Download Chapter 24 - McGraw Hill Higher Education

Chapter 24:
Macroeconomic Policy
©2012 The McGraw-Hill Companies, All Rights Reserved
1
Learning Objectives
1. Analyze the effects of anti-inflationary monetary
policy
2. Discuss the policy options available to the central
bank in response to an aggregate demand shock
3. Discuss the policy options available to the central
bank in response to an aggregate supply shock
4. Explain the roles of core rate of inflation, anchored
inflationary expectation, and central bank credibility
in keeping inflation low
5. Describe how fiscal policy can affect both AD and
AS
6. Address the question: why is macroeconomic
policy as much an art as a science?
©2012 The McGraw-Hill Companies, All Rights Reserved
2
Using Monetary Policy To Reduce High
Inflation: The Short Run
 Monetary policy can be used to reduce short-run
and long-run inflation
 Start at potential output, Y1, and 1
 Increase
LRAS
Inflation ()
the interest rate
at each level of inflation
 Shifts AD left to AD2
 Recessionary gap and
short-run equilibrium at
Y2, 2
 Cyclical unemployment
occurs
AS1
1
2
©2012 The McGraw-Hill Companies, All Rights Reserved
AD1
AD2
Y2
Y1
Output (Y)
3
Using Monetary Policy To Reduce High
Inflation: The Long Run
 Start at short-run equilibrium with a recessionary
gap at Y2, and 2
 Actual

inflation, 2, is below expected inflation of 1
Expected inflation
decreases
 Lower
 Short-term pain gets
long-term gain
Inflation ()
expected inflation
shifts AS to AS2
 Economy moves down AD2
 New equilibrium at Y1, 3
LRAS
AS1
1
AS2
2
3
©2012 The McGraw-Hill Companies, All Rights Reserved
AD1
AD2
Y2
Y1
Output (Y)
4
Responding to Shocks in Spending
 Aggregate demand shifts from either an
increase in government spending or other
exogenous changes
 Suppose
changes are permanent
 To maintain expected rate of inflation, central
bank tightens monetary policy
 Suppose military spending increases sharply
 Aggregate
demand increases, opening an
expansionary gap
 Inflation exceeds expectations
 central bank must decide whether to maintain
monetary policy or fight inflation
©2012 The McGraw-Hill Companies, All Rights Reserved
5
Accommodating Monetary Policy
 Accommodating monetary policy allows
the effects of a shock to occur
exogenous spending
goes up, the central bank
does not change monetary
policy
 AD shift to AD2 and the
economy moves to an
expansionary gap at Y2, 2
Inflation ()
 When
LRAS
3
AS1
2
1
central bank holds it
MPR and AS shifts to AS2
 Economy settles at Y1, 3
AD2
 The
©2012 The McGraw-Hill Companies, All Rights Reserved
AS2
AD1
Y1
Y2
Output (Y)
6
Maintains Low Inflation After A Change in
Spending
Inflation ()
 The central bank can choose to enforce its inflation target, 1
 central bank tightens monetary policy, shifting MPR left
 AD shift to AD2 and the
economy moves to an
LRAS
expansionary gap at Y2, 2
 central bank tightens monetary
AS1
policy
2
 Interest rates increase
1
AD2
more than if the central bank
had accommodated the change
AD1
 AD shifts back to AD1
Y 1 Y2
 Economy returns to Y1, 1
Output (Y)
©2012 The McGraw-Hill Companies, All Rights Reserved
7
Defending Target Inflation Rate
When aggregate demand increases, the
central bank shifts its MPR
 Each
inflation rate is now associated with a
higher interest rate
 Increase in spending reduces spending and
increases interest rates in the long run
 To fight inflation, the central bank raises its
interest rates to the new, long-run level
©2012 The McGraw-Hill Companies, All Rights Reserved
8
Responding to Shocks In Aggregate Supply
 The economy begins in long-run equilibrium at Y1, 1
 Adverse supply shock shifts aggregate supply to AS2
central bank follows its monetary policy rule and raises
interest rates
 Recessionary gap at Y2
LRAS AS2
with higher inflation, 2
 The central bank must choose
AS


