Lecture Sixteen

Limits of Stabilization Policy; Rules vs. Discretion

(Economics 100b; Spring 1996)
Professor of Economics J. Bradford DeLong
689 Evans, University of California at Berkeley
Berkeley, CA 94720
(510) 643-4027 phone (510) 642-6615 fax
delong@econ.berkeley.edu
http://www.j-bradford-delong.net

February 26, 1996

Limits of Stabilization Policy

Lags in Implementation and Effect
Automatic Stabilizers and Deposit Insurance
Policies Made According to Discretion, or by Following a Rule?

Administration

Limits of Stabilization Policy

Let me give an example of why, when you don't know what you are doing, you might not
want to do anything. Suppose unemployment rate currently forecast to be 8% next year;
pretty sure that the natural rate is 6%; thinking about a government speeding program;
don't know the multiplier--your forecasters shrug their shoulders, and say that maybe it is
one, and maybe it is three, they give 50/50 odds each way.
 If the multiplier is one: need to boost federal spending next year by $240 billion,
and that will get you to 6% unemployment.
 But if the multiplier is three and you boost spending by $240 billion, your
unemployment rate is 2% and inflation is through the roof.
 If the multiplier is three: need to boost federal spending next year by $80 billion,
and that will get you 6% unemployment.
 But if the multiplier is one and you boost spending by only $80 billion, you still
have 7 1/3% unemployment--1 1/3% more than you would like
 Split the difference? If the multiplier were 2, you'd boost spending by $120 billion
o with real multiplier of 3, unemployment at 5%
o with real multiplier of 1, unemployment at 7%

And suppose that you want to minimize the expected absolute deviation from the natural
rate: 8% unemployment is bad, but 4% unemployment (and rapidly rising inflation) is as
bad in a different way. 10% unemployment is twice as bad as 8%, etc.

Now let's look at our three proposed policies, and how much "bad" is left:

 Stimulus of $240 billion: 2% of "bad"

 Stimulus of $120 billion: 1% of "bad"
 Stimulus of $80 billion: 2/3% of "bad"

But this leaves you with (6%, 7 1/3%) 50-50 chances. You've deliberately undershot:
done less than may well prove necessary to reach "full employment"

Why? Because if your policies have uncertain or variable effects, they are one of the
sources of risk and distress that you are trying to stamp out.

 Note that this argument--that if you do not know precisely the effects of your
policies, do less--applies as strongly to policies that shift the monetary base to
control the money stock as to anything else.
 Which is why if you read Friedman's writings in depth, you pretty soon discover
calls for something called "100% reserve banking"--because that makes control of
the money stock from the monetary base much easier.
o Expand on this

And this is why, at least I think this is why, Mankiw has gotten confused: he has taken
Friedman's powerful--and correct--critique of the "limits of stabilization policy" to imply
that Friedman's own policy recommendation involve a passive role.

I think Friedman has gotten tangled up to some degree in the same confusion: limits of
knowledge mean policy should be cautious, yet what is a cautious policy? Unless you
have a good benchmark for what a "neutral" policy is, it is hard to figure out how to be
cautious.

Lags in Implementation and Effect

 Inside lag (fiscal and monetary); data collection; information processing;
legislative enactment; implementation
 Outside lag (fiscal and monetary); multiplier process takes time; investment takes
time;
 "Long and variable lags"; no reason to assume that investment response to a shift
in interest rates always takes the same amount of time, or has the same magnitude
of effect.

Talk about original draft of 1946 Employment Act, the Full Employment Act of 1946

Talk about political commentaries and Federal Reserve appointments...//assumption of

the worst as far as motives are concerned...
Automatic Stabilizers and Deposit Insurance

Any policies to stabilize the economy that don't have the problem of hitting the economy
more than a year from now? (Possible digression on the trade deficit and Clinton policy)

Yes--automatic stabilizers. What are automatic stabilizers?

Suppose that the consumption function (in billions of dollars) is:

C = 800 + 0.75(Y-T)

that the investment function and government spending are:

I(r) = 1300 - 100(r) r = 3

and, further, suppose that total net taxes and transfers T are not a lump sum amount, but
that instead:

T = .2 x Y

Then:
 Y = C+I+G = 2100 + 0.75(Y-(.2Y)) + 1300 - 100r + G

Y = C+I+G = 2100 + 0.6Y - 100r + G

(1-0.6)Y = 1800 + G

Y = 4500 + 2.5G

Now the marginal propensity to consume c' in this version of the model is 0.75; thus the
simple multiplier 1/(1-c') in this version of the model is 4. But the government-spending
multiplier--in fact, the general multiplier applying to all shocks to the IS curve

 Taxes depend on the level of income. Thus when the multiplier process starts, an
extra $1 of income does not generate an extra $0.75 in consumption but only an
extra $0.60 in consumption, because a $1 increase in pre-tax income is only a
$0.80 increase in disposable income.
Thus the tax system acts as an "automatic stabilizer" to diminish the impact of
shifts in spending on output--it is as if the marginal propensity to consume had
been lowered from .75 to .6, and the multiplier lowered from 4 to 2.5

 My strong aversion to the balanced-budget amendment

Remember the "money multiplier" from last time?

Between August 1929 and March of 1933--during the slide into the biggest Depression
America has ever seen--the Federal Reserve expanded the monetary base--the sum of
currency and reserve deposits--by nearly twenty percent, from $7.1 to $8.4 billion, by
buying on net some $1.3 billion of government bonds from banks and other private firms.
This means that monetary policy was quite expansionary during the slide into the Great
Depression, right?

Milton Friedman would--and did--say no: the problem was that in 1929, banks wanted to
hold $1 in reserves for every $7 in deposits; by 1933 banks wanted to hold $1 in reserves
for every $5 in deposits; in 1929 consumers were happy to hold 1/6 of their spendable
wealth in currency, and 5/6 in checking accounts; by 1933 consumers were terrified that
their banks would fail and wanted to hold 40% of their spendable wealth in currency and
60% in checking accounts.

Thus the money supply fell from $26.5 billion in August 1929 to $19.0 billion in March
1933 because $1 of reserves generated $3.70 of "money" in the first period and only
$2.30 of "money" in the second.

Deposit insurance as a way of avoiding such collapses in the money multiplier

Policies Made According to Discretion, or by Following a Rule?

Suppose that the consumption function (in billions of dollars) is:

C = 800 + 0.75(Y-T)

that the investment function and government spending are:

I(r) = 1300 - 100(r) r = 3

and, further, suppose that total net taxes and transfers T are not a lump sum amount, but
that instead:

T = .2 x Y

Then:
 Y = C+I+G = 2100 + 0.75(Y-(.2Y)) + 1300 - 100r + G

Y = C+I+G = 2100 + 0.6Y - 100r + G

(1-0.6)Y = 1800 + G

Y = 4500 + 2.5G

August 1929:
Monetary Base of $7.1 billion
Money multiplier of 3.7
Money stock of $26.5 billion

March 1933
Monetary Base of $8.4 billion
Money multiplier of 2.3
Money stock of $19.0 billion