XVIII. Issues in economic policy

Stabilization and deficits,

1980 - 2007

XVIII.1 Introduction

• The whole course – 2 models– Classical (in different forms): long term– Keynesian: short term– Positively sloped AS in short- to medium-term

• From policy perspective– How to deal with short term fluctuations

(described by Keynesian model) to help the economy to follow the long term development path, without undermining the potential?

Active or passive policies?

A never-ending debate among the economists

1. First broad school – we basically know the nature of short term fluctuations and the tools how to react support the active approach

2. Second broad schools – we do not know enough and there are many obstacles be much more careful, passive in economic policy decisions

XVIII.2 Short term stabilization

The difficulties

• Inside and outside lags

• Automatic stabilizers

• Problems of forecasting

• Political cycle

Requirements

• Post-WWII socio-political consensus and memory of Great Depression

• Later: welfare state logic and social pressure

Lucas critique

• Limited effects of governmental policies:• If policies anticipated, than quick

adjustment and no effect on output (and other variables)

• If un-anticipated policy (or some random, exogenous shock), than after some short term fluctuations adjustment to natural values anyway

• Policy impotence proposition – PIP

Rules vs. discretion

• Rules:– Public announcement of a particular rule

that will be applied in a particular situation– Commitment to follow such a rule– Passive or active rules

• Discretion: policy makers are (basically) free to react as they believe in each particular situation

Why rules?

• Incompetent politicians

• Opportunistic politicians

• Political cycle Attempts to bring the economic policy

making outside everyday politics

• Constitutional steps (balanced budget requirements, etc.)

XVIII.3 Monetary policies

• Monetarist rule – stable growth rate of money supply

• Nominal GDP targeting– if nominal GDP growth over a target,

nominal supply decrease– If nominal GDP bellow target – vice versa

• Exchange rate targeting

XVIII.3.1 The fallacy of activist monetary policy

• Stop and go monetary policy of 1960s (see LXIV)– Based on Phillips curve trade off

– Belief that monetary authorities can permanently lower rate of unemployment but accepting higher inflation

– Econometric models that promised an engineering approach to policy

• Contradicted by recessions 1973-74 and 1981-82 and stagflation periods

Critique: monetarism

• See LXIII– Long and variable lags of monetary policy– Challenged: optimal control theory (example of

control of complicated machinery systems, e.g. rockets)

– Supported by Lucas• policy is a kind of strategic game between policy

makers and people

• People learn to predict the action of “controllers”, i.e. monetary authorities (why rockets don’t)

Critique: Failure of Phillips curve• See LXIII• Define expected price as Pe and expected

inflation as

and original Phillips curve can be expressed

• However, whenever , than inflation might rise, even with high unemployment.

e Pe P 1

P 1

e .u, with e 0

e 0

Critique: time inconsistency (1)

• Also called policy credibility problem• On the one hand: activist central bank,

that really wants to keep inflation low• On the other hand: given the short run

price and wage rigidities, such central bank can easily increase output and employment temporarily by allowing for higher infaltion– See previous Lecture on NKE

Critique: time inconsistency (2)

• After some time: agents learn the reality and adjust expectations

• In medium term: output and employment return to original values– Gains in larger emplyoment and profits vansih

• But larger inflation remains– Due to the logic of long term vertical AS

• So in practice: activist central bank might often become inflation-prone

Experience from disinflation (1)

• See LXVI• Phillips curve

– In original version no useful concept– Expectation-augmented version seems to be more

realistic concept– Fitting the data, see Ch. VII.4.1– … but we assume that

• NKE - instead perfect foresight or AEH, rational expectations

• Short-term validity

1´e

Experience from disinflation (2)

Sacrifice ratio• If parameters of Phillips curve determined, the

relation can be used to quantify the amount of output (and unemployment) that must be sacrificed to lower the inflation by – e.g. – 1%

• In most studies: 5% of annual GDP must be given up to lower inflation by 1%

• The similar results can be achieved using Okun’s law

Okun’s law – a remainder (1)

• LXIV– Change in output equals change in

employment– Total labor force constant

• That implies

• Statistical reality for US 1960-98

u-u-1= Y-Y-1 Y-1 gY

u-u-1 -0.4 gY 3

Okun’s law – a remainder (2)

1. Annual growth has to be at least 3% to prevent unemployment from rising

– Both labor productivity and labor force are growing in time normal growth rate = 3%

2. Output growth of 1% over 3% leads only to 0.4% decrease in unemployment

– Labor hoarding– Increase in labor participation rate

Differences over countries, Okun’s law in general

u-u-1=-b gY-gY

Different speed of disinflation

• Speed and social costs– “Cold turkey” – quick disinflation, accepting

a substantial slow down of economic activity (probably even negative growth), but over short period of time

– Gradual disinflation, when lower growth not so marked, but spread over longer period

• Total, accumulated costs high in any case

XVIII.3.2 Inflation targeting

• The most recent (and most popular) conduct of monetary policy

• Neither rule or discretion– The central bank estimates and announces a target

for inflation (kind of a rule)– Steering the actual inflation towards the target by

changing nominal basic interest rate and/or using other tools (open market operations, etc.)

