The Close Economy New Consensus And Policy Implications Economics Essay Example

to the traditional IS curve, which helps manage aggregate demand along with aggregate supply. Both the original IS curve and NCM IS incorporate elements of lagged accommodation and forward-looking behavior (Phillip Arestis, page 25, 2007). Sticky prices occur when there is a delay in adjusting prices combined with the relationship described by the Philips curve and long-run price flexibility. The optimization of intertemporal utility assumes that debts are fully paid according to the transversality condition (Phillip Arestis, page 169, 2009b). In the framework of New Keynesian Macroeconomics (NCM), economic agents are creditworthy and do not require a specific monetary asset. The interest rate for fixed-interest financial assets remains universal but can vary based on changes in economic conditions and borrowing activities. Consequently, there are no liquidity-constrained firms or individuals in this scenario, making commercial banks unnecessaryPrivate banking institutions and monetary variables are not important in the NCM model. Instead, this analysis focuses on optimizing household utility functions through consumption, challenging the role of investment. Household investment aims to increase income by raising capital stock, while investment is primarily used for capital stock adjustment. However, within the NCM framework, the importance of capital stock diminishes. Therefore, private disbursements like family expenses do not impact finding investments that drive economic activity.

Equation 2 illustrates the relationship between several factors: current inflation rate at time T, domestic output gap at time T, expectations held at time T, past inflation rate (time t-1), future inflation rate (time t+1), and stochastic shocks. This equation represents the Phillips curve where the current inflation rate is influenced by the current output gap as well as past and expected future inflation rates. It shows

that constant inflation can coexist with a zero output gap.

Similar to equation one, this model considers sticky prices, lagged price levels, and complete price flexibility in the long run. Furthermore, b2 and b3 in this equation add up to 1, indicating a vertical Phillips curve in the long run. According to NCM's perspective, this vertical long-run Phillips curve aligns with potential output and corresponds with the concept of Non-Accelerating Inflation Rate of Unemployment (NAIRU).The term within parentheses is significant as it represents a crucial channel for monetary policy. When a central bank successfully achieves low inflation, it reduces expectations for future inflation. This creates an opportunity to lower current inflation at a reduced cost. The credibility of the central bank regarding future inflation is demonstrated by the term ( ). The effectiveness of controlling inflation not only relies on the central bank's policy stance but also on how economic agents perceive future economic conditions. Economic agents must comprehend how monetary authorities will react to macroeconomic developments since they shape the economy and its future outcomes.

Modern central banking involves managing private expectations. Equation 3, which is referred to as Taylor's regulation, represents a monetary policy operating rule that determines the nominal rate of involvement. This equation considers various factors such as the equilibrium real interest rate, expectations held at time T, future and past inflation rates, past domestic output gap, inflation target rate, and past nominal rate of involvement. It replaces the traditional LM-curve and proposes that monetary policy systematically adjusts to economic development instead of being an exogenous process. According to the equation, if inflation exceeds the target rate, it results in a higher interest

rate to control inflation.The text explains that if inflation is below the target rate, a lower interest rate is necessary to stimulate the economy and increase inflation. According to Malcom Sawyer (2008), Taylor's rule, which incorporates the central bank's determination of interest rates based on "Taylor's rule," is well-known and significant. However, this usage has two implications: it solely focuses on setting domestic interest rates without considering international factors like exchange rates and other countries' interest rates. Additionally, adjustments in interest rates are responsive to the output gap and inflation rate; changes in one variable depend on fluctuations in another. Equation two shows that a zero output gap results in constant inflation, while equation three suggests that when inflation reaches target levels and the output gap is zero, the nominal interest rate can be assumed equal to the equilibrium real interest rate (RR*) set by monetary policy regulation. This implies that if the central bank accurately estimates RR*, it can guide the economy towards a state of zero output gap and constant inflation. In relation to equation one, when aggregate demand aligns with a zero output gap, it means that the real interest rate RR* achieves equality between savings and investment in the private sector economy.The equilibrium rate of involvement is similar to the Wicksellian natural rate of involvement, where saving and investing are balanced at the supply side equilibrium level of income. Furthermore, this equation has other characteristics. Economic activity remains unaffected by aggregate demand and occurs around the supply side equilibrium. In this model, the equilibrium corresponds to a zero output gap in which the real interest rate equals the target rate and

