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Fiscal and monetary policy rules

in an unstable economy

Soon Ryoo Peter SkottAdelphi University Umass and Aalborg University

12th International Post Keynesian Conference

UMKC, September 2014

Overview

Harrodian instability

Consumption and investment

Monetary and fiscal policy rules

Conclusions

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HARRODIAN BENCHMARK

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Basic equations

Investment

Consumption

Equilibrium condition

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ġ uud

C

K1su

u g

s

Harrodian problems

Warranted vs natural growth

Unstable dynamics

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gw sudn

ġ g

s ud; 0

Reconciling natural and warranted

rates Interest rates

Choice of technique

‘Optimal’ fixed Leontief production function

Fiscal policy

Deficit if private saving exceeds investment at full

employment

Implications for

Consumption behavior and goods market equilibrium

Debt dynamics

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Steady growth results

OLG setting: empirical relevance of ‘dynamic inefficiency’

dynamic inefficiency implies AD problems

‘Stock-flow consistent’ setting

Robust across models: Low growth causes high debt

High government consumption causes low debt

Why? With higher I or G, full-employment consumption needs to get

squeezed → higher taxes

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Short-run stabilization?

Automatic fiscal stabilizers

Are they sufficient?

Do monetary Taylor rules stabilize?

Taylor rule for fiscal policy?

Supercharged fiscal stabilizer

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MODEL

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Policy instruments

Monetary:

Real interest rate, r

Fiscal

Government consumption, G; γ=G/K

Proportional tax rate, τ

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Consumption: taxes, interest and

wealth Target consumption-wealth ratios

Gradual adjustment

Budget constraint

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B pC

vN pC

#

#

BpBB

B

pYDpCvNB

Consumption function

Assume investment financed by retained

earnings (adjustments in retention rate)

Then:

Note:

The equity ratio α is irrelevant

Public debt has income and wealth effects

Consumption rates depend on β.

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pC 1cpYrBcpIcvB

c 1/1and cv /1

Investment

Excess capacity desired because of

Demand volatility

Entry deterrence

…

Weigh cost of holding excess capacity

against the benefits

Desired utilization depends on cost of

finance:

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udurr

ġ uud

Dynamic system

Investment dynamics

Debt dynamics

Employment dynamics

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e uk where k K/L

ġ uud

udurr

brgburb

kkgn

u c1urbcbcgg

IMPLICATIONS

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Taylor rule

3D system if ρ3=0

Local stability possible if desired utilization

sufficiently sensitive to changes in r

Threshold value depends on debt ratio

High debt ratio endangers stability

Intuition

Expansionary induced fiscal effect

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r r1uu2kk3ppT

Keynesian policy rule

Government consumption as active

instrument

Full stabilization of employment at e* -- γ set

to give u=e*/k -- is possible but implies:

2D system in (g,k)

Lotka-Volterra structure and conservative

fluctuations

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Modified Keynesian rule

Use γ to get

2D system in (g,k)

Locally stable

Induced b-dynamics is stable for plausible

parameter values

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ug,b,uHkk,gn, H1 0,H2 0,H0,00

Austerity rule

Extreme version: keep B/Y constant

Unstable 2D system in (g,b)

Arbitrary B/Y target fails to ensure g*=n

Modified version: keep b=B/K constant

Unstable; Harrodian instability aggravated

Implications:

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CONCLUSIONS AND

EXTENSIONS

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Conclusions

Need for policy

Automatic stabilizers dampen effects of shocks

but fail to remove Harrodian instability

Taylor rule is not stabilizing when debt ratios

are high

‘Keynesian policy rule’ is stabilizing

‘Austerity policy rule’ is de-stabilizing

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Extensions

Interactions between fiscal policy and ‘Taylor

rule’

Inflation dynamics

Other stabilizing mechanisms

‘reserve army effects’

Fiscal rules in ‘full’ cycle model

Empirics on ‘implicit fiscal policy rules’

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THANKS!

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