Stabilization Policy - Lecture Notes | ECON 161, Study notes of Economics

Download Stabilization Policy - Lecture Notes | ECON 161 and more Study notes Economics in PDF only on Docsity! Chapter 13 1 Final Lecture Notes: Chapter 13: Stabilization Policy J. Bradford DeLong Economic Policy Institutions Monetary policy in the United States is made by the Federal Reserve, which is our central bank. In other countries the central bank bears a different name. The most common is the name of its country: the central bank of country X is probably named "The Bank of X." The principal policy-making body of the Federal Reserve system is its Federal Open Market Committee [FOMC]. It is the FOMC that lowers and raises interest rates, and that increases and decreases the money supply. The Federal Reserve's Board of Governors can alter bank regulations, and can and raise or lower the interest rate at which the Federal Reserve itself lends to banks and businesses. But most of the time it is the FOMC that plays the leading role within the Federal Reserve. Today the Federal Reserve is the most important organization making macroeconomic policy. Because monetary policy is the most powerful tool for stabilizing the economy, the Federal Reserve plays the leading role in stabilization policy. Fiscal policy plays second fiddle. This institutional division of labor is probably the correct one. Over the past 50 years in the United States monetary policy has proven itself to be more powerful, faster-acting, and more reliable than fiscal policy. The Federal Reserve The Federal Reserve has a central office and twelve regional offices. Its central office is the Board of Governors, comprised of a Chair, a Vice Chair, and five Governors, all of them nominated by the President and confirmed by the Senate. The Board of Governors' offices are in Washington D.C. Chapter 13 2 Final The Federal Reserve’s twelve regional offices are the twelve Federal Reserve Banks. They are scattered around the country. There are Federal Reserve Banks in San Francisco, Minneapolis, Dallas, Kansas City, St. Louis, Chicago, Cleveland, Atlanta, Richmond, Philadelphia, New York, and Boston. The members of the Board of Governors and the Presidents of the twelve regional Federal Reserve Banks meeting together make up the Federal Open Market Committee [ FOMC], which is the principal policy-making body. The Chair, the Vice Chair, the other five Governors, and the President of the Federal Reserve Bank of New York are always voting members of the FOMC. The eleven Presidents of the other Federal Reserve Banks alternate. At any moment four of them are voting members and seven of them are non- voting members of the FOMC. The Federal Reserve was created just before World War I. Its Congressional architects feared that a unitary central bank based in Manhattan would pay too much attention to the interests of bankers and financiers and not enough attention to the interests of merchants and producers. A near-century of experience, however, suggests that they were wrong: bankers in St. Louis think like bankers in New York. The Federal Reserve failed to handle its first great crisis, the Great Depression that started in 1929. Depending on who you believe, the Federal Reserve either did nothing to help cure the Great Depression, or it made things much worse and played a major role in causign the Great Depression. Since World War II, however, the Federal Reserve has done a much better job: there has been no repeat of the Great Depression. The Federal Reserve's performance in the 1970s is generally regarded as inadequate. The 1970s were a decade of rising inflation and relatively high unemployment. Today, after two straight decades in the 1980s and 1990s of very successful monetary stabilization policy, the prestige of the Federal Reserve is high. It has almost unlimited freedom to conduct monetary policy as it wishes. Few outside the organization wish to challenge its judgments or decisions. The FOMC tries to reach its decisions by consensus. If a consensus cannot be achieved, the members of the FOMC are more likely to postpone the issue than to make a decision that some substantial minority of its members oppose. However, once the FOMC decides on a change in policy that change is implemented immediately. It takes only minutes for Chapter 13 5 Final The Budget Process Departments plan Congress considers and votes on spending bills Congressional committees accept, amend, and reject Presidential budget proposals Congress passes its budget resolution President adds his priorities and submits a budget to the Congress Departments negotiate with the President's Office of Management and Budget Presidential vetoes? Continuing resolutions? Government shutdowns? Legend: The process by which the Congress and the President make fiscal policy is arcane and byzantine. Some broad classes of expenditure, called "mandatory," are the result of open-ended long-term government commitments, and continue whether or not Congress explicitly appropriates money for them in the current year. Social Security, Medicare, Medicaid, unemployment insurance, food stamps, and so forth fall into this category of so-called "mandatory" spending. Other broad classes of expenditure, called "discretionary," must be explicitly appropriated by Congress in each fiscal year. Defense spending, the National Park Service, NASA, the National Institutes of Health, highway spending, education spending, and so forth fall into this category of so-called "discretionary" spending. Chapter 13 6 Final