Mankiw 5/e Chapter 14: Stabilization Policy

Mankiw 5/e Chapter 14: Stabilization Policy

Topic 12: Stabilization Policy (chapter 14) Question 1: Should Shouldpolicy policybe be active activeor orpassive? passive? slide 2 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 topromote full employment and production. The model of aggregate demand and supply (Chapters 9-13) shows how fiscal and monetary policy can respond to shocks and stabilize the economy. slide 3 Arguments against active policy 1. Two lags >>Inside lag: the time between the shock and the policy response takes time to recognize shock takes time to implement policy, especially fiscal policy

Outside lag: the time it takes for policy to affect economy If conditions change before policys impact is felt, then policy may end up destabilizing the economy. slide 4 Forecasting the macroeconomy Because policies act with lags, successful stabilization policy requires the ability to predict accurately future economic conditions. Ways to generate forecasts: With leading indicators: data series that fluctuate in advance of the economy Standard Macro econometric models: Large-scale models with estimated parameters

that can be used to forecast the response of endogenous variables to shocks and policies slide 6 Mistakes Forecasting the Recession of 1982 Unemployment 11.0 rate (percent) 10.5 10.0 1982:4 9.5 9.0 1982:2 8.5

1981:4 1983:2 8.0 1983:4 7.5 1981:2 7.0 Actual 6.5 6.0 1980

1981 1982 1983 1984 1985 1986 Year slide 7 Forecasting the macroeconomy Because policies act with lags, policymakers must predict future conditions.

The The preceding preceding slides slides show show that that the the forecasts forecasts are are often often wrong. wrong. This This is is one one reason reason why

why some some economists economists oppose oppose policy policy activism. activism. slide 8 The Lucas Critique Due to Robert Lucas won Nobel Prize in 1995 for rational expectations Forecasting the effects of policy changes has often been done using models estimated with historical data.

Lucas pointed out that such predictions would not be valid if the policy change responds differently to peoples expectations to policy change. slide 9 An example of the Lucas Critique Prediction (based on past experience): an increase in the money growth rate will reduce unemployment The Lucas Critique points out that increasing the money growth rate may raise expected inflation, cost of reducing inflation is measured by sacrifice ratio. Which is the no. of % points of GDP that must be forgone to reduce inflation by 1 % point slide 10

The Jurys Out Looking at recent history does not clearly answer Question 1: Its hard to identify shocks in the data, and its hard to tell how things would have been different had actual policies not been used. slide 11 Question 2: Should Shouldpolicy policy be beconducted conductedby by

Rules Rulesor orDiscretion? Discretion? slide 12 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 13

Arguments for Rules 1. Distrust of Policymakers and the Political Process misinformed politicians politicians interests sometimes not the same as the interests of society slide 14 Arguments for Rules 2. The Time Inconsistency of Discretionary Policy def: policy makers may want to announce in advance the policy, but later after the private decision makers have acted on basis of their expectations, policy makers renege on their announcement.

Destroys policymakers credibility, thereby reducing effectiveness of their policies. slide 15 Examples of Time-Inconsistent Policies To encourage investment, government announces it wont tax income from capital. But once the factories are built, the govt reneges in order to raise more tax revenue. slide 16 Monetary Policy Rules a.Steady growth in MS would yield stable output ,employment and prices

b. Nominal GDP targeting when velocity is c not constant . Inflation targeting targetting c.Inflation d. Target Federal Funds rate based on inflation rate gap between actual & fullemployment GDP slide 17 The Taylor Rule i ff + 2 + 0.5( 2) 0.5(GDP Gap) where: i ff = nominal federal funds rate

Y Y GDP Gap = 100 Y = the percent by which real GDP is below its natural rate slide 18 The Taylor Rule i ff + 2 + 0.5( 2) 0.5(GDP Gap) If = 2 and output is at its natural rate, then monetary policy targets the nominal Fed Funds rate at 4%. For each one-point increase in , mon. policy is automatically tightened . If GDP rises above its natural level, so that the GDP gap is negative, the fed fund rate rises accordingly.

slide 19 Does Greenspan follow the Taylor Rule? 12 The Federal Funds Rate Actual and Suggested Actual Taylor's rule Percent 10 8 6 4

2 0 1987 1990 1993 1996 1999 2002 slide 20 Central Bank Independence A policy rule announced by Central Bank will work only if the CB is independent of the government.

Credibility depends in part on degree of independence of central bank. Researchers found there is no relationship between central bank independence and real economic activity slide 21 Inflation and Central Bank Independence Average Average 9 inflation in ation Spain

8 New Zealand Italy United Kingdom Denmark Australia France/Norway/Sweden 7 6 5 Belgium 4

Japan Canada Netherlands Switzerland Germany 3 2 0.5 United States 1 1.5 2

2.5 3 3.5 4 4.5 Index of central-bank independ Index of central bank independence slide 22 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 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 slide 23 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 slide 24

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