Comments on Macroeconomics, a textbook by Steven Landsburg and Lauren Feinstone (1997).

Chapter 1: Introduction

Chapter 2: Income, Output, and Expenditure

p. 22: "Every dollar saved by one person is a dollar borrowed and spent by someone else." Not so. There are 2 things you could do with your savings. You could, as L&F suggest, lend them to someone else. But you could also use them to increase your money holdings.

"Let's say the economy is in a slump...Some people think such a problem could be cured if [people] ... just spent more instead of saving so much. You will see later in this book that for somewhat more complicated reasons, the conclusion that more spending can be desirable is sometimes correct. But the simplistic version of the argument--that spending more will mean more money for busineses...--cannot be right: for each additional dollar of my income that I spend, I have to save $1 less; and that means $1 less for someone else to spend." Well, for every extra dollar that I spend, I do have to save less; but, that does not imply $1 less for someone else to spend if my new spending comes from decreased money holdings. But L&F are right that decreasing savings per se won't do the trick--it's decreasing money holdings that we should aim at, in this perspective. (However, L&F might have gone on to argue that, if I reduce money holdings by a $1, someone else will have to increase their money holdings by $1, if we assume the total amount of money to be constant.)

Chapter 3: Borrowing and Lending

p. 43: "When you hear a phrase like "'You can save your money,' you should immediately translate it into 'You can buy bonds.'" Again, not so--you can also "save money" by increasing your money holdings.

p. 49: "Sometimes people say (incorrectly) that the interest rate is the price of money. This is grossly misleading. Even in a world without money, there would still be interest rates: you would still be able to trade a hamburger today for some number of hamburgers tomorrow. The interest rate is not the price of money; it measures the price of current consumption. More precisely, you can obtain the price of current consumption (in terms of future consumption) by starting with the interest rate and adding 1."

L&F are correct that consuming an extra apple in the current period only would cost 1+r apples in the future period (where 1 + r is the real interest rate); i.e., the future apples price of current apples is 1+r. For example, say Alternative One is to consume

10 apples in the current period

10 apples in the future period.

If we decide to consume an extra apple in the current period we can achieve that by choosing Alternative Two:

11 apples in the current period

9-r apples in the future period,

so that in the future period we consume 1+r fewer apples in Alternative Two than in Alternative One.

However, if there is no inflation, then increasing money holdings by one extra dollar for the current period only would cost r dollars in the future period; i.e., the future money price of one dollar held in the current period only is r. E.g., say Alternative One is to hold

10 dollars in current period

10 dollars in future period.

If you decide to increase money holdings by one dollar in the current period only we can achieve that by choosing Alternative Two:

11 dollars in current period

10 - r dollars in future period,

so that in the future period we hold r fewer dollars in Alternative Two than in Alternative One. This shows that, contra L&F, the interest rate is the price of money. (When there's inflation, it's the nominal interest rate that represents the price of money.) But it might be better to say that the interest rate is a price of money, since every good has many different prices, depending on what you're trading it off against. L&F are right that there would still be interest rates in a barter economy, but that just shows that the interest rate is the price of other things in addition to money --as seen above it also represents the price of current consumption. In summary, the interest rate is indeed the price of money; but, the interest rate is not the price of only money; and, the interest rate is not the only price of money.

Chapter 4: Consumption

p. 66: "In the real world, there are many ways to save a portion of your income. You can lend it....Another way to save is to purchase a productive asset." And another way L&F neglect to mention here is, you use the income to increase your money holdings. But now let's adopt L&F's simplification for their early chapters and assume a nonmonetary economy. But now let's adopt L&F simplification for this chapter, "the only way to save is to lend."

The individual demand curve for current consumption. We find points on this curve as follows: Take the individuals "income" or "endowment" Y₁ and Y₂ as given. Choose a particular interest rate r. Suppose the individual can lend as much as they want at rate r, up to a maximum net lending of Y₁, their current endowment; or borrow as much as they want at rate r as long as they will be able to pay it back next period--i.e., a maximum net borrowing of Y₂/(1+r). Under these conditions determine how many apples the individual will want to consume in the current period.

As we move along the curve we are changing r. What are we holding constant? We are holding constant the individual's "income" or "endowment"--Y₁ and Y₂.

The aggregate demand curve for current consumption. This is the sum of the individual demand curves at each r. As we move along the curve we are changing r, while holding constant all the individuals' endowments/incomes.

The aggregate supply for current consumption. This shows how many total apples are available for consumption in the current period when individuals are faced with any given interest rate r. L&F assume no storage or productive assets so that the aggregate supply curve is vertical at a level of Y equal to the sum of the individual Y₁'s.

