Unit 5: Policy
Unit 5.1: The Classical System and the Keynesian System
Classical and Keynesian economics come to very different conclusions about macroeconomic performance. Classical economists emphasize market adjustments and self-correction, with little need for government intervention. Keynesian economists emphasize market imperfections, with a role for government involvement to stabilize the economy. Let us systematically compare the two.
Classical economists and Keynesian economists have different views on how the macroeconomy operates, which leads to different conclusions about policy formation. In this section, we will discuss some of the main differences and then at the end we will see how the two can fit together.
Using Microeconomic Tools to Analyze Macroeconomics
Classical Keynesian
Microeconomic supply and demand principles are appropriate for macro-level markets like labor markets and financial markets. Large-scale markets follow the same principles as the markets for apples or soap.
Example: Labor market reaches equilibrium, generating full employment.
Example: Financial markets reach equilibrium, so savings get channeled into investment
Market rigidities are mostly created by the government, so we should aim for markets that are as flexible as possible. For example, shoot for as little regulation as possible.
Real-world markets don’t work like this at the macro level.
Problem 1: Serious wage and price rigidities. Even when economic conditions imply that markets should adjust, the market may not adjust to equilibrium on its own.
• Labor markets – Regulations and long-term contracts. Market might not adjust to equilibrium wage and can feature permanent unemployment.
• Financial markets – Information problems make it difficult for financial markets to function efficiently. System may not effectively channel savings into productive investments.
different if we aggregate the whole economy together. Basic problem is that producers and consumers are intertwined in the macroeconomy, which isn’t true in an individual market.
Example: An individual firm that can cut wages would see an increase in profit. But if all firms cut wages, then profits would fall because firms would have fewer customers.
Example: For a household or firm, spending less will lead to a better financial position. But that’s not true for macroeconomy because if everyone spends less, the economy is poorer. Your spending is my income. Production and income and spending are inextricably linked, which isn’t true for an individual market.
Business Cycles and Recessions
Classical Keynesian
Markets self-adjust to equilibrium. Economic downturns are just short-term bumps while the economy experiences a shock and adjusts to a new equilibrium. Normal condition is good performance.
If economy is in recession, there are unemployed resources and resource costs fall. This leads firms to increase output and employment, so the economy self-adjusts out of recession.
Economic downturns are a normal part of how the economy functions. Not an aberration because the economy is out of equilibrium. Economy may not self-adjust out of recession.
Problem 1: Sticky wages and prices may prevent resource costs from falling.
Problem 2: Even if wages do adjust
downwards, firms will not expand if they have bad expectations about the prospects for future sales.
Government Stabilization Policy
Classical Keynesian
Let the market clear itself out if the economy is not performing well. Economy will eventually adjust back to full-employment equilibrium.
Government can break cycle of bad expectations and low performance. By increasing purchases of goods and services, firms see a market for future sales and will expand. With expansions, incomes are higher, spending goes up and the problem is fixed.
Supply and Demand as Drivers of the Economy
Classical Keynesian
𝐺𝐺𝐺𝐺𝐺𝐺 = 𝐹𝐹(𝐾𝐾, 𝐿𝐿)
Production creates incomes.
Supply-driven view: When firms produce more output, this generates incomes and spending. Keynesian view has the economy totally backwards.
Output depends on production and inputs. High production creates incomes and spending.
𝐺𝐺𝐺𝐺𝐺𝐺 = 𝐶𝐶 + 𝐼𝐼 + 𝐺𝐺 + 𝑁𝑁𝑁𝑁
Spending can stimulate production.
Demand-driven view: More purchases can generate more production. That’s why fiscal and monetary policy can help the economy grow, with a multiplier effect.
Output depends on aggregate expenditures and demand for goods and services. Stimulating demand can actually create more output.
• Price rigidities – If demand rises, firms do not immediately “price” it in. There is some increase in output as well. Demand matters for determining output.
Impact of Government Spending on Economy
Classical Keynesian
𝐺𝐺𝐺𝐺𝐺𝐺 = 𝐹𝐹(𝐾𝐾, 𝐿𝐿)
Crowding out – Higher government spending just sucks output away from consumption and investment. No change to GDP.