Close the recessionary gap
Restore target inflation rate
Inflation ()

2
1
1
AD1
Y2 Y 1
Output (Y)
©2012 The McGraw-Hill Companies, All Rights Reserved
9
Accommodating an Aggregate Supply Shock
 Suppose the central bank moves to close the
recessionary gap
 Eases
Resets target inflation rate to 3
 Lower
interest rates
stimulate consumption and
investment spending

AD shifts to AD2
 Long-run
equilibrium is now
at Y1 and 3
Inflation ()

monetary policy, lowering interest rates at 2
LRAS
3
AS1
2
1
 Aggregate supply shock leads
to higher long-run inflation
AS2
AD2
AD1
Y2 Y 1
Output (Y)
©2012 The McGraw-Hill Companies, All Rights Reserved
10
Responding to An Aggregate Supply Shock
 Suppose the central bank decides to maintain
inflation at 1
Inflation is 2, above expected inflation of 1
The central bank raises interest rates
Along AS2, expected
inflation is 3
LRAS
 When the central bank fails
3
to respond with looser
2
monetary policy, expected
inflation decreases
1
 AS2 shifts back to AS1
 Original long-run equilibrium
Y2 Y 1
is restored
Inflation ()



AS2
AS1
AD1
Output (Y)
©2012 The McGraw-Hill Companies, All Rights Reserved
11
Anchored Inflation
 Anchored inflationary expectations
means people's expectations of future inflation
do not change even if inflation rises
temporarily
 Inflation
anchoring dampens response to an
aggregate supply shock
 Businesses and consumers believe the central bank
will reestablish its target inflation rate
 Shortens the time required to close the
recessionary gap from the shock

Encourages central bank to maintain its original inflation
target
©2012 The McGraw-Hill Companies, All Rights Reserved
12
An Alternative View Explaining Stability
 Structural changes in the economy may have
made it more adept at absorbing changes
 Changes
in technology
 Business practices
 Better management of inventories
 Deregulation
 Shift toward services and away from manufacturing
 Increased openness to trade
 Freer international capital flows
©2012 The McGraw-Hill Companies, All Rights Reserved
13
Oil Price Increases of 2003-2005
 Crude oil price was $3 in 1972


$12 at the end of 1974
$35 in 1981
 Oil shocks were followed by stagflation
 Prices fell gradually after 1981, reaching $23 in 2002



Some exceptions to this trend
Oil prices increased dramatically beginning in 2002
By late 2004, oil was more than $40 and reached $65
in August 2005
 BUT… oil price shocks of 2003 – 2005 did not
create stagflation
©2012 The McGraw-Hill Companies, All Rights Reserved
14
Real GDP growth and Inflation, 2002-2006
©2012 The McGraw-Hill Companies, All Rights Reserved
15
Oil Price Increases of 2003-2005
 One explanation for avoiding stagflation is the
changes in the real price of oil
 While
the nominal price was $65 in August 2005,
the real price (adjusted for inflation) was below
the 1981 price

The 1981 nominal price of $35, adjusted to 2005 prices,
would have been $460 in Egypt and $99 in Morocco
 Another contributing factor was the legacy of
previous oil shocks
 The
1973 oil shock caused factories that were
energy inefficient to close
 Factories were ready for higher priced energy
©2012 The McGraw-Hill Companies, All Rights Reserved
16
Oil Price Increases of 2003-2005
Most economies are less reliant on energy
than previously
 Shift
to services from manufacturing
 Energy efficient homes, appliances, and vehicles
The central bank's history of defeating
inflation and sustaining a low target rate of
inflation helped avoid stagflation
 Inflation
is more firmly anchored than in the
earlier oil shocks
©2012 The McGraw-Hill Companies, All Rights Reserved
17
Core Rate of Inflation
Core inflation excludes energy and food
 Shows
the effects of a supply shock separate
from the change in the price of the good
causing the shock

