Just covering macro policies / conflicts with my A2 Economics class and produced this mind map in OmniGraffle (Apple software). I found it a useful starting point for students to discuss the effectiveness of each policy and the conflicts within macro objectives. This is a very common essay question in CIE Paper 4.
My question would be what policies has the government in your country implemented since Covid-19 and how successful have they been in meeting macro economic objectives?
Modern Monetary Theory says that you can basically print your own currency by having your own central bank, run large deficits, have full employment, have no inflationary pressure and do this year after year. Nouriel Roubini (see video below) warns that while large deficits and monetary stimulus make some sense during a short deflationary economic contraction, sustaining those policies for years, as he expects will happen, will lead to inflation and economic stagnation – stagflation.
However in a time of crisis like Covid-19 there seems to be a lot more justification for this type of policy over the short-term – when you have a collapse of economic activity, a recession, deflationary concerns and a major reduction in the velocity of circulation of money (MV=PT) – a sort of stag-deflation. At this time a ‘helicopter drop’ makes sense because we have a massive fall in supply as well as demand. But monetising fiscal deficits over a number of years produces a negative supply shock that reduces potential output and increases costs ending up with stagflation like in the 1970’s.
Background to MMT
MMT has its roots in the theory of John Maynard Keynes who during the Great Depression created the field of macroeconomics. He stated that the fact that income must always move to the level where the flows of saving and investment are equal leads to one of the most important paradoxes in economics – the paradox of thrift. Keynes explains how, under certain circumstances, an attempt to increase savings may lead to a fall in total savings. Any attempt to save more which is not matched by an equal willingness to invest more will create a deficiency in demand – leakages (savings) will exceed injections (investment) and income will fall to a new equilibrium. When you get this situation it is the government that can get the economy moving again by putting money in people’s pockets.
MMT states that a government that can create its own money therefore:
Cannot default on debt denominated in its own currency;
Can pay for goods, services, and financial assets without a need to collect money in the form of taxes or debt issuance in advance of such purchases;
Is limited in its money creation and purchases by inflation, which accelerates once the economic resources (i.e., labor and capital) of the economy are utilised at full employment;
Can control inflation by taxation and bond issuance, which remove excess money from circulation, although the political will to do so may not always exist;
Does not need to compete with the private sector for scarce savings by issuing bonds.
Within this model the only constraint on spending is inflation, which can break out if the public and private sectors spend too much at the same time. As long as there are enough workers and equipment to meet growing demand without igniting inflation, the government can spend what it needs to maintain employment and achieve goals such as halting climate change.
How does it differ from more mainstream monetary policy – see table below.
Those against MMT are dubious of the idea that the treasury and central bank should work together and also concerned about the jobs guarantee. They argue that if the government’s wage for guaranteed jobs is too low it won’t do much to help unemployed workers or the economy, while if it’s too high it will undermine private employment. They also say that trying to use fiscal policy to steer the economy is a proven failure because politicians rarely act quickly enough to respond to a downturn. They can’t be relied upon to impose pain on the public through higher taxes or lower spending to quell rising inflation.
Governments around the world introduce unprecedented fiscal stimulus packages to compensate those who have been impacted by the enforced lockdown. In New Zealand Finance Minister Grant Robertson announced a $12.1 billion stimulus package to support New Zealanders and their jobs from the global impact of COVID-19 – the largest in the world on a per capita basis. The money is hopefully going to bring as many businesses back from the brink of closure but the crucial aspect of this injection is that it actually does stimulate demand and generate additional spending. Businesses that survive this pandemic and open their doors again will need the demand side of the economy to do its bit.
The lockdown has badly affected the demand side of the economy and it won’t revert back to the way it away was overnight. Will people venture back into areas with large crowds – bars, restaurants, hotels etc? It is essential that demand makes a return in order to inject some inflation into the economy. But with such uncertainty consumers will want to put off a lot of non-essential purchases. Many economists are also concerned with the “output gap.” — the difference between what the economy could produce and what it was producing. The solution to this output gap, particularly one caused by collapsing economic demand, is to invest in infrastructure projects and give consumers cash. If consumers don’t spend then the government should step-in and spend on their behalf to create the demand necessary to return the economy to some sort of normality. One indicator that we shouldn’t be worried at present is inflation – in theory such a stimulus should create inflationary pressure – the 1970’s yes but today this is less likely when you look at the velocity of circulation.
Velocity of circulation of money is part of the the Monetarist explanation of inflation operates through the Fisher equation:
M x V = P x T
M = Stock of money
V = Income Velocity of Circulation
P = Average Price level
T = Volume of Transactions or Output
For example if M=100 V=5 P=2 T=250. Therefore MV=PT – 100×5 = 2×250. Both M x V and P x T are equivalent to TOTAL EXPENDITURE or NOMINAL INCOME in a given time period. To turn the equation into a theory, monetarists assume that V and T are constant, not being affected by changes in the money supply, so that a change in the money supply causes an equal percentage change in the price level.