𝐺𝐺𝐺𝐺𝐺𝐺 = 𝐶𝐶 + 𝐼𝐼 + 𝐺𝐺 + 𝑁𝑁𝑁𝑁
Not zero-sum. Government spending can actually create new output because it increases demand for goods and services
Varying Perspectives on Say’s Law
Classical Keynesian
Say’s Law: Production creates incomes, which creates spending.
No government spending needed to
supplement demand. Demand is always equal to supply.
Say’s Law is unrealistic.
“Nothing can be more childish than the dogma that because every sale is a purchase, every purchase a sale, that therefore there is necessarily an equilibrium of sales and purchases. Nobody is bound to purchase because he has just sold. If the interval of time between the sale and the purchase becomes too pronounced, this asserts itself by producing a crisis.” – Karl Marx
No particular reason that production and incomes must generate purchases – at least not anytime soon. Recessions are created when there is not enough demand relative to output supplied.
Business cycles are normal occurrences stemming from imbalances of supply and demand, potentially permanent.
Money and Interest Rate Determination
Classical Keynesian
Interest rate comes from an equilibrium of supply and demand for loanable funds. That’s why savings and investment are equal.
In the short-run, the interest rate comes from equilibrium in the money market – depends on liquidity preferences and the public’s desired mix between money and interest-bearing assets. Remember the LM relation.
Loanable funds market may not be in equilibrium because that’s not where the interest rate comes from in the short-run. This means that savings and investment may not be equal to each other.
Rationality and Information
Classical Keynesian
Consumers and producers are rational and take into account all the information they have at hand.
No wage illusion – Workers fully incorporate diminished value of real wages when making decisions, so inflation does not affect the labor market.
Money has no influence on real economic activity – If the Fed prints more money, people realize the money is devalued, so printing money does not create new goods and services.
Rational expectations – Government policy is less effective because people anticipate the effects in advance. For example, they adjust to inflation expectations when the Fed implements expansionary monetary policy.
Emphasizes limited information and limits to rational decision-making capacity when consumers and firms make decisions.
Wage illusion is possible – Workers are tricked by rising nominal wages when there is inflation, so inflation and employment outcomes are related to each other.
Money illusion is possible – Firms and workers do not immediately realize that new money is devalued, so they can be “tricked” into working and producing more.
Assessing Keynesian and Classical Economics
Now we have seen the two main branches of macroeconomics. Classical and Keynesian economists have very different ideas about how the economy works and in turn very different views on macroeconomic policy. Which is correct? Unfortunately, there really is no easy answer to that question. Both traditions have survived for a long time and have strong intellectual grounding, and so there are probably useful insights from both. But with such radically different approaches, how can we resolve these insights into a coherent whole?
One point is that the dispute about demand-side versus supply-side growth in the economy depends on whether there are a lot of unemployed resources. If there are many unemployed workers, empty factories, etc… then demand-side stimulus makes some sense. By stimulating purchases of goods and services (e.g. with fiscal and monetary policy), firms will bring these unemployed resources back online – providing jobs and income. When there are unemployed resources, demand-side stimulus can create real growth. Keynesian economics makes some sense here.
On the other hand, when the economy is already at full employment, stimulating demand for goods and services further won’t increase output. In this case, supply is the only driver of growth, so classical economics makes more sense here.
However, the larger point in resolving the Keynesian and classical approaches has to do with the short-run and the long-run. Keynesian economics is about demand – making sure there is enough spending to purchase the output that the economy can produce. Classical economics is about supply – about our level of productive resources and how to grow them in the long-run.
In my view, this is the most coherent way to resolve the two. While classical economics is about long-run growth in productive resources, Keynesian economics is about the economy reaching its full potential in the short-run. That is, Keynesian economics is about short-run economic performance for a given level of resources. Classical economics is about long-run growth in this resource base.
Basically, the story of economic performance in developed countries is that it goes up and down in cycles, but the long-term trend is upwards. Keynesian economics is about managing the ups and downs. Classical economics is about the long-run upward trend.
