This document summarizes a paper on fiscal and monetary policy rules in an unstable economy. It begins by outlining Harrodian instability and consumption/investment behavior. It then examines different policy rules, finding that a Taylor rule is not stabilizing when debt is high, while a "Keynesian policy rule" where government consumption stabilizes employment is stabilizing. An "austerity policy rule" aiming to keep debt ratios constant is destabilizing and aggravates Harrodian instability. The document concludes that automatic stabilizers are insufficient and policy is needed to remove instability, with the paper extending the analysis to interactions of fiscal and monetary policy rules.

1. Fiscal and monetary policy rules
1
in an unstable economy
Soon Ryoo Peter Skott
Adelphi University Umass and Aalborg University
12th International Post Keynesian Conference
UMKC, September 2014

2. Overview
 Harrodian instability
 Consumption and investment
 Monetary and fiscal policy rules
 Conclusions
2

3. HARRODIAN BENCHMARK
3

4. Basic equations
 Investment
 Consumption
 Equilibrium condition
4
ġ u
ud
C
K
1su
u  g
s

5. Harrodian problems
 Warranted vs natural growth
 Unstable dynamics
5
gw
sud  n
ġ  g

s
ud;
0

6. Reconciling natural and warranted
rates
 Interest rates
 Choice of technique
 ‘Optimal’ fixed Leontief production function
 Fiscal policy
 Deficit if private saving exceeds investment at full
employment
 Implications for
 Consumption behavior and goods market equilibrium
 Debt dynamics
6

7. Steady growth results
 OLG setting:
 empirical relevance of ‘dynamic inefficiency’
 dynamic inefficiency implies AD problems
 ‘Stock-flow consistent’ setting
 Robust across models:
 Low growth causes high debt
 High government consumption causes low debt
 Why?
 With higher I or G, full-employment consumption needs to get
squeezed → higher taxes
7

8. Short-run stabilization?
 Automatic fiscal stabilizers
 Are they sufficient?
 Do monetary Taylor rules stabilize?
 Taylor rule for fiscal policy?
 Supercharged fiscal stabilizer
8

9. MODEL
9

10. Policy instruments
 Monetary:
 Real interest rate, r
 Fiscal
 Government consumption, G; γ=G/K
 Proportional tax rate, τ
10

11. Consumption: taxes, interest and
wealth  Target consumption-wealth ratios
 Gradual adjustment
pB
 Budget constraint
11
B   pC
vN   pC
#
#
B
B
B
B
pYD pC vN


12. Consumption function
 Assume investment financed by retained
earnings (adjustments in retention rate)
 Then:
 Note:
 The equity ratio α is irrelevant
 Public debt has income and wealth effects
 Consumption rates depend on β.
12
pC 1
c
pY rBcpI cvB
c 1/1and cv
 /1

13. Investment
 Excess capacity desired because of
 Demand volatility
 Entry deterrence
 …
 Weigh cost of holding excess capacity
against the benefits
 Desired utilization depends on cost of
finance:
13
ġ uud
ud u rr

14. Dynamic system
 Investment dynamics
 Debt dynamics
ġ u
ud
ud u r
u c1

b
u
rbcb cg
rgburb
 Employment dynamics
14
r

k
kgn
e uk where k K/L
g 

15. IMPLICATIONS
15

16. Taylor rule
 3D system if ρ3=0
 Local stability possible if desired utilization
sufficiently sensitive to changes in r
 Threshold value depends on debt ratio
 High debt ratio endangers stability
 Intuition
 Expansionary induced fiscal effect
16
r r
1

u2
u
k3
kppT

17. Keynesian policy rule
 Government consumption as active
instrument
 Full stabilization of employment at e* -- γ set
to give u=e*/k -- is possible but implies:
 2D system in (g,k)
 Lotka-Volterra structure and conservative
fluctuations
17

18. Modified Keynesian rule
 Use γ to get
 2D system in (g,k)
 Locally stable
 Induced b-dynamics is stable for plausible
parameter values
18
u g,b, u Hkk,g n,H1
0,H2
0,H 0,00

19. Austerity rule
 Extreme version: keep B/Y constant
 Unstable 2D system in (g,b)
 Arbitrary B/Y target fails to ensure g*=n
 Modified version: keep b=B/K constant
 Unstable; Harrodian instability aggravated
19

20. CONCLUSIONS AND
EXTENSIONS
20

21. Conclusions
 Need for policy
 Automatic stabilizers dampen effects of shocks
but fail to remove Harrodian instability
 Taylor rule is not stabilizing when debt ratios
are high
 ‘Keynesian policy rule’ is stabilizing
 ‘Austerity policy rule’ is de-stabilizing
21

22. Extensions
 Interactions between fiscal policy and ‘Taylor
rule’
 Inflation dynamics
 Other stabilizing mechanisms
 ‘reserve army effects’
 Fiscal rules in ‘full’ cycle model
 Empirics on ‘implicit fiscal policy rules’
22

23. THANKS!
23