Currency Misalignments and Current Accounts

One of my favourite journal paper titles is Xavier Sala-i-Martin’s AER paper ‘I just ran two million regressions’. The problem that paper tries to deal with is that there are too many potential variables that you could conceivably put in an equation explaining differences in economic growth rates among countries. There is then a serious danger of (intentional or otherwise) data mining. A researcher may want to establish that their pet new variable is important in determining growth, so they try lots of different regressions. When one set of additional variables are included the pet new variable is significant, but when another set is used it is not. Only the first group of regressions are published. Sala-i-Martin’s paper uses techniques that involve looking at all possible permutations of variables, in order to try and assess which are robust, in the sense of tending to be significant whatever else is in the regression.  

A recent ECB working paper by Ca’Zorzi, Chudik and Dieppe does something similar with models of the medium term current account. Why is this important? In my view it’s a key ingredient in being able to say something about exchange rate misalignments. This idea is associated in particular with the work of John Williamson, who christened the approach Fundamental Equilibrium Exchange Rates, or FEER for short. (That led to probably the best title of any of the papers I have co-authored – ‘Are Our FEERs justified’ – where we test the FEER approach against PPP[1].) John’s most recent analysis, co-authored with William Cline, can be found here. This or very similar approaches often go by different names: in Peter Isard’s nice survey it is called the macroeconomic balance approach, and it continues to be used (along with other methods) by the IMF.

The idea behind the FEER approach is to model trade flows as a function of the real exchange rate and activity levels. In the medium term activity levels will be determined from the supply side i.e. the output gap will tend to zero. So if we think we know about this supply side, and we know what the current account will be in the medium term, we can back out the medium term real exchange rate. We can then form a view about the extent to which current exchange rates are misaligned (or, more precisely, what expected interest rate differentials would have to be to justify current exchange rates). I’ve used this approach on a number of occasions in the past: perhaps most notably, to try and assess what Euro/Sterling exchange rate the UK should have entered the EuroZone at if it had decided to join in 2003.

The main problem with this approach is working out what the medium term current account should be. Actual current accounts are a poor guide, because they are influenced by both noise and short term factors, like the economic cycle and currency misalignment. In long term equilibrium it is reasonable to assume that the current account should be zero, because the current account is the change in national wealth. However we know that current accounts can show persistent surpluses or deficits over many years. Intertemporal consumption theory gives us some ideas, but on its own it is not that helpful. Many other factors may matter, such as countries having different demographic profiles.  With no clear encompassing theory to use, empirical studies of the kind cited above may be our best guide.

Incidentally, the New Open Economy Macro (NOEM) approach, which is currently the most widely used microfounded open economy framework, essentially uses the same idea as the FEER: see for example this study by Obstfeld and Rogoff. It is more concerned with microfoundations, and less with data, but it shares with the FEER approach a focus on imperfectly competitive markets for internationally traded goods. As far as I know these authors have never acknowledged Williamson as a precursor, and I’m not sure why. As a result, many macroeconomists think NOEM invented this way of thinking about medium term exchange rates.

The details of which variables the authors of the ECB study find are important in determining medium term current accounts are probably not of wide enough interest to discuss in this post. What is more topical is that they use their robust models to estimate what underlying current accounts currently are for the US, UK, Japan and China. Perhaps unsurprisingly they find that, although the US would be in deficit and China in surplus, the numbers are much smaller than the deficits and surpluses observed in the recent past. More controversial, perhaps, is that they find Japan should also be running a deficit. In the past I and others have tended to assume surpluses for Japan, but this was always partly based on demographic features which were coming to an end, which is maybe what has now happened.

One slightly disappointing aspect of the study is that they did not look at Germany. There is some debate about the extent to which German surpluses represent a temporary misalignment of real exchange rates within the Eurozone, or whether they may be partly structural. The answer is rather important in assessing the extent to which deflation is required outside Germany, and it would have been very interesting to know what this study had to say on this issue.                   

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[1] I should add that I take no credit for the title - I think it came from Rebecca.

Why the National Health Service played a central part in the Olympic Ceremony

Although the British are a patriotic nation like any other, we are also quite happy to criticise our institutions and national efforts. So before the Olympics our press was full of stories about actual or potential problems. Of course, it is another matter if someone overseas repeats these things, as a certain US politician found out. So everyone thought that being in charge of the opening ceremony was a poisoned chalice for Danny Boyle. Get anything wrong, and mistakes would be analysed in fine detail. Get the tone wrong and he would be torn apart.

