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Effects of recent Fed and Congressional macro policy moves

Figure above: static image only. Interactive version appears at the bottom of this post.

Wednesday’s Fed policy decision of course turned out to be a small increase in the Federal Funds Rate. Dean Baker and Paul Krugman were among those opposed to the hike in rates, on the grounds that the recovery had not proceeded far enough, according to many Fed-approved and less-official statistical gauges. Krugman is perhaps less adamant than Baker in his opposition to the long-awaited Fed move, finding grounds to declare a “not-so-bad economy” in the US.

Of course, not everyone pays an interest rate closely tied to the federal funds rate. Roubini provides his assessment of credit-quality issues with the debt of borrowers in emerging markets.

Some basic models remain fundamentally flawed in that the interest rate in them is set by the interaction of the supply and demand for saving. For example, if excess saving develops in these models, the interest rate falls.

Some models appear to have almost no role for the interest rate at all. For example, in the model I presented in my first post on November 29, the only interest rate included is a rate on government debt. While this rate is set by policy alone, we do not include it as a determinant of investment or consumption—which may seem odd.

On the other hand, it directly determines the interest income of the wealthy “K-sector,” which holds the entire debt of the government in this simplified model. Nonetheless, there is some effect on spending by this sector. This effect is not always recognized in simple models, and was emphasized by Wynne Godley, a distinguished UK economist and forecaster known in the US largely for his work at the Levy Economics Institute of Bard College.

One can observe the effect of changing the interest rate by using the CDF below, which depicts the same economy as the CDF in the aforementioned inaugural post. A new lever in the CDF allows the user to change the interest rate. Another lever is for tax policy, which we will get to in a moment. I’ve eliminated the old lever for the speed of adjustment of public-sector spending and production. The arrowheads show the direction of motion of the economy, and the main idea is that the deficit-target rule for fiscal policy produces an unstable configuration, while the rule with a capacity utilization target, produces cycles or a spiral toward equilibrium. The two variables in the picture are public production/spending and capacity utilization (the fraction of the stock of capital goods in use). The levers allow a situation in which no equilibrium (steady state) position exists for all variables at the same time.

freestanding version of cdf for use on your own computer;

larger version of embedded CDF above

(non-Mathematica users will need the free CDF Player program, which can be downloaded at no charge at this link)

See some CDF basics on this page

Admittedly, the effect is a bit small, partly because of the omission of borrowing by households, which is somewhat sensitive to retail interest rates. On the other hand, empirical work shows little influence of interest rates in private companies’ decisions to invest. The model above makes the latter type of spending a function of the after-tax rate of profit and capacity utilization, an idea from Josef Steindl and Michal Kalecki.

It is another matter to make the saving of the entire private sector depend in a significant way on the interest rate, as in some pseudo-Keynesian models, such as the one Lance Taylor uses in his interesting (but somewhat scholarly for some readers) Structuralist take on Krugman’s liquidity-trap economics in the Review of Keynesian Economics (version at publisher website). This critique of course does not apply to Keynes’s model. I describe an ultra-simple alternative Keynesian model from the great Luigi Pasinetti in this old post at multiplier-effect.

Some say that  models that are in various ways symmetric have great appeal in a field that has adopted a physics metaphor as its guiding principle. Thus, perhaps, we get an upward-sloping supply curve and a downward-sloping demand curve to determine every price, including the interest rate. In such models, the interest rate on government debt will depend somehow on the forces of supply and demand for public-sector securities.

In such a view, a move such as the recent tax and spending bill recently passed by Congress might be seen as a more important determinant of interest rates on short-term Treasury paper. The reasoning: deficits add to the supply of government liabilities. However, the addition to government securities in private-sector and non-US hands implied by this gradual expansion of total federal liabilities (including money) will adjust as always to the level of demand from investors, traders, foreign central banks, etc. So, the recent interest-rate decision is distinct from fiscal moves such as the big tax and spending agreement. And interest rates such as those on “junk” bonds are determined largely by the market’s assessment of the likelihood of timely payments.

I will get into distributional questions more in a post in the very near future. And it remains to discuss how the money will be spent.


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