The New Consensus 3-Equation Model – Strength and Weakness

DISCUSS THE STRENGTH AND THE WEAKNESS OF THE NEW CONSENSUS 3-EQUATION MODEL

There has been a great deviation from the AD-AS or IS-LM-AS approach in the intermediate macroeconomics. The reason for this is not far-fetched as students are unable to use the model to explain the economic processes of a shift from one equilibrium to a new equilibrium as curve-shifting appears to be mechanical. The modern monetary macroeconomics is centred around what is often referred to as the 3-equation Model by the New Consensus. This model is based on the IS curve, Phillips curve and interest rate-based monetary policy rule (IS-PC-MR). The LM is replaced by the monetary policy rule. The IS curve covers the equilibrium in the goods market and by so model the demand side, Phillip curve takes into consideration the relationship between unemployment and inflation and by so model the supply side while the MR curve shows how the central banks react to shocks which model the policymaker. The New Consensus replaced the Neoclassical Synthesis and centres their view on the bases of inflation-targeting coupled with the view that central banks are forward-looking in conducting their monetary policy. The new consensus macroeconomic model has received support from both the economic policymakers and the academics alike. More so, this new model utilizes much of the new Keynesian economics assumption. The model has passed through different stages but was not fully analyzed until the 2000s (Carline and Soskice, 2010; Romer 2000; Taylor 2000). As mentioned earlier, the model bases its inflation targeting on the theoretical background which are:

  • stimulating investment spending as it believes that effective output is a function of the real interest rate,
  • the existence of the accelerationist Phillips curve and,
  • the Taylor rule. The latter relate monetary response through nominal interest rate to deviation of output from its potential and inflation from its target. As mentioned by the neoclassical theory of value and distribution, the stock of factors of production as well as their productivity determines the potential output.

A careful examination of an open economy by the new consensus model, they argue that there exists parity with the real interest rate. The implicit assumption maintains that in the short run, uncovered interest rate parity holds as rational expectation dominates the exchange rate market. The outcomes of the model are spelt out by different scholars who have examined the model at diverse times. One of such is that the long-run core inflation is related to shocks in demand and it is external to the influence of exchange rate. Another is that as the null output gap is being targeted, the inflation control mechanism relates to the impact real interest rate has on aggregate demand. The view of the new consensus seems to also assume a negative relationship between productive capacity and high inflation rates as it is assumed that there exists no trade-off between productive capacity and inflation. This makes their policy to be applicable as a monetary authority can set the real interest rate with the natural rate of interest.

The ease with which a broad range of economic issues can be analyzed by the 3-equation model makes it to be taught to undergraduate students (Carlin and Soskice, 2009). The 3-equation can be applied with diagrams to analyze issues such as price shocks in oil and commodities and monetary issues that result from a banking crisis. The diagram is such that the IS diagram which shows the monetary rule is placed vertically above the Phillips curve. As relating to the output, it is the private sector that determines the equilibrium output while the actual output is determined by the AD. The lending rate is determined by the banking system while the policy rate to aid the achievement of the inflation target and desired output gat is determined by the central bank.

 

The strength

The 3-equation model has fostered the progress of macroeconomic analysis and has incorporate concepts that previous economist and policymakers have not been able to consider. Taylor rule through the new consensus equation has been a general way in which monetary policy is been modelled after and the gap between the central bankers and academics has been minimized as monetary policy is seen as interest rate policy. The model also gives assumptions which yielded positive results such as the fiscal policy to be applied to medium to long term while the monetary policy takes care of the short term. It also aims at price stability and presents inflation as a monetary phenomenon which is influenced by the interest rate.

Supporters of the model have outlined the failure of the synthesis of Keynesianism in proffering solutions to the economic events of 1970 nor understanding the events. Furthermore, the Ricardian equivalence which points out that the source of government financing is irrelevant whether through debt or increase in tax as much as the total demand in the economy is the same. It is believed that the increase in government spending is offset by a decrease in consumption by the private agents which result in no change in aggregate demand. Another strength of the model is the ability of the monetary policy not to be subjected to long time lag as it is with the fiscal policy. Avoiding both recognition and decision lag gave the new consensus model an edge. The three-equation model has also brought about an agreement among academics and policymakers about monetary policy and the possible effects.

 

The weakness

As applaudable as the contribution of the model is, the New Consensus Model is not without defects. One of such is the unrealistic assumption of absences of liquidity preference. The generalization of the model that central banks control the rate of interest and can influence it in a stable fashion negates the fact that market power of the banking sector and other variables also influences the interest rate. The model also seems unrealistic by exempting the monetary aggregates which play an important role in the transmission mechanism when applying the monetary policy. This was confirmed in the work of Canzioneri et al (2008) who found out that the enlarged model of the NCM in which banks makes loans and create deposit is better than the standard model which overlooks this important fact.

Unemployment bias is another criticism faced by the model. Keeping the unemployment rate above the natural rate of unemployment by the monetary policy when the economy is yet to attain price stability. The distributional effect of the interest rate left out is another weakness of the model. The interest rate payments that are employed in controlling the economic activities are payment made by firms who engaged in borrowing money from banks. Since consumers will be the one to use the output of the productive activity of the firms, the firm can shift the effect of the interest rate to the consumers and by so doing create inflation or deflation based on whatever policy changes in interest rate. More so, financial institutions that provide loans earn based on their ownership of financial assets through the interest rate without any tangible productive activities.

The downplay of the fiscal policy by the new consensus model and giving high credence to monetary policy is a weakness which critics of the model have pointed out. This is because of the uncertainty that is associated with the size of the effect of government expenditure as well divisiveness that accompanies the effect of fiscal policy. The fiscal policy has been reduced to just focus on the control as well as the sustainability of public finances. The key role of the central bank in the model is achieving the targeted inflation and to secondarily deliver output stabilization in the short-run. Some economist believed that there are some circumstances that require both fiscal and monetary policies to provide support for the economy.

 

Conclusion

Several critics have attacked the new consensus model and many of these criticisms are based on the assumption of the model. The three-equation model apportioned an explicit role to the government and the absence of government in the model. Based on the setbacks drawn out about the three-equation model, the reliability of the model is been questioned. The recent financial crises coupled with the outbreak of the pandemic which slows down the productivity of all economies of the world shows that the fiscal policy cannot just be relegated to managing only the public finances alone. It has also been seen that the inflation-targeting engaged in by the central banks does not manage the money supply actively as expected and their reaction to economic shocks is not too different from the pre-shock actions. So, the three-equation model has put forward by the new consensus has aid the understanding of the macroeconomics as well as giving insight into every part of it as it provides an explanation for adjustment mechanism. However, the model still needs to be revised and necessary alterations to be done to it. It is essential to note that any macroeconomic model that will be the main tool to analyze and proffer solutions to the modern economies issues, the role of the public sector and the fiscal policy must be well considered in it.

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