Imagine the following question on a PhD comprehensive exam:
"Using a macroeconomic model with monopolistically competitive firms, explain how an increase in the expected future price level will cause an increase in the current price level. Also explain whether there is an effect on real output.
Your answer must use words only, with no diagrams or equations. Be very precise about all the mechanisms that would be involved in this interdependent system of simultaneous causation. Your answer must assume no previous knowledge of economic theory or familiarity with economic concepts on the part of the reader. Try to make your answer as realistic as possible, using 10 real-world goods as examples. These should be goods that a homeowner with liquid domestic currency assets living in Sao Paulo Brazil in 1979 might want to buy in response to an increase in the expected future price level. Any transactions in your explanation must be shown to be consistent with double-entry bookkeeping. Please write clearly.
You have 2 hours to answer this question.
Your answer will be graded by a committee composed of: an accountant; a businessman; a Russian day-trader; an economics professor; and anyone else who happens to wander by. You must satisfy all these examiners in order to pass the exam, including follow-up questions in the oral.
Your answer, and the comments of your examiners, will be a permanent part of the public record."
I was foolish enough to try something like this (though I cheated a lot). (Sorry Winterspeak, but when I thought about what I was trying to do, it did seem rather funny, and I couldn't resist posting this, though the joke's really on me.)
Worthwhile Canadian Initiative 
You guys are using imaginary math constructs like this within democratic societies as grounds for multi-trillion dollar bailouts of insolvent mega-banks and corporations and other institutions controlled by the super rich — so you’d better learn how to explain it to the people.
I wouldn’t feel bad Nick, it was clear in an exchange between Winterspeak and Rebel Economist (that appears in the comments before you show up) that neither of those two have a handle on what inflation actually is or what it implies.
I’ve no doubt the rest of the commenters on the thread would be even worse than Rebel or Winterspeak in their understanding (excluding you of course).
So the only thing to do is laugh.
It is sort of funny, all round. But those guys genuinely want to understand, and they’re not daft either, because they all know stuff that I don’t know. As Greg says, it’s our job to try to explain what we think we know, and why we believe it. But God it gets hard sometimes. And the temptation to really cheat, to cook up some story that sounds good but isn’t really, is strong. But yes, let’s have a laugh at our predicament too.
For example: I cheated by:
translating “increase in expected inflation” into “increase in expected future price level”
assuming the nominal interest rate stayed constant
ignoring open economy
using perfect competition, which I don’t believe in
assuming an across the board increase in the expected future price level
assuming perfectly flexible prices, which I don’t believe in
ignoring all distribution effects on nominal contracts
ignoring the seigniorage profits.
Many of those are necessary for the thought experiment to have no real effects, which is what I assumed.
Well, yeah, that’s probaly true. Certainly both Winterspeak and Rebel are fairly serious.
On the other hand, I’ve seen the market player comment on several blogs and the impression he gives is of someone who is daft and is not serious about understanding anything.
BTW: I’m pretty sure the russian guy’s handle translates as “market player” and not “short market”.
Nick: “You have 2 hours to answer this question.”
Almost. How about:
“This is a take-home exam. You may begin writing at 11:00 p.m. Please hand in your completed paper by 8:00 a.m.”
and
“Examiners who make inappropriate or personal remarks may be deleted.”
Indeed, and of course there’s the all important part that the “examiners” in blog comments don’t have any actual power over you, certainly they can’t change the course of the rest of your life.
Phd examiners can change the course of the rest of your life.
“But those guys genuinely want to understand, and they’re not daft either…”
I just read through this post: http://www.winterspeak.com/2010/11/krugman-is-part-of-problem.html
and this post: http://www.winterspeak.com/2010/11/qe2-is-about-rates-not-prices.html.
As far as I can tell Winterspeak knows less than nothing about macro and is not genuinely trying to understand.
“I’ve no doubt the rest of the commenters on the thread would be even worse than Rebel or Winterspeak in their understanding (excluding you of course).”
__
Are you including yourself in that group Adam P?
I wasn’t a commenter on the thread.
Frances: Ah! You saw what time I was commenting, rather than being sound asleep like any sensible person.
Steady guys. Winterspeak and commenters were civil to me, despite my slight loss of patience. Let’s maintain that.
Nick, actually the scary things is: I didn’t.
Blogging is actually a variation on the old chestnut: “Set your own question and answer it. You will be graded on both the quality of the question and the quality of the answer.”
Alternatively: “Set up your own straw man and knock him down. You will graded on the size of the debris field.”
