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CHAPTER 13 Stabilization Policy 13-1 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? 13-2 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? 13-3 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 13-4 Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 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 13-5 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 13-6 Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. Figure 13.1 - Structure of the Federal Reserve System 13-7 Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. Figure 13.2 - Composition of the Federal Open Market Committee 13-8 Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 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 13-9 Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 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 13-10 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 13-11 Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 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 13-12 Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. Figure 13.4 - The Budget Process 13-13 Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 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 13-14 Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. Figure 13.5 - Major Federal Government Expenditures by Category, 1960-2000 13-15 Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. Figure 13.6 - Federal Government Discretionary Spending, Excluding Defense (2000) 13-16 Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 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 13-17 Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 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 13-18 Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 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 13-19 Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 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 13-20 Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. Figure 13.7 - The U.S. Phillips Curve(s), 1955-1980 13-21 Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 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 13-22 Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. Figure 13.8 - The Velocity of Money before 1980 13-23 Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 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 13-24 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 13-25 Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 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 13-26 Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 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 13-27 Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. Figure 13.9 - Different Measures of the Money Stock Behave Differently 13-28 Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 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 () 13-29 Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 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 13-30 Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. Figure 13.10 - Changes in the Currency-toDeposits Ratio 13-31 Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 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 13-32 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 13-33 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 13-34 Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 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 13-35 Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 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 13-36 Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 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 13-37 Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 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 13-38 Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. Figure 13.11 - The Politically-Influenced Business Cycle: Relative Growth in the Second Year of Presidential Terms 13-39 Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 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 13-40 Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. Figure 13.12 - Inflation and Central Bank Insulation from Politics 13-41 Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 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 13-42 Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 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 13-43 Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 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 13-44 Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 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 * '( - ' ) 13-45 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 13-46 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 13-47 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 13-48 Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 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 13-49 Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 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 13-50 Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 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 13-51 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 13-52 Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 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 13-53 Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 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 13-54 Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 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 13-55 Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 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 13-56 Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 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 13-57 Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 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 13-58 Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.