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This paper seeks to look at the underlying framework of the open economy New Consensus models, providing a Post Keynesian critique. It outlines and explains briefly the main elements of and way of thinking about the macro-economy from the standpoint of both its theoretical and its policy dimensions.
There are a few problems and weaknesses with this particular theoretical framework. The critique is based on the summary from Philip Arestis, Malcom Sawyer, Alfonso Palacio -Vera and Giuseppe Fontana supported with the point of view of other post Keynesian economists. We focus here on the important aspects closely related to NCM (New Consensus Macroeconomics): the absence of banks, inflation, monetary policy from this theoretical framework, and the way the notion of the “equilibrium real rate of interest” is utilized by the same framework (Philip Arestis). The analysis is critical of NCM from Keynesian perspective.
A New Consensus in Macroeconomics (NCM) has emerged over the past decade or so and has replaced the IS-LM model. NCM has become highly influential in terms of current macroeconomic thinking and of macroeconomic policy, especially monetary policy. The birth of NCM was made possible after the collapse of the Grand Neoclassical Synthesis in the 1970s. New Keynesian macroeconomics was transformed into what have been labeled now as New Consensus Macroeconomics.
The policy implications of the NCM paradigm are important for the development aspect of macroeconomics. Price stability can be achieved through monetary policy since inflation is a monetary phenomenon and it can only be controlled through changes in the rate of interest. Philip Arestis (2007b) reviewed the open economy aspect of the NCM, which enables some attention to be given to the exchange rate channel of the transmission mechanism of monetary policy in addition to the aggregate demand channel and the inflation expectations channel. Even though NCM as a new way thinking of the macroeconomics, it is not without its problems. There are some issues that have been occurred at the NCM and being criticized by economist including post Keynesian economists.
The New Consensus Macroeconomics Model
Philip Arestis (2009) mentioned that the NCM is a framework which there is no role for money and banking and there is only a single rate of interest. The two key of assumptions that are worth to be known are that price stability is the primary objective of monetary policy and that inflation is a monetary phenomenon which can be controlled by monetary policy and this being the rate of interest under the control of the central bank.
Overview of the open economy NCM model
The equation also resembles the traditional IS function, but they differ substantially. The original IS/LM curve represents demand and supply for goods and service. The NCM IS curve emanates from intertemporal optimization of expected lifetime utility that reflect optimal consumption subject to budget constraint. The marginal rate of substitution between current and future consumption are ignoring uncertainty and adjusted for subjective rate of time discount, is equal to the gross real rate of interest. Both lagged adjustment and forward looking elements. The inter-temporal optimization utility is based on assumption that all debts are ultimately paid in full and removing all the credit risk and default. All inter-temporal optimization utility would be accepted in exchange. There is no need for a specific monetary asset. All fixed interest financial assets are identical so that there is a single rate of interest in any period. Single rate of interest may change borrowing and saving and it doesn’t need for financial intermediaries such as commercial bank or other non bank financial intermediaries. It’s a non monetary model so that private banking institutions or monetary variables are not essential in the NCM framework.
There is some question about the role for investment. Basic analysis is taken for households optimizing their utility function in terms of time path of consumption. Investment is used for the expansion of capital stock to increase income. Investment ensures the adjustment of capital stock to the predetermined time path. By assumption there is no impact on the capital stock. It’s still lack of any effect of variations in private spending upon the economy’s productive capacity (Woodford 2003:352).
Phillips curve with inflation based on current output gap, past and future inflation, expected changes in nominal exchange rate and expected world price. The model allows for sticky prices, the lagged price level in this relationship, and full price flexibility in the long run. It is assumed that b2 + b3 + b4 = 1 in equation 2, it will imply to a vertical Phillips curve. The real exchange rate affects the demand for imports and exports, and also the level of demand and economic activity. The term in equation 2 captures the forward-looking property of inflation. It implies that the success of a central bank in containing inflation depends not only on its current policy stance, but also on what economic agents perceive that stance to be in the future.