Given that, the reaction to the opening ceremony in the UK has been extraordinary. Universal praise for once would not be a cliché. Not just praise of the ‘good effort’ kind – genuine emotion at having captured something quintessentially British. Examples here, and here, and here.  The appreciation seems to have come equally from left and right: when one Conservative MP tweeted that it represented ‘leftie multicultural crap’, his comment was described as ‘idiotic’ by the Prime Minister.

I think those watching from overseas will be able to understand a lot of this. There is the British sense of humour, the evocative depiction of the first transformation from a rural to industrial society, the central role of immigration, and consequent cultural diversity. But why so much time devoted to the National Health Service (NHS)? – that seemed to puzzle some in the US at least.

What is perhaps not understood outside the UK is that the British regard the NHS as an institution on an equal par to our monarchy. Not beyond criticism, but seen as absolutely essential to national life. While many aspects of the 1945 post-war social transformation have been swept aside (nationalisation of utilities) or greatly modified, the idea that the health service should be free to all and paid for through taxation is sacrosanct. In a MORI survey, when people were asked to agree that either ‘The NHS is critical to British society and we must do everything we can to maintain it’ or ‘The NHS was a great project but we probably can’t maintain it in its current form’, nearly 80% chose the former and only 20% the latter. A report for the Healthcare Commission prepared by MORI concluded

“The NHS as a whole, and in particular the principles it embodies, remains a huge source of latent pride. It is still perceived by the British general public to be one of the best of its kind in the world. People also see the NHS as critical to society, and despite concerns about its management, they feel it needs to be protected and maintained rather than re-invented.”

To suggest that the NHS should be replaced by a system based on insurance would be political suicide. That is why David Cameron promised that there would be no top down reform of the NHS if he was elected, and why many – even in his own party – suggest that his failure to honour that commitment may be his undoing.

Of course principles and practice do not exactly converge. There are some minor charges within the NHS, and there is plenty of private, insurance based provision available alongside the NHS. Nor do I want to argue that this attachment to the principle of equality of health provision is necessarily logical or consistent with British attitudes in other areas, but just to note that it exists.

Is this attachment to the NHS national self delusion? After all, many countries seem to have replaced their monarchies with alternative heads of state, and are doing just fine. I think there is a difference. The monarchy in the UK symbolises our history – its actual function is relatively trivial beyond that. The NHS embodies a principle that in critical matters involving health, all members of a society should be equal. Overall the UK is not a particularly equal society, and income and wealth inequalities have been growing, but this is one area where there is a strong national consensus that while additional income should mean that you contribute more to a health service, this does not entitle you to receive better treatment.

Do the British pay dearly for this attachment to equality in health provision? If you look at measures of quality or efficiency, the UK does reasonably well (for example here or here), but what does appear consistent is how badly the US performs in terms of efficiency. (For some clues as to why, see Timothy Taylor here.) So what seems more likely is that it is the US aversion to government involvement in health provision that is a little delusional. Which of course brings us back to that certain US politician, who not only came up with a plan to try and improve the US health care system, but when the President took it up, he has been kind enough to let the President take all the credit.


Postscript (4/08/12)


On US attitudes, see this more recent article by Uwe Reinhardt (HT MT)

Kill the Money Multiplier!

For students, and anyone who still teaches this

Nick Rowe is exasperated at how some bloggers think all mainstream macroeconomists believe in the money multiplier and did not realise that loans can create deposits. He says go and read a first year textbook. It is true that no macroeconomist I have ever talked to about this actually thinks the money multiplier is relevant to monetary policy today. And I am sure that Nick is right that good first year textbooks tell you that loans can create deposits as well as telling us about the money multiplier. But this does raise a rather embarrassing question for macroeconomists – why is the money multiplier still taught to many undergraduates? Why is it still in the textbooks?

One response might be that it takes time for textbooks to catch up with macroeconomic reality. But this would only be an excuse if central banks had been routinely using the money multiplier 20 or 30 years ago. It is true that there was a brief attempt to control monetary aggregates in the UK and the US in the early 1980s, but it was quickly abandoned. In the case of the UK, the money multiplier had nothing to do with how the monetary authorities tried to control monetary aggregates. So this hardly warrants inclusion in a first year macro textbook.

