Definition & Reality in the General Theory of Political Economy

by Thomas Cool

Hicks then concludes that economics is a Discipline. His quote of Keynes (in II.7) above is taken from these pages. My position on this is twofold - the position of hard science with soft data. On one hand I embrace the critical attitude. Indeed, we should develop sound definitions, and remain critical about how these are applied in communication. That is the meaning of the Definition & Reality methodology. And it brings us far, since we can advise to abolish the Tax Void without running regressions and a computer model. On the other hand, Tinbergen’s efforts have not been in vain, and models with estimated coefficients are useful tools for policy analysis. For example, some economists may reject the existence of a Phillipscurve, and all economists should be critical about the data and the parameter values, but such a relationship remains useful in a macromodel that is used for evaluation of policy alternatives. It would be curious to accept the concept of a ‘model’ and to accept other relationships like a consumption function, and reject the use of a Phillipscurve: even though the uncertainties are quite comparable.

In other words, our method remains econometrics, even though we end here with an increased awareness of the role of definitions. We are just in the phase that running regressions is useless if the model is no good. Regressions come in only when we have a good candidate, and regressions even might benefit from some definitory relationships. We even would like to do those regressions ourselves if we had the data and the time. So, for now, let us first develop what we conjecture to be the proper model.

20. Structural and reduced form

There is the useful distinction between the structural and reduced form:

· the structural form represents actual relations as good as possible,

· the reduced form gives the simplest representation, with the interaction minimised.

With y a vector of endogenous variables, x a vector of exogenous variables, and f and g functions, then a structural form is y = f(y, x) and a reduced form is y = g(x).

Since econometrics can only approximate reality, the true structural form can only be approximated. What we consider to be a structural form is an intersubjective consensus. We anyhow have to adopt an approximation, which means that many factors have been removed. However, for two models we can often clearly see that one is simpler than the other, and then we can usefully apply this distinction between the structural and reduced form.

The distinction between structural and reduced form also affects the structure of this book. The next chapters concern the structural form, actually starting with the textbook IS-LM model. We relax the assumption of homogeneous labour, and introduce heterogeneous labour. First we look at labour supply only. Then we look at supply and demand, and at the equilibrating dynamics, which causes the topic of the Phillipscurve. We show how the Phillipscurve and the Constant-Wage-Inflation Rate of Unemployment (CWIRU, a.k.a. NAIRU or natural rate) shift as a consequence of minimum wages or poverty. We then relate minimum wages and poverty to developments in taxation. The co-ordination failure on taxes and minimum wages not only causes the internal imbalance on the labour market, but also an external imbalance, with international trade.