Lect 1

 

 

24Introduction and heritageBriefly, for the long-run, the modern classical model is a compact form of the Walrasiangeneral equilibrium model, so that its implications are consistent with those of the latter.It provides the benchmark conclusions, consistent with the stylized facts, on the long-runrelationship between money and output. For the short-run, the modern classical modelproduces transient and self-correcting deviations from full employment, so that there is nosensible role for systematic monetary and fiscal policies in both the short-run and the long-run. For the short-run, the implications of the model for output and unemployment are notvalid.V. New classical modelThe new classical model imposes the assumption of Ricardian equivalence on the modernclassical model. This assumption is an aspect of intertemporal rationality and the Jeffersonian(democratic) notion that the government is nothing more than a representative of its electorateand is regarded as such by the public in making the decisions on its own consumption. Sucha government is taken to provide just the goods that the population wants and its bonds,held by the public, are regarded by it (the public) as a debt owed by the public to itself.The implications of these assumptions are that the public debt is not part of the net worth ofthe public and that the public increases its private saving by the amount of a bond-financedgovernment deficit. The latter implies that such deficits do not affect aggregate demand inthe economy, and therefore do not change nominal or real GDP (see Chapter 14 for thisanalysis).Of all the macroeconomic models in the classical paradigm, the new classical model is themost restrictive one because of its assumption of Ricardian equivalence.The major alternative to the classical paradigm is the Keynesian one, which has its ownset of models.1.11 The Keynesian paradigm and the Keynesian setof macroeconomic modelsUsing the analogy between the economy and the human bodyThe fundamental difference between the classical and Keynesian paradigms is that while theformer focuses on the healthy state of the economy,32the latter focuses on the pathology –especially the system-wide pathology – of the economy,33which may not fully or soonrecover34from a shock to it (Solow, 1980, 1991). The Keynesian paradigm recognizes thatthe economy may sometimes have equilibrium in all markets, but does not assert that thisoccurs always or most of the time. Further, even if there is equilibrium, it may not be thecompetitive equilibrium of the Walrasian general equilibrium model because the economymay have a different structure or because of group behavior. As a consequence, the Keynesianparadigm implies that when the economy is outside the Walrasian general equilibrium, thegovernment and the central bank may be able to improve on its actual performance throughtheir policies.32 That is, with clearance of all markets.33 That is, when the economy is thrown out of equilibrium.34 That is, return to equilibrium in all markets.

Introduction25We have at various places drawn an analogy between the equilibrium state of theeconomy and the healthy state of the human body, and that between the deviations fromequilibrium and the pathology of the human body. The human body sometimes functions inperfect health and sometimes suffers minor illnesses of a brief expected duration and withoutany need for the help of a professional (doctor). But it could sometimes suffer from seriousillnesses from which the recovery may occur but be slow and be speeded up by the helpof a doctor, or suffer ones from which there is no recovery without the intervention of aspecialist. There may also be illnesses from which there is no cure and no recovery, but wedo not include this limiting state within our analogy. Among the serious illnesses, we notethere can be many possibilities: infection with bacterium A rather than B, infection by abacterium versus a virus, an infection versus a collapse of a lung, a collapse of a lung ratherthan a heart attack, etc. The list of the possible sources of the deviations from the healthystate can be endless.Comparing the approach of the two paradigms to the pathology of the economy andapplying our analogy, when the classical paradigm does envisage deviations away from thehealthy state of the economy, they are supposed to beminor, transitoryandself-correcting.Under it, while the economic body may become ill (that is, deviate from the full-employmentstate), the illnesses are never serious or long lasting, so that a trip to a doctor either neverbecomes necessary or will not really be worth the hassle and the cost. By comparison, theKeynesian paradigm envisages the possibility of more serious departures from the generalequilibrium (healthy) state of the economy. Its deviations from equilibrium can be due todifferent pathogens or breakdowns of the different components of the economy. Further, itallows for the possibilities that the recovery may be slow and could be speeded up with experthelp (from the government and the central bank), or that it may never occur without such help.Using the analogy with the human body, we offer the following two fundamental – andhighly plausible – axioms on the performance of the macroeconomy.α. The economy, like the human body, may sometimes function well and sometimes not.Hence, it is essential to study both states, with the former serving as the benchmark for thetreatment of the latter.β. When the economy, just like the human body, is not functioning properly, the causes,symptoms and effective treatments of the malfunction can be quite varied.The justification for theβaxiom is that one cannot plausibly attribute all possibleillnesses to a single underlying cause or attribute all potential causes to an overarching singlesource. An implication of theβaxiom is that since the Keynesian paradigm focuses on thepathology of the economy, it cannot properly be encapsulated within one model with one rootpathogen. Hence, more than the classical paradigm and its models, which are almost linearor hierarchical in their relationship, the Keynesian paradigm, if it is to do its job properly,has to be a disparate and, at best, a rather loose collection of models.To reiterate, by the nature of their attempts to deal with the pathology of the economy,the Keynesian models have to be, and are, quite varied. If they are to do their job properlyof dealing with the different types of deviations, such models need not – in fact, must not –all focus on the same types of deviation from the overall equilibrium state or make the samerecommendations for policies to address these deviations. Unfortunately, this aspect of theKeynesian paradigm is often not recognized. Frequently, the presentations and discussions