For what it’s worth, I have zero formal education in economics, and I found your basic explanation convincing and clear. (producers want to sell things for more money in the future, while buyers want to buy things for less money right now. that seems pretty intuitive).
I don’t really understand why some of the commenters at that blog are so against the idea of inflation expectations. I can’t imagine what kind of political or theoretical commitments would lead someone there. Is it just antipathy towards economists?
“You guys are using imaginary math constructs like this within democratic societies as grounds for multi-trillion dollar bailouts of insolvent mega-banks and corporations and other institutions controlled by the super rich — so you’d better learn how to explain it to the people.”
I don’t know, Greg. Math is the language of quantities and change. Personally, I think “the people” could use a better grasp on it.
Stephen Bank: Thanks! And that makes my attempt worthwhile. Plus, you got the main message. Plus, you said “want to sell things”, and “want to buy things”, which shows you understand the difference between quantity supplied, quantity demanded, and quantity actually traded.
My internet experience tells me that you’ve come up against some economic doctrinaires. They’re a really tenacious bunch and have their own body of knowledge. The discussion thread was hard to understand, so I don’t think I can I identify them well. They sounded anti monetary policy. I’ve argued with someone like that before. One day they’re advocating deflation as a way to encourage demand. You can argue against them then, but the next day they come out touting the gold standard and Max Keiser. It’s like peeling an onion into a parallel universe.
I think the best way to deal with them is to adopt their way of thinking and debate the best you can using logic and technicalities. It’s also a good idea to keep your messages short, since the internet is mostly edutainment anyway.
Nick, seriously, here’s a quote of Winterspeak in the comment section of this http://www.winterspeak.com/2010/11/qe2-is-about-rates-not-prices.html post.
Winterspeak: When people expect inflation they switch from the financial asset they expect to depreciate to another financial asset that they hope will not depreciate.
This is not consumption.
The (garbage) macro models tie inflation expectations to velocity via the consumption channel (ie. households will move consumption forward).
You don’t see a problem here?
The issue is not whether or not Winterspeak is smart or has some decent economic ideas. The problem is that Winterspeak has concluded a class of macro models is garbage without any understanding of what the model actualy says, nor is their any effort to undertand.
Just unquestioning dismissal of macro theory with a simple minded critique.
Adam: Yes, but. Suppose I argued like this:
“Well, if I thought inflation was coming, I would sell my bonds and buy a farm. And if a lot of people thought like me, the price of bonds would go down and the price of farms would go up. I’m not any richer if I think inflation is coming. I may be poorer, since my bonds are worth less. And since I’m not any richer, I’m not going to go out and consume more. I would probably consume less, since I’m poorer. So, since consumption won’t go up, and might even go down, I can’t see any reason to think that the CPI would go up today, just because I, and people like me, think it will go up tomorrow.”
It is very hard to start with reasoning like that, then add in intertemporal substitution in consumption, and investment demand. And add in all the substitution effects from one asset to another. And, on top of that, to add in the implied monetary policy reaction function that is at the back of our minds (because, for example, we get very different explanations if we assume a fixed nominal money supply or a fixed nominal interest rate, since we get very different LM curves in each case).
Macro is hard. And we make it easy for ourselves by using simple models with a very limited class of goods and assets. What we do looks a bit like cheating, for anyone who cannot or will not abstract from the world in all its complexity.
And Winterspeak was spot on several months back in saying the Eurozone does not have a lender of last resort.
“And look, even if there is an increase in consumption, monopolistically competitive firms, facing horizontal MC curves, will just expand output in line with the increased demand. They won’t raise prices!”
When I was working on my own macro model with monopolistic comp firms, before Blanchard and Kiyotaki in 87, it was very hard for me to get my head straight on why, at the macro level, an increase in demand would cause firms to raise prices, even when it might not do so at the micro level (with horizontal MC curves and isoelastic demand curves).
Sebastien has got it right. These discussions always circle back to the same themes: the glory of gold, the pernicious unfairness of inflation, the virtue of saving, the foolishness of borrowing. Oh, and “scrap the Fed”, of course.
It’s nice of you to answer questions that seem honestly posed, but don’t be baited. Humour and a light touch are usually best. One of my favourites: Barry Ritholtz, fed up with inflationistas pricing stuff in gold terms, posted a graph of gold in units of silver (priced in silver, gold is going to zero), and proclaimed: “Quantitative Mining is debasing gold!”
Explaining things is hard. Persuading folks with a different understanding of things is even harder.
