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Chapter 25 - Macroeconomic policy. In this chapter you will consider whether policymakers should try to stabilize the economy, consider whether monetary policy should be made by rule rather than by discretion, consider whether the central bank should aim for zero inflation, consider whether fiscal policymakers should reduce the government debt, consider whether the tax laws should be reformed to encourage saving.
Macroeconomic Policy Chapter 25 McGrawHill/Irwin Copyright © 2015 by McGrawHill Education (Asia). All rights reserved.251 Learning Objectives Discuss the policy options available to the central bank in response to demand shocks and inflation shocks Explain the roles played by the anchored inflationary expectations and central bank credibility in keeping inflation low Describe how fiscal policy can affect both aggregate demand and aggregate supply Address why macroeconomic policy is as much art as a science 252 Stabilization Policy and Demand Shocks • AS2 AD2 Y 1Y* AD Output Y 253 Responding to Aggregate Inflation Shocks • Central bank follows its monetary policy rule and – raises interest rates – – • • Recessionary gap at Y2 with higher inflation, The central bank chooses Close the recessionary gap Restore target inflation rate Inflation ( ) The economy begins in long-run equilibrium at Y1, Adverse inflation shock shifts aggregate supply to AS2 • LRAS AS2 AS 21 Y Y1 AD Output (Y) 254 Accommodating an Aggregate Inflation Shock Suppose the central bank moves to close the recessionary gap – Eases monetary policy, lowering interest rates at • – Lower interest rates stimulate consumption and investment spending • AD shifts to AD2 Long-run equilibrium is now at Y1 and Aggregate inflation shock leads to higher long-run inflation – • Resets target inflation rate to Inflation ( ) • LRAS AS2 AS 21 AD2 Y Y1 AD Output (Y) 255 Responding to An Aggregate Inflation Shock Suppose the central bank decides to maintain inflation at – – – – – – Inflation is 2, above expected inflation of The central bank raises interest rates Along AS2, expected inflation is LRAS When the central bank fails to respond with looser monetary policy, expected 21 inflation decreases AS2 shifts back to AS1 Original long-run equilibrium Y Y1 is restored Inflation ( ) • AS2 AS AD Output (Y) 256 Anchored Inflationary Expectations • Anchored inflationary expectations means people's expectations of future inflation not change even if inflation rises temporarily – – – Inflation anchoring dampens response to an aggregate inflation shock Businesses and consumers believe the central bank will reestablish its target inflation rate Shortens the time required to close the recessionary gap from the shock • Encourages central bank to maintain its original inflation target 257 1980s Inflation – Act • U.S Inflation was 13.5% in 1980 – – • 3.2% by 1983; stayed – 5% for rest of the decade – 3% in the 1990s Monetary policy defeated inflation – – – – – Short recession in 1980 Deeper recession 1981 – 1982 Negative GDP growth in 1980 and 1982 Unemployment peaked at 9.7% in 1982 Inflation unresponsive 1979 – 1981 258 The Changing Volatility of Real GDP 259 Declining Macroeconomic Variability • Variation in the growth rate in the U.S down by half since 1960 – • Relative stability has benefits – – – • Inflation declined by two-thirds Business and economic planning easier Markets function better Fewer resources devoted to adjusting to inflation and other economic instabilities Fed is usually credited with causing the increased stability by its consistent actions 2510 An Alternative View Explaining Stability • Structural changes in the economy may have made it more adept at absorbing changes – – – – – – – Changes in technology Business practices Better management of inventories Deregulation Shift toward services and away from manufacturing Increased openness to trade Freer international capital flows 2511 Credibility of Monetary Policy • Credibility of monetary policy is the degree to which the public believes the central bank will defend its target inflation rate – • The more credible policy is, the more inflation is anchored Factors that affect credibility – – – Degree of central bank's independence The announcements of explicit inflation targets Established reputation for fighting inflatio 2512 Central Bank Independence • • Central banks insulated from short-term issues are better able to stabilize the economy Indicators of independence are – – – – • Length of appointments to the central bank Whether the central bank's actions are subject to frequent interference Whether the central bank has obligation to finance the national deficit The degree to which the central bank's budget is controlled by the legislative or executive branch Countries with independent central banks have lower inflation 2513 The Fed's Independence • The