Transcript Chapter 25 - McGraw Hill Higher Education - McGraw

Macroeconomic Policy
Chapter 25
McGraw-Hill/Irwin
Copyright © 2015 by McGraw-Hill Education (Asia). All rights reserved.
Learning Objectives
1. Discuss the policy options available to the
central bank in response to demand shocks
and inflation shocks
2. Explain the roles played by the anchored
inflationary expectations and central bank
credibility in keeping inflation low
3. Describe how fiscal policy can affect both
aggregate demand and aggregate supply
4. Address why macroeconomic policy is as
much art as a science
Stabilization Policy and Demand
Shocks
Inflation rate 𝜋
AS2
𝜋e
𝜋1
AD2
AD1
Y 1 Y*
Output Y
Responding to Aggregate
Inflation Shocks
– Central bank follows its
monetary policy rule and
raises interest rates
– Recessionary gap at Y2
with higher inflation, 2
– The central bank chooses
• Close the recessionary gap
• Restore target inflation rate
Inflation ()
• The economy begins in long-run equilibrium at
Y1, 1
• Adverse inflation shock shifts aggregate supply
to AS2
LRAS
AS2
AS1
2
1
AD1
Y2 Y 1
Output (Y)
Accommodating an Aggregate
Inflation Shock
• Suppose the central bank moves to close the
recessionary gap
– Eases monetary policy, lowering interest rates at 2
– Lower interest rates
stimulate consumption and
investment spending
• AD shifts to AD2
– Long-run equilibrium is now
at Y1 and 3
• Aggregate inflation shock
leads to higher long-run
inflation
Inflation ()
• Resets target inflation rate to 3
LRAS
3
AS2
AS1
2
1
AD2
AD1
Y2 Y 1
Output (Y)
Responding to An Aggregate
Inflation Shock
• Suppose the central bank decides to maintain inflation at
1
Inflation ()
– 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
1
inflation decreases
– AS2 shifts back to AS1
Y2 Y 1
– Original long-run equilibrium
is restored
AS2
AS1
AD1
Output (Y)
Anchored Inflationary
Expectations
• 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 inflation 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
1980s Inflation – Act 1
• U.S. Inflation was 13.5% in 1980
– 3.2% by 1983; stayed 2 – 5% for rest of the
decade
– 2 – 3% in the 1990s
• Monetary policy defeated inflation
–
–
–
–
–
Short recession in 1980
Deeper recession 1981 – 1982
Negative GDP growth in 1980 and 1982
Unemployment peaked at 9.7% in 1982
Inflation unresponsive 1979 – 1981
The Changing Volatility of Real
GDP
Declining Macroeconomic
Variability
• Variation in the growth rate in the U.S. down
by half since 1960
– Inflation declined by two-thirds
• Relative stability has benefits
– Business and economic planning easier
– Markets function better
– Fewer resources devoted to adjusting to inflation
and other economic instabilities
• Fed is usually credited with causing the
increased stability by its consistent actions
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
Credibility of Monetary Policy
• 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 inflatio
Central Bank 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
The Fed's Independence
• The Fed is a relatively independent central
bank
– Governors serve 14 year terms
• Appointments by the executive subject to
Congressional approval
– Monetary policy is generally in the Fed's hands
• Some Congressional oversight
– The Fed is not obligated to finance the national
debt
– The Fed is self-funding, largely through its
holdings of US Treasury securities
• The Fed generally has a budget surplus which it
returns to the Treasury
Announcing Numerical 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
Zero Inflation Undesirably 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
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
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
• U.S. average tax rate on income is 30%
Fiscal Policy Effects
• Tax rates reduction increase aggregate
spending through the consumption function
• Whether inflation increases,
decreases, or stays
constant depends on the
relative sizes of the shifts
in AD and LRAS
Inflation ()
– Shifts aggregate demand to the right
– Supply-side effects shift long-run aggregate
supply
LRAS1 LRAS2
1
AD1
Y1
Y2
AD2
Output (Y)
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
Americans Work More than
Europeans
• U.S. average work week is longer
– U.S. 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
Policymaking: Art or Science?
• 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
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
Macroeconomic Policy
Credibility
Independent
Central Bank
Aggregate
Supply Shocks
Exogenous
Spending Shocks
Monetary
Policy
Fiscal
Policy
Supply-Side
Effects
Inflation
Anchored
Inflation
Core Rate
Marginal
Tax Rates