Business Cycles and Equilibrium
Fischer Black
8
What a Non-Monetarist Thinks
The pronouncement and actions of the Federal Reserve Board on monetary policy are a charade. The Board¡¯s monetary actions have almost no effect on output, employment, or inflation. (p. 89)
There aren¡¯t many of us around these days. There¡¯s only one
other person I know of who takes a position almost as strong as mine. There
were lots of non-monetarists in eighteen-century
I don¡¯t agree with either of these positions. I don¡¯t think any aggregate government policies have much of an impact on the economy. But while some of these policies have at least modest effects of some sort, monetary policy has almost no effect at all. Monetary policy might as well not be formulated.
What the Government Can¡¯t Do
I believe that, so long as financial markets are working smoothly, the government cannot control the money stock. If one arm of the government gives the private sector base money that it doesn¡¯t want, another arm of the government must be taking back an equal amount.
If the government doesn¡¯t control the money stock, then it can¡¯t control the economy in any way through control of the money stock. It can¡¯t control the price level or the rate of inflation. It can¡¯t make individuals spend more or spend less on current consumption. ¡
What Does Move the Money Stock?
If the government doesn¡¯t directly influence the money stock, what does?
All the factors that affect the demand for money affect the money stock. For example, increasing dollar income and consumption generally means an increasing demand for money. This will be true whether the increase comes from higher real income or higher prices.
Higher wealth may be one factor that leads to higher consumption, and an increase in the level of the stock market generally means higher wealth. So we may find that the money stock goes up when the stock market goes up. ¡
Some reasons for Thinking This Way
Why am I a non-monetarist? My reasons are mostly theoretical rather than empirical. In fact, they almost have to be theoretical, because I haven¡¯t been able to think of any empirical test, short of using the Federal Reserve System for experiments, that would show whether I¡¯m right or some other school is right.
The basic problem with existing theory is that I have never seen a model of a monetary economy that was consistent with the notion that markets are in continual equilibrium and that expectations are formed rationally, and that allowed for the government to control the money stock. All the models I have seen imply that someone with the model will be able to make profits at the expense of the people whose actions are being modeled. At best, such a model contains the seeds of its own destruction.
I have tried to build such models myself, and I have read about many attempts by others to build such models. Some have tried to say that ¡°imperfections¡± like costs of information and trading costs justify the assumption that monetary policy can be active. But they have never succeeded in building a sensible model in which these imperfections are included as an integral part of the model, and in which there are not profit opportunities in the light of these imperfections. (p. 94)
10
The ABCs of Business Cycles
Business cycle peaks occur when there is a good match between the types of skills or physical capital wanted in an economy and the types of skills or physical capital available; conversely, troughs occur when wants and skills are poorly matched. The business cycle is largely a matter of choice. That is, the level of business cycle fluctuations reflects the trade-offs people face between (A) expected growth, (B) fluctuations in output, and (C) unemployment.
The conventional explanations for fluctuations in output and unemployment all imply that there are unexploited profit opportunities in the world. They cannot hold true in an economy that is in continual equilibrium, where people are constantly seeking profit opportunities.
A more rational explanation for business cycle may be found in shifting demand and supply curves. Shifting tastes and shifting technology lead to wage differentials between different sectors of the economy. These will lead to unemployment as people move from low wage sectors in search of jobs in high wage sectors. Unemployment in the form of job layoffs --- whether short term or indefinite --- occurs when differentials exist between current and future labor productivity.
The average severity of a society¡¯s business cycles is largely a matter of choice. If people choose to invest in sectors with both high and low expected growth, the economy would be more diversified and exhibit lower fluctuations in output, but also lower growth, than it would if people invested only or primarily in sectors with high growth. Investments in sectors that do not move together will allow greater diversification, hence lower fluctuations; but sectors that move together will generate lower unemployment, since wage differentials will be lower.
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Looking for profit opportunities is costly; so are the steps needed to take advantage of profit opportunities that are found. It is costly to convert a plant from producing something that¡¯s in less demand to producing something that¡¯s in more demand. It¡¯s costly for an individual to leave one job in search of a job that pays more. It¡¯s costly to obtain government approval to undertake certain ventures. (p. 105)
What are Business cycles
A business cycle can be likened to a slow motion film of a pebble being washed down a sluice with a rough bottom. ¡ What happens if we speed up the flow of water in the sluice? The pebble will move more rapidly, and its movements will be more erratic. It may even bounce right out of the sluice. As we will see, society can choose business cycles that correspond to a wide range of water speeds; business cycles with slow growth and small fluctuations, or business cycles with fast growth and large fluctuations. The more tolerant of risk the society¡¯s typical person is, the faster the growth and the larger the fluctuations. (p. 107)
What causes Business Cycles?
When we look at business cycles, economists seem more like priests than scientists. Their theories differ for reasons that seem to be largely historical or accidental. There seem to be few facts from which one can draw definite conclusions. We can classify the generally accepted branches of the church as follows:
A ancient, or the Keynesian theories;
B before, or the monetary theories; and
C current, or the rational expectations theories.
The branches overlap a great deal. The Keynesian theories have monetary elements; the monetary theories allow a role for fiscal policy; the rational expectations theories are really cleaned-up monetary theories. No amount of cleaning, though, can disguise the fact that all these theories are disequlibrium theories. In every one, there is a way for individuals to profit if the world works as the theory says it does.
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In my theory, business cycles are caused in part by shifting tastes and shifting technology --- by shifting demand and supply curves. Labor markets provide the simplest example. When demand for shoe machine operator declines and demand for computer operator rises, people will shift out of the first group and into the second. Some people will shift directly, but most of the shift will be indirect. The people who leave the shoe industry will not be the same as those who go into computers. Some people will shift without a break in employment, but some will be unemployed between jobs. The more shifting there is, the more unemployment there will be. (p. 109)
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The level of business cycle fluctuations we have is the level we want, given the trade-off we face between (A) expected growth, (B) fluctuations, and (C) unemployment.