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description= Commentary on monetary policy in the spirit of R. G. Hawtrey;
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agents may be unable to execute their prior plans to buy and sell some agents may make only minor plan adjustments others may have to make significant adjustments and some even scrapping plans that became unviable the disappointment of expectations likely also causes some or all previously held expectations to be revised the interaction between expected and realized prices in a temporary equilibrium model clearly resembles how according to menger the current values of higher order goods are imputed from the expected prices of the lower order goods into which those higher order goods will be transformed hicks never fully developed his temporary equilibrium method see devroey 2006 the temporary equilibrium method hicks against hicks eventually replacing the market clearing assumption of what he called a flex price model for a fix price disequilibrium model hicks had two objections to his temporary equilibrium method a that changes in industrial organization e g the vertical integration of large industrial firms into distribution and retailing rendered flex price models increasingly irrelevant to modern economies and b that in many markets especially the labor market a week is too short for the adjustments necessary for markets to clear hicks s dissatisfaction with temporary equilibrium was reinforced by the apparent inconsistency between flex price models and the keynesian model to which despite his criticisms he remained attached devroey rejected hicks s second reason for dissatisfaction with his creation showing it to involve a confusions between logical time i e a sequence of temporal events of unspecified duration and real time i e the temporal duration of those events the temporary equilibrium model pertains to both logical and real time the function of mondays was to telescope flexible market clearing price adjustments into a discrete logical time period wherein all the information relevant to price determination is brought to bear calling that period a day serves no purpose other than to impart the fictitious appearance of realism to an artifact whether price determination is telescoped into an instant or a day does not matter as for the first reason devroey observed that hicks s judgment that flex price models became irrelevant owing to changes in industrial organization are neither empirically compelling the stickiness of some prices having always been recognized nor theoretically necessary the temporary equilibrium analysis was not meant to be a realistic description of price determination but as a framework for understanding how a competitive economic system responds to displacements from equilibrium hicks seemed to conclude that the assumption of market clearing rendered temporary equilibrium models unable to account for high unemployment and other stylized facts related to macroeconomic cycles but as noted above market clearing in temporary equilibrium does preclude unplanned aka involuntary inventory accumulation and unplanned intertemporal labor substitution aka involuntary unemployment hicks s seeming confusion about his own idea is hard to understand in criticizing temporary equilibrium as an explanation of how a competitive economic system operates he lost sight of the distinction that he had made between disequilibrium as markets failing to clear at a given time and disequilibrium as the absence of intertemporal equilibrium in which mutually consistent optimized plans can be executed by independent agents but beyond devroey s criticisms of hicks s reasons for dissatisfaction with his temporary equilibrium model a more serious problem with hicks s own understanding of the temporary equilibrium model is that he treated agents expectations as exogenous parameters within the model rather than as equilibrating variables here is how hicks described the parametric nature of agents price expectations the effect of actual prices on price expectations is capable of further analysis but even here we can give no simple rule even if autonomous variations are left out of account there are still two things to consider the influence of present prices and influence of past prices these act in very different ways and so it makes a great deal of difference which influence is the stronger since past prices are past they are with respect to the current situation simply data if their influence is completely dominant price expectations can be treated as data too this is the case we began by considering the change in the current price does not disturb price expectations it is treated as quite temporary but as soon as past prices cease to be completely dominant we have to allow for some influence of current prices on expectations even so that influence may have some various degrees of intensity and work in various different ways it does not seem possible to carry general economic analysis of this matter any further all we can do here is to list a number of possible cases a list will be more useful if it is systematic let us therefore introduce a measure for the reaction we are studying if we neglect the possibility that a change in the current price of x may affect to a different extent the price of x expected to rule at different future dates and if we also neglect the possibility that it may affect the expected future prices of other commodities or factors both of which are serious omissions then we may classify cases according to the elasticity of expectations value and capital 2d ed pp 204 05 when hicks wrote value and capital and for more than three decades thereafter treating expectations as exogenous variables was routine except when economists indulged the admittedly fanciful assumption of perfect foresight it was not until the rational expectations revolution that expectations came to be viewed as equilibrating in almost all of milton friedman s theorizing about expectations for example his assumption was that expectations are adaptive even in his famous explication of the natural rate hypothesis friedman 1968 the role of monetary policy assumed that expectations are adaptive to prior experience which corresponds to the elasticity of expectations being less than unity hicks failed to understand that expectations are formed endogenously by agents not parametrically by the model and that endogenous process may sometimes bring the system closer to and sometimes further from equilibrium consider hicks s analysis of a change in the price of one commodity given a fixed interest rate an endogenous money supply and unit elastic price expectations suppose that the rate of interest is taken as given while the price of one commodity x rises by 5 per cent if the system is to be perfectly stable this rise should induce an excess supply of x however many repercussions through other markets we allow for now what are the changes in prices which will restore equality between supply and demand in the markets for other commodities if we consider some other markets only we get results which do not differ very much from those to which we have been accustomed the stability of the system survives these tests without difficulty but when we consider the repercussions on all other markets then we seem to move into a different world equilibrium can only be restored in the other commodity markets if the prices of the other commodities are unchanged and the price ratios between all current prices and all expected prices are