MACROECONOMICS

UNDERSTANDING THE GLOBAL ECONOMY

C H APTER 15
STAB ILIZATIO N P O LIC Y

Paulina Etxeberria-Garaigorta

Ref: Macroeconomics: Understanding the Global Economy

by Miles, Scott and Breedan (2012)
 OUTLINE

1. Output fluctuations and the Tools of Macroeconomic Policy

2. General Arguments against Stabilization Policy
3. Time Inconsistency
4. Rules versus Discretion
 WHAT IS A STABILIZATION POLICY?
The use of Fiscal and Monetary Policy to stabilize the economy.

CAN THE GOVERNMENT STABILIZE

THE ECONOMY BY USING FISCAL AND
MONETARY POLICY?
There are arguments For and Against
1. OUTPUT FLUCTUATIONS AND THE TOOLS OF MACRO POLICY

The idea that governments could manipulate demand and, in doing so,
stabilize the business cycle was the essence of Keynesian economics in
the 1950s and 1960s.
There was optimism that the adoption of demand-management policies
would eradicate events such as the Great Depression.
The main issue concerned how best to boost demand: interest rates, tax
cuts or government expenditure.
1. OUTPUT FLUCTUATIONS AND THE TOOLS OF MACRO POLICY

3 different types of Shocks and 6 possible economic policies:

1. Negative Demand Shock:

1. Expansionary Fiscal Policy
2. Expansionary Monetary Policy USE THE IS-LM MODEL
2. Positive Demand Shock
AND
1. Contractionary Fiscal Policy THE AD-AS MODEL
2. Contractionary Monetary Policy FOR THE ANALYSIS

3. Negative Supply Shock

1. Expansionary Fiscal Policy
2. Expansionary Monetary Policy
1. OUTPUT FLUCTUATIONS AND THE TOOLS OF MACRO POLICY
1. Decrease in Demand Solution: Expansionary Fiscal Policy (G or T )
(Negative Demand Shock) LRAS

Price Level AD

AS

P0
P1

Y1 Y0 Real GDP
1. OUTPUT FLUCTUATIONS AND THE TOOLS OF MACRO POLICY

Price Level LRAS

Government
AD responds by
increasing demand

Use Fiscal Policy AS

to offset lower Increase G

spending P0 Decrease T
Increase M
P1

Y1 Y0 Real GDP
1. OUTPUT FLUCTUATIONS AND THE TOOLS OF MACRO POLICY
2. Decrease in Demand Solution: Monetary Policy: lower interest rates
(Negative Demand Shock)

1. Equilibrium in the short and long-run:

2. at potential output
3. Private spending decreases:
4. Y decreases below Potential Y: negative
output gap
5. Expansionary/Countercyclical Monetary
policy:
interest rates decrease
6. Y goes back to pontential Y.

Use Monetary Policy

to offset lower spending
1. OUTPUT FLUCTUATIONS AND THE TOOLS OF MACRO POLICY
3. Increase in Demand Solution: Contractionary Fiscal Policy (G or T )
(Positive Demand Shock) LRAS

Price Level AD

AS
P1
P0

Y0 Y1
Real GDP
1. OUTPUT FLUCTUATIONS AND THE TOOLS OF MACRO POLICY

LRAS
Government responds
AD by decreasing demand
Price Level

AS
Decrease G
Use Fiscal Policy P0 Increase T
to offset higher Decrease M
spending

Y0 Real GDP
1. OUTPUT FLUCTUATIONS AND THE TOOLS OF MACRO POLICY
4. Increase in Demand Solution: Monetary Policy: rise interest rates
(Positive Demand Shock)

1. Equilibrium in the short and long-run:

2. at potential output
3. Private spending increases:
4. Y increases above Potential Y: positive output
gap
5. Contractionary/Countercyclical Monetary
policy:
interest rates rise
6. Y goes back to pontential Y.

