Lecture Principles of economics (Asia Global Edition) - Chapter 25

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

Learning Objectives

1. Discuss the policy options available to the

central bank in response to demand shocks

and inflation shocks

2. Explain the roles played by the anchored

inflationary expectations and central bank

credibility in keeping inflation low

3. Describe how fiscal policy can affect both

aggregate demand and aggregate supply

4. Address why macroeconomic policy is as

much art as a science

Stabilization Policy and Demand

Shocks

•

AD 1

Y 1

AD2

Y*

AS2

– Central bank follows its

monetary policy rule and

raises interest rates

– Recessionary gap at Y2

with higher inflation, 2

– The central bank chooses

• Close the recessionary gap

LRAS

Output (Y)

1

AD 1

Y 2

2

AS2

Accommodating an Aggregate

Inflation Shock

• Suppose the central bank moves to close the

recessionary gap

– Eases monetary policy, lowering interest rates at 2

• Resets target inflation rate to 3

– Lower interest rates

stimulate consumption and

investment spending

• AD shifts to AD2

– Long-run equilibrium is now

at Y1 and 3

• Aggregate inflation shock

leads to higher long-run

LRAS

1

AD 1

3

Y

2

AD2 AS2

Responding to An Aggregate

Inflation Shock

• Suppose the central bank decides to maintain inflation at

1

– Inflation is 2, above expected inflation of 1

– The central bank raises interest rates

– Along AS2, expected

inflation is 3

– When the central bank fails

to respond with looser

monetary policy, expected

inflation decreases

– AS2 shifts back to AS1

– Original long-run equilibrium

Y 2

2

AS2

3

Anchored Inflationary

Expectations

people's expectations of future inflation do 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

1980s Inflation – Act 1

• U.S Inflation was 13.5% in 1980

– 3.2% by 1983; stayed 2 – 5% for rest of the

The Changing Volatility of Real

GDP

Declining Macroeconomic

Variability

• Variation in the growth rate in the U.S down

by half since 1960

– Inflation declined by two-thirds

• Relative stability has benefits

– 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

An Alternative View Explaining

Stability

• Structural changes in the economy may have

made it more adept at absorbing changes

– Increased openness to trade

– Freer international capital flows

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

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

The Fed's Independence

• The Fed is a relatively independent central

bank

– Governors serve 14 year terms

• Appointments by the executive subject to Congressional approval

– Monetary policy is generally in the Fed's hands

• 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

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

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

• Can only be achieved if nominal rates are less than inflation, so nominal rates would be negative

– Measured inflation overstates actual inflation

• A true inflation of zero means measured inflation of about 1%

– A small amount of inflation makes labor markets

work better

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

Marginal Tax Rates

• Cost – Benefit Principle says individual make

labor supply decisions based on the added

costs and added benefits of an action

dollar

pre-tax income

• Many taxes are not based on income

– Property tax, gasoline tax, sales tax

• U.S average tax rate on income is 30%

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

LRAS1

1

AD 1

LR AS 2

Y

Americans Work More than

Americans Work More than

Europeans

• U.S average work week is longer

– U.S takes fewer vacations and holidays

– Retire later

– Less unemployment

• Marginal interest rates matter

– When European marginal rates were lower, they

worked more

• Other factors matter

– More unionization in Europe

– Government regulations regarding hours per week

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

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

Supply-Side Effects Marginal Tax Rates