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New Macroeconomics Consensus Economics Essay

The New Consensus Macroeconomics (NCM) emerged from the collapse of the Grand Neoclassical Synthesis in the 1970s and evolved around the notion of inflation targeting, and has arisen from a combination of central banks “learning what works (and what doesn’t)” (Charles Bean) and from a convergence of thinking in academic macroeconomics. The NCM has emerged over the past decade or so and has become highly influential in terms of recent macroeconomic thinking and of macroeconomic policy, especially monetary policy. The NCM is now firmly established amongst both academia and economic policy circles. It is also true to say that it draws heavily on the so-called new Keynesian economics. Woodford (2009, pp.2–3) argues that the New Consensus has come about “because progress in macroeconomic analysis has made it possible to see that the alternative which earlier generations felt it necessary to choose were not so thoroughly incompatible when understood more deeply.” Academic contributions also helped the foundations of the NCM on both theoretical and empirical grounds, for example, “[t]he Taylor Rule became the most common way to model monetary policy” [Goodfriend (2007) p. 59]. Goodfriend (2007), “[o]ne reason the Federal Reserve began to talk openly about interest rate policy in 1994 was that academic economists had begun to do so. Indeed, thinking about monetary policy as interest rate policy is one of the hallmarks of the new consensus that has made possible increasingly fruitful interaction between academics and central bankers.” (p.29)

Arestis (2009) explains some basic assumptions of the NCM model, such as, intertemporal optimization of a utility function that reflects optimal consumption smoothing, which is based upon the transversality condition, which, in turn, meaning that economic agents are credit worthy, debts are also perfectly accepted in exchange, and that nobody is liquidity constrained. The model is also a non-monetary model, so there are no private banks or monetary variables. The objective is price stability, as inflation is a monetary phenomenon, and is therefore controlled via changes in the interest rate, rather than by the money stock. In the NCM, fiscal policy should not be used for short term objectives, but solely for medium to long term ones.

There are theoretical issues in the NCM, which can have harmful implications on policy making. For instance, liquidity preference is absent, in view of the transversality condition, which is highly unrealistic. The central bank is in charge of, and can therefore change, the rate of interest and influences the term structure in a stable fashion, but the term structure of interest rates is influenced by other variables, such as the market power of the banking sector. The NCM is absent of monetary aggregates, as well as banks, who play an important role in the transmission mechanism of monetary policy. Such major theoretical issues leave the NCM model to be considered highly unrealistic and jeopardise the policy which is created using this framework. Canzioneri et al (2008) generates two models, the “standard” NCM, with no banks or monetary aggregates, compared with the “enlarged” model, which banks that create deposits and make loans, and concludes that monetary indicators are useful in forecasting inflation in the enlarged NCM model and not so in the standard model.

The policy implications of the NCM paradigm are particularly important for this development aspect of macroeconomics. Price stability can be achieved through monetary policy since inflation is a monetary phenomenon; as such it can only be controlled through changes in the rate of interest. It is, thus, agreed that monetary policy is effective as a means of inflation control. This is no longer controversial in view of “the worldwide success of disinflation policies of the 1980s and 1990s” (Woodford 2009, pp.12–13). Goodfriend (2007) also argues that this particular set of propositions, amongst many others, has been backed by actual monetary policy experience in the United States and other countries around the globe, following the abandonment of money supply rules in the early 1980s.