Another response is that there is no harm in including the money multiplier. It is a possible mechanism of monetary control, and a good intellectual exercise for students. Well, good intellectual exercises may be fine for more advanced textbooks, but they are a waste of precious time for students who may study no more macro. (I will not comment on how possible it actually is.) But I think it also does harm, because it gives the impression that banks are passive, just translating savings into investment via loans. If it is taught properly, it also leaves the student wondering what on earth is going on. They take the trouble to learn and understand the formula, and then discover that in the last few years central banks have been expanding the monetary base like there is no tomorrow and the money supply has hardly changed! (A more minor cost is that it can lead to debates over - as far as I can see - almost nothing of substance.)

I think I know why it is still in the textbooks. It is there because the LM curve is still part of the basic macro model we teach students. We still teach first year students about a world where the monetary authorities fix the money supply. And if we do that, we need a nice little story about how the money supply could be controlled. Now, just as is the case with the money multiplier, good textbooks will also talk about how monetary policy is actually done, discussing Taylor rules and the like. But all my previous arguments apply here as well. Why waste the time of, and almost certainly confuse, first year students this way?

I’ve complained about this before in this blog, and in print. (In both cases I was remiss in not mentioning Brad DeLong’s textbook, which does de-emphasise the LM curve.) The comments I received were interesting. The only real defence of teaching the LM curve was that it told you what would happen if monetary policy acted in a ‘natural’ way due to ‘impersonal forces’, whereas something like the Taylor rule was about monetary policy activism. Well, I count this as an excellent reason not to teach it, because it gives the impression that there exists such a thing as a natural and impersonal monetary policy. Anyone who was around during the monetarist experiments in the early 1980s knows that fixing the money supply is hardly automatic or passive.

I know this is a bit of a hobbyhorse of mine, but I really think this matters a lot. Many students who go on to become economists are put off macroeconomics because it is badly taught. Some who do not go on to become economists end up running their country! So we really should be concerned about what we teach. So please, anyone reading this who still teaches the money multiplier, please think about whether you could spend the time teaching something that is more relevant and useful.

What is New Keynesian Economics really about?

For economists. This post arose out of remark I made in response to comments. I’m not sure I want to defend the original remark too much, but I think there is a discussion here that some may find interesting.

In my discussion with heterodox economists, I was asked by someone whether I had actually read any major heterodox thinkers, or just looked at blogs. In response I listed some of those that I had read, including Axel Leijonhufvud. In passing I said I thought you could make a case for Leijonhufvud being the first New Keynesian economist. I guess this was a red rag to a bull, and Lars Syll wrote another post saying how wrong I was. (He is fast overtaking Scott Sumner in the perceived Wren-Lewis error count.)

So what did I mean? Of course I knew that Leijonhufvud is highly critical of much of modern macro. But what I had in mind was what I remembered of ‘Keynesian Economics and the Economics of Keynes’, which I read when young and which made a big impression. (For a more recent assessment, see this review by Howitt.) At the time there were attempts being made to partially microfound Keynesian economics by looking at rationing regimes where either goods or labour markets did not clear. Leijonhufvud was critical of this, and the earlier, emphasis on wage and price rigidity as being at the heart of Keynesian economics, both in terms of an interpretation of Keynes but also as useful macroeconomics. What I also remember, but did not fully appreciate at the time, was a good deal of discussion of the importance of intertemporal coordination failures, in which people’s expectations about long-term interest rates differ from the marginal efficiency of capital.

For many, New Keynesian economics is just a microfounded version of Old Keynesian economics. But what that means in practice is that New Keynesian theory is explicitly intertemporal, which IS-LM is not. Another way of describing New Keynesian theory, which I have used myself, is that it is a RBC analysis with price stickiness added on. In a technical sense that may be true, but I think it can be misleading in that it perpetuates the idea that these models are ‘all about’ wage and price rigidity.

Now it may or may not be the case that wage and price rigidities are preconditions for Keynesian analysis. I have argued elsewhere that a better way of saying it would be that price flexibility coupled with an appropriate monetary policy may rule out Keynesian problems, but that at the Zero Lower Bound (ZLB) inflation targeting does not. However it is also plausible to argue that the existence of money is a precondition for effective demand to matter in determining output, but not many people say that money is what New Keynesian analysis is all about. (Particularly as money is often not even part of the model.) You could also argue that imperfect competition was an essential ingredient in New Keynesian analysis, but again not many would characterise New Keynesian analysis as the macroeconomics of imperfect competition.

If I had to characterise New Keynesian theory by one thing, it would be the analysis of economies where the real rate of interest differed from the ‘natural’ real rate. The natural rate is the real interest rate that would obtain if output was determined by an RBC model – less precisely, if output was determined from the supply side. We often say the natural rate of interest is the real interest rate that would occur under flexible prices, but that is shorthand for the above, and perhaps misleading shorthand on occasion.

