I. Introduction
A. Objectives
1. Describe the goals of macroeconomic stabilization policies
2. Explain how the state of the economy influences the popularity of the government.
3. Distinguish between fixed-rule and feedback-rule stabilization policies.
4. Explain how the economy responds to aggregate demand shocks and aggregate supply shocks under fixed-rule and feedback rule policies.
5. Explain why lowering the rate of inflation usually increases unemployment.
B. Topics to be covered
1. The stabilization problem
2. Alternate stabilization policies
3. Stabilization policies and aggregate supply shocks
4. Taming inflation
II. The Stabilization Problem
A. The stabilization problem is to "deliver a macroeconomic performance that is as smooth and predictable as possible."
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A. There are two major stabilization targets:
1. real GDP growth and
2. inflation.
B. The goal for real GDP growth is keeping it close to the growth in long-run aggregate supply.
1. Attaining this goal for real GDP growth helps prevent:
a. fluctuations in unemployment and
i. Avoid labor surpluses or shortages
b. fluctuations in the international trade balance.
i. Avoids borrowing and repaying
ii. Allows us to consume what we produce
C. Keeping the inflation rate low and predictable:
1. Money more useful as medium of exchange when inflation rate (INFRTE) is predictable.
a. Encourages borrowing and lending
b. Easier to make long term contracts (including labor contracts)
2. Keeps the value of exchange rates constant and
a. Encourages international borrowing and lending
b. enables international transactions to be made with less risk.
3. USA does not have a very good record of stabilizing growth or inflation rate.
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A. In the US, three groups of decision makers have the power to specify and execute macroeconomic stabilization policy:
1. Congress (Legislature),
2. the Board of Governors of the Federal Reserve, and
3. the Administration (The President).
4. Power is divided (Checks and balances)
B. The Congress and the President are responsible for the federal budget,
1. the Federal budget is a statement outlining the government's expenditures and tax receipts.
a. The preparation of the federal budget begins 10 months before the budget is scheduled to take effect.
b. This lag means that fiscal policy is not used to fine-tune the economy.
2. Fiscal policy has three components:
a. spending plans,
i. Goods and Services (Government controls)
ii. Transfers (Government does not control)
depends on real GDP (Y)
b. tax laws,
i. Actual tax revenues depend on GDP (Y)
c. and the deficit.
i. Is the difference between spending and taxes
ii. Every year since 1969 US has had a deficit
iii. Source of much worry
- Clinton raised tax rates-
d. All are specified by the federal budget.
C. The Federal Reserve Board
1. Monetary policy is decided upon by:
a. the Federal Open Market Committee, a committee within the Federal Reserve System.
b. The Fed buys and sell in two big markets:
i. The bond market (Influence interest rates)
ii. The foreign exchange market (influence exchange rates)
2. The FOMC meets monthly and the Fed trades daily
D. The Administration can:
1. give advice and
2. attempt to persuade the Federal Reserve System about the proper macroeconomic stabilization policies.
a. Most members not his appointees
b. Cannot be reappointed
c. President appoints chairman for 4 years.
i. Some influence over him
ii. Not much
3. Can try to persuade Congress
a. Sometimes of same party
b. Congress elected locally (not necessarily at same time as the president)
c. Can threaten to veto spending bills -
i. Not credible threat - no line item veto
d. Economic report of the President
i. Prepared by Council of Economic Advisers
ii. Not very powerful group
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A. In the US, the most important constraint affecting the making of macroeconomic policies is:
1. how their impact on the nation's economic performance affects voters, specifically
2. how it affects the election probabilities of politicians.
B. An economist, Ray Fair, discovered that:
1. In the US, for every one percentage point increase in the real GDP growth rate,
a. the incumbent party gains a one percentage point increase in the Presidential voter share and
DELTA VOTER SHARE / DELTA GDP Growth Rate = 1% pt
2. for every three percentage point increase in the inflation rate,
a. the incumbent party loses one percentage point in the voter share.
DELTA VOTE SHARE / DELTA INFLRTE = - 1/3 % pts
3. Appears to be more votes in increasing growth rate of GDP than in reducing inflation rate.
2. Since 1960, in every election year, except one (1980),
a. the economy was improving and thereby
b. increasing the popularity of the incumbent party.
c. Incumbent (Jimmy Carter) lost in 1980.
