Transcript Reassessing Discretionary Fiscal Policy

Reassessing
Discretionary Fiscal Policy
John B. Taylor
Stanford University
Presented at Amherst College
April 25, 2000
Fiscal Policy Gun Is Reloaded
• Last attempts at discretionary fiscal policy
– 1992 Bush Stimulus package: rejected
– 1993 Clinton Stimulus package: rejected
• Reason for rejection: budget deficit
• Now deficits are gone, so counter-cyclical
policy is ready to be used again
• But should we use it?
Why a reassessment?
• Changes in monetary policy
– More emphasis on inflation control and keeping
aggregate demand close to aggregate supply
– More reactive to both inflation and real GDP
– Favorable effects on both
• Changes in macroeconomic policy evaluation
research
– New normative macroeconomics
• Example. Monetary Policy Rules, U. Chicago Press, 1999
A Simple Framework For
Analyzing Countercyclical Policy
y =  ar + u
r = b + v
 = -1 + cy-1 + w
r = real interest rate
y = real GDP
(measured relative to potential GDP)
 = the inflation rate
u,v, and w are shift terms
INFLATION
RATE
INFLATION
RATE
Potential
GDP
INFLATION
RATE
Potential
GDP
3
Potential
GDP
3
3
IA
2
1
IA
2
1
AD
REAL GDP
2
1
AD
REAL GDP
FIGURE 1. Keeping Aggregate Demand in Line with Potential GDP
IA
AD
REAL GDP
Three cases relating to
countercyclical monetary policy:
(1) Goldilocks economy--ideal, no change
(2) Too cold--cut interest rates
(3) Too hot--raise interest rates
“Too hot” example from Fed’s
Monetary Policy Report,
Feb. 2000.
• “aggregate demand may well continue to
outpace gains in potential output over the
near term, an imbalance that contains the
seeds of rising inflationary and financial
pressures that could undermine the
expansion. ... [T]he level of interest rates
needed to align demand with potential
supply may have increased substantially”
Compare discretionary fiscal
policy
• Cyclical goals same as monetary policy:
– keep AD = potential when inflation is on target
• Also shifts AD curve, but
– Lags longer (implementation)
– Harder to reverse
– Could make Fed’s job harder
• And Fed reacting more than before
Zero Bound on Interest Rate
• Example of Japan
• Causes non-linearity in policy rule
r = b (with b > 0) for i > 0
r = i -  = -  for i < 0
– Possibility of downward spiral
• Kinked aggregate demand curve
• Role for fiscal policy enhanced
Nominal interest rate
Constant Real
Interest Rate
Policy
Rule
Inflation rate
0
Target
Inflation Rate
AD
IA
0
Real GDP
Figure 2. The Kinked Aggregate Demand Curve. The upward sloping unstable region starts
when the zero lower bound on the interest rate is reached.
Other arguments
• Monetary policy constrained by fixed
exchange rates
• Credibility problems prevent central bank
from reacting to y
Fiscal and monetary rule together
r = h+ gy + r*
s = fy + s*
where
s is the budget surplus as a share of GDP
s* is the structural surplus
s - s* is the cyclical surplus.
Table 1. Response of the Surplus and Its Components to the Output Gap
total
Sample period
structural
cyclical (f)
1960.1 – 1982.4
-.13
.45
.32
1983.1 – 1999.3
.31
.37
.68
1960.1 – 1999.3
.01
.43
.45
Percent of GDP
4
2
0
Fiscal policy rule:
Structural surplus + .5Gap
-2
-4
Actual
surplus
-6
-8
60
65
70
75
80
85
90
95
Conclusion
• Fiscal policy should focus on the automatic
stabilizers
– Could even become less responsive, as appears to have
happened already
• Save discretionary actions for longer-term issues
and for unusual situations when monetary policy
might have relatively little power.
• Monetary policy has done a good job at keeping
aggregate demand close to potential GDP.
– Seems hard to improve on this performance with a
more active discretionary fiscal policy, and such a
policy might even make this job more difficult.
END