LECTURE 2 THE NEW CONSENSUS MACROECONOMICS

1. 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

2. Presentation • Introduction • The Economics of the New Consensus Macroeconomics • Economic Policy of the New Consensus Macroeconomics • Summary and Conclusions

3. Presentation • Introduction • The Economics of the New Consensus Macroeconomics • Economic Policy of the New Consensus Macroeconomics • Summary and Conclusions

4. 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.

5. Presentation • Introduction • The Economics of the New Consensus Macroeconomics • Economic Policy of the New Consensus Macroeconomics • Summary and Conclusions

6. [ ] ) - E p + t t 1 ] ] [ [ } b - + s ; E er E p + , 1 t W t 2 2 t t + g × + g × - + g × + g T p Y p p R s ; + - - - t 1 1 t 1 2 t 1 3 t 1 3 The Economics of the New Consensus Macroeconomics Aggregate demand equation [ ] ( ) ( a = a + a × + a × + a + × g g g × + s rer Y Y E Y R ; 4 - + t t 0 1 t 1 2 t t 1 3 t 1 Phillips curve [ ] { = b × + × + b × + b × g p Y p E p - + t 1 t t 1 3 t t 1 4 Monetary policy rule [ [ ] ] ( ) ( ) = - g × + * R 1 RR E t 3 t

7. [ E p + , 1 t W t The Economics of the New Consensus Macroeconomics Real Exchange rate equation [ ] ] [ ] { ( ) ( ) } = d + d × - - - + d × + d × + rer R E p R CA E rer s ; + + 0 1 1 , 2 3 1 4 t t t t W t t t t Current account equation = l + l × + l × + l × + g g CA rer Y Y s ; 0 1 2 3 , 5 t t t W t Nominal Exchange rate equation = + - er rer P P ; , t t W t t

8. 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;

9. 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;

10. 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 long-term output has been determined via the supply side;

11. 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;

12. 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.

13. 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.

14. 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;

15. Presentation • Introduction • The Economics of the New Consensus Macroeconomics • Economic Policy of the New Consensus Macroeconomics • Summary and Conclusions

16. 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;

17. 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.

18. 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.

19. 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.

20. Presentation • Introduction • The Economics of the New Consensus Macroeconomics • Economic Policy of the New Consensus Macroeconomics • Summary and Conclusions

21. 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.