Selecting or creating the best macroeconomic policy is a massive undertaking. The laws put into place to manage a whole nation’s economy influence every single person who lives and works there. Implementing a big-picture economic plan involves asking significant questions like: Should the central bank increase or lower the federal funds rate? How much government debt is too much? How do we balance the inequality between the people with the most money and the people who have the least?
Economists who specialize in the field of macroeconomics, like Dr. James Bullard, the new dean of Purdue University’s Mitchell E. Daniels, Jr. School of Business, use evidence from their research to find answers to these tough questions.
In Bullard’s working paper “Optimal Macroeconomic Policies in a Heterogenous World,” he and his coauthors Riccardo DiCecio, Aarti Singh and Jacek Suda developed an economic model that serves as a benchmark to see how adept U.S. policymakers are at selecting the best policies and provided suggestions for further improvement.
To do this, Bullard and his coauthors study a Dynamic Stochastic General Equilibrium (DSGE) heterogenous-agent life-cycle model. That means Bullard and his fellow researchers built a theoretical framework to analyze a whole economy taking into consideration that economic variables change over time, economic shocks can occur unpredictably and the people, households and businesses that make up an economy can be wildly different from each other, especially at different points in their lives.
They found that broadly speaking, the best macroeconomic policies that their model points to are similar to the actual policies already in effect in many economies today. In other words, the policies that maximize the utility (or happiness) of citizens in a hypothetical model-estimated economy match those policies that already exist in the real world.
Bullard and his coauthors point to their four model-recommended policies for a healthy economy.
The first recommendation is that monetary authorities should respond to shocks, or unexpected events that can suddenly affect an economy, by raising or lowering interest rates. Monetary policymakers aim for a sweet spot that ensures the economy is stable and people are not borrowing or saving too much. The Federal Reserve is responsible for setting monetary policy in the U.S., and they often raise or lower the target range of the federal funds rate (the interest rate that financial institutions charge each other for loans in the overnight market for reserves) to respond to economic shocks.
Secondly, a treasury authority should ideally keep a fixed amount of government debt that is never fully paid off. The goal is to keep the national debt at a certain level relative to the total economic output of the country, much like someone manages their personal debt relative to their income. For example, the U.S. Department of the Treasury monitors the debt-to-GDP ratio to make sure it stays at a sustainable level.
Third, an unemployment insurance program is crucial to provide a social safety net for workers. Here in the states, unemployment benefits are provided to eligible workers who have lost their jobs through no fault of their own and are actively seeking new employment. Eligibility requirements vary from state to state, but terminated workers usually must meet their state’s requirements for time worked or wages earned during a set period. According to Bullard, “... this paper is saying is that, from the perspective of optimal policy, the government should be making sure that these insurance markets are out there and operating properly. As long as these insurance markets are out there you are protected against these shocks.”
The fourth and final recommended policy is an income redistribution program designed to lower economic inequality. Fiscal authorities, like Congress and the president in the U.S., want to make sure that people do not have drastically different means to purchase goods and services. Governments around the world often use a tax and transfer program to achieve their income redistribution goals, which involves the collection of tax revenue and transferring that money to fund things like tax credits, subsidies and food or housing assistance programs.
It may seem counterintuitive to suggest that we truly have the optimal policies in place given the existence of economic inequality. However, Bullard says they have not only accounted for economic inequality within the model but also have represented it uniquely by including a “life cycle” component.
“When people are talking about inequality they say ‘oh gosh’ that surgeon is making a lot of money,” says Bullard. “What about the fact that people earn more in the middle of their life cycle? That should be a big factor when you’re talking about who is earning what at what time.” He continues, “This brings out the notion that a big component of observed inequality is due to simple life cycle differences.”
When Bullard and his coauthors calibrated (or input real numbers into) their model using U.S. data from 1995-2023, they found that U.S. macroeconomic policy has been close to the optimal set of policies outlined in theory. However, the research indicates that existing macroeconomic policy is less effective during periods of extreme economic shocks like the global financial crisis of 2007-2008 or the COVID-19 pandemic.
According to the researchers, these rare but major events require a specialized set of policies that could be deployed as a reaction to specific shocks. The overall macroeconomic strategy could remain the same, but preparing for the worst by having contingency plans could help soften the negative effects of unusual economic incidences.
Bullard notes that we already have contingency plans, like those recommended in the paper, in place for shocks like seasonal hurricanes. “You do have FEMA and they are thinking about natural disasters that could occur and how the government would react in those cases,” says Bullard.
However, the approach policymakers make differs regarding other events like a pandemic, a once-in-a-millennium natural disaster, or objects in outer space colliding with Earth. For these events, Bullard says, “… the attitude has been when that happens ‘we’ll cross that bridge when we come to it.’”