26Introduction and heritageof the Keynesian models miss this requirement for variety within the Keynesian paradigmand seek to force the various Keynesian models into a single format or view it as one unifiedmodel. The danger in doing so is that a single prescription could be given as a cure-all forvery disparate causes and be inappropriate for many.35Chapter 15 provides a small numberout of the variety of Keynesian models in the literature.Frequent themes in the Keynesian modelsA common concern of the Keynesian models is with the potential for involuntaryunemployment, which produces deviations of actual employment from its full-employmentlevel. Consequently, these models tend to pay special attention to the structure of the labormarket, its demand and supply functions and whether or not equilibrium holds between them.Within this focus, many Keynesian models assume nominal wage rigidity, often justified bytheories of nominal wage contracts between the workers and the firms. However, there arealso Keynesian models that consider the deviations from general equilibrium that could occureven when the nominal wage is fully flexible.The assumption of the rigidity or stickiness of prices in the economy is often regarded asanother common theme of Keynesian models. While this assumption can impose deviationsfrom a general equilibrium, it need not be the only cause of or reason for potential deviations.Therefore, models within the Keynesian paradigm need not, and should not, all be based onprice rigidity. There is, consequently, also a place for Keynesian models that consider thedeviations from general equilibrium that could occur even when the prices are fully flexible.Chapter 15 provides a look at some of the Keynesian models. While some of the modelspresented there assume equilibrium in the macroeconomic models, others do not do so. Whilesome assume a special form of the labor supply function, others assume a different form.While some assume – or imply on the basis of nominal wage contracts – nominal wagerigidity of some form, others do not do so. Similarly, while some models assume or implyprice level stickiness or rigidity, others do not do so. This variety in modeling within theKeynesian paradigm becomes even more evident when the Keynesian and the neoKeynesianmodels are compared.To reiterate, the variety of modeling, though perplexing and sometimes seeminglycontradictory, in the Keynesian paradigm is essential to the proper study of the pathology ofthe economy. It would be a mistake to force the Keynesian models into a single straightjacket,even though this would provide an attractive means of comparing the classical and Keynesianparadigms as a whole.1.12 Which macro paradigm or model must one believe in?While most textbooks and economists would consider this to be a legitimate question, ourremarks above suggest that it is an improper, and quite likely a dangerous one, for the35 An example of this is the economists’ inappropriate policy prescriptions, based mainly on traditional classicalideas, during the early stages of the Great Depression in the 1930s. These worsened the depth of the fall in GDPand lengthened the depression – and contributed to the demise of faith in the traditional classical ideas. Anotherexample of inappropriate policies, based on the aggregate demand management approach in the Keynesianparadigm, occurred in response to the supply shocks of 1973 and 1974. This led to stagflation and contributedto the demise of faith in the Keynesian paradigm.

