Any macroeconomic theory should help us understand the real world and provide explanations of historical events and reasonable forward-looking outlooks as to what might happen as a consequence of known events – for example, changes in policy settings. A theory doesn’t stand or fall on its absolute predictive accuracy because it is recognised that forecasting errors are a typical outcome of trying to make predictions about the unknown future.<\/p>\n
However, systematic forecast errors (that is, continually failing to predict the direction of the economy) and catastrophic oversights (for example, the failure to predict the 2008 Global Financial Crisis) are an indication that a macroeconomic theory is seriously deficient.<\/p>\n
In this section we present some stylised facts about the way in which modern industrialised economies have performed over the last several decades. These facts will be referred to throughout the textbook as a reality check when we compare different approaches to the important macroeconomic issues such as unemployment, inflation, interest rates and government deficits.<\/p>\n
The facts provide a benchmark against which any macroeconomic theory can be assessed. If a macroeconomic theory generates predictions which are at odds with what we observe then we conclude that it doesn’t advance our understanding of the the real world and should be discarded.<\/p>\n
Unemployment<\/strong><\/p>\n [NOTE: SECTION ON INVOLUNTARY UNEMPLOYMENT TO COME HERE]<\/p>\n Japan<\/strong><\/p>\n Japan has been the second largest economy since its reconstruction after the Second World War led to spectacular growth in the 1960s. It is now the third largest economy behind the United States and China. The period since 1990 provides a very interesting case study for macroeconomists because it has been marked by some extremes, some of which the rest of the world has encountered since the onset of the Global Financial Crisis.<\/p>\n In the second half of the 1980s, Japan experienced a massive real estate and share market boom, which drove prices up to extraordinary, levels. The “asset price bubble” collapsed in 1989 after the Ministry of Finance substantially increased interest rates to put an end to the inflationary spiral.<\/p>\n Asset prices fell dramatically during the 1990s and the government was forced to use expansionary fiscal policy and near zero interest rates to maintain real economic growth during this period.<\/p>\n Figure 1a shows the Basic Loan Rate (averaged over the month) for Japan from July 1985 to May 2012 The data is available from the Bank of Japan (http:\/\/www.stat-search.boj.or.jp\/index_en.html). We will learn in Chapter 14 how the short-term (or overnight) interest rate that the central bank sets in the economy influences the longer-term interest rates (for example, mortgage rates). In general, the lower is the overnight rate, the lower will be all other subsequent rates (which are expressed by their maturity in terms of time).<\/p>\n Figure 1a captures the interest rate hike in the late 1980s as the Government sought to quell the out-of-control asset price bubble and the two decades of near-zero interest rates that followed.<\/p>\n Figure 1a Basic loan rate in Japan, July 1985 to May 2012<\/strong> Now consider Figure 1b which shows the evolution of the Japanese government budget deficit as a percentage of GDP since 1980. A budget deficit arises when total revenue taken from the economy by the government sector is less than spending that the government injects into the economy. Figure 1b scales that balance by the size of the economy to put the movements into perspective.<\/p>\n In Chapter 13, where a detailed analysis of fiscal policy is developed you will be exposed to various views about the budget balance. But the orthodox macroeconomic textbooks that are used in undergraduate programs around the world teach students that budget deficits push up interest rates because they require the government to borrow from the private sector and thus compete for scarce funds with other borrowers.<\/p>\n The budget deficit in Japan (as a percent of GDP) has expanded since the early 1990s and in 2011 was 10.1 per cent of GDP having been in surplus in 1992 at the outset of their asset crisis.<\/p>\n Juxtaposing Figures 1a and 1b, it is clear that in a large industrialised nation such as Japan, rising budget deficits do not cause rising interest rates. In general, budget deficits have risen substantially as a percent of GDP in the aftermath of the Global Financial Crisis as governments sought to defend their economies against another Great Depression. Over the same period interest rates have fallen to near zero levels in many nations.