Topic 12


Stabilization Policy
(chapter 14)

Question 1:
Should policy
policy be
active or

slide 2

Arguments for active policy • Recessions cause economic hardship for millions of people. slide 3 . • 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 4 . especially fiscal policy  Outside lag: the time it takes for policy to affect economy If conditions change before policy’s impact is felt. then policy may end up destabilizing the economy.Arguments against active policy 1. Two lags >>Inside lag: the time between the shock and the policy response  takes time to recognize shock  takes time to implement policy.

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 slide 6 .Forecasting the macroeconomy Because policies act with lags.

0 1983:4 7.5 10.Mistakes Forecasting the Recession of 1982 Unemployment 11.5 1981:4 1983:2 8.0 rate (perc ent) 10.5 6.0 Actual 6.5 9.0 1982:4 9.0 1980 1981 1982 1983 1984 1985 1986 Year slide 7 .5 1981:2 7.0 1982:2 8.

Forecasting the macroeconomy Because policies act with lags. activism. slide 8 . wrong. policymakers must predict future conditions. This This is is one one reason reason why why some some economists economists oppose oppose policy policy activism. The The preceding preceding slides slides show show that that the the forecasts forecasts are are often often wrong.

• Lucas pointed out that such predictions would not be valid if the policy change responds differently to people’s expectations to policy change. slide 9 .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.

• Which is the no. cost of reducing inflation is measured by sacrifice ratio.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. of % points of GDP that must be forgone to reduce inflation by 1 % point slide 10 .

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. slide 11 .

Question 2: Should Should policy policy be be conducted conducted by by Rules Rules or or Discretion? Discretion? slide 12 .

slide 13 .Rules and Discretion: basic concepts • Policy conducted by rule: Policymakers announce in advance how policy will respond in various situations. policymakers use their judgment and apply whatever policies seem appropriate at the time. and commit themselves to following through. • Policy conducted by discretion: As events occur and circumstances change.

Distrust of Policymakers and the Political Process  misinformed politicians  politicians’ interests sometimes not the same as the interests of society slide 14 .Arguments for Rules 1.

slide 15 . policy makers renege on their announcement. The Time Inconsistency of Discretionary Policy  def: policy makers may want to announce in advance the policy.Arguments for Rules 2.  Destroys policymakers’ credibility. but later after the private decision makers have acted on basis of their expectations. thereby reducing effectiveness of their policies.

government announces it won’t tax income from capital.Examples of Time-Inconsistent Policies To encourage investment. the govt reneges in order to raise more tax revenue. But once the factories are built. slide 16 .

employment and prices b.Steady growth in MS would yield stable output .Inflation targetting d. Target Federal Funds rate based on  inflation rate  gap between actual & fullemployment GDP slide 17 .Monetary Policy Rules a. Inflation targeting c. Nominal GDP targeting when velocity is c not constant .

The Taylor Rule i f   + 2 + 0.5(GDP Gap) where: i f = nominal federal funds rate GDP Gap = 100  Y Y Y = the percent by which real GDP is below its natural rate slide 18 .5(  2)  0.

so that the GDP gap is negative. then monetary policy targets the nominal Fed Funds rate at 4%. slide 19 .The Taylor Rule i f   + 2 + 0.5(  2)  0.5(GDP Gap) • If  = 2 and output is at its natural rate. • If GDP rises above its natural level. policy is automatically tightened . • For each one-point increase in . mon. the fed fund rate rises accordingly.

Does Greenspan follow the Taylor Rule? 12 The Federal Funds Rate Actual and Suggested Actual Taylor's rule Percent 10 8 6 4 2 0 1987 1990 1993 1996 1999 2002 slide 20 .

Central Bank Independence • A policy rule announced by Central Bank will work only if the CB is independent of the government. • Researchers found there is no relationship between central bank independence and real economic activity slide 21 . • Credibility depends in part on degree of independence of central bank.

5 3 3.Inflation and Central Bank Independence Average Average 9 inflation in½ ation Spain 8 New Zealand Italy United Kingdom Denmark Australia France/Norway/Sweden 7 6 5 Belgium 4 Japan Canada Netherlands Switzerland Germany 3 2 0.5 United States 1 1.5 4 4.5 Index of c entral-bank independ Index of central bank independence slide 22 .5 2 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. Advocates of active policy believe:  frequent shocks lead to unnecessary fluctuations in output and employment  fiscal and monetary policy can stabilize the economy 2.Chapter summary 1. employment slide 23 .

Chapter summary 3. 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 slide 24 . Advocates of discretionary policy believe:  discretion gives more flexibility to policymakers in responding to the unexpected 4.