Macroeconomic Policy

Alan Marin

• Publisher: Routledge
• Year: 2005
• ISBN:
  9781134888689
• Edition: 1
• Topic: Business
• Subtopic: Business generale
• Index: Business

Macroeconomic Policy examines the central tenets of both Keynesian and Monetarist schools. It begins by examining the aims of macroeconomic policy: low unemployment, low inflation, high levels of output and high rates of growth. In practice these goals interact and policies which promote one are often detrimental to another. As well as examining how the different schools manage the trade-off between goals, the book also considers their distinctive attitude to markets, how they manage concepts of the short and long run and their different notions of uncertainty.

1
WHAT NEEDS EXPLAINING?

THE CHANGE

Those of us who learned our Economics before 1970 would have been incredulous if told that there would be unemployment rates in double digits in many developed countries, and that it would be widely claimed that nothing could be done about the problem. To be more precise, economists who learnt their subject between, let us say, 1950 and 1970, and those who taught them, would have shared this view with only a few exceptions. In addition, governments and political commentators both at the academic and the journalistic ends of the scale, would have shared the assumption that governments which presided over such unemployment would not last beyond the next general election. Furthermore, it was felt that such electoral punishment would be justified—governments had the ability to avoid widespread unemployment if only they managed the economies suitably. A few economists had not gone along with the consensus, but they were a small minority and their views were generally ignored. Their appeal to academic economists was beginning to widen slightly, but had not yet spread at all into the wider world. Until the late 1960s, even amongst academic economists, these dissenters (often the followers of Milton Friedman) were known primarily for other aspects where they disagreed with the mainstream consensus, and their views about the possibility or desirability of controlling unemployment were generally downplayed.

Our aim in this book is to try to clarify the issues involved in the arguments over whether governments can and should control the level of employment and output by the use of macroeconomic policies. In the process of discussing disagreements over whether governments could have prevented the rise in unemployment in the past two decades, we shall also deal with views as to why unemployment has risen, and whether government macroeconomic policies have themselves contributed to the rise. At the end of the book, in Chapter 7, we also examine some other reasons suggested for the rise in unemployment that have not been dealt with in the preceding chapters.

In the early years of the 1980s, British Prime Minister Margaret Thatcher was sometimes referred to by her opponents, with a degree of derision, by the name ‘Tina’—these also being the initial letters of her oft-repeated statement that ‘there is no alternative’. One way of summarising the question that this book tries to examine is whether it is correct to claim that there is no alternative to the types of policies, and their results, that have been adopted in most, though not all, countries in the past decade.

THE APPROACH OF THIS BOOK

Those who have already studied some economics will have come across some of the issues which are debated in the disagreements over macroeconomic policies. However, all too often, because they have been introduced in passing while teaching the techniques of macroeconomic analysis, the knowledge of even these policy issues is not coherent. Unfortunately, there is insufficient understanding of the interrelationship between the issues, and of whether agreeing with one side of the debate on one issue entails taking a particular position on one of the others.

We hope to provide a framework which will enable our readers to see where the issues fit in, both those that they have already studied and those which are probably less familiar. One way that we shall try to do this is to provide, especially in the earlier chapters, a ‘quasi-historical’ approach. We call it ‘quasihistorical’ because we are not concerned with chronological questions which are legitimately important to a truly historical account. For example, for our purposes it will not be relevant when exactly a particular idea was first proposed or, necessarily, by whom. In particular, if after its initial appearance the idea lay dormant and was not taken up and discussed by others, we shall only consider it at the point where it did become the focus of argument. Nevertheless, because current debates often contain bits taken from discussions that occurred earlier, and, most importantly, these ‘bits’ remain disconnected if no account is taken of the context in which they were debated, a coherent framework does require some view of how the subject of macroeconomic policy management has developed. Furthermore, understanding the relevance of many of the points which crop up in debates over the role of government in controlling economic activity, involves a realisation of the extent to which they were put forward as a rebuttal of arguments made by those who took a different view.

The reference to opposing viewpoints in the previous paragraph leads to another aspect of our approach which is controversial amongst economists. At various points in the book we shall refer to views of ‘Monetarists’ and ‘Keynesians’. Some economists dislike the splitting of views into opposing camps, feeling that this seems to reduce economics to little more than a football match between two sides. In addition, they think that there is too much heterogeneity of opinion to classify the arguments into just two opposing groups. We do recognise that there are many disagreements within what we shall categorise as ‘Monetarist’ or ‘Keynesian’ views, and we intend to try to avoid the temptation of exaggerating the internal consistency within groups, or the breadth of the disagreements between them, just because it might add a little extra spurious dramatic colour to what might otherwise be considered dry analysis—anyway, we consider the subject-matter interesting enough not to need extra excitement. However, we do feel that there is enough of a thread running through the debates over macroeconomic policy so that there is a sense in which there is a continuous Monetarist view and a continuous Keynesian one. This is despite the fact that as we treat the issues in our ‘quasi-historical’ approach, we shall recognise the way the arguments have changed over time. We shall draw attention to these changes, and to the differences between economists whom we shall describe as being, in some sense, within the same camp.

