Aggregate Demand,Aggregate Supply,Investment and Savings,Monetary Policy,Monetary Policy,Price Levels and Inflation for bcom notes

Aggregate Demand

key terms

aggregate demand: The amount of total goods and services demanded at a given price level.

• Aggregate demand comes from those who make purchasing decisions in an economy. Each contributor to aggregate demand plays an important role in economic fluctuations. Those who make up aggregate demand for a given country are:
  • You, your mom and dad, your friend, your next door neighbor, and anyone else who demands stuff – you are all consumers. Consumers make up the part of aggregate demand called consumption (C).
  • Businesses — they need stuff to build stuff. They build factories and purchase capital. They are also a part of aggregate demand called investment (I).
  • The government — they buy stuff too. They buy big tanks and lots of lawyers (an example of buying a service). They build roads and dams; buy pens and pencils; and pay for a lot of catered dinners. They are also a part of aggregate demand called government (G).
  • Foreigners — they buy a lot of our stuff too. They buy our banking services, our airplanes, and our music. They are also a part of aggregate demand for their part in net exports (NX).

Note: These are the same elements of GDP which measures overall output.

• Aggregate demand changes when the price level changes. When the general price level is high, there is less demand; when the general price level is low, there is more demand.
  • Why?
    • When everything around you is expensive or getting more expensive (so the general price level is rising), you feel poorer. Because you feel poorer, you demand less goods and services. When everything around you is getting cheaper (price level falling), you feel richer and demand more goods and services.
    • There are slightly more complicated ways in which the price level affects investment and net exports, but the relationship is the same. (For a more comprehensive introduction see an introductory economics textbook such as N. Gregory Mankiw's Principles of Economics 4th Edition chapter 33.
  • As a result, we can draw the aggregate demand curve on a graph with the general price level on the y axis and output (Y) or GDP on the x-axis.

The graph tells us that if there is a change in the price level of the economy (say from 1 to 2) then GDP will fall (say from 100 million to 70 million).
Aggregate demand is also influenced by things other than the price level. Any change to consumption, investment, government spending, or net exports that do not have to do with changes in the overall price level will cause a shift in the aggregate demand curve.

Aggregate Supply

key terms

aggregate supply: The amount of total goods and services supplied at a given price level.
Aggregate supply consists of all the goods and services produced by all the firms in an economy.  There is a difference in the decision of how much firms produce in the long and short run.

• Long-run aggregate supply curve (LRAS)
  • In the long run, firms decide how much of their goods to make by looking at the amount of available capital and labor.
• The amount produced based on the amount of capital and labor available is called the natural rate of output. Movements away from the natural rate are called short-run economic fluctuations.
• In the long run, if there is a change in the demand for a firm’s good, the firm will change the price of its good or change the wage paid to its employees without changing the amount it produces (the "natural" amount). Every firm in the economy does the same thing.
• Therefore, in the long run, firms do not choose the amount they are going to produce based on the overall price level; the price level will adjust to the amount that they decide to produce. Therefore the long-run aggregate supply curve is vertical. 

All this graph shows is that if the overall price level changes (say from 1 to 2) there will be no change in output (Y) (in this case it stays at 100).

• Short-run aggregate supply curve (SRAS)

• In the short run, individual firms do take into consideration the overall price level when they make their decision on how much to produce.
• This result is based on the assumption that a firm cannot change its price or wage paid to employees in the short run. (Refer to a textbook such as N. Gregory Mankiw’s Principles of Economics 4th edition chapter 33 for an in depth discussion on why the short-run aggregate supply curve is upward sloping.)
  • For example, assume a firm starts to see the general price level rise, but it cannot raise its own prices because it is stuck (assume the firm printed its prices in a catalog and cannot change the price until it prints a new catalog). In order to take advantage of the higher price level, it decides to produce more. A firm without sticky prices will just raise the price of its good when it sees the general price level rise, causing firms with sticky prices to produce even more.
• So, as the overall price level rises, more goods are supplied in the short run. Reversing the logic you will see that as the price level falls, fewer goods will be supplied.

The graph tells us that if there is a change in the general price level of the economy (say from 1 to 2) then GDP (Y) will rise (say from 70 million to 100 million).

There are things other than the price level that can affect the aggregate supply curve. Changes in the cost of producing goods will shift the aggregate supply curve.

Economic Fluctuations

key terms

Mouse-over a link for a quick definition or click to read more in-depth!
aggregate demand
aggregate supply
capital
GDP
labor
unemployment

Temporary movements of economic variables away from their natural position. When the movements away from the natural position are caused by unexpected changes, there has been a shock to the economy. 
Economic fluctuations are evident in a graph of GDP for the United States.

As you can see there is a general trend showing potential GDP (the level of GDP that corresponds to the amount of labor and capital available in the economy – see the long-run aggregate supply curve growing at a fairly constant rate over time. There are, however, points in time where real GDP is above the growth line (see 1999) and points of time where it is below the growth line (see 1983).  These movements way from the natural growth line are economic fluctuations.
Policy makers and the general population are most often concerned with fluctuations in output, inflation , unemployment.  Economists think about fluctuations in terms of what is called aggregate demand and aggregate supply. If we place the aggregate demand curve (AD) along with the short-run aggregate supply curve (SRAS) and long-run aggregate supply curve (LRAS) on the same graph, we can find the overall price level as well as the level of output (or GDP) in the economy. Once we know the level of output and how it changes, we can also find the level of unemployment and how it changes using Okun's Law .

As illustrated in this graph, the intersection of the three lines represents the economy in long-run equilibrium. At this point the economy is producing at the level that labor, capital, and technology would dictate according to the long-run aggregate supply curve (YN). The economy is at its natural rate. The natural rate can change through time if there are changes to the long-run aggregate supply curve. In fact, continual technological advancements have caused the long-run aggregate supply curve to persistently move to the right. This is the reason for the growth in potential GDP shown in the United States. The economy represented in the graph above would correspond to an economy where real GDP is equal to potential GDP. We are concerned with fluctuations around the natural rate (when real GDP is not equal to potential GDP), so for simplicity’s sake, assume that the long-run aggregate supply curve remains fixed in the short run.
Fluctuations around the natural rate occur when changes to the aggregate demand curve or changes to the short-run aggregate supply curve lead to a short-run equilibrium that is different from the natural rate (YN). When these changes are unexpected they are called shocks.
Aggregate demand shock:
What would happen if Al Qaeda were to declare a truce with the West? Everyone feels pretty happy about the future and decides to go buy things. This is a positive consumer confidence shock, leading to a shift in the aggregate demand curve.

At the short-run equilibrium (a), output (Y2) is greater than the natural rate (YN) and the price level has risen (from P1 to P2).  The result of the increase in consumer confidence is a short-run increase in output and inflation.
Short run to long run:
The economy will not stay at this point (a) forever.  Eventually, all the reasons for a short-run aggregate supply curve will disappear (businesses can eventually change their prices or renegotiate a new wage contract). So in the long run there is no short-run aggregate supply curve.