inflation matches the objective rate. This relationship can be described in terms of NAIRU or Non-Accelerating Inflation Rate of Unemployment, which closely relates to labor market conditions. When unemployment falls below NAIRU, inflation rates increase; conversely, when unemployment exceeds NAIRU, inflation rates decrease (Phillip Arestis, page 26-28, 2007). There is no long-term trade-off between inflation and unemployment. To prevent inflation from accelerating, it is expected that the economy will operate at NAIRU. Additionally, in the long term, the level of demand does not have an independent role but adjusts according to the supply side level of economic activity associated with NAIRU. The adjustment of demand relies on decisions regarding interest rates wherein the equilibrium interest rate acts as a benchmark for comparing demand and supply. It becomes Cardinal Bank's responsibility to determine this interest rate rather than relying solely on market forces.The limitation of monetary policy's effectiveness in influencing economic analysis is that it only has temporary effects on economic activity rather than lasting effects. This is due to two reasons: the inability to control money supply, rendering monetary control impossible, and the requirement of a stable demand for money to predict inflationary effects through monetary targeting. However, there has been a shift in macroeconomics theory and policy implications where aggregate demand is no longer considered a significant factor in determining economic activity. Instead, monetary policy has taken its place as a crucial instrument. This shift involves moving from controlling the money stock to focusing on interest rate policy. The objective of modern-day monetary policy is to achieve low inflation rates, which indicate strong growth rates. To accomplish this goal, experts such as banks or

economists operating through an independent central bank should conduct inflation targeting as part of monetary policy (Philip Arestis, page 8, 2003). Inflation targeting emphasizes the importance of expected inflation and promotes transparency and reliability through the central bank's own inflation forecast and targeting process.Despite the central bank's efforts to calculate inflation, there is a concern regarding the margin of error associated with these calculations. This can undermine the credibility and reputation of the central bank since economic calculations inherently involve uncertainty. Additionally, it remains uncertain if the central bank has full control over inflation due to external factors such as wages, taxes, and oil prices.

According to Philip Arestis and Malcom Sawyer (2005), central banks that practice Inflation Targeting possess five key characteristics. These include a commitment to price stability through monetary policy and recognizing that stabilizing output supports price stability. Another characteristic involves establishing a specific numerical target for inflation within a set time frame. Transparency is also crucial in explaining monetary policy by issuing reports on inflation and other macroeconomic variables.

In contrast, the new consensus in macroeconomics does not consider money as causally significant in the NCM model. Instead, interest rates and money supply are controlled by the central bank based on demand.Cardinal Bank primarily focuses on achieving stability in monetary value rather than emphasizing money movements.

However, an important distinction exists between this approach mentioned above and Keynesian's concept of endogenous money. The Keynesian theory acknowledges the significant roles of money in relation to real variables unlike the NCM approach which views money as a residual without further function.The theoretical model of NCM incorporates the Phillips curve, which guides monetary policy decisions. By adjusting

interest rates, the central bank can influence real interest rate levels, aggregate demand, economic activity, and ultimately impact inflation expectations and targeting. However, it is important to note that the Phillips curve shows a trade-off between unemployment and inflation in the short term but becomes vertical in the long run. This poses challenges when targeting inflation through monetary policy using interest rates since the Phillips curve becomes vertical over time.

Some argue that central bank independence can stimulate the economy by reducing unemployment without causing long-term inflationary effects. Despite this argument, supply-side equilibrium remains unaffected by demand and serves as an economic reference point. Monetary policy primarily focuses on addressing short-term inflation concerns without considering longer-term consequences.

