FISCAL POLICY WITHIN THE NEW CONSENSUS MODEL

FISCAL POLICY WITHIN THE NEW CONSENSUS MODEL 7

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Abstract

New Consensus in Macroeconomics is one of the recent developments inmacroeconomics. The framework downgrades the effectiveness of fiscalpolicy and instead upgrades the role of monetary policy. For thisreason, the contribution aims to focus on the contention by seekingthe fiscal policy. The paper considers fiscal policy within thepresent new consensus theoretical model, which disapproves theeffectiveness of fiscal policy. The paper will review and thenappraise recent empirical and theoretical developments found infiscal policy front. The discussion also poses the concern on whetherthe rules of fiscal policy need to replace the rules of monetarypolicy. The possibility of the monetary and fiscal policy isdiscussed and concluded that a careful consideration needs to bewithin the framework of New Consensus Model, fiscal policy deserves adetailed attention compared to other policy.

KeyWords: new consensus macroeconomics, monetary policy rules, andfiscal policy

Table ofContents

Abstract 2

Introduction 4

Research Question 4

The effects of fiscal policy in the NMC model 5

State of the NMC model and why fiscal policy is not there. 6

Recent Empirical Development 9

Developed Country Case 9

Developing Country Case 9

Should fiscal policy replace monetary policy 10

and Conclusion 10

References 11

Introduction

The section will look into the effectiveness of fiscal policy withinNCM. Here we will forward the model into the open economy case anddiscuss the effects and implications of monetary policy. Using themodel, we will also explore the function and effectiveness of thefiscal policy within the model and their potential impact on theeconomy.

Research Question

Theconduct of monetary policy in the economic environment has changedconsiderably over the past year. The objective is, to summarize, themonetary policy effectiveness and challenges of implementation.Monetary policy has not adequately covered all the aspects of theeconomy despite several reforms and the plans in place to cut downinflation targets. An integrated assessment of monetary and fiscalpolicies is deemed appropriate to evaluate the policy stand and mix(Agenor, McDermott, and Prasad, 2000).The evaluation of bothmonetary and fiscal policies needs models with micro foundations.However, the fiscal policy maintains its insignificant and realrigidities of existing models. Therefore, the paper will cover thepossibility of integration of fiscal policy and the associatedimportance of integration with the existing monetary policy.

Monetarypolicy is a macroeconomic tool used by the central banks and otherregulatory committees to determine the growth rate, size money supplyand the effects on interest rates. It is used to attain wider marketobjectives such as inflation, growth and liquidity and inflation.Thepolicy can either be expansionary or contractionary, whereexpansionary increases the money supply in the economy during thelater increase amount of money very slowly or shrinks the supplyAlesina and Tabellini, n.d.). To enhancethe stability of price or low inflation. For example in US, theobjective is to ensure inflation rate is below 3% which would thenensure economic growth. To lower unemployment rate, the policy keepsunemployment at the natural rate of 4%, which stood at 5.7% in 2003,committed to improve economic growth by increasing real GDP by 3%(Alesina, Campante, and Tabellini, n.d).In2003, the rate was 4% also to ensure financial market stability. Thetool will ensure that financial markets are not too high or too lowso as to attract investors.

The effects of fiscal policyin the NMC model

TheNew Consensus Macro economy approach combines the equilibrium modelwith the nominal price stickiness’. The fiscal policy tends to havedemand effects if it has an influence on the expectation of theeconomic agents that concern the future wealth and income that istermed as the demand side effects. Additionally, it has the supplyside effects of a position where it assists to improve the laborsupply and market efficiency along the competition within the economy(McDermott, Prasad, and Agénor, 1999). Thereare several ways in which fiscal policy affect the New MonetaryConsensus model based on the quantitative easing. A lot ofmonetarists in the traditional era sees that money supply can easilyincrease due to the open market operations, by the government buyingshort-term debts from the private sectors and the supplies reserves(Arestis and Sawyer, 2008).

Insome countries Quantitative easing can be easily performed throughno-traditional open market operations when the long term governmentdebts are bought thus bringing the interest rates to around zero.Central banks can also perform quantitative easing by purchasingseveral short-term or long-term assets but this may not be that easyas the central banks lacks the unilateral authority to give money tothe people. The banks can instead do this through money-financed taxcut. Quantitative easing always leads to money drop but with fiscalpolicy there is no guarantee that the extra reserves that is suppliedwill find its usefulness in the country’s economy (Arestis,n.d.). For instance new cash will not find way into the handsof the consumers and the investors. This is possible especially whenthe people are reluctant to take advantage of borrowing and the bankstoo are not releasing money to the borrowers (Woo,2009).

