Tuesday, April 7, 2015

Mark Thoma, information equilibrium is the model you're looking for

I just read Mark Thoma's The Fiscal Times piece that he referred to as In Search of Better Macroeconomic Models at his own link. It seemed like every other line I was inserting a mental "which you can solve with information equilibrium" ... so in this post I'm going to excerpt with commentary. Let's begin.
... we know that when [there is unemployment], we can make everyone better off by moving to the equilibrium point. So why would firms or workers negotiate such an outcome? Why would both sides, in essence, leave money on the table?
Wage stickiness is probably an entropic force. Nothing stops individuals from taking wage cuts (i.e. being 'rational'), but it is overwhelmingly unlikely that hundreds of thousands of individuals simultaneously take this same rational choice. You can imagine this as it being unlikely that their individual financial histories are lined up at that moment. See: Wage stickiness is an entropic force
It turns out that attempting to add up individual equations to obtain aggregate, macroeconomic relationships creates all sorts of difficulties that are difficult or impossible to overcome.
In the information equilibrium approach, you make minimal assumptions about these individual equations -- in a sense only assuming that they can be added up. See: Entropy and microfoundations
Unfortunately, the representative agent approach is unsuited for studying behavior in financial markets. The problem is that there is no way for a single representative household to trade stocks and bonds with itself based upon different forecasts of future economic conditions
In the information equilibrium picture there is a detailed balance of financial transactions going back and forth in either direction. When agents change their decisions based on e.g. their perceptions of economic conditions, the millions of decisions add up to an imbalance -- a net flow in one direction or another. See: Towards ADM equilibrium and What does the AD-AS model mean?
The older, aggregate style models seem to do a much better job of predicting macroeconomic outcomes – as I explained in my last column, during the crisis they behaved admirably – but it is never clear if the equations are consistent with rational maximizing behavior.
Under some conditions, utility maximization and entropy maximization can be the same thing (actually, since utility is unobservable, we can always redefine it to make the utility and entropy maximizing equilibrium identical). See: Utility in an information equilibrium model
For some questions, the aggregate approach is best despite the criticism it has received in recent years from those using modern models, and we shouldn't think of it as going backwards if we adopt this approach when it provides simple, fast, and accurate answers to our questions.
The great thing about information equilibrium for Mark Thoma is that it recovers a lot of the old models like AD-AS, IS-LM, etc. In fact the information equilibrium approach justifies the diagrammatic approaches because those diagrams are basically entropic force diagrams for market forces. See: What does the AD-AS model mean?Why focus on supply and demand? and Information equilibrium: macroeconomics

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