neoclassical economics:•Equilibria in all markets simultaneously (S=D)•Tatonnement•Assumes perfect competition and no technological progress  it is static. •Yields a system of equations with fixed coefficients to be solved simultaneously.6Models and Reality Models and Reality (Continued)(Continued)Four bridges to reality:1. Quantity Theory (Locke through Friedman)•Money is not wealth. Money can only reflect or distort real relationships.•Prices vary in direct proportion to the supply of money.•Friedman: wage-push inflation is not possible.•Cost-push vs. Demand-pull inflation•Prior to Keynes, the quantity theory was macroeconomics.2. Theory of monopolistic competition7Models and Reality Models and Reality (Continued)(Continued)3. Keynesian revolution: Attack on Say’s law1. Say’s Law argued that in the long run, the “real forces” of the economic system would tend to full employment equilibrium. Keynes writes that in the long run we are all dead.–Even if Say’s Law was valid in a static model, it could not show that a full-employment equilibrium was dynamically attainable since the process of moving toward an equilibrium through time displaces the equilibrium itself.–In a depression, static equilibrium was impossible because:1. Inelasticity of investment (investment trap)2. Desire of savers to hoard money (liquidity trap)3. Stickiness of wages and prices4. (Expectations are nonergodic)4. Phillips curve: the missing equation8Models and Reality Models and Reality (Continued)(Continued)Interpretative Theory–Link to sociological and consider social conventions and institutions–Link to political theory.•Resolve the problem that price theory is distributive and political theory is redistributive.–Economic theory has to return to time and history.9What is Equilibrium?What is Equilibrium?(1) Temporal Optimum(2) Inter-temporal Optimum(3) Plans are realized(4) Mutually Consistent Plans (S=D?)(5) State that Persists(6) Expectations are Correct(7) Markets Clear (S=D)(8) Accidental10General Equilibrium TheoryGeneral Equilibrium TheoryAssumptionsAssumptions(1) All Agents Optimize(2) Perfect Information. (All agents seek and find full and free information.)(3) No Start-up or Setup Costs (Free Entry & Exit)(4) All Factors are Homogeneous(5) All Factors are Continuously Variable & Substitutable(6) Markets Adjust Instantly(7) Taxes are Neutral Critical to Pareto Optimality(8) Complete Markets(9) All Markets are competitive(10) No Externalities(11) Constant Returns to Scale Critical To Uniqueness(12) Convex Preferences(13) Convex Production Isoquants  dim. marginal rates of transformation and substitution11GE Cannot AddressGE Cannot AddressGE cannot address questions that require any deviation from its assumptions:(1) It is not possible to pose any monetary question in the context of an Arrow-Debreu model since moneywould have no role.(2) Cannot consider certain forms of uncertainty andcertain forms of market expectations important toKeynesian theory and policy.(3) Cannot address questions involving asymmetry ofinformation among agents.(4) Cannot address oligopoly or imperfect competition.(5) Cannot address small markets.12Inconsistencies in GEInconsistencies in GE(1) If agents cannot affect prices (competitive market assumption) who is it that bids the price to the equilibrium price?(2) GE assumes that because market power is distributed (tacitly: Evenly), effectively no market participant has economic power.- Is this realistic? What about Donald Trump?- Airplane Hijacker analogy- Does this equality of distribution of market power assume that the equlibrium already exists?(3) Certain information