1. Path dependency and macroeconomic policies Malcolm Sawyer University of Leeds and FESSUD The views expressed during the execution of the FESSUD project, in whatever form and or by whatever medium, are the sole responsibility of the authors. The European Union is not liable for any use that may be made of the information contained therein

2. Introduction The separation of demand and supply has been a central feature of economic analysis: and in much macroeconomic analysis separation of real and monetary. The ‘natural rate’ : ‘the level that would be ground out by the Walrasian system of general equilibrium equations, provided there is embedded in them the actual structural characteristics of the labour and commodity markers, including market imperfections, stochastic variability in demands and supplies, the cost of gathering information about job vacancies and labor availabilities, the costs of mobility, and so on’. ‘I use the term "natural" for the same reason Wicksell did-to try to separate the real forces from monetary forces’ (Friedman, 1968).

3. ‘Potential output’ 'Potential output' is central to much theorising on monetary policy and fiscal policy. In monetary policy, for example, in Taylor’s rule for interest rate, ‘natural rate of interest’ and output gap (=actual output minus ‘potential output’) In fiscal policy, with the notion of ‘structural budget positions’ And as a ‘benchmark’ for a constant rate of inflation Note this is a macroeconomic concept whereas capacity output is a microeconomic concept

4. ‘Potential output’ Potential output may not exist in the sense that coefficient on expected inflation not unity Potential output as a suitable objective/target for policy (as implied by Taylor's rule; balanced structural budget)? Lack of transparency Do ‘potential output’ and non-accelerating inflation rates of unemployment (NAIRU) exist?

5. Path dependency Path dependency: the general arguments Unemployment Investment and the capital stock

6. Structural budget positions Calculations in effect relate to operation of automatic stabilisers: no allowance for discretionary fiscal policies The structural budget position is t*(Y*) - G* where t is the tax and transfer function, which is the underlying ('structural') function and G* the underlying (structural) government expenditure on goods and services.

7. Structural budget positions Often calculated as a ‘ready reckoner’ from output gap, e.g. 1 per cent change in output gap leads to 0.5 per cent change in budget deficit/GDP ratio

8. Potential output: the concept

9. Similar approach is unemployment/NAIRU used, and production function approach using employment corresponding to NAIRU to estimate potential output

10. Potential output: issues Reliance on Phillips curve with unit coefficient on expected inflation; Path dependency – which can be illustrated by reference to the NAIRU (non-accelerating inflation rate of unemployment):

11. Eurozone

12. UK

13. Potential output: issues Ambiguity over measurement illustrated by different estimates from national and international organisations, and by changes in estimates relating to a specific time period.

14. Potential output: issues ‘The Treaty [on Stability, Coordination and Governance] relies on the structural deficit concept. But its measurement is problematic, especially after strong macroeconomic shocks. In fact, the Treaty specifies that the Commission’s estimates will have to be used. But they have two drawbacks. First, the Commission’s potential output estimates are always close to observed output because they consider as structural the reduction of the capital stock resulting from a fall in investment during the crisis, like a large part of the decline in potential labour force (due to unemployed people’s discouragement), of the fall in productivity, and the rise in the unemployment rate: thus they underestimate the cyclical element of the deficit and will hence impose pro-cyclical policies. Second, these estimates are strongly revised over time. For instance, potential output estimates for 2006 were revised substantially downwards in 2008.’ (Mathieu and Sterdyniak, 2013, p. 177)

15. Balanced budgets BD = G – T = S – I + CA (G government expenditure; T tax revenue; S private savings, I private investment; FA financial account (inflow) = M (imports) – X (exports including net income)

16. ‘One size fits all problem’ S – I = X – M + G – T S private savings, I private investment, X exports (plus net income), M imports, G government expenditure and T tax revenue It is well-known that savings, investment etc. differ markedly between countries

17. Is structural budget balance feasible? G – tY = S i (Y, α) – I i (Y, α) – NX i (Y, α) Where superscript i indicates intentions, α a vector containing those variables, which would lead to shifts in the functions, which could range over ‘animal spirits’, interest rates, exchange rate and world trade.

18. Is structural budget balance feasible? G – tY = S i (Y, α*) – I i (Y, α*) – NX i (Y, α*) where α* is the structural level The question can then be posed as to nature of the solution for Y from this equation. In particular, would a balanced budget result ? In other words does the equation S i (Y*, α*) – I i (Y*, α*) – NX i (Y*, α*) = 0 hold?

19. Is structural budget balance feasible? If there is a ‘natural rate’ of interest which balances savings and investment, and an exchange rate which balances current account, then it would be possible.

20. Implications Need for consistency checks in the estimation of ‘structural budget’ positions Difficulties of calculation and the implementation of macroeconomic policy Lack of transparency with the use of ‘potential output’ The ‘endogenity issues’ of ‘potential output’ and ‘structural budget’

21. Implications Implications for ‘fiscal consolidation’ especially in a recession For the formulation of fiscal (and monetary) policy