Krugman's Nonsensical Recession Causing Shift Factor
Wednesday December 31, 2008
More on Monday's discussion.
Consider the consumption portion of the utility function in the Krugman paper:
Does this make any sense to anybody? Krugman's implied argument is not that the recession is due to the fact people are spending less money (which in this model is an effect, not a cause). His argument is not that people have less money to spend or that people are worried about having less money in the future (because they might get laid off). Rather it is that people currently derive less satisfaction with their purchases than they did last year.
Is this what passes for macroeconomics these days?
Consider the consumption portion of the utility function in the Krugman paper:
U = ... s(t) * ln( C(t) ) ...Where:
C is private consumption... I’ve introduced a shift factor s on consumer demand, as a crude way to allow for the kind of negative demand shock we’re experiencing right now.Note the functional form. The equation implies that in the recession (where we have a low s(t)) we receive less utility from spending a dollar than we do during 'regular' times. In other words, the recession is caused by the fact that spending 50 cents on an orange in 2008 makes us less happy than spending 50 cents on an orange did in 2007.
Does this make any sense to anybody? Krugman's implied argument is not that the recession is due to the fact people are spending less money (which in this model is an effect, not a cause). His argument is not that people have less money to spend or that people are worried about having less money in the future (because they might get laid off). Rather it is that people currently derive less satisfaction with their purchases than they did last year.
Is this what passes for macroeconomics these days?
Comments
If in fear, or in the anticipation of lower prices in the future, or in less ability to borrow, or in less willingness to lend, people decide to increase their cash holdings, then, yes, that would mean they obtain less satisfaction from spending than they did before. This is why they increase their cash holdings; it generates more satisfaction than it did previously. Now that may be circular in that deciding to spend less, they do spend less, end up with less to spend, and this increases fear, causing them to cut back more, but this is just the vicious cycle.
Or if you prefer, your satisfaction from the orange is the same, but you now obtain even greater satisfaction from cash.
Psychology is not always that easy to rationalize, and can for that reason be hard to model. So what can you do?
If people gets a very bad view of the future, that might shift demand for consumer consuption more than what would have been rational. People are afraid (even though most of them very well could end up with a better economy next year due to lower interest rate (and around here still a real wage growth from 2008 to 2009)), and starts spending less.