Lucas and Keynes
2023 05 16
I doubt many readers of this post will have heard of Lucas. Noah Smith begins his appreciation this way:
Lucas is considered and he considered himself as an opponent of “Keynesian” macroeconomic polies. I think, however, Lucas helps understand when "Keynesian" policies are helpful.
An economic "shock" of any kind to some markets in a system in which all resources are fully employed at a particular set of relative prices will result in some resources becoming unemployed until a new set of relative prices results. If all prices were equally flexible up and down, some prices would go up others down and no resources would become unemployed. With such flexibility there would be no need for changes in any of the instruments of monetary policy. [The new set of relative prices might be quite disadvantageous to some people and fiscal policy might be used to re-distribute income to them.] Sure enough, there are only relative prices in the kind of DSGE models that Noah give Lucas credit for inspiring. They are not "macroeconomic" at all.
But of course, we do not live in a fully price-flexible world. Some prices do not adjust easily especially wages, especially downward. Mortgages and rents are other outstandingly inflexible prices. In this real world, macroeconomic policy has a crucial role. One way to tell the story is that the shock leaves some people receiving more income than they were expecting to spend (at the existing set of prices) and others with less. Adding this up aggregate demand falls. One response to this could be some kind of fiscal policy that transfers income from to those who can and don’t to spend to those who expected to spend and can’t in amounts that re-establish equalities of income and expenditures at the new set of relative prices. But note that in this scenario in the new equilibrium average prices are higher because the only way relative prices can change when some cannot go down is for others to go up = inflation. And “monetary policy” would need to adjust its policy instruments – money supply, interest rates whatever – to make the inflation possible.
Where then might “Keynesian” policies come from? Again, starting from full employment with all relative prices in equilibrium) suppose the shock is perfectly financial –- suddenly no one knows the value of their assets including depositors in banks that have failed or my may fail at any moment –- almost everyone will want to spend less than their income. The “demand for money” will increase; aggregate demand for goods and services will fall; and almost everyone will find themselves with less income than they expected. In that case a fiscal policy that transfers income willy nilly (a “helicopter drop” of money into every bank account would be perfect) would work pretty well if monetary policy plays along. All prices rise (there were no relative prices that needed to change reestablish equilibrium) and the inflation reduces the demand for money relative to goods and services. Y = C + I +G. (C + I) mysteriously go down but G exactly compensates, and Y is unchanged. There are no relative prices; prices do not matter; therefore, money does not matter. If this sounds like a “Keynesian” response to a stylized Great Depression, I succeeded.