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A New Monetary and Fiscal Framework for Economic Stability

CEF, July 2011

Roger E A FarmerDepartment of Economics UCLA

1 (c) Roger E A Farmer July 1st 2011

The Current SituationThe Current Situation

The Great Recession ended in June of 2009 The Great Recession ended in June of 2009

Unemployment has remained at 9% for the t 23 thpast 23 months

The Fed has no plans to extend Quantitative pEasing

A second large fiscal expansion is unlikely A second large fiscal expansion is unlikely

What can we do to reduce unemployment? p y


The Plan of My TalkThe Plan of My Talk I will present some evidence from the US

on the connection between unemploymenton the connection between unemployment and wealth

I will discuss a new way of explaining these data

I will discuss the implications for economic policypolicy


The Bottom LineThe Bottom Line Use traditional monetary policy (e.g. a

Taylor Rule to control inflation)Taylor Rule to control inflation) This involves varying the interest rate by

expanding or contracting the monetary baseexpanding or contracting the monetary base

Use a new policy of stock-market targeting to control unemployment This would involve buying and selling assets by

varying the composition of the monetary base


WealthWealth

220 45

Two Sources of US Wealth

US wealth

180

200

35

40Shaded areasare recessions

US wealth is:

2/5

120

140

160

20

25

30 2/5 housing

80

100

120

10

15

203/5 factories and

60 530 35 40 45 50 55 60 65 70 75 80 85 90 95 00 05 10

The Real Value of the Case-Shller Home Price Index

and machines

5

The Real Value of the S&P 500

(c) Roger E A Farmer July 1st 2011

The Stock Market During the Great Depressiong p

28 000 0

Unemployment and the Stock Market During the Great Depression

24,000

28,000 0

5

Shaded areasare recessions

16,000

20,000 10

15

8,000

12,000 20

25

4,000 301929 1930 1931 1932 1933 1934 1935 1936 1937 1938

The S&P 500 Measured in Wage UnitsUnemployment Rate

6

Unemployment Rate


Wealth During the Great DepressionWealth During the Great Depression

80,000 0

Unemployment and Wealth During the Great Depression

60 000

70,000

,

5

10


50,000

60,000 10

15

30,000

40,000 20

25

20,000 301929 1930 1931 1932 1933 1934 1935 1936 1937 1938

The Real Value of WealthUnemployment Rate

7

Unemployment Rate


The Stock Market During the Great RecessionThe Stock Market During the Great Recession

28 000 4

Unemployment and the Stock Market During the Great Recession

24,000

26,000

28,000 4

5

6

20,000

22,000 7

8

Sh d d

14,000

16,000

18,000 9

10

11


12,000 122001 2002 2003 2004 2005 2006 2007 2008 2009 2010

The S&P 500 Measured in Wage Units

8

Unemployment Rate


Housing Wealth During the Great RecessionHousing Wealth During the Great Recession

Unemployment and Housing Wealth During the Great Recession

180

190

200 3

4

5

150

160

170 6

7

8

120

130

140 9

10

11


110

120 11

122001 2002 2003 2004 2005 2006 2007 2008 2009 2010

The Real Value of the Case-Shiller Home Price Index

9

The Real Value of the Case Shiller Home Price IndexUnemployment Rate


Post-War Unemployment and the Stock Marketp y

3 0 0 8

Unemployment and the Stock Market

2.6

2.8

3.0 0.8

1.0

1.2


2.0

2.2

2.4 1.4

1.6

1.8

1.4

1.6

1.8 2.0

2.2

2.4

1.2 2.650 55 60 65 70 75 80 85 90 95 00 05 10

The Unemployment Rate (transformed)

10

The Log Ratio of the S&P to GDP


There is a Stable Relationship Between these Two Variablesthese Two Variables

Second sample1980q1‐‐2011q1

First sample1946q1‐‐1979q3 p is the log ratio

dependent p u p uvariablep(‐1) 1.34 ‐0.3 1.34 ‐0.4

1980q1 2011q11946q1 1979q3 p is the log ratio of the S&P 500 to GDP

p( )(0.08) (0.05) (0.09) (0.12)

p(‐2) ‐0.34 0.2 ‐0.34 0.4(0 08) (0 05) (0 09) (0 12)

u is the transformed(0.08) (0.05) (0.09) (0.12)

u(‐1) ‐0.02 1.6 0.14 1.4(0.1) (0.06) (0.04) (0.07)

transformed unemployment rate

u(‐2) 0.02 ‐0.6 ‐0.13 ‐0.5(0.1) (0.06) (0.04) (0.07)

c 0 0.16 0 0.15

11

(0.05) (0.05)


Characterizing these DataCharacterizing these Data u and p both have a unit root

They are cointegrated

There is some evidence of non linearity There is some evidence of non-linearity

There is also evidence that volatility matters

I will ignore both of these aspects in this I will ignore both of these aspects in this talk


The Cointegrating RelationshipThe Cointegrating Relationship

10

11

8 28u p 8

9

10

Rat

e

To reduce the steady state unemployment rate by 1%: The ratio of the t k k t t GDP

6

7

empl

oym

ent R

stock market to GDP must increase by a factor of 28

3

4

5Une

2

3

.02 .04 .06 .08 .10 .12 .14 .16

13

The Ratio of the S&P to GDP


Back to BasicsBack to Basics

Is the economy self-correcting?

