The GEM Project, with its emphasis on wage rigidities, most heavily contributes to the supply side of macro analysis. Think about how the development of stabilization-relevant macroeconomics would have been altered if, during the brief period of active efficiency-wage research, I had not only introduced but also microfounded nonconvex WERs. The new macro tool would have established the centrality of total nominal spending in post-Austrian instability modeling. Business cycles caused by real shocks would have been properly assigned a substantially lesser role in macro research. Analysts could have emphasized policymaker-useful issues such as in-depth analysis of stationary and nonstationary nominal-demand disturbances. The GEM Project’s most consequential contribution to the demand side is opening up rigorous analysis to the various types of nominal disturbances, helping to make macro theory more policymaker useful.
Generalized exchange reprises the Early Keynesian (EK) starring role for the propagation of macro shocks by disturbances in total spending, producing powerful same-direction employment and output instability. Responding to observable meta-externalities, EK theorists emphasized the discretionary management of aggregate demand. In two-venue modeling, monetary interventions in support of real-side objectives are reasserted and refined. Activist stabilization policy has been microfounded by replacing the unhappy, properly criticized Keynesian reliance on free parameters.
Stationary Demand Disturbance (SDD). Demand-management problems confronting stabilization policymakers can be usefully separated into two classes. SDDs produce garden-variety recessions, for which automatic stabilizers and routine Fed open-market operations to reduce short-term interest rates and thereby ease credit conditions constitute an effective response. Stationary demand disturbances are the most easily managed class of instability. In mainstream macroeconomics, SDD is the focus of New Keynesian (NK) analysis, as illustrated by Woodford restricting the total spending disturbances in his NK bible, Interest and Prices (2003), to be stationary. Only in such limited circumstances can competent central bankers agree with Woodford that “ … the crucial monetary policy question is that of the appropriate level for short-term interest rates.”
SDD instability little impacts trend growth in LEV employment. Profit effects are sufficiently transitory that feedback to longer-term growth in output and LEV employment can usually be ignored in the compact workplace-marketplace synthesis. Occurring at high frequencies, the central SDD stabilization problem portrayed by Woodford in Interest and Prices as well as other SVGE theorists is rooted in the Fed’s capacity to distinguish between (i) adverse demand disturbances that, in combination with relevant market frictions, induce short-lived market inefficiency and (ii) spending slowdowns associated with market-efficient reallocations of resources. The focus on distinguishing between slight deviations in the longer-term growth path that are inefficient or efficient follows from the coherent SEV model class inherently restricting stationary contractions in employment to be wholly voluntary and therefore small.
Unchecked nonstationary demand disturbance (NDD). The most perilous stabilization problem is the mutation of a demand disturbance into a NDD capable of generating market failure on the scale that occurred in the 1930s. In generalized-exchange modeling, the long lags required for job destruction to induce rational reference-standard (ҜJ) recalibration and consequent LEV wage give-backs are critically important. Unchecked NDD substantially damages the longer-term paths of profits, investment, output, and LEV (good) jobs. Stabilization authorities, in order to design and implement an effective response, must understand the Project’s acute-instability demand macrodynamics, especially with respect to necessary remedial-policy speed and size.
When unfolding conditions indicate, especially to lenders and investors, that an adverse demand disturbance is overwhelming the combination of automatic stabilizers and orthodox “lean-against-the-wind” monetary stimulus focusing on short-term interest rates, macro policymakers must act quickly and aggressively to stabilize and restore growth in total nominal spending, creatively using the power of the central-bank’s balance sheet. Authorities must be prepared; and their preparations must be credible. The extreme-instability problem class was vividly illustrated in the United States by the mutation of the SDD that developed in 2007 and early 2008 into the virulent NDD that was organizing itself later in 2008 and 2009.
NDD macro-dynamics assigns a central role to the robust MWR Channel. That keystone two-venue feature has been shown to be inherently incompatible with coherent market-centric modeling, disqualifying mainstream macroeconomics from effective analysis of the NDD instability class. For example, in a NDD context, a focus by stabilization policymakers on price-inflation and short-term interest rates is both wrong and dangerous. The Fed’s playbook must be expanded from standard open-market operations to active, creative use of its balance sheet to halt and reverse collapsing total spending. Nonstationary demand disturbances threaten mega-externalities that incur huge welfare loss in modern, specialized economies. Confronting such risk, product-price behavior provides inadequate information; and directing the Fed to focus on managing inflation is simply foolish.
Blog type: New Keynesians
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