Download A New Monetary and Fiscal Framework for Economic Stability CEF, July 2011

A New Monetary and Fiscal
Framework for Economic Stability
CEF, July 2011
Roger E A Farmer
Department of Economics UCLA
1
(c) Roger E A Farmer
July 1st 2011
The Current Situation

The Great Recession ended in June of 2009

Unemployment has remained at 9% for the
pastt 23 months
th

The Fed has no p
plans to extend Quantitative
Easing

A second large fiscal expansion is unlikely

What can we do to reduce unemployment?
p y
2
(c) Roger E A Farmer
July 1st 2011
The Plan of My Talk

I will present some evidence from the US
on the connection between unemployment
and wealth

I will discuss a new way of explaining
these data

I will discuss the implications for economic
policy
3
(c) Roger E A Farmer
July 1st 2011
The Bottom Line

Use traditional monetary policy (e.g. a
Taylor Rule to control inflation)


Use a new policy of stock-market targeting
to control unemployment

4
This involves varying the interest rate by
expanding or contracting the monetary base
This would involve buying and selling assets by
varying the composition of the monetary base
(c) Roger E A Farmer
July 1st 2011
Wealth
Two Sources of US Wealth
220
45
200
40
Shaded areas
are recessions
180
35
160
30
140
25
120
20
100
15
80
10
60
5
30
35
40
45
50
55
60
65
70
75
80
85
90
95
00
05
10
US wealth
is:
2/5
housing
3/5
factories
and
machines
The Real Value of the Case-Shller Home Price Index
The Real Value of the S&P 500
5
(c) Roger E A Farmer
July 1st 2011
The Stock Market During
g the Great Depression
p
Unemployment and the Stock Market During the Great Depression
28 000
28,000
0
Shaded areas
are recessions
24,000
5
20,000
10
16,000
15
12,000
20
8,000
25
4,000
30
1929
1930
1931
1932
1933
1934
1935
1936
1937
1938
The S&P 500 Measured in Wage Units
Unemployment Rate
6
(c) Roger E A Farmer
July 1st 2011
Wealth During the Great Depression
Unemployment and Wealth During the Great Depression
80,000
,
0
Shaded areas
are recessions
70,000
5
60 000
60,000
10
50,000
15
40,000
20
30,000
25
20,000
30
1929
1930
1931
1932
1933
1934
1935
1936
1937
1938
The Real Value of Wealth
Unemployment Rate
7
(c) Roger E A Farmer
July 1st 2011
The Stock Market During the Great Recession
Unemployment and the Stock Market During the Great Recession
28 000
28,000
4
26,000
5
24,000
6
22,000
7
20,000
8
Shaded
Sh
d d areas
are recessions
18,000
9
16,000
10
14,000
11
12,000
12
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
The S&P 500 Measured in Wage Units
Unemployment Rate
8
(c) Roger E A Farmer
July 1st 2011
Housing Wealth During the Great Recession
Unemployment and Housing Wealth During the Great Recession
200
3
190
4
180
5
170
6
160
7
150
8
Shaded areas
are recessions
140
9
130
10
120
11
110
12
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
The Real Value of the Case
Case-Shiller
Shiller Home Price Index
Unemployment Rate
9
(c) Roger E A Farmer
July 1st 2011
Post-War Unemployment
p y
and the Stock Market
Unemployment and the Stock Market
30
3.0
08
0.8
2.8
1.0
Shaded areas
are recessions
2.6
1.2
2.4
1.4
2.2
1.6
2.0
1.8
1.8
2.0
1.6
2.2
1.4
2.4
1.2
2.6
50
55
60
65
70
75
80
85
90
95
00
05
10
The Unemployment Rate (transformed)
The Log Ratio of the S&P to GDP
10
(c) Roger E A Farmer
July 1st 2011
There is a Stable Relationship Between
these Two Variables
First sample
1946q1‐‐1979q3
1946q1
1979q3
dependent
p
u
variable
p(‐1))
p(
1.34
‐0.3
(0.08)
(0.05)
11
Second sample
1980q1‐‐2011q1
1980q1
2011q1
p
u
1.34
(0.09)
‐0.4
(0.12)
p(‐2)
‐0.34
(0 08)
(0.08)
0.2
(0 05)
(0.05)
‐0.34
(0 09)
(0.09)
0.4
(0 12)
(0.12)
u(‐1)
‐0.02
(0.1)
1.6
(0.06)
0.14
(0.04)
1.4
(0.07)
u(‐2)
0.02
(0.1)
‐0.6
(0.06)
‐0.13
(0.04)
‐0.5
(0.07)
c
0
0.16
(0.05)
0
0.15
(0.05)
p is the log ratio
of the S&P 500
to GDP
u is the
transformed
unemployment
rate
(c) Roger E A Farmer
July 1st 2011
Characterizing these Data

u and p both have a unit root

They are cointegrated

There is some evidence of non
non-linearity
linearity

There is also evidence that volatility
matters

I will ignore both of these aspects in this
talk
12
(c) Roger E A Farmer
July 1st 2011
The Cointegrating Relationship
11
u  8  28 p
10
Une
employment R
Rate
9
8
To reduce the steady
state unemployment rate
by 1%: The ratio of the
stock
t k market
k t tto GDP
must increase by a factor
of 28
7
6
5
4
3
2
.02
.04
.06
.08
.10
.12
.14
.16
The Ratio of the S&P to GDP
13
(c) Roger E A Farmer
July 1st 2011
Back to Basics

Is the economy self-correcting?

