alternative perspectives on stabilization policy - its · chapter 18 alternative perspectives on...

© 2016 Worth Publishers, all rights reserved

Alternative Perspectives on Stabilization Policy

18 CHAPTER

Modified for ECON 2204 by Bob Murphy

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?

1

2 CHAPTER 18 Alternative Perspectives on Stabilization Policy

Question 1:

Should policy be active or passive?

-4

-2

0

2

4

6

8

10

1970 1975 1980 1985 1990 1995 2000 2005 2010 2015

Growth rate of U.S. real GDP Percent change from 4

quarters earlier

Average growth

rate

Increase in unemployment during recessions

peak trough increase in no. of

unemployed persons (millions)

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 December 2007 June 2009 6.14


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. 10–15) shows how fiscal and monetary policy can respond to shocks and stabilize the economy.


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,

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.


Automatic stabilizers

§  definition: policies that stimulate or depress the economy when necessary without any deliberate policy change.

§  Designed to reduce the lags associated with stabilization policy.

§  Examples: §  income tax § unemployment insurance § welfare


Forecasting the macroeconomy

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

Two ways economists generate forecasts: § Leading economic indicators (LEI)

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


The LEI index and Real GDP

437

ADDITIONAL CASE STUDY 18-3 Leading Indicators in Action

Figure 1 shows the percentage change in real GDP and the percentage change in the index of leading economic indicators for the period 1960–2014.

Source: Department of Commerce, Bureau of Economic Analysis, and The Conference Board.

The relationship between changes in the index of leading economic indicators and changes in real GDP is far from exact, but the index does frequently appear to “lead” movements in GDP.


The LEI index and real GDP, 1960s

source of LEI data: The Conference Board

-10

-5

0

5

10

15

20

1960 1962 1964 1966 1968 1970

annu

al p

erce

ntag

e ch

ange

Leading Economic Indicators Real GDP




-20

-15

-10

-5

0

5

10

15

20

1970 1972 1974 1976 1978 1980

annu

al p

erce

ntag

e ch

ange





-20

-15

-10

-5

0

5

10

15

20

1980 1982 1984 1986 1988 1990

annu

al p

erce

ntag

e ch

ange





-15

-10

-5

0

5

10

15

1990 1992 1994 1996 1998 2000 2002

annu

al p

erce

ntag

e ch

ange


Mistakes forecasting the 1982 recession U

nem

ploy

men

t rat

e


Forecasting the macroeconomy

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

The preceding slides show that the forecasts are often wrong.

This is one reason why some economists oppose policy activism.


The Lucas critique

§  Due to Robert Lucas who won Nobel Prize in 1995 for his work on 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 alters expectations in a way that changes the fundamental relationships between variables.


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, in which case unemployment would not necessarily fall.


The Jury’s out…

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 outcomes would have been different had actual policies not been used.


Question 2:

Should policy be conducted by rule or discretion?


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.


Arguments for rules

1. Distrust of policymakers and the political process § misinformed politicians § politicians’ interests sometimes not the same

as the interests of society


446

ADDITIONAL CASE STUDY 18-12 The Economy Under Democratic and Republican Presidents

As discussed in the Chapter 18 of the text and in the previous two supplements, one view of politicians is that they have a short time horizon that coincides with the election cycle. According to this view, policies are designed to ensure reelection rather than with the long-term health of the economy in mind. If this view is correct, then one would expect to find similar patterns of macroeconomic policies regardless of which political party is in office.

But for the United States, data on real GDP growth suggest that the two political parties choose different macroeconomic policies. In other words, politicians are not simply opportunists trying to guarantee their reelection, but instead may be expressing the partisan preferences of their constituencies.

Table 1 shows economic growth in each of the four years of presidential administrations since 1948. Average growth in Republican administrations is quite a bit lower than in Democratic administrations during the first two years of a term, but then is higher in the last two years. In addition, negative growth typically occurs in the second year of a Republican administration, whereas growth is usually booming during the second year of a Democratic administration.

Table 1 Real GDP Growth During Democratic and Republican Administrations (percentage-change, 4th quarter over 4th quarter)

Year of Term

President First Second Third Fourth

Democratic Administrations Truman -1.5 13.4 5.5 5.3 Kennedy/Johnson 6.4 4.3 5.2 5.1 Johnson 8.5 4.5 2.7 5.0 Carter 5.0 6.7 1.3 0.0 Clinton I 2.6 4.1 2.3 4.5 Clinton II 4.4 5.0 4.7 2.9 Obama I -0.2 2.7 1.7 1.6 Obama II 3.1 2.4 Average 3.5 5.4 3.3 3.5 Republican Administrations Eisenhower I 0.5 2.7 6.6 2.0 Eisenhower II 0.4 2.7 4.5 0.9 Nixon 2.1 -0.2 4.4 6.9 Nixon/Ford 4.0 -1.9 2.6 4.3 Reagan I 1.3 -1.4 7.8 5.6 Reagan II 4.3 2.9 4.4 3.8 Bush (senior) 2.8 0.6 1.2 4.3 G.W. Bush I 0.2 2.0 4.4 3.1 G.W. Bush II 3.0 2.4 1.9 -2.8 Average 2.1 1.1 4.2 3.1

Source: Bureau of Economic Analysis, U.S. Department of Commerce.

