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CHAPTER 15Stabilization Policy

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To Accompany

MACROECONOMICS, 7th. EditionN. Gregory Mankiw

Tutorial written by:

Mannig J. SimidianB.A. in Economics with Distinction, Duke University

M.P.A., Harvard University Kennedy School of GovernmentM.B.A., Massachusetts Institute of Technology (MIT) Sloan School of

Management

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To many economists, the case for active government policy is clearand simple. Recessions are periods of high unemployment, lowincomes, and increased economic hardship. The model of aggregatedemand and aggregate supply shows how shocks to the economy cancause recessions. It also shows how monetary and fiscal policy can prevent recessions by responding to these shocks. These economistsconsider it wasteful not to use these policy instruments to stabilize theeconomy.Other economists are critical of the government’s attempts to stabilizethe economy. These critics argue that the government should take a hands-off approach to macroeconomic policy. At first, this view mightseem surprising. If our model shows how to prevent or reduce theseverity of recessions, why do these critics want the government to refrain from using monetary and fiscal policy for economic stabilization?

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Economists distinguish between two types of lagsthat are relevant for the conduct of stabilization policy: the inside lag and the outside lag.

The inside lag is the time between a shock to the economy and thepolicy action responding to that shock. This lag arises because it takes time for policymakers first to recognize that a shock has occurred and then to put appropriate policies into effect to deal with it.

The outside lag is the time between a policy action and its influenceon the economy. This lag arises because policies do not immediatelyinfluence spending, income, and employment.

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Some policies, called automatic stabilizers, are designed to reducelags associated with stabilization policy. Automatic stabilizers arepolicies that stimulate or depress the economy when necessarywithout any deliberate policy change. For example, the system ofincome taxes automatically reduces taxes when the economy goesinto a recession, without any change in the tax laws, because individuals and corporations pay less tax when their incomes fall.Similarly, the unemployment insurance and welfare systems automatically raise transfer payments when the economy moves into a recession, because more people apply for benefits. One canview these automatic stabilizers as a type of fiscal policy withoutany inside lag.

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As we learned, since policy only affects the economyafter a long lag, successful stabilization requires the ability to predict future economic conditions.One way forecasters try to look ahead is with leading indicators. Aleading indicator is a data series that fluctuates in advance of the economy. A large fall in a leading indicator signals that a recessionis more likely to occur in coming months.Another way forecasters look ahead is with macroeconometric models,which have been developed by both government agencies and by private firms. They seek to predict variables such as unemployment andinflation and other endogenous variables.

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Nobel laureate Robert Lucas emphasized that people form expectationsof the future. Expectations play a crucial role because they influence all sorts of economic behavior. Both households and firms decide to consume and invest based on expectations of future earnings. These expectations depend on many things, including the policies of the government. He argues that traditional methods of policyevaluation such as those that rely on standard macroeconometric models—do not adequately take into account this impact of policy onexpectations. This criticism of traditional policy evaluation is known as the Lucas Critique.

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Policy is conducted by rule if policymakers announce in advance howpolicy will respond to various situations and commit themselves tofollowing through on this announcement. Policy is conducted bydiscretion if policymakers are free to size up events as they occur andchoose whatever policy the policymakers consider appropriate at the time.The debate over rules versus discretion is distinct from the debate overpassive versus active policy. Policy can be conducted by rule and yet beeither passive or active.

An active policy rule might specify:money growth = 3% + (Unemployment Rate – 6%)This rule tries to stabilize the economy by raising money growth whenthe economy is in a recession.

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Opportunistic policymakers take advantage of an exploitable Phillip’s curve and face naïve voters who

forget the past, are unaware of the policymakers’incentives, and do not understand how the economy

works. In particular, politicians don’t take into account thetradeoff between inflation and unemployment when their

political gain is at stake.

Opportunistic policymakers take advantage of an exploitable Phillip’s curve and face naïve voters who

forget the past, are unaware of the policymakers’incentives, and do not understand how the economy

works. In particular, politicians don’t take into account thetradeoff between inflation and unemployment when their

political gain is at stake.

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Policymakers announce in advance the policy they will follow to influence the expectations of private decision-makers.

But, later, after the private decision-makers have acted on the basisof their expectations, these policymakers may be tempted to renegeon their announcement.

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1) To encourage investment, the government announces that it will nottax income from capital. But, after factories are built, the governmentis tempted to raise taxes.

2) To encourage research, the government announces that it will givea temporary monopoly to companies that discover new drugs. But,after the drugs have been discovered, the government is tempted torevoke the patent.

3) To encourage hard work, your professor announces that this coursewill end with an exam. But, after you studied and learned all the material, the professor is tempted to cancel the exam so that he orshe won’t have to grade it.

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P

Y

P*

AD

Y

LRAS

Y''

Monetarists are economists who advocate that the Fed keep the money supply growing at a steady rate. Monetarists believe that fluctuations in the money supply are responsible for most large fluctuations in the economy.

Y'

AD'

Here we can see that this economy isgrowing (LRAS is shifting rightward)so continued increases in the supply ofmoney (via +AD) don’t necessarilyimply increases in inflation.AD''

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A second policy rule that economists widely advocate is nominalGDP targeting. Under this rule, the Fed announces a planned pathfor nominal GDP. If nominal GDP rises above the target, the Fedreduces money growth to dampen aggregate demand. If it fallsbelow the target, the Fed raises money growth to stimulate aggregatedemand.

Because a nominal GDP target allows monetary policy to adjust to changes in the velocity of money, most economists believe it would lead to greater stability in output and prices than a monetarist policy rule.

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In the late 80s, many of the world’s central banks adopted someform of inflation targeting. Sometimes inflation targeting takes theform of central bank announcing its policy intentions.

The Federal Reserve has not adopted an explicit policy of inflationtargeting (although some commentators have suggested that it is,implicitly, targeting inflation at about 2 percent).

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We have looked at whether policy should take an active orpassive role in responding to fluctuations in the economy, andwhether policy should be conducted by rule or discretion.

Although there is persistent debate between both sides, there isone clear conclusion: no simple and compelling casefor any particular view of macroeconomic policy has been made.

In the end, one must weigh the various political and economicarguments and decide what role the government should play instabilizing the economy.

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Inside and Outside lagsAutomatic StabilizersLucas critiquePolitical business cycleTime ConsistencyMonetaristsInflation Targeting

Inside and Outside lagsAutomatic StabilizersLucas critiquePolitical business cycleTime ConsistencyMonetaristsInflation Targeting