The economy must be in equilibrium and thus cannot stay at point (a). In the long run, the businesses that decided to produce more in the short run because they couldn’t change their price find that they are overworking their machines and workers and would rather increase their price. So when they can, they cut production back to the natural level and prices rise. We move along the new aggregate demand curve to point (b) with permanently higher prices (P3) at the same level of output as before the shock (YN).
Policy:
The policy makers may find that the initial rise in price is harmful and would like to undo the resultant inflation. They can use either monetary policy or fiscal policy to move the aggregate demand curve back to its original position. In terms of monetary policy, the central bank could increase interest rates (by lowering the money supply). That would cause a decrease in investment and thus a shift back of the aggregate demand curve. The fiscal authority, on the other hand, could either increase taxes or decrease spending. Either policy move would bring aggregate demand back to its original position. The economy would return to the original price level and level of output (b).

Short-run aggregate supply shock:
What effect might the floods of 2008 in the Midwest have on the economy? The flood destroyed the crops of many farmers, adversely affecting the short-run aggregate supply curve.

In the short run the economy moves to point (a). Output falls below the natural rate and prices rise. This combination of low output and inflation is called stagflation. Without any intervention the economy would eventually return to the original point were the aggregate demand curve crosses the long-run aggregate supply curve (recall there is no short-run aggregate supply curve in the long run).
Policy:
Policy makers have a dilemma if they want to offset this particular kind of economic fluctuation. Both the monetary and fiscal authorities are limited in that they can only shift the aggregate demand curve. If they increase aggregate demand, they will increase the level of equilibrium output, but they will also push prices even higher. If they decide to decrease aggregate demand, they can reduce the price level but they will also push equilibrium output further away from the natural rate. Fiscal and monetary coordination is helpful during such a situation.

Investment and Savings

key terms

• Notice that the way economists use the word investment is not the same as you may be used to. You may think of someone asking you where you are going to invest your money, or if you put your money into the stock market you might be asked if you felt it was a good investment.
• You putting your money in the stock market, an IRA account, a CD, or a savings account is called savings.
• Investment is what is done with your savings.
• When you buy a stock (savings) you give money to a business (expecting a return) so that they can build a machine or build a new building (investment).
• When you put your money in a savings account (savings), the bank doesn’t just leave the money there; it loans your money to a business to build a factory or buy a machine or to a consumer to buy a house (investment)
• Thus in the end investment = savings.
• Investment is an important piece of GDP and aggregate demand.
• Investment is sensitive to the interest rate. In order for a business to purchase capital or build a building or for a homeowner to get a mortgage, they must borrow the money (from you the saver).
  • If the interest rate is high, it is more expensive to pay back a loan. As a result, businesses may wait to build a new building and investment falls.
• If the interest rate is low, it is easier to pay back a loan. As a result a potential homeowner may decide by build a house now rather than later and investment rises.
• This sensitivity to the interest rate, which a monetary authority can control in
•  

  Monetary Policy

  key terms

  Monetary policy is a central bank’s use of either the money supply and/or interest rates to influence economic activity (Froyen, Richard (2009). Macroeconomics Theories and Policies. Pearson Prentice Hall).
  
• How does the central bank conduct its policy?
• There are a number of tools that the central bank can use, but most often it uses its control of the supply of money to influence the interest rate.
  • Any central bank has a stash of money that it keeps in its vault.
    • If it wants to increase the money supply, it takes money out of its vault and puts it into circulation (usually by buying bonds).
    • If it wants to decrease the money supply, it takes money out of circulation and puts it in its vault where no one else can touch it (usually by selling bonds).
  • As the money supply increases, the interest rate falls.
  • As the money supply decreases, the interest rate rises.
• What is the result of monetary policy?

	Interest Rate	Output	Unemployment	Inflation
Money Supply Increases
Money Supply Increases

Note: Output changes because of the interest rate's affect on investment.

• Why does the central bank conduct policy?
  • People dislike fluctuations in the economy, especially when unemployment or inflation rises.
• People look to the central bank to prevent these fluctuations.
• NOTE: There is a trade-off. As the central bank pumps money into the economy it lowers unemployment, but it also causes inflation.
• NOTE: If the central bank wants to lower inflation, it must accept an increase in unemployment!
• General challenges to the conduct of monetary policy:
  • The monetary authority must make its decision on whether to increase or decrease the money supply based on current information (which is not complete) as well as forecasts of what the economic condition will be in the future (which is not perfect). Misinformation could cause the monetary authority to do the wrong thing.
  • Though the monetary authority can act quickly to fluctuations in the economy by changing the money supply, it takes a while for the change in the money supply to actually influence prices and unemployment. By the time the policy has an effect on the economy, there may no longer be a need for it (this is called a long outside lag).

Price Levels and Inflation

• The price level is the overall measure of prices in a given country or region at a particular point in time.
• Inflation is an increase in the price level over a specified period of time.
  • The inflation rate is the percentage change in the price level from one period of time to the next. The rate of inflation varies from country to country
• Deflation is a decrease in the price level over a specified period of time.
• A negative inflation rate would mean there is deflation.
• How is the price level measured? The Consumer Price Index (CPI).
  • There is a “basket” of goods and services commonly bought by the average consumer. This “basket” is actually a very specific list of what you might buy: apples, chicken, gas, a dishwasher, dry cleaning services, a shirt, a movie ticket, an iPod, a car repair, etc.
  • A group of government workers goes out and writes down the prices of everything on that list. They then come back and calculate how much their list, or basket, would have cost.
    • The cost of this basket is the price level, also called the price index, for that time period. Because the basket is specific to what consumers would buy, it is called the consumer price index (CP

• How is inflation measured?
  • Every few months these workers go back out to measure the price of their basket and record the price index for each new time period. 
  • Because the basket of goods is not changing, if the price of the basket changes from one period of time to the next you know the general price level has changed. If the price of the basket increases, the country has experienced inflation. 
  • To calculate the inflation rate, say from period 1 to period 2, you just calculate the percentage change.
    Inflation>_1,2 = 100% * (CPI₁ - CPI₂) / CPI₁

• What determines the price level and inflation rate?
  • In the long run the price level is determined by the amount of money available in the economy.
    • The relationship between the supply of money, the price level, and inflation is captured in the quantity theory of money:
      M*V = P*Y
      Where (M) is the supply of money, (V) is the velocity of money, (P) is the price level, and (Y) is output.
    • If you look at the percentage change of this relationship and assume that money velocity (V) and output (Y) are fixed, you get:
      % change in the money supply (M) = % change in the price level (P)
    • If the money supply increases 10 percent, prices will increase 10 percent. There is too much money chasing too few goods (remember we assumed the amount produced (Y) stayed the same).
  • The supply of money is most often controlled by a country’s central bank.
• There are episodes in history (and today) when the amount of money available was controlled more so by politicians than an independent central bank. In times of crisis, some of these countries started printing mass amounts of money, leading to extreme episodes of inflation called hyperinflation.
• In the short run the price level and inflation are determined by fluctuations in aggregate demand and short-run aggregate supply. This can result from either shocks or fiscal and monetary policy.  
• When price fluctuations are minimal and inflation is fairly constant at a low rate (say around 2%), price stability has been obtained.

• What are the costs of inflation?
  • If your income does not rise at the same rate as inflation, you will not be able to purchase as many things as prices rise.
• This is a real problem for those on fixed incomes such as retirees living off of their fixed pensions.
• The value of your savings is eroded.
• The $100 you save today will not buy as much in the future once you take it out of savings.
• It causes uncertainty about future prices and thus complicates today’s economic decisions.
• Maintaining price stability is the major goal of the ECB.
• Before the ECB came into existence, potential members of the EMU were forced to bring inflation under control in the Maastricht treaty.