Despite these caveats, we do think that there is enough continuity and similarity of outlook within each of the two groups that we shall characterise as Monetarist and Keynesian, to make such a distinction illuminating rather than the reverse. Just what these continuities and consistencies of outlook consist of, will, we hope, become clear in the succeeding chapters.

Although, very often, the differences seem to lead to policy prescriptions that come out fairly consistently on one side or another of the political divide in many countries, our primary interest is in the economic analyses behind these prescriptions. We do not intend to try to judge whether any, some, or all of the economists involved came to their policy recommendations because they were convinced by the economic arguments, or whether their judgement over the relative validity of the economic argument was coloured by their political inclinations.¹

One final point needs to be made in this section. Because we think it clarifies the policy debates to put them into what we have described as a ‘quasihistorical’ context, there may be a danger of giving the impression that the Monetarists are simply reacting to the Keynesian arguments, and have had no coherent outlook of their own. This is not the case. The various strands in the Monetarist analyses do represent a coherent and consistent approach. However, because of the predominance of Keynesian macroeconomics over the past half-century viewed as a whole (for example, in the vast majority of introductory and intermediate textbooks), for much of the time Monetarist arguments have emerged into wider debates as objections to what they have seen as the prevailing ‘orthodoxy’. Some Monetarist writing has even seemed to enjoy taking the position of underdog and iconoclast.

OVERVIEW OF SOME OF THE ISSUES

A wide range of issues will be covered in the discussions of macroeconomic policy. Some will recur rather more frequently than others, in various contexts. At this point it might be helpful to indicate briefly a few of these themes, as a set of signposts for some of the more detailed treatments in the contexts of the particular policy debates. Readers will find it worthwhile to return to this section after they have studied the subsequent chapters.

Aims

In any discussion over macroeconomic policies, some disagreements may simply reflect disagreements over what should be the aims of public policies. Sometimes it may be that some people think that there is one aim which is paramount and that others are completely unimportant. More often, perhaps, there may be disagreements over the relative weights to be given to the aims when there is a trade-off, because the fuller achievement of one aim entails a lesser achievement of another.

The aims of macroeconomic policy are commonly considered to be: (i) low unemployment, (ii) low inflation, (iii) high levels of output and (iv) high rates of growth of output. These are often considered to be ‘obviously’ desirable, though, as we shall see, not invariably so. A satisfactory exchange rate or the avoidance of a balance of payments deficit are sometimes also considered as aims, but these are probably more correctly seen as constraints in the achievement of the other aims.

As we shall see later in this book, varying importance has been ascribed to these aims. For example, in the early years of Keynesian pre-eminence, particular stress was laid on low unemployment as the overriding aim of macroeconomic policy. Conversely, it has been suggested, some Monetarists worry primarily about controlling inflation and downplay concern with unemployment by analysing it as always voluntary.

Although we shall be dealing with macroeconomic policies, it is necessary to remember that not only may there be conflicts between the macroeconomic aims to which the policies are directed, but that these policies may interact with what are usually considered microeconomic issues. For example, the desirability of a rise in tax rates for purposes of reducing aggregate consumption when there is inflation may interact with consideration of the incentive and income distribution aspects of the level of taxation.

Relevance of markets

In the previous section we referred to our view that despite changes within what we shall call Monetarist and Keynesian views, there are important continuities. We start with a fundamental division between the two sets of views that seems to have persisted over time. Even when the focus of argument has shifted, and where the disagreements do not seem to centre on this fundamental issue, those on either side still seem to differ in their views on this very basic issue in their other statements.

The issue: the neo-classical paradigm of microeconomics is of a perfectly competitive market which moves smoothly and reasonably quickly from one equilibrium to another. Even within microeconomics there is an analysis of monopoly and other ‘imperfections’, but outside the specialist field of industrial economics, or in the pages of journals at the frontiers of research, the focus is usually on the perfectly competitive market. Those who take Monetarist positions in macroeconomics, tend to assume that the economy as a whole can be described as fitting this neo-classical paradigm with only trivial exceptions. In contrast, Keynesians assume that there is at least one important market that does not act according to the perfectly competitive paradigm. The obvious candidate for such a market would seem to be the labour market (although in recent years Keynesians have extended their analysis to product markets as well). It seems to us, that it is because the labour market is the obvious candidate for such an imperfection, if one believes that there is such a widespread imperf ection anywhere, that many of the arguments over the y ears have focused on the labour market. For example, even when the discussions are over the causes of inflation, which is defined in terms of product price changes, the disagreements always focus on wage setting.

