1

V. ECONOMIC FLUCTUATIONS
AND STABILIZATION POLICIES
Lecture Slides Set 5-2

Sarah Lynne Salvador Daway-Ducanes, Ph.D.

Econ 101, 1st Semester, AY 2020-21
Topics Covered in These Slides
•V. Economic Fluctuations and Stabilization Policies
•A. Economic Fluctuations: Business Cycles
•1. Definition
•2. Leading Economic Indicators
•3. Sources
•B. Stabilization Policies
•1. Active vs. Passive
•2. Rules vs. Discretion
 3

IV. ECONOMIC FLUCTUATIONS

AND STABILIZATION POLICIES
B. Stabilization Policies
V. B. Stabilization Policies

Stabilization Policy
•Refers to policy actions aimed at reducing the severity of short-run economic
fluctuations

•Dampens business cycles by keeping output and employment close to the

natural level

•Example: Using monetary policy to combat the effects of adverse supply

shocks…
V. B. Stabilization Policies

Stabilizing Output with Monetary Policy

P LRAS

The adverse
supply shock
moves the B SRAS2
P2
economy to
A SRAS1
point B. P1
AD1

Y
Y2 Y
V. B. Stabilization Policies

Stabilizing Output with Monetary Policy

P LRAS
But the central bank
accommodates the
shock by raising AD
B C SRAS2
P2
A
Results: P1 AD2
P is permanently AD1
higher, but Y
remains at its full- Y
employment level. Y2 Y
V. B. Stabilization Policies 7

Should policy be active or

passive?
V. B. Stabilization Policies 8

Arguments for & against Active Policy

•FOR
•Recessions cause economic hardship for millions of people.
•The model of aggregate demand and supply shows how fiscal and monetary
policy can respond to shocks and stabilize the economy.

•AGAINST
•Policies act with long & variable lags
•Uncertainty about future economic conditions affect agents’ expectations and
actions that may render policy regimes based on forecasts ineffective.
•If conditions change before policy’s impact is felt, the policy may destabilize
the economy.
V. B. Stabilization Policies

Lags in Policy Effects

•Dilemma: stabilization may be destabilizing even if it is known how long the
effects of a shock will persist due to policy lags

•Types of policy lags

•Inside lag: the time between the shock and the policy action
•Outside lag: the time it takes for the policy to take effect
V. B. Stabilization Policies

Lags in Policy Effects

INSIDE LAGS
Recognition lag
time it takes for policymakers to recognize that action is to be taken
negative if shock is anticipated
Decision lag: delay between recognition and policy decision
(#congressional/senate hearings)
Action lag: delay between policy decision and implementation

OUTSIDE LAG
Distributed lag: policy effects are spread over time; there are buildup effects
Expansionary MP  lower interest rate …  higher investment and greater
wealth …  series of higher consumption spending … increase in output
V. B. Stabilization Policies

Lags in Policy Effects

•Fiscal policy or monetary policy?

•Which has a longer inside lag? Longer outside lag?

•MP tends to have a shorter inside lag since the Monetary Board decisions tend to be
quick and decisive. However, MP tends to have longer outside lags, as this depends
on the response of investors.

•Per the Bangko Sentral Review (2012), MP tends to have an outside lag of 12-15
months.

•In contrast, FP tends to have a longer inside lags (#congresshearings).

V. B. Stabilization Policies 12

Importance of Automatic Stabilizers

•Automatic stabilizers
are policies that stimulate (or depress) the economy during a recession
phase (an expansion phase) without any deliberate policy change

•Designed to reduce the lags associated with stabilization policy

•Examples:
•Income tax
•Unemployment insurance
•Welfare benefits
•When Y is low during a recession, the income tax declines (or
unemployment insurance or welfare benefits increase), which raises
disposable incomes, encouraging consumption and/or investment.
V. B. Stabilization Policies 13

Uncertainty and Macroeconomic Forecasts

Because policies act with lags, policymakers must predict future conditions.

Two ways economists generate forecasts:

• Leading economic indicators
data series that fluctuate in advance of the economy
• Macroeconometric models
Large-scale models with estimated parameters that can be used to forecast the
response of endogenous variables to shocks and policies

The proceeding slides will show that forecasts are often wrong.

This is a reason why some economists oppose policy activism.