Inflation rates for the US and Europe are illustrated below.

Note: CPI measures of inflation were not available for every member or the EU, so I use the GDP deflator for my price level to calculate inflation � though not the same as CPI it does give a similar picture of what is happening with inflation.
Note: The Euro Area inflation rate is from a weighted average of price levels for the members of the EMU.

Unemployment

Unemployment is a measurement reflecting the number of people actively looking for, but unable to find work.

• The unemployment rate is the percentage of the labor force that is unemployed:
  U = 100 * # of unemployed / # in labor force
• The labor force consists of all the workers that are currently working or are actively searching for work
  • Stay-at-home moms, for example, are not considered as a part of the labor force, but a mom who works outside the home (or is looking for work outside of the home) is.
  • The natural rate of unemployment or full employment is the level of unemployment or employment that corresponds to the natural rate of output around which the unemployment rate fluctuates in the short run.
    • The natural rate of unemployment is not the same for every country. In fact, the natural rate of unemployment in Europe is much higher than that in the United States.
    • The natural rate of unemployment is higher in Europe because there are laws and conditions in place that make it more difficult to hire workers, make the wage higher than it would be in the market, or make it easier to delay finding a job compared to the United States. For example, in most European countries
      • There are higher minimum wage laws than in the US.
      • Labor unions are much stronger and are able to negotiate higher wages than in the US.
      • The government supports the unemployed (with welfare payments) much more and longer than in the US.
    • Unemployment that is the result of factors such as those listed above is called structural unemployment, and leads to the relatively higher natural rate of unemployment in Europe.
  
  Note: The Euro Area is the weighted average unemployment rate of the 12 original members of the EMU.
  
  • The higher average unemployment rate after the mid 1980s illustrates the higher structural unemployment rate for Europe.
  • As you can also see from the chart above, the unemployment rate fluctuates through time. These short-run changes in unemployment coincide with changes in output according to Okun's Law.  Therefore the movements around the natural rate of unemployment are due to economic fluctuations.
    • Unemployment that occurs as a result of economic fluctuations is called frictional unemployment.
  • What is the role of policy?
    • The government can reduce structural unemployment by:
  • Reducing minimum wage laws.
  • Drafting laws that make the wage respond better to market conditions.
  • Providing training and job finding services for the unemployed.
  • Reducing or shortening welfare payments to the unemployed.
  • If a policy maker can control economic fluctuations, then it can exert some control on the frictional unemployment rate.
  • Policy makers can use
  • Fiscal policy to increase output and thus lower unemployment by lowering taxes or increasing spending
  • Monetary policy to increase output and thus lower unemployment by increasing the money supply in order to lower interest rates
  
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Understanding central bank operations

I have arrived in Washington now and it is late Monday. I am staying on local Newcastle time because for a short-trip it is easier to avoid jet lag that way. So I started work today at around 20:00 Washington time and will finish close to dawn. I think I will play Night Shift on You Tube to keep me company through the night … err day (Australian time). On the plane coming over, among other things, I read a paper written a couple of years ago by the Federal Reserve Bank of New York about the way in which monetary policy can be “divorced” from bank reserves. It is a useful paper at the operational level because it brings out a number of important points about bank reserves and the way central banks can manipulate them or ignore them. That is what this blog is about.

In the September 2008 edition of the Federal Reserve Bank of New York Economic Policy Review there was an interesting article published entitled – Divorcing Money from Monetary Policy.
It demonstrated why the account of monetary policy in mainstream macroeconomics textbooks (such as Mankiw etc) from which the overwhelming majority of economics students get their understandings about how the monetary system operates is totally flawed.
The FRBNY article begins by stating that:

Monetary policy has traditionally been viewed as the process by which a central bank uses its influence over the supply of money to promote its economic objectives. For example, Milton Friedman (1959, p. 24) defined the tools of
monetary policy to be those “powers that enable the [Federal Reserve] System to determine the total amount of money in existence or to alter that amount.” In fact, the very term monetary policy suggests a central bank’s policy toward the supply of money or the level of some monetary aggregate.

In his Principles of Economics (I have the first edition), Mankiw’s Chapter 27 is about “the monetary system”. In the latest edition it is Chapter 29. Either way, you won’t learn very much at all from reading it.
In the section of the Federal Reserve (the US central bank), Mankiw claims it has “two related jobs”. The first is to “regulate the banks and ensure the health of the financial system”. So I suppose on that front he would be calling for the sacking of all the senior Federal Reserve officials given the massive collapse that occurred under their watch.
The second “and more important job”:

… is to control the quantity of money that is made available to the economy, called the money supply. Decisions by policymakers concerning the money supply constitute monetary policy (emphasis in original).

And in case you haven’t guessed he then describes how the central bank goes about fulfilling this most important role. He says that the:

Fed’s primary tool is open-market operations – the purchase and sale of U.S government bonds … If the FOMC decides to increase the money supply, the Fed creates dollars and uses them buy government bonds from the public in the nation’s bond markets. After the purchase, these dollars are in the hands of the public. Thus an open market purchase of bonds by the Fed increases the money supply. Conversely, if the FOMC decides to decrease the money supply, the Fed sells government bonds from its portfolio to the public in the nation’s bond markets. After the sale, the dollars it receives for the bonds are out of the hands of the public. Thus an open market sale of bonds by the Fed decreases the money supply.

The very next paragraph gets to the message he wants students to take away “because changes in the money supply can profoundly affect the economy”. Why? That is easy, “(o)ne of the Ten Principles of Economics … is that prices rise when the government prints too much money”. Please read my blog – Do not learn economics from a newspaper – for more discussion on why these principles are just an ideological brainwashing exercising.
The upshot is that students who purport to learn economics from a course using this textbook will be ill-equipped to say anything sensible about how the actual monetary system operates.
The FRBNY state clearly that:

In recent decades, however, central banks have moved away from a direct focus on measures of the money supply. The primary focus of monetary policy has instead become the value of a short-term interest rate. In the United States, for example, the Federal Reserve’s Federal Open Market Committee (FOMC) announces a rate that it wishes to prevail in the federal funds market, where overnight loans are made among commercial banks. The tools of monetary policy are then used to guide the market interest rate toward the chosen target.

This is practice is not confined to the US. All central banks operate in this way and I have shown in other blogs that central banks cannot control the “money supply”.
However, the FRBNY try to build a bridge between the two viewpoints by claiming that “the quantity of money and monetary policy remain fundamentally linked”. How do they construct that argument?
They say that because commercial banks hold “reserve balances at the central bank” and demand “reserve balances … inversely … [to] … the short-term interest rate”, which is the “the opportunity cost of holding reserves” then the central bank can “manipulate the supply of reserve balances” by exchanging “reserve balances for bond” (open market operations) to ensure that the “marginal value of a unit of reserves to the banking sector equals the target interest rate”. This allows the interbank market (for overnight funds) to clear and maintain the policy rate.
The FRBNY say that “(i)n other words, the quantity of money (especially reserve balances) is chosen by the central bank in order to achieve its interest rate target”. This is, in fact, fairly loose language. It is clear that the level of reserve balances in the system are chosen by the central bank to maintain the policy rate as I will explain. But using terminology like the “quantity of money” is misleading and doesn’t match the concept of the “money supply” that the likes of Friedman and Mankiw were referring to. They were in fact referring to a close relationship between what is known as the monetary base and broad money. In mainstream economics, the link is provided by the money multiplier model.
However, that construction of banking dynamics is false. There is in fact no unique relationship of the sort characterised by the erroneous money multiplier model in mainstream economics textbooks between bank reserves and the “stock of money”.
You will note that in Modern Monetary Theory (MMT) there is very little spoken about the money supply. In an endogenous money world there is very little meaning in the aggregate concept of the “money supply”.
Central banks do still publish data on various measures of “money”. The RBA, for example, provides data for:

