Transcript VII. The Golden Age and Fall of Keynesian Economics

XIV. Economic development
and policies in 1960s, end of
Bretton-Woods
XIV.1 Keynesian framework
General principles
Keynesian belief in demand side
management
• Insufficient demand – expansionary policy
– Fiscal: higher governmental
expenditures, lower taxes
– Monetary: increase of nominal money,
support for the decrease on interest
rates (lower the official discount,
obligatory reserves of the banking
sector, open market operations)
• Demand too high - restrictions
Building blocks: Okun’s law (1)
• Previous lectures:
– Changes in output related to changes in
(un)employment so far assumed as proportional
Y  Y1
u  u1  g, g 
*100, u in %
Y1
– Additional assumption: total labor force constant
• What is the statistical reality?
– US 1960-98
u - u-1  -0.4gY  3
– Relation between output and (un)employment is not
proportional

• Generalization
already in 1960s: Arthur Okun
Building blocks: Okun’s law (2)
1. Annual growth has to be at least 3% to prevent
unemployment from rising
– Both labor productivity and labor force are
growing in time → normal growth rate = 3%
2. Output growth of 1% over 3% leads only to
0.4% decrease in unemployment
– Labor hoarding
– Increase in labor participation rate
Differences over countries, Okun’s law in general

u - u-1  - gY  gY*

*
g
where Y is a normal growth rate
Building block: Phillips curve
• See L XIII: expectations-augmented
version accepted by Keynesians
 -  -1  u  u 
*
• Application of the Phillips curve
– Probably the basic principle
–
Trade-off between inflation and
unemployment
– Select desired unemployment, which
implies given level of inflation and use a
mix of fiscal and monetary policy tools to
achieve this target
Building block: Aggregate Demand
• The relation between money growth, inflation and output growth
• Aggregate demand (see LVII and LVIII on ISLM): the relation between
output and real money stock, government spending and taxes (tools
of monetary and fiscal policies)



dY    dG  Ir L r . MS P . dMS MS  dP P 
• Fiscal policy
– In the short run, prices assumed fixed: impact on output via
standard fiscal multiplier
– However, not a depression situation, in reality prices not fixed,
impact on expectations and inflation, problems with time lags
• Monetary policy more flexible
– Assumption: the demand side above, output depends only on
amount of real money, i.e.
M
Y
or, in terms of growth rates
P
gY  gM  
Money growth, inflation and
output growth
• Application of fiscal policies in 1960s - see bellow
– However, too many obstacles
• Re-birth on monetary policies even in the Keynesian
framework - medium term, economies converge to
natural values, neoclassical synthesis
• Three basic equations above, for AD only relevant is
money growth

u - u-1  - gY  gY*

 -  -1  u  u* 
gY  gM  
• Exercise: try to see what happens if - e.g. - decrease of
money growth


• Keynesian framework: smoothing the cycle, stop and
go policies
Stabilization
Long term: stabilization in the logic of
neoclassical synthesis
• Economies converge towards long term
equilibria
Existence of inherent business cycles - need
for anti-cyclical policies
• Discretionary policies, fine tuning
• Built-in stabilizers
• Budget deficit
• Increase of the importance of the tax
policies
XIV.2 Monetarist framework
Implications of expectationsaugmented Phillips curve
• Difference from Keynesian approach: there is no
permanent trade-off between inflation and
unemployment
– In the short-run yes, but as soon as inflationary expectations
adjust, the trade-off disappears → output and unemployment
returns to natural levels
• Crucial: how the expectations are formed?
• Both monetarists and neoclassical synthesis adaptive expectation hypothesis (AEH):
Pe  P1  1 P1e  P1 , 0  1
• or

