Download Five Debates Over Macroeconomic Policy + Revision

Five Debates Over Macroeconomic
Policy + Revision
Mankiw and Taylor, Chapter 39
In discussing these debates the aim is to review and
revise existing material, not introduce new material
•www.le.ac.uk
Five (+2) Debates over Macroeconomic Policy
1. If only we knew what we know!
2. Are structural deficits real or not?
3. Should the government balance its budget?
4. Do we need macro-prudential policy?
5. How did economists get it so wrong?
Other ongoing debates, which again are useful revision are:
1. Should monetary and fiscal policymakers try to stabilise
the economy?
2. Should the tax laws be reformed to encourage saving?
There is no “right” answer
• Individual opinions
• Political considerations
• Power and rent-seeking involved
1. If only we knew what we know!
• Pro: Information Helps Make Accurate Decisions
• Con: Economic Forecasting is Nothing More than a
Con-Trick
– Black Swan events mean we never know for sure
what is going to happen
– Most economists missed the financial crisis in
2007
– Need to use data and forecasts acknowledging
their uncertainties
2. Are structural deficits real or not?
• Cyclical versus structural deficits
– Deficits rise in a recession. Structural deficits are
when there is a deficit irrespective of the business
cycle
• Pro: Policy makers need to eradicate structural deficits
– So that when countries enter a recession their debt
levels are manageable
• Con: Structural deficits are a myth
– We cannot measure the ‘output gap’ reliably
3. Should the government balance its budget?
Revision. An aside on the loanable funds model:
investment tax credits affect the demand curve
Pro: The government should balance its
budget
• Budget deficits impose an unjustifiable burden on
future generations by raising their taxes and
lowering their incomes
• When the debts and accumulated interest come due,
future taxpayers will face a difficult choice:
– They can pay higher taxes, enjoy less government
spending, or both
Pro: The government should balance its
budget
• By shifting the cost of current government benefits
to future generations, there is a bias against future
taxpayers
• Deficits reduce national saving, leading to a smaller
stock of capital, which reduces productivity and
growth
Con: The government should not balance
its budget
• The problem with the deficit is often exaggerated
• The transfer of debt to the future may be justified
because some government purchases produce
benefits well into the future
– e.g. spending on education today, even if it means
running a deficit, may pay off in the future with
higher GDP growth
– It’s an investment
Con: The government should not balance
its budget
• Government debt can continue to rise because
population growth and technological progress
increase the nation’s ability to pay the interest on
the debt
• That is, we need to look not at debt, but at debt to
GDP ratios
– And as long as Debt ↑ no more quickly than
nominal GDP then Debt/GDP is stable
4. Do we need macro-prudential policy?
• Pro: Financial crisis was down to leverage and
excessive risk taking by many banks
– Macro-prudential policy would monitor banks’
capital ratios and seek to minimise their risk
taking, especially when they’re “too big to fail”
• Con: Impossible to detect excessive risk-taking (and
financial bubbles) in “real-time”
– Banks will find ways round the rules in any case,
even if countries can agree on common rules
5. How did economists get it so wrong?
• Belief in efficient markets; and
• Distrust of government intervention
The efficient markets hypothesis
– Asset prices reflect all publicly available information
about the value of an asset
→ Price = Value. Prices move only as info changes
– Each company listed on a major stock exchange is
followed closely by many money managers
• and they buy shares whose price < value and sell
those whose price > value
• ‘If an economist had a formula that could reliably forecast prices a
week in advance, say, then that formula would become part of
generally available information and prices would fall a week earlier’
• Equilibrium of supply and demand sets the
market price, so all shares are fairly valued
14
EMH
• Stock markets
– Exhibit informational efficiency
• Informational efficiency
– Asset prices reflect all available information
• At a given point in time, the market price is the best
guess of the stock’s value
• Prices only change as new information (news) arrives.