• Currency – Private non-bank sector’s holdings of notes and coins.
• Current deposits with banks (which exclude Australian and State Government and inter-bank deposits).
• The M1 measure – Currency plus bank current deposits of the private non-bank sector.
• The M3 measure – M1 plus all other ADI deposits of the private non-ADI sector. So a broader measure than M1.
• Broad money – M3 plus non-deposit borrowings from the private sector by AFIs, less the holdings of currency and bank deposits by RFCs and cash management trusts.
• Money base – Holdings of notes and coins by the private sector, plus central bank reserves (deposits of banks with the Reserve Bank and other Reserve Bank liabilities to the private non-bank sector.

Note that ADI are Australian deposit-taking institutions; AFI are Australian financial intermediaries; and the RFCs are Registered Financial Corporations. Here is the RBA’s excellent glossary for future reference.
The mainstream theory of money and monetary policy asserts that the money supply (volume) is determined exogenously by the central bank. That is, they have the capacity to set this volume independent of the market. The monetarist portfolio approach claims that the money supply will reflect the central bank injection of high-powered (base) money and the preferences of private agents to hold that money. This is the so-called money multiplier.
So the central bank is alleged to exploit this multiplier (based on private portfolio preferences for cash and the reserve ratio of banks) and manipulate its control over base money to control the money supply.
To some extent these ideas were a residual of the commodity money systems where the central bank could clearly control the stock of gold, for example. But in a credit money system, this ability to control the stock of “money” is undermined by the demand for credit.
The theory of endogenous money is central to the horizontal analysis in MMT. When we talk about endogenous money we are referring to the outcomes that are arrived at after market participants respond to their own market prospects and central bank policy settings and make decisions about the liquid assets they will hold (deposits) and new liquid assets they will seek (loans).
A leading contributor to the endogeneous money literature is Canadian Marc Lavoie. In his 1984 article (‘The endogeneous flow of credit and the Post Keynesian theory of money’, Journal of Economic Issues, 18, 771-797) he wrote(page 774):

When entrepreneurs determine the effective demand, they must plan the level of production, prices, distributed dividends, and the average wage rate. Any production in a modern or in an “entrepreneur” economy is of a monetary nature and must involve some monetary outlays. When production is at a stationary level, it can be assumed that firms have at their disposal sufficient cash to finance their outlays. This working capital, in the aggregate, constitutes credits that have never been repaid. When firms want to increase their outlays, however, they clearly have to obtain extended credit lines or else additional loans from the banks. These flows of credit then reappear as deposits on the liability side of the balance sheets of banks when firms use these loans to remunerate their factors of production.

The essential idea is that the “money supply” in an “entrepreneurial economy” is demand-determined – as the demand for credit expands so does the money supply. As credit is repaid the money supply shrinks. These flows are going on all the time and the stock measure we choose to call the money supply, say M3 is just an arbitrary reflection of the credit circuit.
So the supply of money is determined endogenously by the level of GDP, which means it is a dynamic (rather than a static) concept.
Central banks clearly do not determine the volume of deposits held each day. These arise from decisions by commercial banks to make loans. The central bank can determine the price of “money” by setting the interest rate on bank reserves. Further expanding the monetary base (bank reserves) as we have argued in recent blogs – Building bank reserves will not expand credit and Building bank reserves is not inflationary – does not lead to an expansion of credit.
So what the FRBNY is talking about is the relationship between bank reserves (used to satisfy any imposed reserve requirements and facilitate the payments system) and the policy interest rate setting. They recognise that this relationship – between reserves and monetary policy – “can generate tension with central banks’ other objectives because bank reserves play other important roles in the economy”.
They specify these roles in this way:

… reserve balances are used to make interbank payments; thus, they serve as the final form of settlement for a vast array of transactions. The quantity of reserves needed for payment purposes typically far exceeds the quantity consistent with the central bank’s desired interest rate. As a result, central banks must perform a balancing act, drastically increasing the supply of reserves during the day for payment purposes through the provision of daylight reserves (also called daylight credit) and then shrinking the supply back at the end of the day to be consistent with the desired market interest rate.

This statement allows you to gain some appreciation of we mean by the liquidity management operations of the central bank. It must ensure that all private cheques (that are funded) clear and other interbank transactions occur smoothly as part of its role of maintaining financial stability. But, equally, it must also maintain the bank reserves in aggregate at a level that is consistent with its target policy setting given the relationship between the two.
The FRBNY say that the central bank’s role as lender of last resort (standing ready to lend reserves on demand to facilitate the payments system) exposes them to credit risk (bank failure) and “may also generate moral hazard problems and exacerbate the too-big-to-fail problem, whereby regulators would be reluctant to close a financially troubled bank”. These exposures have clearly been topical over the course of the recent crisis.
How might this compromise monetary policy? To answer that we need to understand the relationship between bank reserves nad the monetary policy target.
During a crisis central banks increased bank reserves to keep the system “liquid”. As I explain in this blog – Quantitative Easing 101 – many commentators thought the injection of reserves was about easing credit. But banks don’t lend reserves anyway (except among themselves in the interbank market).
But the consequence of “increasing the supply of the most liquid asset in the economy – bank reserves” was to drive the “market interest rate below the FOMC’s target rate and thus interfered with monetary policy objectives”. This arises because banks with excess reserves (and some have to have excesses if there is an overall system excess) will try to lend them out to other banks in the interbank market if there is no return provided by the central bank on those reserves. The competition within the interbank market drives the “market interest rate” down and so a dislocation occurs between the interbank rate and the policy rate.
You will sometimes read in MMT literature that budget deficits drive interest rates down. The logic is that the deficits add reserves to the cash system which are in excess of the levels desired by the banks and so they try to rid them via interbank market competition. That statement however should not be taken as a reflection of what actually happens in reality. It is clear that the central bank sets the short-term interest rate according to its current policy aims and its excpectations of likely movements in variables that influence its monetary policy formation. Some call this the “central bank reaction function”, although concept is tainted by its association with deficit terrorist John B. Taylor.
But the conduct of fiscal policy is executed within institutional structures that do not allow these reserve excesses to occur to any degree. So governments have volunatarily introduced legislation or regulations that force it to issue debt to match their net spending – in some cases the former has to come before the latter. Under these institutional constraints, it is not accurate to say that budget deficits drive down or put downward pressure on interest rates. If the governments abandoned these gold standard/convertible currency artefacts, which are totally unnecessary in a fiat currency system, then budget deficits would force the central bank to issue debt to maintain a positive interest rate target (that is, to drain the excess reserves).
Anyway, that was an aside.
The point is that operating factors link the level of reserves to the monetary policy setting under certain circumstances. These circumstances require that the return on “excess” reserves held by the banks is below the monetary policy target rate. In addition to setting a lending rate (discount rate), the central bank also sets a support rate which is paid on commercial bank reserves held by the central bank.
Many countries (such as Australia and Canada) maintain a default return on surplus reserve accounts (for example, the Reserve Bank of Australia pays a default return equal to 25 basis points less than the overnight rate on surplus Exchange Settlement accounts). Other countries like the US and Japan have historically offered a zero return on reserves which means persistent excess liquidity would drive the short-term interest rate to zero.
The support rate effectively becomes the interest-rate floor for the economy. If the short-run or operational target interest rate, which represents the current monetary policy stance, is set by the central bank between the discount and support rate. This effectively creates a corridor or a spread within which the short-term interest rates can fluctuate with liquidity variability. It is this spread that the central bank manages in its daily operations.
During the current crisis the US Federal Reserve started paying a positive return on bank reserves. The FRBNY says that:

