Stabilization Policy

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Stabilization Policy: Challenges

             Dr. Qianwei Ying


          Chap 17 and Chap 19
      Learning Objectives

 Two Different Explanations on Great Depression
 Two policy Debates
1. Should policy be active or passive?
   Lags, Uncertainty, Lucas critique
2. Should policy be by rule or discretion?
   Time inconsistency problem
   Political Business Cycle Problem
   Monetary Policy Rules

                                                   slide 1
                                 The Great Depression
                           240                                            30
                                                     (right scale)
billions of 1958 dollars

                           220                                            25

                                                                                 percent of labor force
                           200                                            20

                           180                                            15

                           160                                            10

                           140                      Real GNP              5
                                                    (left scale)
                           120                                            0
                             1929   1931   1933   1935    1937     1939

                                                                              slide 2
      Shocks to the IS curve
 asserts that the Depression was largely due to
  an exogenous fall in the demand for goods &
  services – a leftward shift of the IS curve.
 evidence:
  output and interest rates both fell, which is what
  a leftward IS shift would cause.

                                                   slide 3
      Reasons for the IS shift
 Stock market crash  exogenous C
    Oct-Dec 1929: S&P 500 fell 17%
    Oct 1929-Dec 1933: S&P 500 fell 71%
 Drop in investment
    “correction” after overbuilding in the 1920s
    widespread bank failures made it harder to obtain
     financing for investment
 Contractionary fiscal policy
    Politicians raised tax rates and cut spending to
     combat increasing deficits.
                                                        slide 4
      A shock to the LM curve
 asserts that the Depression was largely due to
  huge fall in the money supply.
 evidence:
  M1 fell 25% during 1929-33.
 But, two problems with this hypothesis:
   P fell even more, so M/P actually rose slightly
     during 1929-31.
    nominal interest rates fell, which is the opposite
     of what a leftward LM shift would cause.

                                                     slide 5
      The effects of falling prices
 asserts that the severity of the Depression was
  due to a huge deflation:
     P fell 25% during 1929-33.
 This deflation was probably caused by the fall in
  M, so perhaps money played an important role
  after all.
 In what ways does a deflation affect the

                                                 slide 6
      The effects of falling prices
 The stabilizing effects of deflation:
 P  (M/P )  LM shifts right  Y
 Pigou effect:
     P      (M/P )
             consumers’ wealth 
             C
             IS shifts right
             Y
                                          slide 7
      The effects of falling prices
 The destabilizing effects of expected deflation:
   e
     r  for each value of i
     I  because I = I (r )
     planned expenditure & agg. demand 
     income & output 

                                                     slide 8
      The effects of falling prices
 The destabilizing effects of unexpected deflation:
  debt-deflation theory
P (if unexpected)
    transfers purchasing power from borrowers to
    borrowers spend less,
       lenders spend more
    if borrowers’ propensity to spend is larger than
       lenders’, then aggregate spending falls,
       the IS curve shifts left, and Y falls
                                                   slide 9
      Why another Depression is
 Policymakers (or their advisors) now know
  much more about macroeconomics:
    The Fed knows better than to let M fall
     so much, especially during a contraction.
    Fiscal policymakers know better than to raise
     taxes or cut spending during a contraction.
 Federal deposit insurance makes widespread
  bank failures very unlikely.
 Automatic stabilizers make fiscal policy
  expansionary during an economic downturn.
                                                     slide 10
      Two policy debates

1. Should policy be active or passive?
2. Should policy be by rule or discretion?

                                             slide 11
Question 1:

 Should policy be active or

                              slide 12
   Increase in unemployment during
                                    increase in no. of
   peak            trough         unemployed persons
     July 1953        May 1954           2.11
     Aug 1957        April 1958          2.27
    April 1960    February 1961          1.21
December 1969    November 1970           2.01
November 1973       March 1975           3.58
 January 1980         July 1980          1.68
     July 1981   November 1982           4.08
     July 1990      March 1991           1.67
   March 2001    November 2001           1.50