Introduction27formulation of economic policies. The proper study of the economy requires the study ofboth its healthy state and its diseases. Since we cannot be sanguine that the economy willalways operate in general equilibrium, the models of the Keynesian paradigm must not beneglected. Since we cannot be sure that the economy will never be in general equilibrium,the models of the classical paradigm must also not be neglected. Both paradigms have theirrelevance and usefulness. Neglecting either of them can lead to erroneous policies that imposehigh costs on the economy and its citizens.For the practical formulation of monetary policy, the relevant and “interesting” questionis not the a priori choice between the classical and the Keynesian models, but rather theperpetually topical one:what is the current state of the economy like and which model ismost applicable to it?There is rarely a sure answer to this question. Consequently, thejudgment on this question and the formulation of the proper monetary policy are an art,not a science – and very often rest on faith in one’s prior beliefs about the nature of theeconomy.While one cannot dispense with one’s beliefs and economists rarely give up theirconception of the nature of the economy, the fundamental role of economics must be kept inmind. This is that economics is a positivist science, with the objective of explaining the realworld. This is done through its theories, which, by their very nature, must be simplifications –more like caricatures – of reality. As such, they may be valid or not, or be better for explainingsome aspects of reality rather than others. Intuition and econometrics are both needed anduseful in judging their validity and relative value. In brief, one should not hold a dogmaticbelief in one theory for all purposes.A side implication of the positivist objective of economics is the normative one – i.e.the ability to offer policy prescriptions to improve on the performance of the economy,hopefully as a means of increasing the welfare of its citizens. Both the Keynesian and theclassical paradigms are essential to these roles.One way of judging the extent to which the macroeconomic theories are valid or applicablefrom a monetary perspective is to compare their implications with the stylized facts of theeconomy.Some stylized facts on money and outputStylized facts on the relationship between money and output are general conclusions aboutthis relationship, established on the bases of intuition and empirical studies. Some of theseare:1   Over long periods of time, there is a roughly one-to-one relationship between the moneysupply and the price level.2   Over long periods of time, the relationship between inflation and output growth is notsignificant.3   Over long periods of time, the correlation between money growth rates and nominalinterest rates is very high.4   Changes in money supply and interest rates have a strong impact on aggregate demand.5   Over short periods (a few years), increases in aggregate demand, because of increasesin money supply or reductions in interest rates, increase output. This effect builds to apeak and then gradually decreases, so that there is a “hump-shaped pattern” of the effectof monetary policy on output, with the maximum increase in output occurring with a laglonger than one year, sometimes two or more years.

