Change of Research Methodology from Supply Side to Demand Side - Macroeconomy from a Chinese Perspective

The Change of Research Methodology from the Supply Side to the Demand Side – Pan Deng’s Notes on Macroeconomics

What is the difference between supply side analysis and demand side analysis?

Supply-side analysis: Given the factors of production (labor, capital) and technology, how much output can the economy produce

• This is a purely technical question
• The object of research is an objective thing independent of human will
• Research methods applicable to natural sciences (from phenomena to laws, from laws to predictions)

Demand side analysis: How much the economy needs for output

• Economic needs ultimately come from people
• Human subjective will (preference) is something that must be considered in the analysis of needs
• The combination of human subjective will (preference) and purchasing power forms economic demand
• The research object is a complex combination of subjective (human will) and objective (objective things)
• The Research Methods of Natural Sciences Are No Longer Applicable—An Example of the Disappearing Phillips Curve

An example of a vanishing Phillips curve

In the 1950s, William Phillips proposed that there is a negative correlation between inflation and unemployment. This quantitative relationship is also found in the US data.

After the Phillips curve came out, it was quickly regarded as one of the basic facts of macroeconomics. In practice, the invention of the Phillips curve has also made macro regulators feel like a treasure. It seems that as long as a certain price of rising inflation is paid, the unemployment rate can be suppressed. From the perspective of macro policymakers, unemployment is obviously a worse thing. Lowering the unemployment rate can lead to higher approval ratings for the government. Therefore, after the oil shocks of the 1970s, the United States began to consciously push up inflation to bring down unemployment.

However, policymakers and economists were surprised to find that when policy began to use the Phillips curve to regulate the economy, trying to push up inflation to hold down unemployment, the Phillips curve disappeared! Instead of reducing unemployment, high inflation has caused stagflation in which high inflation and high unemployment coexist.

The Phillips curve was established in the 1950s and 1960s because the government did not artificially create inflation at that time, so people believed that rising inflation represented a good economy. Therefore, when inflation rises, the enthusiasm of the people to participate in work will be relatively high, thereby driving down the unemployment rate. But when the government began to consciously push up inflation to reduce unemployment, the people realized that higher inflation was just from the government printing more money, and it did not mean that the economy was getting better, so it would not be due to rising inflation. And work more. In this way, the rise of inflation will no longer have a restraining effect on the unemployment rate, but will only bring about "stagflation" in which high inflation and high unemployment coexist.

Reasons for the disappearance of the Phillips curve

• The Phillips curve is based on people's expectations of low inflation (a rise in inflation is interpreted by people as a positive economy, which leads to companies expanding production and increasing staff)
• Low inflation expectations are replaced by high inflation expectations when the government consciously pushes down unemployment by pushing up inflation
• With high inflation expectations, rising inflation is no longer associated with low unemployment—rising inflation is interpreted as government printing money, and companies simply raise nominal prices without expanding production and staff

The way people behave will change because of changing expectations, so it is not stable - the macroeconomic quantitative relationship based on human behavior is therefore not stable . This is the transition from supply-side to demand-side research methodology.

Rational Expectations Revolution

• Lucas Critique: It is invalid to use the quantitative relationship between observed historical data to evaluate the effect of economic policy adjustment
• If you think of the macroeconomy as a machine, it is a machine whose internal structure and parameters change depending on how the machine operates
• The conclusions of macroeconomic analysis cannot be built on the quantitative relationship between macro variables, because these relationships are accidental and variable
• Macro analysis needs a micro-foundation: The foundation of macro analysis needs to be built on the deepest "invariance" in the economy—that is, human rationality.

Three Levels of Macroeconomics

• macro is macro, micro is micro
• The macro is the sum of the micro
• The macro is not just the sum of the micro

Methodology after Rational Expectations: Macro Analysis Based on Micro Foundations

• Don't separate the macro and the micro (you must jump out of the first level of understanding the macro)
  • Don't assume a solid quantitative relationship between macroeconomic indicators (don't make ad hoc assumptions)
  • Don't think of the quantitative relationship of macroeconomic indicators as a mysterious black box - always ask what is the economic mechanism behind the quantitative relationship
• The macro is the sum of the micro (the second level of understanding the macro)
  • Correspondence between macroscopic phenomena and microscopic phenomena
  • Understand macroscopic phenomena from the optimal choice (rationality) of rational people at the microscopic level
  • To explain macro phenomena, we need to tell micro stories

Macroeconomics was completely different before and after the rational revolution, and the paradigm of macroeconomics in economics research has undergone fundamental changes. This change can be described by Thomas Kuhn:

尽管如此,范式改变的确使科学家对他们研究所及的世界的看法变了。仅就他们通过所见所为来认知世界而言,我们就可以说:在革命之后,科学家们所面对的是一个不同的世界。......
革命之前科学家世界中的鸭子到革命之后就成了兔子。......
在科学革命的时候,常规科学传统发生了变化,科学家对环境的知觉必须重新训练一一在一些熟悉的情况中 他必须学习去看一种新的格式塔。在这样做之后,他所探究的世界似乎各处都会与他以前所居住的世界彼此间不可通约了。

Equilibrium Economics Methodology

Macroeconomic analysis should build a micro-foundation from the trigger of human rationality. From the previous macro-analysis of mechanism to the macro-theory after the rational expectations revolution, what is needed is not only a change in methodology, but also a change in world outlook. The balanced economics that we are accustomed to now has crossed these obstacles well, making economics the only natural science among social sciences , and giving economics the status of imperialism;

The disappearance of the Phillips curve tells us that once people's subjective initiative is ignored, economic analysis will inevitably lead to wrong conclusions. However, as the research object shifts from nature to human society, researchers have entered the ideal world from the materialistic world. In the natural sciences, the effective materialist scientific research methods are no longer applicable to economic problems.

Rationality – a bridge across materialism and idealism

A Philosophical Discussion of Reason

1. A helpless choice when rational assumptions are made
   • Usually, there is only one optimum, but there are countless ways that are not optimal;
   • The optimal response to rationality is rationality, and the optimal response to irrationality is not irrational;
   • The economics of arbitrary assumptions cannot develop
2. The Truth Defense of Rational Assumptions
   • Correspondence theory of truth: a statement is true if and only if it corresponds to the facts;
   • Consistency Theory of Truth: A statement is true because it is most consistent with the overall network of our experiences and beliefs;
   • Pragmatism of truth: a statement is true because it is the most "effective", that is, it makes us act better;
3. The price of rational assumptions
   • Rational assumptions limit the vision of economists and abstract humanity from the economy;
   • When we assume that all humans are rational, we lose sight of irrational actions and their consequences;

General Equilibrium Analysis

General equilibrium has been discussed in detail in financial economics, so here is a brief overview;

Steps to solve the general equilibrium:

1. Solve the optimization problem of all micro-individuals, and express their optimization behavior as a function of price;
2. Use the market clearing condition to find out the equilibrium price and everyone's behavior;

And solving the general equilibrium is within the scope of positive economics, in other words, we are studying the "how". At the same time, "what should be" is an equally important question, and this kind of question belongs to the category of normative economics; the answer to the question "what should be" is Pareto optimal . Then there are the first and second theorems of welfare economics:

The First Theorem of Welfare Economics

• In a perfectly competitive market, the equilibrium is Pareto optimal
• In a perfectly competitive market, if both consumer preferences and production technologies are convex, then any Pareto-optimal allocation can be achieved using a competitive equilibrium

Then another step to solve the general equilibrium is obtained:

• Solve the optimization problem of the central planner;