The determination of the key interest rate by the central bank has become an instrument of monetary policy. The first is the apparent end to the use of fiscal policy to "fine tune" the economy.
2 THESIS OF THE BOOK
To the extent that it works, it has detrimental effects on the level of economic activity and on future investment and productive capacity. We think that the level of employment does not depend on the operations of the labor market, but on the level of aggregate demand.
NOTES
1 INTRODUCTION
The 'new consensus' 11 We begin by addressing the theoretical basis for the new consensus within macroeconomics (hereafter NCM) and IT in the section immediately below, followed by an assessment of the theoretical basis for NCM and IT.
2 ‘NEW CONSENSUS’ IN MACROECONOMICS
Clearly, however, such an equation would be redundant since the money stock defined in this way is similar to a residual and does not return to affect other variables in the model. Thus, monetary policy is discussed in the MKK without reference to the money stock; in chapter 5 we will discuss at length the importance of this disregard of any reference to the money stock.
3 INFLATION TARGETING
Inflation is considered to be determined by monetary policy (in the form of the interest rate), through the route of interest rate affecting aggregate demand (equation 2.1), and aggregate demand affecting the inflation rate (equation 2.2). Higher (lower) interest rates tend to decrease (increase) aggregate demand and lower (higher) aggregate demand is assumed to decrease (increase) the inflation rate.
4 MAIN FEATURES OF INFLATION TARGETING
The budget (at least on the current account) can and should be balanced over the course of the business cycle. Monetary policy can be used to achieve the objective of low inflation rates (which in this view is always desirable, as low and stable inflation rates are conducive to healthy growth rates).
5 AN ASSESSMENT OF THE THEORETICAL FOUNDATIONS OF NCM AND IT
The loss function contains forecasts of both inflation and the output gap as target variables.9 However, price stability is the primary goal in the view of IT proponents. For example, Bernanke (2003a) states the case in the following way: “The essence of limited discretion is the general role of a commitment to price stability.
6 THE SEPARATION OF REAL AND MONETARY FACTORS
First, it can be noted that the estimates of the NAIRU (or equivalent) often vary over time. The OECD produces estimates of the non-accelerating wage rate of unemployment (NAWRU) on a biannual basis (see OECD, Economic Outlook database).
7 THE CAUSES OF INFLATION
The IT framework deals with the effects of the interest rate on aggregate demand and thus on the inflation rate. This would mean that those charged with inflation targeting, even if the rate of change in output is relevant to inflation.
8 SUMMARY AND CONCLUSIONS
The macroeconometric model of the Bank of England
There are two features of the Bank of England model in relation to the NCM model to which we draw attention. First (and perhaps inevitably), the Bank of England model is an open economy model with equations for determining the exchange rate, whereas the NCM model was a closed economy.
2 THE MACROECONOMETRIC MODEL OF THE BANK OF ENGLAND AS AN EXAMPLE OF ‘NEW
CONSENSUS’
In equation (3.5) the nominal exchange rate is taken to depend on the exchange rate expected to prevail one period ahead (derived in a model-consistent way), the interest rate differential (between UK and global) and a term marked as risk premium (even in the long term). Through equations (3.3) and (3.4), the level of economic activity is set on the supply side of the economy, at a level corresponding to the NAIRU.
3 IMPLICATIONS
In the Bank of England model (and more generally), the interest rate changes to cause changes in the level of aggregate demand. In the Bank of England model, both nominal and real interest rates affect aggregate demand.
4 SUMMARY AND CONCLUSIONS
Can monetary policy affect inflation or the real economy?
This chapter aims to investigate the extent to which monetary policy can have significant effects on inflation or the real economy. Using monetary policy to focus only on inflation is clearly based on the view that monetary policy will have a significant effect on inflation and on the view that monetary policy will have no effect on the real economy (other than a short-run effect on demand aggregate, which in turn is seen to affect inflation).
2 THE TRANSMISSION MECHANISM AND THE CONTROL OF INFLATION
Thus, monetary policy should determine the money supply and let interest rates become an endogenous quantity. Exchange rate changes directly affect import prices and these affect the inflation rate.
3 EMPIRICAL EVIDENCE
Empirical Evidence based on Macroeconometric Models
These results indicate that a one percentage point increase in the interest rate held for two years. First (at least within the context of the macroeconometric models), there are limits to a permanent change in the interest rate.
Empirical Evidence based on Single Equation Techniques
This means that the chain from a change in the central bank's discount rate to the final target for inflation is long and uncertain. Others have commented on the absence of the money supply in many current debates about monetary policy.