The economic agents are in a position to know how economy work & the consequences of their actions that take place today for future, so they need to know how monetary authorities would react to macroeconomic development. The practice of modern central banking can be described as the management of private expectations. The term can be seen to reflect central bank credibility. If a central bank can credibly signal its intention to achieve and maintain low inflation, then expectations of inflation will be lowered and this indicates that it may be possible to reduce current inflation at a significantly lower cost in terms of output. Therefore with this way the monetary policy operates through expectations channel. This forward looking Phillips curve could produce credibility problems known as inflation bias and the stabilization bias. The inflation bias can come about in view of imperfect competition and the stabilization bias is due to lack of central bank reputation and credibility therefore inability to influence inflation expectations through the expectations channel (Gali and Getler 2007).
Monetary policy where nominal interest rate based on expected inflation, output gap, deviation of inflation from target and equilibrium real rate of interest. The operating rule, implies that policy become a systematic adjustment to economic development in predictable manner. It says that nominal rate of interest is the sum of the real interest rate and expected inflation and therefore it may incorporate a symmetric approach to inflation targeting.
Implying that monetary policy operates with random shocks. In the tradition of Taylor rules where the exchange rate is assumed to play no role in the setting of interest rate except the changes in the exchange rate have an effect on the rate of inflation which would feed into the interest rate rule. The neutrality of money property is assumed, so that doubling the stock of money would have no effect and consequently, the stock of money is merely a residual in this model.
There are 4 further characteristics of this equation.
The first is that the level of economic activity fluctuates around a supply side equilibrium, where the supply side equilibrium is unaffected by the path of aggregate demand. In the model this equilibrium corresponds to =0 and inflation is equal to target rate and real interest rate is equal to RR*. This can be expressed in terms of the non accelerating inflation rate of unemployment (NAIRU). The NAIRU is a supply side phenomenon closely related to the labor market.
Unemployment below the NAIRU → higher rates of inflation
Unemployment above the NAIRU → lower rates of inflation
In the long run there is no trade off between inflation and unemployment and the economy has to operate on average at the NAIRU if accelerating inflation is to be avoided. Also in the long run, inflation viewed as a monetary phenomenon in that the pace of inflation is connected with the rate of interest. In (King, 2004b, p. 1) it is said that ‘Monetary policy determines inflation and the supply capacity of the economy determines the rate of growth’, summary from the argument by the Governor of the Bank of England. The control of money supply is no longer considered as an instrument of monetary policy for 2 reasons: firstly, monetary control may not be possible because money supply cannot be controlled and secondly, to predict effects on inflation in monetary targeting, it requires a stable demand for money. The instability of the demand of the money makes the impact of changes in the money supply a highly uncertain channel of influence that clearly monetary targeting requires sufficient knowledge of the parameter that underpin the demand of the money. These parameters, especially the interest rate elasticity of the demand for money may be unstable so that information content of money for future inflation would be very low and then money will become to be a good predictor of future inflation. Gali and Gertler in 1999 had argued that monetary targeting is associated with greater inflation variability in output, for it induces higher volatility in interest rates.
The second is that the essence of Say’s law holds, namely the level of effective demand does not play an independent role in the long run determination of the level of economic activity and adjusts to underpin the supply side determined level of economic activity which correspond to the NAIRU. The implication of this analysis is that there is a serious limit of monetary policy and monetary policy cannot have permanent effects on the level of economic activity but it can only have temporary effects. The third is that exchange rate considerations are postulated not to play any direct role in the setting of the interest by the central bank. The exchange rate is an important channel through which the effects of interest rate can operate. It transmits both certain effects of changes in the policy instrument, interest rate and various foreign shocks. Exchange rate targeting is thought to be effective only when it is credible and this depends to a large extent on domestic macroeconomic policies. With that relation IT is thought to operate better than exchange rate targeting. The implement of IT may lead to a more stable currency since it signals a clear commitment to price stability in a freely floating exchange rate system. But that doesn’t mean that exchange rate should be forgotten because by monitoring the exchange rate into decisions on setting monetary policy is thought desirable for estimation. The fourth is that the monetary policy rule in equation 3 embodies the notion of an equilibrium rate of interest, labeled as RR* and indicates that when inflation is on target and output gap is zero, the actual real rate set by monetary policy rule is equal to this equilibrium rate. This means when the central bank has an accurate estimate of RR*, the economy can be guided to an equilibrium of the form of a zero output gap and constant inflation.