P  P  P
e
e

Policy implications
• By repeating back substitution:
expected inflation becomes a
geometrically weighted average of past
actual inflations
– Larger weight given to the most recent
actual inflations
• Practical policy implication: there is a
time gap between an increase in actual
inflation and an increase in natural rate
→ allows for a temporary reduction of
unemployment bellow
The accelerationist hypothesis
• The fallacy of Keynesian approach: any
attempt to maintain unemployment
permanently bellow the natural rate →
acceleration of inflation → need for permanent
increase of money growth
– People will (sooner or later) adjust the expectations
→ to maintain unemployment under natural level →
need for even higher inflation, etc.
– On labor market: need for permanent real wage
bellow an equilibrium level → permanent increase
of wages, prices, etc.
• End result: permanent accelerating inflation
The role of monetary policies
• Vertical LRPC: aggregate demand management can
affect output and unemployment in the short-run only is a discretionary monetary policy a viable option?
– Yes, in case there is an urgent need to deal with strong external
disturbance and/or the time lag between increase in actual
inflation and expectations adjustment is long
• Main monetarist policy proposition: fixed rate of
monetary growth, consistent with long run growth
potential of the economy. Main reasons:
– Steady money growth → economy settles around natural
values and steady inflation
– Capitalist economies are stable around natural values (compare
with Keynesianism above)!
– Discretionary monetary policies may be destabilizing
– As we don’t know exactly where the natural values are,
attempts to stabilize unemployment may lead to inflation ↔
inflation larger evil than unemployment
XIV.3 Policies under B-W system
Policy goals
• Internal balance – full employment and price
stability
– Different side of the same coin, unemployment →
deflation, over-employment → inflation
– Many other disruptive effects of internal disbalance
• External balance – definition: it does not have
to coincide with zero current account
– High CA deficit might be (very) desirable, when
country is able to repay the debt financing (loans) in
the future
– High CA surplus might be a problem:
• Too low domestic investment, given total domestic savings
• Too many foreign claims, risk as to future payments
• Target for protections from abroad
Policy options (1)
• Reminder from Ch.XII: at fix, monetary policy
inefficient and domestic interest equals foreign one
• Maintaining internal balance – assume:
– Economy at equilibrium with full employment
– Investment exogenous, taxes as well, short run: P and P*
fixed
– Net export being a function of real ExR and disposable
income:
NX  NXE.P* P,Yf - T
– then equilibrium condition for a goods market
Yf  CYf - T I  G  NXE.P* P,Yf - T

defines combinations of E and fiscal policy expansion
(either G↑ or T↓) that maintain this equilibrium (output on
potential level)
Policy options (2)
• Maintaining the external balance:
– suppose that there is a desirable level of CA deficit NXX
*
f
– The equation NXX NX E.P P,Y - T
defines combinations of E and fiscal expansion that
maintain desired deficit NXX