unchanged since elasticities of expectations are unity and ex hypothesi rates of interest are unchanged then there is no opportunity for substitution anywhere the demands and supplies for all goods and services will be unchanged being equal before they will be equal still it is a general proportional rise in prices which restores equilibrium in the other commodity markets but it fails to produce an excess supply over demand in the market for the first commodity x so far as the commodity markets taken alone are concerned the system behaves like wicksell s system it is in neutral equilibrium that is to say it can be in equilibrium at any level of money prices hicks s footnote here is as follows the reader will have noticed that this argument depends upon the assumption that the system of relative prices is uniquely determined i do not feel many qualms about this assumption myself if it is not justified anything may happen if elasticities of expectations are generally greater than unity so that people interpret a change in prices not merely as an indication that they will go on changing in the same direction then a rise in all prices by so much per cent with constant rate of interest will make demands generally greater than supplies so that the rise in prices will continue a system with elasticities of expectations greater than unity and constant rate of interest is definitely unstable technically then the case where elasticities of expectations ae equal to unity marks the dividing line between stability and instability but its own stability is of a very questionable sort a slight disturbance will be sufficient to make it pass over into instability 1 id pp 254 55 of course to view price expectations as equilibrating variables does not imply that price expectations do equilibrate it means that expectations adjust endogenously as agents obtain new information and that if agents expectations are correct intertemporal equilibrium will result current prices are also equilibrating variables but contrary to the rational expectations postulate expectations are only potentially not necessarily equilibrating whether expectations equilibrate or disequilibrate is an empirical question that does not admit of an a priori answer hicks was correct that owing to the variability of expectations the outcomes of a temporary equilibrium model are indeterminate and that unstable outcomes tend to follow from unstable expectations what he did not do was identify the role of disappointed expectations in the coordination failures that cause severe macroeconomic downturns disappointed expectations likely lead to or coincide with monetary disturbances but contrary to clower 1965 the keynesian counterrevolution a theoretical appraisal monetary exchange is not the only or even the primary cause of disruptive expectational disappointments in the complex trading networks unerlying modern economies susceptible to macroeconomic disturbances credit is an essential element of commercial relationships most commerce is conducted by way of credit only small amounts of legal commerce is by immediate transfer of legal tender cash or currency in the imaginary world described by the adm model no credit is needed or used because transactions are validated by the walrasian auctioneer before trading starts but in the real world trades are not validated in advance agents relying instead on the credit worthiness of counterparties establishing the creditworthiness of counterparties is costly so specialists financial intermediaries emerge to guage traders creditworthiness it is the possibility of expectational disappointment which are excluded a priori from the adm general equilibrium model that creates both a demand for and a supply of credit money not vice versa at times this had been done directly but it is overwhelmingly done by intermediaries whose credit worthiness is well and widely recognized intermediaries exchange their highly credible debt for the less well or less widely recognized debts of individual agents the debt of some these financial intermediaries may then circulate as generally acceptable media of exchange but what constitutes creditworthiness depends on the expectations of those that judge the creditworthiness of an individual or a firm the creditworthiness of agents depends on the value of assets that they hold their liabilities and their expected income streams and cash flows loss of income or depreciation of assets reduces agents creditworthiness expectational disappointments always impair the creditworthiness of agents whose expectations have been disappointed their expected income streams having been reduced or their assets depreciated insofar as financial intermediaries have accepted the liabilities of individuals or businesses suffering expectational disappointment those financial intermediaries may find that their own creditworthiness has been impaired because the foundation of the profitability of a financial intermediary is its creditworthiness in the eyes of the general public the impairment of creditworthiness is a potentially catastrophic event for a financial intermediary the interconnectedness of economic and especially financial networks implies that impairments of creditworthiness in any substantial part of an economic system may be transmitted quickly to other parts of the system such expectational shocks are common but under some circumstances the shocks may not only be transmitted they may be amplified leading to a systemic crisis because expectational disappointments and disturbances are ruled out by hypothesis in the adm model we cannot hope to gain insight into such events from the standard adm model it was precisely hicks s temporary equilibrium model that provided the tools for such an analysis but unfortunately those tools remain underemployed 1 to be clear the assumption of unit elasticity of expectations means that agents conclude that any observed price change is permanent if agents believe that an observed price change is permanent they must conclude that to restore equilibrium relative prices all other prices must change proportionately hicks therefore posited that rather than use their understanding given their information of the causes of the price change agents automatically extrapolate any observed price change to all other prices such mechanistic expectations are hard to rationalize but hicks s reasoning entails that inference thoughts and details on the fiscal theory of the price level published july 21 2024 adam smith bimetalism chris sims earl thompson eric leeper fiscal theory of the price level gold standard james tobin john cochrane keynes michael woodford 6 comments tags economics economy finance inflation money the fiscal theory of the price level has been percolating among monetary theorists for over three decades eric leeper being the first to offer a formalization of the idea with chris sims and michael woodford soon contributed to its further development but the underlying idea that the taxation power of the state is essential for the acceptability of fiat money was advanced by adam smith in the wealth of nations to explain how fiat money could be worth more than its minimal cost of production the smith connection suggests a somewhat surprising and non trivial intellectual kinship between the fiscal theory and modern monetary theory that proponents of neither theory are pleased to acknowledge while the fiscal theory has important insights it seems to promise more than it delivers presuming to offer a m...
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