Good Questions from Casey Mulligan

by Will Wilkinson on December 17, 2009

To recap, New Keynesians tell us that income and labor usage increase when something reduces labor supply at the individual level, as long as the nominal interest rate does not adjust upward.

This miracle is exactly what centuries of tax collectors have dreamed about. They could take a larger share of the economic pie and in doing so make the pie grow! All they have to do is make sure that the nominal interest rate cannot adjust upward.

That leaves us with the question. Is it a great misfortune of history that the New Keynesian miracle was not discovered until 2009?

Or have tax collectors over the years understood what New Keynesians do not: incentives matter, regardless of whether there’s a Federal Reserve, and regardless of the details of how nominal interest rates adjust?

Read the whole thing here.

I don’t want to besmirch sober-minded New Keynesians, and Mulligan doesn’t either, so it would be nice to come up with a way of referring to this particular kind of magical thinking. I think I like “zero gravity economics.” (You can propel yourself across the universe with a can of Tab!) Better ideas?

When you’re in a liquidity trap…

  • Insiderman
    Assume no inflation. Increasing taxes reduces after-tax wages. In order to stay even with his current lifestyle, the worker must increase nominal wages by working more. The increased nominal wages further increase tax revenues.

    The problem with the theory relates to confusing wages and wage rates. In order to increase number of hours worked at a given marginal product of labor, workers must decrease their wage rate (which are sticky anyway in a Keynesian world). This may or may not increase total wages earned, depending on where you are on the labor supply curve.

    Alternatively, you could simply call the whole theory a doppelganger of the Laffer curve.
  • The argument supposedly applies when the labor market is not clearing. The market wage rate is above equilibrium, the quantity of labor demanded is less than the quantity of labor supplied, and the amount of employment is determined by the short side of the market, the quantity demanded.

    The incentive effects of taxes impact the supply of labor. Unless taxes increase so much that supply falls enough to create a shortage at the current market wage, then the impact of higher taxes on labor supply are irrelevant.

    Of course, maybe market wages will drop enough to clear labor markets. Or, maybe there are alternative ways of raising labor demand that don't reduce labor supply. But if labor markets are in surplus, the impact of taxes on the supply of labor doesn't impact employment.
  • pithlord
    Anc crazy Newtonian physicists think 1 pould lead balls fall just as fast as 4 pound lead balls! And don't get me started about those biologists who think elephants are descended from fish.

    The implicit assumption here is that the macroeconomy obeys common sense. But you and Mulligan don't believe that anymore than the wildest New Keynesian or you'd realize what a danger all those Chinese cheap goods are to American jobs.
  • I certainly don't think the macro-economy obeys common sense. But one can't simply announce that one has overturned immensely well-validated micro and macro theory, either. The claim is that you get these exotic effect under certain special conditions. But, as Mulligan notes in several posts, there's no evidence for that.
  • If you don't think the macro-economy obeys common sense, then why are you citing an argument from common sense as if it were dispositive?

    And do you think that it's quite fair to say that all the New Keynesians did was "simply announce" their theory? Or is that possibly a straw man?

    Sorry to rag on you, Will, but, well, jeez.
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