Chapters 19 and 20. Stabilization policy: Why and How? ECON320 Prof Mike Kennedy

Why stabilization? 1 To understand the need for stabilization policy we have to know the social costs or welfare losses associated with fluctuations in inflation and unemployment The case for stabilization rest on the hypothesis that the public is averse to fluctuations in their consumption, employment and in inflation Since employment and consumption move with GDP we can write out a formal Social Loss function as The equation says that society’s welfare loss from macroeconomic instability increases with the variances of output and inflation from their equilibrium levels 1 Note for Chap 19, you are responsible for pp and pp , the summary

Stabilisation policy: Why? con’t Issues raised are: – Why variability and not average values of y and π ? – What determines the weights a y and a π ? – Should output be stabilised around its natural level regardless of the shock? – What is the appropriate target for π ? – What are the properties of an optimal policy rule if policy makers want to minimise the social loss function (SL)?

Stabilisation policy: The general conclusions of the literature Market imperfection prevent people from insuring themselves against unanticipated income losses from unemployment The average level of welfare could be increased if employment were stabilised around its natural level Empirical evidence suggests that the welfare losses of recessions are large and are borne disproportionately by low-paid and low- skilled workers While it is efficient to stabilise output around its potential level when there are demand shocks, it is not when there are supply shocks, distinguishing between the two is difficult at best High and volatile output and inflation create a number of welfare losses, due in large part to nominal rigidities and tax distortions The other goal of policy then is to stabilise inflation around a target level which should be low but not zero

Stabilisation policy: How? We know that fluctuations cause welfare losses, making a case for stabilisation policy But, is the economy really too complex to manage? – This is the case for having a policy rule like that suggested by Friedman (fixed money growth rate) and later Taylor (focussing on an inflation target but allowing for output changes) Rules may help to establish credibility for policy makers The case for discretion says that the policy maker should have leeway to react to the situation as it develops In general most economists favour rules In practice, policy makers use lots of discretion, sometimes with poor results as we will see at the end

Optimal monetary policy with limited information: Inflation targeting Assume that the central bank cannot observe the shocks but it does know the output and inflation gaps Also assume that the central bank does not target an output level above potential – it cares only about the inflation gap Since it cannot observe the shocks or their source the bank assumes that these shocks take their expected values of zero The social loss function is that shown on slide 2 The Marginal Social Loss wrt each gap is

Inflation targeting Also assume that inflation expectations are static π = π -1 With static inflation expectations, we need to take account of the fact that a change in today’s output and inflation gaps will effect all future output gaps according to (see Chap 18): Assuming a positive social rate of discount, call it ϕ, the discounted values of all future marginal gains/losses for each are:

Inflation targeting: The optimal Monetary Policy Rule From the SRAS curve we have Assuming as we must that the forecast of the shocks ( s ) are zero then Next set the (discounted) marginal gains from an increase in the output gap to the (discounted losses) from an increase in the inflation gap equal to each other MPR curve

Inflation targeting: The MPR curve and the policy rule Next, write the AD curve in terms of the policy interest rate ( i p ) Where we have assumed that Now use the MPR curve to eliminate the output gap and we get We now get a policy rule in terms of only the inflation gap. Note that the concern about the output gap (output and employment) does enter the rule through the coefficient – The higher is this coefficient, the smaller the weight on the inflation gap

The MPR and the AD curves The above is the theoretical underpinnings of inflation targeting The general expression for goods market equilibrium is given by If we insert the optimum policy rule into this expression we get the AD curve Comparing this to the MPR we see they are the same when z = 0 This shouldn’t be a surprise since inflation targeting is designed to ensure a socially optimal trade off

A temporary unfavourable supply shock with optimal policy response

A temporary unfavourable supply shock with optimal policy response: The details In the first period the economy is hit with a negative supply shock ( s > 0 ) causing the SRAS to shift upwards At the new equilibrium, there is a negative output gap and higher inflation In the next period, the shock disappears but the SRAS curve only shifts down to E 2 as inflation expectations are based on last period’s level of inflation ( π -1 ) This yields a new and lower level of π and the SRAS curve keeps shifting back towards equilibrium Since there are no demand shocks, the AD curve remains unchanged and equal to the MPR curve

A temporary negative demand shock

A temporary negative demand shock: The details The shock ( z < 0 ) pushes the AD curve off the MPR curve causing inflation to fall below target In the next period, the shock disappears and AD is again equal to MPR but, because inflation expectations are static the SRAS curve has shifted With inflation in period 2 still below target, the central bank keeps interest rates below their equilibrium and the economy moves back towards equilibrium As before there is a cycle in output

Time paths of the two shocks

The Taylor rule with inside and outside lags Some definitions – Inside lag, the time it takes to recognize the shock (recognition lag) and then the time to implement the policy response (implementation lag) – Outside lag, the time it takes for policy actions to have an effect on the economy The outside lag is rooted in the structure of the economy – the delays in responding to policy actions For most economies to takes about two years for a change in interest rates to have the maximum effect on inflation To the extent possible, the central bank and/or the government must take account of these lags in designing policy responses

Taylor rule when there are lags in the response of the economy to policy actions Suppose we have the following – The AD curve, assuming it takes 1 year for a change in the policy rate to affect y – The SRAS curve, assuming it takes an additional year for output to affect inflation Noting the then:

