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Macroeconomic Stabilization
M. Finkler
Goals for Macro Stability
• Keep inflation low enough to not affect decision making
• Keep GDP close to GDP Potential
• Dual Mandate – 1977 Congressional amendment to the
Federal Reserve Act
– “The Board of Governors of the Federal Reserve System and
Federal Open Market Committee shall maintain long run growth
of monetary and credit aggregates commensurate with the
economy’s long run potential to increase production, so as to
promote effectively the goals of maximum employment, stable
prices, and moderate long term interest rates.”
• January 25, 2012, FOMC noted that “the maximum level of
employment is largely determined by non-monetary factors
that affect the structure and dynamics of the labor market.”
Fundamental Positions of Economists
on Macroeconomic Stabilization
• Economy is self-correcting; aim policies
towards long run growth (freshwater school)
• Economy is unstable; use policy in a countercyclical fashion (saltwater school)
• Majority of economists favor the latter view
• A substantial (3%+), sustained (1 year or
more) rise in the average level of prices
• Debate about which target: CPI, PCE, GDP
Deflator, asset prices
• Why worry about inflation? Both pure and
impure inflation have costs.
Pure Inflation
• Pure: all nominal variables rise together
(adjusted by some price index)
• Indexing may not be complete or rapid
• Menu & shoe leather costs exist (even in a
virtual world)
• Resources must be devoted to protection
against inflation (e.g., TIPS inflation premium)
Impure Inflation
• Tax system is not neutral – it taxes some nominal gains not
just real gains
• Not all inflation can be predicted
• Inflation generates winners and losers
Borrowers win from rising (unexpected) inflation
Lenders lose from rising (unexpected) inflation
Well off can more easily protect selves
Losers attempt to shift losses onto others
• Inflation has been used to reconcile competing claims
against income
– If debt service payments can’t be met, inflation makes it
possible, but then lenders lose
– Currency devaluation causes foreign debt holders to lose
Costs of Inflation
• Over time, lenders put in a risk premium to
protect themselves against unexpected
• Inflation and uncertainty tend to rise together
– Risk averse firms postpone hiring and K purchases
• Rampant inflation reduces confidence and
destabilizes economies: Chile (1970s),
Nicaragua and Peru (1980s), Eastern Europe
(1990s), and Zimbabwe (2000s). Argentina?
Active vs. Passive Policy
• Active (Keynesian) – Use AD Management tools
to stabilize Π, Y, and L
– Possible to intervene to reduce Y and L losses
– Business cycles have been less volatile since WWII
• Passive (New Classical, Real Business Cycle) – Set
policy for the long run
– Active policy inhibits structural adjustment
– Relative prices become distorted and moral hazard
– C. Romer – Less volatility since WWII? - better data
– Activist policy can be manipulated by the party in
power for political purposes
Policy Lags
• Inside lag – time required to make a decision and
implement policy
• Outside lag – time required for policy to affect
desired variables
• Monetary policy has short inside lag and long
outside lag (various transmission channels)
• Fiscal policy inside lags tend to be long (except in
an emergency), but outside lags can be short.
(Spending and taxing changes can be quickly
Automatic Stabilizers
• Progressive income tax system (rates rise with
income) dampens booms and softens
contracting periods
• Unemployment insurance does the same
thing (recall: C. Zimmerman discussion)
• Typically specific conditions (not decisionmaking) generates policy response so no
inside lag. (Unemployment compensation,
agricultural price supports)
• Forecasting is very difficult so discretionary
policy intervention can be mistimed or
• Leading indicators often give false signals
(need 3 or more same sign before odds of
correct signal > 50%)
• R2 not helpful – only 11 recessions since WWII
• Turning points are very hard to predict
Lucas Critique
• Keynesian policy makers argue that policy makers need
not worry about how households and businesses will
perceive policy
• Lucas argued that HH and firms anticipate policy in
making long term commitments
– Will there be a tax reduction or increase?
– Will there be incentives to hire more labor?
– Will there be incentives to invest in plant and equipment?
• Essentially, moral hazard must be considered. (Bailouts,
subsidies, tax incentives)
• Lucas (New Classicists) argue for clearly articulated and
credible policies; these reduce uncertainty.
Rules versus Discretion
• Activist rules: those which attempt to be
countercyclical – e.g. Taylor’s FFR rule
• Passive rules: those which don’t change with
the state of the economy (except under very
unstable conditions) – e.g. Friedman’s k% rule
• Discretion provides flexibility to policy makers
to respond as they see fit without being
bound to specific actions.
• Treasury Secretary Paulson (2008)
• Who is “Too Big to Fail”? Which forces are
systemic? Who gets “bailed out”?
• Fed intervened when Bear, Stearns was
headed for bankruptcy. It did not for Lehman
• Former case meant that latter was a surprise.
• Discretion can lead to political manipulation
based on election cycle, lobbying, and size of
stakeholder interest (GM? AIG?)
Time Inconsistency
• If policy makers have discretion, they might
optimize choice at each point in time rather than
establish a long term policy.
• For example, they might declare π* = 2%, wait
until contracting is done and then implement
policy that is more expansionary
• If π expectations are backward looking, it doesn’t
• If π expectations are forward looking, it does so
credibility of target is critical.
• John Taylor (EROP 1990) :
– “Policy credibility will often lead to economic
performance that is superior to that in which policy is
not credible. …A credible disinflation plan initiated by
the monetary authorities will bring down inflation
more quickly and with less chance of recession than a
plan with little credibility.”
– “If the public is confident that appropriate policies are
being followed, then households and businesses can
plan for the future, which promotes savings,
investment, and economic growth.”
Independence of Central Bank
• Until recently, consensus view has been that the
CB should be independent of treasury
• Note that fiscal policy and monetary policy in
conflict means incoherent policy.
• Figure 18-2 should independence matters for CB
• New Zealand is often the most frequently cited
• Canada, UK, and ECB have announced targets.
Not clear that they follow them.
Kydland and Prescott
• Let U = Un – α*(π- πe) + ε - Phillips Curve
• CB objective to minimize welfare loss which could
be L(U, π) = U + γ* π2
• Derivative of L wrt π, set to zero
yields π= α/2 γ
• If public knows & believes π* = 2% then πe= πe
and U = Un + ε
• Time inconsistency says get people to believe
that inflation target is credible and then
implement expansionary policy. Note: Japan.