1. A post-Keynesian alternative to the New consensus on monetary policy Marc Lavoie University of Ottawa

2. What is the New consensus? New Keynesian “consensus-type model”, where policy reaction functions are “an essential part of the macroeconomic system”. Also called, the New Keynesian Synthesis Their formal version is the DSGE model J.B. Taylor, Blinder, D. Romer, Woodford, Meyer.

3. 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

4. The new consensus: summary The new consensus is simply a variant of monetarism; but without any causal role for money. It is monetarism without money.

5. New consensus model: A simplified version IS function: g = g 0 ! $ r +, 1 Vertical Phillips curve d B /dt = ( (g ! g n ) +, 2 Central bank reaction function: r = r 0 + " 1 ( B ! B T ) + " 2 (g ! g n e ) A similar model could be build with an output gap or a rate of capacity utilization instead of g

6. How is the New consensus linked to post-Keynesian theory? Positively “The main change is that it replaces the assumption that the central bank targets the money supply with an assumption that it follows a simple interest rate rule” (Romer 2000: 154). Negatively The New consensus reproduces accepted dogma among neoclassical economists, la pensée unique as the French say.

7. La pensée unique Expansionary fiscal policy only leads to higher inflation rates and higher real interest rates in the long run; More restrictive monetary policy only leads to lower inflation rates in the long run.

8. How is the New consensus linked to post-Keynesian theory ? (2) About the reaction function Post-Keynesians There is an interest rate reaction function because it cannot be otherwise. Money supply targeting is impossible in principle and in practice. New Consensus There is an interest rate reaction function because interest rate targeting is more successful to dampen shocks to money demand than money supply targeting.

9. How is the New consensus linked to post-Keynesian theory ? (3) About the IS function Post-Keynesians The IS function is based on aggregate demand, with investment reacting negatively to the real interest rate. New Consensus (see Dullien) The IS function is based on aggregate supply. A higher real interest rate reduces present consumption, lowers wages and real wages (prices are rigid, adjust with lags), and hence reduces the supply of labour and output.

10. New consensus model: An alternative version (Setterfield) IS function: g = g 0 ! $ r +, 1 Vertical Phillips curve d B /dt = ( (g ! g n ) +, 2 Central bank reaction function: dr = " 1 ( B ! B T ) + " 2 (g ! g n e )

11. Implicit to the New Keynesian model A natural real interest rate r 0 = r n = (g 0 ! g n )/ $ which implies (g ! g n ) = $ (r – r n ) A natural growth rate, given by supply-side factors g n = a constant

12. Figure 5: The hidden consensus equation 0  gngn gngn

13. 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. 41-42

14. 2000 survey of AEA economists Question: Real GDP eventually returns automatically to potential real GDP? –Agree: 63 % –Disagree: 37 % –Journal of Economic Education, Fall 2003

15. 2000 survey of AEA economists Question: There is a natural rate of unemployment to which the economy tends in the long run ? –Agree: 68 % –Disagree: 32 %

16. Figure 1: The graphical new consensus with r = r 0 + " 1 ( B ! B T ) IS AD r r g g     RF MP    gngn Start with the historically given rate of inflation

17. Figure 2: New consensus with rising MP curve IS AD r r g g     RF MP    gngn

18. Figure 3A: Impact of a rise in effective demand: There is a lag in inflation IS AD r r g g     RF MP gngn IA g2g2 11 33 r3r3 r1r1   A B A B

19. Figure 3: Impact of a rise in effective demand IS AD r r g g     RF MP g 3 =g n IA g2g2 11 33 r3r3 r1r1     A B C A B C

20. Figure 4A: Bringing back inflation to its target rate IS 1 AD 2 r4r4 r g g     RF 1 MP gngn IA g2g2 TT 33 r1r1 r3r3     A B C A B C g4g4   D D AD 1 AD 4 IS 2 RF 4  

