Knowledge that Transforms

Traditionally, macroeconomic models are void of asset price dynamics. One explanation of this neglect involves the notion of short-run If one defines a equilibrium to be a situation in which relative asset prices are constant, the problem of asset price dynamics is assumed away at the outset. But this abstraction from the dynamics of relative asset prices in general is unjustified. The typical macroeconomic equilibrium is characterized by two features: 1) The stocks of assets (money, bonds, and capital goods) are fixed (instantaneously). 2) Asset markets are in equilibrium in the sense that we observe points lying on the asset demand functions. In general neither 1) nor 2) requires that relative asset prices be constant in equilibrium. But as we shall note below, one case in which this will be so is if the actual prevailing values of the real rates of return and coupon rates on the assets are expected to continue unchanged throughout all future periods. Under this extremely restrictive assumption of static expectations the existing asset prices will be expected to continue throughout the future, and the price dynamics degenerates. More generally we define dynamic equilibrium to be a situation in which 1) and 2) are satisfied and in addition relative asset prices are constant. The uniqueness and stability of such a shortrun dynamic equilibrium becomes the crucial question that we will discuss below. If we discover that an economy always converges rapidly to a unique dynamic equilibrium, that fact would provide a justification for models which do not contain price dynamics. On the other hand, rapid convergence cannot be presumed a priori, and in fact we shall discover that some rather strong regularity conditions are required to ensure stability. When these regularity conditions are not satisfied, the possibility arises of dynamic instability, a result that would destroy the validity of macroeconomic models formulated on the assumption that a dynamic equililibrium prevails at every instant. Thus we will carefully examine the underlying mechanism generating price dynamics. Since we do not postulate dynamic equilibrium, our formulation may be viewed as a disequilibrium approach to macroeconomics. Our model contains three main ingredients: (i) A new adaptive-type mechanism for generating price expectations simultaneously with a portfolio rate of return condition. (ii) A savings function, postulated to depend upon (expected) disposable income and wealth, with disposable income defined to ensure the consistency of planned savings and planned (expected) wealth accumulation. (iii) Asset demand functions that determine the value of the stocks of various assets as functions of expected rates of return, income, and wealth. Capital gains play a crucial role because they enter via the definition of the expected rates of return

The paper examines the question of whether land rents should be considered costs. The motivation for this paper arose from a study of a search model of resource exploration. The study showed that when no new information is revealed in the process of search, exploration can be completely characterized by a reservation cost rule. If probability distributions are known and firms are risk-neutral, the sequence of extraction would be efficient. The area with the lowest reservation cost would be and should be exploited first. It is implied that, for the purpose of resource allocations, unexplored land can be considered a commodity with essentially the same characteristics as known deposits. The author then examines a specific example which shows that, when the characteristics of nonreplenishable resources can be screened, it may not be desirable to screen all resources at the same intensity. He also examines the allocation of screening effort in a decentralized economy with complete futures markets. A final note concerns the general intuitive explanation of the differentiated screening equilibrium. (MCW)

Over the past few years, expectations, and in particular inflationary expectations, have come to play a central role in macroeconomic theory. In modeling these expectations two alternative procedures have typically been adopted. One approach is to specify them by some autoregressive function of the variable being predicted, so that at any specified time t, say, they can be treated as given, being predetermined by past values of that variable. The most common of such autoregressive procedures is the adaptive expectations hypothesis in which the forecast is adjusted in proportion to the immediate past forecast error. Despite their widespread use in a variety of contexts, these autoregressive hypotheses have periodically come under severe criticism, especially when applied to predicting endogenous variables. The objections have been along the following lines. By forecasting an endogenous variable using past values of that variable alone, one is clearly disregarding a considerable volume of available information relevant to that variable. In particular one is ignoring any knowledge one might have of the economic structure being analyzed, the very purpose of which is to provide predictions of the endogenous variable. Indeed there is no reason for the predictions generated from the autoregressive scheme to be consistent with those implied by the model. Hence it has been argued that if forecasters are aware of the structure of the relevant economic system, the rational way for them to form their expectations is to base them on the predictions of the economic model. Of course this criticism does not apply to predictions of exogenous variables, since by definition these are not explained within the framework of the model. This hypothesis, known as the rational expectations hypothesis, originated with John Muth. Formally it requires the forecaster's predicted value for period t, say, to equal the expected value of that variable as predicted by the system, conditional on all information available at the time the prediction is made (usually time (t 1)). The insistence that expectations be rational is also open to objections. In order for a prediction to equal the corresponding conditional expected value, it is necessary for the economic agents to have perfect knowledge of the complete economic structure, except for the truly random disturbances. This means that they must know the values of all relevant parameters determining the underlying economic relationships, as well as the means of all exogenous variables, including exogenous government policy variables. While one can argue, as I shall, that given the availability of consistently estimated economic models, it may not be too unreasonable to assume that economic forecasters have unbiased estimates of relevant parameters, it is most unlikely that they will have such knowledge of exogenous variables, especially those under government control. Indeed, as I shall show below, in certain cases to be discussed, it is precisely in the government's interests to deliberately misinform the public as to its proposed policies if it wishes them to be effective. As a result of the overwhelming quantity of information it assumes, the use *Professor of economics, Australian National University. An earlier version of this paper was presented to the Workshop in Macroeconomics at the University of Virginia; I wish to thank participants of the workshop for their helpful comments. The exposition of the paper has benefited from the suggestions of the managing editor and an anonymous referee.

