Lecture 7 Macroeconomic Policy in Practice(1).pptx

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5-1 Ch. 6 (Gordon) Ch. 5 (Dornbusch) Lecture 7: Macroeconomic Policy in Practice
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5-2 Objectives Explore the limitations of macroeconomic policy. Consider the classification of variables into targets, instruments and indicators. Explain policy lags. Compare the gradualist and cold-turkey policies to reduce inflation. Examine the positive theory of policy-making. 2
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5-3 Chapter organisation 1. Targets, instruments and indicators: a taxonomy 2. Policy makers: working backwards 3. Interest rates and aggregate demand 4. Policy lags: inside and outside lags, and automatic stabilisers 5. Anti-inflationary strategies: gradualism versus cold-turkey policies 6. Activist policy: the Taylor rule 7. The positive theory of policy making 3
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5-4 1. Targets, instruments and indicators: a taxonomy Targets are identified goals of policy. Targets are subdivided into ultimate targets and intermediate targets. We focus on output, prices and unemployment — these are intermediate targets. Ultimate targets are things such as ‘improve the welfare of society’ or ‘have low and stable inflation’. Instruments are the tools the policy maker manipulates directly. An example is the SBV having an exchange rate target. The SBV instrument would be the purchase or sale of cash or foreign exchange reserves. continued 4
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5-5 Indicators are economic variables that indicate whether we are closer to our desired targets. An example: an increase in interest rates (an indicator) sometimes signals that the market anticipates increased future inflation (a target). Other examples of indicators are consumption expenditure, changes in inventories, consumer sentiment and inflationary expectations. 5 Targets, instruments and indicators: a taxonomy continued
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5-6 2. Policy makers: working backwards Policy makers ask where output and inflation should be. They then ask what change in AD or AS is required to achieve these targets. Finally, they consider how large a policy change is required to move the AD or AS curves by the necessary distance. Given the uncertainty in policy formulation, it is sometimes sensible to implement policy by taking a small step in the right direction. 6
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5-7 3. Interest rates and aggregate demand Higher interest rates reduce purchases of durable goods and hence reduce aggregate demand.
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