Recently, attention has turned to an alternative approach to monetary policy implementation that has the potential to eliminate the basic tension between money and monetary policy by effectively “divorcing” the quantity of reserves from
the interest rate target. The basic idea behind this approach is to remove the opportunity cost to commercial banks of holding reserve balances by paying interest on these balances at the prevailing target rate. Under this system, the interest rate paid on reserves forms a floor below which the market rate cannot fall. The supply of reserves could therefore be increased substantially without moving the short-term interest rate away from its target. Such an increase could be used to provide liquidity during times of stress or to reduce the need for daylight credit on a regular basis.

So the US is catching up with the other nations in this regard.
To see how this works the FRBNY provide the following diagram (Exhibit 1) which outlines a simple model of the way in which reserves are manipulated by the central bank as part of its liquidity management operations designed to implement a specific monetary policy target (policy interest rate setting).
Note they ignore “vault cash” which means that reserve balances and reserves can be used “interchangeably”.

While the article is about monetary policy implementation in the US, the general principles apply to all central banking operations.
The demand for central bank reserves by banks arises for two reasons. First, in the US, banks face reserve requirements which means that if a specific bank experiences a shortfall in its reserves it has to pay a penalty (“proportional to the shortfall”). In other nations, such as Australia and Canada the only “requirement” is that the banks keep there reserves in the black on a daily basis. But the imposition of reserve requirements is a hangover from the gold standard days and is totally unnecessary in today’s banking environment. Please read my blog – Lending is capital- not reserve-constrained – for more discussion on this point.
The second factor determining the demand for reserves arisise because:

… banks experience unanticipated late-day payment flows into and out of their reserve account after the interbank market has closed. A bank’s final reserve balance, therefore, may be either higher or lower than the quantity of reserves it chooses to hold in the interbank market. This uncertainty makes it difficult for a bank to satisfy its requirement exactly and generates a “precautionary” demand for reserves.

Thus central bank reserves are intrinsic to the payments system (or clearing house system) where a mass of interbank claims are resolved by manipulating the reserve balances that the banks hold at the central bank. This process has some expectational regularity on a day-to-day basis but stochastic (uncertain) demands for payments also occur which means that banks will hold surplus reserves to avoid paying any penalty arising from having reserve deficiencies at the end of the day (or accounting period – which in the US is a moving two-week average).
To understand what is going on not that the diagram is representing the system-wide demand for bank reserves where the “horizontal axis measures the total quantity of reserve balances held by banks while the vertical axis measures
the market interest rate for overnight loans of these balances”.
On the horizontal axis the required reserves are regulated and are the absolute minimum that the system has to hold overall.
On the vertical axis, the penalty rate is the rate the central bank imposes on banks if they access the “primary credit facility” (which is sometimes known as the discount window). You might like to read the FRBNY article to understand some of the nuances associated with the use of the discount window, in particular, the fact that banks will sometimes borrow above the discount rate to avoid the stigma associated with signalling that they need help.
But the feature the FRBNY highlight is that “penalty rate … lies above the FOMC’s target interest rate”.
Why should the demand for reserves take this particular shape? The question the FRBNY ask is:

… given a particular value for the interest rate, what quantity of reserve balances would banks demand to hold if that rate prevailed in the interbank market?

Note that it would not make sense to set the penalty rate below the likely market (interbank) rate. If the market rate equals the penalty rate then banks will be indifferent as to where they access reserves from so the demand curve is horizontal.
Once the price of reserves falls below the penalty rate, banks will then demand reserves according to their requirments (the legal and the perceived). So “aggregate reserve demand will be close to the total level of required reserves”. The higher the market rate of interest, the higher is the opportunity cost of holding reserves and hence the lower will be the demand. As rates fall, the opportunity costs fall and the demand for reserves increases. But in all cases, banks will only seek to hold (in aggregate) the levels consistent with their requirements.
At low interest rates (say zero) banks will hold the legally-required reserves plus a buffer that ensures there is no risk of falling short during the operation of the payments system. So the FRBNY say:

If the market interest rate were exactly zero, however, there would be no opportunity cost of holding reserves. In this limiting case, there is no cost at all to a bank of holding additional reserves above the fully insured amount. The demand curve is therefore flat along the horizontal axis after this point; banks are indifferent between any quantities of reserves above the fully insured amount when the market interest rate is exactly zero.

Bear in mind this is a very simple model. Its value is that it demonstrates that the market rate of interest will be determined by the central bank supply of reserves. “If the supply is smaller than the total amount of required reserves, for example, the equilibrium interest rate would be near the penalty rate. If, however, the supply of reserves were very large, the equilibrium interest rate would be zero. Between these two extremes, on the downward-sloping portion of the demand curve, there is a liquidity effect of reserve balances on the market interest”.
At the supply level the FRBNY call the “target supply”, the central bank can hit is monetary policy target rate of interest given the banks’ demand for aggregate reserves. This allows you to understand how monetary operations work. Monetary policy involves the announcement of a policy rate and then the liquidity management operations require the central bank to set “the supply of reserves to this target level”. In practice, the situation is a little more complicated and the central bank actually works to “flatten the demand curve” to take out the volatility in short-period fluctuations around the target rate.
So contrary to what Mankiw’s textbook tells students the reality is that:

… monetary policy is implemented … by changing the supply of reserves in such a way that the … [interbank market] … will clear at the desired rate.

The FRBNY say that “(i)n other words, the stock of “money” is set in order to achieve a monetary policy objective” but we know the more accurate statement is the level of reserves is set in order to achieve the monetary policy target in the absence of the payment of a support rate.
The next diagram (Exhibit 2 in the FRBNY paper) adds the payment of a support rate, which they term the deposit rate. The major impact is to lift the rate at which the demand curve becomes horizontal or which “allows banks to earn overnight interest on their excess reserve holdings at a rate that is the same number of basis points below the target”. The support rate becomes the minimum market interest rate (arbitrage will ensure that is so) and it defines the lower bound of the corridor within which the market rate can fluctuate without central bank intervention.
So in this diagram, the market interest rate is still set by the supply of reserves (given the demand for reserves) and so the central bank still has to manage reserves appropriately to ensure it can hit its policy target.

