Each chapter of this book has focused on one part of the economy, uncovering the key economic forces at work. As we’ve progressed, I bet you’ve noticed that the relationships described in any one chapter depend on other economic variables, whose determinants are described in some other chapter. This is the interdependence principle in action, and macroeconomics is all about understanding these interdependencies.
Our crowning achievement in this chapter is uncovering how these disparate elements fit together into a coherent whole. The result is a complete model of the macroeconomy that you can use to track the full macroeconomic implications of any change in market conditions. You can use it to forecast how economic conditions are likely to change, what the major threats are to your forecast, and how policy makers can respond.
A model is particularly valuable when you can ask it “what if” questions. And you can use the Fed model to ask: What will happen if the global economy craters, the stock market booms, or productivity growth takes off? Policy makers use the Fed model to ask “what if” questions that directly affect economic policy. At the Fed, they ask: What if we raise interest rates? What if we lower interest rates? They use a computerized version of the Fed model to figure out what sorts of economic outcomes will result from each interest rate setting, and then choose the policy that corresponds with what they judge to be the best set of outcomes. At the White House and the Treasury, they use similar models to ask: What if we raise government spending? What if we cut taxes? These analyses help guide fiscal policy. And businesses around the country use related models to game out the likely consequences of whatever economic shocks their executives see on the horizon.
The approach in this chapter puts you remarkably close to the cutting edge of how economists—both those at policy institutions like the Fed, as well as leaders in the financial sector—analyze the economy. And it has a number of features that make it particularly useful.
Our analysis of the Fed model has been dynamic, analyzing shifts over time from one equilibrium (say, when the real interest rate is low) to another equilibrium (after the interest rate has risen). A shortcoming of our analyses so far is that they have been largely silent about the pace at which these changes will occur. These dynamics play an important role in economic forecasting, and they’re an important feature of the more complicated computerized versions of the Fed model used in Washington and on Wall Street.
A key strength of the Fed model is that it provides a coherent way to trace out the consequences of the many random (or stochastic) shocks that hit the economy. It provides a framework for analyzing virtually any spending, financial, or supply shock.
The Fed model also takes a general equilibrium approach, which means that rather than analyzing individual markets or variables separately, it analyzes all of them jointly, paying careful attention to the ways in which choices in one domain affect those in others. In general equilibrium, everything can depend on everything else, and it’s our job to sort out what will happen. The Fed model applies this approach to business cycles, jointly considering consumption, investment, government purchasing, and importing and exporting decisions; it evaluates spending decisions together with production choices; it explores the relationship between the financial sector and the broader economy; and it explores the connections between output and pricing decisions, and hence inflation. It provides a useful framework for analyzing the key economy-wide prices—like the real interest rate, inflation, the exchange rate, wages, and stock prices—which can transmit shocks from one market to another.
But perhaps the real value of the Fed model is that, unlike MONIAC, you can do all of this without getting wet.