V. A. Economic Fluctuations: Business Cycles

Leading Economic Indicators (LEI)

•Leading indicator – a variable whose cyclical component either peaks or
reaches a trough before the real GDP cycle does

•Used to forecast short-run changes in economic activity

•Used in planning by businesses and government, despite not being a perfect

predictor

•In the Philippines, this is estimated by the Philippine Statistics Authority (PSA)
V. B. Stabilization Policies

Mistakes in Forecasting Unemployment during the 1982 Recession in the US

Unemployment rate
V. B. Stabilization Policies 16

The Lucas critique

•Espoused by Robert Lucas
who 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
alters expectations in a way that changes the fundamental relationships
(estimated relationships) between variables.
V. B. Stabilization Policies 17

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, which would in turn raise actual inflation, which would
result in a rise in the overall cost of production, reducing aggregate supply and
thus, equilibrium output.

•Thus, unemployment would not necessarily fall.

V. B. Stabilization Policies 18

Should policy be conducted by

rules or discretion?
V. B. Stabilization Policies 19

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.
V. B. Stabilization Policies 20

Arguments for Rules

1. Distrust of policymakers and the political process
• Misinformed politicians
• Politicians’ interests sometimes not the same as the interests of society:
political business cycle?
• Government spending tends to increase in the run up to the elections
V. B. Stabilization Policies 21

Arguments for Rules

2. Time inconsistency of discretionary policy
• Time inconsistency: A scenario in which policymakers have an incentive to
renege on a previously announced policy once others have acted on the
previous announcement.
• This destroys the policymaker’s credibility, thereby reducing the effectiveness
of policies.
V. B. Stabilization Policies 22

Examples of Time Inconsistency

1. To encourage investment the government announces it will not tax income from
capital. But once the factories are built, government reneges in order to raise
more tax revenue.

2. To reduce expected inflation, the central bank announces it will tighten monetary
policy. But faced with high unemployment, the central bank may be tempted to cut
interest rates.

3. Aid is given to poor countries contingent on fiscal reforms. The reforms do not
occur, but aid is given anyway, because the donor countries do not want the poor
countries’ citizens to starve.
V. B. Stabilization Policies 23

Monetary Policy Rules

 Constant money supply growth rate
• Advocated by Friedman and other Monetarists
• Works only if the velocity of money is stable or the money demand function is
stable
• Rule: Raise money growth rate if unemployment is greater than the “natural
rate of unemployment.”

 Target growth rate of nominal GDP

• To stabilize business cycle fluctuations and mitigate its impacts
• Rule: Automatically increase money growth whenever nominal GDP grows
slower than targeted; decrease money growth when nominal GDP growth
exceeds target.
V. B. Stabilization Policies 24

Monetary Policy Rules

 Interest-rate-targeting rule (Taylor rule)

ഥ + 𝟎. 𝟓(𝝅 − 𝝅
𝒊 = 𝝅 + 𝟎. 𝟓 𝒚 − 𝒚 ഥ)

• Rule: Raise 𝑖 when

• 𝜋 increases; and/or
• 𝑦 > 𝑦;
ത and/or
• 𝜋 > 𝜋ത
• to reduce investment and thus AD and output Y (and also 𝜋)
V. B. Stabilization Policies 25

Monetary Policy Rules

 Target inflation
• Rule: Lean-against-the wind policy: automatically reduce money growth
whenever inflation rises above the target rate  reduces AD and inflation
• Many countries’ central banks now practice inflation targeting, but allow
themselves a little discretion
• Criticism: Fed did not provide enough monetary stimulus due to “inflation fears”,
leading to the largest decline in nominal GDP since the Great Depression
(Sumner, 2012)
• Bad news if there are negative supply shocks, since to keep the inflation target,
the central bank will have to conduct contractionary monetary policy, which will
further exacerbate the recession effects of the negative supply shock
V. B. Stabilization Policies 26

Inflation Targeting in Industrial Economies

Country/Area Current Target Index Targeted Who Sets Target?
Australia 2-3% CPI Central Bank and Gov’t
Canada 1-3% CPI Central Bank and Gov’t
Harmonized Index of
Euro-zone Below 2% Central Bank
Consumer Prices
Israel 1-3% CPI Central Bank
New Zealand 1-3% CPI Central Bank and Gov’t
Sweden 2% (with permissible CPI Central Bank
United Kingdom fluctuations of ±1%) CPI Central Bank
V. B. Stabilization Policies 27

Central Bank Independence

•A policy rule announced by the central bank will work only if the announcement
is credible.

•Credibility depends in part on the degree of independence of central bank –

that it will not succumb to pressures to ‘monetize’ the central/national
government’s debts, as this may lead to runaway inflation, such as what
happened in Latin America in the 1980s.
V. B. Stabilization Policies

Inflation and Central Bank Independence

average inflation

index of central bank independence

 Summary
1. 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
 Summary
3. 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