Chapter 17 - Institutions and Economic Policy Flashcards
What is the Credibility Bias? (or inflation bias)
Policy makers promise that they will keep inflation = 0, people believe this and expected inflation also = 0.
- policymaker has incentive to deviate and pursue a more inflationary policy
- promise to keep inflation = 0 not credible
Phillips curve with output on one axis and inflation on other.
Is PC downward or upward sloping?
upward sloping.
- given level of expectations, higher inflation = stimulates output
- higher output, bids up price of scarce resources and causes inflation
Phillips curve with unemployment on one axis and inflation on the other axis.
Is PC downward or upward sloping?
Downward sloping.
- UE, inversely related to output
- as output increases UE falls
- lower the UE, higher avg wage increases made by firms and higher inflation will be
how could inflation bias be removed from MP?
1) Fixed norm for inflation
- passing law that requires CB to keep inflation at some low level/ fixed norm for inflation
- ability to stabilise output may be curtailed
- CB doesn’t have complete control over inflation (rules for when inflation falls out of a certain range)
2) MP rule
- CB has to follow specific rule for any given circumstance
- difficult to make rule for each situation
- making incomplete rules = limits flexibility
3) LT contracts
- giving board members of CB long-term contracts can ensure they care about the LT effect of their policies
4) Contract for the CB
- delegate all policy making decisions to an independent body and set up incentives for that body to keep inflation low
What solutions to inflation bias doe BOE employ?
- Explicit inflation target of 2%
- MP setting its objectives to be:
1) maintain price stability
support economic policy of
2) Gov including objectives of growth & employment
3 different responses to fiscal crisis
1) Reduce the primary deficit
- time required to increase taxes and reduce gov expenditure
2) Debt monetisation
- where the CB buys gov bonds financed by an increase in the monetary base
- bonds have repayments fixed in nominal terms = high inflation lowers value in real terms
- issue: expansion of MB = increased inflation and may increase future cost of borrowing
3) Default
- stopping payment of interest and repaying bonds that mature, the government’s debt burden immediately vanishes
- issue: difficult for government to borrow on the market again
- if it can it will be at a very high rate
𝜆1 > 𝜆2
interpret the candidates and which one is more inflation-averse
i.e. will target lower inflation at expense of higher UE
(also what policy will they pursue?)
high 𝜆 indicates a higher weight on UE
- strong incentive to pursue expansionary policy to reduce UE
(candidate 1)
low 𝜆 is more inflation averse. Candidate 2 - lower decision weight on UE and higher decision weight on inflation, therefore will target a lower level of inflation than candidate 1
Choice of candidates in the LR
- in LR UE converges to natural level irrespective of MP
- however choosing a more inflation averse head = lower LR inflation
Long Run debt ratio equation
D/Y = [(G - T +iD)/Y]/ 𝜋 + 𝑔
D/Y = (deficit/GDP) / GR of nominal GDP
Questions with loss functions and Phillips curve
- When wage setters can perfectly see inflation rate chosen by policy makers, set expected inflation equal to actual inflation
- λ = high, higher weight on employment therefore less care on inflation
- a = low, means flatter Phillips curve
- both combined = expansionary policy to reduce UE but at risk of high inflation
Calculating government expenditure relative to GDP…
Use equation
∆(D/Y) = (G-T)/Y + (r-g)D/Y
- rearrange to get government expenditure of GDP on LHS
- to do this set LHS = 0
- net government debt on RHS is what you multiply (D/Y)
G/Y = T/Y - (r-g) D/Y
Reasons for deficit bias in fiscal policy (3)
1) Myopia
- gov can raise expenditure and lower taxes today, w/ costs coming later (power & votes if voters are oblivious to associated costs)
- Voters may be myopic & credit constrained
2) Political fragmentation (& division of power)
- politicians pushing their own specific interests, not taking responsibility for the country as a whole
- even if they agreed on an issue, the execution of its solution = disagreement and can = no action
3) Strategic deficits
- if current party thinks future party will waste resources of gov, it may spend money today to reduce scope of future policy
Why might myopic governments underinvest in public infrastructure?
It will care about expenditure that has an immediate payoff than future payoff
- investment in public infrastructure e.g. transport systems and schools will be lower than is optimal
How can deficit bias be removed?
1) Debt targets and ceilings
- relatively permanent commitment on debt = day to day constraint on policy restrictions
2) Budgetary procedures
- make sure effects of fiscal policy are fully considered before measures are passed
- sufficient time given for considering this then policy may be more constrained
3) Delegation
- fiscal policy to independent body
- issue: might lack democratic accountability
- distributional consequences = fiscal policy can get inherently political
4) Fiscal policy councils
- similar to delegation but would give advice on fiscal policy
In a world with FULL Ricardian equivalence, how serious is the problem of high government debt?
Individuals take account of utility of future generations
- if gov cuts taxes, people will save to compensate
- therefore aggregate consumption, saving and production are unaffected by the level of debt
- and so is the utility of future generations
Intergenerational redistribution (unlikely that Ricardian equivalence holds, so how does this affect IntR?)
People will spend some of their disposable income, thus aggregate savings falls with tax cut.
- in closed economy = lower capital accumulation
- with fully integrated FM = capital stock unaffected BUT foreign assets will decline
- in reality - combo of 2
- decline in K-stock and foreign assets = future generations are poorer
- running a deficit, government allows people today to borrow at expense of future generations = redistribution of income from future to current generations
Matter of judgement! productivity increases over time therefore, future generations will probably be better off than those currently living and paying taxes
- also can expect future generations to experience difficulty from environmental problems (CC) and ageing population