Food and energy are the most volatile elements of
the CPI and most likely to cause a supply shock
Core inflation lets the central bank prevent
the inflation from a supply shock from
becoming permanent
©2012 The McGraw-Hill Companies, All Rights Reserved
18
Core Rate of Inflation
 Central banks in the Middle East and North Africa
do not focus on the core rate of inflation.
1.
2.
3.
Most of these central banks already face a daunting task
in regularly reporting accurate CPI figures.
Food and energy represent a large proportion of the
CPI basket (e.g., 67 percent in Morocco) and excluding
them would not be meaningful.
Most of these countries have consistently faced high
inflation and have yet to consider setting inflation
targets.
 A small number of countries, including Tunisia,
Morocco, and Egypt, have started reporting their
core rate of inflation.
©2012 The McGraw-Hill Companies, All Rights Reserved
19
Inflationary Expectations And Credibility
Credibility of monetary policy is the degree
to which the public believes the central
bank will defend its target inflation rate
 The
more credible policy is, the more inflation
is anchored
Factors that affect credibility
 Degree
of central bank's independence
 The announcements of explicit inflation targets
 Established reputation for fighting inflation
©2012 The McGraw-Hill Companies, All Rights Reserved
20
Central Bank’s Independence
 Central banks insulated from short-term
issues are better able to stabilize the economy
 Indicators of independence are
 Length
of appointments to the central bank
 Whether the central bank's actions are subject to
frequent interference
 Whether the central bank has obligation to finance
the national deficit
 The degree to which the central bank's budget is
controlled by the legislative or executive branch
 Countries with independent central banks
have lower inflation
©2012 The McGraw-Hill Companies, All Rights Reserved
21
Central Bank's Independence
The central bank is a relatively independent
central bank
 Monetary
policy is generally in the central
bank's hands
 The central bank is not obligated to finance the
national debt
 The central bank is self-funding, largely through
its holdings of different securities

When the central bank has a budget surplus, it
returns it to the government
©2012 The McGraw-Hill Companies, All Rights Reserved
22
Announcing Inflation Target
 Proponents argue announced target adds to credibility
of monetary policy and strengthens anchoring

Reduce uncertainty in the financial markets
 Some countries use announced targets or a narrow
range for inflation
These central banks provide additional economic data to
support their target
 Targets must be consistently met

 Announced targets have been successful in
industrialized and developing countries


Highly successful in Brazil, Chile, Mexico, and Peru
Not very successful in Turkey due to frequent target
revisions
©2012 The McGraw-Hill Companies, All Rights Reserved
23
Zero Inflation Undesirable Target
 Zero inflation has several undesirable
consequences
 Imperfect
control over inflation mean periods of
deflation are possible
 Central bank may use negative real interest rates
at times

Can only be achieved if nominal rates are less than
inflation, so nominal rates would be negative
 Measured

inflation overstates actual inflation
A true inflation of zero means measured inflation of
about 1%
A
small amount of inflation makes labor markets
work better
©2012 The McGraw-Hill Companies, All Rights Reserved
24
US Inflation 2002 - 2003
 Inflation in September, 2002 was 1.5% -- and falling


Federal funds rate was 1.75%
Further declines would make monetary policy difficult
to implement if there were an adverse supply shock
 Consumption and planned investment respond to
real interest rates


In September 2002, the real interest rate was 0.25%
Additional stimulus might require negative real interest
rates

Hard to achieve when inflation is low
 Federal funds rate fell to 1.0% by June 2003
©2012 The McGraw-Hill Companies, All Rights Reserved
25
US Inflation 2002 - 2003
Fed has options even at 0% inflation
 Long-term
interest rates are higher than the
federal funds rate

If the Fed needed additional stimulus, it could buy
long-term US Treasury securities
• Increased demand for bonds increases the price and
lowers the interest rate
 Fed
is not allowed to buy stocks, but some
other central banks are allowed
 Fed could commit to a low federal funds rate,
stimulating investment spending
©2012 The McGraw-Hill Companies, All Rights Reserved
26
Central Bank Reputation
 A central bank's success at stabilizing the economy
depends on whether its acts align with its
reputation

