It is commonly asserted that with excess plant capacity, expansive policy stimulates output and lowers unemployment without substantially boosting inflation, while at full capacity most of the impact is on inflation. This assertion is critically examined. First, two common definitions of capacity--engineering and economic—are examined and found to be nebulous. The concepts of supply and demand are older, but better. Full capacity is reinterpreted as points where the supply curve is steep and excess capacity as points where it is fairly flat. Then the "Keynesian" model in which stimulative policy shifts only the demand curve is compared to the "classical" model where stimulative policy shifts both demand and supply curves. For the former model the assertion on capacity utilization is correct, while in the latter it is not. Empirical tests are performed to determine whether measured capacity utilization is useful for predicting inflation. The tests are ambiguous, but certainly do not strongly favor capacity utilization.
This paper presents a monetarist model of the business cycle with price-setting firms. The model is estimated, and the point estimates used in simulations to illustrate the properties of the model. The real goods market is found to be stable, although subject to sharp changes in output. This model is consistent with rational expectations. Nevertheless, monetary policy can have a lasting impact, and the simulations show this to be the case. Fiscal policy too is found to influence the business cycle, but its short-run effects are substantially smaller than its impact effects. The possibility of an activist government policy in this model does not imply the efficiency of an activist policy.
In "Open Market Operations in a Model of Regulated, Insured Intermediaries" [JPE, forthcoming] we show that once-for-all open market purchases need not be inflationary. Here we show this result can carry over to various stationary accommodation rules given stochastic deficits. In particular, the inflationary and deflationary effects of stochastic deficits are not offset by, nor welfare improved by, a monetary policy that leans toward monetarism. Moreover, a constant money growth rule is not in the class of stationary policies given the kind of stochastic deficit we analyze, which by itself is a serious indictment of the monetarist proposal.
In “The Inefficiency of Interest-Bearing National Debt,” (JPE, April 1979) we argued that private sector transaction costs are needed in order to explain interest on government debt. It follows that if the government’s transaction costs do not depend on its portfolio, then, barring special circumstances, an open-market purchase is deflationary and welfare improving. In this paper we show that this result can survive a potentially relevant special circumstance: reserve requirements which limit the size of insured intermediaries.
This paper presents a welfare analysis of monetary policy rules that differ as regards the extent to which monetary policy accommodates an exogenous, stochastic deficit. Examples show that a nonaccommodating rule, one involving a higher ratio of bonds to currency the higher the deficit, is not necessarily better than rules that accommodate: either a rule involving a constant ratio of bonds to currency or one involving a lower ratio of bonds to currency the higher the deficit. Moreover, the nonaccommodating rule can imply more variation in the price level than the accommodating rules.
The formation and maintenance of the institutions of money and a futures market are analyzed in an overlapping generations model with a first period. With money and a futures market the economy converges to the allocation where costly transactions are foregone and marginal products and marginal utilities equated. However, neither institution may be formed, or money may be formed without a futures market. Moreover, stochastic output technologies raise the possibility of persistent recession and depression and of valuable government insurance of the futures market.
The determination of the mechanism for ordering strategies in a game theoretic conflict is the keystone of economic science, at least insofar as economics is to remain an outgrowth of that (otherwise relatively minor) school of English philosophy, Utilitarianism. A method for the solution of the general game is presented in this paper, and the implications for economic theorizing discussed.
An alternative solution concept is recommended for noncooperative games with multiple equilibra. Players maximize security level in a contracted game. Examples in economics are given in which this solution concept yields a unique solution: a fiat money model, the capital overaccumulation problem, and multiple rational expectations equilibria generally.
According to the folklore of economics, game theory has failed. This paper argues that that is an incorrect interpretation of the game theory literature. When faced with a well-posed problem, game theory provides a solution. When faced with an ill-posed problem, game theory fails to provide a solution. This is, indeed, the best one can hope for from a method of analysis! Further, some suggestions are made for facing game theory with well-posed economic problems.
