Chapter 19 Policy in an Uncertain World

Chapter 19 Policy in an Uncertain World
Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley.

Objectives Explore the limitations of macroeconomic policy
Understand how uncertainty impacts on the outcome of policy implementation Explain policy lags Understand the issue of rules versus discretion Analyse the issue of dynamic inconsistency Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley.

Chapter Organisation 19.1 Policy: Working Backwards
19.2 Lags in the Effects of Policy 19.3 Expectations and Reactions 19.4 Uncertainty and Economic Policy 19.5 Multiplier Uncertainty and Policy: a Formal Analysis 19.6 Targets, Instruments and Indicators: a Taxonomy 19.7 Activist Policy 19.8 Which Target? A Practical Application 19.9 Dynamic Inconsistency and Rules Versus Discretion 19.10 Dynamic Inconsistency: a Formal Approach 19.11 The Positive Theory of Policy Making Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley.

19.1 Policy: Working Backwards
The process of studying macroeconomics is: Observe a shock or policy change Recognise the transmission mechanisms linking the shock to our AD and AS models Analyse how the AD and AS curves shift in terms of directions and amounts Take into account the slopes of the AD and AS curves Calculate the output and price level changes. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley.

Policy: Working Backwards
Policy makers use the same tools but run the exercise in reverse: Policy makers ask where output and price levels should be. Then they ask in which direction and how far AS and/or AD need to shift to hit these targets. The final step is to calculate how large a policy change is required to move AS and/or AD the necessary distance. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley.

19.2 Lags in the Effects of Policy
Consider an economy at full employment which experiences an unexpected adverse AD shock. Policy makers must distinguish whether the disturbance is permanent or transitory: If the disturbance is transitory with AD rapidly adjusting it would be best to do nothing Why? Policy actions have lagged effects which may cause overshooting in the correction process. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley.

Lags in the Effects of Policy

Figure 19.1 highlights the policy intervention problem: Without intervention output declines but then recovers. If expansionary policy is implemented output recovers faster but may overshoot the full employment level. Restrictive policy may then have to be applied to return the economy to it full employment point. If the disturbance is permanent (persistent) policy makers must intervene. However, their ability to intervene is made difficult by lags in the effects of policies. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley.

There are two types: Inside and Outside lags Inside lags The time period it takes to undertake policy action Are divided into recognition, decision and action lags Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley.

The recognition lag The period that elapses between the time a disturbance occurs and the time the policy makers recognise that action is required. The decision lag The delay between the recognition of the need for action and the policy decision. This involves time in formulating an appropriate policy response. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley.

The action lag The lag between the policy decision and its implementation Usually short for monetary policy as actions can be undertaken almost as soon as the decision is made Fiscal policy actions are relatively slower to implement They require legislation drafting and approval by both houses of parliament Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley.

Inside lags are discrete lags. There is a period time between each lag from recognition to action. Outside lags are distributed lags. Policy effects are spread over time and gradually accumulate. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley.

Outside lags Are associated with the impact of policy on the economy Example: The impact of an increase in money supply gradually increases spending and GDP over several quarters Implication: A large increase in money supply is needed to quickly reverse an adverse AD shock Problem: This will have large effects on GDP which could overcorrect and cause inflation Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley.

Monetary versus fiscal policy lags Fiscal policy has relatively shorter outside lags but considerably longer inside lags than monetary policy. For this reason fiscal policy is less useful for stabilisation. Gradualist versus cold turkey policies Gradualist policies more the economy slowly towards a target. Cold turkey policies generate a 'shock effect'. This shock may have negative as well as positive effects. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley.

19.3 Expectations and Reactions
Uncertainty about the effects of policies arises because policy makers do not know: The precise values of multipliers How the economy will react to policy changes. Reaction uncertainties Assume that the government decides on a temporary tax cut. The effectiveness of the tax cut depends upon the reaction of the public. If the government is wrong in its estimation of reaction, a policy change could destabilise the economy. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley.

Expectations and Reactions
If the public knows the tax cut is only temporary: Their permanent income will increase by a small margin So the increase in spending will be small. If the public think that the cut will last longer: Their MPC out of the tax cut would be higher So a small tax cut may raise spending by a larger amount. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley.

Expectations and Reactions
Credibility and policy regime Policy makers only have credibility when their announcements are believed by individuals. Policy makers have to earn credibility by behaving consistently over long periods of time. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley.

19.4 Uncertainty and Economic Policy
Policy makers may go wrong in using active stabilisation policies because of: Uncertainty about expectations Difficulty in forecasting shocks, such as the hikes in the price of oil. Economists do not know enough about the true structure of a dynamic economy. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley.

Uncertainty and Economic Policy
This uncertainty arises because: Economists disagree about the correct model of the economy. This is evidenced by the large number of different macroeconomic models. Even with a given model, there are uncertainties about the correct values of parameters and multipliers. Uncertainty about the effects of policy changes due to incomplete knowledge of the multiplier value is known as 'multiplier uncertainty'. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley.

19.5 Multiplier Uncertainty and Policy: a Formal Analysis
Multipliers measure the quantitative effects of policy. Policy may not always achieve its designated target. There may be a gap between the actual change in income Y and the desired change in income Y*. This gap may be measured through the loss function. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley.

Multiplier Uncertainty and Policy: a Formal Analysis
Assume the effect of a change in monetary policy can be expressed as: Y = βM (19.1) In this equation Y is output, M is the money supply and is the money multiplier The loss function measuring the loss due to any gap between actual and target output is: L = ½(Y – Y*)2 (19.2) Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley.

