Transcript Powerpoint slides

LECTURE 8
Stabilization policy
Øystein Børsum
7th March 2006
Overview of forthcoming lectures

Lecture 8: Stabilization policies



Lecture 9: Limits to stabilization policies




Goals for stabilization policies: Stable output and inflation
Optimal policy rule: Demand and supply shocks
Rational expectations and the Policy Ineffectiveness Proposition,
the Ricardian Equivalence Theorem and the Lucas Critique
Policy rules versus discretion: Credibility of economic policy
Real business cycles (section 19.4)
Lecture 10: Open economy



Features of a small, open economy with perfect capital mobility
Aggregate demand and aggregate supply in the open economy
Long-term macroeconomic equilibrium in the open economy
Overview of stabilization policy in the AS-AD model
with a Taylor rule

Stable output and stable inflation are popular policy goals

In the case of demand shocks, the adequate policy response
with respect to output and inflation stabilization is the same

In the case of supply shocks, there is a clear trade-off between
the two goals

The priorities of monetary policy are represented by the choice
of parameters in the Taylor rule

The optimal policy rule depends on whether supply or demand
shocks are dominant, as well as policy preferences

Within a framework of rules-based policies, activist fiscal
policy and monetary policy are essentially the same: Demand
management Therefore, they lead to the same outcomes and
have the same limitations
Presumption: A desire for stabilization policies

Hypothesis: The observed aversion to fluctuations in output
and inflation can be represented by a social loss function:
SL   y2   2 ,
2

  E  yt  y   ,


2
y
 0
2

  E   t   * 


2

Motivating output stability as a policy goal

Consumers prefer to smooth consumption over time, but may
not be able to do so: Credit constraints, insurance market
imperfections

High consumer risk aversion?

Stable income (output) may help consumers to smooth
consumption

Labor market inefficiencies probably increase when employment
fluctuates

Uneven distribution of the cost of recession (low-paid, unskilled
and young workers suffer most): Successful stabilization policy
may help to improve the distribution of income and welfare
Motivating stable inflation as a policy goal

Surprisingly hard to motivate in theory…

A fluctuating rate of inflation generates:
o
Inflation forecast errors: Households will regret saving,
investment and labor supply decisions
o
Arbitrary redistribution of real income and wealth between
creditors and debtors

Protection against unanticipated inflation: Indexation of
nominal contracts

Indexation is rare in real life, probably because the contracting
parties (e.g., employers and employees) focus on different
price indices
The inflation target should be low and positive

Costs of a fully anticipated inflation
o
o
o
o

The case for a positive target inflation rate:
o
o
o

”Shoe-leather costs”
”Menu costs”
Distortion of relative prices (due to unsynchronized price setting)
Tax distortions (due to a non-indexed tax system)
Lower bound on the nominal interest rate (“liquidity trap”)
Downwards nominal wage and price rigidity
Quality improvements of goods and services are not fully
captured by official price indices
Most OECD countries aim at ”Low and stable inflation” with a
target rate of 2 – 2½ %
Policy based on rules vs. discretionary policy

Examples of policy rules:
o
o
o
The Taylor rule (flexible inflation targeting)
A fixed exchange rate policy
The Friedman rule (constant money growth)

Discretionary policy: Policy makers react in an ad-hoc manner
to the specific circumstances of the situation, using all relevant
available information

Trade-off: Credibility vs. flexibility

Credibility anchors inflation expectations: The legacy of
“stabilization” policies in the 70s and 80s
AS-AD model (restated)
yt  y  1  gt  g    2  rt  r   vt
with
rt  it  te1
it  r  te1  h  t  *   b  yt  y 
t      yt  y   st
e
t
with
  t 1
e
t
Policy problem: Find the monetary policy that
minimizes the social loss function

g  g,
At first, we disregard fiscal policy:
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AD curve:
 1   2b 
v
   *
 y  y  
2h
 2h 

AS curve:
  1    y  y   s
SL    
2
y
2


Social loss function:

Decision variables (in the Taylor rule): h and b
Deriving the variances of output and inflation in the
general case

Demand shock variable z (see chapter 17):
v
z 
1   2b


 2z 
v2
1   2b 
2
The asymptotic (long-run) variances of output and inflation
become (see appendix chapter 20):
2
2 2
2



s
2
z
y  2 2
,
   2 
2 2
2




s
 2  2 2z
   2 
2h

1   2b
Case 1: An economy with only demand shocks
2s  0.
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Only demand shocks:
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The variances of output and inflation simplify
2
2
2

2

v
2y  2 2 z
 2 2 2
   2   2 h  2 2 h 1   2b 
2
2


v
2  2 z  2 2
  2  2 h  2 2 h 1   2b 

Higher values of h and b reduce both variances: No trade-off
between the inflation gap and the output gap
Higher weight on the output stabilization (higher b)
reduces both the output gap and the inflation gap
Illustration of the short-run effects of a negative demand shock under different weights on the
monetary policy parameter b
Conclusion: No policy trade-off in an economy with
only demand shocks

The central bank should react to demand shocks by pursuing
a countercyclical monetary policy (b > 0).

There is no trade-off between stabilizing output and stabilizing
inflation when business cycles are driven by demand shocks.

When faced with demand shocks, the central bank should
react as strongly as possible to the output and inflation gaps.
Case 2: An economy with only supply shocks
2z  0.

Only supply shocks:

The variances of output and inflation simplify
2

s
2y  2
  2  1 /  
where
1
1   2b


2h
2

 2  2 2 s
   2 

A low variance of output can only be achieved at the expense
of a high variance of inflation, and vice versa: A clear trade-off
between the inflation gap and the output gap
With supply shocks, there is a clear trade-off
between the inflation gap and the output gap
Illustration of the short-run effects of a negative supply shock under different designs of
monetary policy
Conclusion: Clear policy trade-off in an economy
with only supply shocks
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If policy makers primarily seek to stabilize output, b should be
positive and high (countercyclical policy) and h should be
close to zero so that the AD curve becomes steep.

If policy makers primarily seek to stabilize inflation, b should
be negative (procyclical policy) and h should be high so that
the AD curve becomes flat.
The general case: In optimum, there is a trade-off
between the output gap and the inflation gap
SL  2y  2
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Minimize the social loss function:
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First-order conditions with respect to h and b:
SL
0
h
SL
0
b



 y2
 2

0
h
h
 y2
 2

0
b
b
Implications: In a social optimum, a smaller variance of output
can only be achieved at the expense of a larger variance of
inflation, and vice versa
Optimal monetary policy design depends on which
shocks are dominant and the policy preferences
Optimal monetary policy under the Taylor rule
Rules-based fiscal stabilization policy work in the
same way as rules-based monetary policy
g  g  c  *    cy  y  y 
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Fiscal policy rule:
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Monetary policy follows the Taylor rule
r  r  h    *  b  y  y 

The AD curve with activist fiscal policy:
 1  1cy   2b 
v
   *
 y  y  
1c   2 h
 1c   2 h 
Decreased interest in fiscal stabilization policy


Policy lags are seen to disadvantage fiscal policy relative to
monetary policy

Recognition lag (data measurement)
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Decisions lag (political system)
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Implementation lag (administrative process)
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Effectiveness lag (from change in instrument to effect in target)
Direct constraints on the room for fiscal policy

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EU: Maastricht treaty (1992) and the Stability and Growth Pact
(1997)
Credibility problems (cf. lecture 10) are likely to be more
pronounced for fiscal than for monetary policy