Spending & Interest Rates

Models are a key tool in macroeconomics and we need to invest time in learning the key tricks, checking that,

  • we know the difference between exogenous and endogenous variables
  • the number of equations equals the number of endogenous variables to solve for
  • a solution actually exists
  • where models are dynamic, stability is feasible

Models are useful. They help us to focus on key issues at hand, removing unnecessary detail and sometimes revealing conclusions that were not immediately obvious. But models can also lead us astray if we are not careful. Key pitfalls include

  • catching partial derivative disease; assuming all other things equal (ceteris paribus) when, in real life, they are not
  • thinking that the whole is simply the sum of the parts; not always so as we move from micro motivations to macro consequences, with the Paradox of Thrift a great example
  • believing that the model will work in all circumstances; parameters and behaviour often change, for example, when an economy moves from boom to bust
  • assuming that all driving forces are objective, measurable variables; our case studies will touch on the the power of expectations – how beliefs about the future shape the present and how uncertainty (the degree of comfort with the expectations formed) can play an additional role in spending decisions
  • supposing that governments (and central banks) invariably get matters under control; it is not always obvious what fiscal and monetary levers to pull, nor are the impacts easy to predict given limited information about the future and the vagaries of human behaviour 

The standard workhorse model of domestic business cycles comprises three equations. One is the Phillips Curve – the relationship between the output gap and inflation that we tackled in Session 6. Another is the TR/MP curve that examines one relationship between real interest rates and expenditure, operating through monetary policy and financial markets. That we shall leave to Session 10 where we draw on material from our Money & Finance session, recognising that real interest rates are not simply an outcome of monetary policy but also inflation expectations and risk premia.

For session 8 we focus on another relationship between real interest rates and expenditure – called the IS curve – that operates through non-financial goods and services markets, notably consumption, investment and government spending. We shall follow convention, and the textbook, in calling that relationship an IS curve even though the name often confuses and misleads. Strictly speaking it is the combination of real interest rates and the output gap that ensures planned withdrawals (W) equal planned injections (J). As you know from our accounting identities, W=J does not require I=S so the properties of the IS line would be clearer if we all called it the WJ line!

In constructing the IS curve and examining its slope and shift factors we focus on consumption (C), investment (I) and government spending (G). Net exports are dealt with only briefly since we shall delay discussion of external trade and cross-border capital flows to Sessions 12 and 13.

The Jones textbook (notably chapters 16 and 17) devotes a lot of space to the micro foundations of domestic private sector spending,  so we do not need to repeat that in the lecture. In any case, the empirical evidence supporting micro/neoclassical models is somewhat patchy.

  • For example, the so-called Euler Equation (Jones, pp 452-455) – derived from intertemporal models of utility-maximising consumption models – appears not to fit the facts. The Euler Equation predicts that, for any degree of impatience, higher real interest rates are associated with stronger planned consumption growth – in other words, present consumption is restrained in favour of more consumption in the future. In practice, it seems that the opposite is the case. This could be a mirage (the statistical problems of separating out causes and effects are notoriously hard) but it could reveal more fundamental problems such as the absence of assumed perfect financial markets and, even more damning, the wholly misleading use of a representative individual to reflect decisions by a heterogenous mix of consumers who build habits and sometimes “act dumb”. Even if individuals do act rationally, outcomes can still end up in a collectively irrational “bad equilibrium”.
  • As for investment, we examine evidence that accelerator (output gap) influences, together with expectations and uncertainty, appear much more important than variations in posted interest rates. The past affects the present but, arguably, the future is even more important; and no-one knows for sure what is going to happen. Hence, a huge role for sentiment, confidence and speculation – fickle stuff that is hard to capture or model. Such Keynesian-style thinking is nonetheless well suited to exploring hysteresis (cycle-trend interactions) and the stagnation themes revealed in Session 4. Indeed, problems of self-fulfilling prophecies – and thus the possibility of persistent deviations from the full-employment steady state  – underpin the rationale of contra-cyclical fiscal and monetary policy. Moreover, the policy instruments can be extended from classic “hard” tools (spending, taxes, interest rates) to “soft” brushes (nudges, guidance, artful communications).
  • Government spending is another focus of Session 8. This leads us into a discussion of the so-called “crowding out” phenomenon, automatic stabilisers and the concept of the Keynesian expenditure multiplier (topics that shall be examined more deeply in Session 9). Again, we learn that elementary textbook “rules” are often invalid – the real world does not easily fit into simple theoretical boxes. Sometimes government action works as intended, sometimes not; the state of the economy and the degree to which private sector behaviour is influenced are key variables that can be tricky to pin down. “Partial derivative disease” is particularly dangerous; assuming other things equal (ceteris paribus) is often misleading, sometimes just plain wrong. On Planet Earth, “fixed” rarely happens.

A key conclusion from our session is that there can be no decisive right answers about the impact of government spending on the economy. You should dip further into that debate but not get discouraged by the enormously wide range of views on offer. Your opinion is as good as anyone else’s but the important point is that you should see where the arguments are coming from and what assumptions are most in need of further investigation.

Macroeconomics is full of such belief-challenging controversies and intellectual fisticuffs. It is what makes the subject so interesting and relevant. As Banksy said about his own trade, “People say graffiti is ugly, irresponsible and childish… but that’s only if it’s done properly.

21 Mar 2019