Stabilization Policy: Active vs. Passive and Rule vs. Discretion, Study notes of Economics

Download Stabilization Policy: Active vs. Passive and Rule vs. Discretion and more Study notes Economics in PDF only on Docsity! 1 m ac ro CHAPTER FOURTEEN Stabilization Policy CHAPTER 14 Stabilization Policy slide 1 Learning objectives In this chapter, you will learn about two policy debates: 1. Should policy be active or passive? 2. Should policy be by rule or discretion? CHAPTER 14 Stabilization Policy slide 2 Question 1: Should policy be active or passive? CHAPTER 14 Stabilization Policy slide 3 U.S. Real GDP Growth Rate, 1960:1-2001:4 -15 -10 -5 0 5 10 15 20 1960 1965 1970 1975 1980 1985 1990 1995 2000 p e rc e n t CHAPTER 14 Stabilization Policy slide 4 Arguments for active policy ß Recessions cause economic hardship for millions of people. ß The Employment Act of 1946: “it is the continuing policy and responsibility of the Federal Government to…promote full employment and production.” ß The model of aggregate demand and supply (Chapters 9-13) shows how fiscal and monetary policy can respond to shocks and stabilize the economy. CHAPTER 14 Stabilization Policy slide 5 Change in unemployment during recessions 2.11May 1954July 1953 1.67March 1991July 1990 4.08November 1982July 1981 1.68July 1980January 1980 3.58March 1975November 1973 2.01November 1970December 1969 1.21February 1961April 1960 2.27April 1958Aug 1957 increase in no. of unemployed persons (millions) troughpeak 2 CHAPTER 14 Stabilization Policy slide 6 Arguments against active policy 1. Long & variable lags inside lag: the time between the shock and the policy response ß takes time to recognize shock ß takes time to implement policy, 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. CHAPTER 14 Stabilization Policy slide 7 Automatic stabilizers ß definition: policies that stimulate or depress the economy when necessary without any deliberate policy change. ß They are designed to reduce the lags associated with stabilization policy. ß Examples: – income tax – unemployment insurance – welfare CHAPTER 14 Stabilization Policy slide 8 Forecasting the macroeconomy Because policies act with lags, policymakers must predict future conditions. Ways to 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 CHAPTER 14 Stabilization Policy slide 9 The LEI index and Real GDP, 1960s source of LEI data: The Conference Board The Index of Leading Economic Indicators includes 10 data series (see FYI box on p.383 ). -10 -5 0 5 10 15 20 1960 1962 1964 1966 1968 1970 an nu al p er ce nt ag e ch an ge Leading Economic Indicators Real GDP CHAPTER 14 Stabilization Policy slide 10 The LEI index and Real GDP, 1970s source of LEI data: The Conference Board -20 -15 -10 -5 0 5 10 15 20 1970 1972 1974 1976 1978 1980 an nu al p er ce nt ag e ch an ge Leading Economic Indicators Real GDP CHAPTER 14 Stabilization Policy slide 11 The LEI index and Real GDP, 1980s source of LEI data: The Conference Board -20 -15 -10 -5 0 5 10 15 20 1980 1982 1984 1986 1988 1990 an nu al p er ce nt ag e ch an ge Leading Economic Indicators Real GDP 5 CHAPTER 14 Stabilization Policy slide 24 Examples of Time-Inconsistent Policies Aid to poor countries is contingent on fiscal reforms. The reforms don’t occur, but aid is given anyway, because the donor countries don’t want the poor countries’ citizens to starve. CHAPTER 14 Stabilization Policy slide 25 Modeling Time-Inconsistent Policies Central Bank minimizes L(u, π) = u + γ π2 given P.C. u = un – α (π – πe) [see appendix] u π un πe Indifference curves Optimal discretion Phillips curves Optimal rule (better) CHAPTER 14 Stabilization Policy slide 26 Monetary Policy Rules a. Constant money supply growth rate ß advocated by Monetarists ß stabilizes aggregate demand only if velocity is stable CHAPTER 14 Stabilization Policy slide 27 Monetary Policy Rules b. Target growth rate of nominal GDP ß automatically increase money growth whenever nominal GDP grows slower than targeted; decrease money growth when nominal GDP growth exceeds target. a. Constant money supply growth rate CHAPTER 14 Stabilization Policy slide 28 Monetary Policy Rules c. Target the inflation rate ß automatically reduce money growth whenever inflation rises above the target rate. ß Many countries’ central banks now practice inflation targeting, but allow themselves a little discretion. a. Constant money supply growth rate b. Target growth rate of nominal GDP CHAPTER 14 Stabilization Policy slide 29 Monetary Policy Rules c. Target the inflation rate a. Constant money supply growth rate b. Target growth rate of nominal GDP d. The “Taylor Rule” Target Federal Funds rate based on ß inflation rate ß gap between actual & full-employment GDP 6 CHAPTER 14 Stabilization Policy slide 30 The Taylor Rule John Taylor has proposed the following monetary policy rule: i = π + 2 + 0.5(π – 2) + 0.5(Y – Y) where i = nominal interest rate (fed. funds rate) π = inflation (Y – Y) = the “output gap” CHAPTER 14 Stabilization Policy slide 31 The Taylor Rule ß If π = 2 and output is at its natural rate, then monetary policy targets the real Fed Funds rate at 2% (and the nominal rate at 4%). ß For each one-point increase in π, mon. policy is automatically tightened to raise the real Fed Funds rate by 0.5 ♣For each one percentage point that GDP falls below its natural rate, mon. policy automatically eases to reduce the Fed Funds Rate by 0.5. i = π + 2 + 0.5(π – 2) + 0.5(Y – Y) CHAPTER 14 Stabilization Policy slide 32 Does Greenspan follow the Taylor Rule? The Federal Funds Rate Actual and Suggested 0 2 4 6 8 10 12 1987 1990 1993 1996 1999 2002 P er ce n t Actual Taylor's rule CHAPTER 14 Stabilization Policy slide 33 Central Bank Independence ß A policy rule announced by Central Bank will work only if the announcement is credible. ß Credibility depends in part on degree of independence of central bank. CHAPTER 14 Stabilization Policy slide 34 Inflation and Central Bank Independence Index of central-bank independence Average inflation 4.543.532.521.510.5 9 8 7 6 5 4 3 2 Spain New Zealand Italy United Kingdom DenmarkAustralia France/Norway/Sweden Japan Canada NetherlandsBelgium United States Switzerland Germany Average inflation Index of central bank independence CHAPTER 14 Stabilization Policy slide 35 Chapter summary 1. Advocates of active policy believe: ß frequent shocks lead to unnecessary fluctuations in output and employment ß fiscal and monetary policy can stabilize the economy 2. Advocates of passive policy believe: ß the long & variable lags associated with monetary and fiscal policy render them ineffective and possibly destabilizing ß inept policy increases volatility in output, employment 7 CHAPTER 14 Stabilization Policy slide 36 Chapter summary 3. Advocates of discretionary policy believe: ß discretion gives more flexibility to policymakers in responding to the unexpected 4. Advocates of policy rules believe: ß the political process cannot be trusted: politicians make policy mistakes or use policy for their own interests ß commitment to a fixed policy is necessary to avoid time inconsistency and maintain credibility CHAPTER 14 Stabilization Policy slide 37