A Macroeconomics Reader

By Brian Snowdon; Howard R. Vane | Go to book overview

NOTES
1
For a devastating attack on the underlying methodological premises of the representative agent approach, see Kirman (1992).
2
The term ‘constrained’ in the concept of ‘constrained Pareto efficiency’ is simply inserted to remind readers that the constraints—absence of a complete set of markets, the imperfections of information, and so on—were indeed taken into account. Even when the government faces these constraints, when the economy is not constrained Pareto efficient, there exist interventions in the market which can make all individuals better off. There are, to be sure, innumerable papers in the literature showing that with incomplete markets and imperfect information, the economy may be constrained Pareto efficient. The point of the Greenwald-Stiglitz (1986) paper was to show that these papers all entail special assumptions; and that in general, the market economy is not constrained Pareto efficient.
3
Some new Keynesians are wont to claim that this insistence on micro-foundations is what distinguishes them from Keynes and the older Keynesians. Though much macroeconomic analysis in the Keynesian tradition in the 1950s and 1960s did stray from a solid grounding in micro-foundations, Keynes himself clearly argued each of his macroeconomic relations on the basis of microeconomic analysis. In fact, we would argue that Keynes did the best he could with the micro-foundations which were available at the time. Macroeconomists of the 1950s and 1960s faced a dilemma: the microeconomics that was fashionable at that time—assuming perfect information, complete markets, and so on—was obviously inconsistent with the spirit of the Keynesian model. It made sense for them to ignore that kind of microeconomics.
4
There are still other strands emphasizing, for example, imperfect competition or coordination failures.
5
For example, Hansen (1951), Solow and Stiglitz (1968), Barro and Grossman (1971), and the large subsequent literature surveyed in Benassy (1982).
6
In taking this approach, this second strand of new Keynesian thought addresses one of the major criticisms of real business cycle theory—that real shocks to the economy are simply not large enough to account for the magnitude of the observed fluctuations. Standard neoclassical models have strong forces working to stabilize the economy: price adjustments act like shock absorbers; savings and inventories act as buffers; lags mean that even a major new innovation will take years to be absorbed into the economy; and many shocks have offsetting effects in different sectors, implying limited aggregative impacts.
7
For a more detailed discussion of the arguments presented in this section, and the empirical evidence in its support, as well as a more complete list of references, see Greenwald and Stiglitz (1987, 1988b, 1988c, 1989, 1990a, 1990b, 1991a, 1993), Stiglitz (1992a), and Greenwald et al. (1984).
8
One explanation for why firms do not issue equities upon which we do not put much credence is the costly state verification model, which notes that using equity requires verifying the state (the firm’s profits), so the costs of implementing equity contracts thus exceed that of debt contracts. While this argument has some relevance for small businesses, firms that have already issued equity have little or no marginal cost of verifying their state when they seek to issue additional equity.
9
A major lacuna in this theory is the failure to explain why debt contracts are denominated in nominal terms. However, there are models, such as Cooper (1990), which show that there may be Nash equilibrium with imperfect indexing; that is, given that all other contracts are not indexed, firms would not want to just index debt contracts.

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