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Question 1:

Should policy be active or


Chapter 15: Stabilization Policy
passive?

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Growth rate of U.S. real GDP Increase in unemployment during recessions


Percent 10 increase in no. of
change peak trough unemployed persons
from 4 8 (millions)
quarters July 1953 May 1954 2.11
earlier 6
Aug 1957 April 1958 2.27
April 1960 February 1961 1.21
Average 4
growth December 1969 November 1970 2 01
2.01
rate 2 November 1973 March 1975 3.58
January 1980 July 1980 1.68
0 July 1981 November 1982 4.08
July 1990 March 1991 1.67
-2
March 2001 November 2001 1.50

-4
1970 1975 1980 1985 1990 1995 2000 2005 2010 Increase from 12/2007 thru 6/2009: 7.2 million!!!

Arguments for active policy Arguments against active policy


Policies act with long & variable lags, including:
 Recessions cause economic hardship for millions
of people. inside lag:
the time between the shock and the policy response.
 The Employment Act of 1946:  takes time to recognize shock
gp
“It is the continuing policy
y and responsibility
p y of the  takes time to implement policy
policy,
Federal Government to…promote full employment especially fiscal policy
and production.”
outside lag:
 The model of aggregate demand and supply the time it takes for policy to affect economy.
(Chaps. 9-13) shows how fiscal and monetary
policy can respond to shocks and stabilize the If conditions change before policy’s impact is felt,
economy. the policy may destabilize the economy.
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Automatic stabilizers Forecasting the macroeconomy

 definition: Because policies act with lags, policymakers must


policies that stimulate or depress the economy predict future conditions.
when necessary without any deliberate policy
change. Two ways economists generate forecasts:
 Leadingg economic indicators
 Designed to reduce the lags associated with
stabilization policy. data series that fluctuate in advance of the
economy
 Examples:  Macroeconometric models
 income tax Large-scale models with estimated parameters
 unemployment insurance that can be used to forecast the response of
 welfare endogenous variables to shocks and policies

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The LEI index and real GDP, 1960s The LEI index and real GDP, 1970s
20 20
The Index of
15
centage change

centage change
Leading 15
10
Economic 10
5
Indicators
5 0
includes 10
annual perc

annual perc
-5
5
data series 0
-10
-5
(see p.258 ). -15
-10 -20
1960 1962 1964 1966 1968 1970 1970 1972 1974 1976 1978 1980
source of LEI data: Leading Economic Indicators source of LEI data: Leading Economic Indicators
The Conference Board Real GDP The Conference Board Real GDP

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The LEI index and real GDP, 1980s The LEI index and real GDP, 1990s

20 15
centage change
annual perccentage change

15 10
10
5
5
0 0
annual perc

5
-5 -5
-10
-10
-15
-20 -15
1980 1982 1984 1986 1988 1990 1990 1992 1994 1996 1998 2000 2002
source of LEI data: Leading Economic Indicators source of LEI data: Leading Economic Indicators
The Conference Board Real GDP The Conference Board Real GDP

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Mistakes forecasting the 1982 recession Forecasting the macroeconomy

Because policies act with lags, policymakers must


ployment rate

predict future conditions.

The preceding slides show that the


Unemp

forecasts are often wrong


wrong.
This is one reason why some
economists oppose policy activism.

CHAPTER 15 Stabilization Policy 13

The Lucas critique An example of the Lucas critique


 Due to Robert Lucas  Prediction (based on past experience):
who won Nobel Prize in 1995 for rational An increase in the money growth rate will reduce
expectations. unemployment.
 Forecasting the effects of policy changes has  The Lucas critique points out that increasing the
often been done using models estimated with money growth rate may raise expected inflation
inflation,
historical data. in which case unemployment would not
necessarily fall.
 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.
CHAPTER 15 Stabilization Policy 14 CHAPTER 15 Stabilization Policy 15

The Jury’s out… Question 2:

Looking at recent history does not clearly answer


Question 1: Should policy be conducted by
 It’s hard to identify shocks in the data. rule or discretion?
 It’s hard to tell how outcomes would have been
different had actual policies not been used.

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Rules and discretion:


Arguments for rules
Basic concepts
 Policy conducted by rule: 1. Distrust of policymakers and the political
Policymakers announce in advance how process
policy will respond in various situations,  misinformed politicians
and commit themselves to following through.  politicians’ interests sometimes not the same
 Policy conducted by discretion: as the interests of society
As events occur and circumstances change,
policymakers use their judgment and apply
whatever policies seem appropriate at the time.

CHAPTER 15 Stabilization Policy 18 CHAPTER 15 Stabilization Policy 19

Arguments for rules Examples of time inconsistency


1. To encourage investment,
2. The time inconsistency of discretionary govt announces it will not tax income from capital.
policy
But once the factories are built,
 def: A scenario in which policymakers govt reneges in order to raise more tax revenue.
have an incentive to renege
g on a
previously announced policy once others
have acted on that announcement.
 Destroys policymakers’ credibility, thereby
reducing effectiveness of their policies.

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Examples of time inconsistency Examples of time inconsistency


2. To reduce expected inflation, 3. Aid is given to poor countries contingent on fiscal
the central bank announces it will tighten reforms.
monetary policy.
The reforms do not occur, but aid is given
But faced with high unemployment, anyway, because the donor countries do not want
the central bank may be tempted to cut interest the poor countries’
countries citizens to starve.
starve
rates.

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Monetary policy rules Monetary policy rules

a. Constant money supply growth rate a. Constant money supply growth rate
 Advocated by monetarists. b. Target growth rate of nominal GDP
 Stabilizes aggregate demand only if velocity  Automatically increase money growth
is stable. whenever nominal GDP g grows slower than
targeted; decrease money growth when
nominal GDP growth exceeds target.

CHAPTER 15 Stabilization Policy 24 CHAPTER 15 Stabilization Policy 25

Monetary policy rules Central bank independence

a. Constant money supply growth rate  A policy rule announced by central bank will
work only if the announcement is credible.
b. Target growth rate of nominal GDP
 Credibility depends in part on degree of
c. Target the inflation rate independence of central bank.
AAutomatically
t ti ll reduce
d money growthth whenever
h
inflation rises above the target rate.
 Many countries’ central banks now practice
inflation targeting, but allow themselves a little
discretion.

CHAPTER 15 Stabilization Policy 26 CHAPTER 15 Stabilization Policy 27

Inflation and central bank independence Chapter Summary


1. Advocates of active policy believe:
verage inflation

 frequent shocks lead to unnecessary fluctuations


in output and employment
 fiscal and monetary policy can stabilize the
economy
av

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
index of central bank independence

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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