The New Consensus Model Policy Implications
The major economic policy implication of the NCM is that monetary policy has been upgraded in the form of interest rate policy, where a major objective of policy is “maintaining price stability” (King 2005: 2). This policy is undertaken through inflation targeting (IT). An important assumption that permits monetary policy to have the effect that it is assigned by the NCM is the existence of temporary nominal rigidities in the form of sticky wages, prices, and information, or some combination of these frictions, so that the central bank, by manipulating the nominal rate of interest, is able to influence real interest rates and real spending in the short run.
The important aspect of IT is the role of expected inflation shown in equation 3. The inflation target itself and the forecasts of the central bank are thought of as providing a strong steer to the perception of expected inflation. Given the lags in the transmission mechanism of the rate of interest to inflation, and the imperfect control of inflation, inflation forecasts become the intermediate target of monetary policy in this framework, where the ultimate target is the actual inflation rate (Svensson 1997 and 1999). In these circumstances “The central bank’s forecast becomes an explicit intermediate target. Inflation targeting can then be viewed as a monetary policy framework under which policy decisions are guided by expected future inflation relative to an announced target.” (Agenor 2002:151)
The inflation forecast IT, however may create a serious problem, which is due to the large margins of error in forecasting inflation and by signaling the uncertainty inherent in economic forecasts and this can damage the reputation and credibility of central banks. There is still the problem of how interest-rate projections are undertaken. The two types that used by central banks constant interest rate projections or projections based on market expectations, are problematic, as Woodford (2007) highlights. The main problem common to both approaches to projections is that the nominal interest rate will remain fixed in the future regardless of how inflation evolves in the first case; or that it is exogenously determined, again unaffected by inflation in the second case and either projection cannot be sustained. Woodford (2007) suggests that a way forward would be the adoption of a forecast IT approach, which would also be concerned with output stabilization, but even in this approach the problems just alluded to would still be there.
There can be a self-justifying element though to inflation forecasting in so far as inflation expectations build on forecasts, which then influence actual inflation. The centrality of inflation forecasts in the conduct of this type of monetary policy represents a major challenge to countries that pursue IT. Indeed, there is the question of the ability of a central bank to control inflation. Oil prices, exchange rate gyrations, wages and taxes, which can have a large impact of inflation, and a central bank has no control over these problems. To the connection between the source of inflation and those factors IT policy will be problematic because negative supply shocks are associated with rising inflation and falling output. It is also true that such inflation forecasts are not always available (Goodhart 2005). Central banks decide on changes in interest rates in view of forecasts of future inflation as it deviates from its target along with output as it deviates from potential output, but such forecasts are not easily available or, when they are published, this is undertaken on an ex post basis after the decision on interest rate change has been undertaken.
There is still the question of the extent to which NCM is useful for policy analysis. Chari, Kehoe, and McGrattan (2008) argue that the NCM models are not useful for policy analysis. From the point of view of this contribution, the relevant criticism applies to the use of equation 3 and the manipulation of the short-term rate of interest for monetary policy purposes. The assumption is that the short-term rate of interest is stationary. This assumption implies, of course, that the long-term rate of interest is smoother than what the data reveal. This implies that NCM models do not identify the source of inflation persistence and expectations accurately and therefore conclusions on the costs of disinflation are not accurate. The NCM policy advice is thereby erroneous.
Assessing the NCM from a Keynesian Perspective
Post-Keynesian economists are critical of a number of important features of the New Consensus model described above. We can divide these criticisms into two distinct areas.
Firstly, many post-Keynesians are critical of the IS curve which underlies the analysis, the efficiency of monetary policy in the short run and monetary neutrality in the long run.
Secondly, all post-Keynesians reject the concept of a vertical long run Phillips curve.