Additionally, the wealth effect and expectations wealth effect doesnot occurs from persuading the public to buy government bond insteadit occurs when the banks rain real money on the population mainly bya way of cut tax when acquiring money. The wealth effect on the otherhand depends on the expectations, for example if the taxpayersperceive a cut in the tax. And when the central bank is buyinggovernment debts taxes should not be raised with the aim of payingfor the debts (Banerjee, n.d.).Thus theresult would be permanent increase in the incomes by the people. Thetransparency of the fiscal policy can help handle this expectationefficiently. The role of expectations and inflation tends todelineate the difference between money drop under the New Monetaryconsensus as it produces an illusion of money and money drop in theNew Monetary consensus. Adaptive expectations and not realizing themleads to the increase in the money supply which in turn leads toinflation as people will increase their spending, pushing the pricesupwards thus neutralizing the effect of increasing demand. The moneyillusion from the expectations make consumers to spend more (Botman,and Kumar, n.d.).

State ofthe NMC model and why fiscal policy is not there.

NewMonetary Consensus model provides a tool for majority of centralbanks in the world, these tools are useful in the control ofinflation in various countries. This consensus has reasoning from theundeveloped economy models and monetary policy rules. It is presentedby a vibrant model that has three equations that are so flexible tobe accepted by new formulations without losing the basiccharacteristics and duties of the central bank’s reaction function(Maravalle and Claeys, 2012). With this,the equations may differ in the number of variables but the modeltend to remain the same. These equations include

  1. An equation of aggregate demand,

  2. Philips curve, and

  3. A monetary policy rule

Theequation of aggregate demand has the same structure as thetraditional IS curve though it comes from an inter-temporaloptimization outline. It tends to relate product responses to changesin the real interest rate (Dabrowski, n.d.).Philips curve deals with the price adjustments, it explainshow inflation responds to variation in the production capacity andthe expectations. Monetary policy Rule is an equation is thespecification that provide guidelines of how money circulates in theeconomy (OZDEMIR, 2006). NMC modelstates that monetary policy plays an important role in determiningshort term economic activities in any country. It does this byinsisting on the temporary nominal price rigidities just the same waythe traditional IS-LM model was. Thus it is based on a dynamicgeneral equilibrium framework with money and temporary nominalrigidities in the prices (Manasse, 2006).

Since NMC model tend to explain both the employment and output model,it is seen as the mainstream that can handle all the macroeconomicmodels and that all the models must incorporate individualinter-temporal decision making basing the arguments on the rationalexpectations. The results are mainly due to the behavior of rationalindividuals within the confines of a countless of rigidities in thecapital and labor markets. The NMC holds that the Central Bankscannot alter the stock of money but they can only set the short-terminterest rates thus the supply of money is left to be determined bythe credit needs of the economy (Erbil, 2011).The fiscal policy has the idea that central banks are responsible forcontrolling inflation but according to NMC inflation is controlled bythe interest rates in the countries and not the supply of money. Thisnotion, together with old ISLM has the idea that changes in theinterest rates affects the investment and output in the long run,this have produced a consensus that monetary policy has thecapability of affecting both output and inflation mainly throughadjustments in the rate of interest. At times fiscal policy becomesa useful tool when it comes to controlling inflation but the NMC seemto bind all the functions of fiscal policy thus the issue of thispolicy can easily be handled by NMC model (Suzuki,n.d.).

Fiscal policy is mainly useful in the extreme deflationary periodsthus there is no need of including it in the NMC model. This isbecause NMC deals with the daily problems of inflation. Even thoughfiscal policy may have important authorities and some reasons todeviate from well balanced budget especially during emergencies butthen in the long run it has to preserve public’s confidence(Fontana, n.d.). The distortionary andinflationary impacts can be nurtured in difficult times to reachstabilization through the monetary policy. The claims that fiscalpolicy is a stabilization tool does not actually link it to the goalof ensuring that there is full employment thus it is included in theNew Monetary Consensus. The theoretical and the methodologies are notthe same for both policies whereby in the New Monetary Consensus,employment is mainly determined from the optimization of the behaviorof the rational individuals (Vladimirov andNeycheva, 2009).

Recent Empirical Development

Theempirical and theoretical development of NCM within the fiscal policyconcluded that the system was ineffective. The reason behind thisproposition is dependent on three assumptions. The assumptionsinclude thehousehold used temporarily, the households were subjected toliquidity constraints and the householdanticipated for intertemporal financial constraints (Ganleyand Salmon, n.d.).However, the evidence before the fiscalpolicy has been questioned, and results were provided to show theeffectiveness of the policy.

DevelopedCountry Case

Thestudy resolves the prediction of New Consensus Model thatthe expenses that government indulges themselves in have substantialadverse implications on consumption. Conversely, the empirical theoryconcludes the positive impact on the consumption. The pieces ofevidence provided do not approve the assumption of the model (GarciaDuarte, n.d.). According to the literature, models that studythe implication of the policy need to support two householdtypes.