For long-run growth, the classical model is the appropriate model. While Keynesian economics might help us stabilize the economy and reach full potential in the short-run, there is no question that the only way for the economy to grow in the long-run is for there to be growth in productive resources and technology and skills. Spending does not generate long-run growth.
The Government and Economic Growth
The classical model seems to take a dim view on the role of government in the economy. Output is supply-determined, and government spending just crowds out private spending. Furthermore, the taxes that we use to finance government activities are distortionary – Lower taxes on individuals would promote more work and savings, and lower taxes on businesses would promote more employment, investments in capital and new innovations.
There’s something to be said for this. Most economists probably wouldn’t disagree with the general point that a government too big and intrusive can crowd out private business, and that taxes that are too high are an impediment to economic growth. But it’s also important to remember that the government does some things that are crucial for long-run economic growth. Among the more important ones:
• Education and human capital
• Infrastructure development
• Research and technology funding
• Legal system that protects property rights
If we gut government investments in these growth-generators, the economy is going to end up worse, not better. Some things that the government does are critical for long-run growth.
Unit 5.2: Monetary Policy
We talked in unit 3 about the foundations of the monetary system – money demand, the money supply and the relationship between money and macroeconomic activity. In this section, we will go into more detail about how the Fed actually conducts monetary policy.
Interest Rate Targeting
Practically, the Fed conducts monetary policy by targeting the interest rate. The target rate that the Fed keeps its eye on is the federal funds rate – the rate at which banks make loans to each other. Importantly, the federal funds rate is set on the market, not directly by the Fed. But the Fed can manipulate the money supply in order to make the federal funds rate hit its target.
• If the Fed wants the interest rate to fall, it can buy bonds from banks. This action increases bank reserves, creating a surplus of money and pushing the rate of interest for loans down.
• If the Fed wants the interest rate to rise, it can sell bonds to banks. This action reduces bank reserves, creating a shortage of money and pushing the rate of interest for loans up.
Of course, there are many interest rates in the economy – the interest rate you pay on your credit card, the interest rate you pay on a home loan, the interest rate you earn on your CD, etc… Why does the Fed target the federal funds rate specifically? Well, interest rates in the economy tend to move up and down together. The federal funds rate is kind of a floor, and if it increases then other interest rates in the economy rise as well.
To reiterate, it’s technically wrong to say that the Fed “sets” interest rates since interest rates are determined on the market. But, practically, the Fed can manipulate the money supply in order to hit its target interest rate.
The Taylor Rule
How does the Fed determine its target interest rate? Most central banks use some kind of policy rule for determining its monetary policy, although the rule it uses may be vague (more on this later). Monetary policy typically targets the inflation rate and GDP / unemployment rates.1
Here is the notation we will use.
1 By Okun’s Law, GDP and the unemployment rate are basically the same outcome. High GDP growth means low
𝜋𝜋 Actual inflation rate
𝜋𝜋∗ Fed’s target inflation rate
𝑌𝑌 Actual GDP
𝑌𝑌∗ Full-employment potential (target) GDP
𝑌𝑌𝐷𝐷 Percentage deviation from potential GDP: 𝑌𝑌𝐷𝐷 =𝑌𝑌−𝑌𝑌∗ 𝑌𝑌∗
The Taylor Rule is the most well-known monetary policy rule. The Taylor rule says that the Fed should increase the interest rate when its goal is to reduce aggregate demand, which is appropriate in two circumstances:
• Increase the interest rate when inflation is higher than its target rate
• Increase the interest rate when GDP is higher than its full-employment level
By contrast, the Taylor rule says that the Fed should reduce the interest rate when its goal is to increase aggregate demand, which is appropriate in two circumstances.
• Reduce the interest rate when inflation is lower than its target rate
• Reduce the interest rate when GDP is lower than its full-employment level
Basically, when the economy is overheated the Taylor rule calls for increasing the interest rate. Remember that increasing the interest rate reduces consumption spending, investment spending and net exports. All of this reduces aggregate demand, which slows down the economy.
