Wednesday, February 1, 2012

It’s amazing, isn’t it, that professional economists could argue about the relationship of identity and equilibrium and fail to come to a quick agreement?  I see that David Glasner and Scott Sumner are still having at each other over at Uneasy Money.  And I am truly baffled by Glasner’s claim “that it is incoherent to state that the income-expenditure model of national income requires savings to equal investment whether or not equilibrium obtains...”

It’s all rather easy: an accounting identity imposes a necessary relationship between a set a variables on the basis of their definition, but it doesn’t say what the value of any particular variable will be.  Behavioral arguments, which may employ the concept of equilibrium (but don’t have to), attempt to explain or predict these values.  A behavioral argument may be right or wrong—people may behave the way you say they do, nor not—but an identity is an identity is an identity.

I disagree strongly with Noah Smith and Paul Krugman, however on the question of whether one can learn anything substantive from identities; clearly the answer is yes.  Rather than make a theoretical argument, I will link to a chapter from my introductory macroeconomics text.  It is all about identity---there is no discussion at all about equilibrium—but I think students would learn a number of useful things about national and global economic patterns from reading it.  See if you agree.

And the next time you accuse someone of not fully comprehending an identity, look in the mirror.


Ken Houghton said...

The problem, as it were, with an identity is that it reduces the number of equations required to see the true relationship.

Especially in the case of S=I, it's fairly clear that the identity is dependent on savings being available for use. (If I put $100 in my mattress, S!=I.) So if I say, Y=C+I+G+NX and use the "identity" to claim Y=C+S+G+NX => S=Y-C-G-NX, I am not so much discussing savings as I am savings being put to use—that is, investments. And my "identity" ceases to mean what I claimed it did.

Simple question: the Fed is currently paying interest on Excess Reserves. Excess reserves are the banks's equivalent of "stuffing the mattress," but they produce a real cost to G (interest paid).

Are excess reserves an investment? By the equations above, I would argue no (the increase in Y is negated by the increase in G; no value created). But are they savings? The people who deposited them in the bank certainly assume they are. So does Savings equal Investment in a time of Excess Excess Reserves?

Identities make economists lazy. For that alone, one should be very careful about using them.

Shane Taylor said...

In a blog post titled "Understanding sectoral balances for the UK," Martin Wolf seemed to agree with Peter on this one:

"[S]ome people note that the sectoral balances are identities: they must add up to zero. This is correct. But there are many different ways they can add, both in terms of the relative sizes of the surpluses and deficits and levels of economic activity. This sectoral way of thinking can be easily converted into standard macroeconomic models, in which interest rates and income jointly determine the equilibrium outcome. The important contribution of this way of thinking is that it forces one to ask how one expects the economy to add up."

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