However when the velocity of money is falling, monetary policy which would otherwise cause inflation doesn’t seem to do so. The velocity graph (USA) above shows that you need to go back to 1949 to find a time when it was lower than today, and it was actually rising rapidly after the postwar lows. Remember that this graph was before the Covid-19 lock down. Velocity needs to increase at rapid rate to cause any inflation.
We have no idea of how the future is going to unfold because we have never seen anything like this before – to quote Rogoff and Reinhart – This time it is definitely different.
I blogged yesterday regarding the shape of recovery after the coronavirus pandemic and have been reading Paul Krugman who suggests that conventional monetary policy can’t offset an economic shock like coronavirus.. Since the GFC in 2008 it is evident that low interest rates are the new normal and according to Larry Summers (former Treasury Secretary) we are in an era of secular stagnation. This refers to the fact that on average the ‘natural interest rate’ – the rate consistent with full employment – is very low. There can be periods of full employment but even with 0% interest rates private demand is insufficient to eliminate the output gap. The US was in a liquidity trap (see graph below) for 8 of the past 12 years; Europe and Japan are still there, and the market now appears to believe that something like this is another the new normal.
Krugman suggests that there are real doubts about unconventional monetary policy and that the stimulus for an economy should take the form of permanent public investment spending on both physical and human capital – infrastructure and health of the population. This spending would take the form of deficit-financed public investment. There has been the suggestion that deficit-financed public investment might lead to ‘crowding out’ private investment and also how is the debt repaid? Krugman came up with three offsetting factors
First, when the economy is in a liquidity trap, which now seems likely to be a large fraction of the time, the extra public investment will have a multiplier effect, raising GDP relative to what it would otherwise be. Based on the experience of the past decade, the multiplier would probably be around 1.5, meaning 3% higher GDP in bad times — and considerable additional revenue from that higher level of GDP. Permanent fiscal stimulus wouldn’t pay for itself, but it would pay for part of itself.
Second, if the investment is productive, it will expand the economy’s productive capacity in the long run. This is obviously true for physical infrastructure and R&D, but there is also strong evidence that safety-net programmes for children make them healthier, more productive adults, which also helps offset their direct fiscal cost.
Thirdly, there’s fairly strong evidence of hysteresis — temporary downturns permanently or semi-permanently depress future output (Fatás and Summers 2015). Again, by avoiding these effects a sustained fiscal stimulus would partially pay for itself. Put these things together and they probably outweigh any fiscal effect due to stimulus raising interest rates.
Can the Japanese experience tell us anything?
The policies proposed are similar to those by Japan in the 1990’s but the environment there was unique from what most other developed economies are experiencing. Krugman makes two points:
Japan allowed itself to slide into deflation, and has yet to convincingly exit.
Japan’s potential growth is low due to extraordinarily unfavourable demography, with the working-age population rapidly declining.
As a result, Japan’s nominal GDP has barely increased over time, with an annual growth rate of only 0.4% since 1995. Meanwhile, interest rates have been constrained on the downside by the zero lower bound. Even with this Japan still faces no hint of debt crisis. Therefore according to Krugman, with negative shocks to economies becoming more prevalent it maybe better to implement a productive stimulus plan instead of trying to come up with some short-term measures every time there are shocks to our economy.
Source: “The Case for a permanent stimulus”. Paul Krugman cited in “Mitigating the COVID Economic Crisis: Act Fast and Do Whatever It Takes” Edited by Richard Baldwin and Beatrice Weder di Mauro
Currently covering Keynes vs Monetarist in the A2 course. Here is a powerpoint on the theory that I use for revision purposes. I have found that the graphs are particularly useful in explaining the theory. The powerpoint includes explanations of:
– C+I+G+(X-M) – 45˚line – Circular Flow and the Multiplier – Diagrammatic Representation of Multiplier and Accelerator – Quantity Theory of Money – Demand for Money – Liquidity Preference – Defaltionary and Inflationary Gap – Extreme Monetarist and Extreme Keynesian – Summary Table of “Keynesian and Monetarist” – Essay Questions with suggested answers.
Supply shock – will become more visible in the coming weeks as importers from China maybe unable to source adequate supply given widespread shutdowns across Chinese manufacturing.This loss of intermediate goods for production of final products cause a decline in revenue and consumer well-being. A good example of supply shocks were the oil crisis years of 1973 (oil prices up 400%) and 1979 (oil prices up 200%).
Demand shock – is already affecting consumer demand as travel slows, people avoid large gatherings, and consumers reduce discretionary spending. Already many sports fixtures have been cancelled which in turn hits revenue streams. With the uncertainty about job security demand in the consumer market will drop – cars, electronics, iPhones etc. Also tourism and airline industries are also exposed to the fall in demand.
Financial shock – although the supply and demand shocks will eventually subside, the global financial system is likely to have a longer-lasting impact. Long-term growth is the willingness of borrowers and lenders to invest and these decisions are influenced by: increased uncertainty regarding the global supply chain; a loss of confidence in the economy to withstand another attack; and a loss of confidence regarding the infrastructure for dealing with this and future crises.
Monetary policy is limited to what it can do with interest rates so low. Even with lower interest rates this does not tackle the problem of coronavirus – cheaper access to money won’t suddenly improve the supply chain or mean that consumers will start to spend more of their income. The RBNZ (NZ Central Bank) could instruct trading banks to be more tolerant of economic conditions.
