Assignment #1

The Experts and the Omnipotent:

Two Policy Proposals for Full Employment

Economics 501: Advanced Macroeconomics

Dr. S. Bell

20 September, 2004

Currently, the economy is operating far below capacity. The goal of my Council of Economic Advisors (CEA) and me, the omnipotent policymaker (a.k.a. "The Omnipotent"), is to move the economy to full employment. However, we have differing view of how this may be accomplished. We have each conducted our own analysis of potential policies that will facilitate our reaching this shared goal. For our respective analyses, we have employed the Hicks-Hansen IS-LM model, which has allowed us to assess the impacts of our policies on the equilibrated goods sphere (IS), the equilibrated money sphere (LM), and, ultimately, the equilibration of the two spheres in a single model. What follows are the results of our respective analyses.

The CEA’s Proposal: Under the Influence of Flexible Prices

The Council of Economic advisors have suggested that full employment is simply accomplished by eliminating labor market rigidities by such means as eliminating the minimum wage and union busting. This approach is very orthodox in nature. With minimal, though potent, government intervention, the CEA proposal provides a catalyst, and opens the floodgates which allow the self-equilibrating forces of our market economy to operate freely. The stage is set whereby market forces, unrestrained by government-imposed restrictions, sets off a chain of events which, ultimately, results in an outward shift of the LM curve, creating a new IS-LM equilibrium at the full employment level.

The ultimate effect of the CEA’s proposal would be an outward shit of the LM curve. A more conventional method for affecting such a change might include an increase in the money supply, thereby reducing the interest rate associated with each level of income in the liquidity preference model and, subsequently, the LM curve of the IS-LM model. However, the CEA has opted for a different path to economic expansion—a plan which invokes the price flexibility of classical theory along with the growth and output principles suggested by Keynes in The General Theory. This approach—a fusion of the IS-LM model with exogenously determined, flexible price levels—is commonly known as the "neoclassical synthesis."

Price flexibility is vital to the success of the CEA’s proposal. The presence of wage rigidities prevents such flexibility. However, with the CEA’s proposed government-initiated removal of rigidities such as minimum wage and unions dictating terms of labor compensation, market forces will be free to move toward market-clearing levels, which is the first major step in the CEA’s blueprint for expansion.

With free-market forces at play, there is great potential for the price level to decrease (the importance of which will be explained momentarily). At the existing level of unemployment—below full employment—there is a surplus of labor at the prevailing real wage. Left to its own devices, the labor marketplace (free from government restrictions) will naturally self-equilibrate to a level at which the wages (nominal and real) are lower, but all those who wish to work at the new wage are employed; there is full employment. Due to the decrease in wages and, hence, production costs, firms lower their prices. This precipitates a drop in the aggregate price level, which is essential to the chain of events—known as the Keynes effect—which ensues.

The new, lower price level directly impacts the money supply. The money supply (initially measured in nominal terms) increases in real value. That is, given a constant money supply, the falling price level increases the value of the real money supply (M/P). The effect of this increase is akin to an increase in the nominal money supply. With increased money supply, interest rates drop. This drop in interest rates precipitates increased investment. The initial, elevated investment level, in concert with a multiplier effect, results in increased, full employment output.

The Advisors’ Proposal: Is it Adequate?

The CEA proposal, though crafted with the best intentions, possesses potential pitfalls. For instance, wages are traditionally sticky in a downward direction. Despite the removal of labor market rigidities, and allowance for the marketplace to self-equilibrate, will the wages fall enough to significantly lower the price level and increase the real money supply? Furthermore, there are certain limits to how far the LM curve can shift. A particularly elastic LM curve could prove very unresponsive to the monetary policy put forth by the CEA. Similarly, investment may be interest-inelastic, with minimal response to lower interest rates and, hence, output may not grow as much as anticipated. Lastly, the CEA’s course of action does not take into account the endogenous price level forces present in the IS-LM model. Increased demand for output, precipitated by increased investment, will lead to a rising price level, negating (to some extent) the full impact of the expansion. In light of these challenges, an alternative policy seems necessary.

The Omnipotent’s Proposal: A Careful Blend of Policies

Besides having genuine concerns about the effectiveness of the CEA’s proposal, the Omnipotent is also pragmatic. It is an election year. Policy aimed at reducing wages is too risky; it wouldn’t be prudent. Furthermore, whatever policy is adopted, the value of the dollar must remain unaffected. To ensure this stability, the domestic interest rate must remain unchanged. Fiscal or monetary policies alone may have adverse impacts. For instance, fiscal policy (e.g. increased government spending or reduced taxes), though potentially swift in impact, shifting the IS curve outward to the full employment level, could drive the price level and domestic interest rate upward. Monetary policy, on the other hand, though potentially highly effective as it shifts the LM curve outward, may be slow and result in a domestic interest rate that is extremely (potentially, too) low. Therefore, the best policy is a blend of fiscal and monetary policy—the fiscal actions providing a swift impact, pushing the economy to full employment, while the monetary policy, with its downward effect on interest rates, pushes the (now-) increased interest rate back to its original level. A look at the mechanics of the two policies will help illustrate their respective impacts and the equilibrating forces that emerge from the two forces working together.

Fiscal policy, affecting the IS curve, appears to hold great potential for increasing output to full employment. Fiscal policies which spark increased government expenditure, decreased taxes (and therefore increased spending by households and investment by firms), or policies which foster increased exports over imports result in increased output. Due to the expansion in output, the IS curve is shifted outward to a new, higher output IS-LM equilibrium. However, as output increases, endogenous forces affecting the price level and interest rates are at play. With increasing demand, the aggregate price level increases, affecting the value of the real money supply in a downward direction, its impact similar to contracting the nominal money supply. As this occurs, interest rates will rise. The increased interest rate will negatively impact the level of investment spending, contracting the initial, expanded IS curve inward. Though output may be higher than before—indeed, it may even be at the full employment level—the interest rate is now higher than before the policy was initiated. This contradicts one of the Omnipotent’s key policy restrictions: the domestic interest rate must not be affected by whatever policy is adopted. Policy, strictly fiscal in nature, is not the answer. Monetary policy holds promise, but it too has its limitations.

The most direct monetary policy involves increasing the money supply. In doing so, interest rates fall, resulting in higher levels of income associated with each level of interest, affecting an outward shift in the LM curve, resulting in a new level of IS-LM equilibrium. The decreased interest rates encourage new investment, resulting in higher levels of output. Like the fiscal policy discussed, the outward shift of the LM curve is limited by the fact that, in the real world, prices are not constant. The increased demand associated with the new levels of output will drive the price level up. The increased price level diminishes the value of the real money supply. The initial shift, occurring before the price level increase took full effect, is contracted to a new level—not as high as it was before the price level increase took effect, but higher than its initial level and, potentially, at full employment. As with the fiscal policy and the shifting of the IS curve, there is a new interest rate associated with the new equilibrium. However, in this case it is lower than the original rate of interest. Again, the major policy restriction of holding the domestic interest rate constant is not met.

When executed in policy vacuums, these individual policies, though promising, fail to deliver the desired results of full employment without affecting the domestic interest rate. Furthermore, the monetary policy suggested is not immune from the same challenges of interest-inelastic investment or an overly elastic LM curve confronting the CEA’s policy proposal. Therefore, the Omnipotent recommends a carefully blended policy, incorporating fiscal and monetary policies, each in doses smaller than if they were executed individually. In doing so, the benefits of each—increased investment and output—coordinate to bring the economy to a level of full employment, while offsetting their respective impacts on the level of interest.