Download XIV. Current issues in economic policy

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: short term
– Positively sloped AS in short- to medium-term
• 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
Requirements
• 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
 P1
e
 
P1
and original Phillips curve can be expressed

   e  .u, with  e  0
• However, whenever  e  0 , than inflation
might rise, even with high unemployment.


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 infaltion
– 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 emplyoment and profits vansih
• 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
– … but we assume that  e   ´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-1 =-b g Y -g 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)
 by - 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. 25-27
– 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.