2 THE OMISSION OF MONEY
3 FOUR WAYS TO ‘REINSTATE’ MONEY
- LM and Stable Demand for Money
- A Four-equation Model
- Passive Money and Active Money Views
- Credit Market ‘Frictions’
However, the underlying cause of this story is the change in demand for loans: without that change, the money supply would not change. When there are 'frictions' in the credit market, the 'external financing premium' is inversely proportional to the net worth of the borrowers.
4 MODEL ASSESSMENT
However, it must be remembered that the stock of money will not remain higher unless the demand for loans remains greater. It can also mean that, when the stock of money is high, there are credit limits (since the stock of loans is high).
5 SUMMARY AND CONCLUSIONS
The inflationary process
The nature of the supply-side equilibrium is also of considerable relevance to economic performance and economic policy. In Friedman's original paper, and in much subsequent work, the determinants of the 'natural rate of unemployment' are seen to be related to the labor market.
2 SOME KEY ELEMENTS OF A STRUCTURALIST VIEW
The first is that the position of the p-curve depends on the capital of the economy. According to Figure 6.3, the position of the w-curve depends on the coefficients a1, a4 and the target real wage.
3 INVESTMENT
When aggregate demand is relatively high, the economy will operate to the right of the zero investment point: net Figure 6.3 The W curve. Furthermore, the course of the economy cannot be understood without reference to the level of aggregate demand.
4 IMPLICATIONS OF STRUCTURALIST ANALYSIS FOR THE INFLATIONARY PROCESS
Moreover, there is no automatic mechanism that brings the level of aggregate demand to equilibrium on the supply side. Therefore, the evolution of the capital stock depends on the time path of the level of aggregate demand.
5 EMPIRICAL CONSIDERATIONS
- Investment
- Labour Market Flexibility
- Regional Disparities of Unemployment
- Declining Unemployment and Low Inflation in the 1990s
Indeed, based on the argument developed above, the corresponding increase in the inflation barrier should have been substantial. He concludes (based on regression analysis of changes in unemployment in the mid-1990s) that 'actions taken to reform labor markets do not explain any of the reduction in the unemployment rate.
6 SUMMARY AND CONCLUSIONS
In a federal system, such as the US, there may be variations in the employment laws. The tightness in the labor market is measured by the excess of CBO's estimate of the non-accelerating inflation rate of unemployment (NAIRU) above the actual unemployment rate.
2 NCM AND ENDOGENOUS MONEY
There are well-known theoretical and empirical arguments on the ambiguity of the sign of the relationship between savings and the interest rate. Fourth, the 'equilibrium' interest rate is determined only in the light of domestic considerations and may not be consistent with interest rates in the rest of the world.
3 THE KEYNESIAN VIEW OF ENDOGENOUS MONEY
Commercial banks provide loans at an interest rate that is a markup over the central bank interest rate (the markup determined by the liquidity preference of banks, their market power and their attitude to risk). The Keynesian endogenous money approach recognizes the importance of the central bank interest rate for the general level of interest rates.
4 WHAT IS THE ROLE OF MONETARY POLICY WITHIN THE KEYNESIAN ENDOGENOUS MONEY ANALYSIS?
However, the interest rate on loans is closely linked to the interest rate set by the central bank. However, the processing of the channels through which the monetary policy is conducted indicates the role of credit rationing and changes in the structure of interest rates.
5 THE EFFECTIVENESS OF MONETARY AND FISCAL POLICIES
It was suggested there that there are (at least within the context of the macroeconometric models used for the purposes of Chapter 4) limits to a permanent change in the interest rate. For monetary policy alone to be able to offset that reduction (to keep demand at Y*) would require a change in the real interest rate of –∆d/(α + β).
2 THE ‘NEW CONSENSUS’ MACROECONOMICS AND FISCAL POLICY
It then goes on to consider whether crowding out is inevitable, along with institutional and quantitative aspects of fiscal policy. There are also concerns which can be summarized under the heading "institutional aspects of fiscal policy".
3 CROWDING OUT IS NOT INEVITABLE
Reinventing Fiscal Policy 123 ning of spending and thus the size of the capital stock (which we explored in Chapter 6). Considering the importance of RET, we discuss it in detail in the following chapter.
4 INSTITUTIONAL ASPECTS OF FISCAL POLICY
But long and variable external lags can be a feature of monetary policy as much as (or more than) fiscal policy. It is the case that most of the literature on the effectiveness of fiscal policy has focused on developed countries.
5 QUANTITATIVE EFFECTS OF FISCAL POLICY
The overall conclusion of this rather brief summary of the empirical evidence on the effectiveness of fiscal policy is encouraging. In this chapter, it was argued that shifts in the level of aggregate demand can be easily offset by fiscal policy.
