Part 1B: Against active policy. Stabilization Policy CHAPTER 14. Part 1A: Arguments for active policy. Two policy debates:

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1 CHAPTER 14 Two policy debates: 1. Should policy be active or passive? 2. Should policy be by rule or discretion? slide 0 Part 1A: Arguments for active policy US economy has undergone expansions and recessions in the post-ww2 period Recessions cause economic hardship The Employment Act of 1946: it is the continuing policy and responsibility of the Federal Government to promote full employment and production. Wage and price rigidities create a case for intervention (adjusting AD in response to shocks) slide 1 Part 1B: Against active policy ARGUMENT 1: LONG AND VARIABLE LAGS Inside lag: takes time to recognize shock and to implement policy Outside lag: takes time for policy to affect economy NOTE 1: Policy may be destabilizing if conditions change NOTE 2: automatic stabilizers (taxes, unemployment insurance) mitigate these problems (no need for explicit policy change) slide 2 1

2 ARGUMENT 2. ACTIVE POLICY REQUIRES FORECASTS, WHICH ARE OFTEN WRONG Because of the above lags in implementing policy, policymakers must predict future conditions. How to make forecasts: Leading economic indicators: Macroeconometric models slide 3 The LEI index and Real GDP, 1990s annual percentage change source of LEI data: The Conference Board Leading Economic Indicators Real GDP slide 4 Mistakes Forecasting the Recession of 1982 Unemployment rate (percent) :2 1981:4 1982:4 1983: :2 1983:4 Actual Year slide 5 2

3 ARGUMENT 3: MODELS ARE NOT POLICY INVARIANT (Lucas Critique) Forecasting effects of policy changes is done using models estimated with historical data. Models are not policy invariant! Predictions invalid if policy changes alter expectations in a way that changes the key links between variables. E.G. Prediction (based on past): an increase in M S will reduce U Lucas Critique: increase in M S may raise expected inflation, without affecting unemployment slide 6 Active or passive? Looking at recent history does not clearly answer: hard to identify shocks in the data, hard to tell how things would have been had actual policies not been used. slide 7 PART 2: Rules vs Discretion Policy conducted by rule: Policymakers announce in advance how policy will respond in various situations, and commit themselves to do so. Policy conducted by discretion: As events occur and circumstances change, policymakers use their judgment and apply whatever policies seem appropriate slide 8 3

4 Arguments for Rules 1. Distrust of policymakers misinformed politicians politicians interests not the same as society 2. The Time Inconsistency of 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. slide 9 Examples of Time-Inconsistent Policies Government announces it won t t tax income from capital. Once factories are built, government reneges in order to raise more tax revenue. To reduce expected inflation, CB announces it will tighten monetary policy. But faced with high unemployment, CB may be tempted to cut r. To encourage you to study, I promise a terribly hard final exam. Once the exam arrives slide 10 Monetary Policy Rules a. Constant money supply growth rate b. Target nominal GDP increase (decrease) money growth whenever nominal GDP grows slower (faster) than targeted c. Target the inflation rate reduce money growth whenever inflation above target Many CB now practice inflation targeting, but allow themselves a little discretion. slide 11 4

5 d. The Taylor Rule i = nominal Fed Funds rate i = Inflation 0.5 GDPGAP If π = 2 and GDPGAP=0, then i=4% (and r = i- π =2%) For each one-point increase in π, tighten policy so as to raise i by 1.5 (and the real rate by 0.5) For each one percentage point that GDP falls below its natural rate, ease to reduce the Fed Funds Rate by 0.5. slide 12 Does Fed follow the Taylor Rule? Percent The Federal Funds Rate Actual and Suggested Actual Taylor's rule slide 13 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. In the data, countries with larger CB independence have lower average inflation rates slide 14 5