Sunday, September 25, 2016

Krugman's Keynesians and information equilibrium

Keynes' General Theory (image from Bauman Rare Books)


I was reading Robert Waldmann on macroeconomic puzzles (a very good post) and it inspired me to see how one should understand Keynes in the light of information transfer economics (see link for definitions used below). Waldmann sets up an understanding in terms of Krugman's (see here [pdf] and I swear there was a recent blog post Krugman wrote about it again but I can't find it).  Anyway, Waldmann says (and quotes Paul Krugman from the linked pdf):
As usual, the challenge to the young macroeconomist goes back to Keynes. The General Theory of Employment Interest and Money begins with [B]ook 1 containing models which are not difficult enough (aside from the fact that they were explained clearly and in detail a year later by Hicks). It also includes Chapter 12 on long term expectations (beauty contests and all that) clearly presenting problems too hard for Keynes. ... Here (as almost always) I am following Krugman 
[begin Krugman] I’d divide Keynes readers into two types: Chapter 12ers and Book 1ers. Chapter 12 is, of course, the wonderful, brilliant chapter on long-term expectations, with its acute observations on investor psychology, its analogies to beauty contests, and more. Its essential message is that investment decisions must be made in the face of radical uncertainty to which there is no rational answer, and that the conventions men use to pretend that they know what they are doing are subject to occasional drastic revisions, giving rise to economic instability. What Chapter 12ers insist is that this is the real message of Keynes, ... [end Krugman] 
The lack of puzzles is due to the fact that the puzzle addressed in book 1 is solved in book 1 and the problems posed in [chapter 12] declare themselves to have "no rational answer".


This kind of encapsulates the information transfer picture. Book 1 in this view is a particular information equilibrium model (I started writing it explicitly here, but Hicks version as the IS-LM model can be seen as information equilibrium as well). For example, Keynes' Postulate I states that:
I. The wage is equal to the marginal product of labour

This is the information equilibrium relationship (W/P) : Y ⇄ L where Y is real output, W is nominal wage, P is the price level and L is the labor supply. The second postulate could be tackled in terms of the information equilibrium take on utility. The other relationships can be understood in terms of the information equilibrium IS-LM model. I will eventually try to put together the whole of Book 1 in terms of information equilibrium.

Chapter 12, on the other hand, is non-ideal information transfer. As Waldmann put it "Keynes wrote that there will be manias, panics, and crashes no matter what policy makers do ...". I find it interesting that what Keynes was discussing in Chapter 12 is the state of long-term expectation and that one way to think about deviations from information equilibrium is as expectations with varying degrees of accuracy. In general, non-ideal information transfer gives us a way to look at various economic shocks. Since it is not information equilibrium (from which we could see rational agents as emergent as long as we stay near equilibrium), non-ideal information transfer represents (as Krugman says above) "radical uncertainty for which there is no rational answer". There may eventually be an answer, but it will come from psychology and sociology.

The information transfer framework allows us to join together Krugman's "Book 1 Keynesians" and his "Chapter 12 Keynesians" in a coherent whole. Both are 'correct' (at least in terms of the IT framework) -- under the right conditions.

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