3. This is indicative of a political business cycle,
a. where the business cycle results from policies designed to insure the reelection of the incumbent political party.
b. Fiscal Policies and the election cycle
i. Deficits decrease in first year
ii. Deficits increase in 4th year
c. monetary policies and the election cycle
i. Money growth rates decline in 1st year
ii. Money growth rates increase in 4th year
II. Alternative Types of Stabilization Policies
A. Stabilization policies are either one of two types:
1. fixed rules or
2. feedback rules.
B. A fixed rule is a "specified an action to be pursued independently of the state of the economy."
1. Milton Friedman proposes a fixed rule:
a. Sets the monetary growth rate at a level such that the inflation rate averages zero.
b. Maintain that growth rate constantly
C. A feedback rule determines how stabilization policies should respond to changes in economic activity.
1. For instance, a central bank policy of expanding the money supply (M) when unemployment (U) rises is an example of a feedback rule.
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II. Stabilization Policy and Aggregate Demand Shocks
A. Assume :
1. An unanticipated, temporary fall in aggregate demand temporarily lowers real GDP (Y).
Y < Y*
B. The effect of a fixed rule
1. If policy makers operate using fixed rules that hold constant the money supply (M), the level of government spending (G) and taxes (TX),
2. No fiscal policy response
3. No monetary policy response
4. Assuming the AD shock was temporary and is gradually reversed:
a. The economy will return to its full-employment equilibrium
b. when aggregate demand recovers.
c. Unusually rapid growth of GDP during the recovery
2. If policy makers use feedback rules where the money supply and government spending increase with unemployment and taxes fall,
a. the aggregate demand curve is shifted back more quickly so that
b. full employment is reached rapidly.
c. but now policy makers have to offset natural increase in AD with contractonary policies.
d. Must avoid overshooting - soft landing
E. The Two Rules compared:
1. Ultimate equilibrium point is the same
a. but under the fixed rule, more time is spent below full output and employment
2. Many economists suggest that fixed rules operate better in practice. Three reasons are advanced:
a. Full employment GDP is not known
b. Policy lags are longer than the forecast horizon
c. Feedback rules lead to less predictable policies
3. Proper use of feedback rules requires that policy makers know whether policy should be expansionary or contractionary.
a. But this requires knowledge of what is a full- employment level of real GDP, and
b. no one knows with certainty the full-employment level of real GDP.
2. The effects of policy actions operate with lags.
a. May take 2 years for policy to have its full effect.
b. These lags may be longer than policy makers can forecast, so that
b. actions taken in response to actual or forecasted events may have their maximum effect only when the economy faces new problems.
c. Federal Reserve's actions have become an important source of fluctuations rather than a stabilizer.
3. Fixed rules are more predictable;
a. to make long term contracts, people need to make forecasts of price levels.
i. to forecast inflation rate, you must forecast aggregate demand.
ii. To forecast Aggregate demand, you must forecast policy actions of the government and the Fed.
4. Feedback rules inflict more uncertainty upon the economy.
a. Generally not in writing
b. Fed tries to be unpredictable
c. the result is unpredictable fluctuations in Aggregate Demand.
5. Congress cannot be bound to a predictable feedback rule.
5. When determining interest rates and wage contracts, people need to forecast future inflation rates.
c. This is done more easily and accurately when policies are more predictable.
III. Stabilization Policy and Aggregate Supply Shocks
A. Aggregate supply fluctuations make stabilization rules problematic for two reasons:
1. cost-push inflation and
2. the possibility of slowdowns in productivity growth.
3. In both cases, the economy suffers from "stagflation"
B. Cost-push inflation results when the short-run aggregate supply curve shifts left.
1. Caused by cost increases
a. wage increases
b. raw material prices
2. Cost push inflation cannot continue unless accommodated by an increase in the money supply.
C. In the face of a shift to the left by the SAS,
1. fixed rules for monetary and fiscal policies allow the economy to suffer stagflation
a. where real GDP falls and
Y < Y*
b. the price level rises.
b. Eventually wages and input prices fall
c. the SAS curve returns to its original position and
d. the level of output returns to full employment.