28Introduction and heritage6   The impact of an expansionary monetary policy on prices occurs with a longer lag thanon output, so that the impact of monetary shocks on output does not mainly occur throughprice movements.7   Contractionary monetary policies initially reduce output significantly, often for longerthan a year and sometimes for several years. The cost in terms of output tends to belarger if inflation is brought down gradually rather than rapidly. It is lower if the policyhas greater credibility.Using analytical terminology, money is not neutral in the short-run but is neutral in thelong-run. These conclusions hold for monetary policy, whether it changes the money supplyor interest rates. Chapter 14 provides a more detailed list of the stylized facts on the impactof monetary policy on output.1.13 Walras’s lawFor the closed economy, the standard models of the two paradigms assume four goods:commodities,money,bonds(i.e.allnon-monetaryfinancialassets)andlabor.Therefore,thereshould be four equilibrium statements, one for each of the four goods, and the correspondingfour curves in the diagrammatic expositions. However,Walras’s law(see Chapter 18) ensuresthat equilibrium in any three out of the four markets implies equilibrium in the fourth one, sothat one of the markets need not be explicitly studied. This allows the diagrammatic expositionto work with only three equations/curves. Current macroeconomic analysis usually doesso for those of the commodity market (the IS equation/curve), the money market (the LMequation/curveifmoneysupplyistheinstrumentofmonetarypolicybuttheIRequation/curveif the interest rate is the instrument of monetary policy) and the aggregate supply function(AS equation/curve) or, in its place, a price–output adjustment equation, as in Chapters 14and 15. In this procedure, the bond market is the one excluded from explicit analysis, sothat the bond market curve is not usually drawn. It does, however, remain implicitly in theexposition and can be deduced from the other curves.361.14 Monetary policyThe standard assumption of monetary analysis was that the central bank exercises controlover the economy by exogenously controlling the money supply. In this case, the appropriateanalysis of aggregate demand is called IS–LM analysis, since the analysis of the moneymarket generates the IS equation/curve. However, for certain types of economies, controllingthe economy’s interest rate may be a surer way of controlling aggregate demand than itsmoney supply. The central banks of several developed economies, including those of theUnited States, Canada and Britain, now seem to rely more on the interest rate rather than onthe money supply as the primary monetary policy instrument.37For their economies, the LMcurve is not appropriate. Instead, the analysis generates an IRT (interest rate target) curve,which, in addition to the IS curve, determines the aggregate demand in the model. The IS–LMand IS–IRT analyses are set out in Chapter 13.36 This is done in Chapter 19.37 This is also so for the European Central Bank, which claims to treat the interest rate as its primary monetarypolicy instrument but also monitors monetary aggregates.

Introduction29If the central bank sets the interest rate as its exogenous monetary policy instrument,it must be willing to supply the amount of money demanded at that interest rate. It cando this by appropriate changes in the monetary base, either of its volition or by allowingcommercial banks to borrow from it. In this case, the money supply becomes endogenous tothe economy.1.15 Neutrality of money and of bondsNeutrality of money (and credit/bonds) is the proposition that changes in the money supplyand monetary policy do not alter output and employment, as well as the real values of manyother real variables. For the short run, most models do not imply neutrality. However, asChapters 13 to 15 show later, the reasons for such non-neutrality differ between the twoparadigms and often also among the models of each paradigm. Note that in the long-runanalyses of most models, whether in the classical or the Keynesian paradigm, money andcredit are neutral, which is consistent with the stylized facts on the economy set out in Section1.12 and also in Chapter 14.Money and credit (non-monetary financial variables) are usually not neutral in theshorttermin real-world economies. Sudden shifts in the availability of money and credit are amongthe most important reasons for fluctuations in output and unemployment. Notable examplesof such non-neutrality are provided by currency, credit and exchange crises, which originatein the financial sector and spread to the real sectors of the economy.An illustration: the subprime crisis of 2007 in the USAThe “subprime crisis” originating in the United States in 2007, and its impact on the realsectors of the US and world economies, provide a compelling illustration of the non-neutrality of both money and credit in the economy. Subprime loans in this context wereloans made as mortgages to borrowers who were poor credit risks in terms of their incomesand the collateral that they could provide. However, when house prices were rising sharply,such mortgages seemed to be a good bet for both borrowers and lenders. House pricesrose sharply from 2002 to 2006, at some point becoming a “bubble.”38These mortgageswere bundled into “asset-backed corporate securities,” which were sold in financial marketsand held by a wide variety of financial firms, especially investment bankers, both in theUSA and in other countries. These securities were used, in turn, to back up short-termcommercial securities sold by financial firms to corporations as liquid, safe investments.As the bubble in US house prices began to collapse in 2006 and house prices fell, theconcern over defaults by mortgagees sharply reduced the demand for mortgage-backedcorporate securities, as well as the funds made available for loans in this market.39Thisprocess also increased the general awareness of risk and the risk premium – labeled as there-pricing of risk – for other types of bonds, so that the ability of households and firmsgenerally to obtain funds for their expenditures became curtailed and the cost of external38 Prices are said to have a bubble if they exceed the price implied by the fundamentals of demand and supply inthe market.39 The securities backed by risky mortgages are very small compared with the financial assets of banks and othereconomic agents, but the uncertainty about how much of such securities is held in a particular firm’s portfoliocreates a hidden risk and increases the risk to lenders of providing further credit to it.

