Finance and Macroeconomics
By Arnold Kling
Tyler Cowen recommends two articles by Perry Mehrling on the relationship between the theory of finance and monetary theory/macroeconomics.
One of the articles is a nice summary of the work of Fischer Black.
What Black did was to conceive of the assets not as financial assets but as real assets, which moreover arise endogenously because someone chooses to make a real investment. In equilibrium, both quantity and price are determined, hence it is a model of general equilibrium not partial security price equilibrium. Even so, the model inherits the essential feature of CAPM that the prices of all capital goods derive from just two fundamental prices of capital, the rate of interest and the price of risk. These two prices, and two prices only, are sufficient statistics that summarize production opportunities and investor preferences throughout the entire economy.
I first encountered Black’s model of macroeconomics about 1979 or so. He wrote that any macro model should postulate that the agents in the model understand exactly how it operates. I commented that “the assumption that agents in the economy understand its operations is contradicted by the paper under discussion.” Although I doubt that my insult was particularly significant, in general Black felt rejected by the profession. Meanwhile, I had not yet studied finance. When I did, I could appreciate Black’s perspective.
The problem that Black’s work addresses is that modern finance theory is at odds with Keynesian macroeconomics. Financial markets provide very efficient means for people to diversify risk. As Merhling points out, this means that Federal Reserve open market operations should have no effects on the economy. The classical critique of Keynesian economics is that monetary policy should only determine the price level. The finance-theory critique goes even further and asks why financial markets would not have built in expectations and hedges concerning open market operations.
All of this may sound like “inside baseball” in macroeconomic theory, and it is to some extent. However, I believe that in practice the diversity, complexity, and efficiency of financial markets does make the Fed much less potent than is commonly assumed. It seems to me that changes in long-term interest rates often lead changes in the Fed Funds rate that is controlled by the central bank. See Can Greenspan Steer?
For Discussion. Would considerations of finance theory appear to strengthen fiscal policy, even as such considerations weaken monetary policy?