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2009-04-26

21st century macroeconomic policy framework

Subtract: The current financial and economic crises have exposed some of the deficiencies or inadequacy of the current macroeconomic policy tools in dealing with them. This paper proposes a new and third major macroeconomic tool to expand the existing macroeconomic instruments available at the authorities’ proposal. The new tool will be more potent in dealing with a major credit crisis such as the current one where the main conventional macroeconomic tools are ineffective.

We have been experiencing a great recession. The current one is more severe than any recessions since the Great Recession but not yet as severe as that one. However, at one stage the world main banking institutions nearly collapsed had the authorities not taken emergency rescue measures. So far it appears that the world has averted a very serious likelihood of another great depression. Aren’t we lucky!

Having said that, the world is far from out of the woods yet and is still in trouble of very serious financial and economic crises. World authorities, though having attempted various policy measures and used every policy tool at their disposal whether they were coordinated or not and conventional or not, are still pondering how to get the world out of the current world wide economic abyss. It seems there is still a long way before they are confident that they have got their policy prescriptions right and a real recovery as a result of those policies taken but not just hope is under way.

People would wonder what economists can do to aid the authorities in their difficult tasks. After all, is should be the economists task to provide theoretically sound and practically implementable policy frameworks for authorities to use to deal with any economic issues especially serious economic woes. Undoubtedly there have been various voices from economists since the outbreak of the current economic woe. It appears, however, there is a lack of a degree of consensus among economist that has been developed thus far.

I have not reviewed a comprehensively of how economists have proposed or prescribed to deal with the current crisis, I got a feeling that the main reasons lie probably in the following:

It is the tradition of economists to disagree among themselves and with others on issues;
They, as the authorities and other as a whole, have not got the “correct” solutions or prescriptions to the underlying problems;
Maybe some of them have got the “correct” ones, but their voice have not been dominant or accepted.

Irrespective which the causes are, it is still up to economists to demonstrate they can or have got the correct answers to the current problems. This article is an attempt of the author as an amateur economist to contribute to this task.

Current Keynesian macroeconomic policy framework
Although there are different macroeconomic policy frameworks available at present, the Keynesian framework is the one probably most authorities like to use in dealing with relatively serious economic downturns. Most economists may agree that the successes of the applications of the Keynesian framework have been a mixed one. For example, the rise of new classical economics as a result of the rational expectations revolution in the 1970s was a major response to the rather unsuccessful of the mainly Keynesian macroeconomic policies in the wake of the first oil shock.

Nevertheless, the Keynesian macroeconomic framework arose as a response by part of the economic profession to deal with serious economic downturns or recessions including possibly depressions. It appears it remains the dominant one, given that other frameworks are either providing no policy action prescriptions or even likely to be less effective, at least in the eyes of government authorities which have the task to either deal with or at least to portray to the public that they are doing something to deal with slowing or declining economies with rising unemployment.

From demonstrating policy approaches under the Keynesian macroeconomic theory, the framework of the IS-LM curves and the aggregate demand and supply curves become handy to do so. The IS-LM framework can show how the two main macroeconomic policy tools can be used to move the economy to its normal course when there is a downturn occurring. The aggregate demand and supply curves, on the other hand, provide a ‘general equilibrium’ approach to complete the whole picture of the economy from the macro point of view. It includes the supply side of the economy with labour market demand and supply and a production function of the economy assuming fixed current capital stocks. The supply side also provide a feedback to the demand side in terms of the price level, which in turn affects the demand side through real money supply, that is nominal money supply divided by the price level.

The IS-LM curves framework is shown in the figure 1. In the diagram, the vertical axis is interest rate and the horizontal one national output like GDP. The Keynesian theory goes like this. When there is an economic downturn, there is insufficient demand from the private sector resulting output to be below the desirable level or full employment level, such as Y0. The Keynesian policy prescription is to either increase government expenditures (fiscal policy) that will shift the IS curve to the right or up and lift the economy’s output (and the interest rate), or to increase money supply to shift the LM curve to the right or down to also lift the output (and reduce the interest rate), or a combination of the two to move both the output and the interest rate to the desirable levels.

Figure 1 The IS-LM diagram


Figure 2 shows the aggregate demand and supply diagram. The vertical axis shows the price level and the horizontal axis the output. The DD curves represent aggregate demand of the economy and the SS curve the aggregate supply. The expansionary fiscal or monetary policies discussed above are reflected by a shift in the aggregate demand curve from DD0 to DD1 with a resultant rise in the price level. This rise in price level will feed back into the IS-LM framework to decrease the real supply of money for given nominal supply and move the LM curve upwards or to the left. This in turn will cause the aggregate curve in the following diagram to move down or to the left, offsetting some of the effects of the original expansionary fiscal and monetary policies. However, it is not our intention to demonstrate this complex feedback effects here.

Figure 2 The aggregate demand and supply diagram















Limitations of the existing Keynesian macroeconomic framework
The above illustrations show a highly simplified version of Keynesian framework, but the essence of the framework is captured. It shows the essential nature of the Keynesian framework as a demand management of macroeconomic policies. It has not included how expectations of the economic agents in the economy are formed and how they could affect the framework. This can add into the picture of one of the ways that the supply side can come into play. However, adding realistic expectations only moderate the effectiveness of rather than negate completely the essence of the Keynesian approach. The rational expectations revolution added some new insights into how the economy might work, but offered few practical policy tools that government authorities can use in dealing with economic downturns.

