price stability and debt stability: a wicksell-lerner-tinbergen framework for macroeconomic policy
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Functional Finance and Monetary Policy session at 12th International ConferenceTRANSCRIPT
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Price Stability and Debt Stability
Price Stability and Debt Stability: AWicksell-Lerner-Tinbergen Framework for
Macroeconomic Policy
J. W. Mason and Arjun Jayadev
September 25, 2014
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Price Stability and Debt Stability
Introduction
I Debate: Is ability to reach full employment through fiscaldeficits constrained by public debt sustainability?
I Debate about definition of sustainability.
I One useful definition of sustainable debt: stable debt-GDPratio
I Question: Does expansionary fiscal policy imply risingdebt-GDP ratio?
I Answer: No. (Sometimes requires debt-GDP ratio to convergeto higher, but finite, level).
I Why? Interest rate and deficits affect debt trajectory
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Price Stability and Debt Stability
Our Framework
I Wicksellian “natural interest rate” (zero output gap) and“sustainable budget balance” (constant debt-GDP ratio) arejointly determined.
I Medium-run analysis: Given average level of private demand,inflation and growth over a business cycle or decade, whatcombinations of interest rate and budget balance areconsistent with each goal?
I Simplest solution: Coordination of monetary and fiscal policyto achieve both.
I But political and practical arguments for distinct portfolios, orfor central bank “independence”
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Price Stability and Debt Stability
Dynamics of Policy Adjustment
I Tinbergen issue: we have two instruments (interest rate andbudget balance) and two targets (constant debt ratio and fullemployment/price stability).
I “Sound finance” rule assigns interest rate to output gap andbudget balance to debt-GDP ratio. “Functional finance” rulehas opposite assignment.
I In principle, assignment makes no difference. Both implyidentical equilibrium values for interest rate and budgetbalance.
I Sound finance and functional finance appear radically differentbut do not generally imply different policy outcomes
I But in practice, wrong assignment can amplify shocks,creating endogenous “policy cycles” or divergence
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Price Stability and Debt Stability
Policy Goals: Price Stability or Full Employment
Standard assumptions of textbook “3-equation” macroeconomicmodels, shared by all practical forecasters:
I There is a well-defined level of potential output
I Goal of macro policy: minimize “output gap”I Keeping output at potential encompasses goals of both price
stability and full employment
I Current output is a negative function of the interest rate anda positive function of government deficits
I Private demand (including the trade balance) varies over time
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Price Stability and Debt Stability
IS equation
y = z − ηi − γb + τ id (1)
Implies linear combinations of interest rate and budget balancecompatible with price stability – for each fiscal surplus or deficit,there is a different “natural” interest rate
I y : output gap, as percent of potential output
I z : output gap when interest rate and primary deficit are zero
I i : interest rate (average rate on government debt)
I b: primary budget surplus
I d : debt-GDP ratio
I γ: average multiplier on government spending and taxes
I η: percent change in GDP from one point change in i
I τ : multiplier on interest payments on public debt
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Price Stability and Debt Stability
Price stability or Full Employment Locus
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Price Stability and Debt Stability
Policy Goals: Debt Stability
I Strong definition of sustainability: debt-GDP ratio cannot risefrom current level
I By definition, ensures that ratio will not rise above any criticalthreshold
I Analysis would be the same if we instead required debt ratioto fall (or rise) by fixed percent of GDP each period
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Price Stability and Debt Stability
DS equation
“Least Controversial Equation in Macroeconomics”: change indebt-GDP ratio is depends on i interest, b budget balance and g ,GDP growth rate. Debt can reduced by raising b or lowering i(historically both)
∆d =i − g
1 + gd − b (2)
g : growth rate of GDP∆d = 0 satisfied by linear combinations of i and b. For everyinterest rate, there is a different sustainable budget balance
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Price Stability and Debt Stability
Debt Stability Locus
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Price Stability and Debt Stability
IS curve and law of motion of government debt together defineunique combination of fiscal balance and interest rate with outputat potential and constant debt-GDP ratio:
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Price Stability and Debt Stability
Tinbergen and assignment of rules
I Sound Finance:
I Interest rate =⇒ output gapI Budget balance =⇒ debt stability
I ’Functional’ Finance:I Interest rate =⇒ debt stabilityI Budget balance =⇒ output gap
I Sound finance = moving vertically toward potential outputlocus and horizontally toward debt stability locus.
I Functional finance = moving horizontally toward potentialoutput locus and vertically toward debt stability locus.
I Adjusting each instrument independently based on its owntarget can produce cycles in interest rate-fiscal balance space.Dynamics matter!
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Price Stability and Debt Stability
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Price Stability and Debt Stability
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Price Stability and Debt Stability
Feedback effects in Policy Space
Intuition:
I Raising interest rate to eliminate a positive output gapincreases interest burden of government debt, requiring highertaxes or lower expenditure to keep debt ratio stable.
I Moving the fiscal balance toward surplus to stabilize the debtratio reduces demand, requiring lower interest rate to keepoutput at potential.
