Knowledge that Transforms

This is a nontechnical summary of a much longer study which will appear with the same title in Richard Freeman, Birgitta Swedenborg, and Robert Topel, eds. (forthcoming). I am especially indebted to Henry Ohlsson and Birgitta Swedenborg, and to Stan Engerman, Vic Fuchs, Assar Lindbeck, Stephen Lundgren, and Agnar Sandmo for comments on initial drafts. I alone am responsible for the views expressed here.

Between 1984 and 1995 New Zealand changed from a closed and centrally controlled economy to one of the most open countries in the OECD. The reforms liberalizing the economy were notable for their very comprehensive coverage and innovations that included: performance contracts for senior civil servants and the central bank, legislated constraints on fiscal expenditure decisions backed by accrual accounting, tax neutrality, subsidy-free agriculture, and no industry-specific regulation of competition. Modern microeconomics contributed much to policy design. Economic growth has been vigorous since 1991, but a different sequencing of reforms may have enhanced outcomes.

The tradeoff between an insurer's or medical provider's incentives to select good risks and to produce efficiently is governed by the supply-price analog to the demand-price tradeoff between moral hazard and risk aversion. Under a variety of models the optimum supply price is a mixture of capitation and fee-for-service payments. Empirical literature shows that pure capitation payment leaves strong incentives for selection that are acted upon. The presence of contracting costs in a Rothschild-Stiglitz model means a limited pooling equilibrium can exist and that poor risks will not be at their preferred outcome.

The paper examines the literature that attempts to resolve the equity premium and riskfree rate puzzles. It demonstrates that the puzzles will confront any model of asset prices that relies on three crucial assumptions: preferences have a particular parametric form, asset markets are complete, and asset trade is frictionless. A survey of the literature that relaxes these assumptions reveals that there are now several plausible explanations of the seemingly low riskfree rate, but the large size of the equity premium remains a puzzle.

NEARLY EVERYONE would see the truth as between Hamlet and Puck. Including Hamlet and Puck. Hamlet is feigning madness, and Puck is just being, well, puckish. Model-writing economists, however, tend not to the middle but to the “infinite in faculties” extreme. Although the postulate of unbounded rationality has dominated economic modeling for several decades, the dominance is relaxing. Is this encouraging? Why bounded rationality? In this survey, four reasons are given for incorporating bounded rationality in economic models. First, there is abundant empirical evidence that it is important. Second, models of bounded rationality have proved themselves in a wide range of impressive work. Third, the standard justifications for assuming unbounded rationality are unconvincing; their logic cuts both ways. Fourth, deliberation about an economic decision is a costly activity, and good economics requires that we entertain all costs. These four reasons, or categories of reasons, are developed in the following four sections. Deliberation cost will be a recurring theme. Most references are to the last 15 years, though many earlier works are also cited. A longer version of the survey, including many more references, is available from the author on request.

FIRST ARTICULATED by scholars of the ISalamanca school in sixteenth century Spain,1 purchasing power parity (PPP) is the disarmingly simple empirical proposition that, once converted to a common currency, national price levels should be equal. The basic idea is that if goods market arbitrage enforces broad parity in prices across a sufficient range of individual goods (the law of one price), then there should also be a high correlation in aggregate price levels. While few empirically literate economists take PPP seriously as a short-term proposition, most instinctively believe in some variant of purchasing power parity as an anchor for long-run real exchange rates. Warm, fuzzy feelings about PPP are not, of course, a substitute for hard evidence. There is today an enormous and evergrowing empirical literature on PPP, one that has arrived at a surprising degree of consensus on a couple of basic facts. First, at long last, a number of recent studies have weighed in with fairly persuasive evidence that real exchange rates (nominal exchange rates adjusted for differences in national price levels) tend toward purchasing power parity in the very long run. Consensus estimates suggest, however, that the speed of convergence to PPP is extremely slow; deviations appear to damp out at a rate of roughly 15 percent per year. Second, short-run deviations from PPP are large and volatile. Indeed, the one-month conditional volatility of real exchange rates (the volatility of deviations from PPP) is of the same order of magnitude as the conditional volatility of nominal exchange rates. Price differential volatility is surprisingly large even when one confines attention to relatively homogenous classes of highly traded goods. The purchasing power parity puzzle then is this: How can one reconcile the enormous short-term volatility of real exchange rates with the extremely slow rate at which shocks appear to damp out? Most explanations of short-term exchange rate volatility point to financial factors such as changes in portfolio preferences, short-term asset price bubbles, and monetary shocks (see, for example, Maurice Obstfeld and Rogoff forthcoming). Such shocks can have substantial effects on the real economy in the presence of sticky nominal wages and prices. I See Lawrence H. Officer (1982, ch. 3) for an extensive discussion of the origins of PPP theory; see also Dornbusch (1987).

Hans van Ophem (1993) employed a switching regression model with earnings entering the choice equation to investigate earnings differentials between the public and private sectors. Ophem also described a 'modified switching regression model' in which only the equation for unknown earnings is substituted into the choice equation. He argued that the coefficients in the choice equation can be identified in the modified switching regression model without exclusion restrictions and that estimates from the modified switching regression model are more efficient than estimates from the standard switching regression model. The authors show that there are flaws in Ophem's analysis which invalidate his claims. Copyright 1996 by MIT Press.

This paper explores the usage of various industrial policy tools in Japan. Contrary to the conventional wisdom, the authors find that a disproportionate amount of Japanese targeting occurred in low-growth sectors and sectors with decreasing returns to scale. In addition, they find no evidence that productivity was enhanced as a result of industrial policy measures. Copyright 1996 by MIT Press.

The study presented here uses data from the NORC General Social Surveys to explore the effects of measurable school characteristics on student achievement. What separates this study from many others is the use of aggregate data on older cohorts, usually associated with research on the influence of school inputs on earnings. Earnings studies have tended to find substantial effects, while much of the research on achievement using contemporary, cross-sectional data has not. We find substantively large effects, similar in size to those found in many earnings-focused studies. In this way, our results point to the importance of aggregation and cohort effects in modeling the relationship between school inputs and student outcomes. The level of data aggregation, in particular, appears important, bringing into question causal interpretations of the results of studies using aggregate data to assess school input effects.