Download Economic Policy of the New Consensus

LECTURE 2
THE NEW CONSENSUS
MACROECONOMICS
Philip Arestis
Cambridge Centre for Economic and Public Policy
University of Cambridge
University of the Basque Country
Department of Applied Economics V
Presentation
1. Introduction
2. The Economics of the New Consensus
Macroeconomics
3. Economic Policy of the New Consensus
Macroeconomics
4. Summary and Conclusions
Presentation
Introduction
2. The Economics of the New Consensus
Macroeconomics
3. Economic Policy of the New Consensus
Macroeconomics
4. Summary and Conclusions
1.
Introduction
 Following from Lecture 1 we proceed to deal
with the theoretical and policy implications of
the New Consensus Macroeconomics
(NCM);
 We begin in Lecture 2 with the theoretical
framework of this theoretical framework
before we turn our attention to the economic
policy implications;
 In Lecture 3 we assess the overall
framework of this particular paradigm.
Presentation
1. Introduction
2. The Economics of the New
Consensus Macroeconomics
Economic Policy of the New Consensus
Macroeconomics
4. Summary and Conclusions
3.
The Economics of the New Consensus
Macroeconomics
Aggregate demand equation
[ ]
[ ]) + a (rer) + s
Yt g = a0 + a1  Yt -g1 + a2  Et Yt +g1 +a 3 (Rt - Et pt +1
4
t
1
;
Phillips curve
[ ]
]
pt = b1  Yt g + b2  pt -1 + b3  Et pt +1 + b4  {Et [pW ,t + 1 - Et
Monetary policy rule
[
[ ]
]
[ er ]} + s ;
t
Rt = (1- g 3 )  RR* + Et pt +1 + g 1  Yt -g1 + g 2 ( pt -1 - pT) + g 3  Rt -1 + s3 ;
2
The Economics of the New Consensus
Macroeconomics
Real Exchange rate equation
[ ]
[
]
[
]
rert = d 0 + d 1 {(Rt - Et pt +1 )- (RW ,t - Et pW ,t +1 )}+ d 2  CAt + d 3  Et rert +1 + s 4 ;
Current account equation
CAt = l0 + l1  rert + l 2  Yt g + l3  YWg,t + s5 ;
Nominal Exchange rate equation
ert = rert + PW ,t - Pt ;
The Economics of the New Consensus
Macroeconomics
 Six equations and six unknowns: output,
inflation, interest rate, current account,
nominal and real exchange rate;
 Basic assumption: intertemporal optimization
of a utility function that reflects optimal
consumption smoothing;
 Based on the transversality condition
meaning that all debts are ultimately paid in
full: economic agents are credit worthy; all
IOUs are perfectly acceptable in exchange;
nobody is liquidity constrained;
The Economics of the New
Consensus Macroeconomics
 It is a non-monetary model: no banking or
any other financial sector or monetary
variables.
 Objective: price stability; inflation is a
monetary phenomenon;
 Inflation is controlled directly via changes in
the rate of interest;
The Economics of the New
Consensus Macroeconomics
 A change in the nominal rate of interest is
followed by the real rate of interest affected in
the same way (price and wage rigidity is
assumed);
 Changes in the real rate of interest can only
affect aggregate demand in the short run;
 It should be noted that investment in this
theoretical framework reflects changes in the
capital stock, which is determined once longterm output has been determined via the
supply side;
The Economics of the New
Consensus Macroeconomics
 In the latter sense investment and capital
stock are treated as exogenous;
 Endogenising investment and capital stock
lead to reasonable conclusions once capital
adjustment costs are present through the use
of an adjustment-cost function that implies
constant returns to scale in production;
 In the absence of capital adjustment costs the
model produces unrealistic results in
response to changes in monetary policy;
The Economics of the New
Consensus Macroeconomics
 Ultimately, it is the case that explicit inclusion of
endogenous investment is an attractive proposition
and worth undertaking, as suggested above;
 However, the results with exogenous and
endogenous assumptions do not differ by much with
respect to the cyclical behaviour of output and real
interest rates;
 Calibrations undertaken show that results with the
exogenous investment assumption match those with
endogenous investment and capital very closely.
The Economics of the New Consensus
Macroeconomics
 Phillips curve is vertical in the long run at
NAIRU;
 Changes in the rate of interest affect inflation
only in the long run;
 NAIRU is a supply-side variable;
 Say’s Law holds: the level of effective
demand does not play an independent role in
the long-run level of economic activity.
The Economics of the New
Consensus Macroeconomics
 See Figure 2.1;
 Assume a closed economy for simplicity;
 Explain the new 3-equation model;
 See Figure 2.2;
 Assume an open economy, now;
 Explain the 4-equation model;
Presentation
1. Introduction
2. The Economics of the New Consensus
Macroeconomics
3. Economic Policy of the New Consensus
Macroeconomics
4. Summary and Conclusions
Economic Policy of the New
Consensus
 Inflation Targeting (IT) is embedded in
equations 1-3;
 IT is a monetary policy framework whereby
public announcement of official inflation target
is undertaken;
 Equations 2 and 3 entail an important role for
‘expected inflation’;
 Credibility attained through pre-commitment
to the inflation target without government
interference;
Economic Policy of the New
Consensus
 Transparency of inflation forecasts is a
paramount element of the policy, and it
enhances credibility; but…
 The centrality of inflation forecasts and the
margin of errors represent a major challenge
to this framework;
 The channels of monetary policy are twofold:
changes in the rate of interest works through
the output gap relationship and also through
inflation expectations as in the Phillips Curve
relationship.
Economic Policy of the New
Consensus
 These ingredients are supported by the
publication of the minutes of the Central
Bank’s Monetary Policy Committee, by the
Inflation Report and the speeches of the
Monetary Policy committee members;
 Further important ingredients: Accountability;
Credibility; and Individual Reputation of the
Monetary Policy members, especially in those
cases where minutes are published, which
reveal outcome of voting.
Economic Policy of the New
Consensus
 Fiscal policy should not be used for short-
term objectives; only for medium- to long–
term ones;
 Constrained discretion: neither pure
discretion nor rules;
 Constrained discretion is, thus, an important
ingredient of the IT economic policy
framework.
Presentation
Introduction
2. The Economics of the New Consensus
Macroeconomics
3. Economic Policy of the New Consensus
Macroeconomics
4. Summary and Conclusions
1.
Summary and Conclusions
 We have highlighted the theoretical framework and
the policy implications of the New Consensus
Macroeconomics;
 Our next step is to assess this particular theoretical
framework and its current state in view of the
current economic crisis.