- Post-Keynesians, following Keynes, reject the simple interest rate/investment relation implied in the IS model. They believe, that the relation between interest rates and investment is more complex than the simple functions assumed in the IS relation. In addition, many economists, following Keynes (1936, pp.202-8) once again, do not think that there is a one for one relationship between the short term interest rate set by the central bank, and the long term interest rates or the lending rates which affect the components of aggregate demand. In fact, Kalecki argues, partly for this reason, that “it is the quantity of credit rather than its price which influences investment” (Kriesler 1997). Empirically, evidence suggests that the interest elasticity of investment is non-linear and asymmetric (Taylor 1999). While an increase in interest rates is likely to reduce investment in times of economic booms (u > un), the reverse is not true, as is well illustrated by the case of Japan in the 1990s. Reductions in interest rates are unlikely to stimulate investment in times of recession.
- Partly for this reason, post-Keynesians, as do many monetary economists, believe that monetary policy takes a considerable amount of time to have any effect, especially on the inflation rate, unless interest rates are changed by drastic amounts. Monetary policy is known to be a particularly blunt instrument, with long and variable lags. Monetary policy acts upon inflationary forces by weakening aggregate demand and labor conditions (Arestis and Sawyer 2004).
- In contrast to some New Keynesian authors who believe that “short-run non-neutrality and long-run neutrality are … as well accepted as any proposition in monetary economics” (Mankiw 1999, p.72), post-Keynesians reject the so-called neutrality of money in both the short run and the long run.
- Post-Keynesians deny that logic requires that in the long run the actual rate of capacity utilization ought to converge towards an exogenously given normal rate of capacity utilization. Kaleckian economists “argue in favor of an endogenous determination of capacity utilization even in the long run on the ground that firms may not have a unique level of capacity utilization but are content if it remains within a band, or that ‘normal’ ‘desired’ capacity utilization itself may be endogenous”.
- Post-Keynesians reject the notion of a supply-determined natural growth rate. This critique applies equally to the classical model and to the endogenous growth models, where saving leads the way, and to the New Consensus model, where the natural rate is determined by population growth and technological progress, as in the Solow model (Taylor 2000, p. 91). Post-Keynesians believe that if the concept of a natural growth rate is to be of any assistance, it is determined by the path taken by the actual growth rate, as pointed out very early in Kaldor (1960, p. 237).
- Post-Keynesians reject the vertical long-run Phillips curve. In addition, many are even skeptical about short-run trade-offs between GDP/capacity and inflation. There are two reasons for this. First, there is a large range of capacity utilization rates which are consistent with an absence of demand-led pressures, for reasons tied to the absence of decreasing returns over a large range of production levels (Lavoie 2004, p. 24). Second, it is believed that with “co-ordinate wage bargaining a 8 constant inflation rate becomes compatible with a range of employment levels, and the NAIRU as the short run limit to employment is no longer unique” (Hein 2002, p. 314).
In particular, many post-Keynesians (but not all) are dubious of the notion that inflation needs to rise with increased capacity utilization. Changes in capacity utilization need only be inflationary at levels of capacity near full utilization. Similarly, only at very low levels of capacity would we expect some reduction of the inflation rate. In this case, the Phillips curve would be horizontal for large ranges of output and employment (Freedman, Harcourt and Kriesler 2004). The mechanism whereby the upward sloping short run Phillips curve is transmitted to a vertical long run Phillips curve will not hold in the case of a horizontal Phillips curve, as increased output will not, in the short run, be inflationary. In this case, the long run Phillips curve will also be horizontal over the relevant range. In such cases, what is crucial is cost-inflation, as reflected in the rising costs of commodities, as well as the credibility of the target inflation rate set by the monetary authorities.