                                                    slide 13
      Arguments for active policy

 Recessions cause economic hardship for millions
  of people.
 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
  (Chaps. 9-11) shows how fiscal and monetary
  policy can respond to shocks and stabilize the
                                                     slide 14
      Arguments against active policy
Policies act with long & variable lags, including:
 inside lag:
 the time between the shock and the policy response.
    takes time to recognize shock
    takes time to implement policy (decide and action),
     especially fiscal policy
 outside lag:
 the time it takes for policy to affect economy.

    If conditions change before policy’s impact is felt,
         the policy may destabilize the economy.
                                                      slide 15
       Lags in the effects of Policy

Is the disturbance
permanent (or persistent)
or temporary?
    •Figure 17-1 illustrates
    a temporary aggregate
    demand shock
    • Today’s policy actions
    take time to have an

                                       slide 16
        Monetary Versus Fiscal Policy
 Fiscal policy directly impacts aggregate demand
    Affect income more rapidly than monetary policy
    Shorter outside lags than monetary policy
    Longer inside lags than monetary policy
• Long inside lags makes fiscal policy less useful for
   stabilization and used less frequently to stabilize the economy

It takes time to set the policies in action, and then the policies
          themselves take time to affect the economy.
    Further difficulties arise because policymakers cannot
            be certain about the size and the timing
                 of the effects of policy actions.              slide 17
    Case: The big fire of Yellow-Stone

    The Debate in the National Congress in 1988
                                                  slide 18
      Automatic stabilizers (No inside lag)

 Definition:
  policies that stimulate or depress the economy
  when necessary without any deliberate policy
 Designed to reduce the lags associated with
  stabilization policy.
 Examples:
   income tax
   unemployment compensation
                                                slide 19
           Uncertainty: Expectations and
    Government uncertainties about the effects of policies on the
     economy arise because:
    1. Policymakers do not know what expectations firms and
         consumers have
    2.   Government does not know the true model of the economy

     Work with econometric models of the economy in
         estimating the effects of policy changes
          An econometric model is a statistical description of the
            economy, or some part of it

                                                                 slide 20
       Reaction Uncertainties

 Suppose the government decides to cut taxes to stimulate a
  weak economy  temporary tax cut
                 How big of a cut is needed?
   One possibility: temporary tax cut will not affect long-term
    income, and thus not long-term spending  Large tax cut
   Alternatively: consumers may believe tax cut will last
    longer than announced, and MPC out of tax cut is larger 
    Smaller tax cut might be sufficient
   If the government is wrong about consumers’ reactions,
    it could destabilize rather than stabilize the economy.
                                                               slide 21
       Uncertainty and Economic Policy

 Policymakers can go wrong in using active stabilization policy
  due to:
    Uncertainty about the expectations of firms and consumers
    Difficulties in forecasting disturbances
    Lack of knowledge about the true structure of the economy
        Uncertainty about the correct model of the economy
        Uncertainty about the precise values of the parameters
         within a given model of the economy

                                                             slide 22

   Y  M
   Loss  0.5(Y  Y *) 2
                            Suppose the multiplier
                           can either be 0.5 or 1.5,
Suppose the monetary      and each appears with
policy multiplier is 1,    the probability 0.5,
Y*=3,What’s the            Y*=3,what’s the
optimal M?                 optimal M?

                                                slide 23
      Forecasting the macroeconomy

Because policies act with lags, policymakers must predict
future conditions.
Two ways economists 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

                                                              slide 24
      The Lucas critique

 Due to Robert Lucas
  who won Nobel Prize in 1995 for rational
 Forecasting the effects of policy changes has often
  been done using models estimated with historical data.
  E.g. Y*=G+  M
 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

                                                        slide 25
      An example of the Lucas critique

 Prediction (based on past experience):
  An increase in the money growth rate will reduce
 The Lucas critique points out that increasing the
  money growth rate may raise expected inflation,
  in which case unemployment would not
  necessarily fall.