DevelopingCountry Case

Theexperience of the developing countries shows that fiscal policy ispro-cyclical instead of counter-cyclical (Macroeconomicsand new macroeconomics, 1989).&nbspMeaning,that the budget deficit as GDP percentage increases during the boomperiod but reduces during recessions. This is inconsistent with thecounter-cyclical case where it is the vice-versa. The pro-cyclicalpoint of view is applicable to discretionary changes that occurs infiscal policy but is not applicable to the automatic stabilizerswhich offer counter-cyclical parameters of the fiscal policy(Thornton, 2007).

Should fiscal policy replace monetary policy

Overthe recent past economies have had a considerable interest in thefiscal policy rules? The policyis meant to contain the deficits of the public sector and reduce thedebts of the public sector by pointing out the targets for the debts,spending, or deficits of government. Some thefiscal policy that will replace the monetary policy are well includedin the six equations. The puzzling question of this framework is iffiscal policy is active (Huart, 2012). Thereis no defined answer that has beenprovided. For a to be effective, there must be implementations andenforcements behind it.

Summary and Conclusion

Inconclusion, when certain additional assumptions are in the NCM, thenfavorable results will be reported on fiscal policy. One of the mostassumptions is the Ricardian equivalence assumption. Ricardianassumed the short planning carried out by households were meant tolook down upon the intertemporal smoothing. Meaning that every changethat happens in the fiscal policy affects the decisions of householdto work and consume. From the discussion, thefiscal policy has been rendered ineffective for various reasons.Additionally, there are various arguments in the paper which suggeststhat the motive behind the argument is shown to rely on weakerfoundations (Kumar and Botman, 2006).Theevidence on the effectiveness of the policy is not always on the sideof the New Consensus Model perspective. When the NCM model is fromthe monetary to fiscal rule, it will possess various advantages. Inconclusion, although the policy has varied negative implications, itdoes not deserve to downgrade as shown In NMC (Talviand Vegh, n.d.).

References

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Alesina, A. and Tabellini, G. (n.d.). Why isFiscal Policy Often Procyclical?.&nbspSSRNJournal.

Alesina, A., Campante, F. and Tabellini, G.(2008). Why Is Fiscal Policy Often Procyclical?.&nbspJournalof the European Economic Association,6(5), pp.1006-1036.

Arestis, P. and Sawyer, M. (2008). Newconsensus macroeconomics and inflation targeting: a Keynesiancritique.&nbspEcon.soc., 17(spe).

Arestis, P. (n.d.). New ConsensusMacroeconomics: A Critical Appraisal.&nbspSSRNJournal.

Banerjee, R. (n.d.). Optimal Procyclical FiscalPolicy Without Procyclical Government Spending.&nbspSSRNJournal.

Botman, D. and Kumar, M. (n.d.). FundamentalDeterminants of the Effects of Fiscal Policy.&nbspSSRNJournal.

Dabrowski, M. (n.d.). Fiscal and MonetaryPolicy Determinants of the Eurozone Crisis and Its Resolution.&nbspSSRNJournal.

Erbil, N. (2011). Is Fiscal Policy Procyclicalin Developing Oil-Producing Countries?.&nbspIMFWorking Papers, 11(171), p.1.

Fontana, G. (n.d.). Whether New ConsensusMacroeconomics? The Role of Government and Fiscal Policy in ModernMacroeconomics.&nbspSSRNJournal.

Ganley, J. and Salmon, C. (n.d.). TheIndustrial Impact of Monetary Policy Shocks: Some StylizedFacts.&nbspSSRNJournal.

Garcia Duarte, P. (n.d.). From Real BusinessCycle and New Keynesian to DSGE Macroeconomics: Facts and Models inthe Emergence of a Consensus.&nbspSSRNJournal.

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Macroeconomics and new macroeconomics.(1989).&nbspJournalof Macroeconomics, 11(2), p.319.

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Suzuki, Y. (n.d.). Sovereign Risk andProcyclical Fiscal Policy in Emerging Market Economies.&nbspSSRNJournal.

Talvi, E. and Vegh, C. (n.d.). Tax BaseVariability and Procyclical Fiscal Policy.&nbspSSRNJournal.

Thornton, J. (2007). Explaining ProcyclicalFiscal Policy in African Countries.&nbspJournalof African Economies, 17(3),pp.451-464.

Vladimirov, V. and Neycheva, M. (2009).Determinants of Non-Linear Effects of Fiscal Policy on Output: TheCase of Bulgaria.&nbspSouthEast European Journal of Economics and Business,4(1).

Woo, J. (2009). Why Do More Polarized CountriesRun More Procyclical Fiscal Policy?.&nbspReviewof Economics and Statistics, 91(4),pp.850-870.