2 FISCAL POLICY AND ‘FUNCTIONAL FINANCE’
This approach to fiscal policy suggests either that fiscal policy has no effect on the level of economic activity (because crowding out) or that there is a positive relationship between government spending (the budget deficit) and the level of economic activity. The effects of fiscal policy (especially if it is in the form of a budget deficit) from a.
3 CROWDING OUT MARK 1: INTEREST RATES
The Case for Fiscal Policy 137 assumption) the interest rate cannot adjust sufficiently to align ex ante savings and investment at an acceptable level of economic activity. The general expectation of the 'functional finance' approach is that budget deficits have no effect on interest rates (when the budget deficit is designed to 'move up' excessive savings) and ironically this is the conclusion reached by the Ricardian equivalence literature. .
4 CROWDING OUT MARK 2: SUPPLY-SIDE EQUILIBRIUM
Regarding the second issue, one proposed mechanism was the operation of the actual balance effect. The other adjustment mechanism postulated relates to the operation of interest rate policy by the central bank.
5 CROWDING OUT MARK 3: RICARDIAN EQUIVALENCE
Now introduce functional finance in such a way that the budget deficit can be "cleaned up". excess private savings; this means that. When fiscal policy is essentially passive (ie, automatic stabilizers operate but there is no active discretionary policy), the budget deficit changes cyclically.
6 THE INTERTEMPORAL BUDGET CONSTRAINT
If the growth rate of the outstanding bonds is h with an initial level of B(0), then give The sustainability of a primary budget deficit (of given size relative to GDP) requires that the growth rate exceed the after-tax interest rate.
7 SUMMARY AND CONCLUSIONS
It can therefore be argued that fiscal policy (of the 'right kind') increases the growth rate of the economy. The macroeconomic policy of the European Economic and Monetary Union (EMU) is the subject of this chapter.
2 THEORETICAL UNDERPINNINGS OF THE EMU MODEL
In the long run, inflation is viewed as a monetary phenomenon, in the sense that the rate of inflation is in line with the interest rate. Shocks to the level of demand can be absorbed by variations in the interest rate to ensure that inflation does not develop (if unemployment falls below the NAIRU).3.
3 EMU MACROPOLICIES
There is therefore a complete separation between the monetary authorities, in the form of the ECB, and the fiscal authorities, in the form of the national governments that make up the EMU. The Stability and Growth Pact is the concrete manifestation of the shared need for fiscal discipline.
4 MONETARY POLICY
- Institutional and Policy Arrangements
- Policy Defects of the ECB Monetary Policy Arrangements
- Problems with the ECB Monetary Policy
- Further Critique
Fourth, the ECB's assessment of the level of economic activity is completely impervious to the behavior of interest rates. Macroeconomic Policies in the European Economic and Monetary Union 171 Worst still is the ECB's insistence that the current level of interest rates in the euro area is the 'right' one (see Duisenberg, 2003b, for a recent statement).
5 FISCAL POLICY
Institutional and Policy Arrangements
These institutional arrangements of the SGP indicate a general deflationary trend in the functioning of the SGP. These predictions led to the possibility of the early warning mechanism, especially in the case of Germany and Portugal.
More Flexible SGP Fiscal Rules?
France even refused to adhere to the European Commission's 'flexible' interpretation of the SGP, which required that country to cut the structural deficit by 1 percent in 2004, instead of the 0.7 percent planned by France and by 0.5 in 2005; instead, France pledged to make further spending cuts in 2004. The economic slowdown in the eurozone also made it clear that the fiscal rules of the SGP are counterproductive during a slowdown and that budget rules cannot withstand the effects of recession .
Flaws Relating to the Balanced Budget Requirement
The general position in the Stability and Growth Pact with its demand for an overall balanced budget and a maximum deficit of 3 per cent. of GDP is deeply deficient. The SGP effectively resolves these issues by establishing the dominance of the monetary authorities (ECB) over the fiscal authorities (national governments).
6 POLICIES FOR FULL EMPLOYMENT AND LOW INFLATION
Institutional Changes
The draft European Convention (2003a, 2003b) does not indicate any proposals for changing the fiscal and monetary policy of the euro area (confirmed in the final draft as agreed at the intergovernmental conference on 17-18 June 2004). The objectives of the ECB and thus the deflationary tendency in its operation remain intact.
Economic Policy Changes
Modigliani (1965), "The Relative Stability of the Velocity of Money and the Investment Multiplier", American Economic Review, 55, September. Sawyer (2003c), "The Nature and Role of Monetary Policy When Money is Endogenous", Working Paper Series, no.