Early in one fiscal year the Executive Branch departments and agencies that administer federal programs begin planning for the next. Throughout the fall they negotiate with the President's Executive Office--the Office of Management and Budget. The end of these negotiations, modified by the President's own priorities, becomes the President's budget submission to the Congress in January. The Congress considers the President's budget request, conducts its own internal debates, and by the end of April is supposed to have passed a budget resolution giving spending targets for broad classes of expenditure. Using the budget resolution as a guide, the Congress alters and amends the laws that control mandatory spending, alters and amends and tax code, and passes the appropriations bills necessary for discretionary spending. By the end of September all of the appropriations bills are supposed to have been passed, so that the new fiscal year can begin with the pieces of the government knowing what and how much should be spent over the next twelve months. More often than not, however, Congress fails to pass or the President vetoes one or more appropriations bills. In that case the government continues more-or-less on autopilot if the Congress passes and the President signs a continuing resolution until the appropriations bill is passed. If they don’t, the government "shuts down." Discretionary spending is cut back to the bone. Non-essential employees are sent home. The Washington Monument and other major tourist attractions are closed. Government office buildings are inhabited by only a skeleton crew of key functionaries and unpaid interns until the Congress and the President reach agreement, and pass and sign the appropriations bills necessary for the government's discretionary spending programs to go forward. However, even during a government "shut down," most of what the government does continues. Mandatory spending does not have to be explicitly appropriated every year, and continues even if there is total gridlock in Washington. The lesson to draw from this overview is that making fiscal policy in the United States is complicated, baroque, and time-consuming. The inside lag--the time between when a policy proposal is made and when it becomes effective--for fiscal policy is measured in years. By contrast, the "inside lag" associated with FOMC-decided changes in monetary policy is measured in days, weeks, or at most two months. The FOMC can turn on a dime. The Congress and the President cannot. This is a key advantage that makes the Chapter 13 7 Final Federal Reserve more effective at undertaking stabilization policy to manage aggregate demand. The History of Economic Policy The government did not always see itself as being responsible for stabilizing the economy and taming the business cycle. It accepted this responsibility in the Employment Act of 1946, which: • established Congress’s Joint Economic Committee. • established the President's Council of Economic Advisers. • called on the President to estimate and forecast the current and future level of economic activity in the U.S. • announced that it was the "continuing policy and responsibility" of the federal government to "coordinate and utilize all its plans, functions, and resources... to foster and promote free competitive enterprise and the general welfare; conditions under which there will be afforded useful employment for those able, willing, and seeking to work; and to promote maximum employment, production, and purchasing power." Passage of the Employment Act marked the rout of the belief that the government could not stabilize the economy and should not try to do so. In this view, monetary and fiscal policies to fight recessions would keep workers and firms producing in unsustainable lines of business and levels of capital intensity, and would make the depression less deep only at the price of making it longer. This doctrine that in the long run even deep recessions like the Great Depression would turn out to have been "good medicine" for the economy drew anguished cries of dissent even before World War II. John Maynard Keynes tried to ridicule this "crime and punishment" view of business cycles, concluding that he did not see how "universal bankruptcy could do us any good or bring us any nearer to prosperity…" Indeed, it was largely due to Keynes's writings, especially his General Theory of Employment, Interest and Money, that economists and politicians became convinced that the government could halt depressions and smooth out the business cycle. But Keynes was not alone. For example, Ralph Hawtrey, an advisor to the British Treasury and the Bank of England, called it the equivalent of "crying, 'Fire! Fire!' in Noah's flood." But you still can see traces of this view in economics in places (like the real business cycle theories discussed at the end of chapter 7). The high water mark of confidence that the government could and would manage to use its macroeconomic policy tools to stabilize the economy came in the 1960s. In that decade President Johnson’s chief economic advisor, Walter Heller, wrote of the New Dimensions of Political Economy that had been opened by the Keynesian Revolution. The Department of Congress changed the title of its Business Cycle Digest to the Business Conditions Digest--because, after all, the business cycle was dead. Chapter 13 10 Final The leading indicator that has been most closely watched is the money supply. Before the instability of the 1980s monetarists used to claim that the