With the world still reeling under what has been correctly identified as the biggest crisis since the Great Depression, interest in macroeconomics as a subject has got reignited. The crisis which originated in the US later spread across Europe and has also adversely impacted the so-called ‘emerging’ economies. Since this book addresses the latter, it is important to see it in the light of the Global Financial Crisis (GFC) and the churning going on in macroeconomics as a subject.
Keynesian economics has been broadly divided into two camps, which draw their lineage from the old camps of a similar nature. The old camp was divided between the two Cambridges of the MIT, USA and of Cambridge University, UK. The former constituted of economists like John Hicks, Paul Samuelson, James Tobin came to be known as the Neoclassical Synthesis, whereas the latter constituted of Keynes’s contemporaries like Michal Kalecki, Joan Robinson, Nicholas Kaldor, which was named as the post-Keynesian Economics.
In line with the old division, the two trends today have kept this debate, albeit in a more elaborate and nuanced form, alive. On the one hand, the New Keynesian economics (the current mainstream macroeconomics) stresses on the rigidity in wages and prices (resulting from efficiency wages, insider-outsider models etc.) as the impediment to full employment in the economy. These rigidities, therefore, open the possibility for policy intervention in the short run but only in the short run. On the other hand, contemporary post-Keynesians stress on the role of money and expectations in explaining involuntary unemployment. In fact in sharp contrast to the New Keynesian tradition, Keynes’s own analysis of unemployment was developed in a world of flexible prices (with rigid nominal wage), thereby showing that rigidity of prices was never at the core of either explaining lack of demand (or involuntary unemployment) or effectiveness of policy.
This book self confessedly falls in the New Keynesian tradition. When looked at within the mainstream tradition of macroeconomics, this text is truly a concise form of its various arguments, especially its open economy version. Interpreting that framework for an economy like ours will make significant contributions to this field. A rival of this book is another popular book titled Development Macroeconomics co-authored by Pierre-Richard Agenor and Peter J Montiel but its subject matter is Latin American economies. The Latin American rivals draw intellectually on its predecessor, Lance Taylor’s Structuralist Macroeconomics, even though their methodology is quite mainstream.
Since this book presents itself as a textbook based on a developing country, I would like to review it in that light and not as whether it is doing justice to the new Keynesian framework. To my mind, textbooks should always be taken more seriously than other books since they help form the opinions of students and teachers. So, any text-book should be representative of the overall state of the subject. Unfortunately
this book completely overlooks the
extensive work on the macroeconomics of Emerging and Developing Economies (EDEs) under the name of Structuralist Macroeconomics. Should any of this matter? I believe so.
The conception of an economy, developing or developed alike, is vastly different between these two traditions. One of these beliefs, to which this textbook belongs, that the reason an economy is stuck with under-utilization of resources i.e., labour and capital, is because the prices are not allowed to fall sufficiently to clear the markets for labour and capital. Monetary policy is effective in situations such as these since rigidity of prices ensures non-neutrality of money. A corollary of this argument would be that in the absence of such rigidities, the economy functions with full utilization of resources and that money in neutral. The primary concern of this school is accordingly focussed on finding the reasons for such rigidities. Important though such research may be in our quest to understand rigidities, they have
got the wrong end of the stick. Rigidity
of prices have nothing to do with either
under-utilization or efficacy of monetary policy. The ills of the economic system lies elsewhere.
The Keynes-Kalecki tradition, in sharp contrast, argues that the reason an economy is stuck with under-utilized resources is because investment demand is not enough to utilize all the available resources. Price rigidity (Kalecki) or no rigidity (Keynes) do not play any role in keeping the economy from achieving full utilization of its resources. The policy implications of such an understanding is very different from the previous tradition. Instead of relying exclusively on monetary policy, which at best has an indirect influence on investment through the interest rate, this tradition argues for an astute combination of fiscal and monetary policy with the latter playing second fiddle to the former. The omnipotent monetary policy of the new Keynesian tradition either as a stimulus to employment or to control inflation is seen more sceptically here. An expansionary monetary policy, whether through quantitative easing or a declining interest rate, can influence the level of activity only if the interest rate that the central bank fixes influences the rates of interest on long term loans. And even if it does that, investment needs to be sensitive to the interest rates for this policy to yield results. In situations of under-utilization of capacity, merely a fall in the cost of loans will not bring forth higher investment, thereby undermining the stimulating role that monetary policy can perhaps play in situations of otherwise buoyant demand.