Fed is a relatively independent central bank – Governors serve 14 year terms • – Monetary policy is generally in the Fed's hands • – – Appointments by the executive subject to Congressional approval Some Congressional oversight The Fed is not obligated to finance the national debt The Fed is self-funding, largely through its holdings of US Treasury securities • The Fed generally has a budget surplus which it returns to the Treasury 2514 Announcing Numerical Inflation Target • • • Proponents argue announced target adds to credibility of monetary policy and strengthens anchoring – Reduce uncertainty in the financial markets Some countries use announced targets or a narrow range for inflation – These central banks provide additional economic data to support their target – Targets must be consistently met Announced targets have been successful in industrialized and developing countries – Highly successful in Brazil, Chile, Mexico, and Peru 2515 Zero Inflation Undesirably Target • Zero inflation has several undesirable consequences – – Imperfect control over inflation mean periods of deflation are possible Central bank may use negative real interest rates at times • – Measured inflation overstates actual inflation • – Can only be achieved if nominal rates are less than inflation, so nominal rates would be negative A true inflation of zero means measured inflation of about 1% A small amount of inflation makes labor markets work better 2516 Central Bank Reputation • A central bank's success at stabilizing the economy depends on whether its acts align with its reputation – Inflation hawk is committed to achieving and maintaining low inflation, • – • Accepts some short-run cost in reduced output and employment Inflation dove is not strongly committed to achieving and maintaining low inflation Inflation hawks are more successful in maintaining stable output and employment, even in the short run – Stronger anchoring of inflation expectations 2517 Marginal Tax Rates • Cost – Benefit Principle says individual make labor supply decisions based on the added costs and added benefits of an action – – • Many taxes are not based on income – • Marginal tax rate is the tax rate on an additional dollar Average tax rate is total taxes divided by total pre-tax income Property tax, gasoline tax, sales tax U.S average tax rate on income is 30% 2518 Fiscal Policy Effects Tax rates reduction increase aggregate spending through the consumption function – – • Shifts aggregate demand to the right Supply-side effects shift long-run aggregate supply Whether inflation increases, decreases, or stays constant depends on the relative sizes of the shifts in AD and LRAS Inflation ( ) • LRAS1 LR AS Y1 Y AD AD Output (Y) 2519 Americans Work More than Europeans Relative Hours Worked (US = 100) Marginal Tax Rate Japan 104 37% US 100 UK 88 44 Canada 88 52 Germany 75 59 France 68 59 Italy 64 64 Country 40 2520 Americans Work More than Europeans • U.S average work week is longer – – – • Marginal interest rates matter – • U.S takes fewer vacations and holidays Retire later Less unemployment When European marginal rates were lower, they worked more Other factors matter – – – More unionization in Europe Government regulations regarding hours per week More generous social security systems 2521 Policymaking: Art or Science? • Macroeconomic policy works best with – – – – – Accurate knowledge of current economic conditions Knowledge of the future path of the economy without policy Precise value of potential output Good control of fiscal and monetary policies Knowledge of how and when the economy will respond to policy changes 2522 Barriers to Perfect Policies • • Policy makers act with an approximate understanding of the economy Policy is subject to lags – The inside lag is the delay between the time a policy change is needed and the time it is implemented • – Shorter for monetary policy than for fiscal policy The outside lag is the delay between policy implementation and the major effects of the policy occur • Longer for monetary policy than for fiscal policy 2523 Macroeconomic Policy Credibility Independent Central Bank Aggregate Supply Shocks Exogenous Spending Shocks Monetary Policy Inflation Anchored Inflation Fiscal Policy Supply-Side Effects Marginal Tax Rates Core Rate 2524 ... nominal rates would be negative A true inflation of zero means measured inflation of about 1% A small amount of inflation makes labor markets work better 25 16 Central Bank Reputation • A central bank's... security systems 25 21 Policymaking: Art or Science? • Macroeconomic policy works best with – – – – – Accurate knowledge of current economic conditions Knowledge of the future path of the economy... without policy Precise value of potential output Good control of fiscal and monetary policies Knowledge of how and when the economy will respond to policy changes 25 22 Barriers to Perfect Policies