T2 Topic 5: Stabilization Policy

Question 1

How should policymakers respond to the business cycle? (2 views)

Answer 1

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

Question 2

See

Answer 2

Post war US data slide

Question 3

Explain policy lag argument against active policy?

Answer 3

Argues economy is more like a ship than a car tf policymakers tend to oversteer (lags are long and variable (Friedman))

Question 4

What is an inside lag?

Answer 4

The delay between a shock hitting the economy and policymakers’ reactions (shorter for MP than FP)

Question 5

What is an outside lag?

Answer 5

Delay between policy action and effect on economy (eg. 18-24months for interest rates)

Question 6

Why do lags cause a problem for active policy?

Answer 6

During the lag the economy’s state may change

Question 7

What do automatic stabilisers do?

Answer 7

Shorten the inside time lag associated with fiscal policy

Question 8

How do automatic stabilisers work?

Answer 8

They either stimulate/contract the economy without the need to enact new policies (eg. Income tax/unemployment insurance)

Question 9

How do policy makers try to avoid time lags, and what is the issue with it?

Answer 9

They attempt to predict the economic status of the future - but this is very uncertain (see slide data)

Question 10

See page 5

Answer 10

Shows very difficult to estimate U - tend to underestimate change in U either direction!

Question 11

Why are forecasts uncertain?

Answer 11

Forecast future based on current and past data, but even that is subject to revision, also no way to predict unexpected events (eg. War)

Question 12

Why is expected future government policy important?

Answer 12

Because consumption and investment decisions depend on expected future income/profitability and these depend on future gov policy

Question 13

Lucas (1976)?

Answer 13

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’

Question 14

How can the announcement by the government of a credible plan to reduce inflation lead to a the possibility of a costless disinflation?

Answer 14

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)

Question 15

Explain how the mechanism for reducing inflation might put off policymakers?

Answer 15

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!)

Question 16

What is discretion?

Answer 16

Policymakers set policy on a period-by-period basis, as they see ‘fit’ (active approach)

Question 17

What are rules?

Answer 17

Policymakers announce in advance how they will respond to various situations and commit themselves to act in this way (active/passive approach)

Question 18

Give 3 reasons economic policy may be misguided if politicians act with discretion?

Answer 18

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)

Question 19

What is Friedman’s rule?

Answer 19

Passive rule
k% rule - money growth=k%/yr

k is a constant roughly equal to rGDP growth

Question 20

What is McCallum’s rule?

Answer 20

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

Question 21

What is the Taylor rule?

Answer 21

Active rule

θπ=θY=0.5

Question 22

What do rules do?

Answer 22

They help to take away discretion from policymakers

Question 23

How can governments lose credibility?

Answer 23

Time inconsistency of discretion policy:

Governments makes promises for future, then don’t keep them - if happens a lot leads to fall in credibility

Question 24

See

Answer 24

Non economic examples in notes and bit below it

Question 25

What is the general principle?

Answer 25

We need ti remove discretion from the government/CB and impose a credible rule

Question 26

2 rules for monetary policy?

Answer 26

• Monetarists (eg. Friedman): control money supply so it grows at a constant rate/yr
• Inflation targeting: currently used in many countries

Question 27

Why have monetarist rules fallen out of use?

Answer 27

Due to instability in money demand have fallen out of use since 80s

Question 28

See Discretion vs Rules: a model

Answer 28

now (notes)

Question 29

Why in a social loss function is π squared?

Answer 29

To make deflation just as bad as inflation

Question 30

What does gamma measure in the social loss function? What does it mean if gamma is greater/less than 1?

Answer 30

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

Question 31

What is the minimum loss L(0,0)?

Answer 31

0

Question 32

What is unfettered discretion?

Answer 32

When the government doesn’t issue the CB w. objectives/targets, and the general public are aware of this

Question 33

3 assumptions for the unfettered discretion model?

Answer 33

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)

Question 34

Find the loss under discretion

Answer 34

See proof notes

Question 35

What is inflation targeting?

Answer 35

Government issues CB with an inflation target, general public know what it is

Question 36

What π* should the government set if target is ‘fully credible’?

Answer 36

Full credibility implies Eπ=π=π*, using U determined by PC can see it must be at u=u(n)

Question 37

Comparing the 2 regimes for monetary policy? Why does this occur?

Answer 37

u(n)<u></u>

Question 38

How is IT done in the UK?

Answer 38

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)

Question 39

Note

Answer 39

Even under IT there is still discretion (flexible IT)

Question 40

What is the case for CB independence?

Answer 40

Even under IT, the CB needs to maintain credibility of monetary policy tf they are independent

Question 41

What does the page 15 data show?

Answer 41

That the more independent the CB, the lower the avg inflation

Question 42

Edit to loss under inflation targeting analysis for a real life application?

Answer 42

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

Question 43

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

Answer 43

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

Question 44

Economic research suggests that countries with greater central bank independence can achieve lower rates of inflation

Answer 44

with no real apparent economic costs

Question 45

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.

Answer 45

‘lower than’

Question 46

Conducting fiscal policy such that G=T, where G is government spending and T is tax revenue, is an example of?

Answer 46

A passive rule