Chapter 15 - Stabilization policy

Question 1

What are inside lags and outside lags?

Answer 1

Inside: the time between a shock to the economy and the policy action responding to that shock. Arises because it takes time for policy makers first to recognise that a shock has occurred and then it takes time to put appropriate policies into effect, especially fiscal policy.

Outside: the time between a policy action and its influence on the economy. Arises because policies do not immediately influence spending, income and employment.

Question 2

Why does monetary policy have a much shorter inside lag than fiscal policy?

Answer 2

CB can decide and implement in less than a day, but monetary policy has a substantial outside lag. Changes M and r, which influences I and aggregate demand, however, many firms make investment plans far in advance.

Question 3

How do some economists argue stabilisation policy can be destabilising due to lags?

Answer 3

Monetary policy becomes pro-cyclical, pushing the economy even further away from steady state. If economy’s condition changes between beginning of policy action and impact on the economy – active policy may end up stimulating the economy when it is heating up or depressing it when it is cooling off. I.e. if conditions change before policy’s impact is felt, then policy may end up destabilizing the economy.

Question 4

What are automatic stabilizers?

Answer 4

Some fiscal policies designed to reduce the lags associated with stabilization policy. Policies that stimulate or depress the economy without any deliberate policy change. E.g. income taxes automatically reduces taxes when the economy goes into a recession because less are paid when incomes fall. Also unemployment insurance and welfare systems.

Question 5

How can we forecast the macroeconomy and why is it important?

Answer 5

Because policies act with lags, policymakers must predict future conditions. They can use leading economic indicators (data series that fluctuate in advance of the economy) or macro econometric models (Large-scale models with estimated parameters that can be used to forecast the response of endogenous variables to shocks and policies)

Question 6

What is the Lucas critique?

Answer 6

Lucas has emphasised that economists need to pay more attention to the issue of how people form expectations of the future. Especially important: the policies pursued by the government. When policy makers estimate the effect of any policy change, they need to know how people’s expectations will respond to the policy change. Lucas has argued standard macro econometric models does not do that.

Question 7

How is macroeconomic history relevant?

Answer 7

If history shows active policy has successfully insulated the economy from shocks, the case for active policy should be clear and vice versa. However, disagreements over history arise because it is not easy to identify the sources of economic fluctuations.

Question 8

What do advocates of active policy argue?

Answer 8

Advocates of active policy view the economy as subject to frequent shocks that will lead to unnecessary fluctuations in output and employment unless monetary or fiscal policy responds. Many believe that economic policy has been successful in stabilizing the economy.

Question 9

What do advocates of passive policy argue?

Answer 9

Advocates of passive policy argue that because monetary and fiscal policies work with long and variable lags, attempts to stabilize the economy are likely to end up being destabilizing. In addition, they believe that our present understanding of the economy is too limited to be useful in formulating successful stabilization policy and that inept policy is a frequent source of economic fluctuations.

Question 10

What is conducting by rule vs. by discretion?

Answer 10

By rule: Policymakers announce in advance how policy will respond in various situations and commit themselves to following through.

By discretion: As events occur and circumstances change, policymakers use their judgment and apply whatever policies seem appropriate at the time.

Question 11

Why might policy be improved by commitment to a policy rule?

Answer 11

Distrust of policy makers and the political process: incompetence, opportunism – manipulation of the economy for electoral gain: the pollical business cycle

Time inconsistency of discretionary policy: policy makers may want to announce in advance to influence the expectations of private decision makers but later the policy makers may be tempted to renege on their announcement. I.e. policy makers inconsistent over time, to make announcement credible, policy makers may want a rule. If the CB is committed to a policy of low inflation, there will be lower inflation without higher unemployment

Question 12

What do monetarists advocate for the CB in regard to monetary policy?

Answer 12

Monetarists advocate that the central bank should keep the money supply growing at a steady rate to yield stable output, employment and prices.

Believe fluctuations in the money supply are responsible for most large fluctuations in the economy.

