chapter 14 - Chapter 14 Learning objectives In this...

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Unformatted text preview: Chapter 14 Learning objectives In this chapter, you will learn about two policy debates: 1. Should policy be active or passive? Should policy be by rule or discretion? Stabilization Policy 2. CHAPTER 14 Stabilization Policy slide 0 CHAPTER 14 Stabilization Policy slide 1 Question 1: U.S. Real GDP Growth Rate, 1960:1-2001:4 1960:120 15 percent Should policy be Should policy be active or passive? active or passive? 10 5 0 -5 -10 -15 1960 CHAPTER 14 1965 1970 1975 1980 1985 1990 1995 2000 slide 3 Stabilization Policy slide 2 CHAPTER 14 Stabilization Policy Arguments for active policy Recessions cause economic hardship for millions of people. The Employment Act of 1946: “it is the continuing policy and responsibility of the Federal Government to…promote full employment and production.” The model of aggregate demand and supply (Chapters 9-13) shows how fiscal and monetary policy can respond to shocks and stabilize the economy. CHAPTER 14 Change in unemployment during recessions peak July 1953 Aug 1957 April 1960 December 1969 November 1973 January 1980 July 1981 July 1990 CHAPTER 14 trough May 1954 April 1958 February 1961 November 1970 March 1975 July 1980 November 1982 March 1991 Stabilization Policy increase in no. of unemployed persons (millions) 2.11 2.27 1.21 2.01 3.58 1.68 4.08 1.67 Stabilization Policy slide 4 slide 5 1 Arguments against active policy 1. Long & variable lags inside lag: the time between the shock and the policy response takes time to recognize shock takes time to implement policy, especially fiscal policy outside lag: the time it takes for policy to affect economy Automatic stabilizers definition: policies that stimulate or depress the economy when necessary without any deliberate policy change. They are designed to reduce the lags associated with stabilization policy. Examples: – income tax – unemployment insurance – welfare CHAPTER 14 If conditions change before policy’s impact is felt, then policy may end up destabilizing the economy. CHAPTER 14 Stabilization Policy slide 6 Stabilization Policy slide 7 Forecasting the macroeconomy Because policies act with lags, policymakers must predict future conditions. Ways to generate forecasts: • Leading economic indicators: data series that fluctuate in advance of the economy • Macroeconometric models: Large-scale models with estimated parameters that can be used to forecast the response of endogenous variables to shocks and policies CHAPTER 14 The LEI index and Real GDP, 1970s 20 annual percentage change 15 10 5 0 -5 -10 -15 -20 1970 1972 1974 1976 1978 1980 source of LEI data: The Conference Board slide 8 Leading Economic Indicators Real GDP Stabilization Policy CHAPTER 14 Stabilization Policy slide 9 The LEI index and Real GDP, 1980s 20 annual percentage change 15 10 5 0 -5 -10 -15 -20 1980 1982 1984 1986 1988 1990 The LEI index and Real GDP, 1990s 15 annual percentage change 10 5 0 -5 -10 -15 1990 1992 1994 1996 1998 2000 2002 source of LEI data: The Conference Board CHAPTER 14 CHAPTER Leading Economic Indicators Real GDP slide 10 source of LEI data: The Conference Board CHAPTER 14 CHAPTER Leading Economic Indicators Real GDP slide 11 Stabilization Policy Stabilization Policy 2 Mistakes Forecasting the Recession of 1982 Unemployment 11.0 rate (percent) 10.5 10.0 9.5 9.0 8.5 8.0 7.5 7.0 6.5 6.0 1980 1981 1982 1983 1984 1985 1986 Year 1981:2 Actual 1983:4 1981:4 1982:2 1983:2 1982:4 Forecasting the macroeconomy Because policies act with lags, policymakers must predict future conditions. The preceding slides show that the The preceding slides show that the The forecasts are often wrong. forecasts are often wrong. This is one reason why some This is one reason why some economists oppose policy activism. economists oppose policy activism. CHAPTER 14 Stabilization Policy slide 12 CHAPTER 14 Stabilization Policy slide 13 The Jury’s Out… Looking at recent history does not clearly answer Question 1: • It’s hard to identify shocks in the data, • and it’s hard to tell how things would have been different had actual policies not been used. Question 2: Should policy Should policy be conducted by be conducted by rule or discretion? rule or discretion? CHAPTER 14 CHAPTER Stabilization Policy slide 14 CHAPTER 14 Stabilization