CHAPTER FOURTEEN Stabilization Policy

This chapter: Should monetary and fiscal policy take an active role in stabilizing the business cycle, or should it remain passive? Should policy be conducted by discretion, or should it be governed by a rule set out in advance? There are good arguments on both sides of these questions. The fundamental issue: how policymakers should use the theory of short-run fluctuations developed in the previous chapters.

I. Should Policy Be Active or Passive? Many economists (policy should be active): - the case for active government policy is clear and simple. -Recessions are periods of high unemployment, low incomes, and increased economic hardship. -The model of aggregate demand and aggregate supply shows how shocks to the economy can cause recessions. -It also shows how monetary and fiscal policy can prevent recessions by responding to these shocks. -they consider it wasteful not to use these policy instruments to stabilize the economy.

Other economists (policy should be passive): - they are critical of the government’s attempts to stabilize the economy. - they argue that the government should take a hands-off approach to macroeconomic policy - this view might seem surprising: if our model shows how to prevent or reduce the severity of recessions, why do these critics want the government to refrain from using monetary and fiscal policy for economic stabilization? Let’s see some of their arguments!!

1. Lags in the Implementation and Effects of Policies Economic stabilization would be easy if the effects of policies were immediate - BUT….there are LAGS!! Economists distinguish between 2 types of lags in the conduct of stabilization policy: the inside lag and the outside lag. The inside lag = the time between a shock to the economy and the policy action responding to that shock. This lag arises because it takes time for policymakers first to recognize that a shock has occurred and then to put appropriate policies into effect. The outside lag = the time between a policy action and its influence on the economy. This lag arises because policies do not immediately influence spending, income, and employment.

Fiscal policy - has a long inside lag, usually because of the long legislative process (e.g. In United States, changes in spending or taxes require the approval of the president and both houses of the Congress) Monetary policy - has a substantial outside lag. Monetary policy uses as instruments the money supply and, therefore, the interest rates and these will affect investment. But many firms make their investment plans in advance, that is why it will take at least 6 months for the monetary policy to affect economic activity.

Automatic Stabilizers They are designed to reduce lags associated with stabilization policy. Automatic stabilizers are policies that stimulate or depress the economy when necessary without any deliberate policy change. Examples: the system of income taxes automatically reduces taxes when the economy goes into a recession, without any change in the tax laws, because individuals and corporations pay less tax when their incomes fall. the unemployment insurance and welfare systems automatically raise transfer payments when the economy moves into a recession, because more people apply for benefits. One can view these automatic stabilizers as a type of fiscal policy without any inside lag.

Case study: The 1990 Recession In United States, in the middle of 1990, a recession began Unemployment increased from 5.1% in June 1990 to 7.7% in June 1992 One early cause of this recession: a contractionary shift in the LM curve due to monetary policy (in the late 1980s the unemployment rate was below its natural rate and inflation was increasing, therefore, the Fed slowed the rate of money growth) interest rates rose, they put downward pressure on investment demand, and aggregate demand decreased

Case study: The 1990 Recession Another cause: two shocks to the IS curve: - many financial institutions (esp. savings and loans associations) were near bankruptcy. This made bankers and banks regulators more cautious in approving loans. Therefore, firms reduced their demand for investment goods - consumer confidence fell because of uncertainty caused by the Gulf War (when Iraq invaded Kuwait). Consumer spending fell as well.

Case study: The 1990 Recession Could the recession have been avoided? In retrospect, it is clear that a more expansive monetary policy would have helped. The Fed did lower the interest rates, but very gradually and not enough. This might be due to the fact that the Fed was not aware of the magnitude of the IS shocks it might have misinterpreted this as evidence of expansionary shifts in the LM curve rather than contractionary shifts in the IS curve. Because data on income are available only after one lag and because income responds to monetary policy with a lag, anyway the Fed would have learnt of its mistake when it was too late to prevent the recession.

2. The Difficult Job of Economic Forecasting As we learned, since policy only affects the economy after a long lag, successful stabilization requires the ability to predict future economic conditions. One way forecasters try to look ahead: - Leading indicators = data series that fluctuate in advance of the economy. A large fall in a leading indicator signals that a recession is more likely. In USA, there is an index of leading economic indicators that is made up of 11 series that are often used to forecast changes in economic activity about 6 to 9 months ahead (average workweek of production workers in manufacturing, new orders for consumer goods and materials adjusted for inflation, new building permits issued, index of consumer expectations, etc.)

Another way forecasters look ahead: -Macroeconometric models, which have been developed by both government agencies and by private firms. They seek to predict variables such as unemployment and inflation and other endogenous variables.

Case study: Mistakes in forecasting the Great Depression Even after the stock market crash of 1929, economic forecasters remained confident that the economy would not suffer very badly In late 1931, when the economy was in a bad situation, the economist Irving Fisher predicted that it would recover quickly. But next events showed that these forecasts were much too optimistic Dominguez, Fair and Shapiro: “Forecasting the Depression: Harvard versus Yale”, American Economic Review, 1988: it shows how badly economic forecasters did during the Depression and it argues that they could have not done better with the modern forecasting techniques available today.