No Banks and No Money
NCM model is characterized by an interest-rate rule, where the money market and financial institutions are typically not mentioned let alone modeled, where the money market and financial institutions are typically not mentioned let alone modeled. The downgrading of monetary aggregates in NCM models has gone too far even for non-monetarists (see, for example, Goodhart, 2007). It is also the case that in the NCM model there is no mention of banks in the analysis. But, then, banks and their decisions play a considerably significant role in the transmission mechanism of monetary policy. Furthermore, decisions by banks as to whether or not to grant credit plays a major role in the expansion of the economy, in the sense that failure of banks to supply credit would imply that expansion of expenditure cannot occur. It is also the case that in the real world many economic agents are liquidity constrained. They do not have sufficient assets to sell or the ability to borrow. Their expenditures are limited to their current income and few assets, if any. Consequently, this perfect capital market assumption, which implies the absence of credit rationing (meaning that some individuals are credit constrained), means that the only effect of monetary policy would be a ‘price effect’ as the rate of interest is changed. The parts of the transmission mechanism of monetary policy, which involve credit rationing and changes in the non-price terms on which credit is supplied, are excluded by assumption.
The perceived riskiness of borrowers and uncertainty clearly implies that a single interest rate cannot capture reality. A whole schedule of interest rates is more appropriate and realistic.
- In the downswing of the cycle, official interest rates decline, but risk premia rise. It thereby becomes ambiguous as to the way interest rates move;
- In the upswing of the cycle, official interest rates rise on the whole, but risk premia fall.
It would be wise to cross-check for the combined effects of official changes in the rate of interest and risk aversion. This, it is argued, can be undertaken by studying the time path of money and credit aggregates (Goodhart 2007). These observations clearly suggest that there is a disjuncture between the NCM analysis and the role of monetary policy. The NCM model is thereby incomplete and unsuitable for monetary-policy analysis. Indeed, it “leaves open the underlying question of how the central bank manages to fix the chosen interest rate in the first place” (Friedman 2003: 6).
The question is how real money balances should enter equation (1). This can be undertaken through the assumption that marginal utility of consumption depends on real money balances. The standard way is to resort to the money-in-the-utility function models, whereby real money balances are supposed to affect the marginal utility of consumption and, as such, enter equation (1) in the above six-equation model. This is the non-separability principle. A utility function is additively separable between consumption and real money balances if it can be separated into two functions:
- containing only consumption;
- the other only money.
If the utility function is not additively separable then real balances will enter equation (1). Early evidence produced by Kremer et al. (2003) in the case of Germany, supports the non-separability assumption. Subsequent studies, however, reach the opposite conclusion. The empirical work undertaken by Ireland (2004), Andres et al. (2006) and Jones and Stracca (2008) suggests that there is little evidence that supports the inclusion of real money balances in equation (1) in the cases of the US, the euro area and the UK. Friedman (2003) appears to be correct when he argues that without “integrating the credit markets into both the theoretical and the practical analysis of monetary policy is going to be harder” (p. 6).
Monetary Policy Issues
Economic policy designed to eliminate bubbles would lead to “financial repression,” a very bad outcome in this view. The experience with financial liberalization is that it caused a number of deep financial crises and problems unparalleled in world financial history, culminating to the financial crisis of August 2007. It is true that over the recent past, when bubbles emerged, monetary authorities of the major central banks have argued that monetary policy should not interfere with the free functioning of financial markets. Proactive monetary policy under such circumstances would require the authorities to outperform market participants. Central bankers prefer to deal with the consequences of the burst of a bubble by minimizing the damages to the real economy-an approach that has been adopted by all major central banks around the world.
Net wealth is defined as the assets (financial and tangible) less the liabilities of the personal sector, which include mortgage debt and consumer credit. Such a wealth target deals with the consequences of the rise and fall of asset prices in the economy and is not a target of asset prices per se-equities or houses. Net wealth is an ideal variable to monitor (and control) bubbles simply because it is at the heart of the transmission mechanism of asset prices and debt to consumption.
Monetary policy should be tightened / loosened as the ratio of net wealth-to-disposable income, over a period of time, is above/below a predetermined threshold. This would allow asset price booms, but it would prevent them from becoming bubbles that will ultimately burst with huge adverse consequences for the economy as a whole. Such an approach will also help regulate financial engineering, since the central bank will monitor the implications of financial innovations as they impact net wealth, even if it is ignorant of them.
