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Chapter 15: Stabilization Policy Should Policy Be Active Or Passive?

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Chapter 15: Stabilization Policy Should Policy Be Active Or Passive? 11/6/2013 Question 1: Should policy be active or Chapter 15: Stabilization Policy passive? CHAPTER 15 Stabilization Policy 0 CHAPTER 15 Stabilization Policy 1 Growth rate of U.S. real GDP Increase in unemployment during recessions Percent 10 increase in no. of change peak trough unemployed persons from 4 8 (millions) quarters July 1953 May 1954 2.11 earlier 6 Aug 1957 April 1958 2.27 April 1960 February 1961 1.21 Average 4 growth December 1969 November 1970 2012.01 rate 2 November 1973 March 1975 3.58 January 1980 July 1980 1.68 0 July 1981 November 1982 4.08 July 1990 March 1991 1.67 -2 March 2001 November 2001 1.50 -4 1970 1975 1980 1985 1990 1995 2000 2005 2010 Increase from 12/2007 thru 6/2009: 7.2 million!!! Arguments for active policy Arguments against active policy Policies act with long & variable lags, including: . Recessions cause economic hardship for millions of people. inside lag: the time between the shock and the policy response. The Employment Act of 1946: . takes time to recognize shock “It is the continuinggp policy and resp onsibility of the . takes time to implement policy, Federal Government to…promote full employment especially fiscal policy and production.” outside lag: . The model of aggregate demand and supply the time it takes for policy to affect economy. (Chaps. 9-13) shows how fiscal and monetary policy can respond to shocks and stabilize the If conditions change before policy’s impact is felt, economy. the policy may destabilize the economy. CHAPTER 15 Stabilization Policy 4 CHAPTER 15 Stabilization Policy 5 1 11/6/2013 Automatic stabilizers Forecasting the macroeconomy . definition: Because policies act with lags, policymakers must policies that stimulate or depress the economy predict future conditions. when necessary without any deliberate policy change. Two ways economists generate forecasts: . Leading economic indicators . Designed to reduce the lags associated with stabilization policy. data series that fluctuate in advance of the economy . Examples: . Macroeconometric models . income tax Large-scale models with estimated parameters . unemployment insurance that can be used to forecast the response of . welfare endogenous variables to shocks and policies CHAPTER 15 Stabilization Policy 6 CHAPTER 15 Stabilization Policy 7 The LEI index and real GDP, 1960s The LEI index and real GDP, 1970s 20 20 The Index of 15 Leading 15 10 Economic 10 5 Indicators 5 0 includes 10 entage change entage change c c -5 data series 0 -10 -5 (see p.258 ). -15 annual per annual per -10 -20 1960 1962 1964 1966 1968 1970 1970 1972 1974 1976 1978 1980 source of LEI data: Leading Economic Indicators source of LEI data: Leading Economic Indicators The Conference Board Real GDP The Conference Board Real GDP CHAPTER 15 Stabilization Policy 8 CHAPTER 15 Stabilization Policy 9 The LEI index and real GDP, 1980s The LEI index and real GDP, 1990s 20 15 15 10 10 5 5 0 0 entage change entage change c c -5 -5 -10 -10 -15 annual per annual per -20 -15 1980 1982 1984 1986 1988 1990 1990 1992 1994 1996 1998 2000 2002 source of LEI data: Leading Economic Indicators source of LEI data: Leading Economic Indicators The Conference Board Real GDP The Conference Board Real GDP CHAPTER 15 Stabilization Policy 10 CHAPTER 15 Stabilization Policy 11 2 11/6/2013 Mistakes forecasting the 1982 recession Forecasting the macroeconomy Because policies act with lags, policymakers must predict future conditions. The preceding slides show that the loyment rate loyment p forecasts are often wrong. Unem This is one reason why some economists oppose policy activism. CHAPTER 15 Stabilization Policy 13 The Lucas critique An example of the Lucas critique . Due to Robert Lucas . Prediction (based on past experience): who won Nobel Prize in 1995 for rational An increase in the money growth rate will reduce expectations. unemployment. Forecasting the effects of policy changes has . The Lucas critique points out that increasing the often been done using models estimated with money growth rate may raise expected inflation, historical data. in which case unemployment would not necessarily fall. Lucas pointed out that such predictions would not be valid if the policy change alters expectations in a way that changes the fundamental relationships between variables. CHAPTER 15 Stabilization Policy 14 CHAPTER 15 Stabilization Policy 15 The Jury’s out… Question 2: Looking at recent history does not clearly answer Question 1: Should policy be conducted by . It’s hard to identify shocks in the data. rule or discretion? . It’s hard to tell how outcomes would have been different had actual policies not been used. CHAPTER 15 Stabilization Policy 16 CHAPTER 15 Stabilization Policy 17 3 11/6/2013 Rules and discretion: Arguments for rules Basic concepts . Policy conducted by rule: 1. Distrust of policymakers and the political Policymakers announce in advance how process policy will respond in various situations, . misinformed politicians and commit themselves to following through. politicians’ interests sometimes not the same . Policy conducted by discretion: as the interests of society As events occur and circumstances change, policymakers use their judgment and apply whatever policies seem appropriate at the time. CHAPTER 15 Stabilization Policy 18 CHAPTER 15 Stabilization Policy 19 Arguments for rules Examples of time inconsistency 1. To encourage investment, 2. The time inconsistency of discretionary govt announces it will not tax income from capital. policy But once the factories are built, . def: A scenario in which policymakers govt reneges in order to raise more tax revenue. have an incentive to renege on a previously announced policy once others have acted on that announcement. Destroys policymakers’ credibility, thereby reducing effectiveness of their policies. CHAPTER 15 Stabilization Policy 20 CHAPTER 15 Stabilization Policy 21 Examples of time inconsistency Examples of time inconsistency 2. To reduce expected inflation, 3. Aid is given to poor countries contingent on fiscal the central bank announces it will tighten reforms. monetary policy. The reforms do not occur, but aid is given But faced with high unemployment, anyway, because the donor countries do not want the central bank may be tempted to cut interest the poor countries’ citizens to starve . rates. CHAPTER 15 Stabilization Policy 22 CHAPTER 15 Stabilization Policy 23 4 11/6/2013 Monetary policy rules Monetary policy rules a. Constant money supply growth rate a. Constant money supply growth rate . Advocated by monetarists. b. Target growth rate of nominal GDP . Stabilizes aggregate demand only if velocity . Automatically increase money growth is stable. whenever nominal GDP grows slower than targeted; decrease money growth when nominal GDP growth exceeds target. CHAPTER 15 Stabilization Policy 24 CHAPTER 15 Stabilization Policy 25 Monetary policy rules Central bank independence a. Constant money supply growth rate . A policy rule announced by central bank will work only if the announcement is credible. b. Target growth rate of nominal GDP . Credibility depends in part on degree of c. Target the inflation rate independence of central bank. AtAutoma tilltically re duce money grow thhth whenever inflation rises above the target rate. Many countries’ central banks now practice inflation targeting, but allow themselves a little discretion. CHAPTER 15 Stabilization Policy 26 CHAPTER 15 Stabilization Policy 27 Inflation and central bank independence Chapter 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 erage inflation v a 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 index of central bank independence 5 11/6/2013 Chapter 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 6.
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