In NCM models, the Wicksellian natural rate of interest plays a crucial role in determining output and inflation (Phillip Arestis and Malcom Sawyer, page 768, 2008). According to equation three in their study, when inflation aligns with targets and there is no output gap, the actual real rate set by monetary policy equals the equilibrium rate. This equilibrium rate resembles the Wicksellian natural rate of interest that balances savings and investment at full employment.Achieving the natural rate of interest can be difficult due to factors such as it being negative or unattainably low (Arestis & Sawyer, 2008, p.769). The use of cash eliminates the possibility of negative interest rates; however, equation one shows that the actual interest rate can still be negative. This indicates a lack of positive interest rates in the economy and investments. Equation one also demonstrates that the interest rate influences aggregate demand by remaining above zero and including a vital component of demand.

Furthermore, it is impossible

for the central bank to predict or determine the equilibrium interest rate. As a result, achieving this equilibrium exceeds their capabilities as it constantly changes. According to New Consensus Macroeconomics (NCM), maintaining a constant equilibrium rate necessitates keeping all guidelines and parameters unchanged.

However, Post-Keynesians criticize NCM's underlying assumptions and argue against relying solely on monetary policy as proposed in the New Consensus (NC) model. They believe that implementing a mix of policies like income policy, fiscal policy, and wage bargaining is more effective in improving the economy.

Post-Keynesians contend that adjusting interest rates has substantial and enduring effects on various aspects of the economy such as unemployment, real wage rates, and growth.Post-Keynesian economists, including Philip Arestis, Malcolm Sawyer, Peter Kriesler, and Marc Lavoie, criticize the inflation targeting approach for causing policy recessions and its inability to address deflation due to a lower limit on interest rates. In our paper, we examine these criticisms by analyzing Philip Arestis' 2009 paper summarizing arguments against the NCM model evaluation and the implementation of IT in different countries. According to Angeriz and Arestis (2007/2008), macroeconomic stability cannot always be determined solely by price stability and low inflation. Juselius (2008) finds insufficient evidence supporting a long-term relationship between the Phillips curve and unemployment. Additionally, Arestis, Baddeley, and Sawyer (2007) argue that there is inadequate evidence to support the belief that aggregate demand and economic policy do not affect NAIRU (non-accelerating inflation rate of unemployment). According to Angeriz and Arestis (2007/2008), countries without IT policies have had the same impact on inflation as IT countries. However, the IT policy model only considers demand-pull inflation and not cost-push inflation, as pointed out by

Arestis/Sawyer (2009). Philip Arestis (2009a) agrees with White's (2006) idea that achieving price stability in the short term may not be enough to prevent economic downturns in the medium term.The importance of price stability in achieving sustainable growth and economic benefits is not guaranteed, as evidenced by the crises in Japan during the early 1990s and Southeast Asia during the late 1990s. Post-Keynesians argue that alongside other objectives such as output stabilization, it is necessary to pursue price stability. They reject the simplistic interest rate-investment relationship described in the IS model and believe it to be more complex than Keynes assumed. Many experts also disagree with a direct one-to-one relationship between short-term interest rates set by central banks and long-term interest rates or loan rates that impact aggregate demand. The new consensus model focuses on an interest rate rule but does not explicitly mention money supply or financial institutions. However, there is widespread recognition that banks and their decisions play a significant role in monetary policy. The granting or withholding of credit by banks has a substantial impact on the economy as it affects expenditure growth. If banks do not provide credit, there will be no increase in spending. In reality, many economic agents have limited liquidity, meaning they lack sufficient assets to borrow or sell, which restricts their ability to spend based on their current income and some assets availability. When credit rationing is absent, only the "price effect" would result from monetary policy. Post-Keynesians also acknowledge the importance of risk, uncertainty, and having a single interest rate factor involvedThe inclusion of banks and money markets in the New Consensus Model is crucial for

a comprehensive understanding of macroeconomic behavior over time. Without them, two issues would arise. Firstly, the standard model lacks consideration for monetary amounts within a broad framework. In contrast, the extended model incorporates bank deposits and loans, which impact aggregate demand and supply. Post-Keynesians argue that this inclusion introduces real money balances such as bank deposits and cash, along with government bond holdings by household representatives.

