Download What we know about monetary policy The government may have a

Apostolis Philippopoulos
What we know about monetary policy
The government may have a potentially stabilizing policy instrument in its
hands. But is it effective? In other words, is the relevant policy multiplier
nonzero?
1. Short run (given prices and expectations): A loose monetary policy leads
to an increase in real money balances, a decrease in nominal interest rates
and an increase in real economic activity. Open economy: even in the short
run, there can be offsetting mechanisms that shift the AD back partly or fully
like in the case of fixed exchange rates and high capital mobility.
2. Medium and long run: Money is neutral. Monetary policy is irrelevant to
the real allocation. The AS is vertical since all monetary variables change
proportionally. Disinflation is costless.
3. Transition from the short run to the medium run: It all depends on how
fast inflationary expectations and prices adjust; see shifts of the short run
AS. The main results are: (i) Monetary policy is effective (i.e. it can affect
the real economy) only if it is unexpected. This gives the incentive for
monetary surprises (see below). (ii) There is only a temporary trade-off
between higher inflation and lower unemployment (the modern Phillips
curve).
4. If the question is “Does the choice of the monetary policy regime matter
to the real economy”, the answer is:
(i)
If there is full price flexibility and complete current information,
the choice does not matter to the real economy. Of course, it
matters to prices.
(ii) If expectations and prices are given, the choice of the monetary
and exchange rate policy regime matters to the real economy.
Regime desirability depends on the type of the shock. See e.g. the
Poole model where there is the dilemma between money stock
rules and interest rate rules (this is an IS-LM model) or the
Mundell-Fleming model in an open economy.
(iii) If there are temporary nominal fixities and incomplete current
information on the part of markets like in 3 above, and
policymakers can follow optimally chosen feedback or active or
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state-contingent policy rules being fully informed about the current
state of the economy and optimally react to it, the choice of the
monetary policy regime does not matter to the real economy. If
they are not fully informed, the same message as in (ii) above, i.e.
the choice of the regime or the type of policy rule matters to the
real economy.
5. The above was about effectiveness. But monetary policy may not only be
ineffective, but “it can also do more harm than good in the hands of
policymakers”. A game between the central bank and wage setters. This is a
prisoner’s dilemma problem. Rules versus discretion. Ways of improving
credibility: the role of institutions (like the ECB and the independent central
banker) and the role of reputation. See Chari and Kehoe (Journal of
Economic Perspectives, 2006, vol. 20. no. 4, pp. 3-28).
6. General lesson: monetary policy should be conducted by rules that try to
keep nominal interest rates and inflation low.
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What we know about fiscal policy
1. Effectiveness of fiscal policy instruments
In the short run, expansionary fiscal policy affects AD and output. But there
are adverse side-effects from loose fiscal policy that crowd out private
activity. They work via traditional channels like interest rates, exchange
rates, inflation, etc. Open economy: under flexible exchange rates and high
capital mobility, fiscal policy can be fully ineffective in the short run.
In the medium- and long-run, output is back to its natural level with lower
private consumption and investment. Specifically, in dynamic setups,
individuals react to government deficits and public debts by increasing their
own savings in anticipation of higher taxes in the future to repay the debt
(Ricardian equivalence) so that they offset the potential stimulating affects
of fiscal expansions.
2. Stabilization
Governments attempt to stabilize the economy from shocks (oil price
shocks, financial shocks, etc). Stabilization takes the form of (i) automatic
stabilizers (ii) counter-cyclical, or active, or feedback, policy rules according
to which the government follows pre-announced policy rules that react to the
state of the economy and (iii) discretionary policy according to which the
rules change depending on the state of the economy. Don’t forget that
shocks are not bad per se: they are bad only when there are market failures
that do not allow the economy to cope with these shocks in an efficient way.
To study the effects and desirability of automatic stabilizers and active
policy, we use dynamic stochastic general equilibrium (DSGE) models.
Active policy has been subjected to criticism (see e.g. Tanzi, CESifo Forum,
3/2005). This is because (i) Fiscal policy operates with time lags so that it is
hard to time it over the cycle. (ii) Fiscal action fixes one thing but may
destabilize another. Actually, feedback policy rules can destabilize an
otherwise stable economy. (iii) It is hard, in practice, to distinguish between
rule-like counter-cyclical behaviour and discretionary behaviour driven by
electoral cycles, etc. (iv) As said, individuals react to government deficits
and public debts by increasing their own savings in anticipation of higher
taxes in the future to repay the debt (Ricardian equivalence) so that they
offset the potential affects of fiscal actions.