Use Monetary Policy

to offset higher spending
1. OUTPUT FLUCTUATIONS AND THE TOOLS OF MACRO POLICY
5. Decrease in supply Solution: Increase Government Expenditure
(Negative supply Shock) LRAS
Government responds
AD by increasing demand
Price Level 3

2 AS
Big
P0 increase in
1 price

Y0 Real GDP
1. OUTPUT FLUCTUATIONS AND THE TOOLS OF MACRO POLICY
Video about the Application of Fiscal Policy as a response to a negative AD
shock in the AD-AS model: The Best Case Scenario [3.37 min]

VIDEO Mruniversity expansionary-fiscal-policy

2. GENERAL ARGUMENTS AGAINST STABILIZATION POLICY

I. GENERAL ARGUMENTS II. PROBLEMS WITH FISCAL POLICY

4. Flexibility and Policy Objectives
1. Automatic stabilizers
5. Ricardian Equivalence
2. Uncertainty 6. Consumer Expectations
3. Policy-Making Lags 7. Crowding Out

III. PROBLEMS WITH MONETARY POLICY

IV. Time Inconsistency

 CLASS ACTIVITY 2: STABILIZATION POLICIES. FOR AND AGAINST
INSTRUCTIONS FOR THE ASSIGMENT:
1. Work in Groups created in class
2. Read the slides from Chapter 15 carefully
3. Prepare a Power Point for a 10 minutes talk (do not include too much wording in the slides. Use the “notes”
section to write what you would say in each slide)
4. Structure of the Power Point:
1. General introduction: what are stabilization policies and why do you consider that there is a debate
about their application?
2. Arguments FOR: Include, at least, the arguments that you studied in the Macroeconomics course. You
can include extra arguments.
3. Arguments AGAINST: Include, at least, the arguments from the slides. You can include extra arguments.
4. Your position: is your group for or against? Why?
5. If you divide the work and prepare different parts individually, read the parts from your other team
members. You will have to defend each position and know about all the arguments when I ask you about them.

Remember: the structure has to be clear, and you have to write it in the same style.
2. GENERAL ARGUMENTS AGAINST STABILIZATION POLICY

1. Automatic stabilizers
• Governments do respond automatically to business cycles.
• In an economic crisis:
• INCOME TAXES: Tax revenues decrease due to falling income and private sector spending.
• WELFARE SPENDING: Government spending might rise automatically on transfer payments
such as unemployment benefits.
• Therefore, even without any change in tax or spending policies, recessions are likely to cause
an increase in the government Budget deficit.

• The process underlying this natural change in the stance of fiscal policy during a recession are
called Automatic stabilizers: an increase in government borrowing during a recession helps
stabilize the economy as lower taxation and greater government spending stimulate demand.
• These automatic stabilizers reduce the need for active stabilization policy.
2. GENERAL ARGUMENTS AGAINST STABILIZATION POLICY

2. Uncertainty

• The government might not know how much to shift AD.

• Stabilization policy is complicated by the need to work out whether fluctuations are
caused by temporary demand shocks or permanent supply improvements.
• The government might analyze the causes of a shock incorrectly and apply the wrong
policies.
• The government runs the risk of been the source of volatility if it uses stabilization policy
when it is uncertain of the structure of the economy.
2. GENERAL ARGUMENTS AGAINST STABILIZATION POLICY
What if AD and LRAS both shifts to the right at the same time?
LRAS
AS
AD The government has to
Price Level decide how much of the
change is temporary
1 demand shift and how
P0
much permanent supply
2
shift.

What if the government

”guesses” incorrectly?

Y0 Real GDP
2. GENERAL ARGUMENTS AGAINST STABILIZATION POLICY
The Response of Output to a Monetary Expansion. Predictions from 10 Models

Although all 10 models

predict that output will
increase for some time in
response to a monetary
expansion, the range of
answers regarding the size
and the length of the
output response is large.

Source: Blanchard (2019)

2. GENERAL ARGUMENTS AGAINST STABILIZATION POLICY

There is substantial uncertainty about the effects of macroeconomic policies.

This uncertainty should lead policy makers to be cautious and to limit the use
of active policies.
Policies should be broadly aimed at avoiding large prolonged recessions,
slowing down booms, and avoiding inflationary pressure.
The higher unemployment or the higher inflation, the more active the policies
should be.
In normal times, macroeconomic policies should stop well short of fine
tuning—trying to achieve constant unemployment or constant output growth.
2. GENERAL ARGUMENTS AGAINST STABILIZATION POLICY

3. Policy-Making Lags

3 types:

1. Information lags: arise because economic data are published only with a delay and are normally
revised after publication.
2. Decision lags: the government has to decide how to respond (monetary policy can be
implemented faster than fiscal policy).
3. Implementation lags: it takes some time for the economic policy change to impact the economy.
• The policy has to be changed.
• It has to have an effect on the economy (it takes around 2 years before the peak impact of
changing fiscal and monetary policy is achieved).
• Long, uncertain lags mean that stabilization policy may be destabilizing.
2. GENERAL ARGUMENTS AGAINST STABILIZATION POLICY

