Wow! What do you think? Evaluate Mankiw's proposal using sound economic theory on monetary policy, recessions, and inflation. [Remember that evaluate means to show pros and cons as you commit to a decision.]Until recently, most economists relied on monetary policy [to escape a recession]. Recessions result from an insufficient demand for goods and services — and so, the thinking goes, our central bank can remedy this deficiency by cutting interest rates. Lower interest rates encourage households and businesses to borrow and spend. More spending means more demand for goods and services, which leads to greater employment for workers to meet that demand.
The problem today, it seems, is that the Federal Reserve has done just about as much interest rate cutting as it can. Its target for the federal funds rate is about zero, so it has turned to other tools, such as buying longer-term debt securities, to get the economy going again. But the efficacy of those tools is uncertain, and there are risks associated with them.
In many ways today, the Fed is in uncharted waters. So why shouldn’t the Fed just keep cutting interest rates? Why not lower the target interest rate to, say, negative 3 percent? At that interest rate, you could borrow and spend $100 and repay $97 next year. This opportunity would surely generate more borrowing and aggregate demand.
The problem with negative interest rates, however, is quickly apparent: nobody would lend on those terms. Rather than giving your money to a borrower who promises a negative return, it would be better to stick the cash in your mattress.
Unless, that is, we figure out a way to make holding money less attractive.
There is a way of obtaining negative interest rates: through inflation. Suppose that, looking ahead, the Fed commits itself to producing significant inflation. In this case, while nominal interest rates could remain at zero, real interest rates — interest rates measured in purchasing power — could become negative. If people were confident that they could repay their zero-interest loans in devalued dollars, they would have significant incentive to borrow and spend.
Having the central bank embrace inflation would shock economists who view price stability as the foremost goal of monetary policy. But there are worse things than inflation. And guess what? We have them today. A little more inflation might be preferable to rising unemployment or a series of fiscal measures that pile on debt bequeathed to future generations.
Wednesday, May 27, 2009
Negative interest rates?
Tuesday, May 12, 2009
Obama Gives Keynes His First Real-World Test
John Maynard Keynes is an unlikely hero for our time.
Keynes, a British economist who died more than 60 years ago, inspired President Barack Obama's plan to save the U.S. economy with a massive round of government spending. The British economist published his big theory, the one underpinning most of what Obama intends to do, in 1936.Keynes corrected what he saw as a fundamental error in the economics that had come before. Classical economics teaches that if there's a downturn, the economy will eventually sort itself out. If people aren't buying enough, prices will drop to a point where people start spending. Keynes' radical insight was to look out the window in the 1930s and see that sometimes things don't right themselves. The economy goes into a downward spiral. The usual dynamic of supply and demand breaks down.
"A failure of effective demand is what he called it," says Alan Blinder, a Princeton economist who served as economic adviser to President Bill Clinton. Basically, people aren't spending enough money, either because they don't have any or because they got laid off or are afraid they're about to get laid off. If people aren't spending enough money, there's no way for the economy to automatically adjust. During the Great Depression, no one had figured out how to get people spending again. Then came Keynes.
"The Keynesian prescription is if all else fails, the government can spend the money," Blinder says. Normally, in a free-market economy, the public doesn't look to the government to prop up spending. "But Keynes' idea, which was revolutionary at the time, is if the private sector won't do it, then the public sector can do it as a fill-in stopgap," Blinder adds.
The Great Experiment
Many of the economists say they just don't know whether the Keynesian approach will work. Financial catastrophes don't happen often enough to prove theories like his. In fact, as economists like Blinder will tell you, this is the problem with economics.
Anti-Keynesians say this massive stimulus package is too risky an experiment on an unproven theory. It might not get America out of the recession, they say. It might cause vicious inflation and a bloated government, and leave a trillion more dollars in debt as a constraining burden on Americans' children and grandchildren.
The Obama administration is betting that won't happen. They're trusting this theory. They're trusting Keynes.
How might Neo-Classical and Keynesian economists look at this current crisis? Examine their differences. What are their respective strengths and weaknesses?
Responding to an Historic Economic Crisis: The Obama Program
First, I'd like to describe how best to think about this crisis.
One of the most important lessons in any introductory economics course is that markets are self-stabilizing.
- When there is an excess supply of wheat, its price falls. Farmers grow less and others consume more. The market equilibrates.
- When the economy slows, interest rates fall. When interest rates fall, more people take advantage of credit, the economy speeds up, and the market equilibrates.
This is much of what Adam Smith had in mind when he talked about the "invisible hand."
However, it was a central insight of Keynes' General Theory that two or three times each century, the self-equilibrating properties of markets break down as stabilizing mechanisms are overwhelmed by vicious cycles. And the right economic metaphor becomes an avalanche rather than a thermostat. That is what we are experiencing right now.
What is the task of policy in such an environment?
The first component of the President's program is direct support for jobs and income to engage the multiplier process in favor of economic expansion. Increases in income lead to financial repair which supports further increases in income. Rising employment will lead to rising spending, which leads to further increases in income and employment.
The Recovery and Reinvestment Act is the largest peacetime economic expansion program in the country's history. It will inject nearly $800 billion into the economy, ¾ of it within the next 18 months. The Council of Economic Advisors' estimates suggest that the Recovery and Reinvestment Act will save or create 3.5 million jobs. It will at the same time do some of the work that the nation has needed done for a long time—doubling renewable energy capacity in the next 3 years, supporting middle class incomes, modernizing ten thousand schools, and making the largest investment in the spine of our national economy – the nation's infrastructure – since Dwight Eisenhower's investment 50 years ago.
It is surely too early to gauge the broader economic impact of the President's program. But it is modestly encouraging that since it began to take shape, consumer spending in the US, which was collapsing during the holiday season, appears, according to a number of indicators, to have stabilized.
What specific fiscal policy priorities seem to be at work here, and what are their pros and cons for AD or AS? You can view the line-item breakdown here. What specific things in this economic climate might hinder the multiplier effect of Obama's fiscal policy? Don't just write about general theory...