Inflation hawk is committed to achieving and
maintaining low inflation,


Accepts some short-run cost in reduced output and
employment
Inflation dove is not strongly committed to achieving
and maintaining low inflation
 Inflation hawks are more successful in maintaining
stable output and employment, even in the short
run

Stronger anchoring of inflation expectations
©2012 The McGraw-Hill Companies, All Rights Reserved
27
Fiscal Policy Effects
 Tax rates reduction increase
aggregate spending through
the consumption function
aggregate demand to the
right
 Supply-side effects shift longrun aggregate supply
 Whether inflation increases,
decreases, or stays constant
depends on the relative sizes
of the shifts in AD and LRAS
Inflation ()
 Shifts
LRAS1 LRAS2
1
©2012 The McGraw-Hill Companies, All Rights Reserved
AD1
Y1
Y2
AD2
Output (Y)
28
Tariq, Single Self-Employed Person's Taxes
Tax and transfer policies also affect potential
output by affecting the supply of labor
 Lower
tax rates on earnings may increase
potential output by inducing people to work
more hours
 A reduction in Tariq’s tax rate from 40 percent
to 30 percent increases his after-tax wage from
$6 to $7 per hour
©2012 The McGraw-Hill Companies, All Rights Reserved
29
Marginal Tax Rates
Cost – Benefit Principle says individual
make labor supply decisions based on the
added costs and added benefits of an action
 Marginal
tax rate is the tax rate on an
additional dollar
 Average tax rate is total taxes divided by
total pre-tax income
Many taxes are not based on income
 Property
tax, gasoline tax, sales tax
©2012 The McGraw-Hill Companies, All Rights Reserved
30
Taxes in the MENA
 Egypt


Total taxes collected in Egypt were about 15.4 percent of GDP
and many of these taxes, such as property taxes, do not depend
on income.
The highest marginal tax rate was 20 percent in 2008.
 Morocco


Total taxes collected in Morocco were about 27.4 percent of
GDP in 2008.
The highest marginal tax rate was 42 percent in 2008 (lowered to
38 percent in 2009).
 UAE, Qatar, and Saudi Arabia



There are no taxes on personal income.
These governments rely primarily on oil and natural gas revenues
and to a lesser degree on taxes on profits.
Taxes on profits are estimated at around 14 percent, 11 percent,
and 15 percent in the UAE, Qatar, and Saudi Arabia, respectively.
©2012 The McGraw-Hill Companies, All Rights Reserved
31
The Potential Effects of Tax Rate Reductions on
Aggregate Demand and Aggregate Supply
©2012 The McGraw-Hill Companies, All Rights Reserved
32
Americans Work More than Europeans
Relative Hours Worked
(US = 100)
Marginal Tax
Rate
Japan
104
37%
US
100
40
UK
88
44
Canada
88
52
Germany
75
59
France
68
59
Italy
64
64
Country
©2012 The McGraw-Hill Companies, All Rights Reserved
33
Americans Work More than Europeans
 US average work week is longer
 US
takes fewer vacations and holidays
 Retire later
 Less unemployment
 Marginal interest rates matter
 When
European marginal rates were lower, they
worked more
 Other factors matter
 More
unionization in Europe
 Government regulations regarding hours per week
 More generous social security systems
©2012 The McGraw-Hill Companies, All Rights Reserved
34
Policymaking: Art or Science?
 Economy is complex
 Actors
learn, adapt, and change
 Macroeconomic policy works best with
 Accurate
knowledge of current economic
conditions
 Knowledge of the future path of the economy
without policy
 Precise value of potential output
 Good control of fiscal and monetary policies
 Knowledge of how and when the economy will
respond to policy changes
©2012 The McGraw-Hill Companies, All Rights Reserved
35
Barriers to Perfect Policies
Policy makers act with an approximate
understanding of the economy
Policy is subject to lags
 The
inside lag is the delay between the time a
policy change is needed and the time it is
implemented

Shorter for monetary policy than for fiscal policy
 The
outside lag is the delay between policy
implementation and the major effects of the
policy occur

Longer for monetary policy than for fiscal policy
©2012 The McGraw-Hill Companies, All Rights Reserved
36