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CHAPTER 13
Stabilization Policy
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Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Questions
• What principles should guide
stabilization policy?
• What aspects of stabilization policy do
economists argue about today?
• Is monetary policy or fiscal policy
more effective as a stabilization
policy?
• How does uncertainty affect the way
stabilization policy should be made?
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Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Questions
• How long are lags associated with
stabilization policy?
• Is it better for stabilization policy to
be conducted according to fixed rules
or to be conducted by authorities with
substantial discretion?
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Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Government Policy
• There are two kinds of government
policy
– fiscal policy
• shifts the IS curve
– monetary policy
• shifts the LM curve
• The government uses policy to
stabilize the macroeconomy by
minimizing the impact of shocks
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Monetary Policy Institutions
• Monetary policy in the U.S. is made by
the Federal Reserve which is the
central bank
– the principal policy-making body of the
Federal Reserve system is the Federal
Open Market Committee (FOMC)
• the FOMC lowers and raises interest rates and
increases and decreases the money supply
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Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Monetary Policy Institutions
• The Federal Reserve has a central
office and 12 regional offices
– the central office is the Board of
Governors in Washington, DC
– the 12 regional offices are the 12 Federal
reserve banks scattered around the U.S.
– the members of the Board of Governors
and the Presidents of the regional Federal
Reserve Banks make up the FOMC
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Figure 13.1 - Structure of the Federal
Reserve System
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Figure 13.2 - Composition of the Federal
Open Market Committee
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Monetary Policy Institutions
• The FOMC meets approximately once
a month to set interest rates
– emergency meetings can also be
scheduled on short notice
• When the FOMC decides on a policy
change, it is implemented
immediately
– it takes only minutes for interest rates to
shift in response to FOMC actions
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Monetary Policy Institutions
• The FOMC changes interest rates by
carrying out open-market operations
– in an expansionary open-market
operation, the Federal Reserve buys
government bonds, increasing bank
reserves, and lowering interest rates
– in a contractionary open-market
operation, the Federal Reserve sells
government bonds, decreasing bank
reserves, and raising interest rates
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Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Monetary Policy Institutions
• The Federal Reserve can also alter
interest rates in two other ways
– the Board of Governors can alter legally
required bank reserves
– the Board of Governors can lend money
directly to financial institutions
• These tools are used very rarely
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Fiscal Policy Institutions
• Fiscal policy in the U.S. is managed by
Congress
– the Congress creates the tax laws that
determine the amount of taxes imposed
by the federal government
– the Congress’s spending bills determine
the level of government purchases
• Tax and spending levels are set
through a process called the budget
cycle
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Figure 13.4 - The Budget Process
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Government Expenditures
• Mandatory expenditures include
spending for Social Security, Medicare,
Medicaid, unemployment insurance,
and food stamps
• Discretionary expenditures must be
appropriated each year by Congress
– these include defense spending, NASA,
highway spending, education spending,
and so forth
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Figure 13.5 - Major Federal Government
Expenditures by Category, 1960-2000
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Figure 13.6 - Federal Government Discretionary
Spending, Excluding Defense (2000)
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Fiscal Policy Institutions
• Because of the way the budget
process is set up, making fiscal policy
in the U.S. is complicated and timeconsuming
– the time between when a policy proposal
is made and when it becomes effective
(the inside lag) can take years
– the inside lag associated with monetary
policy changes can be measured in days
or weeks
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The History of Economic Policy
• The Employment Act of 1946
– established Congress’s Joint Economic
Committee and the President’s Council of
Economic Advisors
– called on the President to estimate and
forecast the current and future level of
economic activity in the U.S.