– It is expected to perform policy credibly to achieve this target

– Target within an interval to give the Central Bank a certain level of discretion

• Independence of the Central Bank

Advantages

• Clear accountability of Central Banks

• Transparency and predictability

• Stability for the investors: relatively easy to predict future interest rates

• No link to political cycle

• Emerging countries: safeguard against high and hyper inflations

Shortcomings (1)

• Targeting CPI and assumption of causal link: growth of money supply → CPI– CPI accurately reflects money supply (?)– In case of exogenous shock (e.g. oil or food

price shock) → sharp increase of CPI possible, but no relation to domestic economic events → Central Banks acts against inflation → needless slow-down of domestic economic growth, deepening of the negative effect of exogenous shock

Shortcomings (2)

• Inflation targeting is not consistent with any long term growth theory/strategy– Policy just smoothes the cycle

• No explicit set of monetary policy recommendations– One attempt – Taylor rule, see next slides

Taylor’s rule (1)

• Rule, stipulating how much Central Banks should change nominal interest rate, reacting to two important signals:– Divergence of actual inflation from target inflation

– Divergence of actual GDP from its potential

• π* - inflation target, r* - equilibrium real interest (i.e. consistent with inflation target and implying desired nominal interest i*), y and y* - log of actual, respectively potential output

Taylor’s rule (2)

• The rule

• a,b 0• Originally Taylor: a=b=0.5

• In case of stagflation, when monetary policy goals may conflict, Central Banks should change the weights for reducing inflation vs. increasing output ad hoc (according the situation)

*** y-yb-ari

Taylor’s rule (3)

• Alternatively (natural unemployment u*):

• Why a>0 ? – for spending, real interest rate is important, i.e. when inflation raises, then real interest should raise to slow-down the economy

• Following the rule: increase of π by 1% implies that Central Bank increases nominal interest by more than 1%

*** u-ub~

--a~ii

0 b~ 0 b 1, a~ a1

Application and performance

• Since 1990, many countries, both developed and developing, use Taylor rule– First country: New Zealand 1990, Czech

Republic since 1999– Not FED (different role, given by US

Constitution)

• Till the crisis in 2008, Taylor rule produced seemed to work satisfactorily

• One seed of the crisis?– See Lecture XX

XVIII.4 Fiscal policies

• Debts and deficits

• Balanced budget deficit– Not a good idea for today’s economies– Need for higher flexibility

• Stabilization role

• Tax smoothing

• Inter-temporal solutions

Basic concepts• Actual budget deficit (BD) = government

revenues minus government expenditures• Primary deficit – BD minus interest

payments• Structural deficit (actual or primary) –

adjusted for short-term fluctuations of economic cycle (determination of potential output required!)

• Financing of deficit = government borrowing• Government debt = accumulation of past

borrowings

XVIII.4.1 Fiscal sustainability

• Different definitions– Ratio of government net assets to GDP remains

constant– Debt/GDP over time repeatedly converges to a

constant value– Fiscal sustainability is not consistent with

permanently increasing tax rate• Prevailing practice today – intertemporal

definition of solvency of the country: – Given starting debt, discounted value of

current and future primary expenditures today does not exceed discounted value of current and future revenues today

Fiscal rule• Permanent restriction of fiscal policy through simple

numerical limits for budgetary aggregates• Features:

– Long term – numerical target for long period– Tool for fiscal policy control– Fiscal indicator for practical application– Simple - easy monitoring and communication with broad public

• Taxonomy of the rules– Budget deficit limits– Debt restriction, e.g. limit for a maximum debt, legally binding (e.g.

60% GDP, given by Constitution in Poland today)– Rules, restricting maximum expenditures or minimum revenues

• Most widespread: budget deficit limits:

primary deficit (nominal interest – nominal GDP growth) * (debt/GDP)

XVIII.4.2 Barro-Ricardian Equivalence

• Opposite to the traditional view that tax cut increases consumption spending

• B-R equivalence:– forward looking consumers, who understand

that lower tax today means larger budget deficit that will have to be repaid in the future

– government will have to increase taxes in the future

– people increase savings today to be able to pay larger taxes in the future

Implication for stabilization policies

• Tax cut – decrease of public saving

• Higher consumer saving because of B-R equivalence – increase of private saving

• Total national savings intact – no effect on the AD

Do people really behave like that ?

There is not strong believe in B-R equivalence• David Ricardo himself did not believe in his

idea• Myopia• Borrowing constraints• Do people really care about the future so

much?– Robert Barro: bequests

Literature to Ch.XVIII

• Mankiw, Macroeconomics, Ch. 14-15

• Blanchard, Macroeconomics, Ch. 25-27– general review of policy problems

• Bernanke, Laubach, Mishkin, Posen: Inflation Targeting, Princeton University Press, 1999– Mostly case studies, but very useful general chapters

1-3.