21. Figure 4: Bringing back inflation to its target rate IS 1 AD 2 r4r4 r g g     RF 1 MP gngn IA g2g2 TT 33 r1r1 r3r3     A B C A B C g4g4   D D AD 1 AD 4 IS 2 RF 4   D

22. Post-Keynesian alternatives (1): Reject the vertical Phillips curve and replace it with a long-run downward- sloping Phillips curve (Setterfield) or a flat Phillips curve (Kriesler-Lavoie) Or, (2) Endogenize the natural rate of growth g n (Lavoie)

23. Similarity with PK critique of natural rate of unemployment Hargreaves-Heap (Economic Journal 1980) Cottrell (JPKE, 1984-85) dU n /dt = N (U ! U n ) +, 3

24. Post-Keynesian views “Disequilibrium adjustment paths can affect equilibrium outcomes” (Colander, 1996: 60), leading to multiple equilibria and to path-dependent equilibria. “The natural rate of growth is ultimately endogenous to the demand-determined actual rate of growth” (Setterfield, 2002: 5)

25. Post-Keynesian views II “Neoclassical growth economists on the one hand,... treat the rate of growth of the labour force and labour productivity as exogenous to the actual rate of growth.... Economists in the Keynesian/post- Keynesian tradition,... maintain that growth is primarily demand driven because labour force and productivity growth respond to demand growth” (León-Lesdema and Thirlwall, 2002).

26. Post-Keynesian views III “But at the same time technical progress is being speeded up to keep up with accumulation. The rate of technical progress is not a natural phenomenon that falls like the gentle rain from heaven. When there is an economic motive for raising output per man the entrepreneurs seek out inventions and improvements. Even more important than speeding up discoveries is the speeding up of the rate at which innovations are diffused. When entrepreneurs find themselves in a situation where potential markets are expanding but labour hard to find, they have every motive to increase productivity” (Robinson 1956, p. 96).

27. Post-Keynesian views IV “The stronger the urge to expand … the greater are the stresses and strains to which the economy becomes exposed; and the greater are the incentives to overcome physical limitations on production by the introduction of new techniques. Technical progress is therefore likely to be greatest in those societies where the desired rate of expansion of productive capacity … tends to exceed most the expansion of the labour force (which, as we have seen, is itself stimulated, though only up to certain limits, by the growth in production)” (Kaldor, 1960, p. 237).

28. Kaldor 1933 revisited ‘We shall call an equilibrium “determinate” or “indeterminate” according as the final position is independent of the route followed or not [path dependence]; we shall call equilibrium “unique” or “multiple” according as there is one, or more than one, system of equilibrium prices corresponding to a given set of data; and finally,we shall speak of “definite” or “indefinite” equilibria, according as the actual situation tends to approximate of position of equilibrium or not’ [stability or instability].

29. 2000 survey of AEA economists Question: Changes in aggregate demand affect real GDP in the short run but not in the long run ? –Agree: 62 % (potential growth is given) –Disagree: 38 % (potential growth is affected by short-run effective demand)

30. The alternative PK model g = g 0 ! $ r +, 1 d B /dt = ( (g ! g n ) +, 2 r = r 0 + " 1 ( B ! B T ) + " 2 (g ! g n ) r 0 = r nT = (g 0 ! g n )/ $ dg n /dt = N (g ! g n ) +, 3

31. PK model becomes a system of two differential equations

32. The dynamics of this system are pretty straightforward, because the determinant of this system is zero; and because its trace, is always negative. The amended new consensus model displays a continuum of equilibria. The model is said to contain a zero root.

33. As the long-run equilibrium is not predetermined anymore, the steady-state rate of accumulation now depends on transitional dynamics, which cannot be ignored: short-run events have a qualitative impact on long-run equilibria. It is common to speak of ‘path-dependence’ for such a characteristic. It is possible to show that this kind of model displays hysteresis in the sense of a ‘permanent effect of a transitory shock’ (Olivier 1999).

