Demystifying economics

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Lars Pålsson Syll
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from Lars Syll

The first thing to understand about macroeconomic theory is that it is weirder than you think. The heart of it is the idea that the economy can be thought of as a single infinite-lived individual trading off leisure and consumption over all future time …

This approach is formalized in something called the Euler equation … Some version of this equation is the basis of most articles on macroeconomic theory published in a mainstream journal in the past 30 years …

The models may abstract away from features of the world that non-economists might think are rather fundamental to “the economy” — like the existence of businesses, money, and government … But in today’s profession, if you don’t at least start from there, you’re not doing economics.

J W Mason

Yes indeed, mainstream macroeconomics sure is weird. Very weird. And among the weirdest things are those Euler equations Mason mentions in his article.  

In a post on his blog, sorta-kinda ‘New Keynesian’ Paul Krugman argues that the problem with the academic profession is that some macroeconomists aren’t “bothered to actually figure out” how the New Keynesian model with its Euler conditions —  “based on the assumption that people have perfect access to capital markets, so that they can borrow and lend at the same rate” — really works. According to Krugman, this shouldn’t  be hard at all — “at least it shouldn’t be for anyone with a graduate training in economics.”

If people (not the representative agent) at least sometimes can’t help being off their labour supply curve — as in the real world — then what are these hordes of Euler equations that you find ad nauseam in ‘New Keynesian’ macromodels gonna help us?

Yours truly’s doubts regarding the macroeconomics modellers’ obsession with Euler equations is basically that, as with so many other assumptions in ‘modern’ macroeconomics, the Euler equations don’t fit reality — and it seems as though I’m not alone holding that view:

This equation underlies every DSGE model you’ll ever see, and drives much of modern macro’s idea of how the economy works …

[T]he Euler Equation says that if interest rates are high, you put off consumption more. That makes sense, right? Money markets basically pay you not to consume today. The more they pay you, the more you should keep your money in the money market and wait to consume until tomorrow.

But what Canzoneri et al. show is that this is not how people behave. The times when interest rates are high are times when people tend to be consuming more, not less.  No matter what we assume that people want, their behavior is not consistent with the Euler Equation … The consumption Euler Equation is an important part of nearly any such model, and if it’s just wrong, it’s hard to see how those models will work.

Noah Smith

In the standard neoclassical consumption model — used in DSGE macroeconomic modeling — people are basically portrayed as treating time as a dichotomous phenomenon – today and the future — when contemplating making decisions and acting. How much should one consume today and how much in the future? Facing an intertemporal budget constraint of the form

c_t + c_f/(1+r) = f_t + y_t + y_f/(1+r),

where c_t is consumption today, c_f is consumption in the future, f_t is holdings of financial assets today, y_t is labour incomes today, y_f is labour incomes in the future, and r is the real interest rate, and having a lifetime utility function of the form

U = u(c_t) + au(c_f),

where a is the time discounting parameter, the representative agent (consumer) maximizes his utility when

u´(c_t) = a(1+r)u´(c_f).

This expression – the Euler equation – implies that the representative agent (consumer) is indifferent between consuming one more unit today or instead consuming it tomorrow. Typically using a logarithmic function form – u(c) = log c – which gives u´(c) = 1/c, the Euler equation can be rewritten as

1/c_t = a(1+r)(1/c_f),

or

c_f/c_t = a(1+r).

This importantly implies that according to the neoclassical consumption model that changes in the (real) interest rate and the ratio between future and present consumption move in the same direction.

So good, so far. But how about the real world? Is the neoclassical consumption as described in this kind of models in tune with the empirical facts? Hardly — the data and models are as a rule inconsistent!

In the Euler equation, we only have one interest rate,  equated to the money market rate as set by the central bank. The crux is that — given almost any specification of the utility function  – the two rates are actually often found to be strongly negatively correlated in the empirical literature.

Well, that more or less says it all, doesn’t it? Modern mainstream macroeconomics is indeed “weirder than you think.” If an economic model is found to be inappropriately used in research, then it is the model that has to be revised. Economic processes and structures are not about to change just to make the model relevant. Using scientific models is fine, but it has to be done within the limits set by the nature of the beast!