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7.11 Policy Implications

Following the contributions of Fischer (1977), Phelps and Taylor (1977), it

was clear that the new classical conclusion that government demand management

policy was ineffective did not depend on the assumption of rational

expectations but rather on the assumption of instantaneous market clearing.

In new Keynesian models which emphasize sticky prices, money is no longer

neutral and policy effectiveness is, at least in principle, re-established. Since

in the Greenwald–Stiglitz model greater price flexibility exacerbates the problems

of economic fluctuations, new Keynesians have also demonstrated the

potential role for corrective demand management policies even if prices are

flexible (but not instantaneously so). In a world where firms set prices and

wages in an uncoordinated way, and where they are uncertain of the consequences

of their actions, it is not surprising that considerable inertia with

respect to prices and wages results.

In a market economy endogenous forces can frequently amplify the disturbing

impact of exogenous shocks. While new Keynesians tend to be more

concerned with the way an economy responds to shocks than with the

source of the shocks, experience during the past quarter-century has confirmed

that economies can be disturbed from the supply side as well as the

demand side. Indeed, as Benjamin Friedman (1992) has observed, it is often

practically and conceptually difficult to draw a clear distinction between

what is and what is not the focal point of any disturbance. Because in new

Keynesian models fluctuations are irregular and unpredictable, new Keynesians

are not enthusiastic supporters of government attempts to ‘fine-tune’ the

macroeconomy. Many new Keynesians (such as Mankiw) accept the monetarist

criticisms relating to old-style Keynesianism as well as several of the

criticisms raised by new classical economists, such as those related to dynamic

consistency (see Chapter 5). There is no unified new Keynesian view

on the extent of discretionary fiscal and monetary action that a government

may take in response to aggregate fluctuations (see Solow and Taylor, 1998).

However, most new Keynesians do see a need for activist government action

of some form because of market failure, especially in the case of a deep

recession. For example, Taylor (2000a) argues that while fiscal policy should

normally be used to achieve long-term objectives such as economic growth,

there is a strong case for the explicit use of fiscal expansionary policy in

‘unusual situations such as when nominal interest rates hit a lower bound of


Because of uncertainty with respect to the kinds of problems an economy

may confront in the future, new Keynesians do not support the fixed-rules

approach to monetary policy advocated by Friedman (1968a) and new classical

equilibrium theorists such as Lucas, Sargent, Wallace, Barro, Kydland

and Prescott during the 1970s. If the monetarists and new classicists successfully

undermined the case for fine-tuning, new Keynesians have certainly

championed the case for what Lindbeck (1992) has referred to as ‘coarsetuning’

– policies designed to offset or avoid serious macro-level problems.

Here it is interesting to recall Leijonhufvud’s (1973, 1981) idea that market

economies operate reasonably well within certain limits. Leijonhufvud argues


The system is likely to behave differently for large than for moderate displacements

from the ‘full coordination’ time path. Within some range from the path (referred

to as the corridor for brevity), the system’s homeostatic mechanisms work well,

and deviation counteracting tendencies increase in strength.

However, Leijonhufvud argues that outside ‘the corridor’ these equilibrating

tendencies are much weaker and the market system is increasingly vulnerable

to effective demand failures. More recently Krugman (1998, 1999) has also

reminded economists about the dangers of ‘Depression Economics’ and the

potential for a liquidity trap (see Buiter, 2003b).

Echoing this concern, new Keynesian analysis provides theoretical support

for policy intervention, especially in the case of huge shocks which lead to

persistence, because the adjustment process in market economies works too

slowly. An increasing consensus of economists now support the case for

some form of constrained discretion in the form of an activist rule. Indeed,

during the last decade of the twentieth century, macroeconomics began to

evolve into what Goodfriend and King (1997) have called a ‘New Neoclassical

Synthesis’. The central elements of this new synthesis involve:

1. the need for macroeconomic models to take into account intertemporal


2. the widespread use of the rational expectations hypothesis;

3. recognition of the importance of imperfect competition in goods, labour

and credit markets;

4. incorporating costly price adjustment into macroeconomic models.

Clearly this new consensus has a distinctly new Keynesian flavour. Indeed,

Gali (2002) refers to the new generation of small-scale monetary business

cycle models as either ‘new Keynesian’ or ‘new Neoclassical Synthesis’

models. This ‘new paradigm’ integrates Keynesian elements such as nominal

rigidities and imperfect competition into a real business cycle dynamic general

equilibrium framework.