30Introduction and heritagefunds increased.40These made it difficult for households to buy houses,41as well as makingit difficult for some corporations to finance their short-term operations,42which threatenedto reduce production and force the US economy into a recession. The US Federal ReserveSystem and the European Central Bank, as well as the central banks in many other countries,reacted to the crises in the credit markets by measures to substantially increase the moneysupply, as well as by reductions in interest rates. In August 2007, while there was considerableuncertainty in the impact of the subprime crisis in financial markets on the real sectors of theeconomy, there was a general consensus among economists, market analysts, governmentsand central bankers that, barring appropriate and aggressive monetary policies, the financialcrisis would result in a recession in the United States and that this would spread to the worldeconomy.The impact of the subprime crisis on economic activity, the monetary responses to it andthe assessments of the economics profession, as well as those of central bankers and others,clearly show that:•   The consumption and production sectors of the economy depend vitally on the creditsector, so that the supply of credit in the economy is not neutral.•   The supply of credit is not independent of the money supply and interest rates, whichare the instruments of monetary policy, so that monetary policy is also not neutral.To conclude, realistic short-run models of the economy need to embody assumptionsabout the credit and money markets, and the links between them and consumption andproduction sectors, that are necessary to imply such non-neutrality. However, few do so.Chapter 16 does so by embodying a link between the supply of short-term loans forworking capital and production, as well as a link between such loans and the moneysupply.1.16 Definitions of monetary and fiscal policiesThe major policy concern of monetary economics is with the impact of monetary policieson the economy. Monetary policy is defined as policy-induced changes in the money supplyor/and in interest rates. The control of monetary policy will be taken to be by the centralbank or the monetary authority, using these terms as synonymous. The Walrasian generalequilibrium and the modern classical models (Chapter 14) imply that, even in the short-run,there is no positive benefit in terms of higher output or lower unemployment from theirsystematic or anticipated operation (Friedman, 1977; Lucas, 1996), though there are short-run transient effects of random policies. The Keynesian models usually imply that there aresuch benefits in the short run.40 ThisoccurrednotonlyintheUSAbutalsoinmanyEuropean,andother,countriesbecausebanksandcorporationsin those countries either held US subprime mortgage-backed securities or because of contagion, which madethem reassess the riskiness of their portfolios and also raise their premium for risk.41 A decline in house construction due to a decline in the demand for housing, when the availability of mortgagesfell, was an immediate result.42 The problem was not that the corporations, which issue commercial paper to fund their day-to-day operations,became less credit-worthy but that the fear of shaky mortgages in their portfolios made investors, includingbanks, wary of all commercial paper. Fears that banks’ own holdings of commercial paper, backed by themortgage-backed securities, damaged their solvency and profitability even made banks more reluctant to lendto each other.