appropriate measure of the money stock is the only leading indicator worth watching. If the central bank could guide the money stock to the appropriate level through open market operations, then success at managing the economy will immediately and automatically follow. Different measures of the money stock say different things about monetary policy. Republican Party critics of Alan Greenspan continue to blame his tight money policies for George H.W. Bush’s defeat in the presidential election of 1992: during that year M3 grew by less than one percent. Supporters of Greenspan’s point to the extraordinarily- rapid growth of M1 (and short-term real interest rates of less than zero) as evidence of extraordinarily stimulative recession-fighting monetary policy. To say that the money stock is the single most important leading indicator is unhelpful if different measures of “the” money stock say different things. Chapter 13 11 Final Different Measures of the Money Stock Behave Differently Annual Growth Rates of Money Stock Measures -5% -3% -1% 1% 3% 5% 7% 9% 11% 13% 15% 1980 1985 1990 1995 2000 Year M1 M2 M3 Legend: Since 1980 the different measures of the money stock have ceased to move together. A year (like 1996) in which M1 falls can also see M3 grow, with a difference between the two of more than ten percentage points per year. Source: Economic Report of the President, It is much harder to be a monetary economist than it used to be. Even if economists have good reliable forecasts, changes in macroeconomic policy affect the economy with long lags and have variable effects. Estimates of the slope of the IS Chapter 13 12 Final curve are imprecise: this isn’t rocket science, after all. Economists are estimating the reactions of human beings to changes in the incentives to undertake different courses of action. They are not calculating the motions of particles that obey invariant and precisely- known physical laws. Moreover, changes in interest rates take time to affect the level of aggregate demand and real GDP. It takes time for corporate investment committees to meet and evaluate how changes in interest rates change the investment projects they wish to undertake. It takes time for changes in the decisions of corporate investment committees to affect the amount of work being done in building up the country’s capital stock. It takes time for the changes in employment and income generated by changes in investment to feed through the multiplier process, and have their full effect on equilibrium aggregate demand. Thus the level of total product now is determined not by what long-term real risky interest rates are now, but by what long-term real risky interest rates were more than a year and a half ago. As more than one member of the FOMC has said, making monetary policy is like driving a car that has had its windshield painted black. You guess which way you want to go by looking in the rear-view mirror at the landscape behind. The fact that the Federal Reserve’s decision and action cycle is shorter than that of the President and Congress means that the Federal Reserve can if it wishes neutralize the effects of any change in fiscal policy on aggregate demand. As a rule, today’s Federal Reserve does routinely neutralize the effects of changes in fiscal policy. Swings in the budget deficit produced by changes in tax laws and spending appropriations have little impact on real GDP unless the Federal Reserve wishes them to. Fiscal Policy: Automatic Stabilizers There is, however, one kind of fiscal policy that does work rapidly enough to be important. The so-called "fiscal automatic stabilizers" swing into action within three months to moderate business cycle-driven swings in disposable income and so moderate the business cycle. Whenever the economy enters a recession or a boom, the government's budget surplus or deficit begins to swing in the opposite direction. As the economy enters a boom, tax Chapter 13 15 Final before the elections. He urged strongly that everything possible be done to avert this development... by loosening up on credit and... increasing spending for national security. The next time I saw the President, I discussed Burns’ proposals with him, and he in turn put the subject on the agenda for the next cabinet meeting. "The matter was thoroughly discussed by the Cabinet....[S]everal of the Administration’s economic experts who attended the meeting did not share [Burns's] bearish prognosis....[T]here was strong sentiment against using the spending and credit powers of the Federal Government to affect the economy, unless and until conditions clearly indicated a major recession in prospect. "In supporting Burns’ point of view, I must admit that I was more sensitive politically than some of the others around the cabinet table. I knew from bitter experience how, in both 1954 and 1958, slumps which hit bottom early in October contributed to substantial Republican losses in the House and Senate.... "Unfortunately, Arthur Burns turned out to be a good prophet. The bottom of the 1960 dip did come in October.... In October... the jobless roles increased by 452,000. All the speeches, television broadcasts, and precinct work in the world could not counteract that one hard fact." By 1972 Richard Nixon was President, and he had appointed Arthur Burns to be Chair of the Federal Reserve. The year 1972 saw very good economic statistics-- at the price of a sharp acceleration of inflation in subsequent years. Given the smoking gun provided by Nixon in Six Crises, many have diligently searched