Transcript optimal control theory

CHAPTER 24
CHAPTER24
Should Policy
Makers Be
Restrained?
Prepared by:
Fernando Quijano and Yvonn Quijano
© 2006 Prentice Hall Business Publishing
Macroeconomics, 4/e
Olivier Blanchard
Chapter 24: Should Policy Makers Be
Restrained?
Should Policy Makers Be Restrained?
Is a balanced-budget amendment a good idea?
Figure 24 - 1
The Contract with America
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Chapter 24: Should Policy Makers Be
Restrained?
24-1
Uncertainty and Policy
Macroeconomic policy makers in general do not
have all the knowledge required for solving
economic problems.
They rely on macroeconometric models, all of
which give different answers for how to solve a
particular problem.
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Olivier Blanchard
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Chapter 24: Should Policy Makers Be
Restrained?
How Much Do
Macroeconomists Actually Know?
Figure 24 - 2
The Response of
Output to a Monetary
Expansion: Predictions
from 12 Models
While all 12 models
predict that output will
increase for some time in
response to a monetary
expansion, the range of
answers regarding the
size and the length of the
output response is large.
There is substantial uncertainty about the effects of policy.
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Chapter 24: Should Policy Makers Be
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Should Uncertainty Lead Policy
Makers to Do Less?
Should uncertainty about the effects of
policy lead policy makers to do less? In
general, the answer is: Yes.
© 2006 Prentice Hall Business Publishing
Twelve Macroeconometric Models
Together, the set of models in the Brookings project is
representative of the different types of macroeconomic
models used for forecasting and policy simulations.
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Chapter 24: Should Policy Makers Be
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Uncertainty and Restraints
on Policy Makers
There is substantial uncertainty about the effects
of macroeconomic policies. This uncertainty
should lead policy makers to be more cautious,
to use less active policies.
They should stop well short of fine tuning, of
trying to achieve constant unemployment or
constant output growth.
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Chapter 24: Should Policy Makers Be
Restrained?
24-2
Expectations and Policy
Until 20 years ago, the economy was seen as a
machine. Methods of optimal control were
being used to design macroeconomic policy.
People and firms try to anticipate what policy
makers will do. Hence, macroeconomic policy is
a game between them. We don’t need optimal
control theory but rather game theory, which
studies strategic interactions between players.
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Chapter 24: Should Policy Makers Be
Restrained?
Hostage Takings and Negotiations
By giving up the option to negotiate,
governments can prevent hostage takings in the
first place.
Exactly the same logic is involved in the design
of macroeconomic policy to control inflation and
unemployment.
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Olivier Blanchard
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Chapter 24: Should Policy Makers Be
Restrained?
Inflation and Unemployment
Revisited
The relation between unemployment and
inflation is as follows:
   e   (u  un )
Suppose the Fed announces that it will constant
inflation, and wage setters believe that expected
inflation will be zero. Then:
    ( u  un )
In the U.S.,   1. If  = 0, then the announced
policy calls for  = e = 0, and u=un.
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Olivier Blanchard
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Chapter 24: Should Policy Makers Be
Restrained?
Inflation and Unemployment
Revisited
But the Fed could deviate from its stated policy
and achieve an unemployment rate of 1% below
the natural rate with just a 1% increase in the
inflation rate.
    ( u  un )
 If  = 1 and  = 0, then (uun.) =  1%. This
incentive to deviate from the announced policy
once the other player (in this case wage
setters) has made its move is known as the
time inconsistency of optimal policy.
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Chapter 24: Should Policy Makers Be
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Inflation and Unemployment
Revisited
 Wage setters wise up and begin to expect
positive inflation of 1%. Eventually, the
economy returns to the natural rate of
unemployment, but with higher inflation.
 The eventual outcome is likely to be high
inflation. The economy ends up with the same
unemployment rate, but with much higher
inflation.
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Olivier Blanchard
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Chapter 24: Should Policy Makers Be
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Establishing Credibility
Ways to deal with the problem of time
inconsistency, without totally stripping policymaking power from the central bank, include:
Make the central bank independent. This way,
the central bank resists political pressure to
decrease unemployment.
Give incentives to the central bankers to take
the long view-to take into
Choose a conservative central banker who
dislikes inflation.
