Tony Yates and Simon Wren-Lewis, so a quick note before I grade exams just. I’ve never much liked the word “microfoundations,” which comes from the title of the Phelps volume. So, where do you draw the collection? How deep a structure do we need to say something useful? I had formed a debate with Noah Smith about Calvo prices just.
For me, this is really as case where we would like greater detail. Typically, in a New Keynesian model, prices are the friction that makes monetary plan matter. So, for that particular model, it’s the process where prices are established that we’re worried about. That’s where we want the detailed description of what’s happening.
But Calvo prices are pretty crude. You can find the two technologies for changing prices. The price can be transformed by a firm at zero cost, or it’s infinitely costly. And which technology the firm has is determined randomly. Well, that leaves a great deal of unanswered questions. Why would it not be expensive for a company to improve its price?
Why can’t the company write contingent pricing rules? If it’s costly to change prices, surely it must be costly for a company to change other activities, like employment. How come the firm just provide all the demand the will come in the hinged door when its price is fixed? Basically, there’s lots of unfinished business. We’re worried about how exactly things might change if we put in more detail. Do all the results about monetary policy change or what?
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Every piece of research has unfinished business. I have a working paper where quantitative easing (QE) issues, and it matters because short-maturity government debt is way better collateral than long-maturity debt. What’s it indicate for a secured asset to be better security? There is limited commitment, and a borrower can run away with a small fraction of a secured asset that is published as collateral. What decides that small percentage? It’s just exogenous. That’s a piece of unfinished business. I could think of reasons why that small fraction could be endogenous in a deeper model, but I haven’t worked well that away yet.
This brings us to the Lucas critique. Lucas’s ideas were related to previous ideas that arrived of the Cowles Foundation, like the original focus on recognition and structure. AFTER I took Art Goldberger’s econometrics class, he asked us one day to find a definition of structure and bring that into the class next time we met. We found 20 or 30 different explanations, some different wildly.
Apparently structure is in the eye of the beholder. To give you a basic idea how thorny this is, I once got into a disagreement with Bob Lucas about the amount of money demand function, which he could be very keen on. He was endeavoring to tell me how amazing it was that he had found the money-demand standards that was steady for a century.
Ultimately, we realize our models are going to be wrong. That is, to be useful, a model has to be simple, and simplicity implies it’s incorrect. Theory is actually important. The data will not talk with us and directly, as opposed to what Simon seems to think, neither does the data speak to us when we are filtering it through a VAR – that’s yet another way to conclude the info. Theory gives us principles on which to organize how exactly we think about the data, so that we’re not totally lost.