We now already face one of the frustrations/challenges of macroeconomics--shifting the supply curve shifts the demand curve! For example, if everyone gets a bigger current endowment, shifting the aggregate supply curve right, they will want to consume more this period, shifting the aggregate demand curve right.

L&F notice that the substitution effect tends to make consumption demand slope down but that the income effect tends to make consumption demand slope up for a net creditor, so that overall the slope of an individual consumption demand curve is ambiguous. Then they notice that the representative agent is neither a net creditor nor net debtor; hence the representative agent's curve slopes unambiguously downwards. Then, hoping the the aggregate demand curve reflects the representative demand curve, they conclude that aggregate demand slopes unambiguously down.

A flaw in this argument is that it only works at the equilibrium r. Away from the equilibrium r, the representative agent will indeed want to be a net creditor or debtor, and the demand curve can slope up. For example, if r is very big, the representative agent will want to be a net creditor. If we increase r some more, this creditor will be better off, which will tend to increase current consumption, counteracting the substitution effect.

Another flaw to this approach, which L&F acknowledge, is that in an open economy, the representative agent could be a net creditor or debtor even in equilibrium. An application of this might be to Japan. Some economists have claimed that Japan needs to lower interest rates in order to encourage current consumption. But since Japan is a large net creditor, lowering interest rates could actually increase saving. (D. Blatt makes this point.) But this is confusing to me since Japan is a net creditor to other countries so I'm not sure how to think about changes in the domestic interest rate. But the basic point is that if, as in Japan, the average person wants to save a lot, then reducing the returns to savings can actually increase savings.

Chapter 5: Interest Rates and Equilibrium

L&F tell a story to indicate why, if the interest rate is initially out of equilibrium, it will quickly move toward the equilibrium. The problem with this story is that it’s not clear how time in the story relates to time in the model. L&F have presented a 2 period model. Their story can’t explain why the period 1 interest rate should be at equilibrium since it describes what happens after period 1.

Chapter 6: The Government

Chapter 7: Investment

Chapter 8: Economic Growth

Chapter 9: Labor

L&F’s labor demand curve coincides with the marginal product of labor curve. This seems pretty weird, since it means that labor demand is determined solely by technology, and not at all by the demand for goods. It seems like, if consumers want fewer goods, businesses should want to hire fewer workers; but this effect does not apply in the L&F model. How can we interpret this?

Say the only good is apples. Say that MPL = 10 apples and real wage = 5 apples. Then it pays for the firm to hire another worker: the worker increases the firm’s production by 10 apples but the firm only pays him 5 apples. “But what if the firm can’t sell those 10 apples?” No sweat, it can still pay the worker 5 apples out of his production, and have 5 apples “profit” for its shareholders.

In fact, in a one good model like this it we needn’t think of the firm as “selling” apples. The firm hirers workers to produce apples. What does the firm do with the apples the workers produce? It gives some of the apples to the workers as “wages”; it gives all the rest of the apples to its shareholders as “profits/dividends”.

It still seems like if people want to consume fewer apples, fewer people should be hired to grow apples. The model does allow this to happen. If people want more leisure and fewer apples, this will not only decrease the demand for goods, it will also decrease the supply of labor, decreasing the number of workers hired, and also increasing the real wage.

L&F notice that an individual labor supply curve can be either upward or downward sloping, but argue that since the representative agent is neither a net supplier nor demander of labor, the aggregate supply of labor curve must be upward sloping. This argument is subject to the same criticism we made against an upward sloping consumption demand curve--namely, for nonequilibrium wages the representative agent can indeed be a net supplier or demander, so the labor supply curve only has to be upward sloping close to the equilibrium wage.

L&F now combine goods and labor markets to derive an upward sloping supply-of-goods curve. If the interest rate increases, this increases labor supply, which increases the equilibrium wage and the equilibrium amount of labor hired, which increases the quantity of goods supplied. However, this shows that L&F’s “goods supply” curve is not a “true” supply curve. A true supply curve holds all prices (besides the good’s own price) constant as you move along the curve; but L&F allow the wage to change as we move along their “goods supply” curve. The “true” goods supply curve is vertical, since if we hold the real wage constant we hold constant how much labor firms want to hire and hence how much output they want to sell.

Chapter 10: Money

p. 300: "If apples are the average good and the price of apples is P dollars per apple, then the price of money is 1/P apples per dollar."

