Policy Flashcards
What is the basis of macro economics ?
That governments could take into action to improve economic performance
Within policy what are the 3 main points we look at ??
- Uncertainty and policy
- Expectations and policy
- Politics and policy
How much would economists know about the future if they were to:
– They should know whether unemployment is at, above, or below the natural level
– They should know whether this is going to cause inflation or not
– By how much will the increase in money supply decrease the interest rate? What will be the effect on long-term rates? Stock prices?
– What is the effect on the currency? The trade balance?
How much do macroeconomists actually know ??
They defo do not have all the answers or knowledge required for solving economic problems
They rely on models all of which give different answers on how to solve a particular problem
What are 2 schools of thought from economists about policy ??
Milton Friedman said “Because of long and variable lags, activists policy is likely to do more harm than good
Franco Modiglliani said “Economists; knowledge is good enough to allow for increasingly fine-tuning of the economy”
Essentially some economists believe that policy makers should do less and others believe they should do more
Should policy makers do less ?
The short answer is yes
-Substantial uncertainty about effects of macroeconomic policies”
-Because of this policy makers should be more careful
What should the main goal of policies be ?
They should be broadly aimed at avoiding prolonged recessions, slowing down booms and avoiding inflationary pressure;
The higher the unemployment rate, or the higher the inflation rate, the more active policy should be
When should policy makers stop ??
Well short of fine-tuning the economy, trying to achieve constant growth of unemployment or output growth can result in harm done to the economy
Why do policy expectations matter ??
What is an economic example of why expectations of policy matters
-The link between inflation and employment
What is time inconsistency of optimal policy ?
The incentive to deviate from the announced policy, once the other player has made its move
What is the relation between inflation and unemployment ?
What would happen if:
Why is credibility important when it comes to policy ?
Monetary authorities will want to be believed that it will act consistantly with its targets
the Central bank needs to make credible comments and act in accordance to its stated objectives
How do you deal with the problem of time inconsistency without totally stripping policy-making power from the central bank ??
- Making the central bank independent;
- Give incentives to central banks to take the “long” view;
- Choose a “conservative” central banker who dislikes inflation.
What is the relation between inflation and CB independence across OECD countries
W
Are the effects of macroeconomic policies certain ??
No they are always uncertain
What can we say about policy makers and people in the economy ??
That macroeconomic policy can be thought of as a game between them
Issues of time inconsistency means what ?/
-Tight restraints on policy makers
-the solution has larger costs because it prevents the use of all macroeconomic policy altogether
So what are better solutions to fix the issue of time constraints ?
Design better institutions that can reduce the problem of time inconsistency while at the same time allowing the use of policy for the stabilisation of output
What are the 3 issues in fiscal policy where the government budget constraint plays a role ?
-Ricardian Equivalence
-Deficits, output stabilisation and cyclically adjusted deficit
-Wars and deficits
Politics and fiscal restraints are what ?
-Fiscal rules
-Fiscal rules for countries within a monetary union
What is the Ricardian Equivalence ?
The proposition that neither deficits or debts have any effect on economic activity once the government budget constraint is taken into account
An example of the RE is:
Suppose the government raises gov spending, this can either be financed by raising taxes now or by rasing public debt
Does how the spending is financed affect economic activity ?
Consumers do not change their consumption in response to a tax cut if the present value of after-tax labour income is unaffected.
-The effect of lower taxes today is cancelled out by higher taxes tomorrow.
Theory suggests that under certain conditions the timing of taxes does not matter, however, its the present value of tax-liabilities that matters
Does RE apply in practice ??
Evidence suggest that we should take this into account however do not take it too seriously and suggest that debts and deficits do not matter at all
Why should you not take the RE too seriously ??
- Tax cuts are known, but future tax rises are uncertain;
- Individuals are not infinitely lived, or don’t optimise over all future time periods perfectly, so might ignore possibility of future tax increases;
- Not all households are the same.
The fact that budget deficits have adverse effects implies that deficits during recessions should be offset by surpluses during
booms, what does this avoid ?
Avoids a steady increase in debt
What is full employment deficit ??
The deficit would be, under the existing tax and spending rules, if output were at the natural level of output
Cyclically adjusted deficit
The deficit would be, under the existing tax and spending rules, if output were at the natural level of output
What happens when actual deficit is larger but the cyclically deficit is 0 ??
Current fiscal policy is consistent with no systematic increase in debt over time
The debt will increase as long as output is below its natural level, Once natural level is reached the deficit will go away and debt will stabilise
Should cyclically adjusted deficit be at 0 all the time ??
No, as in a recession the gov way want to run a deficit large enough that the CAD is positive
However in this case the return of output to its natural level will not be enough to stabilise debt
The gov would need to take further measures, from tax increases, to cuts in spending to decrease the deficit, so debt stabilises
Why has practice of the cyclically adjusted deficit proven tricky ??
- Not easy to establish how much lower the deficit would be if output was higher
- Very difficult to asses how car output is from natural level, if the calculation is wrong than policy will have severe consequences
How do you establish how much lower the deficit would be if output was higher ??
-A reliable rule suggests that 1% decrease in output automatically leads to a 0.5% increase in deficit of GDP
Why should you run deficits in wars ??
- Deficit finance is a way to pass some of the burden of war to those alive after war, Seems only fair for future generations to share in the sacrifices the war requires
- Deficit spending helps reduce tax distortions
What happens when the government finance gov spending during wars with Deficit financing ??
-Will lead to a sharp increase in gov spending, which in turn increases demand for goods
-Because output is fixed, interest rates will go up
-Then investment will decrease sharply
What happens when the government finance gov spending during wars with taxation financing ??
An increase in taxation will lower consumption sharply.
* By how much, depends upon consumers’ expectations: the longer they expect the war to last, the longer they will expect
higher taxes to last, and the more likely they will decrease consumption.
* In any case, the increase in government spending will be partly offset by the decrease in consumption, and therefore the increase
in the interest rate and decrease in investment will be smaller.