Introduction31Fiscal policy is the use of government expenditures, taxes and deficits (or surpluses) as apolicy to change the economy. While government deficits can be financed through increasesin the money supply (and surpluses be accompanied by decreases in it), macroeconomicsdefines fiscal policy as one in which the money supply is held constant, so that the deficitsmust be financed by government borrowing through increases in its bonds sold to the public.Similarly, fiscal surpluses are assumed to require purchases of bonds from the central bankand their retirement, without changing the money supply in circulation in the economy.The reason for this definition of fiscal policy is to separate the effects of changes in thefiscal variables from those in the money supply. To reiterate, fiscal policy is, by definition,bond-financed fiscal policy.In the real world, fiscal and monetary policies are intertwined, more so in some countriesthan others. However, for analytical purposes, they have to be treated as conceptuallyindependent ones. Hence, a money-financed expansionary fiscal policy – that is, deficitsfinanced by increases in the money supply – will be treated as having two components: anexpansionary (bond-financed) fiscal policy and an expansionary monetary policy.ConclusionsMoney performs the two main functions of medium of payments and store of value, withthe former being absolutely critical to the transactions role of money in the economy.These functions are performed by a variety of assets, with their liquidity characteristicsand substitutability among them changing over time. Innovations in the types of assets andthe changing characteristics of existing financial assets mean that the financial assets whichmeet the role of money keep changing over time.While currency was considered to be the only form of money at one time, currencyand demand deposits were taken to be the only components of money early in thetwentieth century, so that the appropriate measure of money was considered to be M1.By 1960, the measure of money had expanded to include time and savings deposits incommercial banks, and therefore had become M2. In subsequent decades, as the liabilitiesof near-banks became more and more similar to the demand and time deposits of banks,the measures of money were broadened to include the deposits in near-bank financialintermediaries.The recent incursion of electronics into banking in the form of automatic tellers, bankingfrom home through one’s computer or telephone, and the use of smart cards for payments,etc., represents a very fast pace of technical change in the banking industry. It is a safe betthat the empirically appropriate measure of money is changing and will keep changing in thefuture. During this period of change, the demand functions for money have tended to becomeunstable, more so for some definitions than others, so that disputes about the proper measureof money have expanded beyond the simple sum aggregates of M1and M2 to encompassmore complex forms.This chapter has also provided an introduction to the two major paradigms in macroeco-nomics, classical and Keynesian. Each consists of several models. The classical paradigmusually focuses on the general equilibrium of the economy and its models are closely relatedto each other. The Keynesian one focuses on the deviations from the general equilibriumof the economy. Since there can be many different causes of such deviations in real-worldeconomies, the Keynesian models are a much more diverse group than the classical ones.Knowledge of both paradigms is essential for the proper understanding of the economy andfor the appropriate formulation of monetary policies.

32Introduction and heritageThe IS–LM mode of macroeconomic analysis is a mode of exposition of the determinationofaggregatedemandinmodelsoftheclassicalparadigm,aswellasinmodelsoftheKeynesianparadigm. However, the IS–LM technique of analysis is inappropriate for economies in whichthe central bank sets the interest rate, rather than the money supply, in its attempts to controlaggregate demand in the economy. This is now the practice of many central banks. In thiscase, aggregate demand is determined by the IS equation and the interest rate set by thecentral bank.Summary of critical conclusions❖The appropriate definition of money keeps changing. There are currently several definitionsof money in common usage. These include M1, M2 and broader monetary aggregates.❖All definitions of money include currency in the hands of the public and demand/checkingdeposits in commercial banks.❖Banks are one type of financial intermediaries but differ from others in that their liabilitiesin the form of checking and savings deposits are the most liquid of all assets in the economy.❖Financial assets are created, so that an unregulated financial system tends to create amultiplicity of differentiated assets.❖The two main paradigms for macroeconomics are the classical and the Keynesian ones.❖The classical paradigm focuses on the general equilibrium of the competitive economy.❖The Keynesian paradigm focuses on the deviations from the general equilibrium of thecompetitive economy. There can be a variety of reasons for such deviations, requiringdifferent models for their explanations.❖IS–LM analysis assumes that the central bank uses the money supply rather than the interestrate as the monetary policy instrument and sets its level exogenously. However, the LMequation/curve, and therefore the IS–LM analysis, is inappropriate for the macroeconomicanalysis of economies in which the central bank sets the interest rate exogenously. Themore appropriate analysis for such economies is the IS–IRT one.❖In the short-run, money and credit are not neutral in real-world economies. They are neutralin the analytical long-run.