It's more complicated than that. We have to distinguish between the price of a temporary increase in money holdings and the price of a permanent increase in money holdings. 1/P refers to the price of a permanent increase in money holdings. E.g., say Alternative 1 is:

Current Period	Future Period
Hold 10 dollars money	Hold 10 dollars money
Consume 10 apples	Consume 10 apples

Then there is an Alternative 2:

Current Period	Future Period
Hold 11 dollars money	Hold 11 dollars money
Consume 10 - (1/P) apples	Consume 10 apples

This shows that the he price of a permanent 1 dollar increase in money holdings is the consumption 1/P apples in the current period.

However, the price of a temporary increase of 1 dollar in money holdings is current apples. E.g., given Alternative 1 above there is Alternative 3:

Current Period	Future Period
Hold 11 dollars money	Hold 10 dollars money
Consume apples	Consume 10 apples

We've borrowed an extra dollar in the current period, incurring an interest charge of r dollars for the future period. To provide for this future expense, we sell current apples, earning r/(1+r) dollars, which we lend expecting to be repaid r dollars next period, exactly enough to cover our own interest charge. But an increase in P does decrease the price of temporary money holdings.

p. 302: "When the price level changes, there is no change in how much real money people want to hold. Therefore, people adjust their nominal money holdings M so that the fraction M/P remains constant." Not so. L&F deal here only with the substitution effect. There is also an income effect. When P increases, people are poorer because their real money balances decrease. (This is the "real balance effect.) Supposing that real balances are a normal good, this decrease in income causes people to want to lower their real money holdings. In sum, if the price level increases while the money supply is held constant, the demand for real money holdings will not be constant--demand for real money will decrease.

We should notice that the demand for money depends on the supply of money. When money supply increases, people are wealthier and hence demand more money.

Similarly, the demand for real money depends on the supply of real money. When real money supply increases, people are wealthier and hence demand more real money.

We can be more accurate by saying: when the price level changes and money supply changes proportionately, there is no change in how much real money people want to hold. Therefore, people adjust their nominal money holdings M so that the fraction M/P remains constant.

Therefore, the curve that L&F call the "money demand curve" is not really a demand curve since money supply is not held constant along it. But it is a lot more useful than the actual money demand curve, so let's continue to call it money demand.

Here is how to find points on this pseudo-money demand curve: Choose a money supply level M₀. Now find the price level P₀ at which, when money supply = M₀, the quantity of money demanded = M₀. This gives us our first point on the "money demand" curve, (M₀, P₀). Now, choose some new money supply = M₁. Now find the price level P₁ at which, when money supply = M₁, the quantity of money demanded = M₁. This gives us our second point on the "money demand" curve, (M₁, P₁). Under L&F's assumptions, . And we need to reinterpret the axes. If a point on the "money demand" curve has coordinates (x, y), that means that when P=y and money supply = x, the quantity of money demanded = x. I.e., the “money demand curve” tells us, for each P, what is the M for which the demand for money can equal M.

This is a problem we face with many macro aggregate supply and demand graphs: shifting the aggregate supply shifts the aggregate demand. We are able to solve this problem more neatly in the money market than elsewhere because there's a theoretically plausible relation between money supply and money demand, namely, if real money supply is constant then real money demanded should be constant.

L&F's "money demand" curve really shows all the (P,M) combinations at which the money market could be in equilibrium. It's a lot like the IS curve.

pp. 322-323, “The Algebra of Seigniorage”

1. Government raises money supply from M₀ to M₁ by printing M₁ – M₀ worth of new money. Government uses this money to buy apples. Gain to winners (people to whom government distributes the apples) = apples.

2. In response to increase in M, price level rises to . Everyone who holds money loses (real balance effect) from this price increase. L&F calculate their loss as , but I don’t understand this. It seems like the loss, relative to no money supply increase, should be , since is the amount of real money people would have had absent the money supply increase.

Chapter 11: The Neoclassical Model

In the neoclassical model, monetary policy has no real effect. Why?

Say we start with all values in equilibrium. If we double the money supply, the price level also doubles. Real balances are the same as before the prices change, and all real quantities are the same as before.

Wait. If people have more money, won’t that increase their lending and hence decrease interest rates? Well, if people have more real money, they will indeed increase real lending. But if the price level doubles at the same times money supply doubles, real money is constant and there’s no reason for real lending to change.

Wait. It seems weird to suppose that prices respond instantaneously to the change in M. What happens if, when M doubles, prices initially less than double—to simplify, let’s say prices are initially constant. Well then real lending will increase, decreasing the interest rate and increasing investment and output. But this is not an equilibrium, ‘cause…

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By Steven Blatt. Suggestions, comments, questions, and corrections are welcome.