Yes Yes Classical economics New Keynesian economics New-Keynesian economics

No Keynes of the General Theory Farmer’s interpretation of Keynes


A Simple ModelA Simple Model Representative agent

Logarithmic utility

Cobb Douglas technology Cobb-Douglas technology

One good

Inelastic labor

Non-reproducible capital

Money as a unit of account Money as a unit of account15 (c) Roger E A Farmer July 1st 2011

The Classical ModelThe Classical Model

y f L L L y f L L L

' wf L kp yp f Lp kp yp


Classical Economics 101Classical Economics 101GDP (wage

Labor first order condition

1py Lw

py( gunits)

condition ww

Labor Supply exp tL a

Employment (% of the Labor Force)

1


The Keynesian ModelThe Keynesian Model

C bYC a bY pyYw

C and Y are measured in wage units

Y C G wwage units

1L Y1

L Y


Keynesian Economics 101Keynesian Economics 101

GDP 1

1Y L

Labor first order

(wage units)

1 condition

py

A t

pyYw

Aggregate Demand

bY a G L

E l t (% f th L b F )

1

1

19



Questions for Keynesian EconomicsQuestions for Keynesian Economics Theory of Aggregate Demand

Wh d ’t h h ld ti i ? Why don’t households optimize? Keynesians: Credit constraints Farmer: They do Consumption depends on Farmer: They do. Consumption depends on

wealth.

Th f A t S l Theory of Aggregate Supply Why doesn’t the labor market clear?

K i P i ti k Keynesians: Prices are sticky Farmer: Search externalities


The Farmerian ModelThe Farmerian Model

y f L L L L ,y f L L L L

1 , wf L L kp yp 1 ,f L L

p kp yp

kpw

is a random walk

21

w(c) Roger E A Farmer July 1st 2011

Farmerian Economics 101Farmerian Economics 101

GDP (wage

11

Y L

Labor first order

(wage units)

1 condition

pyY

A t

w

Aggregate Demand

kpY


1 w

22



Two LayersTwo Layers How are real variables determined?

A t d d d l Aggregate demand and supply

How are monetary variables determined? Liquidity preference vs. loanable fundsq y p

Do we need monetary economics to understand unemployment? No


Ph.D. Keynesian EconomicsPh.D. Keynesian Economics

GDP (wage

11

Y LLabor first order conditionPrice adjustment(wage

units)1 condition

py

Price adjustmentCauses demand to shift

Aggregate Demand

pyYw

Demand

1bY a G L


1 1

24



Ph.D. Farmerian EconomicsPh.D. Farmerian Economics

GDP (wage

11

Y L

Labor first order

(wage units)

1 condition

pyY

Aggregate

w

Aggregate Demand


1

25



A New Fiscal Policy for Economic StabilityA New Fiscal Policy for Economic Stability Define a broad value weighted stock

market indexmarket index

Set up an exchange traded fund based on p gthe index

Buy an initial share in the fund $800b Buy an initial share in the fund -- $800b --paid for with agency debt

Announce a price path for the fund


How to Trade the FundHow to Trade the Fund Set a target for the unemployment rate at

(for example) 4%(for example) 4%

Let p be the ratio of the value of the index pto GDP

Announce an initial level and a growth Announce an initial level, and a growth rate, for p

Adjust p in response to excess unemployment above or below target


Isn’t this Inflationary?Isn t this Inflationary? No. The new fiscal policy and current

monetary policy can be run independentlymonetary policy can be run independently

If the Fed were to run the new policy:p y The size of the monetary base would be

adjusted to set the interest using, for example, a Taylor Rule

The composition of the monetary base b t T bill d th i d f d ld bbetween T-bills and the index fund would be set in response to an unemployment target


Wouldn’t this ignite a New Stock Market Bubble?Bubble?

No: To remedy the current situation of high l t ld d bi i iti lunemployment we would need a big initial

boost to the stock market

As employment picks up – the policy would choose a lower growth rate for the index, c oose a o e g o t ate o t e de ,with the index converging back a value consistent with the long-run relationship co s s e e o g u e a o s pbetween p and u


SummarySummary The economy is not self-stabilizing.

Any inflation rate is consistent with any unemployment rate as a long-run steady-p y g ystate equilibrium

It took a century or more to learn how to It took a century or more to learn how to use monetary policy to stabilize inflation. We must now learn how to stabilizeWe must now learn how to stabilize unemployment.


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