Should Policy Makers Be Restrained?

Is a balanced-budget amendment a good idea?

Uncertainty and Policy Macroeconomic policy makers in general do not have all the knowledge required for solving economic problems. Macroeconomic policy makers in general do not have all the knowledge required for solving economic problems. They rely on macroeconometric models, all of which give different answers for how to solve a particular problem. They rely on macroeconometric models, all of which give different answers for how to solve a particular problem.

How Much Do Macroeconomists Actually Know? The Response of Output to a Monetary Expansion: Predictions from 12 Models There is substantial uncertainty about the effects of policy.

Uncertainty and Restraints on Policy Makers There is substantial uncertainty about the effects of macroeconomic policies. This uncertainty should probably lead policy makers to be more cautious, and to use less active policies. There is substantial uncertainty about the effects of macroeconomic policies. This uncertainty should probably lead policy makers to be more cautious, and to use less active policies.

Expectations and Policy Until 20 years ago, the economy was seen as a machine. Methods of optimal control were being used to design macroeconomic policy. Until 20 years ago, the economy was seen as a machine. Methods of optimal control were being used to design macroeconomic policy. People and firms try to anticipate what policy makers will do. Hence, macroeconomic policy is a game between them. We don’t need optimal control theory but rather game theory, which studies strategic interactions between players. People and firms try to anticipate what policy makers will do. Hence, macroeconomic policy is a game between them. We don’t need optimal control theory but rather game theory, which studies strategic interactions between players.

Hijackings and Negotiations By giving up the option to negotiate, governments can prevent hijackings in the first place. By giving up the option to negotiate, governments can prevent hijackings in the first place. Exactly the same logic is involved in the design of macroeconomic policy to control inflation and unemployment. Exactly the same logic is involved in the design of macroeconomic policy to control inflation and unemployment.

Inflation and Unemployment Revisited The relation between unemployment and inflation is as follows: The relation between unemployment and inflation is as follows:  Suppose the Fed announces that it will constant inflation, and wage setters believe that expected inflation will be zero. Then:  In the U.S.,   1. If  = 0, then the announced policy calls for  =  e = 0, and u=u n.

Inflation and Unemployment Revisited But the Fed could deviate from its stated policy and achieve an unemployment rate of 1% below the natural rate with just a 1% increase in the inflation rate. But the Fed could deviate from its stated policy and achieve an unemployment rate of 1% below the natural rate with just a 1% increase in the inflation rate.  If  = 1 and  = 0, then (u  u n.) =  1%.  This incentive to deviate from the announced policy once the other player (in this case wage setters) has made its move is known as the time inconsistency of optimal policy.

Inflation and Unemployment Revisited Wage setters wise up and begin to expect positive inflation of 1%. Eventually, the economy returns to the natural rate of unemployment, but with higher inflation. Wage setters wise up and begin to expect positive inflation of 1%. Eventually, the economy returns to the natural rate of unemployment, but with higher inflation.  By credibly committing not to do something that would appear desirable at the time, policy makers can achieve a better outcome—no inflation.

Establishing Credibility Ways to deal with the problem of time inconsistency, without totally stripping policy- making power from the central bank, include: Ways to deal with the problem of time inconsistency, without totally stripping policy- making power from the central bank, include: 1. Make the central bank independent. This way, the central bank resists political pressure to decrease unemployment. 2. Choose a conservative central banker who dislikes inflation.

Establishing Credibility Inflation and Central Bank Independence

Politics and Policy If voters are short-sighted, the temptation for politicians to cut taxes may prove irresistible. If voters are short-sighted, the temptation for politicians to cut taxes may prove irresistible. With the right timing and short-sighted voters, political parties can win elections. Thus, we might expect a clear political business cycle, with higher growth on average before elections than after elections. With the right timing and short-sighted voters, political parties can win elections. Thus, we might expect a clear political business cycle, with higher growth on average before elections than after elections. However, there is little evidence of manipulation of the macroeconomy to win elections. However, there is little evidence of manipulation of the macroeconomy to win elections.

Games Between Policy Makers and Voters The Evolution of the Ratio of U.S. Debt to GDP,

Growth During Democratic and Republican Administrations GDP Growth (% per Year) FirstSecondThirdFourth Democratic Truman Kenney/Johnson Johnson Carter  0.2 Clinton I Clinton II Average: Democratic Republican Eisenhower 4.0  Nixon 2.4  Nixon/Ford 5.2  0.5  Reagan I 1.9  Reagan II Bush  Bush (George W) 1.1 Average: Republican 3.3 

Games Between Policy Makers Game theorists refer to situations in which each side holds out, hoping the other side will give in, as wars of attrition. These wars usually result in delays in the implementation of policy. Game theorists refer to situations in which each side holds out, hoping the other side will give in, as wars of attrition. These wars usually result in delays in the implementation of policy. Also, each party worries more about either inflation or unemployment. We would expect, for example, to see stronger growth during Democratic administrations. Also, each party worries more about either inflation or unemployment. We would expect, for example, to see stronger growth during Democratic administrations.

The Case Against a Balanced-Budget Amendment A balanced-budget amendment would eliminate the problem of deficits, but it would also eliminate the use of fiscal policy as macroeconomic policy instrument. A balanced-budget amendment would eliminate the problem of deficits, but it would also eliminate the use of fiscal policy as macroeconomic policy instrument. A constitutional amendment is not the only way to achieve deficit control and reduction. A constitutional amendment is not the only way to achieve deficit control and reduction.

The Case For a Balanced-Budget Amendment Economists in favor of a balanced-budget amendment are more skeptical of the usefulness of macroeconomic policy in general, and of fiscal policy in particular. Economists in favor of a balanced-budget amendment are more skeptical of the usefulness of macroeconomic policy in general, and of fiscal policy in particular. Lags in the legislative process prevent Congress from changing fiscal policy in time to stabilize the economy. Lags in the legislative process prevent Congress from changing fiscal policy in time to stabilize the economy. Rules that Congress may impose on itself can be changed by a vote later on. Rules that Congress may impose on itself can be changed by a vote later on.