Once we have the ‘wrong’ real interest rate, then (using imperfect competition as a justification) New Keynesian analysis determines output and perhaps employment only from the demand side, and the determination of effective demand becomes critical to the model. Perhaps a better way of saying this is that if real interest rates are at their natural level, we do not need to think about demand when calculating output. In most cases, it is the job of monetary policy to try and get the economy back to this natural real interest rate. This gives you the key insight into why, ZLB problems apart, it is monetary rather than fiscal policy that is the primary stabilising policy.

We can make the same point another way. In the New Keynesian model, business cycles are generally an intertemporal mismatch between demand and supply (unless, for some reason, we get stuck with demand deficiency). What is the relevant price that influences this intertemporal allocation of demand? – the real interest rate, not the price or wage level. So if we have to think about New Keynesian economics as being about some price being wrong, that price is the real interest rate. And thinking in an explicitly intertemporal framework also makes you think twice about adding M/p into an IS curve, which is partly where the idea that sticky prices are crucial comes from.

Of course at some level the idea of characterising a class of models by one key idea is a bit pointless. But at another, more intuitive, level I think it can be helpful. In this case, for example, it suggests why monetary rather than fiscal policy is the policy of choice for stabilisation. This is also a good example of where IS-LM is less revealing: in this framework both policies look as good as each other within the context of the model itself.

This is why I claimed a connection between some of the ideas in Leijonhufvud’s Keynesian Economics and the Economics of Keynes and my interpretation of New Keynesian economics. I could now make sense of Leijonhufvud’s emphasis on talking about real interest rates, rather than wage and price rigidity. But I would be the first to admit that it is easy to see in what other people write what you want to see, so I have no problem with other people disagreeing with me on this interpretation. And even if there is something in what I say, I know of course that Leijonhufvud is highly critical of other aspects of New Keynesian analysis, and that his views may well have changed since that book. But what I do hope is true is that my interpretation of New Keynesian analysis is of some help to those who struggle to see what the nature of the market failure is in some modern Keynesian analysis.    

The macroeconomic magic button

In a recent post on the Eurozone, I talked about an idea from Greek economist Yanis Varoufakis, where he imagined leaders were presented with a magic button that would end their countries macroeconomic woes. He said that leaders in the US and UK would surely press the button, but he was doubtful about Germany. I commented as an aside that I thought he was wrong about the UK, because that button exists, and it is called balanced budget fiscal expansion. (I think he is right about the US, if the only hand needed to press the button was the President. However my arguments below probably also apply to many Republicans.)

The idea is to temporarily increase government spending, and pay for it completely by temporarily raising taxes. There is no increase in government budget deficits or debt. This may seem like giving with one hand and taking with the other, but it has the effect of raising demand, because some of the taxes come from reduced saving, rather than lower consumption. Once demand rises, incomes increase, and theory suggests that in a closed economy the multiplier would be one. (For those who want more detail, see here, and for specific past proposals to implement this policy, see here for the UK and here for the US.) The only argument I have seen that it would not raise demand is if all consumers believed the tax increase was permanent. That seems highly unlikely.

Of course many of us would argue that debt financed fiscal expansion is also a magic button, but many other people do genuinely worry about government debt. With the balanced budget button they do not have to.

I have heard people say that the balanced budget multiplier might be quite a lot less than one in an open economy like the UK. But this depends entirely on where the extra government spending goes. If it is all spent on goods or services produced in the UK, the multiplier is still one.

So why is the government not pushing this button? The answer is that I do not know for sure, because as far as I know they have not addressed this question. That in itself is quite revealing. The obvious thought is that no Chancellor likes raising taxes, but that alone cannot be a full answer, because this government has raised taxes.(1)

Imagine, if you can, that as a price of joining the coalition, the Liberal Democrats had insisted on having the post of Chancellor rather than deputy PM. Would the LibDem Chancellor not have pushed this magic button? The benefits are clear. The cost? Some short term political embarrassment perhaps in relaxing austerity that was before deemed unavoidable. But there is a perfect excuse – the Euro crisis. Unlike their Conservative partners, the LibDems would not be burdened with claiming that fiscal stimulus didn’t work when they were in opposition.