But this news arrives randomly…
• Implication of efficient markets hypothesis
– Stock prices should follow a random walk
• Future changes in stock prices are impossible to predict
from currently available information
15
Implications of the EMH
• If prices do reflect all available information
and are correctly valued, then no stock is
a better buy than any other
• The best you can do is buy a diversified
portfolio (an index fund) like a mutual fund
which buys all the stocks in an index – to
minimise idiosyncratic risk
– Can’t beat the market on a risk-adjusted basis
– There is no means of picking winners and losers
16
Economics got it wrong
• There was too much trust in the ideas that people
behave rationally and that the market is the best
way to allocate resources
• But (new) Keynesians believe that while in the longrun wages and prices may adjust to restore output at
its natural rate, there can be significant short-run
deviations with unemployment higher than its
natural rate
– Does this imply a role for governments to
stimulate the economy, given deficient demand?
Efficient markets still have some currency
• Efficient markets mean precisely that it is impossible
to predict the future (and impossible to predict
crises like the one in 2007/8)
• Markets may get it wrong (experience bubbles) but
they remain preferable to government intervention
Other Debates, and a chance to review
some of the main models in this course
1. Should monetary and fiscal
policymakers try to stabilise the
economy?
Pro: Policymakers should try to stabilise
the economy
• The economy is inherently unstable, and left on its
own will fluctuate
• Policy can manage aggregate demand in order to
offset this inherent instability and reduce the
severity of economic fluctuations
Pro: Policymakers should try to stabilise
the economy
• There is no reason for society to suffer through the
booms and busts of the business cycle
• Monetary and fiscal policy can stabilise aggregate
demand and, thereby, production and employment
Con: Policymakers should not try to
stabilise the economy
• Monetary policy affects the economy with long and
unpredictable lags between the need to act and the
time that it takes for these policies to work
• Many studies indicate that changes in monetary
policy have little effect on aggregate demand until
about six months after the change is made
Con: Policymakers should not try to
stabilise the economy
• Fiscal policy works with a lag because of the long
political process that governs changes in spending
and taxes
• It can take years to propose, pass, and implement a
major change in fiscal policy
Con: Policymakers should not try to
stabilise the economy
• All too often policymakers can inadvertently
exacerbate rather than mitigate the magnitude of
economic fluctuations
• It might be desirable if policy makers could eliminate
all economic fluctuations, but this is not a realistic
goal
Causes of Economic Fluctuations
• Shift in aggregate demand
– Wave of pessimism (credit crunch) –
Aggregate demand shifts left
– Short-run fluctuations: the business cycle
• Output falls
• Price level falls
– Long-run
• Short-run aggregate supply curve shifts right
• Output reverts to it natural rate (so does this mean
there’s no need for government to intervene?)
• Price level falls (to offset shift in AD)
25
Exhibit 8
A Contraction in Aggregate Demand
Price
Level
Long-run
Short-run aggregate
aggregate supply
supply, AS1
AS2
P1
3. . . . but over time, the
short-run aggregate-supply
curve shifts . . .
A
B
P2
C
4. . . . and output returns to its
natural rate.
P3
1. A decrease in aggregate
demand . . .
AD2
Y2
Aggregate demand, AD1
Y1
Quantity of Output
2. . . . causes output to fall in the short run . . .
A fall in aggregate demand is represented with a leftward shift in the aggregate-demand curve
from AD1 to AD2. In the short run, the economy moves from point A to point B. Output falls from Y1
to Y2, and the price level falls from P1 to P2. Over time, as the expected price level adjusts, the
short-run aggregate-supply curve shifts to the right from AS1 to AS2, and the economy reaches
point C, where the new aggregate-demand curve crosses the long-run aggregate-supply curve.
In the long run, the price level falls to P3, and output returns to its natural rate, Y1.
26
AD-SRAS/LRAS model
• Model of long run: Vertical long-run AS curve
• Model of short run: Upward sloping short-run AS curve
– 3 explanations for why this SRAS is upward sloping
• Sticky wages
• Sticky prices
• Misperceptions
SRAS Curve: in summary
• All three theories imply that:
Quantity of output supplied =
= Natural rate of output +
+ a(Actual price level – Expected price level)
• where a determines how much output
responds to unexpected changes in the price
level
• But in the long run, actual prices = expected
prices and SRAS = LRAS = vertical
28
The Long-Run Equilibrium
Price
Level
Equilibrium
price
Long-run
aggregate
supply
Short-run
aggregate
supply
A
Natural rate
of output
Aggregate
demand
Quantity of Output
The long-run equilibrium of the economy is found where the aggregate-demand
curve crosses the long-run aggregate-supply curve (point A). When the economy
reaches this long-run equilibrium, the expected price level will have adjusted to equal
the actual price level. As a result, the short-run aggregate-supply curve crosses this
point as well.
