New Classical Economics and Efficient Markets

 

1.      The Distinction between Adaptive and Rational Expectations:  An expectation that is formed adaptively is based only on past information.  A rational expectation is based on all available past and current information and relies on an understanding of how the economy works.

 

2.      The Key Assumptions Underlying New Classical Macroeconomics:  The new classical model is based on the assumption of imperfect information in the short run, but efficient “market clearing” outcomes as information is fully known.

 

3.      Policy Anticipations Determine the Actual Effects of Policy Actions:  If decision makers adjust to price level and inflation rate expectations rapidly, then policy actions will have no real effect on output or employment.  However, if not fully anticipated in the short-run, then policy can affect real output and employment.

 

4.      Implication for Public Policy to Have a Real Effect:  If monetary or fiscal policymakers wish to change real output and employment, they must find ways to enact policies that are unsystematic, or unpredictable.

 

5.      Implications of efficient markets:  Most applicable in competitive financial markets where bond prices and real interest rates reflect market equilibrium.  Adjustment lags will be more apparent in product and labor markets.

 

 

Modern Keynesians Theory and Rational Expectations

 

1.      The Modern Theory of Wage Stickiness:  The modern Keynesian theory hypothesizes that workers and firms may desire to use wage contracts to avoid the transaction costs entailed in continual wage bargaining, to reduce risks associated with wage variability, or to deal with problems arising from asymmetric information.

 

2.      The Role of Rational Expectations:  Firms and workers make rational forecasts of the price level to set the appropriate wage for the interval that the contract will be in force.  During the contract term, unanticipated fluctuations in the price level can induce changes in employment and real output, resulting in an upward sloping aggregate supply curve.

 

3.      Several Factors Determine the Duration of Wage Contracts with Macroeconomic Implications:  The optimal duration of a wage contract falls as the contract negotiation costs decline and as the volatility in the price level resulting from aggregate demand and supply variation rises.  Contract negotiation costs differ across firms and industries, so contract bargaining and ending dates are staggered.  The overlapping of contracts causes aggregate demand fluctuations to have persistent effects on employment and real output.

 

4.      The Modern Keynesian Theory is Observably Equivalent to the New Classical Model:  The essential predictions of basic versions of both theories are the same.  Both approaches indicate that unexpected policy actions are more likely to have effects on employment and real output, even though they are based on different views about the functioning of the labor market.

 

Objectives and Targets of Macroeconomic Policy

 

1.      The Ultimate Goals of Macroeconomic Policy:  Stable price level, high levels of employment, growth in real output over time.

 

2.      Effectiveness of Monetary and Fiscal Policy: The New Classical School and New Keynesian School agree that monetary and fiscal policy can do little to affect real output over a long-run time horizon.

 

3.      Monetary Policy:  Monetary policy may affect the price level and real output in the short run, but only the price level in the long-run. 

 

4.      Fiscal Policy:  Fiscal policy also primarily affects price and output in the short-run, but it may affect the allocation of resources between private and public goods that could influence economic growth. 

 

The Intermediate Targets of Monetary Policy

 

1.     Finding an Intermediate Target for Monetary Policy: An intermediate target between policy actions and ultimate goals is chosen by the Fed based on theoretical as well as practical issues.  

 

2.     Characteristics of Intermediate Targets:  Four key attributes are (i) they can be frequently observed with up-to-date information, (ii) they are consistent with the central bank’s ultimate objectives, (iii) they are definable and measurable, and (iv) they are controllable.

 

3.     The Menu of Intermediate Target Variables: Three alternative targets are (i) monetary or credit aggregates, (ii) interest rates, and (iii) nominal GDP. 

 

4.     Interest-Rate Targeting: The indirect effects of interest rates on financial markets are expected to ultimately affect aggregate spending.  It is clearly the best target for stabilization in the face of variation in money demand. 

 

5.     Monetary Aggregate Targeting:  Monetary aggregate targeting is the best policy in the face of autonomous changes in aggregate demand because the interest rate serves as an automatic stabilizer. 

 

6.     Targeting Nominal GDP:  The advantage of nominal GDP targeting is that it potentially can reduce the inflationary consequences of aggregate supply variability.  In this respect, it is superior to monetary aggregate or interest rate targeting that focus on aggregate demand.

 

 

The Role of Monetary Theory

 

1.      The Indirect channel:  Changes in the money supply affect AD through changes in the interest rate due to adjustment in the bond market and the foreign exchange market.

 

2.      The Direct channel:  Changes in the money supply directly affect how much people want to spend on real goods and services.  Financial markets adjust to maintain a stable proportion of money versus other financial assets and real assets.

 

3.      The Effectiveness of the Indirect Channel:  A change in the money supply will cause a change in the market rate of         interest due to the substitution between money and bonds or foreign exchange.  (A “liquidity trap” may result in no change in interest rates as all new money is held and monetary policy is ineffective).   A change in the market rate of interest changes desired spending or aggregate demand.  (Interest inelastic investment or other desired spending makes monetary policy ineffective.)

 

4.      The Effectiveness of Direct Channel:  In this view, people hold their money in financial assets and REAL ASSETS (real        estate, cars, etc…).   The demand for money is a stable proportion of total assets, so that the velocity of money is constant.  (The equation of exchange holds after asset adjustment.)

 

5.      How Much Money is Needed:  If the velocity of money changes with interest rates, then the velocity of money will change in the opposite direction of the money supply.  Then money must change more than proportional to output.  If the velocity of money is constant a simple proportional rule can be applied based on potential growth in real output.

 

6.      What Determines the Velocity of Money: (i) Customs and Conventions of Commerce.   The velocity of money has increased over time as a variety of commercial innovations (charge accounts, credit cards, ATMs, debit cards) have facilitated exchange.  (ii) The frequency with which workers get paid.  (More frequent pay period lower the average amount of money held, increasing velocity. 

(iii) The better money serves as a store of value. (Higher inflation and higher interest rates of money substitutes increase velocity.)

 

7.      Other Issues in Monetary Policy:  (i) Lags include recognition lag, implementation lag, and impact lag (asymmetrical impact lag of up to 2 years during a downturn could be destabilizing.) (ii) Independence of Central Bank from political pressures (changes considerably among countries.) (iii) The case for rules versus discretion.  (The effectiveness of rules depends on policy commitment and credibility as opposed to time inconsistency problem.)

 

On Line Application:  http://www.ecb.int

 

Navigation:  Open the ECB home page.  In the right-hand margin, click on “About the ECB”

 

Application:  Explore for a discussion of the goals of the ECB. 

 

1.      Is stabilization of the price level of member nations the only goal of the ECB?  Are there other goals?  What are they?  Explain the basis for making your statement.

 

2.      Based on this discussion, how independent does the ECB appear to be?  Compare with your understanding of the independence of the Fed.

 

In the right-hand margin click on “Key Speeches” and then on Wim Duisenberg: Testimony before the Committee on Economic and Monetary Affairs of the European Parliament, Brussels, 23 January 2002. 

 

3.  What similarities exist between Duisenberg’s testimony and the Greenspan’s Humphrey-Hawkins testimony?