Policy slide 15 Rules and Discretion: basic concepts Policy conducted by rule: Policymakers announce in advance how policy will respond in various situations, and commit themselves to following through. Policy conducted by discretion: As events occur and circumstances change, policymakers use their judgment and apply whatever policies seem appropriate at the time. Arguments for Rules 1. Distrust of policymakers and the political process misinformed politicians politicians’ interests sometimes not the same as the interests of society CHAPTER 14 Stabilization Policy slide 16 CHAPTER 14 Stabilization Policy slide 17 3 Arguments for Rules 2. The Time Inconsistency of Examples of Time-Inconsistent Policies TimeTo encourage investment, government announces it won’t tax income from capital. But once the factories are built, the govt reneges in order to raise more tax revenue. Discretionary Policy def: A scenario in which policymakers have an incentive to renege on a previously announced policy once others have acted on that announcement. Destroys policymakers’ credibility, thereby reducing effectiveness of their policies. CHAPTER 14 Stabilization Policy slide 18 CHAPTER 14 Stabilization Policy slide 19 Examples of Time-Inconsistent Policies Time- Examples of Time-Inconsistent Policies Time- To reduce expected inflation, the Central Bank announces it will tighten monetary policy. But faced with high unemployment, Central Bank may be tempted to cut interest rates. Aid to poor countries is contingent on fiscal reforms. The reforms don’t occur, but aid is given anyway, because the donor countries don’t want the poor countries’ citizens to starve. CHAPTER 14 CHAPTER 14 Stabilization Policy slide 20 Stabilization Policy slide 21 Monetary Policy Rules a. Constant money supply growth rate advocated by Monetarists stabilizes aggregate demand only if velocity is stable MV = PY Monetary Policy Rules a. Constant money supply growth rate b. Target growth rate of nominal GDP automatically increase money growth whenever nominal GDP grows slower than targeted; decrease money growth when nominal GDP growth exceeds target. CHAPTER 14 Stabilization Policy slide 22 CHAPTER 14 Stabilization Policy slide 23 4 Monetary Policy Rules a. Constant money supply growth rate b. Target growth rate of nominal GDP c. Target the inflation rate automatically reduce money growth whenever inflation rises above the target rate. Many countries’ central banks now practice inflation targeting, but allow themselves a little discretion. CHAPTER 14 Monetary Policy Rules a. Constant money supply growth rate b. Target growth rate of nominal GDP c. Target the inflation rate d. The “Taylor Rule” Target Federal Funds rate based on inflation rate gap between actual & full-employment GDP slide 24 Stabilization Policy CHAPTER 14 Stabilization Policy slide 25 The Taylor Rule rff = 2 + 0.5(π − 2) − 0.5(GDP Gap) where: i ff = nominal federal funds rate The Taylor Rule rff = 2 + 0.5(π − 2) − 0.5(GDP Gap) If π = 2 and output is at its natural rate, then monetary policy targets the real Fed Funds rate at 2% (and the nominal rate at 4%). For each one-point increase in π, mon. policy is automatically tightened to raise the real Fed Funds rate by 0.5 For each one percentage point that GDP falls below its natural rate, mon. policy automatically eases to reduce the Fed Funds Rate by 0.5. slide 26 rff = i ff − π = real federal funds rate Y −Y GDP Gap = 100 × Y = the percent by which real GDP is below its natural rate CHAPTER 14 Stabilization Policy CHAPTER 14 Stabilization Policy slide 27 Does Greenspan follow the Taylor Rule? The Federal Funds Rate Actual and Suggested Actual Taylor's rule Central Bank Independence A policy rule announced by Central Bank will work only if the announcement is credible. Credibility depends in part on degree of independence of central bank. 12 10 8 Percent 6 4 2 0 1987 CHAPTER 14 1990 1993 1996 1999 2002 slide 28 Stabilization Policy CHAPTER 14 Stabilization Policy slide 29 5 Inflation and Central Bank Independence Average 9 inflation 8 7 6 5 4 3 2 0.5 1 1.5 2 2.5 Belgium Spain New Zealand Italy Australia United Kingdom Denmark France/Norway/Sweden Japan Canada Netherlands United States Switzerland Germany 3 3.5 4 4.5 Index of central bank independence slide 30 CHAPTER 14 Stabilization Policy 6 ...
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