Let me recommend this article by Larry Wright on the issues involved,”Argument and Deliberation: a Plea for Understanding,” The Journal of Philosophy, Vol. 92, No. 11, 1995, 565-85.
Formalism fails as a strategy for compelling assent — it often doesn’t even represent the phenomena in a valid way (e.g. math inspired formalism as a strategy for representing language, argument, science and explanation has been a massive bust).
The conceit of Milton Friedman and Paul Samuelson et al was that statistics and formally consistent math “models” would compel assent and agreement — you could force people to the same policy conclusion by putting everything into math and numbers.
Friedman actually wrote a letter to Hayek insisting math and numbers could settle policy differences, and this proved the superiority of his economic science over Hayek’s (a scientific strategy which Friedman patently didn’t understand).
“Explaining things is hard. Persuading folks with a different understanding of things is even harder.”
One of the things I sometimes do, but not often enough, is to first try to see where the other person is coming from. Then explain his own thinking in your own words. Once you have shown you have seen things through his eyes, you can then explain your own perspective. Not easy though.
Nick,
In their defence, prices rising due entirely to shifts in metaphysical supply and demand curves yet without any increase in the volume of physical transactions does sound rather mysterious.
Also, I guess MMT is hostile to the idea of inflation expectations in general.
vimothy: it is indeed. Plus, as one of the commenters said, in effect: “So, but somebody must be actually setting the price. And how would that somebody even know that demand had increased, unless he actually saw an increase in actual sales?”
Which is correct. There is no mythical Walrasian auctioneer observing supply and demand and adjusting price to equalise supply and demand in meta-time before trade is allowed to actually take place. (Some organised financial markets and auction markets aside).
Firms typically set prices for their products. And a firm won’t know that demand has increased until after it sees a sustained rise in actual sales (especially if customers drop in at random).
Disequilibrium macro was following this line of reasoning, in the early 1970’s. But, as Arnold Kling says, it was Theory X. It got swept away by the flood of theory Y, equilibrium theory, which just ignored this problem. And New Keynesian macro cut this Gordian know by just assuming firms set prices every k periods.
You cheated, and copied the wrong answer! It is “Sao Paulo”, not “Sao Paolo”.
Oh No! And I failed Geography too! Apologies to all Sao Pauloians (???)
Original post now edited for spelling.
Nick, your model with inflation expectations allows for infinite prices without a single transaction occurring. How do you realize a price without any transactions?
Sergei: not quite. I assumed the volume of transactions is the same before and after. Not zero.
But, many representative agent models do have prices, and zero transactions!
Technically we can define the “price” as the price that equalises supply and demand, even if quantity supplied, demanded, and transacted are all zero at that price. So it is never observed. It’s a model, not the world.
Yes, and it isn’t really in the spirit of the challenge, which is non-theoretical.
I was thinking about an analogy to a self-fulfilling currency crisis style model (since the mechanism so intuitively obvious), but I suppose it suffers from similar drawbacks…
Nick, no, you assumed that from one equilibrium to another there is a change in expectations, e.g. prices double. But your model allows for not just one doubling of prices but also doubling of doubling and so on until we reach our new equilibrium at infinite prices. Regardless of actual transactions, infinite prices are not possible because prices are finite by definition.
In other words your model does not depend on prices at all.
Sergei: that’s why I cheated!
The original question was “what happens if there is an exogenous increase in the expected rate of inflation?”
I changed it to “What happens if there is an exogenous increase in the expectation of next year’s price level?”
Starting in equilibrium, if the expected price level for 2011 increases, from one exogenously fixed level to another, that will cause the equilibrium price level for 2010 to rise by a finite amount.
If I had tried to answer the original question, I could not have assumed the nominal interest rate stayed constant. Because if I had, the current equilibrium price level would explode to infinity, as you say. I would have needed to invoke some sort of Taylor Rule in the monetary policy reaction function, or else hold the money supply fixed, or have some other nominal anchor.
So I cheated, to keep it simple(r).
I’m reading the comments again, and I’m reminded of a thought I had in the past.
Specifically concerning:
Rogue Economist posted at Winterspeak:
If you are worried about looming inflation, you’re less likely to eat out. You need to preserve your diminished purchasing power for the basic necessities. You will trade down to less costly substitutes. You will repair stuff rather than buy new ones.
Winterspeak replied favorably to that, so I think that’s the kind of answer he expected apart from ‘do nothing’. It sounds to me like they’re misusing microeconomic theory because they’re thinking that an increase in prices, the inflation, automatically means a decrease in demand. That’s the law of demand.
