T2 Topic 5: Stabilization Policy Flashcards
How should policymakers respond to the business cycle? (2 views)
View 1) Economy is inherently unstable and requires gov. intervention to offset fluctuations
View 2) Economy is inherently stable and government intervention only interferes with natural balancing process
See
Post war US data slide
Explain policy lag argument against active policy?
Argues economy is more like a ship than a car tf policymakers tend to oversteer (lags are long and variable (Friedman))
What is an inside lag?
The delay between a shock hitting the economy and policymakers’ reactions (shorter for MP than FP)
What is an outside lag?
Delay between policy action and effect on economy (eg. 18-24months for interest rates)
Why do lags cause a problem for active policy?
During the lag the economy’s state may change
What do automatic stabilisers do?
Shorten the inside time lag associated with fiscal policy
How do automatic stabilisers work?
They either stimulate/contract the economy without the need to enact new policies (eg. Income tax/unemployment insurance)
How do policy makers try to avoid time lags, and what is the issue with it?
They attempt to predict the economic status of the future - but this is very uncertain (see slide data)
See page 5
Shows very difficult to estimate U - tend to underestimate change in U either direction!
Why are forecasts uncertain?
Forecast future based on current and past data, but even that is subject to revision, also no way to predict unexpected events (eg. War)
Why is expected future government policy important?
Because consumption and investment decisions depend on expected future income/profitability and these depend on future gov policy
Lucas (1976)?
Whenever we attempt to analyse the impact of a particular policy change, we need to account for how economic agents will react to that policy change
Tf if we don’t adequately account for expectations, our analysis becomes subject to ‘Lucas critique’
How can the announcement by the government of a credible plan to reduce inflation lead to a the possibility of a costless disinflation?
Previously calculate the sacrifice ratio for a GIVEN Phillips curve; this would lead to large sacrifice ratios (ie. too costly to reduce inflation) tf not attempted
BUT if government announces a credible plan to reduce inflation, agents will alter their Eπ immediately tf PC shifts down straight away and there is no sacrifice ITO output (Rational expectations)
Explain how the mechanism for reducing inflation might put off policymakers?
Contractionary MP -> fall in AD tf temporary fall in Y
Over time Phillips curve shifts back down and end up at Eq with lower inflation
This temp fall in Y puts off policymakers (don’t want to lose elections) (draw diagram!)
What is discretion?
Policymakers set policy on a period-by-period basis, as they see ‘fit’ (active approach)
What are rules?
Policymakers announce in advance how they will respond to various situations and commit themselves to act in this way (active/passive approach)
Give 3 reasons economic policy may be misguided if politicians act with discretion?
1) incompetence: they may not understand the economy well enough to stabilise it successfully
2) vested interests: pressure groups may hold influence over policymakers’ decision making
3) opportunism: temptation to ‘grease the wheels’ of economy prior to election (eg. Cut taxes)
What is Friedman’s rule?
Passive rule
k% rule - money growth=k%/yr
k is a constant roughly equal to rGDP growth
What is McCallum’s rule?
Active rule
Money growth - k%+θu(u%-u(n)%)
Eg) if unemployment is above its natural rate then CB should increase money growth and vice versa
What is the Taylor rule?
Active rule
θπ=θY=0.5
What do rules do?
They help to take away discretion from policymakers
How can governments lose credibility?
Time inconsistency of discretion policy:
Governments makes promises for future, then don’t keep them - if happens a lot leads to fall in credibility
See
Non economic examples in notes and bit below it
What is the general principle?
We need ti remove discretion from the government/CB and impose a credible rule
2 rules for monetary policy?
- Monetarists (eg. Friedman): control money supply so it grows at a constant rate/yr
- Inflation targeting: currently used in many countries
Why have monetarist rules fallen out of use?
Due to instability in money demand have fallen out of use since 80s
See Discretion vs Rules: a model
now (notes)
Why in a social loss function is π squared?
To make deflation just as bad as inflation
What does gamma measure in the social loss function? What does it mean if gamma is greater/less than 1?
It measures society’s relative aversion to inflation
If greater than 1, society dislikes inflation more than unemployment
If less than 1, society dislikes unemployment more than inflation
What is the minimum loss L(0,0)?
0
What is unfettered discretion?
When the government doesn’t issue the CB w. objectives/targets, and the general public are aware of this
3 assumptions for the unfettered discretion model?
1) Private agents set inflation expectations (Eπ)
2) CB chooses actual level of inflation (π)
3) Unemployment determined by PC (equation on sheet)
(also assume CB acts benevolently tf wants to minimise loss function)
Find the loss under discretion
See proof notes
What is inflation targeting?
Government issues CB with an inflation target, general public know what it is
What π* should the government set if target is ‘fully credible’?
Full credibility implies Eπ=π=π*, using U determined by PC can see it must be at u=u(n)
Comparing the 2 regimes for monetary policy? Why does this occur?
u(n)<u></u>
How is IT done in the UK?
In UK, if inflation misses TARGET by >=1% (rule) the governor or the BofE has to write a letter to the Chancellor explaining why (consequence)
Note
Even under IT there is still discretion (flexible IT)
What is the case for CB independence?
Even under IT, the CB needs to maintain credibility of monetary policy tf they are independent
What does the page 15 data show?
That the more independent the CB, the lower the avg inflation
Edit to loss under inflation targeting analysis for a real life application?
Although the model says π*=0, in reality doing this is dangerous due to MEASUREMENT ERROR (ie. error in measuring variables for calculations) -> can lead to deflation which can be v difficult to get out of tf set near 2% target to give space for error
If a benevolent central bank which has discretion to set policy as it sees fit announces a policy to keep inflation low, private agents will
be sceptical of the policy announcement because the central bank will have an incentive to generate higher inflation at a later date, after private agents have formed their inflation expectations
Economic research suggests that countries with greater central bank independence can achieve lower rates of inflation
with no real apparent economic costs
If people’s expectations of inflation are formed rationally rather than based on adaptive expectations and if policymakers make a credible policy move to reduce inflation, then the costs of reducing inflation will be _________________ traditional estimates of the sacrifice ratio.
‘lower than’
Conducting fiscal policy such that G=T, where G is government spending and T is tax revenue, is an example of?
A passive rule
