1. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. Chapter 14 Stabilization Policy in the Closed and Open Economy

2. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 14-2 Introduction to Stabilization Policies Stabilization policies aim at minimizing changes to real GDP from exogenous Demand Shocks including: – Changes in business and consumer optimism – Changes in net exports – Changes in government spending and/or taxes not related to stabilization policy Policy Activism purposefully changes the settings of the instruments of monetary and fiscal policy to offset changes in private sector spending. – An alternate approach recommends Policy Rules that call for a fixed path of a policy instrument like the money supply or a target variable like inflation or unemployment.

3. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 14-3 Policy Rules and Monetary Policy In the 1930s, University of Chicago economist Henry Simons posed a stark contrast between a totally discretionary monetary policy and a fixed rule. – A Discretionary Policy treats each macroeconomic episode as a unique event without a common approach to all events. – A Rigid Rule for policy sets a key policy instrument at a fixed value. In the 1950s, Milton Friedman advocated a Constant Growth Rate Rule (CGRR) that stipulated a fixed percentage growth rate for the money supply. He was part of the Monetarism school of thought. A Feedback Rule sets stabilization policy to respond in a systematic way to a macroeconomic event (e.g. the “Taylor” Rule).

4. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 14-4 Figure 14-1 A Flowchart Showing the Relationship Between Policy Instruments, Policy Targets, and Economic Welfare

5. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 14-5 The Positive Case for Rules Milton Freidman’s arguments for monetary policy rules: – A rule insulates the Fed from political pressure – A rule allows the Fed’s performance to be judged – A rule reduces uncertainty

6. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 14-6 The Negative Case for Rules Rules are favorable to discretionary policies because of the “long and variable” lags between changes in monetary policy instruments and the ultimate response of target variables like inflation and unemployment. Five Types of Lags – The Data Lag – The Recognition Lag – The Legislative Lag – The Transmission Lag – The Effectiveness Lag

7. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 14-7 Figure 14-2 The Percent Change in Real GDP Following a 1 Percentage Point Change in the Treasury Bill Rate, Three Intervals, 1961–2007 Source: See Appendix C-4.

8. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 14-8 Multiplier Uncertainty The multiplier formulas from Chapters 3 and 4 showed the size of the change in real GDP that would result from a change in a policy instrument. Dynamic Multipliers are the amount by which output is raised during each of several time periods after a given change in the policy instrument. Multiplier Uncertainty concerns the lack of firm knowledge regarding the change in output caused by a change in a policy instrument.

9. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 14-9 The Fed and the “Great Moderation” Why has there been a decline in economic volatility since the mid-1980s? – In other words, what caused the “Great Moderation”? Possibility 1: Smaller Demand and Supply Shocks – Government military spending fell and was more stable. – Financial deregulation made residential construction less volatile. – Computers and improved management practices reduced the volatility of inventory investment. – The oil and farm prices shocks of the 1970s were absent in the 1980s. Possibility 2: Improved Federal Reserve Performance – The Fed moved rapidly and decisively in response to movements in the log output ratio.

10. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 14-10 Figure 14-3 The Log Output Ratio and the Moving Average of its Absolute Value, 1960–2007 (1 of 2)

11. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 14-11 Figure 14-3 The Log Output Ratio and the Moving Average of its Absolute Value, 1960–2007 (2 of 2) Source: See Appendix C-4.

12. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 14-12 Figure 14-3 The Log Output Ratio and the Moving Average of its Absolute Value, 1960–2007 Source: See Appendix C-4.

13. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 14-13 Figure 14-4 The Federal Funds Interest Rate and the Log Output Ratio, 1980–2007 Source: See Appendix C-4.

14. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 14-14 Time Inconsistency and Policy Credibility Time Inconsistency describes the temptations of policy makers to deviate from a policy after it is announced and private decision makers have reacted to it. Policy Credibility is the belief by the public that policy makers will actually carry out an announced policy.

15. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 14-15 The Taylor Rule Stanford University economist John Taylor has proposed a simple rule (called the Taylor Rule) for the Fed to follow in setting the real federal funds rate (r FF ): r FF = r FF* + a(p – p*) + b[log(Y/Y N )] (where * represents the desired or target levels of variables and a, b are parameters > 0) – If the Fed cares about avoiding accelerating inflation, then “a” is large. – If the Fed cares about avoiding recession and/or high unemployment, then it chooses a large “b.”

16. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 14-16 Figure 14-5 The Actual Federal Funds Rate and Interest Rates Calculated by Two Versions of the Taylor Rule, 1980–2007 Source: See Appendix C-4.

17. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 14-17 Table 14-1 Assessing Alternative Policy Rules (1 of 2)

18. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 14-18 Table 14-1 Assessing Alternative Policy Rules (2 of 2)

19. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 14-19 Table 14-1 Assessing Alternative Policy Rules

20. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 14-20 M S and Targeting Exchange Rates Under flexible exchange rates, an expansionary monetary policy lowers interest rates, leading to a depreciation that boosts NX and therefore output. Under fixed exchange rates, monetary policy must be used to maintain the fixed exchange rate, and therefore, is no longer available for stabilization purposes.

21. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 14-21 How the Fed Reinvented Instability in Residential Construction

22. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 14-22 The Debate About The Euro What are the benefits and costs of a single currency for the EU? Benefits – Elimination of costs and risks associated with exchange rates  improved intra-EU commerce – Monetary and fiscal discipline  lower inflation Costs – No independent control over M S – Prohibition of fiscal deficits over 3% limits automatic stabilization during recessions

23. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 14-23 International Perspective: The Debate About the Euro

24. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 14-24 Chapter Equations

25. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 14-25 Chapter Equations