Short and long term

There is another common division between analyses of macroeconomic problems which is somewhat related to the previous one. This one also often divides Keynesian and Monetarist views, though not invariably.

Both Monetarist and Keynesian analyses of the economy are most often equilibrium ones. Yet the notion of equilibrium is not identical. In the Monetarist approach, as in standard neo-classical microeconomics, prices and wages are flexible. They move in response to supply and demand, and (as indicated above), ensure that following any changes a new equilibrium is smoothly and reasonably quickly reached. In this equilibrium prices are such that supply equals demand. In many Keynesian models, however, there is a sort of equilibrium, but this is not attained via price and wage flexibility. There can in a sense be excess supply even in equilibrium.² For example ‘Keynesian unemployment’ equilibrium implies an excess supply of labour.

Some economists have therefore adopted the position that although Keynesian analysis is relevant for the short term, over the long term the Classical or Monetarist analysis is pertinent—since even if prices and/or wages are sluggish in the short term, eventually they will be flexible and alter in response to prolonged excess demand or supply.

For policy proposals, the question still remains which set of assumptions is more relevant. Keynes himself coined the phrase ‘In the long-run we are all dead’ as a riposte to those whose policies were based an anlyses of long-run equilibria. Conversely some Monetarists assume that the long-run equilibrium will be reached soon enough for it to be relevant even for all policy discussions (this is especially, though not exclusively, true of the ‘New Monetarists’ to be discussed in Chapter 5). Others sometimes argue that even if the long-run equilibrium is not ‘just round the corner’, a stress on short-run outcomes ignores the long-term implications and that these must also be taken into account. On this argument, mistakes would be made from ignoring any undesirable longerterm effects that would cumulate from a succession of policies myopically aimed at their short-term benefits.

Knowledge, ignorance and risk

It is relatively easy to draw diagrams on blackboards or in books, or to write down equations, which show the relationship between some variables; e.g. a consumption function showing how consumption would vary as income changed. In practice, however, there is always a lack of certainty, which itself may affect policy prescriptions.

The uncertainty covers various aspects. In the consumption function example just given, it may concern just how reliable are the numerical estimates of the marginal propensity to consume, and therefore, for example, the magnitude of the multiplier linking changes in fiscal policy to changes in income. The same applies to all the other relationships involved in predicting the quantitative effect of any policy. Often there will be a range of estimates from different studies, in addition to the variability inherent in each single statistically-based estimate. Even when there is substantial consensus over the size of any eventual impact, there may be uncertainties over the time taken to reach close to the final impact.

Frequently there is uncertainty about the current situation. Data on such variables as aggregate output or the balance of payments are often substantially revised as information is collected and collated. The initial estimates may therefore be misleading, yet some policy stance is necessary—keeping fiscal/monetary policies constant is itself a policy response.³

Some of the disagreements between economists are related to the problem of over how to react given the lack of certainty. Examples will occur throughout this book. It has often been considered that Keynesians were typically more confident about what was reliably knowable than Monetarists. This will, however, turn out to be another case where some of the splits within the groups are also significant (especially in Chapter 5).

If the views expressed in this section are correct, then clearly the disagreements between Keynesians and Monetarists are not restricted to disagreements over the role of the money supply or of monetary policy. Even if disagreements over the flexibility of labour markets are not as central as was suggested earlier in this section (pp. 4–5), the next four chapters will confirm that Keynesians and Monetarists often divide over non-monetary issues. Nevertheless, because it is by now such a well-established usage, we shall continue to use the term ‘Monetarist’ to describe those who oppose the Keynesian viewpoint.

PREREQUISITES AND TECHNIQUES

This book is intended for those who have taken an introductory course in macroeconomics. It is likely to be useful also for some of those who have taken further courses in the subject, as experience suggests that they may still sometimes be confused about the interrelationships between the issues to be covered. Although we shall assume that readers are familiar with the basic terms and concepts such as national income, the multiplier, what is usually meant by the money supply, and so on, some introductory material will be repeated where it is relevant to the policy issues, yet where the particular items are often treated as incidental and isolated examples when basic analytical techniques are taught.

One aspect of the Keynesian model which is sometimes covered in introductory texts and sometimes not is the IS-LM model. We shall therefore not assume a prior knowledge of the IS-LM approach, but will at times refer to it in notes where this may be illuminating for those who have understood the approach. Those readers who are familiar with IS-LM analysis should find it straightforward to draw the diagrams for themselves to illustrate the points in such notes.⁴

In any study of economic issues, the perennial question is what level of technical analysis to use. Our primary method will be to use verbal analysis, occasionally supplemented by diagrams. In add...