Inflation Targeting, the main policy implication of NCM, is designed to fight demand shocks, that is demand-pull type of inflation. Whereas, supply shocks, which produce cost-push type of inflation, cannot be handled. Therefore, the position taken by Inflation Targeting on supply shocks, is that they should either be accommodated, or that supply shocks come and go – and on average are zero and do not affect the rate of inflation; nor do they impact on the expected rate of inflation. There is insufficient attention paid to exchange rate, which are not included in equation (3), and only weighting it into decisions when setting interest rate. A strong real exchange rate contributes to ‘imbalances’ in the economy through its impact on the domestic composition of output: declines in manufacturing and exports, and increases in services and current account deficit, occur. There is a potential danger of a combination of internal price stability and exchange rate instability. The pass-through effect of a change in the exchange rate first on import prices and subsequently on the generality of prices, both goods and services, has weakened since the late 1980s. Consequently, the stronger real exchange rate has had less offsetting effect on domestic prices than in earlier periods; The argument normally used to justify appreciation in the exchange rate that such a move slows inflation is no longer valid under such circumstances;

Fontana (2009) uses a closed economy model in the discussion of NCM policymaking, listing the criticisms of conventional monetary policy under three distinct headings. First, one of the most controversial features of the conventional policy in the NCM model is the “unemployment bias,” namely the persistent tendency of conventional monetary policy to keep the unemployment rate above the natural rate of unemployment, as long as the economy is not at price stability. Dalziel (2002), Fontana & Palacio-Vera (2007), and Fontana (2009c) proposed an “opportunistic” use of the interest rate policy strategy to alleviate the effects of this bias. Under some circumstances, the central bank should give extra weight to output and employment compared to inflation in its monetary policy function. Second, another controversial feature of the conventional policy in the NCM model is related to the distributional effects of interest rate changes. Interest rate payments are a cost for firms borrowing money from banks and, hence, they may fuel an inflationary or deflationary process if policy changes in interest rates are passed on from firms to consumers. Furthermore, interest rate payments are an income for renters, mostly financial agents who do not play any productive role in the economy and earn income from their ownership of financial assets. Lavoie and Seccareccia (1999), Smithin (2006), Rochon and Setterfield (2007) discussed different interest rate policy rules that take into account these distributive effects. Finally, according to the NCM model, monetary policy must respond to changes in the output gap and the difference between current and targeted inflation rate. However, since the bubble of the 1990s, it has been commonplace to discuss if the central bank should also consider asset prices when setting the short-run interest rate. Minsky (1982), Wray (2008) and Tymoigne (2009) argued that financial matters, rather than simply asset prices, should indeed be a major (and possibly the exclusive) concern for the central bank. From the perspective of these authors, continuous manipulations of the short-run interest rate generate financial instability and speculation. For this reason, they suggest that the central bank should set the short-run interest rate permanently at zero. The second set of criticisms is related to the role of fiscal policy in the NCM model. It was previously discussed that the key role played by the central bank in the NCM model, in charge of achieving the desired inflation target and, subject to that, to deliver as much output stabilization as possible in the short-run. By contrast, fiscal authorities are either ignored or asked to concentrate on the control and sustainability of public finances. In other words, the NCM model downplays the role of fiscal policy at the advantage of monetary policy.

Several arguments have been put forward to justify this policy choice. First, supporters of the NCM model have pointed out at the historical evidence of previous decades. The historical explanation for the current disaffection with discretionary fiscal stabilization policy at the advantage of monetary policy usually maintains that the neoclassical synthesis of Keynesianism failed to provide any understanding of the events of the 1970s, let alone to solve them. For this reason, the neoclassical synthesis of Keynesianism was replaced by a new theoretical framework, namely the New Classical Macroeconomics (Lucas and Sargent, 1978), which rejected the use of discretionary fiscal stabilization policies, but Seidman (2003), Blinder (2006), and Forder (2007a, 2007b) called this explanation into question. Whatever the merit of the contributions by New Classical Macroeconomists, the works of Seidman, Blinder, and Forder suggest an alternative story, where ideology, policy mistakes, and particular historical circumstances played a role at least as important as economic theory in the rejection of neoclassical synthesis Keynesianism and the consequent downgrading of fiscal policy (Fontana 2009b).