Long-term contracts are explained as equilibrium strategies of supergames. In the specific coherent general equilibrium model provided, limited mobility of labor, in the form of a fixed cost of moving, generates long-term contracts.
Game theory addresses a problem which is central to economics. Yet, according to the folklore of economics, game theory has failed. This paper argues that this is an incorrect interpretation of the game theory literature. When faced with a well-posed problem, game theory provides a solution. Procedures for facing game theory with well-posed problems are suggested, and examples of economic applications provided. The applications are Samuelson's fiat money model, Phelps' capital overaccumulation problem, multiple rational expectations equilibria, and a bargaining problem.
A model is presented in which demand deposits backed by fractional currency reserves and public insurance can be beneficial. The model uses Samuelson's pure consumption-loans model. The case for demand deposits, reserves, and deposit insurance rests on costs of illiquidity and incomplete information. The effect of deposit insurance depends upon how, and at what cost, the government meets its insurer's obligation--something which is not specified in practice. It remains possible that demand deposits and deposit insurance are a distortion, and reserve requirements serve only to limit the size of this distortion.
A simple model of the process of learning in a diverse economy is presented. This model produces a stylized business cycle with shocks which precipitate the learning process. All agents have the same information, which implies that this business cycle cannot be reduced by improved information flow, counter to many models of output and employment fluctuation.
A new approach to market behavior is suggested. This approach has a coherent game theoretic foundaton, addresses such anomalous economic behaviors as strikes, rigid wages and unemployment, regulation of financial markets, depresssion, and nonmarket allocation, and, more generally, provides insights for Finance, Oligopoly Theory, Industrial Organization, and Macroeconomics. The central theme of the approach is that exchange technologies are a basic building block in a model, as are tastes, endowments, and production technologies. Moreover, the key feature of an institution of exchange is that it allows the making of a binding final offer.
The recurrent banking panics of the 19th century and the Great Depression of the 1930s are widely viewed as failures of our economic system. A simple version of Samuelson’s overlapping generations model is used to generate such failures of Walrasian equilibrium. The spontaneous “panics” generated involve a collapse of bank credit, causing in turn a drop in investment demand. The model suggests that both the recent technological advances in the intermediation industry and the current move towards deregulation of that industry are ominous developments.
Our suggestion consists of three postulates: assets are valued only in terms of their payoffs, perfect foresight, and complete and costless markets under laissez-faire. Together these postulates imply that the crucial anomaly, rate-of-return dominance of “money,” is to be explained by legal restrictions.
Our defense of these postulates is two-fold. First we compare them with existing alternative theories. Second, we provide an illustrative model which : (a) is consistent with the postulates, (b) implies rate-of-return dominance under suitable legal restrictions, and (c) addresses monetary policy questions with standard welfare economics and, in particular, rationalizes in terms of price discrimination a debt management policy that “tailors debt issues to the needs of the market.”
Game theory is both at the heart of economics and without a definitive solution. This paper proposes a solution. It is argued that a dominance criterion generates a, and perhaps the, generalized equilibrium solution for game theory. First we provide a set theoretic perspective from which to view game theory, and then present and discuss the proposed solution.
A simple model of backed money without a store of value function is presented, discussed, and defended. The function of money in the model is to replace complex contingent contracts traded on a centralized exchange with simple trades in decentralized markets.
Iterated contraction by dominance produces a generalized equilibrium. This solution to game theory is motivated, generated, analyzed, and compared to Nash equilibrium. One implication drawn is that a realized event in a social situation need not be uniquely determined by simple individual choices, even though the preference orderings implying those choices are the appropriate primitive.
Monetary policy is analyzed within a model that ignores transaction costs and appeals solely to legal restrictions on private intermediation to explain the coexistence of currency and interest-bearing default-free bonds. The interaction between such legal restrictions and monetary policy is illustrated in versions of overlapping generations models that contain three assets: government-issued currency and bonds and real capital. It is shown that legal restrictions and the use of both currency and bonds permit the government to levy a discriminatory inflation tax and that such a tax may be better in terms of the Pareto criterion than a uniform inflation tax.