Knowledge that Transforms

Two basic tenets of the Walrasian model, behavior based on self-interested exogenous preferences and complete and costless contracting have recently come under critical scrutiny. First, social norms and psychological dispositions extending beyond the selfish motives of Homo economicus may have an important bearing on outcomes, even in competitive markets. Second, market outcomes depend on strategic interactions in which power in the political sense is exercised. It follows that economics must become more behavioral and more institutional. We can return to these themes of the classical tradition, now equipped with the more powerful mathematical tools developed over the past century.

In the field of economics, perhaps the most important break with the past—one that leaves open huge areas for future work—lies in the economics of information. It is now recognized that information is imperfect, obtaining information can be costly, there are important asymmetries of information, and the extent of information asymmetries is affected by actions of firms and individuals. This recognition deeply affects the understanding of wisdom inherited from the past, such as the fundamental welfare theorem and some of the basic characterization of a market economy, and provides explanations of economic and social phenomena that otherwise would be hard to understand.

This paper presents an economic analysis of the intergenerational transmission of ethnic and religious traits through family socialization and marital segregation decisions. Frequency of intragroup marriage (homogamy), as well as socialization rates of religious and ethnic groups, depend on the group's share of the population: minority groups search more intensely for homogamous mates, and spend more resources to socialize their offspring. This pattern generally induces a dynamics of the distribution of ethnic and religious traits which converges to a culturally heterogeneous stationary population. Existing empirical evidence bearing directly and indirectly on the implications of the model is discussed.

In a partially reformed economy, distortions beget distortions. Segments of the economy that are freed from centralized control respond to the rent-seeking opportunities implicit in the remaining distortions of the economy. The battle to capture, and then protect, these rents leads to the creation of new distortions, even as the reform process tries to move forward. In this paper I illustrate this idea with a study of the People's Republic of China. Under the plan, prices were skewed so as to concentrate profits, and hence revenue, in industry. As control over factor allocations was loosened, local governments throughout the economy sought to capture these rents by developing high margin industries. Continued reform, and growing interregional competition between duplicative industries, threatened the profitability of these industrial structures, leading local governments to impose a variety of interregional barriers to trade. Thus, the reform process led to the fragmentation of the domestic market and the distortion of regional production away from patterns of comparative advantage.

What is the current account response to transitory income shocks such as temporary changes in the terms of trade, transfers from abroad, or fluctuations in production? We propose this new rule: the current account response equals the saving generated by the shock times the country's share of foreign assets in total assets. This rule implies that favourable shocks lead to deficits (surpluses) in debtor (creditor) countries. This rule is a natural implication of the intertemporal approach to the current account if investment risk is high and diminishing returns are weak. Evidence from industrial countries broadly supports this rule.

We empirically examine the role of social networks in welfare participation using data on language spoken at home to better infer networks within an area. Our empirical strategy asks whether being surrounded by others who speak the same language increases welfare use more for those from high welfare-using language groups. This methodology allows us to include local area and language group fixed effects and to control for the direct effect of being surrounded by one's language group; these controls eliminate many ofthe problems in previous studies. The results strongly confirm the importance of networks in welfare participation.

We estimate a forward-looking monetary policy reaction function for the postwar United States economy, before and after Volcker's appointment as Fed Chairman in 1979. Our results point to substantial differences in the estimated rule across periods. In particular, interest rate policy in the Volcker-Greenspan period appears to have been much more sensitive to changes in expected inflation than in the pre-Volcker period. We then compare some of the implications of the estimated rules for the equilibrium properties of inflation and output, using a simple macroeconomic model, and show that the Volcker-Greenspan rule is stabilizing.