Wants, Greed, and Capitalism

A special TV program on capitalism (link) will be broadcasted tomorrow by NHK from 11pm (50 minutes) in Japan. The Japanese title of the program is "欲望と資本主義", which roughly corresponds to the title of this blog post. The program aims to (re)consider essential aspects of our economic society and the future of capitalism (as well as its origin), focusing especially on people's wants and greed. I contribute to the program as a navigator, interviewing major players from academia, financial sector and IT industry. The persons whom I made interviews are listed below (alphabetical order):

- Alvin E. Roth, Professor at Stanford University (Nobel laureate)
- Tomas Sedlacek, Chief Macroeconomic Strategist at CSOB
- Scott Stanford, Co-Founder & Managing Partner at Sherpa Capital
- Joseph E. Stiglitz, Professor at Columbia University (Nobel laureate)
- William Tanuwijaya, founder & CEO at Tokopedia

I would be grateful for everyone involved in this wonderful program. Really look forward to watching it :)

Athey et al. (2005)

Original article (link) posted: 07/11/2005

Athey, Atkeson and Kehoe (2005) "The Optimal Degree of Discretion in Monetary Policy" Econometrica

The paper examines a monetary policy game in which the monetary authority has private information about the state of the economy. In the literature, two seminal papers, Taylor (1983) and Canzoneri (1985), established no discretion should be left to the monetary authority if there is no such private information; the best outcomes can be achieved by rules that specify the action of the monetary authority as a function of observables. The introduction of private information creates a tension between discretion and time inconsistency. Tight constraints on discretion mitigate the time inconsistency problem in which the monetary authority is tempted to claim repeatedly that the current state of the economy justifies a monetary stimulus to output. However, tight constraints leave little room for the monetary authority to time-tune its policy to its private information. In short, loose constraints allow the monetary authority to do that fine tuning, but they also allow more room for the monetary authority to stimulate the economy with surprise inflation.

Making use of dynamic mechanism design techniques, they find that the optimal mechanism is quite simple; for a broad class of economics, the optimal mechanism is static (policies depend only on the current report by the monetary authority) and can be implemented by setting an inflation cap, an upper limit on the permitted inflation rate. It is also shown that the optimal degree of monetary policy discretion turns out to shrink as the severity of the time inconsistency problem increases relative to the importance of private information.


Comment
The results they derive seem to be very interesting. In particular, the “inflation cap” result is directly related to the optimal inflation targets and has strong importance with actual monetary policies. As they mention, their work provides one theoretical rationale for the type of constrained discretion advocated by Bernanke and Mishkin (1997). This paper might become a must-read paper for those who work in monetary policies.


References
Bernanke and Mishkin (1997) "Inflation Targeting: A New Framework for Monetary Policy?" J. of Econ, Perspectives, 11
Canzoneri (1985) "Monetary Policy Games and the Role of Private Information" AER, 75
Taylor (1983) "Rules, Discretion, and Reputation in a Model of Monetary Policy: Comments" JME, 12

Romer vs. Uzawa-Lucas

As I illustrated in the previous post, the most cited paper of Robert Lucas is written about (endogenous) economic growth. Surprisingly, its citation is even greater than those of Paul Romer (1986a, 1986b), the pioneering papers in this field (according to Google Scholar).
To understand the essence of these models and their differences, I have checked the Lucas' book on economic growth (this is actually a volume of collected papers), and found insightful exposition.



In the Introduction of the book, the author first provides a nice summary of Paul Romer's pioneering works.