I A lower interest rate implies slower growth in the debt ratio,encouraging spending increases or tax cuts.
I As fiscal balance moves toward deficit, demand increases,requiring higher interest rate to keep output at potential.
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Price Stability and Debt Stability
Convergence or Divergence?
I Whether these cycles converge or diverge depends on theparameter values and the level of debt.
I Conclusions from formal stability analysis:
I Sound finance converges most quickly when η is large, γ and τare small, and the debt ratio d is low.
I Functional finance converges most quickly when γ is large, η issmall, and the debt ratio d is high.
I For plausible parameter values (e.g. from FRBUS model),critical value of d for sound finance to converge is between 0.5and 1.
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Price Stability and Debt Stability
Implication of stability analysis: when debt ratio is high, to avoidexplosive policy cycles budget balance must target output gap andinterest rate must target debt stability.Fiscal space metaphor is backwards!
I At high debt ratios, change in debt ratio depends relativelymore on interest rate, and relatively less on current spendingand taxes.
I Historically, interest rate policy has focused on public debtrather than output when debt ratios were high.
I World War II-era USI “Financial repression” (Reinhart et al.)
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Price Stability and Debt Stability
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Price Stability and Debt Stability
Locating the PS and DS Loci HistoricallyWe estimate PS and DS loci by decade, on following assumptions(proof of concept):
I Output gap measured as deviation from BEA “potentialoutput” trend (other useful measures behave similarly)
I Given output gap and trade balance plus chosen values of γ, ηand τ , can calculate state of private demand as a residual
I Nominal interest rate measured as average rate on federal debt
I Interest rate that matters for private demand is nominal rateminus 0.5× observed inflation.
I Even with strong assumptions of forward-looking, rationaltransactors this parameter should be less than 1
I Net exports add to final demand one for one.
I Parameter values: γ = 1.5, η = 1, τ = 0.5 (typical fromforecasting models)
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Price Stability and Debt Stability
Price Stability and Debt Stability Loci, 1950s
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Price Stability and Debt Stability
Price Stability and Debt Stability Loci, 1960s
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Price Stability and Debt Stability
Price Stability and Debt Stability Loci, 1970s
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Price Stability and Debt Stability
Price Stability and Debt Stability Loci, 1980s
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Price Stability and Debt Stability
Price Stability and Debt Stability Loci, 1990s
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Price Stability and Debt Stability
Price Stability and Debt Stability Loci, 2000s
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Price Stability and Debt Stability
Price Stability and Debt Stability Loci, 2004-2013
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Price Stability and Debt Stability
Historical Estimates as Model Validation
I Any forecasting model uses certain parameter values. Incombination with historical data, these values imply certainpath for autonomous private demand.
I “Autonomous” here meaning independent of fiscal andmonetary policy.
I Tool for model validation – are implied variations in privatedemand consistent with everything else we know abouteconomy?
I Historical variations in private demand informative aboutrange of variation policy will have to respond to in future.
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Price Stability and Debt Stability
Implied Contributions to Demand
Contributions to Output Gap in Percent of GDP, 5-Year Moving Averages
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Price Stability and Debt Stability
The current situation
I Sharp fall in private demand after 2008 implied by appearanceof substantial negative output gap despite increase in demandfrom other sources
I Lower net imports: +2 pointsI Lower interest rates: +3 pointsI Shift toward primary deficit: +7 points
I Movement of private demand of 15-20 points in just a fewyears seem hard to offset with either monetary or fiscal policy
I Implies that macro stabilization needs to focus on underlyingshifts of private demand
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Price Stability and Debt Stability
Conclusions
I Need to better define ‘debt sustainability’. No increase fromcurrent debt-GDP ratio is one plausible definition
I Debt sustainability in this sense is not generally a constrainton active fiscal policy
I If fiscal policy targets output and monetary policy targets debtratio, will normally keep output at potential and debt ratioconstant
I If private demand is very weak and inflation and growth arelow (as now), neither “sound finance” nor “functional finance”rule can achieve both targets
I With each instrument committed to one target, will seeendogenous “policy cycles.” Magnitude of cycles depends onparameters and current debt ratio
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Price Stability and Debt Stability
A 40-Year Sound Finance Spiral?
10-Year Moving Averages, US i and b
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Price Stability and Debt Stability
I 1970s: Debt stable, positive output gap
I Interest increase moves economy toward price stability locusbut off debt sustainability locus
I Increased debt under Reagan due mostly (60 - 80%) to higheri , not primary deficits!
I Rising debt leads to primary surplus in 1990s. Reachesdebt-sustainability locus, moves off price-stability locus.
I Primary surplus under Clinton =⇒ negative output gap;initially masked by tech boom.
I Shift towards surpluses =⇒ lower i required for potentialoutput (near zero 2000, zero in 2008)
I Standard estimates of multiplier, interest elasticity of outputsuggest Clinton surpluses reduced “natural rate” by 5 points.