Taylor rule when there are lags con’t In its forecast, the central bank cannot know the future shocks ( s ) so they are set equal to zero The forecast for inflation two periods ahead based on information today ( π e t+2,t ) is The bank now chooses the policy rate ( i p ) so as to achieve its target ( π e t+2,t = π* ) In the end, the central bank targets its forecast of inflation and this yields the following This looks remarkably like the Taylor rule Note that monetary policy now reacts to the current output gap since the gap contains information regarding the future price level – its part of the forecast

Has using something like a Taylor been successful? From 1960 to 1979 policy makers in both Canada and the US tended to respond slowly to inflation ( h < 0 ) This was a period of both rising inflation as well as more volatile GDP (see next two slides) This changed starting in the 1980s first with Paul Volcker (US) and in Canada with Gerald Bouey and John Crow Once the transition to low inflation was made and general inflation targeting adopted (implicitly in the US) GDP, and with it the output gap, became less volatile

Keeping inflation low has not come at the expense of more GDP volatility, which has declined in the US …

… and in Canada

The recent world wide financial crisis Prior to the financial crisis, the US Fed departed from the Taylor, due in good part to fears about deflation The next slides shows the actual US policy interest rate (Fed funds rate) and that implied by the Taylor rule Actual interest rates were far below what would have been suggested by that rule As slide 24 shows, these low interest rates seem to be linked to the housing boom, driving up US housing starts – Housing starts would have been much lower if interest rates had been higher There is also evidence, provided in an OECD Working Paper, that interest rates below what would be suggested by the Taylor rule contributed to rising housing investment in OECD countries in general (slide 25)

The Taylor rule versus actual US monetary policy leading up to the crisis

Actual and estimated US housing starts

A look at other countries

Fiscal policy The AD curve already allows for the effect of changes in government spending We now need to modify that curve to allow for tax changes From the above we see that an interest rate change equal to α 1 /α 2 percentage points would have the same effect on the economy as a one per cent change in g

Fiscal versus monetary policy If the government and the central bank have the same information the question becomes: who should be responsible for stabilisation? Each has the same recognition lag but monetary policy has a shorter implementation lag – There is no need to go through the political process That said, the outside lag for fiscal policy is shorter – changes in spending and taxes have immediate effects on the economy Tax changes require a little more analysis since they will have an effect on aggregate supply (SRAS) through its effect on pre-tax wage claims

Modifying the SRAS for tax changes If the union bargains for after-tax wages (and denoting b u is the after-tax unemployment benefits), then the wage setting equation becomes The SRAS is now A temporary tax cut driving τ below its trend value will act like a favourable supply shock The figure on the following slide illustrates the effect of a temporary tax cut, where the economy is assumed to be in recession at point E 0 In this case, fiscal policy shifts both the AD and SRAS curves, something that monetary policy cannot do

The effect of a temporary tax cut

The tax cut will shift the aggregate demand curve But it also shift the supply curve as more work is supplied – it acts as a temporary favourable supply shock The effect on inflation is ambiguous The government’s budget balance will fall and debt rise There could be Ricardian effects

Summing up fiscal versus monetary policy While government spending has important supply side effects, these work over the long run – In the short run, the effects are felt mainly through aggregate demand To that extent, these policies cannot achieve anything that could not be achieved by monetary policy acting alone Tax changes, however, can have important effects on both AD and SRAS That said, the implementation lag tends to be long (and sometimes painful – witness the US debt on stimulus during the crisis) For this reason, many economists conclude that short-run stabilisation should be left to central banks – in normal circumstances! An important exception is when interest rates hit the “zero bound” and monetary policy becomes impotent – the “liquidity trap”

In the wake of the great recession, many countries pushed interest rates close to the zero bound …

… with a great many of them still there, suggesting a role for fiscal policy

Fiscal policy when interest rates are at zero From the previous two slides we see that the liquidity trap is back When the economy is at the zero lower bound, the AD curve becomes: Note that AD is now upward sloping! The SRAS remains unchanged

The dynamics of fiscal expansion when i p = 0 The initial equilibrium is E 0 where the economy is in a liquidity trap (see figure next slide) A fiscal expansion shifts the AD curve to the right (and down) where it intersects the SRAS at E 1 a new short-run equilibrium Both output and inflation have increased (an unusual result!) The rise in output has driven up MCs, which raises π With the policy rate stuck at zero, real interest rates fall, and this boosts demand To satisfy the increased demand, output increases from E 1 ’ to E 1 With static inflation expectations, the SRAS curve will shift upwards, triggering further drops in the real interest rate due to rising inflation Eventually the original slope of the AD curve will be restored

Fiscal policy in a liquidity trap

Has fiscal policy been stabilising? Active fiscal policy was no doubt responsible for lessening the economic effects of the financial crisis of But has fiscal policy been actively counter cyclical over long periods of time? We can test this proposition by examining the structural budget balance, which is defined as Variables with bars are structural measures which are measured as follows

Has fiscal policy been stabilising? The OECD has estimated the elasticities in the last two equations on the previous slide Based on this information Fatas and Mihov (2009) have estimated the following The idea is that the coefficient a 1 should be negative and significant if governments are pursuing active counter-cyclical policy The results, shown in Table 20.1, suggest that the answer is no, with the US and the UK being important exceptions This is the reason why economists are sceptical about using fiscal policy for counter cyclical reasons