Secondly, supporters of the NCM model have justified the prominent role of monetary policy at the expenses of fiscal policy in terms of the so-called “Ricardian equivalence” theory, namely the idea that it does not matter whether a government finances spending with debt or tax increase, the total level of demand in the economy is the same. Putting it boldly, if consumers are “Ricardian” they will save more now to compensate for current higher taxes (in the case of tax-financed government expenditure) or future higher taxes (in the case of bond-financed government expenditure), as the government has to pay back its debts. The increased government spending is therefore exactly offset by decreased consumption on the part of private agents, with the result that aggregate demand does not change. As in the previous case, this argument against the use of discretionary fiscal policy has also been called into question. Blinder (2006) and Arestis and Sawyer (2003, 2006), among others, have argued that the “Ricardian equivalence” view is based on unrealistic theoretical assumptions, including long time horizons, perfect foresight, perfect capital markets, and the absence of liquidity constraints. Furthermore, Hemming, Kell, and Mahfouz (2002) have also shown that the “Ricardian equivalence” view is poorly supported by empirical evidence.

Finally, supporters of the NCM model have justified the prominent role of monetary policy at the expenses of fiscal policy in terms of practical or political arguments, namely that fiscal policy has potentially long inside lags compared to monetary policy. Inside lags indicate the amount of time it takes for the government to recognize that fiscal policy needs to be changed (this is the so-called “recognition lag”) and then to introduce appropriate fiscal measures (this is the so-called “decision lag”). The conventional view is that fiscal policy is subject to long inside lags because it takes time to design, approve, and implement fiscal measures. Importantly, the bigger is the discretionary, structural component of the fiscal policy change, the longer are the inside lags. Certainly, the long inside lags of fiscal policy are a potential problem for fiscal policy compared to monetary policy. However, the latter has also it own practical problems; especially regarding the outside lags (Arestis and Sawyer 2003, 2006). The converse of inside lags are outside lags, which indicate the amount of time it takes for policy change to affect the economy, namely the time the fiscal or monetary action takes to feed through the aggregate demand. The conventional view is that outside lags for fiscal policy are variable but short. By contrast, for monetary policy, outside lags are considered to be very long and unpredictable, usually 18–24 months. In short, the choice between fiscal and monetary policy in terms of practical or political arguments is not a clear one.

In conclusion, in the last decade the NCM model has been subject to several criticisms. One of the most controversial assumptions of the NCM model is the absence of the government and an explicit role for fiscal policy in its core three-equation model. Blanchard (2008) maintains that modern macroeconomics is experiencing a period of great excitement: theoretical and empirical advances are going hand-in-hand with convergence in both vision and methodology. Yet, he does acknowledge that the current state of macroeconomics is unsatisfactory regarding the role of government and fiscal policy: “A good normative theory of fiscal policy in the presence of nominal rigidities remains largely to be done” (Blanchard 2008).

The academic literature on the effects of fiscal policy is scarce and divisive (Fontana 2009e). Whereas policymakers around the world are strongly supporting an increase in government expenditure in order to solve the deep financial crisis and economic recession of

2007–09, academics are not sure about the direction of the effects of fiscal interventions, let alone the magnitude of those effects. Giavazzi and Pagano (1990) have studied the effects of large fiscal contractions in Denmark and Ireland in the 1980s concluding that the large consolidations had strong expansionary effects on consumption and output. If this analysis is to be accepted, it suggests that countries like Portugal, Italy, Greece, Spain, and other similar EU countries with high public deficit, should actually reduce rather than increase their state interventions in the economy in the face of the current financial crisis and deep recession. According to Kuttner and Posen (2001), the idea of expansionary fiscal contractions was raised by policymakers in Japan in late 1996 to legislate a large increase in a value-added tax on national consumption, yet, by late 1997 Japan experienced a recession and a series of financial failures, the idea of expansionary fiscal contractions lost most of its appeal.

Academics and policymakers have now achieved a large agreement about the role of monetary policy and its effects on the economy. The NCM model has crystallized this agreement through the three-equation model, but there is nothing like approaching a convergence of views about fiscal policy.