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It is thus better to rely more on automatic stabilizers (which are passive
policy rules). Automatic stabilizers work better, especially in countries with
relatively large public sectors (less so in the US and the UK). But again there
is no strong evidence that larger public sectors are associated with smaller
macroeconomic volatility (recall the trade-off between market and policy
failures).
Pro-cyclical fiscal policy generates instability and is usually associated with
corruption.
3. Resource allocation
Fiscal policy can improve resource allocation (by providing infrastructure
and public goods and correcting for externalities). For a simple model in
which there is a trade-off between public infrastructure and distorting taxes
required to finance it, see Barro (1990). Effects on long-term growth and
welfare, and effects in the short- and medium-run (see Turnovsky, 1995).
What is the optimal allocation of scarce tax revenues among different types
of public spending?
4. Redistribution
Fiscal policy can be used to redistribute income. This is on the grounds of
resource allocation (there is the implicit assumption that markets fail
because of borrowing constraints, etc) and/or on the grounds of equality
(ethics). A trade-off between equality and growth. [If decision-making is via
majority voting, the tax-transfer program that is adopted reflects the
preferences of the median voter. The lower is his income relative to the
mean, the higher will be the tax rate and the associated level of transfers and
size of the transfer program (thus, here inequality is bad for growth because
it implies higher taxes)]. Problems include: (i) Moral hazard. (ii) Rent
seeking and lobbying by interest groups. The idea is that each interest group
applies pressure to increase its subsidies and reduce its taxes. Empirically,
there is evidence that the number of organized interest groups in a country
has a positive effect of the relative size of the government sector. See
Mueller, 2003, chapters 13 and 17.
5. Are budget deficits always bad?
Deficits are not bad per se (see tax smoothing justification). But permanent
deficits are bad. Permanent deficits result from short-sighted behaviour of
policymakers as well as voters (e.g. systematic attempts to raise real activity
at the cost of future generations, electoral or opportunistic motives of the
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incumbent parties, strategic behaviour to hurt the next party in power, the
common pool problem as interest groups compete for government resources
and ignore the effects of their actions on overall public finances (also known
as lobbying and pressure from interest groups for spending-tax favors), etc).
Note that common pool problems become worse in good times (pro-cyclical
policy) because of the so-called voracity effect which means that anti-social,
extractive behaviour becomes worse when the pie gets larger. See Public
Finances in the EMU, 2006, p. 207.
All these problems become worse in a MU where (i) under loose fiscal
policy, there are smaller interest rate rises and crowding-out problems than
under flexible exchange rates (ii) there are no country or exchange rate risks.
Hence national fiscal authorities have an incentive to overspend and
overborrow. See Public Finances in the EMU, 2006, p. 143.
Hence the arguments for fiscal rules like the Stability and Growth Pact,
especially in a monetary union with a single currency. Other popular
national fiscal rules include the so-called golden rule of fiscal policy (public
net borrowing should be limited to the amount of net public investment) and
structurally balanced budget (net borrowing should be allowed only for
cyclical reasons so there must be additional saving in case of a cyclical
upswing; this permits automatic stabilizers in the short run but implies a
balanced budget in the medium run).
6. Spending-tax reforms (fiscal consolidations)
Fiscal consolidations via tax increases are contractionary (i.e. they reduce
growth and increase unemployment). By contrast, fiscal consolidations via
spending cuts are expansionary (i.e. they raise growth and reduce
unemployment), especially in countries with poor public finances. By
spending cuts we mean cuts in government consumption (see government
wages), government investment and transfers/subsidies. See Public Finances
in EMU, 2007, pp. 171, 189, 194.
Why are (socially beneficial) reforms delayed? …
For several explanations, see Saint-Paul (2004, Journal of Economic
Perspectives, vol. 18, no. 4, pp. 49-68), Public Finances in the EMU, 2005,
and Drazen (2000, p. …).
7. Optimal tax policy and credibility
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What is the optimal path of different tax rates over time? Under
commitment, some policy lessons are: (i) tax rates on labor income and
consumption should be roughly constant over time (ii) capital tax rates
should be low so as encourage capital accumulation (low capital taxes
increase the capital-labor ratio, which in turn increases output per worker
(iii) returns to public dent and taxes on assets should fluctuate to provide
insurance against adverse shocks and balance the budget in a present value
sense.
The time inconsistency problem. Mechanisms for commitment (fiscal rules
and reputation).
See Chari and Kehoe (Journal of Economic Perspectives, 2006, vol. 20. no.
4, pp. 3-28).
8. Bureaucracy, corruption, rent seeking policymakers, etc.
…
9. Size versus efficiency of the public sector
Measures of public sector efficiency.
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