PrefBlog

Mixed news on the economy:

On Tuesday, Statistics Canada said real gross domestic product was unchanged in the fourth quarter of 2022 after five consecutive quarters of growth.
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After two quarters of record inventories, businesses accumulated less inventories in the fourth quarter, weighing significantly on real GDP growth.

Real business investment also declined for a third consecutive quarter as higher interest rates weakened housing investment in 2022.

In December, the economy contracted by 0.1 per cent as goods-producing industries declined.
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A preliminary estimate from Statistics Canada suggests the economy bounced back in January, posting 0.3 per cent growth in real GDP.

Last month, the economy added 150,000 jobs, suggesting there’s still steam on the hiring front.

Economic models are getting more complicated:

But traditional models ignore income and wealth inequalities and assume that what’s good for the typical consumer, as defined by the models, must be good for the broader economy.

A newly developed class of quantitative models is particularly suited to guiding central bankers across this new monetary policy territory, in which the wealth and income distributions are a central consideration. Known as HANK models, they combine heterogeneous agent models (macroeconomists’ workhorse framework for studying income and wealth distributions) with New Keynesian models (the basic framework for studying monetary policy and movements in aggregate demand).

HANK models impart new lessons about redistribution and the heterogeneous effects of monetary policy and shed new light on traditional central bank objectives of inflation control and output stabilization. Here are four broad lessons, and some preliminary thoughts, on how HANK models may illuminate our current high-inflation environment.
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The relative size of indirect versus direct channels depends mainly on the aggregate marginal propensity to consume (MPC), which measures how much of a household’s increase in income gets spent and how much is saved. In traditional models, which try to predict the impact of monetary policy on the typical consumer, the MPC is tiny, and consequently the indirect channels are insignificant. HANK models, instead, are built to be consistent with empirical evidence on consumption and saving behavior. Their aggregate MPC is roughly 10 times larger, and thus the various indirect effects dominate the transmission mechanism.
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Many channels of monetary policy have divergent, and sometimes opposing, effects on different households. For example, the direct effects of interest rate changes depend on households’ balance sheets: rate cuts benefit debtors, whose interest payments decrease (such as households with adjustable-rate mortgages) and hurt savers, whose interest income falls. Monetary policy also has heterogeneous effects through its impact on inflation. First, inflation benefits households with lots of nominal debt that is revalued downward. Second, prices rise more for some goods than for others, and different households consume these goods in unequal proportions. Finally, the indirect effects of monetary policy on household disposable income are uneven because some households are more exposed to fluctuations in aggregate economic activity than others.
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By introducing income and wealth inequality, HANK models reestablish a strong link between the two, showing how monetary policy leaves consequential “fiscal footprints.” When the central bank raises interest rates, the treasury’s borrowing costs increase, and the increase must be funded by raising taxes or lowering expenditures, now or in the future, or through future inflation. In HANK models, the details of how and when the government makes up this fiscal shortfall, and which households bear the burden, have a tremendous influence on the overall effects of interest rate hikes.
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Studies of optimal monetary and fiscal policy in HANK models agree that the benefits of aggregate stabilization are dwarfed by the gains from directly alleviating hardship. Optimal policies in HANK models almost always favor redistributing toward hand-to-mouth households in downturns.

One may be tempted to read this as endorsement of using monetary policy to share prosperity and mitigate adversities. But monetary policy is a blunt tool for redistribution or insurance. HANK models tell us that fiscal policy is likely better suited for this task because it can be targeted more precisely to those in need of support.

This entry was posted on Tuesday, February 28th, 2023 at 8:18 pm and is filed under Market Action. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.