Y = Y*
2. feedback rules
a. increase the money supply (M) and
b. government spending (G) and cut taxes (TX).
c. This shifts the AD curve right,
b. boosting real GDP (Y) and the price level (P).
3. Incentives to push up factor prices:
a. Under a fixed rule an increase in wages results in unemployment;
a. with the feedback rule, unemployment is more temporary.
b. Hence workers have a greater incentive to demand higher wages under a feedback rule;
c. that is, the incentive to seize a temporary gain by boosting the price of a resource is greater under a feedback rule.
d. This is a disadvantage of feedback rules.
C. Slowdown in Productivity Growth
1. Some economists think that business cycle fluctuations are created by changes in productivity growth;
2. this is the real business cycle approach.
3. According to this view the short-run and long-run aggregate supply curves are identical.
a. wages are fully flexible immediately
b. Fluctuations due to shifts of LR supply curve
c. Aggregate demand affects price levels but not GDP
3. A slowdown in productivity growth shifts the aggregate supply curve left.
4. Since the aggregate supply curve is vertical, changes in aggregate demand do not change the level of output.
a. Under a fixed rule:
i. neither government spending nor monetary policy changes, so there is no effect on aggregate demand.
ii. The price level (P) remains higher and real GDP lower (Y).
c. With a feedback rule:
i. the money supply (M) and level of government spending (G) increase and taxes decrease.
ii. Aggregate demand increases, but this only further boosts the price level (P).
iii. Thus, contrasted with a fixed rule, under a feedback rule real GDP (Y) decreases by the same magnitude as with a fixed rule but the price level increases by more in response to a supply shock.
D. Nominal GDP targeting attempts to keep the growth rate of nominal GDP steady.
1. Nominal GDP grows because of:
a. The growth in real GDP (Y) and
b. inflation.
G of YN = G of Y + INFRTE
2. Generally Nominal GDP grows rapidly when inflation is rapid
a. So preventing rapid growth of nominal GDP would reduce inflation
3. Generally Nominal GDP grows slowly when real GDP growth is low.
a. Thus a government which is attempting to keep its growth steady tries to avoid excesses of recession.
4. Nominal GDP targeting uses feedback rules and so is subject to the usual drawbacks from feedback rules.
a. especially long and variable time lags of identification and effects
IV. Taming Inflation
A. Often inflation already exists
B. so problem is not how to avoid inflation but how to reduce the inflation rate.
A. If a reduction in the inflation rate is a surprise,
1. Assume economy is originally at full employment on LRAS curve. And LR Phillips curve.
2. Inflation is expected to be 10% next year.
3. There is a surprise downward shift of AD curve.
4. The agreed upon wage rate is too high. Firms take losses and reduce GDP
5. a recession results as the economy moves along a short-run Phillips curve.
6. Because the downward shift in the Ad curve was a surprise, wages went up and that reduced the anti- inflationary impact and created unemployment.
B. If the central bank credibly announces that its goal is to reduce the inflation rate,
1. Lower Aggregate Demand is expected
2. Wage bargains are reduced
3. The aggregate supply curve doesn't shift up so much
4. lower expected inflation rate shifts the short run Phillips curve downward
5. then inflation falls and real GDP does not change.
C. In practice most reductions in inflation cause recessions
1. because people do not believe mere announcements from the central bank;
2. rather they form their expectations on the basis of the central bank's actions.
VI. Summary of the Lecture
Key concepts
1. Federal budget
2. Feedback rule
3. Fixed rule
4. Nominal GDP targeting
5. Political business cycle
6. Real business cycle theory
Review Questions
1. What are the goals of macroeconomic stabilization policy?
2. How does the political business cycle work in countries like the US and the UK?
3. What are the effects of a temporary decrease in aggregate demand if a fixed rule is employed?
4. What will happen to real GDP (Y) and the price level (P) if there is a permanent decrease in aggregate demand under:
a. a fixed rule
b. A feedback rule
5.Why do economists disagree with each other on the appropriateness of fixed and feedback rules?
6. What are the main problems in using fiscal policy for stabilizing the economy?
7. How does nominal GDP targeting reduce real GDP fluctuations and inflation?
8. Why does the credibility of the central bank affect the economic cost of lowering the rate of inflation (INFRTE)?