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X VIII . Issues in economic policy. S tabilization and deficits , 1980 - 2007. X VIII .1 Introduction. The whole course – 2 models Classical (in different forms): long term Keynesian: short term Positively sloped AS in short- to medium-term From policy perspective
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XVIII. Issues in economic policy Stabilization and deficits, 1980 - 2007
XVIII.1 Introduction • The whole course – 2 models • Classical(in different forms): long term • Keynesian: short term • Positively sloped AS in short- to medium-term • From policy perspective • How to deal with short term fluctuations (described by Keynesian model) to help the economy to follow the long term development path, without undermining the potential?
Active or passive policies? A never-ending debate among the economists • First broad school – we basically know the nature of short term fluctuations and the tools how to react support the active approach • Second broad schools – we do not know enough and there are many obstacles be much more careful, passive in economic policy decisions
XVIII.2 Short term stabilization The difficulties • Inside and outside lags • Automatic stabilizers • Problems of forecasting • Political cycle Requirements • Post-WWII socio-political consensus and memory of Great Depression • Later: welfare state logic and social pressure
Lucas critique • Limited effects of governmental policies: • If policies anticipated, than quick adjustment and no effect on output (and other variables) • If un-anticipated policy (or some random, exogenous shock), than after some short term fluctuations adjustment to natural values anyway • Policy impotence proposition – PIP
Rules vs. discretion • Rules: • Public announcement of a particular rule that will be applied in a particular situation • Commitment to follow such a rule • Passive or active rules • Discretion: policy makers are (basically) free to react as they believe in each particular situation
Why rules? • Incompetent politicians • Opportunistic politicians • Political cycle • Attempts to bring the economic policy making outside everyday politics • Constitutional steps (balanced budget requirements, etc.)
XVIII.3 Monetary policies • Monetarist rule – stable growth rate of money supply • Nominal GDP targeting • if nominal GDP growth over a target, nominal supply decrease • If nominal GDP bellow target – vice versa • Exchange rate targeting
XVIII.3.1 The fallacy of activist monetary policy • Stop and go monetary policy of 1960s (see LXIV) • Based on Phillips curve trade off • Belief that monetary authorities can permanently lower rate of unemployment but accepting higher inflation • Econometric models that promised an engineering approach to policy • Contradicted by recessions 1973-74 and 1981-82 and stagflation periods
Critique: monetarism • See LXIII • Long and variable lags of monetary policy • Challenged: optimal control theory (example of control of complicated machinery systems, e.g. rockets) • Supported by Lucas • policy is a kind of strategic game between policy makers and people • People learn to predict the action of “controllers”, i.e. monetary authorities (why rockets don’t)
Critique: Failure of Phillips curve • See LXIII • Define expected price as Pe and expected inflation as and original Phillips curve can be expressed • However, whenever, than inflation might rise, even with high unemployment.
Critique: time inconsistency (1) • Also called policy credibility problem • On the one hand: activist central bank, that really wants to keep inflation low • On the other hand: given the short run price and wage rigidities, such central bank can easily increase output and employment temporarily by allowing for higher infaltion • See previous Lecture on NKE
Critique: time inconsistency (2) • After some time: agents learn the reality and adjust expectations • In medium term: output and employment return to original values • Gains in larger emplyoment and profits vansih • But larger inflation remains • Due to the logic of long term vertical AS • So in practice: activist central bank might often become inflation-prone
Experience from disinflation (1) • See LXVI • Phillips curve • In original version no useful concept • Expectation-augmented version seems to be more realistic concept • Fitting the data, see Ch. VII.4.1 • … but we assume that • NKE - instead perfect foresight or AEH, rational expectations • Short-term validity
Experience from disinflation (2) Sacrifice ratio • If parameters of Phillips curve determined, the relation can be used to quantify the amount of output (and unemployment) that must be sacrificed to lower the inflation by – e.g. – 1% • In most studies: 5% of annual GDP must be given up to lower inflation by 1% • The similar results can be achieved using Okun’s law
Okun’s law – a remainder (1) • LXIV • Change in output equals change in employment • Total labor force constant • That implies • Statistical reality for US 1960-98
Okun’s law – a remainder (2) • Annual growth has to be at least 3% to prevent unemployment from rising • Both labor productivity and labor force are growing in time normal growth rate = 3% • Output growth of 1% over 3% leads only to 0.4% decrease in unemployment • Labor hoarding • Increase in labor participation rate Differences over countries, Okun’s law in general
Different speed of disinflation • Speed and social costs • “Cold turkey” – quick disinflation, accepting a substantial slow down of economic activity (probably even negative growth), but over short period of time • Gradual disinflation, when lower growth not so marked, but spread over longer period • Total, accumulated costs high in any case
