A Coherent Approach to Macroeconomic Theory and Economic Policies

Abstract

Philip Arestis, in this chapter entitled ‘A Coherent Approach to Macroeconomic Theory and Economic Policies’, offers a new approach to macroeconomics, which focuses on the notion that there is often inadequacy of aggregate demand relative to what would be required for full employment of the factors of production. The level and distribution of productive capacity can often be inadequate to underpin full employment. Consequently, and under such circumstances, distributional effects are paramount and should be seriously taken on board in the analysis and policies; and such effects are actually considered in this contribution. Economic policies are thereby very relevant and important. We briefly summarise the theoretical framework that underpins the relevant economic policies before we turn our attention to the latter themselves. We suggest that in addition to the well-known economic policies, namely, fiscal and monetary policies, and of equal importance, co-ordination of them, two new, relevant and important policy dimensions emerge as paramount: distributional effects and financial stability. We also discuss briefly current ‘unorthodox’ monetary policies.

Appendix: Summary of Blocks

In what follows, the sign under the variables indicates the partial derivative of the dependent variable with respect to the relevant independent variable. In all equations in this contribution, lower case letters stand for the rate of change of the relevant variable; otherwise letters indicate the level of the relevant variable.

1.1 Block I: Aggregate Demand and Supply

$$ Y=C+I+G+\left(X-Q\right) $$

(6.1)

where Y is national income, C is consumption, I is investment, G is government expenditure, X is exports and Q is imports and thus (X − Q) is net exports (NE).

$$ C=C\left[\right( WE\left(1- t w\right),P\left(1- t\pi \right),R,\varDelta {\mathrm{BLP}}_{\mathrm{h}}\Big] $$

(6.2)

where W is wages, E total employment so WE is the wage bill, tw is the tax rate on wages, П is total profits, tπ is the tax rate on profits, R is the rate of interest on loans to households and ΔBLP_h is changes in bank lending to households.

$$ I=I\left(P/K,Y/\mathrm{Ya},R,\varDelta {\mathrm{BLP}}_{\mathrm{f}}\right) $$

(6.3)

where the symbols are as above with the exception of K, which is capital stock, ΔBLP_f that stands for changes in bank lending to firms, and Ya, which is a measure of capacity output and corresponds to the ‘desired level’ of operation.

$$ \mathrm{Ya}=\mathrm{Ya}\left(\underset{+}{\mathrm{E}},\underset{+}{\mathrm{K}},\underset{+}{\mathrm{ST}}\right) $$

(6.4)

so that Ya would change over time in the same direction as changes in employment, capital stock and state of technology (ST).

There is a level of employment that corresponds to the capacity-output measure (Ea):

$$ \mathrm{Ea}=E\left(\underset{+}{Y/\mathrm{Ya}},\underset{+}{K},\underset{+}{ST}\right) $$

(6.5)

Ya is taken as a benchmark for firms’ investment decisions and employment.

Aggregate supply of output is:

$$ Ys= Ys\left(\underset{+}{E},\underset{+}{K},\underset{+}{ST}\right) $$

(6.6)

where the aggregate supply output (Ys) is determined by employment, capital stock and state of technology, with the symbols defined as above.

There is a level of employment that corresponds to output:

$$ E=E\left(\underset{+}{Y},\underset{\_}{K},\underset{\_}{ST}\right) $$

(6.7)

1.2 Block II: Distributional Aspects and the Inflationary Process

$$ \pi =\pi \left[\left(\underset{+}{P/ ULC}\right),\underset{+}{Y/ Ya},\underset{\_}{R},\underset{\_}{d{R}_f}\right] $$

(6.8)

where the variables , in addition to the ones defined as above, are: π is the profit rate, P is the level of prices, ULC is unit labour cost and dR_f is the debt ratio of firms, defined as total debt to total assets of firms.

$$ \mathrm{ULC}=\frac{W}{PR} $$

(6.9)

where W is the level of wages, and PR is productivity.

$$ w=w\left\{\left[\underset{+}{{\left(W/P\right)}^d-\left(W/P\right)}\right],\left(\underset{+}{Y/ Ya}\right),\underset{+}{p},\underset{\_}{U},\underset{+}{\pi },\underset{+}{w^e}\right\} $$

(6.10)

where the variables are as above with the exception of the bargaining position of workers, which is defined as the difference between their desired real wage [(W/P)^d] and the actual real wage (W/P); p, which is inflation, U is unemployment, where unemployment is taken as percent of the labour force and w ^e that stands for expectations of the wage rate.

$$ U=U\left[\left(\underset{\_}{Y/ Ya}\right),\underset{\_}{PR}\right] $$

(6.11)

where the variables are as defined above.

$$ p=p\left[\underset{+}{w},\left(\underset{+}{Y/ Ya}\right),\underset{\_}{q},\underset{\_}{er},\underset{+}{p_{\mathrm{rm}}},\underset{+}{p^{\mathrm{e}}}\right] $$

(6.12)

where the variables are as defined above, with the exception of q, which is the rate of change of productivity, er is the rate of change of the nominal exchange rate, p _rm is the rate of change of the prices of raw materials and p ^e that stands for price expectations.

$$ {p}_{\mathrm{rm}}={p}_{\mathrm{rm}}\left(\underset{\_}{er},\underset{+}{WT}\right) $$

(6.13)

where the variables are as defined above with the exception of WT that stands for world trade.