The theoretical and empirical uncertainties about the direction and magnitude of fiscal interventions are compounded by the different forms of fiscal instruments. There is, in fact, a net contrast between the diversity of fiscal interventions and the uniformity of monetary policy interventions, which now take the universal form of changes in the short-run interest rate. In the face of such diverse and often divisive literature on the effects of fiscal policy, it is therefore not surprising that in the NCM model there is no explicit role for the government and fiscal policy. However, there is nothing intrinsically monetary in the nature of stabilization policy in the NCM model (Fontana 2009b). In other words, theoretically there is little or no reason to justify the current marginal role of fiscal policy in modern macroeconomics. If anything, looking at the set of equations 1–3 above, fiscal policy should actually have the most prominent role in the NCM model; the reason being that the role of the policy instrument in the NCM model can be played by any variable affecting components of the aggregate demand function and, prima facie, fiscal policy seems to be more direct in its effects compared to monetary policy.

Setterfield (2007) finds that Arestis and Sawyer (2003, 2004a, 2004b) are right to call attention to the comparative neglect of fiscal policy in NCM. Even if one accepts controversial features of the NCM model, such as its insistence on the existence of “natural” equilibrium values of real variables defined exclusively on the supply-side of the economy, and the paramount importance of creating an acceptable equilibrium rate of inflation through the process of inflation targeting, there appears to be both a potential role for fiscal policy in lending stability to these equilibrium values, and a distinct possibility that fiscal policy is more effective in this role than is monetary policy. At the very least, it would seem that the unquestioned privileging of monetary policy as the instrument for stabilization policy in NCM is inappropriate.

Sims (2002) suggests the most important component of inflation-targeting is the regular reporting of forecasts and of policy analyses by the central bank that the targeting regime entails. This supports bank policy by making it easier to preserve credibility in the face of shocks that create temporary increases in the inflation rate. By announcing a policy path and corresponding inflation path, the central bank may be able to convince people that the inflation will end without having to generate a recession. This regular reporting of forecasts also encourages probabilistic thinking and creates a demand, yet unsatisfied, for policy models that can generate realistic measures of uncertainty about their results. Some apparently unnecessary barriers to transparency of monetary policy persist. Other banks around the world are regularly reporting inflation and output forecasts without ill consequences, indeed with apparently good consequences. In the inflation targeting countries, internal consistency of forecasts and the level of discussion of policy would be elevated by switching to a practice of publishing forecasts in which inflation, output, and interest rates all appear and have been derived from a model to be mutually consistent. The usual objection is that this asks too much of policy boards that already have difficulty agreeing on just the current level of the policy rate. However the task of choosing among and adjusting several proposed time paths for the policy rate does not seem much more difficult than the problem of generating a skewed fan chart distribution that policy boards are already solving. So here again is an area where considerable progress could be had cheaply.

Some mainstream Keynesian economists, Allsopp and Vines (2005), and Blinder (2006), have shown dissatisfaction with the role of fiscal policy in the New Consensus. Whereas they have not challenged the preeminent position that monetary policy now holds in modern macroeconomics, they have maintained that there are circumstances under which monetary policy alone is a weak instrument of stabilization, and a combined monetary-fiscal strategy is needed. Indeed, in the case of the lower bound problem on the short-run interest rate (Krugman, 2005), or country-specific shocks in monetary unions (Kirsanova et al., 2007), some economists went so far to claim that fiscal policy must reclaim a dominant position as a stabilization policy tool (Symposium, 2005). In a similar way, some policy makers have also argued that there are circumstances when a combined fiscal and monetary stimulus provides broader support for the economy than monetary policy actions alone. For instance, this is the view of the Chairman of the Federal Reserve to boost the US economy and minimise the risk of a prolonged recession in response to the poor developments in financial markets, and a fragile outlook for the real economy.

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