Reflections on My Interview with Cloud Yip: Part 2

Cloud Yip is running a series of interviews under the title of “Where is the General Theory of the 21st Century” and I was privileged to be included in that series. Last week I put up my first post about the interview. This week’s post is the second in a series where I expand on my answers to Cloud. Here, I discuss my views on rational expectations and I talk about a new version of search theory, Keynesian Search Theory, that underpins my joint papers with Giovanni Nicolò on “Keynesian Economics without the Phillips Curve” and with Konstantin Platonov, “Animal Spirits in a Monetary Model”. The paper with Konstantin uses Keynesian Search Theory to provide an updated version of the IS-LM model which we call the IS-LM-NAC model. The paper with Giovanni estimates a version of this model on U.S. data and demonstrates that it provides a better way of explaining data than the failed Phillips curve.

I have been making the argument in my books, academic articles and op eds for at least seven years that the Phillips curve is broken and there is a better alternative that I call the belief function. I presented this work at a conference in New York in honour of Edmund Phelps where the paper was discussed by Olivier Blanchard. I’m pleased to see that the importance of this topic is now being widely recognised and my Phillips Curve scepticism has become mainstream.

Here is what I said on the topic in a previous blog post

Policy makers at central banks have been puzzled by the fact that inflation is weak even though the unemployment rate is low and the economy is operating at or close to capacity. Their puzzlement arises from the fact that they are looking at data through the lens of the New Keynesian (NK) model in which the connection between the unemployment rate and the inflation rate is driven by the Phillips curve…

          …The research programme we are engaged in should be of interest to policy makers in central banks and treasuries throughout the world who are increasingly realising that the Phillips curve is broken. In Keynesian Economics Without the Phillips Curve, we have shown how to replace the Phillips curve with the belief function, an alternative theory of the connection between unemployment and inflation that better explains the facts. 

That leads me to the main focus of today’s post: What’s wrong with rational expectations and how is that connected with my replacement for the Phillips Curve? Over to Cloud…

Q: What is your view on the role of the rational expectations approach in macroeconomics?

“F: The classical reformulation of macroeconomics developed by Lucas and Prescott required a radical reformulation of expectations. In the Keynesian model of the 1950s, expectations were determined with a separate equation called adaptive expectations. In the Keynesian model beliefs about future prices might be different from the realization of the future prices. Because of that, those models needed another equation to explain how beliefs or expectations were determined.

Lucas, writing in 1972, removed the adaptive expectations equation and he argued that beliefs are not independent; they are endogenous and must be explained within the model. He argued the world is random. As a consequence of randomness, prices aren’t always equal to what people expect them to be and he introduced the idea of rational expectations into macroeconomics. Instead of adding an equation, adaptive expectations, to determine beliefs, Lucas closed his model by arguing that beliefs should be right on average. He argued that people wouldn’t be expected to be fooled in the long run, and that we can model beliefs or expectations as probability distributions that coincide with the distribution of the actual realizations.

That all sounds very sensible, but it only makes sense in models where there is a unique equilibrium. Even in the model that Lucas wrote down in 1972, there were multiple equilibria. For me, the existence of multiple equilibria is not a problem. It is an opportunity.”

I discussed the role of rational expectations in a world of animal spirits in a 2014 blog linked here. When I describe multiplicity as an opportunity, I mean that it opens the possibility to marry psychology with economics in a new and interesting way. If economic models have multiple possible equilibria, we can model how stories are transmitted through social networks to explain which equilibrium occurs in practice. Economists are good at building models of the macro economy. Psychologists are good at understanding the spread of beliefs. There are clearly gains from collaborative research which was the topic of the conference I helped organize at the Bank of England in July of 2017.

I have been working on models of multiple equilibria since the early 1980s but my early work on this topic dealt with models where there is a unique steady state and the economy is self-stabilizing. In my survey paper on Endogenous Business Cycles I described these models as first-generation models of endogenous fluctuations and I contrasted them with second-generation models in which there is a continuum of steady state equilibria. To explain why there may be many steady state equilibria, I developed a version of search theory that I call Keynesian search theory. That is the topic that Cloud asked me about next.  Back to Cloud…

Q: What is the “Keynesian search model” that you are advocating in your book “Prosperity for All”? How is it different from the mainstream search model that you refer to as classical search theory?

“The Keynesian search model is a variant of what I call classical search models. By classical, I mean the work that evolved from Peter Diamond, Dale Mortensen and Chris Pissarides. In the classical search model, there is a unique equilibrium in the labour market pinned down by the bargaining power of workers relative to firms. In the Keynesian search model, there is a continuum of equilibria and the equilibrium that occurs is selected by aggregate demand, just as in the Keynesian models of the 1950s.

The Keynesian Search Model maintains Keynes’ idea, which I think is important, that beliefs are fundamental. Animal spirits, confidence and self-fulfilling beliefs can influence outcomes. In every single equilibrium of the Keynesian search model there is no incentive for either firms or workers to change their behaviours. The reason has nothing to do with sticky prices; it has to do with the fact that there are incomplete factor markets.

The search model has a search technology, separate from the production technology, that moves people from home to jobs. That technology has two inputs; the searching time of workers and the searching time of the recruiting department of a firm. Because there are two inputs, for the market to function well, there must be two prices. One price for the searching time for workers and another for the searching time for recruiters.

You could imagine a recruiting firm which would offer to purchase the right to find an unemployed worker a job and offer to buy the right to fill the vacancy of the company. This market would operate a little bit like a dating website, where the firm would take the two searching parties, match them and sell the match back to the worker-firm pair.

We do not see the market working in that way, largely because there are moral hazard issues. If I am unemployed and you are paying me to be unemployed, I do not see why I would ever accept a job. As a consequence of the failure of that market, there are equilibria with search externalities that can support equilibria with any level of unemployment.

My Keynesian search model solves the problem of understanding Keynes’s General Theory in a way that is different from the sticky price approach that Samuelson initiated and that continues to be perpetuated by New Keynesian economists today.”

Next week, I will talk about why economists should stop pretending that unemployment is voluntary. It’s time to reintroduce the term, ‘involuntary unemployment’. Stay tuned!