– announced that it was the responsibility
of the federal government to foster and
promote free enterprise and the general
welfare
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The History of Economic Policy
• Before the Great Depression, the
general belief was that the
government could not stabilize the
economy and should not try to do so
• It was largely due to the writings of
John Maynard Keynes that economists
and politicians became convinced that
governments could halt depressions
and smooth out the business cycle
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The History of Economic Policy
• Because of the low and stable inflation
and unemployment rates of the
1960s, economists and politicians
thought that the business cycle was
dead
• However, in the 1970s, expected
inflation rose and the Phillips curve
shifted up
– the result was stagflation
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Figure 13.7 - The U.S. Phillips Curve(s),
1955-1980
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The History of Economic Policy
• By the end of the 1970s, many
economists were convinced that active
monetary policy did more harm than
good
– they argued that the U.S. would be better
off with an “automatic” monetary policy
• one idea is to fix the money stock to a stable
long-run growth path
• the instability of velocity has reduced the
number of advocates of this policy
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Figure 13.8 - The Velocity of Money before 1980
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The Power and Limits of
Stabilization Policy
• Economists today have varied views
as to how the central bank and fiscal
authorities should manage the
economy
– some (such as Milton Friedman) feel that
activist attempts to manage the economy
are likely to do more harm than good
– some believe that the appropriate
government policy can do a lot to
stabilize the economy after shocks occur
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Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
The Power and Limits of
Stabilization Policy
• Even the most activist of economists
recognize the limits of stabilization
policy
– stabilization policy requires us to know
where the economy is and where it is
going
• use large-scale macroeconomic models to
forecast the future
• search for leading indicators
– the level of the stock market is often used
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The Lucas Critique
• Expectations of the future affect
decision-making in the present
• Robert Lucas argued that, because
expectations of the future include
expectations of government policies, if
policies are changed the structure of
the economy may change as well
– economic models from the past may not
be useful in forecasting the future effects
of policy
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Leading Indicators
• The index of leading indicators
contains ten components
• The leading indicator that has been
most closely watched is the money
supply
– there are four measures of the money
supply (M1, M2, M3, and L)
– these four monetary aggregates do not
behave in the same way
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Figure 13.9 - Different Measures of the
Money Stock Behave Differently
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The Money Multiplier
• Open market operations change the
monetary base
– the effects on the money supply are less
direct and less certain
• Changes in the monetary base cause
changes in the money supply through
a process called the money
multiplier ()
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The Money Multiplier
• The money multiplier can be affected
by the the currency-to-deposits ratio
that households and businesses keep
and the level of excess reserves held
by banks
(curr/dep)  1

(curr/dep)  (req/dep)  (exc/dep)
– (curr/dep)=currency-to-deposits ratio
– (req/dep)=ratio of required reserves
– (exc/dep)=excess reserves-to-deposits
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Figure 13.10 - Changes in the Currency-toDeposits Ratio
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Long Lags & Variable Effects
• Even with reliable forecasts, changes
in policy affect the economy with long
lags and have variable effects
– Changes in interest rates take time to
affect investment, aggregate demand,
and real GDP
– The level of GDP today is determined by
what long-run risky interest rates existed
more than a year and a half ago
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Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Monetary vs. Fiscal Policy
• At the end of the World War II era,
most economists and policy makers
believed that the principal stabilization
policy tool would be fiscal policy
• Today, the overwhelming consensus is
that monetary policy has proven itself
to be faster acting and more reliable
than fiscal policy
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Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Monetary vs. Fiscal Policy
• Fiscal policy takes a longer amount of
time to work
– delays due to the political process
• This means that the Federal Reserve
can neutralize the effects of any
change in fiscal policy on aggregate
demand
– swings in tax laws and appropriations
have little effect on real GDP unless the
Federal Reserve wishes them to
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Automatic Stabilizers
• Automatic stabilizers include tax
collections and social transfer
programs such as food stamps and
unemployment insurance
• These work without new policies
having to be created and therefore
can moderate the business cycle much
more quickly than can discretionary
policy
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How Monetary Policy Works
• Monetary policy takes time to work as
well
– the Federal Open Market Committee must
first recognize that there is a problem
and then formulate a policy
– while changes in interest rates will occur
almost immediately, it takes over a year
for changes in interest rates to change
national output and unemployment
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How Monetary Policy Works
• The Federal Reserve can either target
real interest rates or keep the money
stock growing smoothly
– if the principal instability in the economy
is a shifting IS curve, targeting interest
rates will not stabilize the economy
– if the instability in the economy occurs
because money demand is unstable or
because the currency-to-deposits and the
reserves-to-deposits ratios vary, then
targeting interest rates is wiser
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Rules vs. Authorities
• Should monetary policy be conducted
“automatically” according to rules or
should it be left to the discretion of
authorities?