                                                 slide 26
Looking at recent history does not clearly answer
Question 1:
  It’s hard to identify shocks in the data.
  It’s hard to tell how things would have been
   different had actual policies not been used.

Most economists agree, though, that the
U.S. economy has become much more stable
since the late 1980s…

                                                  slide 27
 Question 2:

Should policy be conducted by
     rule or discretion?

                            slide 28
      Rules and discretion:
      Basic concepts
 Policy conducted by rule:
  Policymakers announce in advance how
  policy will respond in various situations,
  and commit themselves to following through.
 Policy conducted by discretion:
  As events occur and circumstances change,
  policymakers use their judgment and apply
  whatever policies seem appropriate at the time.

                                                slide 29
      Arguments for rules

1. Distrust of policymakers and the political
     misinformed politicians
     politicians’ interests sometimes not the same
      as the interests of society

                                                  slide 30
       Arguments for rules

2. The time inconsistency of discretionary policy
    def: A scenario in which policymakers
       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.
       Kydland and Prescott Won 2004 Nobel Prize for their
       contribution on this topic

                                                              slide 31
     Examples of time inconsistency

1. To encourage investment,
  govt announces it will not tax income from capital.
  But once the factories are built,
  govt reneges in order to raise more tax revenue.

                                                  slide 32
      Examples of time inconsistency

2. To reduce expected inflation,
   the central bank announces it will tighten
   monetary policy.
   But faced with high unemployment,
   the central bank may be tempted to cut interest

                                                     slide 33
      Examples of time inconsistency

3. Aid is given to poor countries contingent on fiscal
  The reforms do not occur, but aid is given anyway,
  because the donor countries do not want the poor
  countries’ citizens to starve.

                                                    slide 34
       A Model Description of time
  Loss   (u  u*)  (  0)   2

         e   (u  u*)
                                      *        B   C
The optimal policy is     * 
                                2                  A
The expectation of inflation will finally be

         *

Is combination A better than combination C? Is A
potentially achievable?

Why the final equilibrium is at C but not A?
                                                         slide 35
      A Political Business Cycle?

 Some believe that the business cycle not only
  drives the political cycle but may be influenced
  by the political cycle.
 Politicians may try to time the economic cycle to
  match the election cycle.
 Central bank independence important here.

                                                  slide 36
A Political Business Cycle?

                              slide 37
     Monetary policy rules
a. Constant money supply growth rate
    Advocated by monetarists.
    Stabilizes aggregate demand only if velocity
     is stable.

                                                slide 38
     Monetary policy rules
a. Constant money supply growth rate

b. Target growth rate of nominal GDP
     Automatically increase money growth
      whenever nominal GDP grows slower than
      targeted; decrease money growth when
      nominal GDP growth exceeds target.

                                               slide 39
      Monetary policy rules
a. Constant money supply growth rate

b. Target growth rate of nominal GDP
c. Target the inflation rate
  Automatically reduce money growth whenever
  inflation rises above the target rate.
    Many countries’ central banks now practice
     inflation targeting, but allow themselves a little

                                                     slide 40
      Monetary policy rules
a. Constant money supply growth rate

b. Target growth rate of nominal GDP
c. Target the inflation rate
d. The Taylor rule:
   Target the federal funds rate based on
    inflation rate
    gap between actual & full-employment GDP

                                                slide 41
     The Taylor Rule

  iff =  + 2 + 0.5 ( – 2) – 0.5 (GDP gap)
 iff = nominal federal funds rate target
                 Y Y
 GDP gap = 100 x
           = percent by which real GDP
             is below its natural rate

                                              slide 42
               The federal funds rate:
               Actual and suggested

          10             Actual




           2                      Taylor’s Rule

           1987   1990     1993   1996    1999    2002   2005

                                                         slide 43