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CHAPTER THIRTEEN Rules versus Discretion — Can Policymakers Stick to Their Promises? I. Fundamental Issues 1. What are the ultimate goals of policymakers in open economies? 2. What are the main problems with discretionary policymaking? 3. Why is policy credibility a crucial factor in maintaining low inflation, and how might nations attain policy credibility? 4. What is structural interdependence, and how can it lead nations to cooperate or coordinate their policies? 5. What are the benefits and costs of international policy coordination? 6. Could nations gain from adopting a common currency? II. Chapter Outline 1. Policy Goals in Open Economies a. Internal Goals b. External Goals 2. Rules versus Discretion in Economic Policymaking a. Time Lags and Rules Versus Discretion b. Is Policy Discretion Unavoidable? c. Visualizing Global Economics Issues: The Inflation Bias of Discretionary Policy d. Establishing Policy Credibility e. Policy Notebook: Can Unemployment Insurance Substitute for a Conservative Central Banker? 3. Policymaking in an Interdependent World a. Structural Interdependence and International Policy Externalities b. Accounting for Interdependence: International Policy Cooperation and Coordination 4. The Pros and Cons of International Policy Coordination a. Potential Benefits of International Policy Coordination b. Potential Drawbacks of International Policy Coordination 141 142 Chapter 13 5. Optimal Currency Areas and Monetary Unions a. Optimal Currency Areas b. Is Europe an Optimal Currency Area? c. Policy Notebook: The United Kingdom Studies Hard for What Turns Out to Be a Practice Exam 6. Questions and Problems III. Chapter in Perspective Chapter 13 returns to a discussion of monetary policy. The primary internal and external goals are first discussed, followed by an explanation of how the inflation bias that can occur with discretionary policymaking. The advantages and disadvantages of international policy cooperation and coordination constitute the second major theme of the chapter. The chapter concludes with a brief discussion of the characteristics of an optimal currency area. IV. Teaching Notes 1. Policy Goals in Open Economies a. Internal Goals The objectives of national economic policies are termed policy goals. Internal goals include: Minimizing inflation and its variability: Text Table 13-1 presents the costs of inflation and inflation variability. Maximizing real GDP and reducing its variability: Maximizing employment and reducing its variability. Teaching Tip: Discussion question for students: Can these latter two goals differ? Is maximizing real output the same as maximizing employment? When would they be different? Rules versus Discretion — Can Policymakers Stick to Their Promises? 143 b. External Goals External goals include: Balancing international payments: Large deficits on international flows of funds can cause problems for countries. Managing the value of the currency in the foreign exchange market: Many central banks cannot resist the temptation to intervene in the currency markets, if only to limit volatility (leaning against the wind). Reducing volatility of currency values can reduce business risk. Teaching Tip: Recall the tradeoff between freedom to manage domestic monetary policy and the exchange rate. This tradeoff provides a major motivation for international policy cooperation (see below). At times in the past countries pursued mercantilist policies. Under mercantilism, a country attempts to maximize its exports and eliminate all imports. Special interest groups seeking protection from international competition sometimes still promote mercantilist ideas today. With a mercantilist policy, the external goals can become of paramount importance to a central bank. 2. Rules versus Discretion in Economic Policymaking Discretionary monetary policy means that central bankers use monetary policy to respond to changing conditions in a countercyclical fashion. Obviously to use discretionary policy effectively, the bankers must be able to recognize what phase of the cycle the economy is currently in and how current events are affecting economic performance. The alternative is for a central bank to follow a policy rule that determines money supply growth or the appropriate interest rate for example. 144 Chapter 13 a. Time Lags and Rules versus Discretion All economic policy faces policy time lags. There are three main lags in monetary policy: The recognition lag is the time between when the need for a policy action arises and when the central bank recognizes the need. Problems in collecting and disseminating data and measurement error complicate this process and lengthen the recognition lag. This lag could be a few weeks to a few months, or perhaps longer. The response lag is the time from when the central bank recognizes the need until the central bank responds. For monetary policy this lag should be short because most monetary authorities meet regularly. The typical lag should not be more than a few weeks, although a lack of consensus could lengthen this lag appreciably. The transmission lag is the time from when the central bank responds until the full affects of a policy change are felt in the economy. This lag is variable and depends on market conditions and the degree of anticipation, but it can last months or years. The average is usually quoted at something over 12 months. Consequently, the total policy time lag can easily be over a year. This complicates the process of discretionary monetary policy and brings up the possibility that discretionary policy actions intended to be countercyclical can indeed be destabilizing in the event that their effects occur after economic conditions have changed. b. Is Policy Discretion Unavoidable? Capacity output is the output level that could be produced if all resources were used to their utmost. It is possible that central bankers will manipulate monetary policy to achieve capacity output (perhaps due to political pressures to do so.) Capacity output is higher than the output level that a nation’s economy produces in the long run. If the central bank tries to force output above its long run equilibrium point this will result in inflation. This causes what is termed the inflation bias in discretionary monetary policy. The inflation bias is the tendency for an economy to experience ongoing inflation as a result of the pursuit of discretionary monetary policy. Rules versus Discretion — Can Policymakers Stick to Their Promises? 