Monetary and Fiscal Policy-makers should try to Stabilize the Economy. Monetary Policy should be made by an Independent Central Bank. The Central Bank should aim for Zero Inflation. The Government should Reduce its Debt. The Tax Laws should be Reformed to Encourage Saving. CH 17 2 2

EXAM Same format as December Monday April 18---9AM---Field House This week-chapter 17 Last class Tuesday April 5—Review +discuss exam Office hours after term ends: April 11: 3-4:30 and April 13 and April 14 from 9:30-11

US housing-spending down

Monetary and Fiscal Policy-makers should try to Stabilize the Economy: PRO The economy is inherently unstable, and if left unchecked, the economy will go through long and frequent periods of recession and high unemployment. With careful timing and proper actions, policy-makers can use monetary and fiscal stimulation to prevent recessions or at least minimize their severity. 3 3

Monetary and Fiscal Policy-makers should try to Stabilize the Economy: PRO There is no reason for society to suffer through the booms and busts of the business cycle. Monetary and fiscal policy can stabilize aggregate demand and, thereby, production and employment. 4 4

Monetary and Fiscal Policy- CON Discretionary monetary policy affects the economy with long and unpredictable (variable) lags between the “need to act” and the time that it takes for these policies to exert an influence of output and employment. Many studies indicate that changes in monetary policy have little effect on aggregate demand until about six months after the change is made. 5 5

Monetary and Fiscal Policy-makers should try to Stabilize the Economy: CON Fiscal policy works with a lag because of the long political process to change spending and taxes. All too often these policy initiatives can aggravate rather than reduce the ups and downs of the economy. It might be desirable if policy makers could eliminate all economic fluctuations, but this is not a realistic goal. Instead provide stable environment. 6 6

Policy question Would you be more likely to support active stabilization policy if wages, prices, and expectations adjust quickly in response to economic changes, or if they adjust slowly?

Refers to AD and AS adjustments If wages, prices, and expectations adjust slowly, it will take longer for the economy to return to its natural rates of output and employment. In that case, there’s a better chance that expansionary policy will act in time to alleviate the recession, rather than push the economy into an inflationary boom.

Expectations Adjust From SRAS, Y deviates from YN when P deviates from PE. Y = YN +a(P-PE) YN =Natural rate of output P is actual price level PE is expected price level Related to SRPC

US CBO estimate

GREAT DEPRESSION 1929-1933 Real GDP declined 30% Urate increased from 2.9% to >20% Almost no 2 income families K causes: Uncertainty, C, I (AD) decline M causes –bad mp—MS down Global: international tariff war.

Monetary Policy Should Be Made By An Independent Central Bank: PRO To the extent politicians influence monetary policy, economic fluctuations may come to reflect the electoral calendar - political business cycle. That is, politicians may be tempted to use monetary policy to affect election results. (SR vs LR objectives). 9 9

PRO Independence There is a time inconsistency of policy - the discrepancy between what policy-makers say they will do what they subsequently in fact do. This may make people sceptical about inflation policy—slows adjustment of PE to P. Independent BOC has less incentive tio do this.

PRO Keep monetary policy independent of politics. Evidence across countries suggests that countries with the most independent central banks have the lowest inflation rates.

Monetary Policy Should Be Made By An Independent Central Bank: CON Empowering central banks with complete independence in conducting monetary policy is a problem since it does not limit incompetence and abuse of power. Changes in aggregate demand translate into changes in employment and income, so someone should be accountable for monetary policy changes. 10 10

Monetary Policy Should Be Made By An Independent Central Bank: CON Despite clear and forceful statements by the B of C, it is not obvious that enhancing the credibility of inflation targets has resulted in reducing the short-run cost of achieving lower inflation. Elected policy-makers might find fiscal policy more useful than monetary policy when trying to influence votes. 11 11

Independent bank : CON Elected officials are more accountable. The practical importance of time inconsistency has not been shown. Question is how much independence.

Bank of Canada How independent?? US Fed is similar. Current bank-related issues in US have drawn Fed (Bernanke) more into the political system. Usual central bank goal is price stability.

Obsessing?