<\/p>\n It is clear that orthodox macroeconomics predicts exactly the opposite to what we have observed in the real world. The Global Financial Crisis cannot be dismissed as a special case because we have observed the same patterns in interest rates and budget deficits in Japan, consistently for two decades.<\/p>\n This textbook will develop understandings of the modern monetary system that allows you to explain the two stylised facts. We will learn that the central bank sets the overnight interest rate. We will learn that budget deficits, in fact, place downward rather than upward pressure on interest rates. To understand why that is the case we need to gain a richer understanding of the flow of funds in the monetary system and the role that the central bank plays in managing liquidity in the economy. We also need to learn what drives budget outcomes and the role the government plays in influencing budget deficits or surpluses.<\/p>\n Figure 1b, Government budget deficit as % of GDP, Japan, July 1985 to May 2012<\/strong> Now consider Figure 1c, which shows the annual growth in the Monetary Base for Japan from 1971 to 2010. The average annual rate of growth over this period was 8.42 per cent. The Monetary Base consists of is sometimes referred to as the money base, high-powered money. In the United Kingdom, the central bank refers to it as narrow money. It consists of notes and coin on issue (held in private bank vaults or circulating in the economy) and bank reserves.<\/p>\n In Chapter 14, we will analyse in detail the relationship that the major private banks (the so-called member banks) have with the central bank. In simple terms, the member banks participate in the clearing house or payments system which involves the daily resolution of all the financial claims between the banks (Cheques). To ensure that financial stability is maintained each of the private banks has to maintain a reserve account at the central bank and debts and credits to these reserves are performed on a daily basis to resolve all the transactions in the economy in a stable manner.<\/p>\n When we talk of bank reserves we are referring to the balances that banks have in these reserve accounts. There is a lot of misunderstanding about the role that the reserve accounts play and Chapter 14 will dispel any doubts about that issue.<\/p>\n The monetary base is thus highly liquid.<\/p>\n In orthodox macroeconomics there is a concept called the money multiplier which asserts that the money supply (which is a broad concept and includes deposits placed in the banking sector and other deposit-like accounts) is a predictable multiple of the monetary base. It is argued within that paradigm that movements in the monetary base drive movements in the money supply.<\/p>\n In turn, an orthodox theory called the Quantity Theory of Money (QTM) draws a relationship between the growth in the money supply and the rate of inflation. This idea is critically examined in Chapters 11 and again in Chapters 13 and 14. Suffice to say the QTM claims that when the money supply rises inflation results. Further, that the rise in the money supply is traced back to central bank decisions to expand the monetary base. So ultimately it is the government that causes inflation.<\/p>\n Relatedly, the orthodox theory argues that if the central bank monetises the budget deficit (they call it “printing money”) then inflation is the result because the monetary base and money supply rises and there is “too much money chasing too few goods”.<\/p>\n These arguments, erroneous as you will see, have been used to make powerful cases against the use of budget deficits and against the central bank purchasing treasury debt.<\/p>\n Figure 1c shows that the growth in the monetary base in Japan since 1970s has been rather strong at various times and the accumulated result of the annual growth has resulted in a monetary base stock that has expanded by 24 times between 2010 and 1970 whereas nominal GDP has expanded around 6 fold over the same period.<\/p>\n Figure 1c Annual growth in Monetary Base, Japan, 1971 to 2010, per cent per annum<\/strong> Now consider Figure 1d, which shows the annual inflation rate for Japan since 1971 up until April 2011. Like many nations, Japan suffered a substantial burst of inflation in the mid-1970s when the OPEC cartel hiked oil prices and Japan, being an oil-important and dependent industrial nation, suffered what economists refer to as a major supply shock (that is, the raw material costs (oil) rose sharply and pushed up production costs).<\/p>\n The period since the asset bubble burst in the early 1990s has been characterised by very low inflation rates (accompanying the low interest rates) and at times Japan has struggled with periods of deflation (negative inflation).<\/p>\n
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