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

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

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

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.

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

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

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

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;

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;

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;

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;

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.

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.

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;

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

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;

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.

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.

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.

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

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.