I argued with someone in the past and he seems to have thought the same. To prove that deflation was a good thing, he repeatedly cited the decrease in computer hardware prices in Silicon Valley. He then took that and concluded that deflation stimulates demand by lowering prices. By looking at it like an elementary microeconomic problem he completely missed most of what we know about inflation and deflation. Inflation is something that comes from multiple agents conducting successive transactions with multiple goods: even if our Brazilian did not generate inflation, history has shown that someone else obviously did. It sounds to me like an easy mistake to make if you’re not an economist.
[very lightly edited for civility. NR. Keep it civil please.]
“And we make it easy for ourselves by using simple models with a very limited class of goods and assets. What we do looks a bit like cheating, for anyone who cannot or will not abstract from the world in all its complexity.”
That’s a bit unfair. The heterodox folk have models, too. Everyone abstracts away from the real world, it is how we think about the world.
You can make a good case that the flow-of-fund models are more accurate than DSGE models. They predicted this crisis, and do a better job at predicting macro time series such as employment and inflation. They are more “useful”, but are rejected because they don’t have utility maximization.
But what are the micro roots of NK models?
They aggregate preferences, which you can’t do unless there is a dictator. So they are dictator models, with the same outcomes as social planner outcomes.
You don’t have multiple simultaneous micro transactions giving rise to new macro effects, you have a single actor choosing to consume or save, and the outcome of this choice is supposed to determine economy-wide allocation of capital investment and consumption in each period.
It would be as if you tried to explain ocean waves by looking at a single molecule of H20, ignoring exchanges of energy and momentum in which one molecule in one state interacts with a different molecule in a different state. In that case, even mystical models that talk of angels “pushing” on water would be more accurate representations of the aggregate phenomena.
In statistical mechanics, you do not obtain the result that the aggregate behavior can be described by the same hamiltonian as that of the individual element.
At the same time, there is no allowance for asset bubbles. When you save, you increase the (real) capital stock by the exact amount saved. It’s magic. Therefore there are no (financial) asset bubbles, there can only be an excess of real capital or an excessively low real interest rate. But between 1997 and 2007, real U.S. household net worth (which is the value of all the capital stock) increased by 170%, even though 1/(real FedFunds) increase by 120% and net investment, as a share of GDP, was less in the period 1997-2007 than the post war average. That isn’t possible if households, in aggregate, save by increasing their holdings of real capital by the amount saved.
Because it isn’t possible, there are no asset bubbles.
So you have to decide which model you trust more in describing the current predicament. The structural model without utility maximization but with a financial sector, or the dictator model without asset bubbles or a financial sector?
Reasonable people can disagree. Just as some do not believe in any of the predictions of the structural model, others can choose not to believe in any of the predictions (and specifically, the inflation predictions) of the barter-based dictator model. But this shouldn’t be framed in terms of wise experts needing to patiently explain non-intuitive results to non-experts who don’t bother with models.
Nick Rowe said “Macro is hard. And we make it easy for ourselves by using simple models with a very limited class of goods and assets. What we do looks a bit like cheating, for anyone who cannot or will not abstract from the world in all its complexity.”
To me this is the fatal flaw of economics. The discipline has delusions of adequacy. Newton’s model of the solar system wasn’t perfect. If we proposed sending a rocket to Jupiter using Newton’s model without incorporating Laplace’s use of perturbation theory, because Newton’s model is more tractable, we would rightly be laughed at.
Complexity is a defining characteristic of our economy and society. Assuming it doesn’t matter is cheating, but that’s not the bad part. The bad part is that the model error is not always explicit or obvious. Take the Euro as an example. I’m a not old enough to remember the Euro currency debates, but my understanding is that Mundell Fleming was used as a justification for creating the Euro. I don’t think it would be terribly hard to use the very same model today to argue in favour of breaking up Euro.
I don’t ascribe nefarious motives to any economist who used or uses Mundell Fleming to discuss the Euro, but perhaps we should take a step back and reconsider having high confidence in any recommendation from a discipline that gave out a Nobel Prize for a model that argues with itself?
Blogging is easy if you were educated at Chicago and always assume perfect competition. (Of course one’s ideas may not seem plausible.)
Interesting to read your last sentence Joel, because it is a nice expression of what I wanted to say too.
“…a model that argues with itself“. In a sense, all equilibrium models argue with themselves: because there are always competing effects in opposite directions – that is, of course, why we get an equilibrium.