4. Problems with Fiscal Policy

• Not flexible: changes in taxes and government expenditure are administratively difficult and
take time.
• There is a tension between sensible long-run planning for providing public sector services and
using the level of government spending to regulate demand in the economy.
• Governments wish to achieve many objective through tax and expenditure policies: long-run
growth, redistribution environmental, political ends.
• Uncertainty: 3 channels through which attempts by the government to boost demand may be
offset by the behavior of the private sector:
• Ricardian Equivalence
• Consumer Expectations
• Crowding-out
2. GENERAL ARGUMENTS AGAINST STABILIZATION POLICY

5. Ricardian Equivalence

• David Ricardo (1772-1823) argued that whether a government financed spending by raising taxes
or by issuing debt, it would have little impact on demand if people were forward-looking.
Consumers internalize the government´s budget constraint when making consumption decisions.
• It states that the impact of government expenditure on the economy does not depend on
whether higher taxes or government debt is used to finance it: government deficits have no
stimulating effect on the economy.
• What matters is the present value of overall government spending and not whether the spending
is largely financed out of taxes raised today or tomorrow.
• Strong assumptions make it unlikely to hold. But, sometimes, increases in the fiscal deficit have
little effect on demand because of increases in private sector saving. Unless the multiplier effect
of fiscal deficits are predictable, using fiscal policy to stabilize the economy can be destabilizing.
2. GENERAL ARGUMENTS AGAINST STABILIZATION POLICY

5. Ricardian Equivalence
• Government budget constraint
𝐷1 = 𝐺1 − 𝑇1 𝑇2 𝐺2
𝑇1 + = 𝐺1 +
1+𝑟 (1 + 𝑟) (1)
𝑇2 − 𝐺2 = 𝐷1 1 + 𝑟 = (𝐺1 − 𝑇1)(1 + 𝑟)

• Household budget constraint

𝐶2 𝑌2 𝑇2
𝐶2 = 𝑌2 − 𝑇2 + (1 + 𝑟)(𝑌1 − 𝑇1 − 𝐶1) 𝐶1 + = 𝑌1 + − 𝑇1 − (2)
1+𝑟 1+𝑟 1+𝑟

𝐶2 𝑌2 𝐺2 The present value of consumption is the

(1)+(2) 𝐶1 + = 𝑌1 + − 𝐺1 −
1+𝑟 1+𝑟 1+𝑟 present value of pre-tax incomes minus the
present value of government spending.
2. GENERAL ARGUMENTS AGAINST STABILIZATION POLICY

6. Consumer Expectations

• How consumers respond to tax cuts depends on whether they perceive them as transitory or
not:
• Transitory: consumption will respond only weakly, if at all.
• Permanent: consumption will respond.

• As tax cuts made to stabilize the economy are only temporary,

• It might be that they not only have a small effect on the economy
• Adds an additional element of uncertainty as to how fiscal policy will work.
2. GENERAL ARGUMENTS AGAINST STABILIZATION POLICY

7. Crowding-Out

• The traditional view states that increases in fiscal deficit lead to higher interest rates in the
future and lower private-sector demand: higher interest rated “crowd out” the government´s
efforts.
• If private sector is highly sensitive to interest rates, the crowding-out effect can be
substantial.
• Crowding out operated through larger fiscal deficit reducing the amount of funds available to
other borrowers (also corporate sector). This rises interest rates, and lowers I and C.
• If monetary policy is contractionary when there is an expansionary fiscal policy, higher
interest rates might crowd out extra demand because of higher interest rate.

VIDEO Mruniversity fiscal-policy-crowding-out

2. GENERAL ARGUMENTS AGAINST STABILIZATION POLICY
7. Crowding-Out
• The government expenditure multiplier and tax multiplier are the $m change in GDP resulting
from a $1 change in government expenditures and taxes.
• The multiplier effect seems to suggest that when the government spends (or cuts in taxes) $20
billion, Aggregate Demand increases by a larger amount.
• Crowding out occurs when rising government expenditures or tax cuts partially or even fully
displace expenditures by households and firms.
• The CROWDING-OUT EFFECT
• ∆G>0 → ∆AD>0 → ∆Y>0 → ∆ (M/P)_d>0 → ∆ r>0 → ∆ I<0 → ∆ AD<0
• ∆T<0 → ∆AD>0 → ∆Y>0 → ∆ (M/P)_d>0 → ∆ r>0 → ∆ I<0 → ∆ AD<0
• The effect varies depending on Household´s perception if the tax change is permanent or
transitory: If ∆T<0 .
+ Permanent: ∆AD>0 multiplier effect high
+ Temporary: ∆AD>0 multiplier effect low
2. GENERAL ARGUMENTS AGAINST STABILIZATION POLICY

