Knowledge that Transforms

Prize Lecture to the memory of Alfred Nobel, December 8, 1984

Two schools of macroeconomic thought compete today. The Keynesian school attempts to analyze each sector of the economy using the usual tools of optimizing models, but produces general equilibrium descriptions of a macroeconomy which are rarely Pareto efficient. For this reason, economists question the internal consistency of Keynesian models. In contrast, the neoclassical or .rational expectations school maintains consistency with the principles of perfect competition and flexible prices. In essence, the neoclassicists' macroeconomy behaves as an Arrow-Debreu general equilibrium. Once this is understood, we realize that the economy is Pareto efficient, though this does not preclude occasional ex post bad draws. Government policy can be expected to be either neutral or damaging. (In fairness, I am describing polar cases of the Keynesian and neoclassical view.) Nearly all economists are extraordinarily prejudiced in favor of models exhibiting rational behavior (as am I) and the last decade has seen an almost complete intellectual victory for the neoclassical school. Complete victory has been elusive for a single reason. In apparent ignorance of the intellectual arguments of the neoclassical school, the economy persists in behaving pretty much as the modern Keynesian models predict. As premier examples, neither the Great Depression nor the recent massive recession was (in my opinion) a Pareto-efficient equilibrium. The model I present below rigorously adheres to the rule that agents should follow rational principles. In this paper that rule means that agents equate marginal rates of substitution to relative prices. At the same time, I insert a single piece of imperfect information which prevents the formation of a complete Arrow-Debreu general equilibrium. The model predicts qualitative behavior of GNP and employment which is analogous to Keynesian predictions. Government spending is shown to increase GNP and economic welfare. The substantive results of the paper appear in the next three sections. Section I presents the role of imperfect information in the labor market and then goes on to solve for general equilibrium in the absence of government intervention. Section II examines the Keynesian-like behavior of this equilibrium. Section III examines the impact on GNP, aggregate labor supply, and welfare of balanced-budget government spending. The model produces four major results. 1) Aggregate spending and labor supply decisions are not simply the sum of individual decisions. The model identifies the logical error that Paul Samuelson has labeled the fallacy of composition. 2) Say's Law fails. A unit increase in aggregate supply produces a less than unit increase in demand for output. 3) An increase in government spending increases GNP and reduces unemployment. 4) An increase in government spending can generate a Pareto improvement in individual utility. The last section of the paper discusses some of the ways this model differs from the way we usually think about the economy. While the paper develops a particular model of aggregate demand, its real goal is to demonstrate a general principle: once the right set of mathematics is put together, it is easy to produce a model of the economy which is at once rational and Keynesian. In the specific setting I present, all the results fol*Department of Economics, University of Washington, Seattle, WA 98195. The first version of this paper was written while visiting at the Graduate School of Business, Stanford University. The final version was written while a member of the Finance Department, University of Pennsylvania. Shelly Lundberg deserves many thanks for extensive aid and partial absolution from any remaining errors. Stanley Fischer, Mark Flannery, Robert Solow, a number of other friends and colleagues, and two anonymous referees all contributed valuable constructive criticism for which I am most grateful.

High, in effect, is defined in this proposition in either of two ways. Most commonly, it has been taken to mean: high enough to warrant remedial intervention of some sort by the state.4 Recently, however, a growing minority of economists has urged that it be taken to mean instead: high enough to warrant intervention, provided the state can show that rates of return in excess of R1 reflect collusive behavior by the leading firms and not cost advantages which these firms have over their leading rivals.' Both meanings in turn reflect a third: high enough to imply a typical market price closer to PM in Figure lb than to Pc' where PM is the price that would prevail if the leading firms maximized collective, current-period profits and Pc is the price that would prevail if collective, current-period profits approximated zero.6 Proposition 1 rests on a large body of empirical work. Proposition 2, however, does not; nor does it rest on any theoretical analysis. Industrial economists simply have intuited that there is a correspondence between the R1R2 segment in Figure la and the PMP* segment in Figure lb. Are there substantive grounds for the intuition? I argue that there are not. The rates of return that lie along the R1R2 segment are competitive,

Returning to a topic first systematically treated by Poole (1970) in a textbook Keynesian model, this paper compares interest rate and money supply rules. Our analysis, by contrast, is conducted within a rational expectations macro model that incorporates flexible prices and informational frictions. With differential information, interest rate targets can affect the information content of market prices and real activity, but these real consequences can always be replicated by an appropriately chosen money stock rule with feedback to economic activity. However, when the policy authority has incomplete information about the state of the economic system, it faces a discrete choice between an interest rate peg and strict money stock control. Depending on the parameters of the model, either of these policies may be optimal, given the informational constraints faced by the monetary authority.