Proposals that have been considered to stimulate the flow of recycled materials are discussed. The thrust of proposals is that recycling rates are too low and that the Federal government should offer incentives to aid the competitive position of secondary materials sector. This paper examines principal economic arguments that have been offered in support of a Federal program of recycling incentives and analyzes some of the recent legislative proposals in light of available information on the structure of the secondary materials industry. Arguments advanced in support of recycling incentives is that tax equity should be established between recyclers and primary material producers. (Depletion deductions were supported in H.R. 148). A second argument is based upon market failure attributable to external diseconomies in primary material production (air and water pollution and disruption of scenic natural environments). Because resource recovery would lessen these environmental damages and create few new ones of its own, one may wish to subsidize the secondary materials industry. The force of this argument has been reduced by statutes such as the National Environmental Policy Act, the Federal Water Pollution Control Act, and the Clean Air Act. The existing pattern of municipal subsidization of postconsumer waste disposal constitutes amore » deterrent to recycling. A final argument is that the existing structure of Federal regulation favors primary production over secondary material recovery and should be balanced with incentives for recycling. Specifically, the evaluation of recycling subsidies proposed in H.R. 148 and H.R. 10612 is made. H.R. 10612 would grant to purchasers of recyclable materials credits against income tax liabilities. Other approaches involve loan guarantees for recycling facilities, governmental stockpiling to stabilize supply and demand for secondary materials, and the creation of futures markets for secondary materials to reduce price uncertainty. (MCW)« less

A couple of years ago a New York Stock Exchange study (1974) pointed to a of some $650 billion by 1985. Treasury Secretary William E. Simon, comparing his estimates of capital requirements current dollars over the next decade with capital expenditures current dollars over the last decade, came out with a gap of over 2-1/2 trillion dollars without noting the noncomparability of prices (p. 3871). We have indeed a host of estimates from a number of econometric models, government bodies and private institutions, from Barry Bosworth, James Duesenberry and Andrew Carron and many others. A major Bureau of Economic Analysis study under the direction of Vaccara projected a total of $986.6 billion, 1972 prices, for business fixed investment from 1975 to 1980, or 12.0 percent of cumulative gross national product, in order to insure a 1980 capital stock sufficient to meet the needs of a full employment economy, and the requirements for pollution abatement and for decreasing dependence on foreign sources of petroleum (p. 7). Scarcities are sometinmes seen terms of sources of financing. Benjamin Friedman wrote 1975, To an unusually great extent, financial considerations may act during this period [1977-811 as effective constraints on the amount of fixed investment which the economy aggregate is able to do (1975, p. 52). In May 1976, however, Allen Sinai declared, There are no financial shortages of any consequence (p. 2). But with the plethora of articles, studies, claims and warnings, what meaning can we attach to the notion of a capital shortage'? In what sense can there be a shortage a free economy where markets are cleared by the impetus of price movements? In an uncontrolled, competitive system, the rate of investment is not imposed as a prior constraint. Business investment, particular, is the resultant of the utility-maximizing saving propensities of households and the profit or wealth-maximizing production decisions of business. These are subject to the constraints of the general economic atmosphere determined by the monetary and fiscal authorities of government, particular tax and monetary influences, and general currents of the world. Any argument that there is a capital shortage must either imply a literal failure of market clearing or some standard external to the economic system. A failure of markets to clear an equilibrium sense implies fixed or sticky prices. If government were to control prices and set those for capital goods too low, the quantity of capital goods demanded could exceed the quantity of capital goods supplied. Perhaps more to the point, government regulatory agencies might hold prices of certain products, such as electric power, so low that, while the quantity of electric power demanded might be very high, firms anticipating continued low prices would not find it profitable to invest the capacity to meet future needs. Similarly, there may be price fixing financial markets. If the monetary authority and/or inflation force up interest rates while regulatory *Williarn R. Kenan Professor of Economics, Northwestern University, and Senior Research Associate, National Bureau ot Economic Research. I amil indebted to Martin Feldstein, Benjamin Friedman, Marc Nerlove and Beatrice Vaccara for helpful commiients.