Previously quite stable

The Central Bank Should Aim for Zero Inflation: PRO Inflation confers no benefit to society, but it does impose several social costs. If “inflation is bad”, why not 0? Reducing inflation is a policy with temporary costs and permanent benefits. Once the disinflationary recession is over, the benefits of zero inflation would persist. 14 14

The Costs of Inflation At least six costs of inflation are identified as: . Shoeleather costs . Menu Costs . Increased variability of relative prices . Tax liabilities . Confusion and inconvenience . Arbitrary redistribution of wealth 15 15

Aim for Zero Inflation: NO Zero inflation is probably unattainable and getting there involves output and unemployment costs that are too high. The stimulative effect of a little inflation is necessary to keep unemployment reasonably low. The imperfections of measuring price levels result in uncertainty about measuring the successful attainment of zero inflation. 16 16

INFLATION COSTS Not all inflations are the same. Little inflation becomes hyperinflation only with political instability. 5% inflation>>>P doubles in 14 years. Inflation variability more costly: 3% per year for five years (15 total) versus 5,0,5,0,5 (15 total)

Measuring inflation ch 6 CPI—fixed market basket:3 biases Substitution bias—buy less of things that go up more in price but basket is fixed. New products-greater utility from variety Unmeasured quality change—real price lower. Computing power

Government Debt Should Be Reduced: PRO Budget deficits impose an unjustifiable burden on future generations by raising their taxes and lowering their incomes. When the debts and accumulated interest come due, future taxpayers will face a difficult choice: They can pay higher taxes, enjoy less government spending or both. 19 19

The Government Should Balance Its Budget: PRO By shifting the cost of current government benefits to future generations, there is a bias toward too large a public sector. Deficits reduce national saving, thereby retarding capital formation, causing lower productivity, and limiting real growth. Series of deficits leads to debt. 20 20

Budget deficit reduces S

The Government Should Balance Its Budget: CON The deficit is only one small part of fiscal policy. The problem with the deficit and debt is often exaggerated. Intergenerational transfers may be justified and some government purchases produce benefits well into the future (i.e. reducing budget deficit by cutting spending on education). 21 21

The Government Should Balance Its Budget: CON A balanced budget requirement would limit the policy options available to deal with emergencies and future economic crises. The government debt can continue to rise. Population growth and technological progress increase the nation’s ability to pay the interest on the debt. 22 22

Key is debt/GDP

The Tax Laws Should Be Reformed To Encourage Saving A nation’s productive capability is determined largely by how much it saves and invests for the future. S = Y-C-G (simple closed economy) Farm example—eat corn vs seed 25 25

The Tax Laws Should Be Reformed To Encourage Saving: PRO “A nation’s saving rate is a key determinate of its long-run economic prosperity.” When the saving rate is higher, more resources are available for investment in new plant and equipment. 26 26

Tax Laws Should Encourage Saving: PRO “Our society discourages saving in too many ways, such as by taxing the income from capital heavily and by reducing benefits for those who have accumulated wealth and capital.” The consequences of high interest income tax policies are: reduced saving, reduced interest accumulation, lower labour productivity, and reduced economic growth. 27 27

Reform Tax Laws To Encourage Saving: PRO An alternative to current tax policies, advocated by many economists is a consumption tax like the GST-HST. A person pays taxes only on the basis of what they consume (spend) not on what they produce (earn). Income that is saved is exempt from taxation until the saving is later withdrawn and spent on consumption goods. 28 28

Tax Laws Should Encourage Saving: CON Most of the proposed changes in the tax policies to stimulate saving would benefit primarily the wealthy at the expense of lower income groups. High-income households save a higher fraction of their income than low-income households. Any tax change that favors people who save will also tend to favor people with high income. 29 29

Taxes US: Top 1% of taxpayers pay 37% of taxes Top 10% pay 68% ($100K and more) Top 50% pay 97% of all taxes Tax cuts must be on those who pay.

Tax Laws Should Encourage Saving: CON Reforms would be either regressive or would further the inequality of income in our society. Raising public saving by eliminating the government’s budget deficit would provide a more direct and equitable way to increase national saving. 30 30

Summary-17 Advocates of active monetary and fiscal policy view the economy as inherently unstable and believe policy can be used to offset this inherent instability. Critics of active policy emphasize that policy affects the economy with a lag and our ability to forecast future economic conditions is poor, both of which can lead to policy being destabilizing.

Summary-17 Advocates of an independent central bank argue that such independence guards against politicians using monetary policy to try to influence voters. A lower rate of inflation and a more favourable short-run tradeoff between inflation and unemployment is possible. Critics of an independent central bank argue that because it has large and lasting influences on aggregate demand, output, and employment, citizens should have a say on monetary policy

Summary-17 Advocates of a zero-inflation target emphasize that inflation has many costs and few if any benefits. Critics of a zero-inflation target claim that moderate inflation imposes only small costs on society, whereas the recession necessary to reduce inflation is quite costly.

Summary-17 Advocates of reducing the government debt argue that the debt imposes a burden on future generations by raising their taxes and lowering their incomes. Critics of reducing the government debt argue that the debt is only one small piece of fiscal policy.

Summary-17 Advocates of tax incentives for saving point out that our society discourages saving in many ways such as taxing income from capital and reducing benefits for those who have accumulated wealth. Critics of tax incentives argue that many proposed changes to stimulate saving would primarily benefit the wealthy and also might have only a small effect on private saving. (Elasticity issue)