for evidence that the Federal Reserve made economic policy in 1971 and 1972 not in the public interest but to enhance the private political interest of Richard Nixon. However, things are more complicated. Economist Herbert Stein pointed out that Nixon administration economic policy was in fact less expansionary than many Democratic politicians and economic advisors wished: the claim that Burns was leaning to the expansionary side of the center of gravity of opinion is simply not correct. And once Arthur Burns had become Chair of the Federal Reserve, Nixon administration officials found him to be truly and annoyingly independent. Chapter 13 16 Final The verdict is that Richard Nixon dearly wished for the Federal Reserve to tune economic policies in a way that would enhance his reelection chances, but that the institutional independence of the Federal Reserve worked. White House political pressure in 1971-1972 led to little if any change in Federal Reserve policy. Details: Is There in Fact a Political Business Cycle? Few would dispute that politicians seek to tune the macroeconomy to their political advantage. The Bush administration tried to persuade Federal Reserve Chair Alan Greenspan to pursue a more expansionary monetary policy in 1991 to produce better economic numbers for the George Bush reelection campaign in 1992, going as far as threatening not to nominate Greenspan for a second term as Federal Reserve Chair. But it was unsuccessful. Richard Nixon certainly believed when he appointed Arthur Burns to be Fed Chair that Burns would still be the loyal partisan supporter he had been in 1960--contemplating this appointment Nixon referred to the "myth of the autonomous Fed" and laughed. But how successful are governments at manipulating the political business cycle? It is not clear. It is true that in the United States since 1948 the fourth year of a President's term--the Presidential election year--has seen annual real GDP growth average 0.6% more than the average of non-Presidential election years. But there is a fifteen percent probability that at least that large a difference would emerge from random chance and sampling variation alone. Faster growth in Presidential election years is suggestive, but not conclusive. Moreover, other ways of looking at the data deliver even less evidence. Out of twelve post-1948 Presidential terms, fully six--Johnson, Nixon-Ford, Carter, Reagan II, Bush, and Clinton I--saw slower economic growth in the politically- relevant second half of the term than in the first half of the term. This alternative way of looking at the data provides not even a suggestion of evidence one way or another. And it is important when analyzing any situation not to choose to look only at the data in the way that makes one's preferred conclusion appear the strongest. There is, however, stronger evidence not of a politically-motivated component to the business cycle but of a politics-influenced component to the business cycle. In Chapter 13 17 Final all seven post-WWII Presidential terms in which Republicans have occupied the White House, growth in the second year of a Presidential term has been lower than average real GDP growth over that term. By contrast, in only one of the six terms in which Democrats have occupied the White House has second-year growth been lower than average. The odds against this pattern happening are astronomical: there is less than one chance in a thousand that it could be the result of random sampling variation. Economist Alberto Alesina interprets this pattern as showing that the political parties have--or had, for Clinton is the Democratic President for whom the pattern of growth fits the Republican model--different views of the relative costs of unemployment and inflation. Republicans have more tolerance for unemployment and less tolerance for inflation than Democrats do. Hence when Republicans come into office the Federal Reserve feels more free to try to push inflation down to a lower level. Because a considerable portion of inflation expectations relevant for the second year of a Presidential term were formed back before the result of the election is known, actual inflation in the second year of a term is less than expected inflation and so economic growth is relatively low. Chapter 13 20 Final Independence and Macroeconomic Performance", Journal of Money, Credit and Banking. Credibility and Commitment There is always a temptation for the central bank to pursue a more expansionary monetary policy: More expansionary policy raises national product and reduces the unemployment rate. Moreover, it has little impact on inflation in the short run in which expectations of inflation are more-or-less fixed. In the short run, expansionary monetary policy does always seem to be a central bank's best option. Suppose firms and unions agree on large nominal wage and price increases. Then in the short-run it is best for the central bank to accomodate inflation and expand the money supply. To fight inflation by raising interest rates would generate a recession, and inflation would continue anyway. Suppose instead that firms and unions decide on wage and price restraint. Expansionary monetary policy is still better--inflation will be low, and the economy will boom. In either case, pursuing a more expansionary monetary policy produces a better short-run outcome. Moreover, announcing that monetary policy will be more restrictive produces a better short-run outcome as well, for by announcing that fighting inflation is job one the central bank may