Friday, October 24, 2008

On economic thought - 2

So I mentioned last time that microeconomics involves much less math than macro does. Well, let me make a qualification to that. There is an important field of microeconomics that is very math heavy - general equilibrium theory. Mainstream economics of the past 200 years owes a lot of techniques and terms to physics for its mathematical analysis. The idea of 'equilibrium' is thus deeply embedded in economics. In microeconomics, the most commonly encountered equilibrium is that between the supply and demand of any product or service. This is referred to as a partial equilibrium - it says nothing about the supply demand relations of other products, and how they affect the equilibrium under consideration.

General equilibrium theory refers to the attempt to bring together the equilibria of all or most of the products and services in the marketplace. Its earliest proponent was Leon Walras, followed a little later by Vilfredo Pareto. Both these economists belonged to the 'Lausanne School', and were highly mathematical in their thought and approach. The Walrasian and the Paretian ways differed in some details, and were brought together int a more general, more refined and highly mathematical neoclassical general equilibrium theory by Kenneth Arrow and Gerard Debreu. Dynamic programming, comparative statics - the modern GET has it all. Unsurprisingly, GET is considered tough and beyond the scope of introductory courses. As a result, I have very little exposure to it. Why do I speak of it then?

Well, even though it's categorised under micro, and uses microeconomics techniques and variables, the level of analysis in GET is very macro. Crudely, while macroeconomics typically tries to analyse aggregate variables in the economy from a top-down perspective, GET tries to aggregate them from their microeconomic components. If you're talking about all product markets inside the economy, you are pretty much talking of the entire real economy (assuming a closed economy - no currency transactions). It is not surprising that the first true macroeconomic model was more or less a scaled up general equilibrium model with some additions. Irving Fisher's neoclassical macromodel draws heavily from the mathematics and analysis of Walras. GET thus forms an interesting bridge between micro and macroeconomics, and a refined GET could be considered one legitimate way of looking at economics in an integrated fashion.

The importance of such an integrated approach cannot be over-emphasized. Indeed, the most technically sound and scathing criticism of Keynesian macroeconomics came from Robert Lucas, who insisted that macroeconomic models be necessarily founded upon and consistent with microeconomic foundations. A branch of macroeconomics that arose as a response to this critique is called New Keynesian Economics. Essentially, it tries to provide Keynesian macroeconomics with consistent and complete microeconomic foundations. But more on that later.

The thing I want to highlight now about New Keynesian Economics is, it uses something called a Dynamic Stochastic General Equilibrium. This is a GE model that attempts to remove some of the more central flaws of the Neocalssical GE model. It is dynamic, instead of static. It allows room to make technology endogenous. It models transitions between equilibira as stochastic processes, and hence it must be cool.

Basically, DSGE models are the high point economics has yet reached in general equilibrium theory. I don't know much about DSGE models, but they excite me. And they are only one of the many things that get me excited about New Keynesian Economics.


avataram said...

A lot of what I know about General Equilibrium comes from Fischer Black's wonderful "Exploring General Equilibrium". Was surprised to not find a mention of the book.

Kydland & Prescott's nobel?

zen babu said...

Didn't know much about it. Though was reading this tribute to the man vcaled "Understanding Fischer BLack" which mentioned the book.

The RBC theory also uses a DSGE model and has endogenous growth, but my knowledge of it is extremely limited.