Chapter 18: Stabilization Policy

Why is a long inside lag a problem for economic stabilization?

in the US, changes in spending/taxes require the approval of the president and both houses of Congress-leads to delays, which make fiscal policy an imprecise tool for stabilizing the economy.

political business cycle

manipulation of the economy for electoral gain. -distrust of the political process leads some economists to advocate placing economic policy outside the realm of politics.

Which has a shorter inside lag: monetary or fiscal policy?

monetary policy-a central bank can decide on a policy change in less than a day-monetary policy has substantial outside lag.

automatic stabilizers

policies that stimulate or depress the economy when necessary without any deliberate policy change. -designed to reduce lags (inside) -ex: income taxes, unemployment insurance, welfare systems auto. reduce taxes when the economy goes into a recession

policy conducted by rule

policymakers announce in advance how policy will respond to various situations, committed to following through on this.

policy conducted by discretion

policymakers are free to "size up" events as they occur and choose whatever policy they consider to be appropriate.

outside lag

the time between a policy action and its influence on the economy. -arises because policies do not immediately influence spending/income/employment.

inside lag

the time between a shock to the economy and the policy action responding to that shock. -arises because it takes time for policymakers to recognize a shock has occurred and then put policy into effect.

Why do economists advocate rules for policy in terms of nominal variables?

use money supply, nominal GDP, or the price level. no one knows exactly what the natural rate of unemployment is...

policy rule #2: nominal GDP targeting

-Fed announces a planned path for nominal GDP -if GDP above target, decrease M, if GDP below target, increase M -allows monetary policy to adjust to changes in v

policy rule #3: inflation targeting

-Fed announces a target for the inflation rate (usually low) -adjusts M when actual inflation rate deviates from the target -insulates the economy from changes in v

ex: inflation and the Lucas critique

-estimates of the sacrifice ratio are unreliable because they don't consider the fact that if policymakers change policy, workers and firms setting wages and prices will adjust their expectations of inflation. -the change in inflation expectations will alter the trade-off between inflation and unemployment.

How does incompetence in economic policy arise?

-political process reflects the shifting power of special interest groups. -politicians do not have sufficient knowledge of macroeconomics to make informed judgements. -opportunism: arises when the objectives of policymakers conflict with the well-being of the public.

How do economic forecasters look ahead?

-successful stabilization policy requires the ability to predict future economic conditions. -macroeconometric models: make assumptions about the path of exogenous variables (monetary policy) to yield predictions about endogenous variables. (unemployment/inflation)

policy rule #1: monetarists

advocate that the Fed keep the money supply growing at a steady rate. -Milton Friedman -argue that slow and steady growth in the money supply would yield stable output, employment, and prices. -not the best; steady growth in M stabilizes AD only if v is stable. -economists believe policy should allow M to adjust to various shocks

time inconsistency of policy

after private decision makers have acted on the basis of their expectations, policymakers may be tempted to go back on their announcement. -private decision makers are led to distrust policy announcements (inconsistent)

problem with the time inconsistency of discretionary policy (Fed and inflation)

A Federal Reserve with discretion is tempted to inflate in order to reduce unemployment.

Does history settle the debate over stabilization policy?

No-disagreements over history arise because it is not easy to identify the sources of economic fluctuations. -some believe that a shock to private spending caused the Depression, others believe that it was a fall in M (active v passive)

What was the first piece of legislation in which the government held itself accountable for macroeconomic performance?

The Employment Act of 1946: -written after the Great Depression -lawmakers believed that without an active government role in the economy, the Great Depression could occur regularly

leading indicators

a data series that fluctuates in advance of the economy.

active vs passive policy

active: monetary and fiscal policy can prevent recessions by using instruments to respond to shocks/stabilize the economy. passive: gov. should refrain from using monetary and fiscal policy for economic stabilization.

What do advocates of passive policy argue?

because of these lags, successful stabilizaton policy is almost impossible. -attempts to stabilize the economy can be destabilizing.

Lucas critique

criticism of traditional policy evaluation-argued that when policymakers estimate the effect of any policy change, they need to know how people's expectations will respond to the policy change.