And even apart from the forces which generate the equilibrium itself, the nature of the trade-offs in economics around an equilibrium point means that in any interesting question, there are very likely to be competing effects to disentangle.
A well-known example is the old debate about tax rates and supply of labour: will a higher rate of tax (therefore a lower net wage received by workers) reduce the supply of labour? Purely from the viewpoint of price, it will. But from the viewpoint of income, it might not. Perhaps workers will increase their supply of labour to maintain income at a target level. Perhaps they’ll reduce it because they’re not being paid as much for each hour. Economic theory doesn’t tell us which effect is stronger, it simply helps us identify both effects (and in this case, helps us see whether the effects derive from the average or marginal price).
In Winterspeak’s story, we have a similar confusion. It seems quite intuitive to suggest, as Winterspeak’s commenter does, that “If you are worried about looming inflation, you’re less likely to eat out. You need to preserve your diminished purchasing power for the basic necessities. You will trade down to less costly substitutes. You will repair stuff rather than buy new ones.”
If we consider the person in the problem to have a fixed quantity of cash and no other income, with a requirement to make ongoing expenditure on perishable goods, then this is quite a logical response. Or, imagine a pensioner with a non-indexed pension.
Implicit in Nick’s argument (and the mainstream macro argument) are two intertemporal simplifications, one of which must be satisfied to make the model work: that the representative agent possesses not just cash but income, which is expected to rise with inflation; and that most goods can be purchased this year and used next year.
If these assumptions are not satisfied, or not satisfied enough, then it is quite possible that the effect of inflation on wealth (or lifetime income) will dominate its effect on intertemporal substitution.
Again, economic theory can tell us both possibilities, but not which one is stronger. Empirical data (or sometimes common sense) is needed to answer that question. And I think Nick beats Winterspeak on common sense.
At least outside of the Walrasian barter auction room…
“Implicit in Nick’s argument (and the mainstream macro argument) are two intertemporal simplifications, one of which must be satisfied to make the model work: that the representative agent possesses not just cash but income, which is expected to rise with inflation; and that most goods can be purchased this year and used next year.”
But this is exactly the issue in a de-leveraging scenario.
Even if the economy contains only identical consumers, it is not true that the sum of each household’s income statement is equal to the income statement of the group. The income statement of the group will be national income, but national income will in general be less than the average income of the representative household, even if all households have identical incomes and identical preferences.
The difference between the sum of individual’s incomes and national income will be reflected by a growth in debt, which augments the incomes of individual households but disappears when you aggregate the individuals to get the national income.
When the economy is de-leveraging, then for a given level of national income, household incomes are declining due to the decline in borrowing. And this puts downward pressure on prices simply as households are constrained by their decreasing incomes.
And in that environment, it’s unlikely that an increase in expected future prices will be credible in the first place, or if it is credible, that the individual household will have enough income to actually cause more inflation. The latter situation will only occur if the expectation of rising prices causes the de-leveraging to reverse.
The income/wealth effect trade off that you normally see is augmented by an overall income decline during a de-leveraging period, and this can seem — if you are ignoring the effects of debt — as if wealth effects are suddenly dominating the income effects. They are not, but each household’s income is declining faster than national income, and this is a source of downward pressure on prices in addition to the normal trade-offs.
RSJ: huh!?! Borrowing does not contribute to income at the household level. Income is usually discussed in real-terms not nominal. So while net borrowing (against the CB) changes nominal income, it always deflates away in an evenly rotating economy once we consider the process in real-terms.
For similar reasons, net borrowing cannot be declining unless the CB is contracting the money supply, in which case, yes inflation is likely to be declining or negative.
Now what does happen is that the real interest-rate can become distorted. Artificially lows rates leading to a surfeit of investment and accelerating real production and artificially high real rates leading to a deficit of investment and decelerating real production.
“huh!?! Borrowing does not contribute to income at the household level.”
Borrowing is a key driver of income.
Here is an example.
Suppose your economy has two people, A and B, one firm, and one bank. Say the firm has an enterprise value of 2X, and is owned equally by A and B.
At the beginning of the period, A starts out with X assets. B starts out with a house that he purchased for $X some time ago, as well as X in firm assets.
A borrows 2X from the bank in order to buy B’s house. B spends X on goods from the firm and saves the remainder of his income.
A doesn’t buy any goods from the firm.
So the firm receives X in revenue and pays out X in the form of wages and capital income equally to both A and B (the firm does not do any additional investment in this period).
