BEE Partner, South Africa Economy Watch

The endogenous determination of the interest rate

In a boom, banks will lend more and will seek to create new deposits or issue additional notes. To support these activities, they will have to attract additional reserves. This will lead them to bid up interest rates, as they seek to attract idle reserves from one another and from hoards. In a slump, they will issue less and lend less, and will seek to shed reserves, lowering interest rates. In other words, while long-term average rates are determined by costs and competition, current interest rates reflect the balance of supply and demand in the market. They move pro-cyclically.

This is illustrated by a simple model. On the one hand, the rate of interest (in relation to the rate of profit), is likely to affect investment inversely, and investment, in turn, will have an impact on prices and employment. Changes in prices and employment will call for changes in reserves. Read the rest of this entry »

Reserves

The deposits and currency created by the Federal Reserve are the reserves of the modern system. It would seem that if the Fed could control the amount of these reserves, it could thereby limit the ability of banks to lend, and thus control their ability to create deposits. By controlling reserves, the Fed could control the total quantity of money. As we saw earlier, real reserves did constrain banks. It has seemed plausible, and monetarists everywhere have believed, that modern, nominal reserves could provide a similar constraint. But central banks all around the world, including the Federal Reserve, have tried to exercise such control, most recently in the late 1970s and early 1980s, and, in virtually every case, their attempts have failed. Read the rest of this entry »

The government budget tends to move counter-cyclically. In a slump, incomes will be reduced and spending curtailed, so tax collections will fall, but welfare and related spending to support the unemployed will tend to rise. Other government budget items are likely to be unaffected. Hence, the overall effect will be to throw the budget into deficit. By contrast, in a boom, tax collections will rise and welfare spending will tend to decline, so a surplus will tend to emerge. In short, in an economy with demand-based cyclical fluctuations, the central government budget will tend to move in a counter-cyclical fashion.

Now consider the monetary implications of deficits and surpluses. A deficit arises when the government spends more than it receives in taxes; this means a net increase in money in the system. Such money will appear as excess reserves in the banking system. If allowed to remain, it will drive down interest rates. Looked at another way, it will drive up security prices. A surplus is just the opposite; it arises when the government spends less than it takes in, and it creates a reserve deficiency, tending to force interest rates up. Read the rest of this entry »

In the older economy, the monetary system did provide a constraint, and this constraint helped stabilize the economy; changes in the value of reserves worked in conjunction with the price mechanism. By contrast, the modern monetary system offers no constraint, and, in fact, inflations and asset price booms are self-financing, since price rises increase the value of collateral, on the one hand, and raise the value of bank capital on the other. The modern monetary system also allows for a creative use of the central government’s budget. The shift in money from real to nominal, following the changes in technology, has brought a new role for the government. The government budget is both much larger and plays a stabilizing role in the way it affects the economy. Read the rest of this entry »

This rate has to be the target for which policy makers aim. If they try to reduce unemployment below this rate, they may temporarily succeed, but inflation will ultimately take off. If they raise unemployment above this rate, inflation will decline, but it will not stay lower, or even continue to fall, unless inflationary expectations are lowered. For this to happen, unemployment must stay high, but unnaturally high unemployment, coupled with lower than normal inflation, will lead employers to believe that real wages are exceptionally low. So they will begin to hire labor, and unemployment will move back to its natural level. Inflationary expectations are therefore unlikely to be lowered. Read the rest of this entry »

The idea behind the Phillips Curve is that higher inflation is associated with lower unemployment, and vice versa. Intuitively, this seems plausible enough. The stronger the economy, the more business is booming, the more jobs there will be. So we can expect the rate of unemployment to be lower. Indeed, it may fall to a point where shortages of various labor skills begin to emerge. In general, the more the economy is booming, the more likely there are to be shortages and inflationary pressures. By the same token, in a slump, excess labor and excess capacity will reduce inflationary pressures, and may even lead in some areas to price cutting. Read the rest of this entry »

Suppose, for example, that the GDP growth rate exceeds the interest rate by five percentage points. Then the steady-state deficit-to-GDP ratio will be 5 per cent of the debt-to-GDP ratio. If the debt-to-GDP ratio is at, for example, 60 per cent, then the primary deficit-to-GDP ratio can be permanently maintained at 3 per cent. Incidentally, these figures are the same as those stipulated in the European Union Maastricht Treaty as ‘convergence criteria’ for debt and deficit. Note that if the GDP growth rate exceeds the interest rate by five percentage points, then no less than one-fifth of the public sector in our ’small government‘ example, and one-tenth of the ‘big government‘ example, can be permanently financed by allowing the government debt to grow continuously. Taxpayers would be relieved accordingly. Read the rest of this entry »

What would happen if the Job Guarantee were introduced to solve the problem of unemployment in this economy? For simplicity of argument, we assume the Job Guarantee wage is set at the bottom of the private sector wage structure although not low enough to enforce poverty on full-time workers. If there were poverty level wages being paid in Sector B, then there would be pressure on Sector B employers to restructure their jobs in order to maintain a workforce. The Job Guarantee wage sets a floor in the economy’s cost structure for given productivity levels. The dynamics of the economy change significantly. The elimination of all but wait unemployment in Sector A and frictional unemployment does not distort the relative wage structure so that the wage—wage pressures that were prominent in the upturn in the NAIRU economy are now reduced. But the rising demand softens the product market, and demand for labor rises in Sector A. The Job Guarantee introduces no new problems faced by employers who wish to hire labor to meet higher sales levels. They must pay the going rate, which is still preferable to appropriately skilled workers than the Job Guarantee wage level. The rising demand per se does not invoke inflationary pressures as firms increase capacity utilization to meet higher sales volumes. Read the rest of this entry »

In this section we focus on inflation control and show that the Job Guarantee, able to simultaneously generate full employment and price stability, is superior to the current NAIRU approach, which uses unemployment to maintain inflation control. Broadly, there are three options available to an economy that desires price stability. First, as in the NAIRU approach, it can use unemployment as a tool to suppress price pressures. Second, it can introduce a Job Guarantee and use movements in the Buffer Employment Ratio (BER) to control inflation. Third, it can introduce the Job Guarantee policy and augment it with an incomes policy. We do not consider this third option.

The Role of Unemployment in Inflation Control

The OECD experience of the 1990s shows that high and prolonged unemployment eventually results in low inflation (Mitchell, 1996). There are several observationally equivalent theoretical explanations for the inflation—unemployment trade-off. Read the rest of this entry »

The International Labour Office (1999) argues:

[A]ny strategy for full employment must be based on a sound macroeconomic framework. To achieve this, unsustainable current account imbalances, or foreign debt accumulation, must be reduced and low rates of inflation achieved. This requires the continuous adjustment of policies, a realistic exchange rate, fiscal discipline and wage moderation (wage increases in line with labor productivity). But in times of global deflation this is not necessarily sufficient as a guide to policy, and a boost to demand may be needed, perhaps going so far as to generate expectations of inflation, in addition to the accepted policy of balancing budgets over the business cycle as a whole (International Labour Office, 1999). Read the rest of this entry »