1 The New View On Monetary Policy: The New Consensus And Its Post-Keynesian Critique Peter Kriesler and Marc Lavoie

2 The New View On Monetary Policy: The New Consensus And Its Post-Keynesian Critique  Introduction  The New Consensus: the underlying framework  Some critiques: i: The IS Curve ii: The Phillips Curve  Modifications to the Phillips curve

3 THE NEW CONSENSUS  Underlying view of the economy the same as Monetarism Mark 1  Upwards sloping short run Phillips curve with the long run Phillips curve being vertical at NAIRU  ∆π = ß 1 (u – u n ) (1)

4 The New Consensus  “There is substantial evidence demonstrating that there is no long-run trade-off between the level of inflation and the level of unused resources in the economy – whether measured by the unemployment rate, the capacity utilization rate, or the deviation of real GDP from potential GDP. Monetary policy is thus neutral in the long run. An increase in money growth will have no long-run impact on the unemployment rate; it will only result in increased inflation.” Taylor 1999

Phillips Curve  The inflation rate falls when unemployment is above NAIRU, and increases when unemployment is below it.  In other words, there is a short run trade-off between inflation and unemployment, but no long-term trade-off.

Neoclassical Long Run Philips Curve O SRPC 1.P1.P1 Inflation Rate Unemployment rate SRPC 2.P2.P2 NAIRU

7 IS Schedule  Assumes that investment, or more precisely, the growth rate of capital, is inversely responsive to changes in the rate of interest  linear relationship between the rate of interest and the level of output, and hence unemployment  high degree of interest elasticity of investment  u = u 0  ß 4 r (2)

8 Monetary Rule, or what is really new!  Interest rates should be changed if inflation deviated from its target or if real GDP deviates from potential GDP  No longer any attempt to control monetary aggregates  ∆r = β 7 (π – π T ) + β 8 (u – u n ) (3) π T = target inflation rate π T = target inflation rate

9 Some critiques: IS Curve Reject the simple interest rate - investment relation implied in the IS model:  Central bank sets short term interest rate, but it is long term rate which influences aggregate demand, and relation unclear  Monetary policy is a blunt instrument, with long and variable lags.

10 Some post-Keynesian critiques: Efficacy of Monetary Policy  Real interest rate hikes lead to higher inflation rates, through interest cost push.  Post Keynesians reject the neutrality of money in the short and the long run ⇒ monetary variables have real effects.  Empirically, evidence suggests that the interest elasticity of investment is non- linear and asymmetric. Interest rates ↑ → investment ↓ in times of economic booms, the reverse is not true. Interest rates ↓ → unlikely investment ↑ in times of recession.

INTEREST ELASTICITY OF INVESTMENT You can lead a horse to water but you can’t make it drink. You can lead a horse to water but you can’t make it drink. Many economists think that using monetary policy in a recession is like pushing on string. Many economists think that using monetary policy in a recession is like pushing on string.

12 Some post-Keynesian critiques: The Phillips Curve  Post-Keynesians reject the vertical long- run Phillips curve, and some are skeptical about short-run trade-offs between GDP/capacity and inflation.  Post-Keynesians reject the notion of a supply-determined natural growth rate. If the concept of a natural growth rate is to be of any assistance, it is determined by the path taken by the actual growth rate.

Kaldor: The Scourge of Monetarism Assuming that the behaviour of the `real' economy is neutral with respect to monetary disturbances, why should the elimination of inflation be such an important objective as to be given 'over- riding priority'? In what way is a community better off with constant prices than with constantly rising (or falling) prices? The answer evidently must be that … inflation causes serious distortions and leads to a deterioration in economic performance, etc. In that case, however, the basic proposition that the `real' economy is impervious to such disturbances is untenable. Pp

14 Critique of the Phillips curve  Kaldor/Lavoie: why is low inflation good? ⇒ optimal inflation rate which maximises the economy’s natural growth rate ⇒ the natural growth rate is determined by the path of the actual growth rate ⇒ vital role for effective demand. Model is path determined.

15 post-Keynesian modifications to the Phillips curve  Setterfield: demand-type considerations are not the only influence on the inflation rate. Cost considerations, as well as institutional variables are important. Modified Phillips curve → multiplicity of possible long-run rates of growth, capacity utilization and inflation  π = β 9 π -1 + β 10 u + π c (1A) π c “is a vector of institutional variables that affect aggregate wage and price setting behaviour” π c “is a vector of institutional variables that affect aggregate wage and price setting behaviour”

The Kriesler/Lavoie Phillips Curve πnπn u m U fc Rate of capacity utilization Post-Keynesian Phillips Curve Inflation rate u fc : full capacity utilization π n : rate of inflation associated with the normal range of output

17 The Kriesler/Lavoie Phillips Curve  π = ß 11 (u – u m ) + ß 12 (u – u fc ) + π n  For a large range of capacity utilization u such that u m < u < u fc,  ∆π = 0

18 The Kriesler/Lavoie Phillips Curve Over normal range, changes in capacity and employment have no effect on inflation rate ⇒ both monetary policy and fiscal policy will influence output and employment in both the short and long run