29
Shifts to the SRAS curve
• The short-run AS curve might shift because of:
– Changes in labour, capital, natural resources, or
technological knowledge
• i.e. all those factors that explained movements in the
LRAS curve (since they shift SRAS and LRAS), but also
– Expected price level increases and the SRAS curve
shifts to the left (up)
– i.e. SRAS curve depends on sticky wages, sticky prices and
misperceptions. Since these are all set based on expectations of
prices, when price expectations change the SRAS shifts
– In the short run expectations are fixed and economy is at the
intersection of the AD and SRAS curves
– But we will see that, in the long run, expectations shift to ensure
intersection of the AD and LRAS curves
30
Table 2
The Short-Run Aggregate-Supply Curve: Summary
31
Table 2
The Short-Run Aggregate-Supply Curve: Summary
32
2. Should the tax laws be reformed to
encourage saving?
Pro: Tax laws should be reformed to
encourage saving
• A nation’s saving rate is a key determinant of its
long-run economic prosperity
• A nation’s productive capability is determined largely
by how much it saves and invests for the future
• When the saving rate is higher, more resources are
available for investment in new plant and equipment
Saving and Investment
• Raise future productivity
– Invest more current resources in the
production of capital
– Trade-off
• This involves devoting fewer resources to produce
goods and services for current consumption
• To invest more in capital, a society must consume
less and save more of its current income
• Financial markets coordinate S and I in market
economies. Governments can also affect S and I,
and therefore economic growth
35
Diminishing Returns
• Higher savings rate
– Fewer resources are need to make
consumption goods
– So there are more resources to make capital
goods
– Capital stock increases
– Rising productivity
– More rapid growth in GDP
• But there can be difficulties in inferring causation from
correlation (in principle, GDP could be causing
Investment, not the other way round)
36
Diminishing Returns
• Diminishing returns
– Benefit from an extra unit of an input
declines as the quantity of the input
increases
• In the long run, higher savings rate →
– Higher level of productivity
– Higher level of income but not higher
growth in productivity or income
– But the long-run can be a long time
coming
37
Figure
Illustrating the Production Function
Output
per Worker
1
1
2. When the economy has a
high level of capital, an extra
unit of capital leads to a small
increase in output.
1. When the economy has a low level of
capital, an extra unit of capital leads to a
large increase in output.
Capital per Worker
This figure shows how the amount of capital per worker influences the amount of
output per worker. Other determinants of output, including human capital, natural
resources, and technology, are held constant. The curve becomes flatter as the
amount of capital increases because of diminishing returns to capital.
38
Productivity
• Productivity
– Quantity of goods and services produced
from each unit of labour input
• Why productivity is so important
– Key determinant of living standards
– Growth in productivity is the key
determinant of growth in living standards
– An economy’s income is the economy’s
output
39
Pro: Tax laws should be reformed to
encourage saving
• The tax system discourages saving in many ways,
such as by heavily taxing the income from capital and
by reducing benefits for those who have
accumulated wealth
Pro: Tax laws should be reformed to
encourage saving
• The consequences of high capital income tax policies
are reduced saving, reduced capital accumulation,
lower labor productivity, and reduced economic
growth
Pro: Tax laws should be reformed to
encourage saving
• An alternative to current tax policies advocated by
many economists is a consumption tax
• With a consumption tax, a household pays taxes
based on what it spends not on what it earns
– Income that is saved is exempt from taxation until
the saving is later withdrawn and spent on
consumption goods
Con: Tax laws should not be reformed to
encourage saving
• Many of the changes in tax laws to stimulate saving
would primarily benefit the wealthy
– High-income households save a higher fraction of
their income than low-income households
– Any tax change that favours people who save will
also tend to favour people with high incomes