Yes



Classical economics
New Keynesian economics
New-Keynesian
No


14
Keynes of the General Theory
Farmer’s interpretation of Keynes
(c) Roger E A Farmer
July 1st 2011
A Simple Model

Representative agent

Logarithmic utility

Cobb Douglas technology
Cobb-Douglas

One good

Inelastic labor

Non-reproducible capital

Money as a unit of account
15
(c) Roger E A Farmer
July 1st 2011
The Classical Model
16
y  f  L
LL
w
f '  L 
p
pk   yp
(c) Roger E A Farmer
July 1st 2011
Classical Economics 101
GDP
((wage
g
units)
Labor first
order
condition
py
w
py
 1    L
w
Labor
Supply
L  exp  at 
1
Employment (% of the Labor Force)
17
(c) Roger E A Farmer
July 1st 2011
The Keynesian Model
C  a  bY
Y C G
C and Y are
measured in
wage units
py
Y
w
1
L
Y
1
18
(c) Roger E A Farmer
July 1st 2011
Keynesian Economics 101
Labor first
order
condition
GDP
(wage
units)
1
Y
L
1
py
Y
w
Aggregate
A
t
Demand
1
b
Y  a  G 
L
1
E l
Employment
t (% off the
th Labor
L b Force)
F
)
19
(c) Roger E A Farmer
July 1st 2011
Questions for Keynesian Economics

Theory of Aggregate Demand

Wh don’t
Why
d ’t h
households
h ld optimize?
ti i ?



Keynesians: Credit constraints
Farmer: They do
do. Consumption depends on
wealth.
Th
Theory
off Aggregate
A
t Supply
S
l

Why doesn’t the labor market clear?


20
Keynesians:
K
i
P
Prices
i
are sticky
ti k
Farmer: Search externalities
(c) Roger E A Farmer
July 1st 2011
The Farmerian Model
y  f  L, L 
L  L
w
f1  L, L  
p
pk   yp
pk
w
21
is a random walk
(c) Roger E A Farmer
July 1st 2011
Farmerian Economics 101
Labor first
order
condition
GDP
(wage
units)
1
Y
L
1
py
Y
w
Aggregate
A
t
Demand
1
pk
Y 
w
E l
Employment
t (% off the
th Labor
L b Force)
F
)
22
(c) Roger E A Farmer
July 1st 2011
Two Layers

How are real variables determined?


How are monetary variables determined?


A
Aggregate
t demand
d
d and
d supply
l
Liquidity
q
yp
preference vs. loanable funds
Do we need monetary economics to
understand unemployment?

23
No
(c) Roger E A Farmer
July 1st 2011
Ph.D. Keynesian Economics
GDP
(wage
units)
Labor first
order
Y
condition
Price adjustment
Causes demand
to shift
1

L
1
py
Y
w
Aggregate
Demand
1
b
Y  a  G  
L
1
Employment (% of the Labor Force)
24
(c) Roger E A Farmer
July 1st 2011
Ph.D. Farmerian Economics
Labor first
order
condition
GDP
(wage
units)
1
Y
L
1
py
Y
w
Aggregate
Demand
1
E l
Employment
t (% off the
th Labor
L b Force)
F
)
25
(c) Roger E A Farmer
July 1st 2011
A New Fiscal Policy for Economic Stability

Define a broad value weighted stock
market index

Set up
p an exchange
g traded fund based on
the index

Buy an initial share in the fund -- $800b -paid for with agency debt

Announce a price path for the fund
26
(c) Roger E A Farmer
July 1st 2011
How to Trade the Fund

Set a target for the unemployment rate at
(for example) 4%

Let p be the ratio of the value of the index
to GDP

Announce an initial level
level, and a growth
rate, for p

Adjust p in response to excess
unemployment above or below target
27
(c) Roger E A Farmer
July 1st 2011
Isn’tt this Inflationary?
Isn

No. The new fiscal policy and current
monetary policy can be run independently

If the Fed were to run the new policy:
p y


28
The size of the monetary base would be
adjusted to set the interest using, for example,
a Taylor Rule
The composition of the monetary base
b t
between
T
T-bills
bill and
d th
the iindex
d ffund
d would
ld b
be
set in response to an unemployment target
(c) Roger E A Farmer
July 1st 2011
Wouldn’t this ignite a New Stock Market
Bubble?

No: To remedy the current situation of high
unemployment
l
t we would
ld need
d a big
bi iinitial
iti l
boost to the stock market

As employment picks up – the policy would
cchoose
oose a lower
o e g
growth
o t rate
ate for
o tthe
e index,
de ,
with the index converging back a value
consistent
co
s s e with the
e long-run
o g u relationship
ea o s p
between p and u
29
(c) Roger E A Farmer
July 1st 2011
Summary

The economy is not self-stabilizing.

Any inflation rate is consistent with any
p y
rate as a long-run
g
steadyy
unemployment
state equilibrium

It took a century or more to learn how to
use monetary policy to stabilize inflation.
We must now learn how to stabilize
unemployment.
30
(c) Roger E A Farmer
July 1st 2011