It is then clear how the central bank can “divorce” its monetary policy target from the level of bank reserves and allow the central bank to provide whatever reserves it thinks are needed beyond the essential equilibrium target supply shown in the first graph. This can be accomplished by paying the target rate as the support rate.
In addition, such a policy reduces the activity in the interbank market because “banks would have less need to target their reserve balance precisely on a daily basis. In particular, since banks with excess funds can earn the target rate by simply depositing them with the central bank, the incentive to lend these funds is lower than it is under the other approaches to implementation discussed above”.
However, the FRBNY says:

It is important to bear in mind, however, that the market for overnight loans of reserves differs from other markets in fundamental ways. As we discussed, reserves are not a commodity that is physically scarce; they can be costlessly produced by the central bank from other risk-free assets. Moreover, there is no role for socially useful price discovery in this market, because the central bank’s objective is to set a particular price.

While the FRBNY do provide some reasons why an active interbank market is a good thing, the balance lies in the view that it is not. Setting a support rate at the target rate allows the central bank to maintain its policy rate without the uncertainty associated with guessing what level of reserves to supply on a daily basis.
The Fiscal Sustainability Teach-In and Counter-Conference
The Fiscal Sustainability Teach-In and Counter-Conference will be staged in Washington D.C. next Wednesday (April 28, 2010) and details of venues and other relevant arrangements are available at the home page. All are welcome.
This is the first grass roots effort to promote MMT. The day has been chosen to rival the sham Peter G. Peterson Foundation conference exploring the same topic.
If you are near to Washington DC and have the means it would be great to meet you next week.
You will also note that I have included a fund raising widget on my right side-bar at present. Any help for the organisers will be very appreciated. Just click the image and open your bank accounts! Apparently this will only accept funds if you are in the US. The alternative strategy is to use the contact page that the organisers have set up and pursue your enquiry that way.
At present they really need some financial support. It is a shoe-string, community-driven event being organised by committed volunteers who are motivated by the fact that they care and realise something is wrong with the dominance of conservative, free-market think tanks like the PGPF in the public debate.
That is enough for today … I mean tonight! Where am I?

Any substantial increase in the monetary base can be sustained only if interest rates are pushed down to low levels, ultimately to zero.

Any substantial increase in the monetary base can be sustained only if interest rates are pushed down to low levels, ultimately to zero.

The answer is False.
The question statement appeared in an article on October 1, 2013 by well-known economist Brad De Long in the article – John Quiggin: MMT: Noted. He was quoting Australian economist John Quiggin from an earlier critique of Modern Monetary Theory (MMT). De Long must have thought there was some value in perpetuating the myths that appeared in Quiggin’s original article.
It is a pity that these economists still wax lyrical about the monetary system without even understanding some of the basics.
The question (that is, Quiggin’s conclusion) is false because it ignores the fact that the central bank can offering a support rate on excess overnight reserves held with it by the private banks.
The central bank conducts what are called liquidity management operations for two reasons. First, it has to ensure that all private cheques (that are funded) clear and other interbank transactions occur smoothly as part of its role of maintaining financial stability. Second, it must maintain aggregate bank reserves at a level that is consistent with its target policy setting given the relationship between the two.
So operating factors link the level of reserves to the monetary policy setting under certain circumstances. These circumstances require that the return on “excess” reserves held by the banks is below the monetary policy target rate. In addition to setting a lending rate (discount rate), the central bank also sets a support rate which is paid on commercial bank reserves held by the central bank.
Commercial banks maintain accounts with the central bank which permit reserves to be managed and also the clearing system to operate smoothly. In addition to setting a lending rate (discount rate), the central bank also can set a support rate which is paid on commercial bank reserves held by the central bank (which might be zero).
Many countries (such as Australia, Canada and zones such as the European Monetary Union) maintain a default return on surplus reserve accounts (for example, the Reserve Bank of Australia pays a default return equal to 25 basis points less than the overnight rate on surplus Exchange Settlement accounts). Other countries like Japan and the US have typically not offered a return on reserves until the onset of the current crisis.
If the support rate is zero then persistent excess liquidity in the cash system (excess reserves) will instigate dynamic forces which would drive the short-term interest rate to zero unless the government sells bonds (or raises taxes). This support rate becomes the interest-rate floor for the economy.
The short-run or operational target interest rate, which represents the current monetary policy stance, is set by the central bank between the discount and support rate. This effectively creates a corridor or a spread within which the short-term interest rates can fluctuate with liquidity variability. It is this spread that the central bank manages in its daily operations.
In most nations, commercial banks by law have to maintain positive reserve balances at the central bank, accumulated over some specified period. At the end of each day commercial banks have to appraise the status of their reserve accounts. Those that are in deficit can borrow the required funds from the central bank at the discount rate.
Alternatively banks with excess reserves are faced with earning the support rate which is below the current market rate of interest on overnight funds if they do nothing. Clearly it is profitable for banks with excess funds to lend to banks with deficits at market rates. Competition between banks with excess reserves for custom puts downward pressure on the short-term interest rate (overnight funds rate) and depending on the state of overall liquidity may drive the interbank rate down below the operational target interest rate. When the system is in surplus overall this competition would drive the rate down to the support rate.
The main instrument of this liquidity management is through open market operations, that is, buying and selling government debt. When the competitive pressures in the overnight funds market drives the interbank rate below the desired target rate, the central bank drains liquidity by selling government debt. This open market intervention therefore will result in a higher value for the overnight rate. Importantly, we characterise the debt-issuance as a monetary policy operation designed to provide interest-rate maintenance. This is in stark contrast to orthodox theory which asserts that debt-issuance is an aspect of fiscal policy and is required to finance deficit spending.
So the fundamental principles that arise in a fiat monetary system which are relevant here are as follows.

• The central bank sets the short-term interest rate based on its policy aspirations.
• Government spending is independent of borrowing which the latter best thought of as coming after spending.
• Government spending provides the net financial assets (bank reserves) which ultimately represent the funds used by the non-government agents to purchase the debt.
• Budget deficits put downward pressure on interest rates contrary to the myths that appear in macroeconomic textbooks about ‘crowding out’.
• The “penalty for not borrowing” is that the interest rate will fall to the bottom of the “corridor” prevailing in the country which may be zero if the central bank does not offer a return on reserves.
• Government debt-issuance is a “monetary policy” operation rather than being intrinsic to fiscal policy, although in a modern monetary paradigm the distinctions between monetary and fiscal policy as traditionally defined are moot.

Accordingly, debt is issued as an interest-maintenance strategy by the central bank. It has no correspondence with any need to fund government spending. Debt might also be issued if the government wants the private sector to have less purchasing power.
Further, the idea that governments would simply get the central bank to “monetise” treasury debt (which is seen orthodox economists as the alternative “financing” method for government spending) is highly misleading. Debt monetisation is usually referred to as a process whereby the central bank buys government bonds directly from the treasury.
In other words, the federal government borrows money from the central bank rather than the public. Debt monetisation is the process usually implied when a government is said to be printing money. Debt monetisation, all else equal, is said to increase the money supply and can lead to severe inflation.
However, as long as the central bank has a mandate to maintain a target short-term interest rate, the size of its purchases and sales of government debt are not discretionary unless it is prepared to offer a support rate to the banks for excess reserves held. In the absence of that offer, once the central bank sets a short-term interest rate target, its portfolio of government securities changes only because of the transactions that are required to support the target interest rate.
The central bank’s lack of control over the quantity of reserves underscores the impossibility of debt monetisation under these circumstances (no support rate). The central bank is unable to monetise the federal debt by purchasing government securities at will because to do so would cause the short-term target rate to fall to zero or to the support rate. If the central bank purchased securities directly from the treasury and the treasury then spent the money, its expenditures would be excess reserves in the banking system. The central bank would be forced to sell an equal amount of securities to support the target interest rate.
The central bank would act only as an intermediary. The central bank would be buying securities from the treasury and selling them to the public. No monetisation would occur.
However, the central bank may agree to pay the short-term interest rate to banks who hold excess overnight reserves. This would eliminate the need by the commercial banks to access the interbank market to get rid of any excess reserves and would allow the central bank to maintain its target interest rate without issuing debt.

