Saturday, February 5, 2011

Economic Bedtime Stories

From New Monetarist Economics:
Stories are helpful in economics. Particularly in class, a simple story can get the essence of an idea across, and then you can go on to develop the full-blown analysis that puts some rigorous structure on the idea.
One story I like is this one, which comes from Joseph Ostroy (UCLA). There are two people, George and Martha, who agree that they will eat dinner at one or the other's home each Saturday night. They want to share the burden of the cooking equally, but they have very bad memories, and can never remember who last cooked dinner. However, they have a stone. George and Martha have good enough memories that they each can remember where the stone is stored in their respective homes. On Saturday night, each looks in that spot. If the stone is there, they take it over to the other person's house and eat dinner. If the stone is not there, they cook dinner and wait for the other to show up. The person who brought the stone leaves it behind, and the other stores it.

This is a money parable, of course, and it captures the essence of the most important idea that has taken root in monetary economics in the last 30 years: Money is Memory. People use money in exchange because of information frictions - essentially limited recordkeeping, or limited memory.

Paul Krugman has been writing about stories recently, and he too finds these useful. Here's one of his:
Real business cycle theory says that economic fluctuations are the result of technological shocks, amplified by intertemporal labor substitution. My version: think of a farmer who faces sunny and rainy days. On rainy days his labor won’t be as productive as on sunny days; this effect on his output is amplified by his rational decision to stay in bed on rainy days and work extra hard when the sun shines. I think this gets at the essence of the concept; it also makes you wonder, is this really, really what you think happens in recessions?
His RBC story is quite standard. The one I tell to students is pretty close to it. Again, it captures the essence of the idea. Of course, Krugman uses the story to make fun of the idea, but aside from the issue of whether the RBC model helps us understand recessions, the story is quite helpful. At the minimum it can help a student understand intertemporal substitution, which is at the root of much of dynamic macroeconomics.

I have a Keynesian story. There are two farmers, George and Martha (again). George grows peanuts, Martha grows cranberries. George eats only cranberries, and Martha eats only peanuts. These are weird peanuts and cranberries which sprout from the ground every morning, and have to be picked or they rot. Each evening, George and Martha meet at Martha's house, drink beer, and play cards. They get quite drunk, which is what it takes for them to settle down and negotiate the price at which they will trade in the morning. ...MORE