Another serious omission by the NCM supporters is the role of what Keynes (1936) described as “animal spirits,” namely the possibility that individuals act irrationally and for noneconomic reasons. Failure to recognize the importance of “animal spirits” in monetary policy can lead to wrong conclusions, for under such circumstances, monetary policy can become ineffective. Witness the experience since August 2007, over which period interest rates have been reduced substantially, but have had a very feeble effect.
A Further omission is that monetary policy may also influence aggregate supply through changes in the rate of interest. Fixed and working capital may need financial resources since current inputs should be paid before output can be sold and these resources carry financial costs. Therefore, interest rate paid on working capital affects production costs and, thus, the supply side of aggregate output. A number of writers provide evidence of this “cost channel” of monetary policy. Chowdhury, Hoffman, and Schabert (2006) is a recent contribution that restates the importance of this particular channel of monetary policy and provides relevant evidence in its support.
The Equilibrium Real Rate of Interest
The equilibrium real rate of interest plays a crucial role in the NCM. The discrepancy between the actual and the equilibrium rate of interest has been termed the real interest rate gap and can be used to evaluate the stance of monetary policy. It is thereby a useful theoretical concept in the analysis of the relationship between the independence of monetary policy and economic fluctuations (Weber, Lemke, and Worms 2008). In terms of the six equations above, and equation (3) in particular, it is clear that the equilibrium real rate of interest secures output at the supply equilibrium level (zero output gap) consistent with constant inflation. Another way of explaining this result is to say that when the real rate of interest is reached, then there is no problem of deficient (or indeed excessive) aggregate demand.
The real interest rate is at an equilibrium level of RR*. This equilibrium rate is often seen to correspond to what is called the Wicksellian ‘natural rate’ of interest. Wicksell (1898) distinguished between the money rate of interest (as observed) and the ‘natural rate’ of interest, which was the interest rate that was neutral to prices in the real market, and the interest rate at which supply and demand in the real market was at equilibrium. Although it is not self-evident from the model outlined above, this ‘natural rate’ of interest equates savings and investment and does so at a zero output gap. This is implicitly assumed to be consistent with the full employment of labor in that flexible real wages would permit the labor market to clear with full-employment compatible with the zero output gap.
It is also the case that the use of RR* in NCM models with the emphasis on price stability provides an important benchmark for monetary policy analysis in the context of models with a single rate of interest, with no banks and no monetary aggregates. Under these assumptions, the reaction of the interest rate policy instrument to movements in RR* can ensure price stability. Wicksell’s (1898) natural rate of interest thesis, however, recognises the existence of different interest rates that can determine aggregate demand. For example, loan rates are important when bank credit is the main source of financing for firms. Under such circumstances where the rate of interest on bank loans differs from the policy rate of interest, RR* may not be a useful indicator for monetary policy. The crucial distinguishing assumption in this context is whether markets are frictionless or not. Indeed, in markets characterized by friction, a further implication is that monetary policy exerts real effects even in the long run. Consequently, “it might be difficult for a central bank that is uncertain about the true model of the economy to identify its movements and to use it as regular indicator for the conduct of monetary policy” (p. 33).
Similarly, for every rate of interest there is a level of employment for which the rate is the ‘natural’ rate, in the sense that the system will be in equilibrium with that rate of interest and that level of employment. Thus it was a mistake to speak of the natural rate of interest or to suggest that the above definition would yield a unique value for the rate of interest irrespective of the level of employment.
The NCM model portrays an economy in which the interest rate can be adjusted to secure equilibrium in terms of a zero output gap and a balance between aggregate demand and aggregate supply (alternatively between planned savings and planned investment). The rate at which this materializes is, to repeat, the real equilibrium rate of interest. This is an ‘anchor’ or benchmark for monetary policy and corresponds to the intercept in equation (3). But it is the case that a shift in the state of confidence and expectations leading to a shift in the investment schedule would lead to a shift in the real equilibrium rate of interest. The case of equation (3) requires the
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