• Simultaneous
 achievement of external and internal balance
– solution of 2 equations above, see next slide
• Four areas
– I: over-employment and inflation, CA surplus too high
– II: over-employment and inflation, CA deficit too high
– III: underemployment and deflation, CA deficit too high
– IV: underemployment and deflation, CA surplus too high
E
External balance, NX=NXX
I
E
II
IV
III
Internal balance, Yf
Fiscal expansion
Policy adjustment
• If economy away from both lines, combination
of both fiscal adjustment and change of ExR is
needed
• Change in fiscal policy – expenditure changing
– Changes the overall level of aggregate demand in
the economy
• Change in ExR (devaluation/revaluation) –
expenditure switching
– Switches demand between domestic output and
imports
• Policy dilemma at fix: fiscal policy too slow,
ExR adjustment faster, but limited by B-W
system
XIV.4 Economic reality and policies
1955-1970
• In LIX: post-war reconstruction and
policies up to (approximately) 1955
– Introduction to Bretton-Woods system
• LXIV.1-3 above: both Keynesian and
monetarist framework for economic
policies
• This and subsequent sub-sections:
economic reality of 1955-1970
– Data
– The success and failure of different policies
XIV.4.1 US Fiscal and Monetary
Policy in the 1960s
• Closed economy
• US: till 1960s, BoP deficit did not
limit the freedom of policies
• Logic: economic potential,
determined by
– Volume of labor force
– Accumulated capital
– Technology, productivity
Potential supply
• Full capacity output – there is always
a certain level of unemployment
– Phillips curve: hypothetical zero
unemployment means danger of high
inflation
• Target full output: compromise
between costs of unemployment vs.
costs of inflation → potential output
Demand management in
1960s
• Given potential output
• Fiscal and monetary policies to
stimulate or contain aggregate
demand so that both unemployment
and inflation kept of the “desired”
levels and output close to the
potential one
Fiscal policy
• Selection of tools: expenditures or taxes?
– Expenditures: inflexible tool
• Time lags
• Link to the budget deficits and debt
financing
• Kennedy/Johnson tax cut 1963-4
– Growing economy, but less then potential
output
– Unemployment higher then target
– Uneasy interpretation of results because of
1965 increase in expenditures due to the
Vietnam War
Monetary policy
• Subdued to fiscal policy
• Even in 1960, basically “stop and go”
nature
– Monetary expansion in recession times:
1953-4, 1957-8, 1960-1
– Restrictions under inflationary
pressures: 1952, 1955-7, after 1965,
when inflation accelerated due to the
military spending
XIV.4.2 Europe: The Golden Age
LIX: post-war reconstruction, strong
fundamentals for subsequent economic
growth
• Pro-market reforms
• “Coordinated capitalism”
– Direct governmental interventions (indicative
planning)
– Social consensus on wage moderation,
profit retention and social securities
• Dawn of European integration
– Positive effects from regional cooperation
Period of extensive growth
• Persistent, very strong output growth
–
–
–
–
Wage restraint and high savings rates
Very high investment rates + FDI, namely from US
Common Market
Inflow of new labor force – “gastarbeiter”
immigration wave → very elastic labor supply
• Differences across the countries, but golden
age for whole capitalist Europe
– End of 1950s: incorporation of original laggards
(Belgium, Ireland, Denmark, Norway) and European
periphery (Spain, Portugal, Greece)
• How long could have such an extensive
growth lasted?
Problem: wage explosion and labor
conflict
• Till beginning of 1960s: growth based on
investment, investment based on wage restrain
• Since mid-1960s: new pressures, when
“traditional” workers abandoned the social
contracts and started to demand excessive wage
increases
– Social unrest in whole Europe 1968-1969
• Reasons:
– Deep fall of unemployment, not wage disciplination any
more
– People not ready to sacrifice for the sake of
reconstruction and growth any more
– Memories of Great Depression faded away – new
generation
Problem: inflationary expectation
and failure of Keynesian policies
• Mounting inflationary pressures: increase of
inflation and of inflationary expectations
• Weakening of Bretton-Woods system →
devaluation expectations in too many
countries → additional inflationary drive
• Keynesian policy of demand management
– Contributed to increase of inflation
– Believing in (short-run) Phillips curve and in
ability to keep unemployment below natural
level: helped to increase the expectations
• Confirmation of monetarist worries and
predictions
XIV.5 The End of Bretton-Woods
System
1950s
• B-W system:
– Countries limited in their monetary policies
– Adjustment to disequilibria via international reserves
(gold, but mainly USD) → need for keeping reasonable
level of reserves
• To keep reserves → limits of convertibility and of capital flows
• Special position of US
– USD as reserve currency, main task – keeping the USD
price of gold (35 USD per oz.)
– Need to keep gold reserves enough
– Potential constraint on US macroeconomic policy –
when economies grow, will there be enough US gold
reserves?
• Confidence problem
1960s
• Gradual achievement of convertibility
• Increase of international capital flows (despite
controls), more and more of speculative nature,
because of expected devaluations
• More frequent balance of payments crises,
accompanied by losses of foreign exchange
reserves
• Devaluations, indeed (Britain November 1967)
• Need for policies to achieve both internal and
external balance
• All this: crucially dependent on the performance
of the US economy
US economy in 1960s
• Vietnam War, “moon racing” and Great
Society program of President Johnson →
strong fiscal expansion → inflation →
worsening of CA → monetary policy only
temporary contracted, later eased → further
inflation → expected rise in USD price of
gold
• Private speculators started to buy gold →
two-tier gold market (private, where price of
gold allowed to float; official, where fixed) →
end of automatic constraint on worldwide
monetary growth
US recession in 1970
• 1970: US recession with increase of unemployment,
output falling, CA deficit → need for real devaluation
of USD vis-à-vis major other currencies
– Fall US prices – no way because of recession
– Second option – nominal devaluation of USD, uneasy, as all
other countries should be willing to peg their currency to
USD at new (devalued) rate
– August 15, 1971 – President Nixon stopped automatic
exchange of gold for dollars and introduced import
surcharge
• Multilateral negotiation → Smithonian agreement in
December 1971
– USD devalued by 10 % against foreign currencies, price of
gold increased to 38 USD per oz.
• Not the end of the story yet: because of continuing
disequilibria, another speculative attack on USD in
February 1973 → European currencies abandoned
fix and by March 19, 1973 Japan and Europe floated
their currencies against USD → end of B-W system
Literature to Ch. XIV
On Keynesian policies:
• Blanchard, Macroeconomics, Ch. IX
On monetarist policies:
• Snowdon, Vane, Modern Macroeconomic, Ch.4 (and literature there)
On Bretton-Woods:
• Krugman, Obstfeld, Chapter 18
• Solomon, R., The International Monetary System 1945-1976. Harper&Row
1977
• Bordo, Michael D., Eichengreen, B., A Retrospective on Bretton Woods
System, Chicago University Press, 1993
US economy:
• almost all medium level textbook of macroeconomics provide at least
some case studies from this period
• Smith, W.L., Teigen, R.L. (1970), Readings in Money, National Income and
Stabilization Policy, Richard Irwin. Chapters 4 and 5 provide the best
overview of the US economic policies in 1950s and 1960s. No need to read
everything, but introductions to both chapters are good to know plus articles of
Okun (p.313 and 345) and of Council of Economic Advisers.
European economy:
• Eichengreen, B., The European Economy Since 1945. Princeton University
Press, 2007, Chapters 7-8