You can WATCH THE FOLLOWING VIDEOS FOR EXTRA INFORMATION [20 MINUTES]

1. The Limits of Fiscal Policy [7.05 min]

VIDEO Mruniversity fiscal-policy-limitations

1. The Dangers of Fiscal Policy [6.02 min]

https://www.mruniversity.com/courses/principles-
economics-macroeconomics/fiscal-policy-dangers

2. Fiscal Policy and Crowding-out [5.25 min]

2. GENERAL ARGUMENTS AGAINST STABILIZATION POLICY
Question: Which is the “right” scenario?
Answer: Economists are not completely sure.
Question: If the government wants to stimulate the economy,
should it increase expenditure to stimulate the economy?

Answer: Pros and cons.

2. GENERAL ARGUMENTS AGAINST STABILIZATION POLICY

Macroeconomists remain quite uncertain about

the quantitative effects of fiscal policy.

This uncertainty derives from:

1. Usual errors in empirical estimation

2. Different views on the proper theoretical framework and econometric

methodology.
2. GENERAL ARGUMENTS AGAINST STABILIZATION POLICY
• Every time a government considers a plan of fiscal stimulus or fiscal consolidation,
there is a strong debate among policymakers, journalists, and economists on the
effectiveness of such a policy.
• This effectiveness is often summarized by the size of the fiscal multiplier, which
measures how much output expands following a rise in government spending or a tax
cut.
• Nevertheless, fiscal multipliers are not constant structural parameters, but rather they
depend on the characteristics of the economy.
• During the Great Recession of 2008-09, policymakers and academics were surprised to
discover not only a lack of consensus about the size of the effects of fiscal policy, but
also a death of research on the topic since the 1960s. Therefore, some researchers
decided to analyze further this topic.
2. GENERAL ARGUMENTS AGAINST STABILIZATION POLICY

What did
the US Government do
during the Great Recession?
Source: Furman (2018)
2. GENERAL ARGUMENTS AGAINST STABILIZATION POLICY

• The fiscal literature has made tremendous progress in the ten years since the
start of the global financial crisis.
• On average, government purchases multipliers are between 0.6 and 1.
• Tax rate change multipliers between –2 and –3, though these are significantly
greater in magnitude than those predicted by New Keynesian DSGE models.
• However, there is still ongoing debate about specific contexts, such as the
size of fiscal multipliers during “bad” times and the effects of other
characteristics, such as exchange rate regimes.
Source: Ramey (2019)
2. GENERAL ARGUMENTS AGAINST STABILIZATION POLICY

8. Problems with Monetary Policy

• It is a more useful tool for stabilization. Central Banks can change interest rates at very short
notice.
• The lag between a decision and the implementation of monetary policy is virtually zero.
• Many of the problems with fiscal policy happen with monetary policy:
• Private-sector expectations about the aims of policy are critical.
• Time lags between the implementation of policy and its impact on expenditure decisions are
long and variable: much of the effect on output and inflation many only come through after
2/3 years.
• Central Banks do not control REAL interest rates, which is what matters for private sector
spending decisions.
• Only when movements in interest rates can influence expectations of inflation and of future
interest rates, they might have an impact on spending.
2. GENERAL ARGUMENTS AGAINST STABILIZATION POLICY

Using stabilization policy is problematic

and assumes a great deal of knowledge among economic policymakers.

Fiscal policy is not flexible enough

and its impact too uncertain to be extensively used for stabilization
purposes.

Although Monetary policy has drawbacks, it is more suitable

as a short-term demand-management tool.
2. GENERAL ARGUMENTS AGAINST STABILIZATION POLICY

Stabilization through fiscal policy might be helpful in a LIQUIDITY TRAP.