So what do our income statements look like?
A receives X/2 in wages and interest income and has no expenses.
He saves .5X in this period.
A’s balance sheet, by the way, goes from X assets and 0 liabilities to having a house valued at 2X as an asset, .5X of deposits , X in firm stock, and a debt of 2X as a liability.
B receives X/2 in wages and interest income, as well X from the disposal of the asset, for income of 1.5X. He consumes X and saves .5X in this period.
B’s balance sheet goes from having a house valued at X, firm stock valued at X, and no liabilities, to having 1.5X in deposits together with firm stock valued at X. B’s balance sheet increase by the amount that he saved — .5X.
The bank’s balance sheet goes from 0 to 2X in assets (the loan) as well as 2X in liabilities (the deposits).
But what happens at the level of national income — where you are picking your “representative” agent to allocation a portion of national income towards investment and a portion towards consumption based on his preferences?
At the national level, there is no investment. The house already existed and was not improved — no residential investment occurred. And the firm did not invest, either.
Therefore national income is just B’s consumption, or X.
But the sum of individual’s incomes is 2X, as A received .5X in income and B received 1.5X in income.
Therefore the capital gain can be realized as income at the level of individual households, but does not appear in NIPA at all.
It is invisible to the NK model, as the NK model does not allow for an increase in asset values without this being matched by an equal increase in actual investment. NK models — and all “non-heterodox” models, rule out asset bubbles as a result of how they model the law of motion for capital.
Therefore they can’t predict the bursting the asset bubble, or what remedies should be taken once the bubble bursts. They don’t understand that as soon as A stops borrowing, then this puts downward pressure on prices.
“So while net borrowing (against the CB) changes nominal income, it always deflates away in an evenly rotating economy once we consider the process in real-terms.”
Pure fantasy.
“For similar reasons, net borrowing cannot be declining unless the CB is contracting the money supply, in which case, yes inflation is likely to be declining or negative.”
The flow of funds says otherwise.
“Now what does happen is that the real interest-rate can become distorted. Artificially lows rates leading to a surfeit of investment and accelerating real production ”
In this example, there was no excess of real investment, as real investment was zero. According the BEA, actual investment declined over the course of the last cycle, yet we had a pretty big asset bubble, and outsized incomes to boot.
“Your answer must use words only, with no diagrams or equations.”
That is not constraint in blogging unless self-imposed.
Adam P@10:19AM:”it was clear in an exchange between Winterspeak and Rebel Economist”
Not Rebel but Rogue, I suppose.
sorry for offtopic but is there an RSS feed for all comments on this blog?
Sergei: go to the top of the list of comments here, immediately underneath where it says “Comments”. It says: “You can follow this conversation by subscribing to the comment feed for this post.”
RSJ: “That’s a bit unfair. The heterodox folk have models, too. Everyone abstracts away from the real world, it is how we think about the world.”
That’s not really what I meant. Yes, the heterodox folk have models too. And yes, we all abstract, all the time.
What I meant is this. When we build a model, especially a macro model, we simplify all the bits. Someone who is very familiar with one of those bits, say someone working in sales, will look at that bit and say it’s totally wrong. “We can’t just sell what we want to; it takes people like me to make a sale, and your model leaves that out!”
“But what are the micro roots of NK models?
They aggregate preferences, which you can’t do unless there is a dictator. So they are dictator models, with the same outcomes as social planner outcomes.”
Yes, NK models (typically) are representative agent models. But no, they very definitely do not have the same equilibrium as the social planner would choose. Some RBC models do (all the early ones did).
And you can only aggregate preferences if preferences are identical homothetic, not dictator.
RSJ: You are not understanding NK models correctly.
1. Even if all agents are identical, you can get a difference between micro effects and macro effects, and NK models have that. The fallacy of composition does not disappear if all agents are identical.
2. Simple NK models do not allow bubbles in asset prices. This has nothing to do with whether they allow borrowing and lending (which they do allow). It’s because simple NK models have the capital good the same as the consumption good. If the technology is, for example: deltaK+C=Y=F(K,L) then this says the marginal rate of transformation of the capital good into the consumption good is equal to one everywhere. And this pins down the price of K to equal the price of C.
There’s a production process, Y=F(K,L). So K and L produce Y. At the end of the assembly line, where Y comes out, there’s a switch. Flick it one way, and the Y comes out as I. Flick it the other way, and Y comes out as C. What’s more, in very simple models it’s reversible. You can eat the machines. That’s why the price of machines must always equal the price of cake.