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Sunday, February 1, 2009

WILL FISCAL EXPANSION IN THE USA BE OFFSET BY CAPITAL MOVEMENTS INTO OUR COUNTRY AND SLIPPAGE OF AGGREGATE DEMAND INTO IMPORTS?

Today's Buggy Topic

A pretty big verbal mouthful --- the subject-tile above, no?  All the same, it captures the lengthy analysis set out last evening (January 31st, 2009) at Economist's View, an outstanding economics-blog run by Professor Mark Thoma --- a well-known Keynesian macroeconomics specialist.  Here's the relevant thread where you'll find the bugged-out comments.

What's At Stake

The original post by Prof Thoma quoted a good thoughtful and generally easy-to-follow argument set out by a Canadian economist, Professor Nick Rowe, on an important topic that has been slighted --- even ignored largely (not entirely) --- in the ongoing debate over President Obama's large fiscal stimulus program . . . some $850 billion dollars in size.  To wit: the success of any fiscal stimulus program depends on the multiplier impact on aggregate demand.  But there's a danger that some or even a possibility of all the multiplier impact being offset by the US economy's integration into the global economy, and for two reasons:

  • Ordinarily, expansionary fiscal policies --- which increase the federal government's deficits --- will raise interest rates.  In a globally integrated economy, rising interest rates would then attract more foreign capital into the US from abroad.  The more capital flows into the US economy from Europe, Asia, and elsewhere, the more this would lead to the exchange rate of the $US rising against the euro, the yen, the Chinese Yuan (renminbi), and other currencies.  The result?  US exports would decline, and simultaneously US imports from abroad would rise. 

  • The combination of declining exports and rising imports would increase the trade-deficit (current-account deficit: trade in goods and services).  The more that trade-deficit increases, the more slippage there's be of the multiplier effects of President Obama's fiscal stimulus program.  And hence the effort to prod the US economy out of recession would be offset on the trade-side. 

Some Background Links

Almost all of Professor Nick Rowe's original post is fairly understandable even if you can't remember much of your basic macroeconomics course in college or university.  So are the buggy prof's long analysis, and Rowe's reply.

The exception: a reference to the IS-LMBP Mundell-Fleming model that links the macroeconomic study of aggregate demand --- a combination of C (private consumption), I (private-sector investment), G (government spending minus taxes) --- to NX (net exports: in the US case, about 4-5.0% negative in this decade each year).  Robert Mundell won a Nobel Prize in economics a few years ago for this and other important work on trade and capital movements and how they bear on both GDP growth and monetary-and-fiscal policymaking.

The First Link: The IS-LM Model

If you want some basic review, you might find the following two links to articles --- complete with nifty diagrams --- a useful review. 

For the IS-LM model ---- developed in 1937 by Professors John Hicks of Oxford and Alvin Hansen of Harvard (Hicks, a former prof bug professor, eventually won a Nobel Prize in economics for this and other work): click here. Note that this citizendium article is far better and easier to follow then the wikipedia counterpart. 

 The IS-LM model, please observe, was by far the most influential way of presenting Keynesian economics, at any rate down to the 1970s, by which time the revival of classical economics with rational expectations added by Robert Lucas of Chicago tended to undermine its general acceptance.   Along with Milton Friedman's monetarism, Lucas's pathbreaking work --- which earned him a Nobel Prize in economics --- spun off an entire anti-Keynesian approach to macroeconomics that's called New Classicism. 

  • Note: not Neo-Classicism, rather New Classicism.  The former refers to the work of economists in the late 19th and early 20th century on price theory, the creation of marginal analysis, and the allocation of resources in efficient or non-efficient manner . . . with changes in the money supply largely considered unable to either expand or reduce real GDP growth, instead only raise or lower the general price level of an economy. 

  • The methodological key here, keep in mind, is the use of rational expectations in statistical modeling --- a postulate about the behavior of average economic agents: business firms, workers, consumers, and savers and investors.  That postulate, along with assumptions that all markets clear automatically or at least quickly, links the behavior of individual economic agents with the performance of the aggregate national economy . . . something, note quickly, that New Keynesians have also done since the Lucas-inspired revolution of the early 1970s --- only with different views about the failure of markets to clear automatically or quickly.  Hence, in the New Keynesian view, the need for active fiscal and especially monetary policies as countercyclical instruments for fighting both recessions and inflationary tendencies on the aggregate level. 

  • Real Business-Cycle Theory, for which Edward Prescott and Finn Kyland --- the latter at prof bug's former university, UC Santa Barbara --- shared a Nobel Prize in economics in 2004, goes further than the original Lucas innovations about rational expectations.  Contrary to all forms of Keynesianism --- New mainstream or Post-Keynesian radicalism --- real business-cycle theory argues that neither fiscal expansion nor monetary policy that influences either interest rates or the money supply can influence the length and depth of a recession. 

  • Why is that?  On this view, to put it tersely, the business cycle is caused by "real" shocks such as changes in technology, the need to reallocate labor and capital across different sectors as a result of such changes, or because of other shocks like OPEC's oil price rises in the 1970s or again between late 2007 and mid-2008 or maybe because of war.  And since both fiscal policies and monetary policies can only influence "nominal" price levels, they have no beneficial impact as countercyclical efforts to combat recessions.  In fact, they can lengthen them.  In effect, it's pre-Keynesian classical and neo-classical theory of the business cycle revived in a sophisticated manner, using rational expectations theory and some elaborate statistical modeling.

  • For that matter, in the early 1980s, Hicks did criticize some of the simplicities in the IS-LM model that sought, originally, to reconcile Keynes' macroeconomic innovations with classical and neo-classical economics.  He did so, interestingly, from a radical Keynesian slant.  Even so, the IS-LM model is still widely used in textbooks and as a basis of certain kinds of macroeconomic work.

Now Add Foreign Trade and Global Capital Movements to the IS-LM Model

And voila . . . you've now augmented the Hicks-Hansen approach to Keynesianism with the influence of globalizing tendencies --- both for trade in goods and services and, more important still, the impact of increasingly large capital movements around the globe.  So once you've refreshed your memory of the basic IS-LM model, you can find a good wikipedia article on the Mundell-Fleming augmented IS-LM model --- usually called the IS-LMBP: BP referring to balance of payments) --- here.  

Don't Worry Though

If you find the two links hard to understand, you won't have trouble following the original Nick Rowe commentary or prof bug's analysis or Professor Rowe's reply in the thread at Economist's View.