1. LECTURE 2 THE NEW CONSENSUS MACROECONOMICS
Philip Arestis
Cambridge Centre for Economic and Public Policy
University of Cambridge
University of the Basque Country
Department of Applied Economics V

2. Presentation Introduction
The Economics of the New Consensus Macroeconomics
Economic Policy of the New Consensus Macroeconomics
Summary and Conclusions

3. Presentation Introduction
The Economics of the New Consensus Macroeconomics
Economic Policy of the New Consensus Macroeconomics
Summary and Conclusions

4. Introduction
Following from Lecture 1 we proceed to deal with the theoretical and policy implications of the New Consensus Macroeconomics (NCM);
We begin in Lecture 2 with the theoretical framework of this theoretical framework before we turn our attention to the economic policy implications;
In Lecture 3 we assess the overall framework of this particular paradigm.

5. Presentation Introduction
The Economics of the New Consensus Macroeconomics
Economic Policy of the New Consensus Macroeconomics
Summary and Conclusions

6. The Economics of the New Consensus Macroeconomics
Aggregate
demand
equation [ ] ( [ ] ) 1 p E t - + ( ) Y g = a + a × Y g + a × E Y g + a × R + a ×
rer + s ; t 1 t - 1 2 t t + 1 3 t 4 t 1
Phillips
curve [ ] s ; 2 [ 1 , t W p E + ] } er - { p = b × Y g + 2 b × p + b × E p + b × t 1 t t - 1 3 t t + 1 4
Monetary
policy
rule [ [ ] ( ) ] ( ) R = 1 - g × RR * + E ; 3 1 2 s R p Y t T g + × - t 3 t

7. The Economics of the New Consensus Macroeconomics
Real
Exchange
rate
equation { ( [ ] ) ( [ 1 , t W p E + ] ) } [ ]
rer = d + d × R - E p - R - + d × CA + d × E
rer + s ; t 1 t t t + 1 W , t 2 t 3 t t + 1 4
Current
account
equation CA = l + l ×
rer + l × Y g + l × Y g + s ; t 1 t 2 t 3 W , t 5
Nominal
Exchange
rate
equation er =
rer + P - P ; t t W , t t

8. The Economics of the New Consensus Macroeconomics
Six equations and six unknowns: output, inflation, interest rate, current account, nominal and real exchange rate;
Basic assumption: intertemporal optimization of a utility function that reflects optimal consumption smoothing;
Based on the transversality condition meaning that all debts are ultimately paid in full: economic agents are credit worthy; all IOUs are perfectly acceptable in exchange; nobody is liquidity constrained;

9. The Economics of the New Consensus Macroeconomics
It is a non-monetary model: no banking or any other financial sector or monetary variables.
Objective: price stability; inflation is a monetary phenomenon;
Inflation is controlled directly via changes in the rate of interest;

10. The Economics of the New Consensus Macroeconomics
A change in the nominal rate of interest is followed by the real rate of interest affected in the same way (price and wage rigidity is assumed);
Changes in the real rate of interest can only affect aggregate demand in the short run;
It should be noted that investment in this theoretical framework reflects changes in the capital stock, which is determined once long-term output has been determined via the supply side;

11. The Economics of the New Consensus Macroeconomics
In the latter sense investment and capital stock are treated as exogenous;
Endogenising investment and capital stock lead to reasonable conclusions once capital adjustment costs are present through the use of an adjustment-cost function that implies constant returns to scale in production;
In the absence of capital adjustment costs the model produces unrealistic results in response to changes in monetary policy;

12. The Economics of the New Consensus Macroeconomics
Ultimately, it is the case that explicit inclusion of endogenous investment is an attractive proposition and worth undertaking, as suggested above;
However, the results with exogenous and endogenous assumptions do not differ by much with respect to the cyclical behaviour of output and real interest rates;
Calibrations undertaken show that results with the exogenous investment assumption match those with endogenous investment and capital very closely.

13. The Economics of the New Consensus Macroeconomics
Phillips curve is vertical in the long run at NAIRU;
Changes in the rate of interest affect inflation only in the long run;
NAIRU is a supply-side variable;
Say’s Law holds: the level of effective demand does not play an independent role in the long-run level of economic activity.

14. The Economics of the New Consensus Macroeconomics
See Figure 2.1;
Assume a closed economy for simplicity;
Explain the new 3-equation model;
See Figure 2.2;
Assume an open economy, now;
Explain the 4-equation model;

15. Presentation Introduction
The Economics of the New Consensus Macroeconomics
Economic Policy of the New Consensus Macroeconomics
Summary and Conclusions

16. Economic Policy of the New Consensus
Inflation Targeting (IT) is embedded in equations 1-3;
IT is a monetary policy framework whereby public announcement of official inflation target is undertaken;
Equations 2 and 3 entail an important role for ‘expected inflation’;
Credibility attained through pre-commitment to the inflation target without government interference;

17. Economic Policy of the New Consensus
Transparency of inflation forecasts is a paramount element of the policy, and it enhances credibility; but…
The centrality of inflation forecasts and the margin of errors represent a major challenge to this framework;
The channels of monetary policy are twofold: changes in the rate of interest works through the output gap relationship and also through inflation expectations as in the Phillips Curve relationship.

18. Economic Policy of the New Consensus
These ingredients are supported by the publication of the minutes of the Central Bank’s Monetary Policy Committee, by the Inflation Report and the speeches of the Monetary Policy committee members;
Further important ingredients: Accountability; Credibility; and Individual Reputation of the Monetary Policy members, especially in those cases where minutes are published, which reveal outcome of voting.

19. Economic Policy of the New Consensus
Fiscal policy should not be used for short-term objectives; only for medium- to long–term ones;
Constrained discretion: neither pure discretion nor rules;
Constrained discretion is, thus, an important ingredient of the IT economic policy framework.

20. Presentation Introduction
The Economics of the New Consensus Macroeconomics
Economic Policy of the New Consensus Macroeconomics
Summary and Conclusions

21. Summary and Conclusions
We have highlighted the theoretical framework and the policy implications of the New Consensus Macroeconomics;
Our next step is to assess this particular theoretical framework and its current state in view of the current economic crisis.