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Tuesday, July 26, 2016

Economists Give Up on Milton Friedman's Biggest Idea

Noah Smith:

Economists Give Up on Milton Friedman's Biggest Idea: One of the core pieces of modern macroeconomic theory, handed down to us by the great Milton Friedman, probably missed the mark. ...
The idea is called the permanent income hypothesis (PIH). ... The PIH says that people’s consumption doesn’t depend on how much they earn today, but on how much they expect to earn over their lifetime. ...
That assumption about human behavior has huge implications for policy. If true, the PIH means that the effectiveness of a fiscal stimulus is likely to be a lot lower than economists thought in the 1960s. ...
It’s also important for finance. ... Friedman’s idea says that consumers want to smooth out their consumption... So in theory people will spend a lot for financial assets that pay off during recessions, allowing them to avoid tightening their belts.
PIH is so dominant that almost all modern macroeconomic theories are based on it. ... Unfortunately, there’s just one small problem -- it’s almost certainly wrong. Not completely wrong, mind you, just somewhat wrong. ...
The mounting evidence against the PIH -- the papers I cited are only a small sampling -- is causing economists to cast around for an alternative. ...Narayana Kocherlakota ...thinks macroeconomists should set aside their big, complex formal models of the economy, since these elaborate constructions are built on a foundation that probably doesn’t describe reality all that well. He recommends that economists go back to the drawing board, and look around for new, more accurate kernels of insight with which to build the theories of tomorrow.
In the meantime, we should all recognize that Milton Friedman’s ideas might have been too influential. His impact on economics was deep and lasting, but this theory, at least, hasn’t stood the test of time.

    Posted by on Tuesday, July 26, 2016 at 08:25 AM in Economics | Permalink  Comments (46)


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