However, steady growth in M only stabilizes aggregate demand if V is stable

Sometimes the economy experiences shocks, such as shifts in money demand, causing V to not be stable

Most economists believe that a policy rule needs to allow the money supply to adjust to various shocks to the economy

Question 13

What are 3 other rules (besides monetarists) for monetary policy many economists argue for?

Answer 13

(a) Nominal GDP targeting: CB announces a planned path for nominal GDP. If GDP rises above the target, the CB reduces money growth to dampen aggregate demand. If it falls below, the CB raises money growth. Because a nominal GDP target allows monetary policy to adjust to changes in V, most economists believe it would lead to greater stability in output and prices than a monetarist policy rule
(b) Inflation targeting: CB announces inflation rate target (usually a low one) and then adjust the money supply when actual inflation deviates from the target. Insulates the economy from changes in V. has the political advantage of being easy to explain to the public
(c) The “Taylor Rule”. Target short-term interest rate based on inflation rate and gap between actual & full-employment GDP

Question 14

Why do we not make rules in terms of real variables?

Answer 14

No one knows exactly what the natural rate of unemployment is. If the CB chooses target below the natural rate, the result would be accelerating inflation. If they choose target above, accelerating deflations.

Question 15

What are 2 general guidelines for the CB in choosing the target for the official interest rate?

Answer 15

(1) when inflation heats up, the official interest rate should rise. An increase in the interest rate will mean a smaller money supply, and, eventually lower investment, lower output, higher unemployment and reduced inflation
(2) when real economic activity slows, the official interest rate should fall. A decrease in the interest rate will mean a larger money supply and eventually higher investment, higher output and lower unemployment

Question 16

What is the Taylor rule of monetary policy?

Answer 16

The CB needs to go beyond the general guidelines and decide exactly how much to respond to changes in inflation and real economic activity. Nominal Official Interest Rate=Inflation+2.0+0.5(Inflation-2.0)-0.5(GDP gap)
The GDP gap is the percentage shortfall of real GDP from an estimate of its natural level. The Taylor rule has the real official interest rate – the nominal rate minus inflation – responding to inflation and the GDP gap. According to this rule, the real official interest rate equals 2 per cent when inflation is 2 per cent and GDP is at its natural level. For each percentage point by which inflation rises above 2 per cent, the real official interest rate rises by 0.5 per cent. For each percentage point by which real GDP falls below its natural level, the real official interest rate falls by 0.5 per cent. If GDP rises above its natural level, so that the GDP gap is negative, the real official interest rate rises accordingly. One way of interpreting the Taylor rule is as a complement to (or a tool of) inflation targeting, which we discuss in the next section.

Question 17

What do advocates of discretion argue?

Answer 17

Advocates of discretionary policy argue that discretion gives more flexibility to policy makers in responding to various unforeseen situations.

Question 18

What are inflation targets and how are they managed?

Answer 18

Inflation targeting involves setting a target for inflation and changing interest rates from time to time in order to achieve that target over the medium term of one to two years. Too late to change interest rate in response to current inflation, instead, inflation targets are usually based on forecasts of inflation. Not a pre-commitment to a policy rule, CB are left with a fair amount of discretion.

Question 19

What is the purpose of inflation targeting?

Answer 19

Constrains how the discretion is used, judge whether the CB is meeting its objectives.

Question 20

What is the forward-looking Taylor rule?

Nominal Official Interest Rate=Current Inflation+2.0+0.5(Medium-Term Inflation Forecast-Inflation Target)-0.5(GDP gap)

Answer 20

Because inflation targeting depends on setting interest rates according to forecasts of inflation, it might be argued that a Taylor rule consistent with such a policy should include forecast rather than current inflation.
According to this forward-looking Taylor rule, the central bank should raise the short-term real interest rate if inflation is forecast to exceed its target over the medium term.

Question 21

What is the relationship between central bank independence and inflation?

Answer 21

More independent central banks are strongly associated with lower and more stable inflation. No relationship between central bank independence and real economic activity. Thus, benefit of lower inflation without any apparent cost.