When the economy is underperforming the Taylor rule calls for reducing the interest rate. Reducing the interest rate increases consumption spending, investment spending and net exports. All of this raises aggregate demand, which stimulates the economy.
Let’s formalize this. Remember that the real interest rate in the economy is 𝑟𝑟 = 𝑖𝑖 − 𝜋𝜋, where 𝑖𝑖 is the nominal interest rate and 𝜋𝜋 is the rate of inflation. If we rearrange this, we obtain:
𝑖𝑖 = 𝑟𝑟 + 𝜋𝜋
𝑖𝑖 = 𝑟𝑟∗+ 𝜋𝜋
On the other hand, if the Fed’s targets are not being met, then it should set the interest rate per the rules given above. The practical policy issue is how much the Fed should weight its inflation target versus its GDP target in setting its monetary policy rule. We will let 𝛼𝛼 be the Fed’s responsiveness to inflation not meeting the target and 𝛽𝛽 be the Fed’s responsiveness to GDP not meeting the target. Combining, the Taylor Rule says that the Fed’s target interest rate is:
𝑖𝑖 = 𝑟𝑟∗+ 𝜋𝜋 + 𝛼𝛼(𝜋𝜋 − 𝜋𝜋∗) + 𝛽𝛽𝑌𝑌𝐷𝐷
To interpret the Taylor Rule, just think about the deviations from the target.
• If the inflation target is met (𝜋𝜋 = 𝜋𝜋∗) and the GDP target is met (𝑌𝑌𝐷𝐷 = 0), then the Fed just leaves the nominal interest rate at the market level 𝑖𝑖 = 𝑟𝑟∗+ 𝜋𝜋.
• If inflation is higher than the target rate (𝜋𝜋 > 𝜋𝜋∗) or GDP is above potential (𝑌𝑌𝐷𝐷 > 0), then the Fed should set the interest rate higher than the market rate, thus reducing AD and slowing down the economy.
• If inflation is lower than the target rate (𝜋𝜋 < 𝜋𝜋∗) or GDP is below potential (𝑌𝑌𝐷𝐷 < 0), then the Fed should set the interest rate lower than the market rate, thus increasing AD and stimulating the economy.
The coefficients 𝛼𝛼 and 𝛽𝛽 basically just reflect how much the Fed weights inflation deviations versus GDP / employment deviations in making its decisions.
Let’s rearrange the Taylor rule slightly to see an important principle.
𝑖𝑖 = 𝑟𝑟∗+ 𝜋𝜋 + 𝛼𝛼(𝜋𝜋 − 𝜋𝜋∗) + 𝛽𝛽𝑌𝑌𝐷𝐷
= 𝑟𝑟∗+ (1 + 𝛼𝛼)𝜋𝜋 − 𝛼𝛼𝜋𝜋∗+ 𝛽𝛽𝑌𝑌𝐷𝐷
This rearrangement shows the Taylor Principle – When inflation rises above the target rate, the Fed raises the interest rate by a larger amount than the inflation increase in order to stabilize the economy. If inflation rose 2% and the Fed simply increased the nominal interest rate by 2%, this would just keep the nominal rate at its market level. But, the coefficient 1 + 𝛼𝛼 shows that the Fed will increase the interest rate by more than 2%. This higher interest rate puts the brakes on the economy, which shows that the Taylor Rule is designed to stabilize macroeconomic fluctuations.
Finally, it is important to note that the Taylor Rule’s inclusion of the GDP gap anticipates the future. Even if inflation is right on target, GDP higher than potential will cause the Fed to increase interest rates and put the brakes on the economy. Why? Well, when GDP is rising quickly, prices may not rise immediately because of price rigidities, but it is inevitable that prices will eventually rise. The Taylor rule anticipates this future inflation and responds preemptively.
Liquidity Trap
The financial crisis of 2008 and its aftermath continues to pose a challenge for policymakers that is really unprecedented in the monetary history of the US.