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Olivier Blanchard
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Chapter 24: Should Policy Makers Be
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Establishing Credibility
Figure 24 - 3
Inflation and Central
Bank Independence
Across OECD countries,
the higher the degree of
central bank
independence, the lower
the rate of inflation.
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Olivier Blanchard
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Chapter 24: Should Policy Makers Be
Restrained?
24-3
Politics and Policy
We have assumed so far that policy makers were
benevolent – that they tried to do what was best
for the economy. Politicians or policy makers,
however, do what is best for themselves, and this
is not always what is best for the country.
© 2006 Prentice Hall Business Publishing
Was Alan Blinder Wrong in Speaking the
Truth?
Alan Blinder, an economist from Princeton indicated his belief that the
Fed has both the responsibility and the ability to use monetary policy
to help the economy recover.
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Chapter 24: Should Policy Makers Be
Restrained?
Games Between Policy Makers
and Voters
If voters are shortsighted, the temptation for
politicians to cut taxes may prove irresistible.
With the right timing and shortsighted voters,
political parties can win elections. Thus, we
might expect a clear political business cycle,
with higher growth on average before elections
than after elections.
However, there is little evidence of manipulation
of the macroeconomy to win elections.
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Olivier Blanchard
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Chapter 24: Should Policy Makers Be
Restrained?
Games Between
Policy Makers and Voters
Figure 24 - 4
The Evolution of the
Ratio of U.S. Debt to
GDP, 1900-2004
The three major buildups
of debt since 1900 have
been associated with
World War I, the Great
Depression, and World
War II. The buildup since
1980 appears different in
nature.
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Chapter 24: Should Policy Makers Be
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Games Between
Policy Makers and Voters
Table 24-1
Growth During Democratic and Republican Administrations (Percent per Year)
Year
First
Second
Third
Fourth
Democratic
Truman
Kennedy/Johnson
Johnson
0.0
2.6
5.8
8.5
5.3
5.8
10.3
4.1
2.9
3.9
5.3
4.1
Carter
Clinton I
Clinton II
Average: Democratic
Republican
Eisenhower
Nixon
4.7
2.7
4.4
3.4
5.3
4.0
4.3
5.5
2.5
4.1
4.1
4.4
-0.2
4.1
4.1
3.5
4.0
2.4
-1.3
-0.3
5.6
2.8
2.1
5.0
Nixon/Ford
Reagan I
Reagan II
5.2
1.9
3.6
-0.5
-2.5
3.0
-1.3
3.6
2.7
4.9
6.4
3.0
Bush (George H.)
Bush (George W.)
Average: Republican
Average
2.5
0.5
2.9
3.1
1.2
2.2
0.3
2.7
-0.7
3.1
2.2
3.2
2.6
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3.7
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Chapter 24: Should Policy Makers Be
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Games Between Policy Makers
Game theorists refer to situations in which each
side holds out, hoping the other side will give in,
as wars of attrition. These wars usually result
in delays in the implementation of policy.
Also, each party worries more about either
inflation or unemployment. We would expect, for
example, to see stronger growth during
Democratic administrations.
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Olivier Blanchard
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Chapter 24: Should Policy Makers Be
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The Growth and Stability
Pact: a Short History
Figure 1
Euro Area Budget
Deficits as a
Percentage of GDP
since 1990
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Chapter 24: Should Policy Makers Be
Restrained?
Politics and Fiscal Restraints
A balanced-budget amendment would eliminate
the problem of deficits, but it would also eliminate
the use of fiscal policy as macroeconomic policy
instrument.
A constitutional amendment is not the only way
to achieve deficit control and reduction.
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Olivier Blanchard
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Chapter 24: Should Policy Makers Be
Restrained?
Politics and Fiscal Restraints
The “Budget Enforcement Act” passed in 1990,
and extended by new legislation in 1993 and
1997, introduced two main rules:
 It imposed constraints on spending.
Constraints, called spending caps, were set
on discretionary spending for the following 5
years.
 It required that a new transfer program could
only be adopted if it could be shown not to
increase deficits in the future. This rule is
known as the pay-as-you-go or the PAYGO
rule.
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Chapter 24: Should Policy Makers Be
Restrained?
Key Terms
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
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fine-tuning
optimal control
game
optimal control theory
game theory
strategic interactions
© 2006 Prentice Hall Business Publishing


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players
time inconsistency
political business cycle
wars of attrition
spending caps
PAYGO rule
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