influence the expectations of workers, managers, investors, and households. So why--given the obvious short-run benefits of a more expansionary monetary policy-- should anyone ever believe that a central bank will aim for low inflation? Yet in the long run, it is surely the case that a central bank is wiser to keep low inflation as its top priority. Central banks benefit if workers, firms, and investors all believe that future inflation will be low. A central bank that succumbs to the temptation to make inflation higher than expected loses its credibility. All will soon recognize that the central bank's talk is cheap, and that it has a strong incentive once expectations relevant to a period of time are formed to make inflation and money growth higher than expected. So the central bank will find that its words about future policy are ignored in the process of setting expectations. And expectations of inflation will be sky-high. Chapter 13 21 Final Economists give this conflict the awkward name of "dynamic inconsistency": what it is good to have workers, managers, investors, and employers believe that you will do in the future is not what seems best to do when the future becomes the present. Many economists have argued that this dynamic inconsistency problem is a strong point on the side of rules rather than authorities: you don't have to worry about a rule breaking its word. Others have pointed out that central banks that are concerned with their long-term reputation and credibility appear to have little problem resisting the temptation to make inflation and money growth higher than the firms and workers in the economy had expected. And they have little problem acquiring credibility, which they do in many ways including: : • complaining that inflation may be rising. • refusing to admit even the possibility that monetary expansion might reduce unemployment. • repeatedly declaring that price stability is the primary objective. The most important way to acquire credibility is to possess a history of past successful control of inflation. Modern Monetary Policy Whether monetary policy is guided by strict and rigid rules, or made by authorities using their discretion to come up with the best policy for the particular--unique--situation, one question remains: what sort of rule should be adopted, or how should the authority behave? What sort of guidelines for monetary policy should those who set the rules or those who staff the authorities follow? Economists believe that one set of rules to avoid are those that command the central bank to attain values for real economic variables, like the rate of growth of real GDP or the level of the unemployment rate. The rate of growth of real GDP is limited in the long run by the rate of growth of potential output. The level of the unemployment rate is in the long run controlled by the natural rate of unemployment. A central bank target of too high a rate of real GDP growth, or too low a level of the unemployment rate, is likely to end in upward spiraling inflation. A policy that targets nominal variables--like the nominal money stock, or nominal GDP, or the inflation rate--is robust, in the sense that it Chapter 13 22 Final does not run the risk of leading to disaster if our assessment of the macroeconomic structure of the economy turns out to be wrong. Extreme Situations: Financial Crises Open market operations are not the only tool by which the government affects the economy. Because the long-term interest rate is an average of expected future short-term interest rates, expectations of future Federal Reserve policy--closely tied to central-bank credibility--are also important influences on aggregate demand today. Even more important, however, are the existence of deposit insurance to insulate bank depositors from the effects of financial crises, and the expectation that should a financial crisis become deep enough the Federal Reserve will act as a lender of last resort. In extreme situations such alternative policy levers become important tools to try to stem depressions. For nearly four hundred years market economies have undergone financial crises-- episodes when the prices of stocks or of other assets crash, everyone tries to move their wealth into safer forms at once, and the consequent panic among investors can lead to a prolonged and serious depression. Managing such financial crises has been one of the responsibilities of monetary policy makers for more than a century and a half. A financial crisis--like the financial panics in East Asia in 1998--sees investors as a group suddenly (and often not very rationally) become convinced that their investments have become overly risky. As a result, they try to exchange their investments for high-quality bonds and cash. But as everyone tries to do this at once, they create the risk that they hoped to avoid: stock and real estate prices crash, and interest rates spike upward as everyone tries to increase their holdings of relatively safe, liquid assets. The sharp rise in real interest rates that occurs in a financial crisis can severely reduce investment, and send the economy into a deep depression. Moreover, once the crisis gathers force the ability of monetary policy tools to boost investment may well be limited. Financial crises are accompanied by steep rises in risk premiums. They are often accompanied by sharp rises in term premiums as well, as investors decide that they want to hold their wealth in as liquid a form as possible. And financial crises frequently generate deflation as well.