145 Price Level AS2 AS1 C P2 B D A P1 AD2 AD1 y1 y* Real Output The central bank attempts to increase aggregate demand from AD1 to AD2 to move from point A to point B to increase real output from y1 toward capacity y*. Because the short run aggregate supply curve AS1 is upward sloping, this generates inflation. Wage earners recognize the inflation and push wages up so that the aggregate supply curve shifts up from AS1 to AS2, bringing real output back to y1, but only after generating inflation because the price level has now risen from P1 to P2. P2 – P1 is the inflation bias of discretionary policy. Point D occurs if the central bank promises to not increase aggregate demand, but the public feels the promise is not credible. Wage earners then push wages up anyway which then creates stagflation (higher prices and lower real output) and moves the outcome to point D. This implies that point A is an equilibrium point only if the central bank’s promise not to increase aggregate demand is credible. This points out the time inconsistency problem, which simply means that even if the central bank keeps its promise today, it might not tomorrow. Particularly given the policy lags involved, the time inconsistency problem creates an incentive for laborers to go ahead and seek wage increases unless there is a policy rule or some other incentive in place that limits central banker’s ability to pursue discretionary monetary policy. 146 Chapter 13 c. Visualizing Global Economics Issues: The Inflation Bias of Discretionary Policy For Critical Analysis: How could a policymaker who currently lacks policy credibility go about developing it? See the next section. d. Establishing Policy Credibility Solutions to the credibility problem include: Constitutional limits on discretionary monetary policy as Friedman has advocated. Credibility may be built by establishing an anti-inflation reputation. This is a key point that is necessary to limit the inflation bias and to maintain a stable currency value, both of which can be influential in determining the amount of foreign investment a country can attract. Employing a conservative central banker. A conservative central banker is one who makes fighting inflation a higher priority than reducing unemployment. Establishing an independent central bank. This entails both political and economic independence. Political independence is the ability to conduct monetary policy free from interference from politicians seeking reelection (or any other self-interested goal). Economic independence is the ability to set its own budget and not be dependent on the political process for funding. Without economic independence, political independence is unlikely. Evidence indicates that more independent central banks tend to have lower inflation and lower inflation variability. Utilizing anti-inflation contracts for central bankers. The central banker contract is a legally binding agreement that holds the central bank official(s) responsible for keeping the national inflation rate within specified bounds and may include sanctions for failure to do so. New Zealand apparently employs one of these. Rules versus Discretion — Can Policymakers Stick to Their Promises? 147 e. Policy Notebook: Can Unemployment Insurance Substitute for a Conservative Central Banker? For Critical Analysis: What are the pros and cons of seeking to reduce inflation by establishing a generous program of unemployment insurance instead of trying to identify and appoint conservative central bankers? If one cannot find a conservative central banker, or if the central bank is not independent of the political process, then a generous welfare system may make some sense in this context. Cost’s to society will generally be one of the major problems of increasing unemployment insurance however. This may also increase the natural rate of unemployment and can reduce real output (or perhaps increase immigration pressures as in the German Asparagus critical analysis in Chapter 10). 3. Policymaking in an Interdependent World a. Structural Interdependence and International Policy Externalities With international trade of all types growing, linkages between economies are becoming more important. This implies that markets for goods, services and financial assets are becoming structurally interdependent. This interdependence implies that monetary policy actions in one country are likely to cause spillover effects in other countries. These international policy externalities can be negative externalities or positive externalities. The latter are called locomotive effects. Devaluing the domestic currency provides a simple example of a potential negative policy externality if the result is an increase in the domestic trade surplus accompanied by a decrease in another country’s trade surplus. Strategic policymaking can help limit negative externalities, or perhaps promote positive externalities. Strategic policymaking is conducting policy in light of the structural interdependencies and accounting for the possible responses by other countries’ policymakers. 