A budget surplus equivalent to 1 per cent of GDP ratio necessarily reflects a more contractionary fiscal policy stance than a budget deficit equivalent to 1 per cent of GDP.

Question 1:

A budget surplus equivalent to 1 per cent of GDP ratio necessarily reflects a more contractionary fiscal policy stance than a budget deficit equivalent to 1 per cent of GDP.

The answer is False.
The actual budget deficit outcome that is reported in the press and by Treasury departments is not a pure measure of the fiscal policy stance adopted by the government at any point in time. As a result, a straightforward interpretation of movements in the actual outcome is difficult.
While it is true that a larger deficit supports aggregate demand more than a smaller deficit we cannot conclude that this is reflecting the intent of discretionary fiscal policy stance.
To understand that point we need to realise that the actual budget outcome as being the sum of two components: (a) a discretionary component – that is, the actual fiscal stance intended by the government; and (b) a cyclical component reflecting the sensitivity of certain fiscal items (tax revenue based on activity and welfare payments to name the most sensitive) to changes in the level of activity.
The former component is now called the “structural deficit” and the latter component is sometimes referred to as the automatic stabilisers.
The structural deficit thus conceptually reflects the chosen (discretionary) fiscal stance of the government independent of cyclical factors.
The cyclical factors refer to the automatic stabilisers which operate in a counter-cyclical fashion. When economic growth is strong, tax revenue improves given it is typically tied to income generation in some way. Further, most governments provide transfer payment relief to workers (unemployment benefits) and this decreases during growth.
In times of economic decline, the automatic stabilisers work in the opposite direction and push the budget balance towards deficit, into deficit, or into a larger deficit. These automatic movements in aggregate demand play an important counter-cyclical attenuating role. So when GDP is declining due to falling aggregate demand, the automatic stabilisers work to add demand (falling taxes and rising welfare payments). When GDP growth is rising, the automatic stabilisers start to pull demand back as the economy adjusts (rising taxes and falling welfare payments).
The problem is then how to determine whether the chosen discretionary fiscal stance is adding to demand (expansionary) or reducing demand (contractionary). It is a problem because a government could be run a contractionary policy by choice but the automatic stabilisers are so strong that the budget goes into deficit which might lead people to think the “government” is expanding the economy.
So just because the budget goes into deficit doesn’t allow us to conclude that the Government has suddenly become of an expansionary mind. In other words, the presence of automatic stabilisers make it hard to discern whether the fiscal policy stance (chosen by the government) is contractionary or expansionary at any particular point in time.
To overcome this ambiguity, economists decided to measure the automatic stabiliser impact against some benchmark or “full capacity” or potential level of output, so that we can decompose the budget balance into that component which is due to specific discretionary fiscal policy choices made by the government and that which arises because the cycle takes the economy away from the potential level of output.
As a result, economists devised what used to be called the Full Employment or High Employment Budget. In more recent times, this concept is now called the Structural Balance. As I have noted in previous blogs, the change in nomenclature here is very telling because it occurred over the period that neo-liberal governments began to abandon their commitments to maintaining full employment and instead decided to use unemployment as a policy tool to discipline inflation.
The Full Employment Budget Balance was a hypothetical construction of the budget balance that would be realised if the economy was operating at potential or full employment. In other words, calibrating the budget position (and the underlying budget parameters) against some fixed point (full capacity) eliminated the cyclical component – the swings in activity around full employment.
This framework allowed economists to decompose the actual budget balance into (in modern terminology) the structural (discretionary) and cyclical budget balances with these unseen budget components being adjusted to what they would be at the potential or full capacity level of output.
The difference between the actual budget outcome and the structural component is then considered to be the cyclical budget outcome and it arises because the economy is deviating from its potential.
So if the economy is operating below capacity then tax revenue would be below its potential level and welfare spending would be above. In other words, the budget balance would be smaller at potential output relative to its current value if the economy was operating below full capacity. The adjustments would work in reverse should the economy be operating above full capacity.
If the budget is in deficit when computed at the “full employment” or potential output level, then we call this a structural deficit and it means that the overall impact of discretionary fiscal policy is expansionary irrespective of what the actual budget outcome is presently. If it is in surplus, then we have a structural surplus and it means that the overall impact of discretionary fiscal policy is contractionary irrespective of what the actual budget outcome is presently.
So you could have a downturn which drives the budget into a deficit but the underlying structural position could be contractionary (that is, a surplus). And vice versa.
So the fact that the budget deficit is rising might actually indicate that the fiscal austerity program is more contractionary that the Government initially estimated and the automatic stabilisers (loss of tax revenue etc) are more than offsetting the discretionary cuts in net public spending.
It follows that we could get a situation where the budget deficit of 1 per cent of GDP actually reflected a structural surplus of say 2 per cent of GDP and the automatic stabiliser (cyclical) component creating a 3 per cent swing to the deficit.
In the same light, the 1 per cent surplus recorded could reflect a structural deficit of, say 1 per cent, with the a stronger economy pushing the cyclical component of 2 per cent.
The latter situation would be reflect an intent to stimulate the economy, while the former to deliberately contract the economy.

Environmental Sustainability and Economic Growth

I am now using Friday’s blog space to provide draft versions of the Modern Monetary Theory textbook that I am writing with my colleague and friend Randy Wray. We expect to publish the text sometime early in 2014. Comments are always welcome. Remember this is a textbook aimed at undergraduate students and so the writing will be different from my usual blog free-for-all. Note also that the text I post is just the work I am doing by way of the first draft so the material posted will not represent the complete text. Further it will change once the two of us have edited it.

Today, I am continuing to add the sections in Chapter 25. So far we have done 25.1 and 25.2. I am jumping to 25.5 today.
Chapter 25 Recent Policy Debates
In this Chapter we consider the following policy debates:

• 25.1: Ageing, Social Security, and the Intergenerational Debate
• 25.2: Twin Deficits and Sustainability Of Budget Deficits
• 25.3: Fixed Versus Flexible Exchange Rates: Optimal Currency Areas, the Bancor, or Floating Rates?
• 25.4: Economic Growth: Demand or Supply Constrained?
• 25.5: Environmental Sustainability and Economic Growth

