| IS THERE A CORE OF PRACTICAL MACROECONOMICS THAT WE SHOULD ALL BELIEVE ? | | ATULUKU ORIYOMI| | ECON-8220-001:SEMINAR IN MACRO THEORY| 8/30/2011| | The IS curve is the functional relationship between real output and real interest rates derived from behavioral determinants of spending such as (endogenous variables) wealth, income, interest rates, government budget and so on. The sensitivity of investment to interest rates is uncertain or questionable in nature. Nonetheless historical observation states that the higher the interest rates, the lower the spending.
The downward and negatively sloping IS curve is how the Federal Reserve’s believe monetary policy should work. But it is important to note that there is a paradox; while the interest sensitivity of business investment spending is doubtful, the IS relationship between aggregate demand and interest rates is real. This is the reason and motivation for research in monetary policy. After many years IS curve needs to be refined. LM curve- the upward sloping LM curve (relating real output wit nominal interest rates) that was usually paired the IS curve, has been abandoned due to instabilities in both money supply and money demanded.
The LM curve plays no part in policy analysis due to the fact that it is now believed that the central bank control short term nominal interest rates. It should be noted that this point of view should also be altered because while the central bank controls short term interest rates it is real long term interest rates that matters most for spending. When we specify interest rates as a monetary policy instrument the IS curve turns to an Aggregate Demand Curve; and textbooks would usually pair the aggregate supply curve(based on sticky nominal wages) and the short run macroeconomic equilibrium will be the intersection of the two.
It is presumed that the price level will adjust quickly to equate Aggregate Demand with Aggregate Supply while wages remain sluggish. There is no empirical evidence in reality that there is a sharp division between rapid price adjustment and rigid wages adjustment instead both price and wages appear to remain rigid. It is also important to note that practical models used for short run policy analysis do not have an upward sloping supply curve and is not beneficial in solving market clearing price levels. Instead both prices and wages are predetermined in the short run.
The Phillips Curve relates wage or price inflation to the level of resource utilization, it shows an inverse relationship between inflation and unemployment and it is basically the difference between real and nominal interest rates. While the LM Curve has been basically abandoned and the IS curve has been questionable, the Phillips Curve has been consistent empirically and it has been very useful for decades particular in the United States. “Okun’s rule of thumb” is not derived theoretically but from an empirical observation.
Okun’s law is approximate and is a simple linear relationship between the percentage change in output and the absolute change in unemployment rate, because factors other than employment (such as productivity) affect output. Okun’s law states that at one point increase in the unemployment rate is associated with two percentage points of negative growth in real GDP. The relationship varies depending on the country and time period under consideration. Macroeconomics comprises of four main parts.
Firstly, prices and wages are determined in the short run and evolve according to the Phillip Curve equation. Secondly, output is demand determined in the short run. Thirdly, Aggregate Demand is directly related to fiscal policy and is interest sensitive and thus responsive to monetary policy which is responsible for short term interest rates. Lastly, Okun’s law links output growth to changes in unemployment rate. There are two elements needed to bridge the gap between short term interest rates set by monetary policy and long term interest rates that appears to be influenced by aggregate demand.
The two critical failings of the standard macro model that needs theoretical and empirical repair are: * The Term Structure of Interest Rates-The term structure of interest rates is fundamentally important in macroeconomics because monetary policy affects short-term interest rates, but investments depends on long-term interest rates. Theories about the term structure of interest rates thus connect monetary policy and investment but this model fails a variety of empirical tests.
There needs to be a better model of the “term structure” not just for academic correctness, but also because it involves monetary policy which affects short term interest rates which affect the economy especially at such a time as now where we are in a recession and the economy is not growing as quickly as anticipated. * Modeling expectations-Expectations are found everywhere in economic behavior. Rational expectation in economics is the predictions of the future value of economically relevant variables which are not systematically wrong in that all errors are random.
It is important to note that that the empirically success of modeling expectation has been deficient. In conclusion we will look at the effects of expected future government budget deficit. Positive fiscal multiplier is an important macro core belief, but nowadays the opposite seems to be the case globally. It is assumed that deficit reduction promotes economic growth in the short run. There are two rational reasons why convincing changes in fiscal policy implies lower future budget deficits that can stimulate the economy by producing lower long term real interest rates today.
Keynesian flow equilibrium argues that future fiscal contractions creates rational expectation of lower real short rates in the long run which leads to lower long term interest rates today. Long run stock equilibrium, which is the expectation of lower future public debt, leads to lower long rates today. The problems with this theory are: * Theoretical possibilities, not logical and empirical evidence are not established. * Basics of the theory of term structure are known to be wrong. * It assumes that the expected future short term interest rates fall because spending is expected to be weaker in the future.
What we once knew as contractionary fiscal policy may come to be known as expansionary fiscal policy based on a plethora of reasons one being the Clinton budget plan in 1993. Deficit reduction can certainly expand and encourage economic growth and this is important not just from an academic perspective but also at a time like this where our unemployment rate is 9% and we are in a recession. IS-LM model and the given Phillips curve were used to explain the adjustment of prices. There was an assumption that Phillips curve had a natural rate of property which implied that the economy was self regulating in the long run.
Both private and public decision makers used the model to forecast important economic time series and to evaluate the effects of alternate macroeconomic policies. Today the IS- LM model is rarely used by academic macroeconomists. It is mentioned usually by academicians with contemptuous ridicule. While academic macroeconomists stray away IS-LM model augment the Phillips Curve, applied macroeconomists have barely changed the way the economy is analyzed. The ISLM model continues to be the best way to interpret discussion of economic policy in the press among policy makers.
Academic macroeconomists believe applied macroeconomists have not kept up to date with the advancing field of macroeconomics hence to continuous use of obsolete models. REFERENCES Blinder Alan S. 1997 “Is There A Core of Practical Macroeconomics That We Should All Believe? ” The American Economic Review, Vol. 87, No. 2, Papers and Proceedings of the Hundred and Fourth Annual Meeting of the American Economic Association (May):240-43. Jasay Anthony de. 2011 “What Became of the Liquidity Trap? ” Library of Economics and Liberty (June)