148 Chapter 13 b. Accounting for Interdependence: International Policy Cooperation and Coordination International policy cooperation is forming relationships and institutions to collaborate on policy goals, provide and share information about policy approaches, and share economic data. The G7 and the Bank of International Settlements (BIS) are examples. The BIS was originally founded to handle war reparations after World War I. It has since evolved into what is sometimes termed the central banks’ central bank. It serves as a economic policy and research center, as a trustee on government loans and perhaps most importantly as a promoter of global financial regulations. The BIS proposed the international capital standards Basel I, and the recent Basel II, and continues to provide a forum for implementing safeguards into the global financial system. International policy coordination is a step beyond cooperation. In international policy coordination, the different central banks operate as if they were a single entity, jointly determining national economic policies for the mutual benefit of all parties. 4. The Pros and Cons of International Policy Coordination a. Potential Benefits of International Policy Coordination The potential benefits include: Internalizing international policy externalities: Coordinating policies can allow central banks to affect the extent of externalities. For instance, if one country desires to eliminate subsidies, but fears that its domestic industry cannot compete internationally because a trading partner subsidizes its firms, then bilateral negotiations can result in simultaneous elimination of subsidies in both countries. Reducing the tradeoff in simultaneously pursuing internal and external policy goals: For instance, suppose that one country desires to increase its money supply, but not decrease its currency value against a trading partner. The domestic country can increase its money supply, while the trading partner also increases its money supply so that the relative supply conditions of the currencies can be kept the same to help maintain the currency value. Gaining support to withstand domestic political pressures: A central bank may be able to claim that it cannot increase the money supply as the domestic government wishes (this is the usual case) because of outstanding international agreements. Rules versus Discretion — Can Policymakers Stick to Their Promises? 149 b. Potential Drawbacks of International Policy Coordination The potential drawbacks include: A possible loss of national sovereignty: Sovereignty is defined as the nation’s ability to manage its own resources solely for its own benefit and as it sees fit. A coordination agreement may limit sovereignty that may induce the central bank to act in ways not in the best interests of the domestic country, particularly in the short run. Other countries in the agreement may not be trustworthy: The text presents the typical prisoner’s dilemma scenario in Text Figure 13-5 where the two countries can maximize welfare by not cheating, but one country has an incentive to cheat if the other does not. Other policymakers in the agreement may not be competent even if they are trustworthy. Even if policy coordination is successful, the result may sometimes be worse than if no cooperation occurred. The textbook uses the example of a positive spillover effect related to an increase in aggregate demand in two countries. Due to the inflation bias, the increase in demand resulted in higher inflation in both countries without increasing real output. 5. Optimal Currency Areas and Monetary Unions a. Optimal Currency Areas Recall that a group of countries that adopt a common currency is termed a monetary union. In theory, the countries adopting the common currency should comprise an optimal currency area. An optimal currency area is an area where the net costs and risks of maintaining and continuing to convert separate currencies outweigh the benefits of maintaining separate currencies. The benefits of maintaining separate currencies are: Separate currencies allow a more speedy adjustment to changing comparative advantages. Suppose that two countries form a common currency area for instance. If relative advantage shifts to favor Country A over Country B and currencies are allowed to float then the exchange rate of Country B will fall relative to A, restoring competitiveness to Country B’s products. If the exchange rate cannot change and labor cannot move to Country A then sustained unemployment in Country B is the likely result. Separate currencies allow a more speedy adjustment to changing relative economies. Continuing the above example, if inflation in Country B is higher than in Country A, the value of Country B’s currency will fall, adjusting relative prices back in line. Sovereignty is maintained. The above two points indicate that combining the currencies entails a loss of sovereignty to some extent. 150 Chapter 13 Advantages to combining currencies include: reduced currency conversion costs, which for diversified firms operating in multiple countries, can be quite substantial, reduced currency risk and reduction in currency hedging costs, and increased price transparency for products in multiple markets and the resulting increased competition. Several factors affect the optimal currency area, but in particular the major determinants are whether labor and capital are freely mobile within the countries that comprise the currency area and the extent of economic convergence or divergence among the countries in the area. b. Is Europe an Optimal Currency Area? The EMU instituted convergence criteria before any country could join and now has similar criteria (detailed on page 436 of the text) which applicant countries must meet. The EMU is probably not an optimal currency area as we have defined it, and the applicant countries certainly are not. Labor mobility and cultural homogeneity is much lower in the EMU than in the U.S. We are likely to see regional problems in parts of the EMU requiring transfer payments to certain areas. c. Policy Notebook: The United Kingdom Studies Hard for What Turns Out to Be a Practice Exam For Critical Analysis: What factors might explain the hesitancy of the United Kingdom to join the European Monetary Union? The UK and Denmark have opted out. No doubt, part of their reluctance to join is a fear of loss of sovereignty that would result. This is particularly true for the UK, which along with the pound, have long played a key role in international trade and finance. Probably their reluctance also stems from concerns about the long-term viability of the EMU and the costs of maintaining it. Concerns about labor mobility in and out of their country (and its desirability) are likely also a motivating factor. Certainly, it can be argued that the two countries perceive that the benefits of joining in the common currency do not outweigh the costs and perceived risks. Rules versus Discretion — Can Policymakers Stick to Their Promises? 