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«George A. Akerlof * October 2, 2005 Preliminary Draft: Presidential Address American Economic Association, Chicago, IL, January 7, 2007 * This paper is ...»

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The Missing Motivation in Macroeconomics

George A. Akerlof *

October 2, 2005

Preliminary Draft: Presidential Address

American Economic Association, Chicago, IL, January 7, 2007

*

This paper is based on a long-term research program with Rachel Kranton on the implications of identity

for economic behavior and also a manuscript we are currently writing on the missing motivation in economics. Our

previous joint papers (Akerlof and Kranton (2000), (2002) and (2005)) have explored implications outside of macroeconomics of utility functions dependent on people’s notions of what ought to be. Conversations with Kranton have also been the basis for the section on economic methodology. I have also benefitted from conversations with Robert Shiller, with whom I am co-authoring work on behavioral macroeconomics. In addition, I wish to thank Robert Akerlof and Janet Yellen for invaluable advice. E-mail address: akerlof@econ.berkeley.edu.

I. Introduction Macroeconomics changed between the early 1960's and the late 1970's. The macroeconomics of the early 1960's was avowedly Keynesian. This was manifested in the textbooks of the time, which showed a remarkable unity from the introductory through the graduate levels.1 It was even manifested in the appearance of John Maynard Keynes on the cover of Time Magazine.2 Milton Friedman was famously quoted, “We are all Keynesians now,” although in a later disclaimer, he said, almost surely correctly, that he had been quoted out of context.3 But this love-fest was not long-lasting. A little more than a decade later Robert Lucas and Thomas Sargent (1979) wrote “After Keynesian Macroeconomics.” The decline of the old-style Keynesian economics was due in part to the simultaneous occurrence of increased inflation and increased unemployment, an event that seemed impossible with the simple non-accelerationist Phillips Curves of the early 1960's. But it declined also because of a change in the world of ideas. The early Keynesians derived the major components of their model, such as the consumption function, the investment function, and price and wage equations from intuition. For example, they let the consumption function depend upon disposable income and investment depend upon current profits and current cash flow. Regarding wage setting, a key relation was the Phillips Curve, where nominal wage inflation depended upon the unemployment rate (as an indication of the looseness of the labor market). In part the See for example Samuelson (1964), Dernburg and McDougall (1967), and Ackley (1961). The econometric model of Klein and Goldberger (1955) provides a useful synopsis of the variables that the early Keynesians thought most important for a macroeconomic model, and how they would be included.

Time Magazine, December 31, 1965. His appearance on the cover was especially remarkable because Time covers are rarely posthumous. Keynes had died in 1946.

See http://www.libertyhaven.com/thinkers/miltonfriedman/miltonexkeynesian.html, which quotes Friedman, Dollars and Sense, p, 15.

Keynesians took these functions from their observations as to how the various actors in the economy would behave; they also tempered their judgments by looking at statistical relations.4 But another school of thought objected to the casual ways involved in this methodology.

They said that the relations of macroeconomics should instead be derived from sound economic principles. They should be derived from the behavior of profit maximizing firms and utilitymaximizing consumers with objective arguments in their utility functions.

This new methodology had a profound effect on macroeconomics, because it failed to reproduce the components of the standard macroeconomic models. It revealed at least five neutrality results: independence of consumption and current income (given wealth), the Modigliani-Miller theorem, natural rate theory, inability to stabilize output in the presence of rational expectations, and Ricardian equivalence. The excitement these results generated among macroeconomists—among both those who tried to dismiss them and those who accepted them—makes it clear that these neutralities had been unexpected. They were seen as tell-tales that the macro-economists of the previous generation had been thinking in the wrong way. In the new view, scientific reasoning was producing a newer, leaner, more precise economics.

The neutralities are important because they are all believed to hold with some generality.

For that reason they are useful benchmarks for macroeconomics. The neutralities commonly describe equilibria of competitive economies with complete information. This means that they are not completely general, but they still have enough generality to be useful as benchmarks.

They will hold in a competitive model with perfect information and the usual definition of general equilibrium irrespective of people’s preferences, as long as those preferences A good example of this methodology can be seen in Phillips’ (1958) mixture of light theory and statistical analysis in his estimation of the relation between wage inflation and unemployment.

correspond to economists’ typical descriptions of them. Such generality makes them useful as null hypotheses for statistical testing. Furthermore the mind’s eye can often roughly extrapolate how different departures from the pure model will affect the equilibrium outcomes. Indeed in some cases the neutralities will still continue to hold, even though the economy is no longer perfectly competitive or information no longer perfect.