Fiscal policy will be a much more powerful weapon – the government can help households by expanding the social safety net – extending unemployment benefit. Also the guaranteeing of employment should layoffs occur. Tourism and airline industries are being hit particularly hard. Although more of a monetary phenomenon the ‘Helicopter Drop’ could a policy tool of the government. A lot of governments already have introduced ‘shock therapy’ and unleashed significant stimulus measures:
Hong Kong – giving away cash to population – equivalent NZ$2,120.
China – infrastructure projects and subsidising business to pay workers.
Japan – trillions of Yen to subsidising workers. Small firms get 0% interest on loans.
Italy – fiscal expansion and a debt moratorium including mortgages
Just completed the Keynes 45˚ line (still in the CIE A2 syllabus) with my A2 class and find this graph useful to explain it. A popular multi-choice question and usually in one part of an essay. Make sure that you are aware of the following;
1. C and S are NOT parallel
2. The income level at which Y=C is NOT the equilibrium level of Y which occurs where AMD crosses the 45˚ line. To Remember:
1. OA is autonomous consumption.
2. Any consumption up to C=Y must be financed.
3. At OX1 all income is spent
4. At OB consumption = BQ and saving= PQ
5. Equilibrium level of Y shown in 2 ways
a) where AMD crosses 45˚ line
b) Planned S = Planned I – point D
Remember the following equilibriums:
2 sector – S=I
With Govt – S+T = I+G
With Govt and Trade – S+T+M = I+G+X
Below is a link to a very good interview with Corin Dann and Don Brash this morning on National Radio’s ‘Morning Report’. Former Reserve Bank Governor Don Brash says that the major Central Banks need to act together and reduce interest rates to offset the impact of Covid-19. The Central Banks he refers to are: US Fed, Bank of England, Bank of Japan and the European Central Bank. Good discussion of the impact of the NZ dollar on trade and the fact that just the past month in New Zealand, the virus may have cost as much as $300 million in lost exports to China. Worth a listen
It is unavoidable that recessions are part of the economic environment that we live in. In tackling the impact of recessions it has become apparent that one cannot solely rely on expansionary monetary policy of the central bank. Economic conditions have changed, as if an economy was to fall into recession in this low interest environment monetary policy options are far more limited than they were post the GFC. Add to this a higher debt level and you put further pressure on the banking system. A publication this year entitled “Recession Ready – Fiscal policies to stabilise the American economy.” (Published by the Hamilton Group – Washington Center for Equitable Growth) suggests that governments should assist in ensuring that the recovery phase is much quicker than it has been by ensuring confidence amongst businesses and households so they resume investing and spending again. They focus on antirecession programmes known as “automatic stabilisers.”
Automatic stabilisers are the automatic increases in revenues and decreases in expenditure in the government budget that occur when the economy strengthens, and the opposite changes that occur when the economy weakens.
Increase in GDP growth = the government will receive more tax revenues – people earn more and so pay more income tax. As it is assumed that unemployment decreases the amount of money spent on unemployment benefit decreases.
Reduction in GDP growth = lower incomes – people pay less tax. As unemployment increases the government spends more on unemployment benefits. This increase in benefit spending and lower tax collection helps to limit the fall in aggregate demand.
One of the chapters written by Claudia Sahm proposes a direct payment to individuals that would automatically be paid out early in a recession and then continue annually when the recession is severe. During a recession consumer spending (C) declines sharply – see graph – and as it makes up above 70% of most countries aggregate demand – C+I+G+(X-M) – this can lead to employment losses and reduced output. Consumers therefore are integral to boosting aggregate demand and direct stimulus payments to individuals should become part of the system of automatic stabilisers as additional income translates quickly into additional spending.
Trigger to start automatic stimulus payments.
The idea behind this is for direct payments to individuals after a 0.5% in the quarterly unemployment rate. If you look at each recession since 1970 the stimulus trigger of an increase in 0.5% unemployment meant that payments would have been triggered within three months of the start of the past six recessions (USA). But there are some concerns with using unemployment data:
Unemployment rate tends to lag the business cycle as unemployment tends to peak after the recession ahas ended.
The rise in unemployment doesn’t necessarily mean you are in recession – two consecutive quarters of negative GDP.
Lump sum v Tax cuts
There is an argument that a one-off lump sum payment is much effective in boosting spending than changes in income tax which would be spread fiscal stimulus throughout the year. Even if the Marginal Propensity to Consume (MPC) was the same for both lump sum and tax cuts it would not be until early in the next year that the full spending occurred under the tax cut option. The delay in spending from lump sum payments would be three months thus the overall stimulus boost would be both larger and more rapid – see graph below.
Final thought Direct stimulus payments would quickly deliver extra income to millions of households at the start of a recession and maintain income support until the recession has subsided. This should generate more aggregate demand and thereby reducing the impact of the recessionary phase.
Source: “Recession Ready – Fiscal policies to stabilise the American economy.” (Published by the Hamilton Group – Washington Center for Equitable Growth)