34. An example of hysteresis For instance, a temporary increase in the rate of price inflation that would arise independently of excess demand pressure would have permanent effects on the natural rate of growth and the natural real rate of interest.

35. Another example Monetary policy now has real effects that go beyond its impact on the inflation rate. Zero-inflation or low-inflation targeting has a negative impact on the real economy, bringing in high real rates of interest and low real rates of growth.

36. Figure 6: Path-dependence, likely case g gngn dg = 0 dg n = 0 gnEgnE gngn gAgA gnAgnA gnBgnB gBgB  A A* B B* E

37. Figure 8A: Reducing the inflation target: PK model IS AD r r g     gnCgnC CC EE rBrB rCrC     C E B E   gnEgnE  B  rErE TT gBgB C  rB*rB* RF 2 g AD 2

38. Figure 8: Reducing the inflation target: PK model IS AD r r g     RF 3 gnBgnB gnCgnC CC EE rBrB rCrC      C E B E B*   gnEgnE  B  rErE TT gBgB C   rB*rB* RF 2 g

39. Other visual interpretation of hysteresis Time Log K Log q fc Slope is g n = n + a New slope Actual path

40. The New Consensus view Time Log K Log q fc Slope is g n = n + a Actual path

41. A less drastic interpretation of hysteresis, when the central bank reacts to utilization rates, with g = g n + µ (u  u n ) Time Log K Log q fc Slopes are g n = n + a Actual path

42. Other critiques: IS Curve Reject the simple interest rate -investment relation implied in the IS model: Central bank sets short term interest rate, but what about the long term interest rate which is said to influence investment and aggregate demand (however do businesses and households now borrow on a variable interest rate?) Monetary policy is a blunt instrument, with long and variable lags.

43. Some additional critiques: Efficacy of Monetary Policy Real interest rate hikes may lead to higher inflation rates, through interest cost push; it also generates an additional flow of interest payments in a stock- flow consistent model 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.

44. What about the role of fiscal policy? Is counter-cyclical fiscal policy dead? What about the US with Reagan and Bush? What about Europe and its fiscal constraints imposed by the Maastricht Treaty (deficit at a max of 3% of GDP)? Is Canada a counter-example of Keynesian economics (growth picked up when the federal government cut into its expenditures and raised taxes)? Is there an explanation of this phenomenon? (there is!).

45. 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

46. In the long run …. Inflation rate Utilization rate umum u fc

47. Empirical work that gives support to a horizontal Phillips curve Eisner 1995, 1996, identifies a traditional segment, followed by a flat segment, even with high rates of utilization Filardo, Kansas City Federal Reserve Bank Economic Review, 1998, has the three segments of PUP. Driscoll and Holden (2004). Most recent studies at the Bank of Canada cannot find a relationship between the rate of utilization (or the output gap) and the inflation rate: the Phillips curve looks everywhere flat. Bloch and al. (JPKE, 2004) pretend that strong world demand for raw materials is the main source of inflation, and not domestic demand within each country.

48. Conclusion: Even if natural growth rates are not endogenous, it is very likely that current monetary policies have led to overly low rates of utilization and overly high unemployment rates. Central banks tell us that they are doing a good job. But lower interest rates could have been set, without inflation rising. In other words, high rates of capacity utilization may not have the inflationary effects that central banks presume they have.

49. …And this is recognized by some (previous) central bank officers « If expectations of low inflation are firm, and the Phillips curve is almost flat over a wide range at 2 percent inflation, it may be time to make monetary policy explicitly accountable for the cyclical component of output. To implement the idea, following the clause “Within this range monetary policy will continue to aim at keeping the trend of inflation at the 2 per cent target midpoint” the official statement could add “Monetary policy will seek the maximum levels of output and employment consistent with this target.” » K. Clinton (Bank of Canada 1972-2003), Bordeaux 2006.