The need to extend the Keynesian framework to deal with the current crises
Recognising current play of the Keynesian macroeconomic approaches, it is not too difficult to see another major area where those approaches are deficient in a theoretic perspective. While Keynesian theories would argue that monetary policy is ineffective when the interest rate approaches to or is zero and argue that only fiscal policy by increasing government expenditure will be effective in increase demand, it fails to recognise the scenario if and when the money market is in fact not working to such an extent that the aggregate demand becomes effectively vertical at a relatively very low level of economic activity and may even moving further to the left. The level of supply may be so low that it is practically not sufficient to simply increase government spending to remedy the prevailing economic problems. This, in my view, is likely to be the case in the current financial and economic crises.

Figures 3 and 4 are illustration of these crisis scenarios. Figure 3 shows that due to severe credit crunch resulting from the financial crisis, LM curve changed to LM1 and shifted to the left. This particular diagram presents a scenario that the LM becomes a mirror image of a L shape, comprising a vertical and horizontal segment, where interest rate is very low close to zero and the output is greatly dropped. Monetary policy becomes ineffective even the interest rate is very low. Fiscal policy can probably still result in some effects to certain degrees, but its effectiveness is limited either politically or runs into serious difficulties if the private sector investment and final consumptions decline too much.

Figure 3 Great recession and the IS-LM curves

















Figure 4 shows the aggregate demand and supply curves corresponding to such severe credit crunch resulting from the financial crisis. Both curves changed and shifted to the left. The slope of the aggregate demand also curve became steeper. The aggregate supply curve becomes kinked with a horizontal segment and a steeper segment. The resultant result of such changes in the aggregate demand and supply is a flat or even lower price and a greatly lower output corresponding to that in the IS-LM diagram in figure 3.

Figure 4 Great recession and the aggregate demand and supply curves














A new macroeconomic tool
If this assumption is true, what can we do about it or what new policy tools do we need to deal with it more effectively? Given that the conventional macroeconomic tools have lost their potency, one has to look beyond the conventional methods. In effect, some of the world authorities have already attempted unconventional methods, such as the approach by the US Federal Reserves in the so called balance sheet manipulation. Recognising this, economists need to analyse whether those approaches are effective and whether they are the best macroeconomic policy approaches in the circumstances.

Based on these unconventional approaches, my current analysis is that there are serious deficiencies in those particular approaches. However, the balance sheet approach (or alternatively, direct quantitative interventions into financial institutions) can be modified or improved to overcome the current deficiencies and economists probably can formalise the essence of this approach with more effectiveness and minimised costs associated with it as a third main macroeconomic tool, along side the existing conventional fiscal and monetary policy tools. This should represent an extension or expansion of the Keynesian theories, because it still prescribes to the notion of government intervention – the main spirit of Keynesian, though in a different way.

How to implement the new tool?
How can we make this approach more effective and minimise its costs? Under the current US particular circumstances, one way is for the Reserves to provide most of the financial institutions with enough loans which would be able to effectively quarantine their troubled assets for a specified period. This will enable them to be in a position to restore providing credit flows to their appropriate levels and at the same time give enough them time and an opportunity to do whatever are necessary to sort out the problems with those troubled assets in an orderly fashion. By the end of the specified period, those financial institutions will have repaid back all their loans to the Reserves. The processes can be managed in such a way that the seemingly excess supply of money will not cause unwarranted inflation.

In a bank's balance sheet, the loans it owes to the Fed are liabilities and the troubled assets are still assets at their nominal value until part or the whole of the assets are sorted out, so they balance out with each other. This part of the balance sheet for these assets and liabilities is quarantined and allowed not to affect the bank’s normal banking businesses. On the other hand the loans it gets from the Fed represent healthy assets and will replace the troubled assets. In this way the bank’s balance sheet will be “healthy” for the duration of the specified period, so to speak.

In the Reserves balance sheet, the loans to the financial institutions are assets and the liabilities represent money supply. Although seemingly there can be a very large increase in money supply, this is offset by the prevailing contraction of the credit flows, so there is not necessarily pressure for inflation. As mentioned, the process can be managed to prevent inflation from occurring until all the increased money supply is recalled.

The loans from the Reserves to any financial institutions should be charged with an appropriate interest rate. The rate should be set in such a way that it will not be prohibitive to those institutions for them to return to some sort of “normality” with their lending businesses because that is the purpose of the policy, but at the same time represent a real cost, so it is not a free lunch and will deter financial institutions from thinking when there is a problem like this they will be bailed out by the authorities and they incur little costs.

With such loans charged with interests, the taxpayers will generally be better off directly and indirectly through benefiting from the resolution of an economic crisis, but will not be worse off even directly.

Concluding remarks
There is an urgent need for new major macroeconomic tools to complement the existing two main tools to successfully combat the current great recession and lift the world economy out of the ordeal. Direct quantitative interventions into major financial institutions to restore credit flows are likely to be such a tool. The best such interventions in the present circumstances seem to be loans from the monetary authority to the financial institutions with appropriate interest charges for a specified period. This will cause no or little to the taxpayers while resolving the crisis. Inflation can be prevented by prudent management of the processes.

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