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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 LL 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