Multiplier Uncertainty and Policy: a Formal Analysis
The impact of policy change may also be measured with reference to the marginal loss function. The marginal loss function measures the incremental loss or gain due to a change in policy. ML(M) = (βM – Y*) × β (19.3) Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley.

19.6 Targets, Instruments and Indicators: a Taxonomy
Targets are identified goals. Targets are subdivided into ultimate targets and intermediate targets. We focus on output, prices and unemployment—these are intermediate targets. Instruments are the tools the policy maker manipulates directly. An example is the RBA having an exchange rate target. The RBA instrument would be the purchase or sale of cash or foreign exchange reserves. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley.

Targets, Instruments and Indicators: a Taxonomy
Indicators are economic variables that indicate whether we are closer to our desired targets. An example: an increase in interest rates (an indicator) sometimes signals that the market anticipates increased future inflation (a target). Other examples of indicators are consumption expenditure, changes in inventories, consumer sentiment and inflationary expectations. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley.

19.7 Activist Policy Activist policies are policies that respond to economic problems and attempt to stabilise output. Is activist monetary and fiscal policy desirable? Intervention is necessary when the economy has suffered a major economic shock. The debate revolves around the use of policies for finetuning an economy. The major argument against finetuning is that, in practice, policy makers try to do too much. This can be risky and policy may become destabilising. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley.

Activist Policy Rules versus discretion
Should the authorities conduct policy in accordance with pre-announced rules (publicised policy responses to certain shocks)? Or should policy makers be allowed to use their discretion? Given the economy and our understanding of it is always changing, there is no economic case for supporting permanent policy rules. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley.

19.8 Which Target? A Practical Application
Real GDP targeting requires the use of monetary and fiscal policy to achieve a particular rate of growth in real GDP. If we know what potential GDP is, and we are able to hit potential GDP, then real GDP targeting is optimal. The Phillips curve relationship implies that hitting potential GDP is consistent with low actual and anticipated inflation. The problem with targeting real GDP is that guessing too high as to the growth of potential GDP creates inflationary problems. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley.

Which Target? A Practical Application
Nominal GDP targeting Suppose that the nominal GDP target is 4% but real GDP is actually 2%. In the long run, the 4% nominal GDP growth will split into 2% real growth and 2% inflation. This has the advantage over real GDP targeting as inflation won’t be unlimited, which may occur through targeting real GDP. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley.

Which Target? A Practical Application
Inflation targeting This is the opposite to real GDP targeting. This may be easier to achieve than targeting unemployment or real output. Economists who believe the economy is largely self-correcting prefer nominal targets like inflation. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley.

19.9 Dynamic Inconsistency and Rules Versus Discretion
Refers to the tendency of optimal policy to be different a different points in time. Policy makers who have discretion will be tempted to take short-run actions that are inconsistent with the economy’s best long-run interests. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley.

Dynamic Inconsistency and Rules Versus Discretion

The policy maker announces a policy of zero inflation. Economic agents choose a level of anticipated inflation consistent with the announced policy. The economy will be at point A at full employment. Since the short-run Phillips curve is now fixed, the policy maker may reduce unemployment at the expense of a little inflation. The economy moves to point B. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley.

At point B, the policy may be optimal because people’s marginal loss from more inflation equals the marginal benefit from lower unemployment. However, at point B, inflation is greater than expected. Economic agents will come to anticipate higher inflation and the short-run Phillips curve will shift up. The economy moves to point C. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley.

At point C the marginal loss from inflation is high enough that the policy maker is unwilling to increase inflation further to reduce unemployment The economy is at point C although the preferred position is A. A promise by the policy maker to return to point A may not be credible. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley.

How can dynamic inconsistency be reduced? The policy maker may follow a (monetary) rule. However, this rule may become outdated or inappropriate. If the policy maker is independent of political pressures then it is more likely to be consistent. An independent central bank with a clearly- identified charter is an example. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley.

19.10 Dynamic Inconsistency: a Formal Approach
Assume that policy makers choose the level of inflation. The associated level of unemployment is given by the short-run Phillips curve.  = e – ε(u – u*) (19.9) Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley.

Dynamic Inconsistency: a Formal Approach
The policy maker prefers low unemployment and zero inflation. The loss function for this policy is specified by: L = a(u – u*) + 2 (19.10) Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley.

The three steps in the 'game' played by the policy maker are: The policy maker chooses and announces and inflation policy (point A in Figure 19.3). The economy 'picks' anticipated policye (point B). The policy maker implements actual policy that minimises the loss function (point C). Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley.

The final score is calculated by inserting the actual policy and anticipated inflation into the loss function. The loss is minimised by setting the marginal loss function equal to zero. (19.11) (19.12) Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley.

The optimal policy is: (19.13) Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley.

19.11 The Positive Theory of Policy Making
The positive theory of policy making focuses on how policy makers actually behave. In the short run policy makers have to decide how accommodate an inflationary shock knowing that any policy will impact on unemployment. In the long run policy makers have to decide whether to aim for very low, zero or positive inflation. The political business cycle theory studies the interaction between economic policy decisions and political consideration. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley.

The Positive Theory of Policy Making
The political business cycle hypothesis suggests that politicians: Use restrictive policies early in the government's term raising unemployment to reduce inflation. As the election approaches expansionary policies are used to reduce unemployment to gain voter approval. The approach suggests a systematic cycle in unemployment rising in the early part of the government's term and falling in the latter. Empirical evidence to support this hypothesis is mixed. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley.

Chapter 19 Policy in an Uncertain World

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