25.5 Environmental Sustainability and Economic Growth
We started our course in macroeconomics by noting that the main macroeconomic policy goals are full employment and price stability.
A central idea in economics whether it be microeconomics or macroeconomics is efficiency – getting the best out of what you have available. At the macroeconomic level, the “efficiency frontier” is normally summarised in terms of full employment – where all available labour resources are being productively deployed.
We have learned that the concept of full employment is hotly contested among different schools of thought in macroeconomics but this does not negate the fact that the attainment of full employment – using our macroeconomic resources to the limit – remains a central focus of macroeconomic theory and policy. The debate is about what that limit actually is.
However, this debate is framed by economists in terms of the extent to which there are structural impediments which might mean our conception of full employment is associated with higher rates of unemployment than otherwise. We considered those issues in Chapter 14.
We learned that capitalist monetary economies are prone to deliver mass involuntary unemployment as a result of a lack of effective demand.
The solution to involuntary unemployment involves increasing the level of effective demand so that it is consistent with the level that is required to employ all those willing and able to work is filled with public net spending.
This can be achieved by increased government spending to ensure that the shortfall in non-government spending relative to the full employment level of demand is filled.
In addition, the government can also stimulate non-government spending in a number of ways including tax cuts, interest rate cuts, and investment and export incentive schemes.
This suggests that sustaining the economically and socially desirable goal of full employment requires continuous growth in aggregate demand and real GDP as populations expand.
In Chapter 3, we learned that the conventional market-based measures of national income as indicators of well-being are flawed in a number of ways. First, many activities that nurture well-being (for example, home duties, caring for our children) are not counted as economic activity, unless a payment for service is made.
Further, any production that is sold in the market place will add to the conventional measures of GDP. So a society is considered to be “growing” and doing better if it produces increasing quantities of military weapons, which then wreak havoc during times of conflict.
Similarly, a major environmental disaster, such as the 2010 Deepwater Horizon oil spill in the Gulf of Mexico, boosts economic growth as a result of the clean-up operation, even though the event devastates the local marine environment.
We also learned that national income measures of well-being largely ignore distributional issues. How might we feel about two economies which are recording the same growth rates, but where in one, the vast majority of the income growth is secured by a small minority and the rest of the population live in poverty, whereas in the other, the population broadly shares in the increased real income?
Conventional real GDP measures also ignore the costs of increasing depletion rates of non-renewable natural resources. The mining or forestry activity, for example, boosts economic growth but the environmental damage that is left behind is not considered because the firms involved do not count the damage as a cost of production.
Industrial production growth will be “good” for real GDP growth but the associated pollution of the land, water and air that results from the activity might be damaging for our health and, ultimately, undermine the capacity of the economy to produce as the natural systems die. There is growing evidence that unsustainable farming practices are reducing the amount of available productive land and destroying waterways but still count $-for-$ in our measures of economic growth.
It is clear that the capitalist system not only is prone to creating mass unemployment but it also grows on the back of environmental degradation which is destroying our natural capital. This would appear to require a shift in our “growth-at-all-costs” approach to economic policy making.
Mat Forstater (2001: 386) wrote that:

Environmental degradation in the form of unsustainable rates of natural resource depletion and excessive pollution of land, air, and water is characteristic of modern capitalist economies. Humanity now faces significant challenges in the form of both local ecological crises and global environmental problems, such as ozone depletion, global climate change, biodiversity loss, soil erosion, and deforestation …

The question that arises is whether the desire to maintain full employment and the requisite growth that is associated with that policy goal is consistent with environmental sustainability, given the increasing evidence that anthropogenic global warming and resource depletion is endangering the health of the natural environment upon which our economic and social settlements depend.
While full employment appears to be a necessary social and economic goal, can we reconcile it with the obvious need to ensure our natural environment is also sustained?
Thus, even if it were possible to expand aggregate demand enough to promote growth sufficient to keep pace with labour force growth and productivity growth and mop up the huge stocks of long-term unemployment, how could the natural ecosystems, already under great strain, cope?
While the full treatment of what constitutes environmental sustainability is beyond the scope of this textbook some useful observations can be made. For further discussion of what constitutes environmental sustainability see Lawn (2001) and Forstater (2001).
What we will learn is that growth is not necessarily good or bad per se. We can certainly improve our measures of growth to reflect the shortcomings noted above.
At a minimum this requires us to include all the costs of production in our measures of economic activity. Our revised net measures of economic growth will then ensure that we understand whether the changing scale of economic activity is advancing our overall well-being or not. It is entirely possible that the conventional measure of real GDP might show a slowdown in growth (which we would currently interpret as a problem) while new improved measures of real GDP (net of costs) would show an improvement in sustainable growth.
But we can also engender growth that will be sufficient to ensure that all those who want work can find a job at decent pay and conditions and still satisfy the requirements of environmental sustainability.
Clearly, this suggests that it will be necessary to change the composition of final output toward environmentally sustainable activities. It is not increased aggregate demand per se that will be necessary to sustain full employment, but increased aggregate demand in certain areas of activity.
Policy makers intent on eliminating the waste of human potential need to ally that aim with the broader aim of preserving our natural capital and minimising the waste that arises from resource extraction.
That is, our notion of a “macroeconomic efficiency frontier” thus has an extra constraint on it – the need to protect our natural capital.
Phillip Lawn (2001: PAGE NO) defines this in terms of an “optimal macroeconomic scale” which is:

… where the physical scale of a nation’s macroeconomy and the qualitative nature of the goods with which it is comprised maximises the sustainable economic welfare enjoyed by its citizens. The notion of optimal macroeconomic scale is a crucial one because it enables one to understand how the nation can achieve SD without the perceived need for continued growth.

Several elements are present in the concept of an “optimal macroeconomic scale”. First, what are the benefits of creating and maintaining wealth derived from economic activity. Second, what does this cost in terms of depleting the available environmental services.
Natural capital is identified by Lawn (2001: PAGE NO) as “the original source of all economic activity” because it “is the sole source of low entropy matter-energy and the ultimate repository of all high entropy wastes”. Economic activity generates real income (which is the satisfaction derived from consuming goods and services produced) but also imposes social costs on those who produce these goods and services.
Lawn (2001: PAGE NO) notes we have to endure personal costs such as the disutility of work and the stress of commuting as part of the process of generating these economic benefits and the calculation of what he calls “net psychic income” reflects the human costs and benefits of economic activity.
While calculating the human costs of economic activity, we also have to take into account the costs of depleting the available environmental services. Extracting these services (the low entropy matter-energy) creates waste (high entropy matter-energy) which has no further use. This waste depletes our natural capital and is the ultimate resource cost of economic activity.
Trying to define the costs of natural resource depletion is fraught because the biosystem is a living entity and economists are unable to define the use point beyond which it dies.
Sustainable net benefits are the difference between the net psychic income and the environmental costs of economic activity. The maximum macroeconomic scale for a nation occurs when the sustainable net benefits are zero. Beyond this physical scale of production, the environmental costs exceed the net psychic income derived from economic activity.
However, this point is likely to be well beyond the point where the economy maximises its sustainable net benefits for any given technology. The maximum sustainable net benefits is the optimal macroeconomic scale because the difference between the net psychic benefits and the environmental costs are at their greatest.
The macroeconomic efficiency frontier thus is defined by the juxtaposition between the net human benefits and the environmental costs required to create those net human benefits.
The full employment goal then needs to be expressed not just in terms of the total number of jobs required but also the type of jobs and the activities these jobs will be engaged in.
Growth is necessary for employment as the population grows but it cannot be unfettered and left to the market. It has to be a carefully guided growth with new tools not normally used by economists to help governments decide on what their contribution should be and how they should regulate the contribution of the non-government sector.
Consideration of that will lead to a rather dramatic reshaping of our conception of productive work, which is current narrowly defined in terms of “gainful” paid endeavour in pursuit of (private) profit.
Conclusion
WE WILL CONTINUE NEXT WEEK! THE COMPLETE FIRST DRAFT IS NEARING COMPLETION AND I WILL START POSTING REVISED DRAFTS SEQUENTIALLY IN THE COMING WEEKS.