The Lucas Critique Nobel laureate Robert Lucas, emphasized that people form expectations of the future. Expectations play a crucial role because they influence all sorts of economic behavior. Both households and firms decide to consume and invest based on expectations of future earnings. These expectations depend on many things, including the policies of the government. He argues that traditional methods of policy evaluation such as those that rely on standard macroeconometric models– do not adequately take into account this impact of policy on expectations. This criticism of traditional policy evaluation is known as the Lucas Critique.

Some remarks In deciding whether the government policy should be active or passive, we should give some weight to the historical record If the economy suffered large shocks to aggregate demand and aggregate supply and the policy was successful in stabilizing the economy, then the case for active policy should be clear If the economy suffered very few large shocks and if the fluctuations we see can be due to bad economic policies, then the case for passive policy should be clear This means that our view of stabilization policy should be influenced by whether policy has historically been stabilizing or destabilizing

II. Should Policy Be Conducted by Rule or by Discretion? Policy is conducted by rule if policymakers announce in advance how policy will respond to various situations and commit themselves to following through on this announcement. Policy is conducted by discretion if policymakers are free to size up events as they occur and choose whatever policy seems appropriate at the time. The debate over rules versus discretion is distinct from the debate over passive versus active policy. Policy can be conducted by rule and yet be either passive or active.

Political Business Cycles Opportunism in economic policy arises when the objectives of policymakers conflict with the well-being of the public. Some economists fear that politicians care only about winning elections and thus choose policies that further their own electoral ends. A president might cause a recession soon after coming into office to lower inflation and then stimulate the economy as the next election approaches to lower unemployment; this would ensure that both inflation and unemployment are low on election day. Manipulation of the economy for electoral gain is called the political business cycle.

Opportunistic policymakers take advantage of an exploitable Phillip’s curve and face naïve voters who forget the past, are unaware of the policymakers’ incentives, and do not understand how the economy works. In particular, politicians don’t take into account the trade-off between inflation and unemployment when their political gain is at stake.

Time Inconsistency Problem Policymakers announce in advance the policy they will follow in order to influence the expectations of private decision makers. But, later, after the private decision makers have acted on the basis of their expectations, these policymakers may be tempted to renege on their announcement.

Examples of Time Inconsistent Problems 1) To encourage investment, the government announces that it will not tax income from capital. But, after factories are built, the government is tempted to raise taxes. 2) To encourage research, the government announces that it will give a temporary monopoly to companies that discover new drugs. But, after the drugs have been discovered, the government is tempted to revoke the patent. 3) To encourage hard work, your professor announces that this course will end with an exam. But, after you studied and learned all the material, the professor is tempted to cancel the exam so that he or she won’t have to grade it.

Rules for policies If we are convinced that policy rules are superior to discretion, the next question is: what rule should the policymakers choose? For monetary policy, there are three policy rules that various economists proposed:

1. Monetarists Monetarists are economists who advocate that the Fed keep the money supply growing at a steady rate (Milton Friedman). Monetarists believe that fluctuations in the money supply are responsible for most large fluctuations in the economy. They argue that slow and steady growth in the money supply would yield stable output, employment and prices. P Y P* AD LRAS AD' Here we can see that this economy is growing (LRAS is shifting rightward) so continued increases in the supply of money (via +DAD) don’t necessarily imply increases in inflation. AD'' Y' Y''

2. Nominal GDP Targeting Nominal GDP targeting = the Central Bank announces a planned path for nominal GDP. If nominal GDP rises above the target, the Fed reduces money growth to dampen aggregate demand. If it falls below the target, the Fed raises money growth to stimulate aggregate demand. Because a nominal GDP target allows monetary policy to adjust to changes in the velocity of money, most economists believe it would lead to greater stability in output and prices than a monetarist policy rule.

3. Inflation targeting The Central Bank would announce a target for the inflation rate (usually a low one) and then adjust the money supply when the actual inflation rate deviates from the target. It has the political advantage that it is easy to explain to the public.

Inflation targeting: rule or constrained discretion? Throughout 1990’s, many of the world’s Central Banks - Australia, Canada, Finland, Israel, New Zealand, Spain, Sweden, United Kingdom - have adopted some form of inflation target Still, Central Banks are left with a fair amount of discretion: inflation targets are usually set as a range - an inflation rate of 1 to 3%, for example. Also, the Central Banks are sometimes allowed to adjust their targets for inflation, at least temporarily, in case of a supply shock, for instance, that pushes inflation outside the announced range

Rules for fiscal policy The balanced-budget rule: the government would not be allowed to spend more than it receives in tax revenue Budget deficit/surplus Reasons: - it can help stabilize the economy: for instance, when the economy goes into a recession, taxes automatically fall and transfers automatically rise - a budget deficit can be used to shift a tax burden from current to future generations (for ex., if the current generation fights a war for freedom, future generations will benefit as well and should bear some of the burden; the current generation can finance the war with a budget deficit)

Making Policy in an Uncertain World We have looked at whether policy should take an active versus passive role in responding to fluctuations in the economy, and whether policy should be conducted by rule or discretion. Although there is persistent debate between both sides, there is one clear conclusion that there is no simple and compelling case for any particular view of macroeconomic policy. In the end, one must weigh the various political and economic arguments and decide what role the government should play in stabilizing the economy.

Key Concepts of Ch. 14 Inside and outside lags Automatic stabilizers Leading indicators Lucas critique Political business cycle Time inconsistency Monetarists