But the usefulness of the neutralities as benchmarks in all of these cases depends upon their independence of preferences. If, on the contrary, economists’ view of people’s motivation is not realistic, then the neutralities may no longer hold. In that case they no longer serve as a good null for the behavior of real people in real macroeconomies.

In addition, insofar as the behavior assumed by the Keynesians differs from the behavior that produces the neutralities there is likely to be a bias. This bias favors the Keynesians, who based their models on their observation of motivations, rather than on

Abstract

derivations. If there is a difference between real behavior and behavior derived from abstract preferences, the neoclassical methodology has no way to pick up those differences. In contrast, models based on observations of such behavior, will systematically incorporate it, even though, as with any method, there is the possibility for error. It would be no coincidence then if the deviation between Keynesian macro behavior and the behavior derived from the neutralities is due precisely to components of preferences that had been observed by the Keynesians, but were by assumption excluded from neoclassical models.

The innovation of this lecture is to interpret such behavior through preferences that include norms, which are people’s views regarding how they, and others, should or should not behave. Such preferences are a central feature of sociological theory, but they have been all but totally ignored by economists. Inclusion of such norms in utility functions makes Keynesian views of the macroeconomy consistent with maximizing behavior—the maximizing behavior of real people. It simultaneously invalidates each of the five neutralities.

–  –  –

None of the behavior revealing of such norms will be new. On the contrary, I have purposefully chosen phenomena that have been emphasized since The General Theory by macroeconomists (including Keynes himself) who have voiced their continuing doubts about classical interpretations of macroeconomic behavior. Others—especially including those approaching economics through psychology rather than through sociology—have given different interpretations to the exact same behavior. In most cases there is no inconsistency. We are seeing the same phenomena—just through a different lens.

–  –  –

This section will now describe in turn each of the five neutrality results.

1. Dependence of consumption on wealth, not income:

Standard theory tells us that under only somewhat special conditions, consumption depends on wealth, which is the value of current assets plus the discounted value of future earnings.5 Thus there is no tendency for people to make their expenditures conform to the pattern of their income receipts (as long as their wealth is given).

Changes in the pattern of current income that leave overall wealth constant are neutral in See Friedman (1957) and Modigliani and Brumberg (1954).

their effects on current consumption.

2. The Modigliani-Miller Theorem:

One version of the Modigliani-Miller theorem says that a firm’s investment strategy is totally independent of its liquidity position.6 Thus, for example, a corporation with an unexpected windfall will not spend any additional investment dollars. Instead it will pass the windfall on to shareholders or seek other financial investments, since it will only make investments whose risk-adjusted rate of return exceeds the rate of return on capital.

Changes in the firm’s finances will thus be neutral in their effect on current investment.

3. Natural Rate Theory:

According to Natural Rate Theory there is some single rate of unemployment that is the only level that could be permanently maintained without ever-increasing inflation or everincreasing deflation.7 A fiscal/monetary policy mix that sought to maintain employment that was any higher would result in permanently increasing inflation. A fiscal/monetary mix that sought to maintain employment that was any lower would result in permanently decreasing inflation.

Changes in the fiscal/monetary mix that affect long-term inflation will thus be neutral in their effects on long-term unemployment.

4. Rational Expectations:

See Modigliani and Miller (1958).

See Phelps (1968) and Friedman (1968).

According to Rational Expectations Theory a systematic response of monetary policy to the business cycle will have no effect on the stability of the macroeconomy.8 Wage and price setters will foresee the systematic component of monetary policy; they will raise or lower prices and wages exactly proportionally, and thereby neutralize its effect on demand.

The stability of the economy is thus neutral with respect to the systematic reaction of monetary policy to the business cycle.

5. Ricardian equivalence:

According to Ricardian equivalence, under somewhat special conditions, a representative consumer who receives a lump sum intergenerational transfer (for example, in the form of a social security payment) will not spend a single dime extra.1 Instead she will pass on the whole extra income, dollar for dollar to her heirs, who will have to pay the higher tax bills necessary to retire the increased debt incurred in funding the transfer to the previous generation.