50. A first addendum: financial crises Whereas in normal times, all short-run interest rates move in tandem, this is not always the case, especially in times of financial crises, as we have experienced since August 2007, as a result of the subprime crisis. Over a certain number of months, rates on commercial paper have exceeded the overnight rate, while rates on Treasury bills are way below the overnight rate

51. A Minskyan new consensus Thus we must add a quadrant to our little model, carefully distinguishing the overnight rate (the fed funds rate f) from the rate which is relevant to the private sector, which is now called r. Thus the reaction function determines f, but r may not move in tandem with f.

52. Adding another rate of interest to the four quadrant story Assume that the economy starts off from point A, shown in all quadrants of the Figure. In a ‘Minsky moment’, the risk spread τ rises considerably. As there is a rush towards liquidity and riskless assets, the prices of risky assets fall, and hence the interest rates on these assets rise. This is represented in Figure 7 by an upward shift of the transmission mechanism curve, from TM1 to TM2. Thus, even if the financial crisis does not have a direct impact on the real economy – meaning here that the parameters in the IS equation remains put, there will be consequences for the real economy because market rates will rise from r1 to r2. If the central bank does not modify its reaction function, the aggregate demand curve will get shifted downwards from AD1 to AD2 and economic activity will fall to u2, with the economy moving from point A to point B. Then, as inflation rates start to fall, as a result of the rates of capacity utilization being below their normal levels, nominal and real federal funds rate will be brought down by the central bank, moving along the RF1 reaction function.

53. Figure 7 AD 2 r u u  f  f RF 1 unun IA TT 22 r1r1 r2r2    C A A u2u2   B B AD 1 IS RF 2      TM 1 TM 2 r f1f1 f2f2 A AA’

54. Other rates do not follow the overnight rate (the target is 2%) Treasury bill 1-month rate 09/12/2008: 1.64% 09/15/2008: 0.36% (Lehman Monday) 09/17/2008:0.07% 09/18/2008: 0.26% 09/19/2008: 0.75% 09/22/2008: 0.76% 09/23/2008: 0.30% Corporate non-financial 1-month rate 09/12/2008: 2.39% 09/15/2008: 2.47% (Lehman Monday) 09/17/2008:2.51% 09/18/2008: 2.55% 09/19/2008: 2.63% 09/22/2008: 3.02% 09/23/2008: 3.38%

55. Higher risk premia act as a real negative shock on the economy If the monetary authorities react in the normal way, without taking into account the turmoil in the financial markets and the higher risk premia, the economy will be brought back to the normal rate of capacity utilization, but at a steady rate of inflation that will be below the target, at point C. In other words, the risk premium in financial markets acts like a negative shock on the aggregate demand curve, just like a real negative shock would. If this financial shock is large enough it could even bring about negative inflation, and hence debt-deflation as argued by Minsky.

56. The central bank must counter the risk premium shock The higher risk premium requires the central bank to modify its assessment of the natural rate of interest, f0, in a counter-intuitive way, since it must reduce the federal funds rate when long-term market interest rates are rising. The monetary authorities must shift their reaction function, to RF2, and reduce the federal funds rate to f2 in order to keep inflation on target at πT and avoid a reduction in economic activity (thus keeping market interest rates at r1). If they do so, and assuming the financial turmoil does not have further effects, the central bank could succeed in keeping the economy at the normal rate of utilization, thus keeping the economy at points A in the north- east and south-east quadrants, which correspond to points A’ of the north-west and south-west quadrants.

57. A critique of the way some central bankers claim to assess the natural rate of interest The central bank cannot claim, as it sometimes does, that long-term market rates are a proper proxy for the natural interest rate and a guide to help setting the federal funds rate. In the present case, if the central bank were to raise its estimate of the natural rate of interest, in an effort to follow the apparent increase in long-term market rates, it would only make matters worse.