Paul Romer (1986a, 1986b) worked out an explicit model of a growing economy that reconciled the opposing forces of increasing an diminishing returns, and did so in a way that generated sustained production growth and was at the same time consistent with market equilibrium of many, competing producers. The economics of Romer's model are closely related to the ideas of Allyn Young (1928), but his development of these ideas is entirely new. In the theory, goods are produced with a single kind of capital - Romer called it "knowledge capital" - and each producer's output depends both on his own stock of this capital and on the stock held by other firms. Aggregating over producers, production in the economy as a whole is subject to increasing returns: Every 10 percent increase in the total stock of knowledge capital leads to an output increase of more than 10 percent. But an individual producer, who has no control over the economy's total stock of capital, faces diminishing returns to increases in his own capital. Thus the fact of increasing inequality among the economies of the world is reconciled with the absence of a tendency to monopolization within each economy.

Then, the author relates Romer's idea with his own (Lucas, 1988).

Section 4 of my "On the Mechanics of Economic Development" constructs a model designed to deal with the problem posed by diminishing returns along the lines proposed by Romer. In doing this, I found it more convenient to make use of a model of Uzawa (1965) in which there is both physical and human capital but returns, private and social, depend only on the ratio of these two stocks. The theory replaces the increasing returns assumed by Romer with a kind of constant returns, yielding a system which is easier to analyze than Romer's but which circumvents the problems of diminishing returns in a similar way.
The human capital model I used involves an external effect of human capital, patterned on the external effect of knowledge capital that Romer introduced. But in my analysis, this external effect is not needed to ensure the existence of a competitive equilibrium the way it is in Romer's model. If this effect is removed, the model continues to be internally consistent and is in fact even easier to analyze. [footnote] 

[footnote]: Rebelo (1991) stripped the model down to its simplest one-capital-good "Ak" form. Caballe and Santos (1993) provide an elegant analysis of the off-balanced-path dynamics of an Uzawa model without a production externality.

References
Caballe, Jordi, and Manuel S. Santos (1993) "On Endogenous Growth with Physical and Human Capital." Journal of Political Economy, 101: 1042-1067. [313]
Lucas, Robert E., Jr (1988) "On the mechanics Economic Development." Journal of Monetary Economics, 22: 3-42. [13791]
Rebelo, Sergio (1991) "Long Run Policy Analysis and Long Run Growth." Journal of Political Economy, 99: 500-521. [2748]
Romer, Paul M. (1986a) "Increasing Returns and Long-Run Growth." Journal of Political Economy, 94: 1002-1037. [12099]
Romer, Paul M. (1986b) "Cake Eating, Chattering, and Jumps: Existence Results for Variational Problems." Econometrica, 54: 897-908. [58]
Uzawa, Hirofumi (1965) "Optimum Technical Change in an Aggregative Model of Economic Growth." International Economic Review, 6: 18-31. [1142]
Young, Allyn A. (1928) "Increasing Returns and Economic Progress." Economic Journal, 38: 527-542. [2014]

(Number in [ ] shows the citation in Google Scholar.)

Growth "higher" than Rational Expectations

Professor Robert E. Lucas Jr. at Chicago Univ. is perhaps the most famous macroeconomist in the (at least academic) world. He is especially well-known to his series of works on rational expectations.  In fact, he received the Nobel Prize in 1995 due to this contribution:

The Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel 1995 was awarded to Robert E. Lucas Jr. "for having developed and applied the hypothesis of rational expectations, and thereby having transformed macroeconomic analysis and deepened our understanding of economic policy" (from the official website of the Nobel Prize).

However, somewhat surprisingly, I just noticed that Professor Lucas' most cited paper is NOT about rational expectations. According to Google Scholar (search result is here), his most cited paper is "On the mechanics of economic development" (Journal of Monetary Economics, 1988), which is cited more than three times as much as the second one, "Econometric policy evaluation: A critique." The citation of the former exceeds 13,000, which is amazingly high in the field of Economics (maybe in other fields, too).