The extended New Consensus Model is more comprehensive than the standard model as it takes into account these factors. It explores the relationship between government bonds and bank liquidity in relation to the endogenous relationship between interest rates regulated by the Central Bank in the money market and an economic agent's utility function. According to P. Arestis (2009a), although less comprehensive, the NCM theoretical model offers simplicity and a macroeconomic perspective.

In terms of demand and inflation, it is stated that monetary policy in the New Consensus Model only controls demand inflation, not cost inflation represented by interest rates.The IT contends that by using interest rate policy to address demand inflation, equilibrium can be achieved by balancing aggregate demand and supply in order to eliminate output gaps. However, Post-Keynesians question whether monetary policy's influence on aggregate demand is limited if it only focuses on controlling demand inflation. They argue that monetary policy has a greater impact on real variables like investment, which then affects future capital stock but has limited direct effect on inflation itself. Furthermore, there is doubt about the ease of disregarding non-demand related factors such as wages and material costs. According to the text, increasing capacity utilization does not necessarily result in rising prices. In fact, at low

levels of capacity utilization, there may be a decrease in the inflation rate. This leads to a horizontal Phillips curve for high output and employment levels. Unlike traditional theories where an upward-sloping short-term Phillips curve leads to a vertical long-run Phillips curve, this concept does not apply here as increased output does not immediately cause inflation. Even within the relevant range, the long-term Phillips curve will remain horizontal. Therefore, what truly matters is cost-inflation indicated by rising costs of goods and the credibility of the target inflation rate set by monetary authorities.
Advocates of inflation targeting argue that although it is possible to stabilize output in the short term, it is not feasible in the long run as output eventually returns to its equilibrium level. These proponents also emphasize the importance of considering both output and price fluctuations in monetary policy. However, Post-Keynesians disagree with using rising prices as a nominal anchor for effectively stabilizing output. They believe that the supply-side equilibrium, often represented by NAIRU, is not a fixed concept in the economy and can change over certain periods due to factors like labor market institutions and laws. Additionally, they question whether interest rates have a lasting impact on the economy's supply side through their effect on aggregate demand, especially in the context of IT (information technology). According to them, if productivity gains cause NAIRU to change and the central bank fails to recognize it, inflation could worsen because an increase in RR* (the natural rate of interest) is not countered by a corresponding increase in R (the actual rate of interest). However, measuring RR* directly is not possible for the central bank; they can

only estimate its level. Furthermore, Post-Keynesians are skeptical about using rising prices as a tool for monetary policy due to plus pricing. In today's deregulated fiscal markets, implementing plus pricing increases the likelihood of instabilities and disruptions in balance sheets.

These instabilities, such as asset price bubbles and debt bubbles, can have a significant impact on employment and production costs. Information technology alone is not sufficient to address these issues, so Post-Keynesians advocate for additional policy measures alongside IT. They also raise concerns about inflation targeting leading to moral hazard in asset markets. During periods of economic growth, central banks may pay less attention to pricing control but are still responsible for protecting asset values during economic downturns. However, pricing control is not considered a responsibility of central banks as it contradicts the principles of a free market economy. Accurately predicting and controlling asset price movements is challenging, according to King (2004b), and it remains uncertain how effective this would be in practice (Arestis and Sawyer, 2008). Post-Keynesians argue that uncontrollable inflation leads to the formation of euphoric bubbles that eventually burst with severe consequences for investors and the overall economy (P. Arestis and M. Sawyer, 2008, December). The New Consensus theory suggests that a vertical long-term Phillips curve indicates the possibility of inflation occurring.