The nominal federal funds rate is currently 0.4%, meaning that real interest rates are basically zero, and probably even negative depending upon one’s measure of inflation.
Practically, what happened here is that the economy was in such bad shape after the financial crisis of 2008 that the Fed reduced interest rates basically to zero in an attempt to stimulate economic activity as much as it could.
In fact, the Fed even tried a series of new and unconventional tools known as quantitative easing
Practically, the problem that the Fed faced, and still faces to a large extent presently, is known as a liquidity trap or the zero-lower bound problem. Nominal interest rates cannot fall below zero by definition.2 Thus, once interest rates are zero and output still falls short of full-employment level, the Fed is out of options for using monetary policy to stimulate the economy.
We can think about the liquidity trap in the context of an IS/LM model.
A typical IS/LM environment is shown on the left, but a liquidity trap basically creates a horizontal segment on the LM curve. Once the interest rate is equal to zero, the LM curve is flat and increases in the money supply have no hope of restoring full employment. If you think about the economics of what’s happening when the interest rate is zero, people are basically just using money and financial assets equivalently as stores of value (since both pay zero interest). Thus, increasing the money supply doesn’t do much of anything to financial markets.
One upshot of this is that is that increases in the monetary base have no impact on the price level in a liquidity trap, meaning that fears of inflation from the ever-growing monetary base are probably unfounded. The most recent example of a liquidity trap is Japan in the early 2000’s. In that case, a near-doubling of the monetary base produced no change whatsoever in price levels.
2 Think about what that would mean – you’d lose money by buying a bond. Investors can just hold cash to earn a zero
Monetary policy can do nothing in a liquidity trap. So what’s the solution? Examining the IS/LM diagram in the case of a liquidity trap, the only policy option for restoring full employment GDP is an increase in the IS curve – fiscal policy. Indeed, many macroeconomists have said that the lack of fiscal stimulus during the recession was a major policy failure, and one that put undue strain on Fed, forcing it to act outside of its normal parameters to restore GDP targets.
Lags in Monetary Policy
Another challenge associated with the exercise of monetary policy in practice is lags – policy decisions made today only produce an impact on the economy in the future. With respect to monetary policy, it typically takes up to two years before monetary policy changes have the desired impact on real GDP.
To be clear about the source of the lag, the interest rate responds pretty quickly to changes in the money supply. That’s not the problem. The problem is that, while low interest rates do stimulate investment, it takes time to arrange financing and install capital. This means that monetary policy doesn’t work its way down the pipeline to actual investment spending potentially for a couple of years after the policy is enacted. Prices are even slower to adjust because of persistent price rigidities.
Rules or Discretion?
As we discussed earlier, there is near-consensus among economists that monetary policy has mostly nominal (not real) effects in the long-run. But there is substantial disagreement about the use of monetary policy in the short-run. Keynesians support the use of discretionary monetary policy as a way to smooth out economic cycles and want to give monetary policymakers maximum flexibility to respond to economic circumstances. Classical economists (monetarists) are generally skeptical about discretionary use of monetary policy and basically want the Fed to follow some pre-specified rule for managing the money supply – increasing it at a constant rate, or perhaps a rate proportional to population growth or real GDP growth.
Monetarists assert that using money to manage economic fluctuations is inherently problematic, for a few reasons.
• Lags make it difficult for policymakers to determine the appropriate policy.
• The impact of monetary fluctuations on the economy is inherently unpredictable, even if we ignore the timing problem.
• Because of lags, the timing could be way off. A stimulus might become mostly active after the economy has already recovered, which would actually cause additional overheating.
Monetarists attribute a whole series of economic calamities to mismanagement of the money supply. The chief proponent of monetarism, Milton Friedman, has even argued that the Fed was responsible for the Great Depression!
In addition to the inherent unreliability of monetary policy as a policy tool, monetarists also argue that even if the Fed could manage the economy, it can’t be relied on. Political pressure to stimulate the economy during elections can make the Fed not quite the apolitical entity that is supposed to be. Specifically, a politicized Fed might underweight inflation concerns since employment concerns tend to dominate future inflation fears in people’s minds.