151 6. Answers to End of Chapter Questions 1. To a mercantilist, the greatest “success” would entail maximizing exports and eliminating imports. Doing this, however, means forgoing gains from trade, which all residents of countries are typically unwilling to give up. Hence, at least some imports normally occur even in nations where mercantilism is a reigning idea. 2. The recognition lag is the time that passes between the need for a countercyclical policy action and the recognition of this need by a policymaker. The response lag is the interval between the recognition of a need for a countercyclical policy action and the actual implementation of the policy action. Finally, the transmission lag is elapsed time between the implementation of an intended countercyclical policy and its ultimate effects on an economic variable. Monetary policymakers often meet daily and can implement policy changes rapidly, so the response lag is likely to be least problematic for monetary policy. The most problematic policy time lag is likely to be the transmission lag, because it can take at least several months for monetary policy actions to exert their final effects on economic activity. 3. If the central bank’s target level of output exceeds the natural, full-information output level, then workers and firms will recognize that once wages are set the central bank has the ability to increase aggregate demand and push output above its natural level. Hence, worker and firms will negotiate a higher nominal wage to take into account the higher price level that they anticipate will result. The central bank, in turn, will realize that workers and firms will behave this way, so that if aggregate demand does not rise, the wage boost will induce aggregate supply to decline and generate higher prices and lower output. Hence, the central bank induces a rise in aggregate demand to prevent output from declining, and on net the single result is an increase in the price level. This price-level increase is the inflation bias. Appointing a conservative central banker entails putting a person in charge of the central bank who particularly dislikes inflation and who thereby is less likely to boost aggregate demand. As a result, the inflation bias will be smaller. 152 Chapter 13 4. This is an accurate statement. The performance of the central banker is based primarily on his or her ability to achieve a certain inflation target. These contracts permit the central banker to use discretionary policy, but with an aim to achieve the inflation target. 5. Political independence refers to the freedom that the central bank has to make its own judgments about appropriate policy actions. Economic independence refers to budgetary freedom for central banks to be able to implement these policy actions. Yes, both types of independence typically would be required. One can easily envision situations in which a central bank could not successfully reduce inflation unless it can make its own decisions and follow through with appropriate actions that affect its own balance sheet and income statement. 6. The discussion in this chapter indicates that the German leaders were correct. The approach that the German leaders suggested would create a more conservative central bank that would be less prone to implementing policies that would create an inflationary bias. 7. If two nations coordinate their policies, then they essentially behave as if the two countries together constitute a single entity. If they engage in policy cooperation, then they merely share information about their understanding of the global economic situation they confront, inform one another of their basic policy strategies, and perhaps provide advance notice of coming changes in their policies. 8. When two nations jointly determine their policies and act as though the two countries together constitute a single entity, thereby internalizing the spillover effects that their policy actions might entail. In addition, if each nation’s policymaker has few policy instruments but several goals, then by working together to coordinate their instrument choices the two policymakers potentially can do a better job of achieving their objectives. Finally, policymakers in one nation may gain strength to withstand domestic political pressures when they receive support or counteracting pressures from policymakers in the other nation. 9. One disadvantage is the loss of sovereignty that international monetary policy coordination entails. Another is that it is possible that a nation can gain from cheating on its policy-coordinating agreement with another country, making it difficult to set up such an agreement. In addition, policymakers may disagree about how their economies function and interact, so they may have different goals and motivations. Furthermore, it is possible that coordination can heighten the potential for discretionary policymaking to induce an inflationary bias, thereby worsening the problem. 10. The main argument likely would be a claim that in Europe, the advantages summarized in the answer to question 8 above outweigh the potential disadvantages summarized in the answer to question 9.