Topic 12:

Stabilization Policy(chapter 14)

Question 1:

Should policy be Should policy be

active or passive?active or passive?

Should policy be Should policy be

active or passive?active or passive?

slide 2

Arguments for active policy• Recessions cause economic hardship for millions

of people.

• The Employment Act of 1946: “it is the continuing policy and responsibility of the Federal Government to…promote full employment and production.”

• The model of aggregate demand and supply (Chapters 9-13) shows how fiscal and monetary policy can respond to shocks and stabilize the economy.

slide 3

Arguments against active policy1. Two lags >>Inside lag:

the time between the shock and the policy response takes time to recognize shock takes time to implement policy, especially fiscal policy Outside lag: the time it takes for policy to affect

economy

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If conditions change before policy’s impact is felt, then policy may end up destabilizing the economy.

Forecasting the macroeconomyBecause policies act with lags, successful stabilization policy requires the ability to predict accurately future economic conditions.Ways to generate forecasts:• With leading indicators:

data series that fluctuate in advance of the economy

• Standard Macro econometric models:Large-scale models with estimated parameters that can be used to forecast the response of endogenous variables to shocks and policies

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Mistakes Forecasting the Recession of 1982

slide 7Year

Unemploymentrate (percent)

1986

Actual

1983:4

1983:2

1982:4

1982:2

1981:4

1981:2

198519841983198219811980

11.0

10.5

10.0

9.5

9.0

8.5

8.0

7.5

7.0

6.5

6.0

Forecasting the macroeconomyBecause policies act with lags, policymakers must predict future conditions.

slide 8

The preceding slides show that The preceding slides show that the forecasts are often wrong. the forecasts are often wrong.

This is one reason why some This is one reason why some economists oppose policy economists oppose policy activism. activism.

The preceding slides show that The preceding slides show that the forecasts are often wrong. the forecasts are often wrong.

This is one reason why some This is one reason why some economists oppose policy economists oppose policy activism. activism.

The Lucas Critique• Due to Robert Lucas

won Nobel Prize in 1995 for “rational expectations”

• Forecasting the effects of policy changes has often been done using models estimated with historical data.

• Lucas pointed out that such predictions would not be valid if the policy change responds differently to people’s expectations to policy change.

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An example of the Lucas Critique• Prediction (based on past experience):

an increase in the money growth rate will reduce unemployment

• The Lucas Critique points out that increasing the money growth rate may raise expected inflation, cost of reducing inflation is measured by sacrifice ratio.

• Which is the no. of % points of GDP that must be forgone to reduce inflation by 1 % point

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The Jury’s Out…

Looking at recent history does not clearly answer Question 1: • It’s hard to identify shocks in the data,• and it’s hard to tell how things would have been

different had actual policies not been used.

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Question 2:

Should policy Should policy be conducted by be conducted by

Rules or Discretion?Rules or Discretion?

Should policy Should policy be conducted by be conducted by

Rules or Discretion?Rules or Discretion?

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Rules and Discretion: basic concepts• Policy conducted by rule:

Policymakers announce in advance how policy will respond in various situations, and commit themselves to following through.

• Policy conducted by discretion:As events occur and circumstances change, policymakers use their judgment and apply whatever policies seem appropriate at the time.

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Arguments for Rules

1. Distrust of Policymakers and the Political Process misinformed politicians politicians’ interests sometimes not the same

as the interests of society

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Arguments for Rules2. The Time Inconsistency of Discretionary Policy

def: policy makers may want to announce in advance the policy, but later after the private decision makers have acted on basis of their expectations, policy makers renege on their announcement.

Destroys policymakers’ credibility, thereby reducing effectiveness of their policies.

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Examples of Time-Inconsistent Policies

To encourage investment, To encourage investment, government announces it government announces it won’t tax income from capital. won’t tax income from capital.

But once the factories are built, But once the factories are built, the govt reneges in order to raise the govt reneges in order to raise more tax revenue.more tax revenue.

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Monetary Policy Rules

c

. Inflation targeting

slide 17

a.Steady growth in MS would yield stable output ,employment and prices

b. Nominal GDP targeting when velocity is not constant

c.Inflation targettingd. Target Federal Funds rate based on

inflation rate gap between actual & full-

employment GDP

The Taylor Rule

where:

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= nominal federal funds rateffi

GDP Gap = 100Y Y

Y

= the percent by which real GDP

is below its natural rate

+ 2 + 0.5( 2) 0.5(GDP Gap)ffi

The Taylor Rule

• If = 2 and output is at its natural rate, then monetary policy targets the nominal Fed Funds rate at 4%.

• For each one-point increase in , mon. policy is automatically tightened .

• If GDP rises above its natural level, so that the GDP gap is negative, the fed fund rate rises accordingly.

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+ 2 + 0.5( 2) 0.5(GDP Gap)ffi

Does Greenspan follow the Taylor Rule?

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The Federal Funds RateActual and Suggested

0

2

4

6

8

10

12

1987 1990 1993 1996 1999 2002

Per

cen

t

Actual

Taylor's rule

Central Bank Independence

• A policy rule announced by Central Bank will work only if the CB is independent of the government.

• Credibility depends in part on degree of independence of central bank.

• Researchers found there is no relationship between central bank independence and real economic activity

slide 21

Inflation and Central Bank Independence

slide 22

Index of central-bank independence

Average in½ation

4.543.532.521.510.5

9

8

7

6

5

4

3

2

Spain

New ZealandItaly

United KingdomDenmarkAustralia

France/Norway/Sweden

JapanCanadaNetherlandsBelgium United States

SwitzerlandGermany

Average inflation

Index of central bank independence

Chapter summary1. Advocates of active policy believe:

frequent shocks lead to unnecessary fluctuations in output and employment

fiscal and monetary policy can stabilize the economy

2. Advocates of passive policy believe: the long & variable lags associated with

monetary and fiscal policy render them ineffective and possibly destabilizing

inept policy increases volatility in output, employment

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Chapter summary3. Advocates of discretionary policy believe:

discretion gives more flexibility to policymakers in responding to the unexpected

4. Advocates of policy rules believe: the political process cannot be trusted:

politicians make policy mistakes or use policy for their own interests

commitment to a fixed policy is necessary to avoid time inconsistency and maintain credibility

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