– the first reason for automatic rules is that
we fear that the people appointed to
authorities will be incompetent
– the second reason for fixed rules is that
authorities might not have the right
objectives
• political business cycle
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Figure 13.11 - The Politically-Influenced
Business Cycle: Relative Growth in the
Second Year of Presidential Terms
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Central Bank Independence
• Research has suggested that the more
independent a central bank, the better
its performance
– more independent central banks presided
over lower average inflation and less
variable inflation
– countries with independent banks did not
have higher unemployment rates, lower
real GDP growth, or larger business
cycles
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Figure 13.12 - Inflation and Central Bank
Insulation from Politics
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Credibility & Commitment
• In the short run, pursuing a more
expansionary monetary policy can
seem to have great benefits
– higher real GDP, lower unemployment,
little impact on inflation
• In the long run, however, a central
bank is wiser to keep low inflation as
its top priority
– keeps expected inflation low and
maintains credibility
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Credibility & Commitment
• Economists call this conflict between
short-run and long-run interests
dynamic inconsistency
– some economists have argued that this is
another reason to have a fixed set of
rules for monetary policy
– others believe that central banks are
concerned with their long-term reputation
and will resist the temptation to make
inflation and money growth higher than
expected
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Modern Monetary Policy
• What guidelines for monetary policy
should the central bank follow?
– Economists believe that the central bank
should not target real economic variables
such as the growth rate of real GDP or
the unemployment rate
• these are determined in the long run by the
growth of potential output and the natural
rate of unemployment
– Policies which target nominal variables
will work better
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Modern Monetary Policy
• The Taylor rule provides a policy
proposal for the central bank
– the central bank chooses a target for the
inflation rate and then raises interest
rates when inflation is above and lowers
interest rates when inflation is below this
target
r  r * '( - ' )
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Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Financial Crises
• The Federal Reserve has other
important tools that can be used to
try to stem depressions
– deposit insurance insulates bank
depositors from the effects of financial
crises
– if a financial crisis is severe enough, the
Federal Reserve will act as a lender of
last resort
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Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Financial Crises
• A financial crisis sees investors as a
group suddenly become convinced
that their investments have become
overly risky
– they try to exchange their investments
for relatively safe, liquid assets
– interest rates spike upward
– investment can fall sharply sending the
economy into a depression
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Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Financial Crises
• In a financial crisis, the Federal
Reserve can do a lot of good by
rapidly expanding the money supply
to keep interest rates from rising
sharply
• The Federal Reserve can also reduce
the chance of a financial crisis
occurring by doing a good job as the
supervisor and regulator of the
banking system
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Lender of Last Resort
• The Federal Reserve can also help by
lending directly to institutions that are
fundamentally solvent but are
temporarily illiquid
– it can do harm if it bails out institutions
that have gone bankrupt because that
encourages other institutions to take
excessive risks hoping that the central
bank will bail them out in the future
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Deposit Insurance
• One of the reforms of the New Deal
was the institution of deposit
insurance by the Federal Deposit
Insurance Corporation
– federal deposit insurance acts as a
monetary automatic stabilizer
• eliminates the risk of keeping funds in a bank
– the availability of deposit insurance
creates moral hazard
• banks may decide to make risky high-interest
loans
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Chapter Summary
• Macroeconomic policy should attempt
to stabilize the economy: to avoid
extremes of high unemployment and
of high and rising inflation
• Long and variable lags make
stabilization policy extremely difficult
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Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Chapter Summary
• Economists arrange themselves along
a spectrum, with some advocating
more aggressive management of the
economy and others concentrating on
establishing a stable framework and
economic environment
– compared to differences of opinion
among economists in the past,
differences of opinion today are minor
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Chapter Summary
• In today’s environment, monetary
policy is the stabilization tool of
choice, largely because it operates
with shorter lags than does
discretionary fiscal policy
• The fiscal “automatic stabilizers” built
into the tax system nevertheless play
an important role in reducing the size
of the multiplier
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Chapter Summary
• Uncertainty about the structure of the
economy or the effectiveness of policy
should lead policy makers to be
cautious
– blunt policy tools should be used carefully
and cautiously lest they do more harm
than good
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Chapter Summary
• The advantage of having economic
policy made by an authority is that
the authority can use its own
judgment to devise the best response
to a changing--and usually
unforeseen--situation
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Chapter Summary
• The advantages to having economic
policy made by a rule are threefold
– rules do not assume competence in
authorities where it may not exist
– rules reduce the possibility that the policy
will not be made in the public interest but
in some special interest
– rules make it easier to avoid dynamic
inconsistency
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Chapter Summary
• Dynamic inconsistency arises
whenever a central bank finds that it
wishes to change its previously
announced policy in an inflationary
direction
– it is always in the central bank’s shortterm interest to have money growth be
higher, interest rates be lower, and
inflation be a little higher than had been
previously expected
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Chapter Summary
• Today, however, central banks are
generally successful in taking a longterm view
– they pay great attention to establishing
and maintaining the credibility of their
policy commitments
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