Chapter 16: Stabilization Policy - Lecture Notes | ECON 62021, Study notes of Economics

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Chapter 16 “Stabilization Policy” 16.1 Output Fluctuations The output gap is designed to measure the volatility of an economy over time -15 These fluctuations tend to be fairly large -16 The obvious question is what can the government do to decrease the volatility of the business cycle -17 It would seem that government could offset an output gap by manipulating aggregate demand -18 This is primarily done through changes in government spending, taxes, and/or interest rates -19 It appears that government should be able to stabilize output, with the only side effect being changes in the price level -20 This idea, that the government could stabilize the business cycle, grew from Keynesian economics and was popular in the US in the 50s and 60s -21 Events in the 70s and 80s led economists to question the validity of stabilization policy 16.2 General Arguments Against Stabilization Policy Uncertainty is a barrier to effective stabilization policy -22 It can be difficult to determine whether supply or demand shifted -23 If a government guesses wrong, it can exacerbate the problem Policy-Making Lags -24 Both monetary and fiscal policy are subject to long lags -25 Lags can be categorized in three ways: informational lags, decision lags, and implementation lags -26 Informational lags take place because economic data sometimes isn’t available for months after events -27 A decision lag is the time it takes to make a policy decision once the information has been gathered -28 For monetary policy, the decisions can be made quickly; fiscal policy usually has much longer decision lags -29 Implementation lags deal with the time it takes for a policy to effect the economy -30 Empirical estimates suggest it takes around two years to reach the peak impact of fiscal and monetary policy Problems With Fiscal Policy -31 Fiscal policy is not particularly well-suited to sharp changes -32 Budgets are often prepared years in advance, and many segments of government need steady funding -33 Fiscal policy may also be focused on long-term objectives (long-run growth, income equality, etc); constantly changing policies can undermine the achievement of these goals Ricardian Equivalence -34 It is also possible that consumers will not respond to changes in fiscal policy as governments predict -35 Unless the multiplier is predictable and stable, fiscal policy may not produce the changes it intends to Consumer Expectations -36 Consumers may respond differently if they perceive a change to be temporary as opposed to permanent -37 This adds additional uncertainty as to the effects of fiscal policy Crowding Out 16.5Credibility – The Goods News About Shifting Expectations If expectations are adjusted, an economy should be able to lower inflation without much cost -15 A measure of this is the “sacrifice ratio”, the percentage increase in unemployment brought about by a 1% decrease in inflation -16 In practice, disinflation is not costless; people adjust their expectations, but it takes time -17 The credibility of a government will affect how long it takes for people to adjust their expectations 16.6Time Inconsistency Time inconsistency is when your stated plan may no longer be optimal when the future comes -15 An example is the US policy of not negotiating with terrorists. It obviously makes sense to say this up front. However, if a terrorists kidnaps US citizens, it may be optimal in the short-term for the US to negotiate -16 The same idea holds true with monetary policy. A central bank may state it is going to disinflate an economy. If people quickly adjust their expectations, now the central bank could choose not to disinflate and gain the trade-off from the Phillips curve: lower unemployment Monetary Policy As A Game -17 Monetary policy can be modeled as a game, with the central bank and the private sector as the two players -18 The situation becomes one similar to the Prisoner’s Dilemma. In this case, the government will choose the same response regardless of the private sector’s response: high inflation -19 This is an argument against discretionary policy, and provides a rationale for an independent central bank Central Bank Independence -20 A way to solve the problem of time inconsistency is to set up a central bank whose primary goal is controlling inflation, without any reference to unemployment -21 From our game described above, a central bank concerned only with price levels will always choose low inflation regardless of the private sector’s response -22 This prediction holds true in the data: countries with strong, independent banks have substantially lower inflation rates 16.7Rules Versus Discretion There are three broad arguments that a government may benefit from rule-based policymaking as opposed to discretionary policymaking - 1) Problems in obtaining correct information and the other lags of stabilization policy -15 2) Offsetting effects of crowding out -16 3) Time inconsistency -17 These arguments have been persuasive enough that most countries do not attempt to use fiscal and monetary policy to fine-tune the economy -18 Monetary policy is now focused primarily on inflation -19 Fiscal policy is rarely used to smooth the business cycle -20 One problem is the time inconsistency associated with fiscal policy. Surpluses should be used to pay back the accumulated deficits. However, policymakers face obvious temptations to spend these surpluses. -21 This is what has driven some to seek balanced budget amendments -22 A yearly balanced budget is probably not feasible; a better requirement might be to have a budget balanced over 5 to 10 years -23 Also, monetary policy should not be locked into only focusing on inflation; if an economy is in recession, it makes sense to use monetary policy to stimulate the economy while also watching inflation