1.3 Block III: Money and Credit

$$ \varDelta M=\varDelta \mathrm{BDGC}+\varDelta \mathrm{BDP} $$

(6.14)

where ΔM is changes in the money supply, namely, the sum of changes in bank deposits to the government including currency (ΔBDGC) and changes in bank deposits to the public (ΔBDP). In view of the small proportion of ΔBDGC of the total money supply, we treat it as the residual in the following identity:

$$ \varDelta \mathrm{BDGC}=\varDelta \mathrm{BLP}+\varDelta \mathrm{BLG}+\varDelta \mathrm{BLES}\hbox{--} \varDelta \mathrm{BDP} $$

(6.15)

Identity (Eq. 6.15) then defines ΔBDGC as the sum of changes in bank lending to the public (ΔBLP) and to the government (ΔBLG) as well as of changes in bank lending to the external sector including other non-bank lending (ΔBLES), minus ΔBDP. ΔBLES is treated as an exogenous variable and with ΔBLG endogenised in Block IV (see Eq. 6.19), the remaining variables in Eq. (6.15) are endogenised as follows:

$$ \varDelta \mathrm{BLP}=\varDelta \mathrm{BLP}\left(\underset{+}{\varDelta Y},\underset{\_}{\varDelta R},\underset{\_}{MP1}\right) $$

(6.16)

where the variables are as defined above, with the exception for the variable MP1, which stands for monetary policy variables such as credit-rationing by the authorities; this is of course in addition to changes in the rate of interest, which as Eq. (6.18) below shows, it is influenced by changes in the bank rate.

$$ \varDelta \mathrm{BDP}=\varDelta \mathrm{BDP}\left(\underset{+}{\varDelta Y},\underset{\_}{\varDelta R},\underset{\_}{MP2}\right) $$

(6.17)

with the variables as defined above, with the exception of MP2 that stands for monetary policy variables.

Both MP1 (Eq. 6.16) and MP2 (Eq. 6.17) can be thought of as financial-stability policy variables as discussed in Sect. 3.3.

$$ \varDelta R=\varDelta R\left(\underset{+}{\varDelta BR},\underset{+}{\varDelta EF},\underset{+}{\varDelta PDC}\right) $$

(6.18)

where in addition to the variables as defined above, ΔBR stands for changes in the bank rate, ΔEF stands for changes in external financing and ΔPDC that stands for sales of public debt to the non-bank public.

1.4 Block IV: Government Sector

$$ \varDelta \mathrm{BLG}=\mathrm{PSBR}+\varDelta EF\hbox{--} \varDelta \mathrm{PDC} $$

(6.19)

where the variables are defined as above with the exception of PSBR that stands for the public sector borrowing requirement.

PSBR, as portrayed in Eq. (6.20), is simply defined as the difference between government expenditure (G) and tax revenues (T) along with other government revenues (OGR).

$$ \mathrm{PSBR}=G\hbox{--} T\hbox{--} \mathrm{OGR} $$

(6.20)

We treat OGR as exogenous and hypothesise G and T to be determined as shown in Eqs. (6.21) and (6.23), respectively.

$$ G={P}_{\mathrm{G}}{Q}_{\mathrm{Q}}+W{E}_{\mathrm{G}}+U{U}_{\mathrm{B}}+ ID $$

(6.21)

where the symbols are defined as follows, with the exception of G, W and U that are defined as above: Q _Q denotes the amount of goods and services bought by the government, with P _G being their prices, E _G stands for the number of employees in the government sector, U _B is unemployment benefits and ID stands for interest payments on government debt. E _G is defined as in Eq. (6.22):

$$ {E}_{\mathrm{G}}=E\hbox{--} {E}_{\mathrm{P}}\hbox{--} U $$

(6.22)

where E is total working population, as defined above for the purposes of Eq. (6.2), and E _P is employment in the private sector. Clearly E _G + E _P = E that is total employment.

$$ T=T\left(\underset{+}{Y}\right) $$

(6.23)

1.5 Block V: Open Economy Aspects

$$ \varDelta EF=\mathrm{CB}+\varDelta KM\hbox{--} \mathrm{OEF} $$

(6.24)

where ΔEF is equal to the current balance of international payments (CB) plus changes in capital movements (ΔKM) minus other external financing (OEF); the latter variable includes external lending to the public sector plus domestic bank lending to the public sector in foreign currencies. We treat OEF as exogenous and endogenise CB and ΔKM.

$$ \mathrm{CB}= NE+ OCB=X\left(\underset{+}{WT},\underset{\_}{RER}\right)-Q\Big[\left( WE\left(\underset{+}{1- t w}\right),,\Pi \left(\underset{+}{1- t\pi}\right),,\underset{+}{RER}\right)+ OCB $$

(6.25)

where CB and NE are as above, OCB stands for other earnings on foreign investments minus payments made to foreign investors and cash transfers, WT is world trade, RER is the real exchange rate (where the exchange rate is defined as foreign to domestic currency), with WE(1 − tw) and П(1 − tπ) being the income distribution terms as they influence imports; all these variables are in real terms.

Finally, Eqs. (6.26) and (6.27) define ΔKM and RER:

$$ \varDelta KM=\varDelta KM\left[\left(\underset{+}{R/{R}_{\mathrm{W}}}\right),\underset{\_}{(er)^{\mathrm{e}}}\right] $$

(6.26)

where the variable, ratio of domestic interest rates (R) to world interest rates (R _W), is included, along with the expected rate of change of the nominal exchange rate variable, (er)^e.

$$ \mathrm{RER}=\mathrm{RER}\left[\left(\underset{+}{R/{R}_{\mathrm{W}}}\right),,,\underset{\_}{Y},,,\underset{+}{WT},,,\underset{+}{(er)^{\mathrm{e}}}\right] $$

(6.27)

where the variables are as defined above.