This article demonstrates why the procedures used in previous studies do not permit inference about the relationship between interestrates and taxes. We present a model that leads to direct estimates of the degree to which interest rates respond to changes in tax rates. The empirical results imply that the adjustment of taxable interest rates has been large enough to render after-tax yields impervious to tax rate changes. Further, tax-exempt yields are unaffected by changes in taxrates. Thus, there is no evidence of fiscal illusion in interest rates.

Recent statistics indicate that more than one-third of all new marriages will end in divorce. This evidence suggests that even the most happily couples may be wise to view their lifetime choices within a framework that recognizes that periodically each selects one of two strategies: married or not married. When both select the married strategy, the couple remain married. If either party (or both) elect the not-married strategy, the outcome will be divorce. Election of the not-married strategy thus creates a twoperiod world in which each party is married in the first period and divorced in the second. When a marriage dissolves, the couple divides all marital property either by mutual consent or according to the division rules imposed upon them by the state in which they reside. The law separately defines both marital property and the formula used to divide the property. This paper focuses on the interaction of the two variables, specifically, the effect of the state's division rule on the savings-consumption decisions of a divorcing couple.' Savings are of interest because they represent the couple's marital assets; the division rule is important because the amount each party receives at divorce affects the postmarriage economic well-being of each. The analysis can improve our understanding of the economic behavior of couples and will provide insight into the effect of divorce law on family savings patterns. Since law views divorcing spouses as adversaries, the analysis of marital savings and the resulting property division is carried out in a noncooperative game framework in which couples facing divorce each protect their self-interest by maximizing separate lifetime utility functions.2 Three noncooperative games are discussed: Cournot, Stackelberg, and Nash bargaining.

Karl Marx made at least seven major contributions to political economy. First, he established a framework-the materialist conception of history-for analyzing economic, social, and political changes over long periods of time. Marx showed that a society's social or class relations ultimately became impediments to the further development of its productive forces. In order for the productive forces to gain the conditions for their further advance, the rising class associated with the economic expansion would have to overcome, in one way or another, the prevailing ruling classes who were tied to the older productive forces. Once the relations of production were radically altered, political, ideological, and cultural changes would follow. Marx concluded that all class societies, including capitalism, are transitory. Second, Marx investigated the production and circulation processes of industrial capitalism, from which he formulated a labor theory of value for analyzing the exploitation of workers by the capital-owning class. In this analysis, Marx found the origin of surplus value, the methods employed by capitalists to increase surplus value, and the role of the price system in redistributing the surplus value among capitalists. Marx concluded that the working class was bound to suffer impoverishment relative to the growing wealth around it, and, at times, absolutely. Third, Marx studied the processes of capital accumulation-that is, of investment, growth, and cycles-in capitalist societies. He showed that, during the accumulation process, there was a strong tendency for the rate of profit to fall and hence for the eventual retardation of capital accumulation. The ensuing recession restored the conditions required for another upswing, including the replenishment of the industrial reserve army of the unemployed and the strengthening of capital through mergers (centralization of capitals) and write-offs of redundant capital goods. Over the long run, according to Marx, the capital accumulation process created both wealth and poverty, it both drained and refilled the army of the unemployed, and it spawned both increasingly larger enterprises and a proliferation of small ones-the former comprising the monopoly sector and the latter a crowded and intensely competitive sector of small capitals. One of Marx's conclusions from these investigations was that periodic business cycles were endemic to capitalism, as natural and as inevitable as changes of the season; there was no remedy for them within the system of capitalism itself. The cycles were also functional for the (temporary) survival of the system. Fourth, one can find an economic theory of the state in Marx's writings. His researches led him to suppose, as I have just noted, that the state could not alleviate the commercial crises of capitalism, nor even the monetary panics which were but a phase of the broader crises. He was especially skeptical about financial policies as cures for what he took to be decennial cycles, although he did believe that certain budget and bank measures had temporary effects on economic activity-for example, easy money policies, he said, could keep the shopkeeping world in a good mood, presumably until the next crisis. On the other hand, the state could effectively intervene with economic legislation to support the capitalist class against any growing strength of workers, or to prevent the ruling class from destroying, through excessive *Stanford University, Stanford, CA 94305. I am indebted to Kenneth Arrow for valuable comments on an earlier draft.