So I am left with only one plausible reason why the current Chancellor has not pushed the magic button and that is because he does not want to. Why? Well an obvious problem with balanced budget fiscal expansion is that it increases the size of the state. Even though it is only temporary, as a Conservative this is not something you want to do. In addition, if one of the ‘benefits’ of a debt crisis is that it gives you a pretext to shrink the size of the state, then undertaking balanced budget fiscal expansion stops that goal being achieved. You would, in this sense, be wasting a crisis.

Postscript

I originally wrote this before the latest fall of 0.7% in second quarter GDP was announced. (Note for US readers, this is a quarter on previous quarter fall, not annualised!) When I saw the Chancellor talking about these figures, he was being filmed outside a government funded construction project, and I had the feeling he had been doing quite a lot of this recently. This was confirmed in this Stephanie Flanders piece. She notes that this particular construction project was agreed by his Labour predecessor, but then delayed by this Chancellor when he came into office. In addition, a major contributor to the recent GDP fall was construction, in large part because of a decline in public investment!


This reminded me of George Orwell's 1984, where he made famous the idea that the best way to disguise the true purpose of something was to call it the opposite, like the Ministry of Peace that wages perpetual war. Perhaps we are seeing the televisual equivalent. So do not be too surprised, if the UK economy carries on being this successful, to hear that the U.K. Treasury has been renamed the Ministry of Growth. 


(1) Recently the Chancellor has undertaken, with the Bank, various measures designed to stimulate private investment. These are welcome, although they are also generally consistent with the argument I'm making here. Although there may be doubts about some of these measures as an alternative to public investment, to the extent that the market for borrowing for private investment is currently distorted by excessive caution and the rebuilding of banks balance sheets, effective subsidies for borrowing make sense. However their uncertain overall impact means they are no magic button.

Consumption and Complexity – limits to microfoundations?

One of my favourite papers is by Christopher D. Carroll: "A Theory of the Consumption Function, with and without Liquidity Constraints." Journal of Economic Perspectives, 15(3): 23–45. This post will mainly be a brief summary of the paper, but I want to raise two methodological questions at the end. One is his, and the other is mine.

Here are some quotes from the introduction which present the basic idea:

“Fifteen years ago, Milton Friedman’s 1957 treatise A Theory of the Consumption Function seemed badly dated. Dynamic optimization theory had not been employed much in economics when Friedman wrote, and utility theory was still comparatively primitive, so his statement of the “permanent income hypothesis” never actually specified a formal mathematical model of behavior derived explicitly from utility maximization. Instead, Friedman relied at crucial points on intuition and verbal descriptions of behavior. Although these descriptions sounded plausible, when other economists subsequently found multiperiod maximizing models that could be solved explicitly, the implications of those models differed sharply from Friedman’s intuitive description of his ‘model.’...”

“Today, with the benefit of a further round of mathematical (and computational) advances, Friedman’s (1957) original analysis looks more prescient than primitive. It turns out that when there is meaningful uncertainty in future labor income, the optimal behavior of moderately impatient consumers is much better described by Friedman’s original statement of the permanent income hypothesis than by the later explicit maximizing versions.”

The basic point is this. Our workhorse intertemporal consumption (IC) model has two features that appear to contradict Friedman’s theory:

1)      The marginal propensity to consume (mpc) out of transitory income is a lot smaller than the ‘about one third’ suggested by Friedman.

2)      Friedman suggested that permanent income was discounted at a much higher rate than the real rate of interest

However Friedman stressed the role of precautionary savings, which are ruled out by assumption in the IC model. Within the intertemporal optimisation framework, it is almost impossible to derive analytical results, let alone a nice simple consumption function, if you allow for labour income uncertainty and also a reasonable utility function.

What you can now do is run lots of computer simulations where you search for the optimal consumption plan, which is exactly what the papers Carroll discusses have done. The consumer has the usual set of characteristics, but with the important addition that there are no bequests, and no support from children. This means that in the last period of their life agents consume all their remaining resources. But what if, through bad luck, income is zero in that year. As death is imminent, there is no one to borrow money from. So it therefore makes sense to hold some precautionary savings to cover this eventuality. Basically death is like an unavoidable liquidity constraint. If we simulate this problem using trial and error with a computer, what does the implied ‘consumption function’ look like?

To cut a long (and interesting) story short, it looks much more like Friedman’s model. In effect, future labour income is discounted at a rate much greater than the real interest rate, and the mpc from transitory income is more like a third than almost zero. The intuition for the latter result is as follows. If your current income changes, you can either adjust consumption or your wealth. In the intertemporal model you smooth the utility gain as much as you can, so consumption hardly adjusts and wealth takes nearly all the hit. But if, in contrast, what you really cared about was wealth, you would do the opposite, implying an mpc near one. With precautionary saving, you do care about your wealth, but you also want to consumption smooth. The balance between these two motives gives you the mpc.