The "mechanics" paper is a seminal pioneering work in endogenous growth theory and is built on the idea of Uzawa ("Optimum Technical Change in An Aggregative Model of Economic Growth", International Economic Review, 1965); because of this, the model is often called Uzawa-Lucas model. Professor Paolo Mattana, the author of "The Uzawa-Lucas Endogenous Growth Model" explain the model as follows:

R. Lucas, in the late 1980s, writes a path-breaking paper: by taking some initial intuitions of Uzawa (1965) a step further, he proposes a two-sector capital accumulation growth model where human capital plays the role of the key variable through which ongoing growth can be generated. Human capital is understood to refer, in Becker's tradition, to the skills and knowledge intensity of the labor force and is accumulated in the learning (or educational) sector via a linear constant-returns to scale technology, only requiring older vintages of human capital. The Uzawa-Lucas economy differs in a fundamental way from the standard neoclassical model; since a lower bound to the return of accumulation is implicitly imposed, the long-run growth rate basically reflects an endogenous equilibrium where only the "primitives" of a specific economy (endowments, technology and preferences) are relevant. Other factors, such as increasing population or exogenous technical progress, crucial in the traditional theory, have, conversely, no critical influence.

What is the New Keynesian Approach?

I received a comment on the previous post (link) asking about the new Keynesian approach. So, let me try to provide some information based on the author's explanation of this concept. According to Walsh, the new Keynesian approach employs equilibrium models with some frictions or rigidities. He says, the new Keynesian approach uses

models based on dynamic optimization and nominal rigidities in consistent general equilibrium framework.

The monetary frictions or rigidities that Walsh refers include

money-in-utility function, cash-in-advance, search model of money, informational, portfolio, and nominal rigidities, and credit frictions,

which are all discussed in the book.
Another essential book on the new Keynesian monetary economics, written by one of the leading researchers in the field, is the following. This might also be useful for students and central bank economists alike.

Walsh 3rd

A leading advanced textbook in monetary economics has been revised and released last year.

Monetary Theory and Policy, Third Edition


The author describes the new edition, which seems to be an essential reference in the field, as follows:

This third edition reflects the latest advances in the field, incorporating new or expanded material on such topics as monetary search equilibria, sticky information, adaptive learning, state-contingent pricing models, and channel systems for implementing monetary policy. Much of the material on policy analysis has been reorganized to reflect the dominance of the new Keynesian approach. Monetary Theory and Policy continues to be the only comprehensive and up-to-date treatment of monetary economics, not only the leading text in the field but also the standard reference for academics and central bank researchers.

Risk and Liquidity

Hyun Song Shin (Hughes-Rogers Professor of Economics at Princeton University)'s awaited book on financial crises came out recently, titled "Risk and Liquidity":


The book is based on his 2008 Clarendon Lectures (in Finance). The table of contents and sample of a few sections are available from his website (link). Let me quote the comments by Roger Myerson and Franklin Allen, which seem to illuminate the feature and importance of  this outstanding book very well.

In the Great Recession, the world has looked for leading economists to offer a new and better understanding of macroeconomic instability, as Keynes did in the Great Depression. In this book, Hyun Song Shin delivers what was needed. Step by step, he develops as new comprehensive understanding of how macroeconomic booms and busts can be derived from microeconomic forces in the banking system. This book should be recognized as a major contribution to macroeconomic theory.
Roger Myerson, Nobel Laureate in Economics 2007, Chicago University

Hyun Song Shin is one of the leading scholars on financial stability in the world. His experience in this field is not confined to his academic work. He has also advised the President of Korea, the Bank of England and many other institutions on these issues. The recent crisis has underlined how important it is to understand the boom-bust cycle. During the boom asset prices rise, this allows financial institutions to borrow and expand their balance sheets and drive prices up more. Similarly, in the bust part of the cycle they reduce their debt, their balance sheets shrink, they sell assets and prices fall more. Hyun Song Shin done the foundational theoretical and empirical research on this leveraging and deleveraging amplification mechanism. This book provides a very accessible summary of this work. It is essential reading for all academics and practitioners interested in financial crises.
Franklin Allen, The Wharton School of the University of Pennsylvania