As for inflation targeting, the effectiveness of monetary policy is centrally dependent on a fall in investment demand which brings the inflation down. If there is no or little trade-off between output and inflation (huge reserves of labour), then such a policy is likely to do more harm than good since it would require a big trade-off in terms of employment and output to bring about a marginal, if at all, decline in inflation. This will be particularly so if it’s a cost-push inflation, which is most often the case in developing countries. The author herself quotes from her co-authored paper (‘Separating Shocks from Cyclicality in Indian Aggregate Supply’, with Shruti Tripathi, Journal of Asian Economics, 38, pp. 93-103, 2015) ‘Goyal and Tripathi (2015) … support the elastic longer-run supply and the dominance of supply shocks’ (emphasis added). This argument on the shape of the Aggregate Supply Curve (especially for the long run) stands in contrast with the New Keynesian. Then an obvious question that arises is if a framework needs to be altered so much as to make it the same as another framework, why not just work with the latter?
A few other things to quarrel with in the open economy bits of the book is that while discussing the capital account, one gets the impression that it is the capital account which is adjusting to the current account whereas it is more likely the reverse especially for EDEs which are normally not the preferred destinations for capital flows. So, it’s not
the foreign financing needs of an EDE
that is the primary determinant of the
volume or frequency of capital flows but
the push factors of economies which are owners of such finance. For example, Nepal
(or even India) tomorrow cannot decide to run heavy current account deficits which
it doesn’t have the capacity to finance.
The author brings to light an important problem of the Mundell-Flemming (MF) model i.e., its assumption of static price
expectations but the text leaves out an
even more critical omission that the MF model can be blamed for. While the MF model seeks to deal with an open economy, it lacks a foreign exchange market equation. The entire MF model hangs on its assumption of a capital account adjusting to the needs of the current account, which is quite contrary to the lived experience of most of the EDEs. The policy implications are vastly different depending on which way the causality runs in the current to the capital account.
The authors quite succinctly elaborate on different forms of arbitrage conditions that would hold under varying conditions of information, risk aversion etc., in the currency markets. These conditions have been discussed in detail and laid out clearly. I have just one issue to add. While the author says ‘[i]f we distinguish between risk and uncertainty the latter is not amenable to mathematical treatment, like risk is’, most of the chapter is spent on dealing with risk in the currency markets. I believe students should not get dissuaded from studying aspects of an economy which cannot always be mathematically derived. In a world driven by uncertainty, stressing on risk alone takes away the complexity of an economic phenomenon. However, the author is aware of these limitations of risk-based analysis and is upfront about it.
While during discussions on expectations, the current macroeconomic theory draws a distinction between the economic ‘fundamentals’ and the non-fundamentals (say froth), it is never clear what determines these fundamentals. This distinction is used so frequently that one doesn’t feel the need to elaborate on what goes into determining these so-called fundamentals. These chapters, which also have these ‘fundamentals’ running through do not do justice to what constitutes the set of fundamentals. Would the conclusions change if the fundamentals themselves were a function of the expectations in which case there is a two-way causality running from expectations to economic outcomes. Wouldn’t then there be a problem of defining the fundamentals?
The long and short of it is that the distinction between risk and uncertainty that Keynes was so careful about has been given a miss in most of macroeconomics today. While the author is careful in acknowledging it, the text focuses only on a risk-based analysis.
All in all, this is a book that attempts to bring the new Keynesian macroeconomic framework closer to the realities of developing countries, particularly in the South Asian region. In that sense, it is surely a companion to its Latin American counterpart. By itself, it is an important feat since an unaltered new Keynesian framework, which has the developed countries as its subject, cannot surely be taught as it is for countries with situations vastly different from those in the West. Despite this achievement, I am afraid, this book looks at the world with a blinkered vision even as the crisis in the discipline demands opening up the ways of enquiry.
Rohit Azad teaches at the Centre for Economic Studies and Planning, Jawaharlal Nehru University, New Delhi.
This book self confessedly falls in the New Keynesian tradition. When looked at within the mainstream tradition of macroeconomics, this text is truly a concise form of its various arguments, especially its open economy version.