There is a fascinating methodological issue that Carroll raises following all this. As we have only just got the hardware to do these kinds of calculation, we cannot even pretend that consumers do the same when making choices. More critically, the famous Freidman analogy about pool players and the laws of physics will not work here, because you only get to play one game of life. Now perhaps, as Akerlof suggests, social norms might embody the results of historical trial and error across society. But what then happens when the social environment suddenly changes? In particular, what happens if credit suddenly becomes much easier to get?

The question I want to raise is rather different, and I’m afraid a bit more nerdy. Suppose we put learning issues aside, and assume these computer simulations do give us a better guide to consumption behaviour than the perfect foresight model. After all, the basics of the problem are not mysterious, and holding some level of precautionary saving does make sense. My point is that the resulting consumption function (i.e. something like Friedman’s) is not microfounded in the conventional sense. We cannot derive it analytically.

I think the implications of this for microfounded macro are profound. The whole point about a microfounded model is that you can mathematically check that one relationship is consistent with another. To take a very simple example, we can check that the consumption function is consistent with the labour supply equation. But if the former comes from thousands of computer simulations, how can we do this?

Note that this problem is not due to two of the usual suspects used to criticise microfounded models: aggregation or immeasurable uncertainty. We are talking about deriving the optimal consumption plan for a single agent here, and the probability distributions of the uncertainty involved are known. Instead the source of the problem is simply complexity. I will discuss how you might handle this problem, including a solution proposed by Carroll, in a later post.

Can heterodox economists constructively engage the mainstream?

For heterodox economists

                In my first post on the heterodox/mainstream divide, I suggested that there sometimes seemed to be a blanket rejection of mainstream economics by the heterodox, equivalent to the de facto rejection of heterodox economists by most of the mainstream. As someone who is both supportive and critical of mainstream macroeconomics (i.e. I believe it has strengths and weaknesses), I found this attitude disconcerting.

                But impressions can be wrong, so in a second post I presented a simple piece of analysis, that used both a representative agent and rational expectations, and I asked heterodox economists how their own analysis would differ. I repeated the challenge in a subsequent post, redoing my analysis using sector financial balances. Unless I’ve missed something, no one has – in my view at least – provided an answer. (However comments on these posts have seen some welcome interchanges between the two points of view on other issues, for which I am grateful.)

                My question was what the impact of a temporary increase in government spending, financed by taxes, would do to output in an open economy. It was not a trick question – I just happened to be thinking about a presentation on exactly this issue to policymakers, so it was on my mind. Now policymakers, in response to such a question, do not want long lectures on the sins of representative agents, rational expectations or whatever, and they certainly do not want to be told it is a bad question. They want some simple macro analysis.

                So, what do consumers do if they are told that taxes are rising temporarily? First, do they take any notice of what they are told, or do they assume the tax increase is permanent? It really matters which. If the former, do they smooth the impact on consumption, as the representative agent intertemporal model (and other earlier models) suggests, which by the way means that the consumer sector goes into deficit.

                If they do, output will tend to rise. How do traders in the FOREX market react? Do they try and work out if interest rates will rise, and if they do what are the results of this calculation? Do they say that in the past when output has increased the central bank has raised interest rates, or do they recognise that (as I assumed) we are at the zero lower bound and so no interest rate increase was likely?

                There are no obviously right answers to these questions, but I’m genuinely curious about how you would answer them without some appeal to representative agents. You could avoid rational expectations by assuming something simple like static expectations, but that would imply for consumers (after the initial surprise at taxes rising) the same thing as taxes rising permanently – until they were surprised by taxes falling again. And is the idea of consumption smoothing misguided, or just the idea that it results from optimisation?

                The point to all this is my belief that mainstream macro is not some kind of inevitably interlinked construct, that you either have to buy into completely or reject completely. I believe using a representative agent is OK for some questions, but not for others. I think it’s appropriate to assume rational expectations some of the time, but not all of the time. Any analysis has to make assumptions, and it is not clear to me why the assumptions I have made are worse than others. If you think this belief is wrong, the best way to convince me is to give an alternative story of how a temporary tax financed increase in government spending would work. But of course if you are happy to just give lectures about the evils of mainstream economics, then no response is necessary.