Transcript XIV. Current issues in economic policy

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 (again in different form): short term
• Monetarist critique
• Positively sloped AS in short- to mediumterm
• 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
Framework
• 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
e
P
 P1
e
 
P1
and original Phillips curve can be expressed

   e  .u, with  e  0
• However, whenever   0 , than
inflation might rise, even with high
 unemployment.
e
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 inflation
– 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 employment and profits vanish
• 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
e
– … but we assume that    ´1
• NKE - instead perfect foresight or AEH,
rational expectations
• Short-term validity
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
u-u-1 =Y-Y-1  Y-1  gY
• Statistical reality for US 1960-98
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 =-b g -g
-1

Y
Y

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
• The rule

(2)
 
i    r  a  -  b y - y
*
*
*

• 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)
Taylor’s rule
(3)
• Alternatively (natural unemployment
~
u*):
*
*
~
i  i  a  -  - bu - u* 
~
~
1  a  a  1, b  0  b  0
• 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%
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:
•
–
–
–
–
•
Taxonomy of the rules
–
–
–
•
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
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. 2527
– 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.