A possible interpretation of this evidence is that the two parties have different preferences regarding inflation compared to unemployment. Republican administrations come into office seeking to bring down inflation and thus pursue restrictive policies, which may entail a recession. Democratic administrations enter office seeking to lower unemployment and thus pursue expansionary policies, even if these raise inflation. This interpretation does not necessarily argue for rules to constrain policymakers, since any rule would limit the ability of the electorate to express its will.1

1 G. Hess and A. Orphanides, “War Politics: An Economic, Rational-Voter Framework,” American Economic Review 85, no. 4 (September 1995): 828–46.


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.


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.



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 rates.



3. Aid is given to poor countries contingent on fiscal reforms.

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


Monetary policy rules

a. Constant money supply growth rate §  Advocated by monetarists. §  Stabilizes aggregate demand only if velocity

is stable.



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.

a. Constant money supply growth rate



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 discretion.

a. Constant money supply growth rate

b. Target growth rate of nominal GDP



448

CASE STUDY EXTENSION 18-14 Inflation Targeting

In 1989 New Zealand passed legislation requiring the central bank (in consultation with the Ministry of Finance) to establish inflation targets. Over subsequent years, many other countries followed New Zealand’s example. And in 2012, the United States adopted a policy of targeting inflation, when the Federal Open Market Committee of the Federal Reserve set a target of 2 percent. Table 1 provides details on inflation targeting in seven industrial countries and the Euro-zone. Most of these countries set a range within which inflation is allowed to fluctuate and update the target every few years. The Federal Reserve seeks to “maintain an inflation rate of 2 percent over the medium term,” although actual inflation may differ from that rate in the short term.

A key motivation for setting inflation targets is to enhance transparency in monetary policy. Most targets are specified over an intermediate window of time, usually about a year or so. Having a central bank committed to an inflation target helps households and businesses make better decisions by reducing uncertainty associated with policy. And, as the text notes in Chapter 18, even though most countries do not have explicit sanctions for failing to hit the inflation target, their presence does make central bankers more accountable and constrains central-bank discretion

Table 1 Inflation Targeting in Industrial Countries

Country/Area Current Target Index Targeted Who Sets Target?

Australia 2–3% CPI Central Bank and Government

Canada 1–3% CPI Central Bank and Government

Euro-zone Below but close to 2% Harmonized Index of Consumer Prices

Central Bank

Israel 1–3% CPI Central Bank and Government

New Zealand 1–3% CPI Central Bank and Government

Sweden 2% (with small deviations permitted)

CPI Central Bank

United Kingdom 2% (with permissible fluctuations of ±1%)

CPI Government

United States 2% PCE Central Bank



d. Target the Price Level §  Automatically reduce money growth whenever

the price level rises above the target rate and vice versa.

§  Some economists argued for this policy in response to concerns about deflation following the Great Recession.



447

LECTURE SUPPLEMENT 18-13 Price Level Versus Inflation Targeting

Inflation targeting differs from price level targeting: with price level targeting the central bank must correct its past mistakes, which can increase the volatility of prices. To illustrate, suppose that in year 1 country A chooses to target its price level for the next three years along the path detailed in Table 1, while country B chooses to target its inflation rate for the next three years at 2 percent. At first glance it might seem that these are identical targets. The price level target is based on a 2 percent yearly rise in prices. However, operationally the targets are different. Suppose that both countries meet their target for year 2. In country A the price level is 102 and in country B the inflation rate is 2 percent. The following year both countries overshoot their targets. In country A the price level rises to 108.1 while in country B the inflation rate is 6 percent. Prices in both countries rose by 6 percent between year 2 and year 3. The central bank of country A must act to bring the price level back to its target. Because the actual price level in year 3 is above the year 4 target level, the central bank must deflate. To meet its target in year 4, prices must fall by 1.8 percent. In contrast, the central bank of country B merely needs to reduce the inflation rate, bringing it back to the 2 percent target. In country A prices must fall; in country B the rise in prices must be reduced.

Table 1 Price Level Versus Inflation Targeting

Year Price Level Target Inflation Target

1 100.0 2 102.0 2% 3 104.0 2% 4 106.1 2%



§  Assume central bank wants inflation at 2% per year. §  Suppose inflation falls to 1% per year for several

years. §  Under inflation targeting, the central bank aims to

return inflation to its 2% target.

§  Under price level targeting, the central bank aims to return the price level to its target and allows inflation to rise above 2%.

§  The chart assumes central bank allows 3% inflation until price level path is reached and 2% thereafter.



90

100

110

120

130

140

150

160

170

1 3 5 7 9 11 13 15 17 19 21 23 25

Inde

x,Year1

=100

Year

Infla/onTarge/ngvs.PriceLevelTarge/ng

Infla/onTarge/ngPolicy PriceLevelTarge/ngPolicy PriceLevelTarget


Central bank independence

§  A policy rule announced by central bank will work only if the announcement is credible.

§  Credibility depends in part on degree of independence of central bank.

Inflation and central bank independence av

erag

e in

flatio

n

index of central bank independence


Growth and Central Bank Independence

449

CASE STUDY EXTENSION 18-15 Central-Bank Independence and Growth

Figure 1 shows the relationship between the degree of central-bank independence and economic growth in 16 countries from 1955 to 1987. There appears to be no connection between an independent central bank and higher or lower economic growth.

Source: From A. Alesina and L. Summers, “Central Bank Independence and Macroeconomic Performance: Some Comparative Evidence,” Journal of Money, Credit, and Banking 25, no. 2 (May 1993): 151–62, reprinted by permission. Copyright 1993 by the Ohio State University Press. All rights reserved.

C H A P T E R S U M M A R Y

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.

38

C H A P T E R S U M M A R Y

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.

39

alternative perspectives on stabilization policy - its · chapter 18 alternative perspectives on...

Documents