The heterodox versus the superhuman representative agent

                Following this post, I’ve been reading the blogs of quite a few heterodox economists. There is a lot that I have read which is challenging, and which has made me think about things in different (for me) ways, which is good. But there is also lots of stuff that seems less helpful, which when it is repeated over and over becomes (for me) somewhat annoying.

                Stuff like we cannot possibly take microfounded macro seriously, because it is based on an all-embracing representative actor equipped with superhuman knowledge and forecasting abilities. To which I feel like shouting – where else do you start? I always say to PhD students, start simple, understand the simple model, and then complicate. So we start with a representative agent. What else could we do? We could start with aggregate relationships, but unless these are purely statistical, they will almost certainly appeal to theory about what individuals do. 

                What about superhuman knowledge and forecasting abilities? That seems like an extreme position. But the alternative is to assume we know what kind of mistakes agents will make. Where does this knowledge come from? I’m sure different agents are using different models from the one I’m using, but I have no idea what these models are. To keep things simple, I therefore assume I do not know what mistakes they will make, which implies rational expectations. If I want to be more realistic, I can look at the huge mainstream literature on models of learning. It is not a field I know well, but if there is a message there that we should go back to assuming adaptive expectations, I have missed it.  

                Some of the commentators on recent posts seem genuinely puzzled about why it is useful to have a representative agent or assume rational expectations. Others seem to believe that doing so must inevitably lead to laissez-faire results. The ultimate test is empirical relevance of course, and I have tried to make that case elsewhere. However I thought it might be useful to give an example of why I find thinking about a representative agent and rational expectations gives more plausible answers than using pre-microfoundations textbook analysis. It is an example where I’m genuinely curious about what heterodox economists who condemn using representative agents with rational expectations would do instead. As this is a post I’ll keep things as simple as I can and leave out most caveats and qualifications.

                The question is quite topical: what is the impact on output of a balanced budget increase in government spending in an open economy stuck at the zero lower bound (ZLB)? Well the first thing we have to do is ask whether the increase is permanent or temporary. If it’s permanent, if the import content of government spending is similar to consumer spending, and if taxes are lump sum, the answer is nothing. As the tax increase is permanent then consumption falls by the same amount, with no net impact on the demand for domestic output. That is pretty obvious, although anyone using a first year textbook would get this wrong (because they would have the mpc<1).

If the government spending increase is temporary, then the tax increase is also temporary. Thinking about an optimising consumer immediately gets us the result that consumption will initially fall by less than government spending, so there is a short run net increase in demand. (I am assuming that investment is unchanged, for standard reasons described here.) Higher demand raises output and income. If inflation does not change we get a multiplier that would be one if there were no imports. The analysis without imports is here, but we do not need it to show that output must rise.  

                In an open economy, we need to ask what will happen to the exchange rate if we have a temporary balanced budget increase in government spending, lasting no longer than the period interest rates are stuck at zero. Everyone remembers their Mundell Fleming – under flexible exchange rates fiscal policy is ineffective, because the exchange rate appreciates to crowd out the additional demand. But that is completely wrong in this case. Agents in the foreign exchange markets will note that there is going to be no increase in interest rates and no change in the steady state (so no long run appreciation or depreciation), so there is no reason for the exchange rate to move in the short run either. There is no crowding out through the exchange rate, so the analysis in the previous paragraph stands.

                This is pretty simple stuff, but it gives different – and in my view better - answers than many undergraduate textbooks. And both the representative intertemporal consumer and rational expectations were central in getting the answer. Now you may want to complicate in various ways, but that normally means building on this analysis rather than overturning it.

                So this is microfounded intertemporal macro telling us that a balanced budget fiscal expansion works at the ZLB. If you think this is obviously wrong because I’ve assumed all-embracing representative actors equipped with superhuman knowledge and forecasting abilities, tell me how you would do the analysis differently.