The transfer is neutral in its effect on current consumption.

–  –  –

Each of the neutralities is based on the assumption that the respective decision makers are utility maximizers, but their utility functions have been very narrowly described. The utility functions of the decision-makers depend only on real outcomes. For example in the consumption-neutrality models, utility depends on consumption and leisure; in ModiglianiSee Lucas (1972), Sargent (1973) and Lucas and Sargent (1979).

See Barro (1974) for the modern reincarnation of these ideas, first discovered by Ricardo.

Miller it depends only on the discounted real return to shareholders.2 But as early as the beginning of the Twentieth Century, Vilfredo Pareto pointed out that such characterizations of utility missed important aspects of motivation.3 According to Pareto people typically have opinions as to how they should, or how they should not, behave. They also have views on how others should, or should not, behave. Accordingly, they lose utility insofar as they, or others, fail to live up to these standards. Such notions are central to motivation in sociology, but they are absent from economists’ representations of utility. People’s views of how they, and others, should or should not behave, are called norms. Even though these views may be held with great conviction, they are usually not moral or ethical views. For example, there is no great ethical principle that women should wear a hat in a church and men should not (a leading example in Homans’ Introduction to Pareto). Nor are these views always social. For example the protagonist of Rice Mother thought she should not wear red with black.4 It is useful to understand why sociologists have considered norms to be central to motivation. People tend to be happy when they live up to how they think they should be; they tend to be unhappy when they fail to live up to those views. George Loewenstein (1999) has illustrated this principle by asking why climbers pursue mountaineering. There are few tasks that are as distant from the conventional view of utility as mountaineering. It may be very costly. It is extremely arduous. And it is dangerous. People pursue it nonetheless. One of the This section is especially based on previously published articles written with Rachel Kranton (Akerlof and Kranton (2000), (2002), (2005)). The rendition here is taken from our joint manuscript explaining the role of norms in economics. I am especially grateful to her for allowing me to present this joint work as motivation for this lecture.

See Pareto (1920). Homans and Curtis (1934) give an excellent summary of Pareto that is fully consistent upon the emphasis here. Elster (1989) also presents a similar conception of norms.

Manicka (2002).

primary motivations for the mountaineer is the pleasure of framing a view of who he is, and then having the pleasure of living up to those standards.

Mountaineering is of course an extreme activity. But sociologists think that similar motivation applies to a wide variety of every-day activities. Sociologists view people engaged in these activities as having an ideal for how they should behave and then obtaining pleasure from living up to that ideal.5 Sociologists also think people often conceive of that ideal in human terms. The ideal may correspond to the performance of someone they know, of someone they do not know, or even of some fictional character in their imagination.

Teaching provides a mundane example that is familiar to all of us. A teacher usually has a clear view of what it means to be a good teacher. If she lives up to that standard, she feels good about herself; if she falls short she may even feel quite miserable. The same feelings apply to most any activity, from playing golf to being a parent. It applies to the conduct of most jobs.

Randy Hodson (2001), who surveyed ethnographies of the US workplace, found that most employees care about their dignity at work. They want to conceive of what they do as useful.

And they feel a lack of dignity if they are thwarted, either by their own actions or the actions of others. Those who are unable to get such satisfaction are likely to show their displeasure by acting up in some way or other.6 The sociologist Erving Goffman (1961) has illustrated the pleasure derived from pursuing an appropriate activity with the delight of toddlers in riding the merry-go-round. In contrast, for older children, there is a gap between their conception of how they should behave and riding the See especially Akerlof and Kranton (2005).

Akerlof and Kranton (2005) illustrate such motivation by the behavior of Mike, a Chicago steelworker who is interviewed by Studs Terkel (1972). Mike is extremely alienated from his routine job and takes it out by getting into tavern brawls after work.

merry-go-round. For them the merry-go-round is age-inappropriate. They show their discomfort by playing the clown. But such misbehavior is not just the stuff of kids. In surgical operations, because of their inexperience, medical students are given tasks that are ridiculously easy.7 They respond in the same way as the older children at the merry-go-round: they act the clown. These examples are illustrative of behavior that is pervasive. Sociology is dense in examples of people’s views as to how they and others should behave, their joy when they live up to those standards, and their discomfort and reactions when they fail to do so.



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