FOR
1. The recession is so severe that the recognition and implementation lags of fiscal
policy might not be a problem.
2. Since interest rates are zero and unlikely to be increased for some time, there is
little or no crowding-out effect.
AGAINST
1. It can create problems to manage the extra government borrowing.
2. Some argue that the perception that fiscal deficits will have to be repaid in the
future means that the positive effect today is offset by the negative impact of
expectations of higher future taxes and so the fiscal multiplier is small.
 3. TIME INCONSISTENCY

Rule or Discretionary Policies?

1. Policies based on Fixed Rules:

Those responsible for economic policy announce in advance how the
policy will respond to various situations, and they commit to fulfil it.
2. Discretionary Policies:
When events/shocks that change a situation occur, those responsible for
economic policy evaluate the situation and apply specific policies
designed for this event.

1. Distrust towards those responsible for economic policy and political process.
In favor of Rules
2. Time inconsistency with discretional policies.
 3. TIME INCONSISTENCY

§ Def.: A situation when those responsible

for economic policies have incentives
to breach the previously announced policies,
once the economic agents have responded to the first announcement.

§This destroys the trustworthiness of those responsible for economic

policies, reducing the effectiveness of policies.
 3. TIME INCONSISTENCY

Expectations depend on TIME INCONSISTENCY.

When the future arrives,
it may no longer be optimal to carry out your plan.
If people are aware of this problem
they might not believe in your predictions.
 3. TIME INCONSISTENCY

REMEMBER GAME THEORY!!!

Your child, Laura, has just graduated from high school, and is planning to attend State U in
the fall. How should she spend her summer?

◦ Working to help pay for tuition (parents’ preference)

◦ Playing computer games (Laura’s preference)
You tell her the following

◦ If she works, you will help with tuition

◦ If she plays, she’s on her own in August
 3. TIME INCONSISTENCY

Will you do what you say you’re going to do?

Pay for College

Don’t Pay
P l ay

Laura

Work Pay for College What you say…

Don’t Pay
 3. TIME INCONSISTENCY
Will you do what you say you’re going to do?

What Laura thinks…

Pay for College

Don’t Pay
Laura
P l ay

Work Pay for College

Don’t Pay
 3. TIME INCONSISTENCY

Prisoner’s Dilemma
Prisoner 2

Don’t Talk Talk

Don’t Talk -1, -1 -9, 0

Prisoner 1
Talk 0, -9 -6, -6
 3. TIME INCONSISTENCY

3 Examples of Problems Steming from Time Inconsistency in Economics

1) To encourage investment, the government announces that it will not tax income from
capital. But, after factories are built, the government is tempted to raise taxes.
2) To encourage research, the government announces that it will give a temporary
monopoly to companies that discover new drugs. But, after the drugs have been
discovered, the government is tempted to revoke the patent.
3) To encourage hard work, your professor announces that this course will end with an
exam. But, after you studied and learned all the material, the professor is tempted to
cancel the exam so that he or she won’t have to grade it.
 3. TIME INCONSISTENCY

How can we solve the problem?

INDEPENDENT CENTRAL BANK

 4. RULES VERSUS DISCRETION

• Can FIXED RULES solve time consistency and credibility problems?

• Two examples of rules
◦ Central Bank Independence
◦ Fiscal Stability rules
• Monetary Policy: Rule. Target inflation.
• Fiscal Policy: Automatic stabilizers to influence the business cycle.
• Use fiscal policy when interest rates around 0 (Liquidity trap).
• The application of fiscal policy continues to be controversial.
 4. RULES VERSUS DISCRETION
Independence of the Central Bank

A Rule of economic policy

Average inflation
announced by the Central Bank
will work only if it is credible.
Credibility depends partially on
the grade of Independence of
the Central Bank.

Source: Alesina y Summers, “Central Bank Independence and

Macroeconomic Performance: Some Comparative Evidence,”
Journal of Money, Credit, and Banking, May 1993. Index of Independence of Central Bank
 REFERENCES

• Furman, J. (2018), Responding to the Global Financial Crisis. What we did and why we did it. The
Fiscal Rsponse to the Great Recession: Steps taken, paths rejected, and lessons for next time,
Preliminary Discussion Draft.
• Mankiw, G. (2016), Principles of Economics, Pearson
• Miles, Scott and Breedan (2012), Macroeconomics: Understanding the Global Economy.
• Ramey, V. A. (2019), Ten Years After the Financial Crisis: What have we learned from the Reinassance
in Fiscal Research?, Journal of Economic Perspectives, Volumne 33, Number 2, pag: 89-114.