No Free Lunch: Economics for a Fallen World: Third Edition, Revised

Chapter Eighteen: The “macro” view of the economy 463 MACROECONOMICS: CETERIS IS NOT SO PARIBUS Earlier this chapter we mentioned one problem with the Keynesian macro model: the assumption that there is no opportunity cost for idle resources. Another way to consider this is to reflect on how policymakers typically try to influence the economy by stimulating AD with government spending. Given the GDP equation: Y = C + I + NX + G for a macroeconomic policymaker, if the economy is in recession, additional government spending can raise GDP—to increase any variable on the right hand side necessarily will increase GDP on the left hand side. But why would this foundational Keynesian macroeconomic assumption not hold? To answer that, let’s review our concept of ceteris paribus from chapter 1. When we use the assumption of ceteris paribus in any economic model, we are assuming that it is possible to conceptually isolate the effects of a given change of one variable while holding all other variables constant. In standard microeconomics this is a reasonable assumption. For example, when we consider the effect of a freeze on the market for Florida orange juice, we hold the demand curve constant, and shift the supply curve to the left, resulting in a reduced quantity and increased price (just the reverse of Figure 5.10 ). We fully know that, despite our assumption of ceteris paribus, other things such as tastes and preferences, income and price of related goods are all changing to some degree. But the key is they are not necessarily changing because of a freeze in Florida, so we may abstract away from the real world and still learn some important implications from our model. But what if a freeze in Florida necessarily made every orange juice drinker cold, such that they no longer wanted orange juice but wanted hot chocolate instead? In that case, we would also have to shift the demand curve simultaneously. We could not say what would happen with prices and quantity of orange juice because the supply effects of the freeze would be counteracted (at least to some degree) by demand effects in the substitution to hot chocolate. Which would dominate? We cannot know. We would be left with the less than satisfying, “that’s an empirical question.” This means we’d have to wait for the data to come out to see which effect was stronger. We could look at prior history of similar changes to give reasonable predictions, but we should be under no illusion that prior individual choices will necessarily be the same in the future. In the future, even the same people will have gained new knowledge and are thus able to make different choices. We learn, and we update our decisions based on our past experience to make the result even better (see chapter 10). In macroeconomics, the assumption of ceteris paribus is an especially heroic one— quite unlikely ever to hold. Government spending, for example, is not something that can be dialed up or down without necessarily impacting C and I. Consider an