Knowledge that Transforms

This paper takes issue with two basic conclusions prevalent in the literature on central bank behavior. First, the paper argues that it is inappropriate to presume that central banks will, in the absence of any precommitment technology, necessarily behave in a 'discretionary' fashion that implies an inflationary bias. Since there is no functional connection between average rates of money creation (or inflation) and policy responsiveness to cyclical disturbances, it is entirely feasible for the bias to be avoided. In other words, there is no necessary tradeoff between 'flexibility and commitment.' Second, to the extent that the absence of any absolute precommitment technology is nevertheless a problem, it will apply to a consolidated central bank plus government entity as well as to the central bank alone. Thus contracts between governments and central banks do not overcome the motivation for dynamic inconsistency, they merely relocate it.

Just how important a determinant of economic growth is the efficacy with which markets are organized? It is clear that in order to answer this question it is necessary to have both a well-articulated theory of economic growth and a precise notion of what it means for one market to be better organized than another. The newly developed theory of endogenous growth (pioneered by, among others, Paul M. Romer [1986], Robert E. Lucas [1988], Nancy Stokey [1988], and Gene Grossman and Elhanan Helpman [1991]) has equipped economists with a rigorous microeconomic foundation of the growth process. Since its original inception, research in this area has bifurcated: one strand of work has continued to emphasize the importance of capital accumulation (both physical and human) in environments in which agents are competitive price-takers; the other strand has a distinctly neo-Schumpeterian flavor, in which firms are price-setters and purposive innovative activity leads to technological advancement. But what of the role played by market organization? The growth literature has remained relatively silent on this issue. The reason is that the canonical growth model is one in which trade-either competitive or monopolisticly competitive-is coordinated by the Walrasian auctioneer. Given that ex hypothesi trade is frictionless, it is meaningless to use this framework to discuss issues pertaining to improvements in market organization. However, beginning with the seminal contributions of Peter Diamond (1982), Dale T. Mortensen (1982), and Christopher Pissarides (1985), economists have begun to construct models that dispense with the auctioneer's coordinating function. In this setting it is possible to make precise the notion of an improvement in market efficacy, since search and bargaining frictions are explicitly incorporated as an integral part of the trading environment. Yet, it is only very recently that this literature has begun to explore the consequences for perpetual economic growth.

Persistent unemployment, like that plaguing Europe since the early 1980's, has been a persistent problem for economic theory. Competitive equilibrium theory assumes that all markets clear, including the labor market. All theories of unemployment thus must reflect significant departures from that paradigm. The last 20 years have generated a plethora of such theories. The challenge is to construct models that generate unemployment and are broadly consistent with a host of other labor and macroeconomic phenomena, including patterns of real wages and hours. The traditional approach is to focus on a simple static equilibrium in which wages are kept above their market-clearing level for a variety of reasons: in the older versions of this story minimum wages, union power and normative traditions; in its more recent incarnations, efficiency-wage considerations. Within the United States, the older variants of these models have received decreasing credence, as union power has eroded, the real value of the minimum wage has declined and empirical evidence has buttressed a broader set of theoretical arguments based on imperfect competition within the labor market and efficiency-wage considerations suggesting at most negligible effects from these government interventions.

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[T]he literature of risk aversion and risk preference [is] one of the richest sources of ad hoc assumptions concerning tastes. ... [N]o significant behavior has been illuminated by assumptions of differences in tastes. ... [Such theories] have been a convenient crutch to lean on when the analysis has bogged down. ... They give the appearance of considered judgement, yet really have only been ad hoc arguments that disguise analytical failures. -George J. Stigler and Gary S. Becker (1977 p. 89)

The frequency of foreign conflict initiations in the United States is found to be significantly greater following the onset of recessions during a president's first term than in other periods. The authors develop an economic theory of the political use of wars which links the election cycle, war decisions, and economic performance consistent with the observed relationships among these events. An incumbent leader with an unfavorable economic performance record may initiate a war to force the learning of his war leadership abilities and thus salvage, with some probability, his reelection. This obtains despite voter rationality and informational symmetry. Copyright 1995 by American Economic Association.