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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 P1 e P1 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 g Y • Statistical reality for US 1960-98 u-u-1 -0.4 g Y 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 i r a - * * (2) by - 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.