According to Goodfriend and King, the ‘New Neoclassical Synthesis’ models

suggest four major conclusions about the role of monetary policy. First,

monetary policy has persistent effects on real variables due to gradual price

adjustment. Second, there is ‘little’ long-run trade-off between real and nominal

variables. Third, inflation has significant welfare costs due to its distorting

impact on economic performance. Fourth, in understanding the effects of

monetary policy, it is important to take into account the credibility of policy.

This implies that monetary policy is best conducted within a rules-based

framework, with central banks adopting a regime of inflation targeting

(Muscatelli and Trecroci, 2000). As Goodfriend and King note, these ideas

relating to monetary policy ‘are consistent with the public statements of

central bankers from a wide range of countries’ (see, for example Gordon

Brown, 1997, 2001, and the ‘core properties’ of the Bank of England’s

macroeconometric model, Bank of England, 1999; Treasury, 1999).

7.11.1 Costs of inflation

An important element of the growing consensus in macroeconomics is that

low and stable inflation is conducive to growth, stability and the efficient

functioning of market economies (Fischer, 1993; Taylor, 1996, 1998a, 1998b).

The consensus view is that inflation has real economic costs, especially

unanticipated inflation. The costs of anticipated inflation include ‘shoe leather’

costs, menu costs and the costs created by distortions in a non-indexed tax

system. The costs of unanticipated inflation include distortions to the distribution

of income, distortions to the price mechanism causing efficiency losses,

and losses due to increased uncertainty which lowers investment and reduces

economic growth. Also important are the costs of disinflation (the ‘sacrifice

ratio’), especially if hysteresis effects are present (Ball, 1999; Cross, 2002).

Leijonhufvud also argues that during non-trivial inflation the principal–agent

problems in the economy, particularly in the government sector, become

impossible of solution. This is because nominal auditing and bookkeeping

are the only methods invented for principals to control agents in various

situations. For example, Leijonhufvud highlights the problems that arise

when the national budget for the coming year becomes meaningless when

‘money twelve months hence is of totally unknown purchasing power’. In

such situations government departments cannot be held responsible for not

adhering to their budgets since the government has lost overall control. ‘It is

not just a case of the private sector not being able to predict what the

monetary authorities are going to do, the monetary authorities themselves

have no idea what the rate of money creation will be next month because of

constantly shifting, intense political pressures’ (Snowdon, 2004a; see also

Heymann and Leijonhufvud, 1995). Other significant costs arise if governments

choose to suppress inflation, leading to distortions to the price

mechanism and further significant efficiency losses. Shiller (1997) has also

shown that inflation is extremely unpopular among the general public although

‘people have definite opinions about the mechanisms and consequences

of inflation and these opinions differ … strikingly between the general public

and economists’. To a large extent these differences seem to depend on the

finding of Diamond et al. (1997) that ‘money illusion seems to be widespread

among economic agents’.

While the impact of inflation rates of less than 20 per cent on the rate of

economic growth may be small, it is important to note that small variations in

growth rates have dramatic effects on living standards over relatively short

historical periods (see Chapter 11, and Fischer, 1993; Barro, 1995; Ghosh

and Phillips, 1998; Feldstein, 1999; Temple, 2000; Kirshner, 2001). Ramey

and Ramey (1995) also present evidence from a sample of 95 countries that

volatility and growth are related; that is, more stable economies normally

grow faster. Given that macroeconomic stability and economic growth are

positively related (Fischer, 1993), achieving low and stable inflation will be

conducive to sustained growth. For example, Taylor, in a series of papers,

argues that US growth since the early 1980s (the ‘Great Boom’) was sustained

due to lower volatility induced by improved monetary policy (Taylor,

1996, 1997a, 1997b, 1998a, 1998b, 1999).

Recently, Romer and Romer (1999) and Easterly and Fischer (2001) have

presented evidence showing that inflation damages the well-being of the

poorest groups in society. The Romers find that high inflation and macroeconomic

instability are ‘correlated with less rapid growth of average income

and lower equality’. They therefore conclude that a low-inflation economic

environment is likely to result in higher income for the poor over time due to

its favourable effects on long-run growth and income equality, both of which

are adversely affected by high and variable inflation. Although expansionary

monetary policies can induce a boom and thus reduce poverty, these effects

are only temporary. As Friedman (1968a) and Phelps (1968) demonstrated

many years ago, expansionary monetary policy cannot create a permanent

boom. Thus ‘the typical package of reforms that brings about low inflation

and macroeconomic stability will also generate improved conditions for the

poor and more rapid growth for all’ (Romer and Romer, 1999).