XVIII.3.2 Inflation targeting • The most recent (and most popular) conduct of monetary policy • Neither rule or discretion • The central bank estimates and announces a target for inflation (kind of a rule) • Steering the actual inflation towards the target by changing nominal basic interest rate and/or using other tools (open market operations, etc.) • It is expected to perform policy credibly to achieve this target • Target within an interval to give the Central Bank a certain level of discretion • Independence of the Central Bank
Advantages • Clear accountability of Central Banks • Transparency and predictability • Stability for the investors: relatively easy to predict future interest rates • No link to political cycle • Emerging countries: safeguard against high and hyper inflations
Shortcomings(1) • Targeting CPI and assumption of causal link: growth of money supply → CPI • CPI accurately reflects money supply (?) • In case of exogenous shock (e.g. oil or food price shock) → sharp increase of CPI possible, but no relation to domestic economic events → Central Banks acts against inflation → needless slow-down of domestic economic growth, deepening of the negative effect of exogenous shock
Shortcomings(2) • Inflation targeting is not consistent with any long term growth theory/strategy • Policy just smoothes the cycle • No explicit set of monetary policy recommendations • One attempt – Taylor rule, see next slides
Taylor’s rule (1) • Rule, stipulating how much Central Banks should change nominal interest rate, reacting to two important signals: • Divergence of actual inflation from target inflation • Divergence of actual GDP from its potential • π* - inflation target, r* - equilibrium real interest (i.e. consistent with inflation target and implying desired nominal interest i*), y and y* - log of actual, respectively potential output
Taylor’s rule (2) • The rule • a,b 0 • Originally Taylor: a=b=0.5 • In case of stagflation, when monetary policy goals may conflict, Central Banks should change the weights for reducing inflation vs. increasing output ad hoc (according the situation)
Taylor’s rule (3) • Alternatively (natural unemployment u*): • Why a>0 ? – for spending, real interest rate is important, i.e. when inflation raises, then real interest should raise to slow-down the economy • Following the rule: increase of π by 1% implies that Central Bank increases nominal interest by more than 1%
Application and performance • Since 1990, many countries, both developed and developing, use Taylor rule • First country: New Zealand 1990, Czech Republic since 1999 • Not FED (different role, given by US Constitution) • Till the crisis in 2008, Taylor rule produced seemed to work satisfactorily • One seed of the crisis? • See Lecture XX
XVIII.4 Fiscal policies • Debts and deficits • Balanced budget deficit • Not a good idea for today’s economies • Need for higher flexibility • Stabilization role • Tax smoothing • Inter-temporal solutions
Basic concepts • Actual budget deficit (BD) = government revenues minus government expenditures • Primary deficit – BD minus interest payments • Structural deficit (actual or primary) – adjusted for short-term fluctuations of economic cycle (determination of potential output required!) • Financing of deficit = government borrowing • Government debt = accumulation of past borrowings
XVIII.4.1 Fiscal sustainability • Different definitions • Ratio of government net assets to GDP remains constant • Debt/GDP over time repeatedly converges to a constant value • Fiscal sustainability is not consistent with permanently increasing tax rate • Prevailing practice today – intertemporal definition of solvency of the country: • Given starting debt, discounted value of current and future primary expenditures today does not exceed discounted value of current and future revenues today
Fiscal rule • Permanent restriction of fiscal policy through simple numerical limits for budgetary aggregates • Features: • Long term – numerical target for long period • Tool for fiscal policy control • Fiscal indicator for practical application • Simple - easy monitoring and communication with broad public • Taxonomy of the rules • Budget deficit limits • Debt restriction, e.g. limit for a maximum debt, legally binding (e.g. 60% GDP, given by Constitution in Poland today) • Rules, restricting maximum expenditures or minimum revenues • Most widespread: budget deficit limits: primary deficit (nominal interest – nominal GDP growth) * (debt/GDP)
XVIII.4.2 Barro-Ricardian Equivalence • Opposite to the traditional view that tax cut increases consumption spending • B-R equivalence: • forward looking consumers, who understand that lower tax today means larger budget deficit that will have to be repaid in the future • government will have to increase taxes in the future • people increase savings today to be able to pay larger taxes in the future
Implication for stabilization policies • Tax cut – decrease of public saving • Higher consumer saving because of B-R equivalence – increase of private saving • Total national savings intact – no effect on the AD
Do people really behave like that ? There is not strong believe in B-R equivalence • David Ricardo himself did not believe in his idea • Myopia • Borrowing constraints • Do people really care about the future so much? • Robert Barro: bequests
Literature to Ch.XVIII • Mankiw, Macroeconomics, Ch. 14-15 • Blanchard, Macroeconomics, Ch. 25-27 • general review of policy problems • Bernanke, Laubach, Mishkin, Posen: Inflation Targeting, Princeton University Press, 1999 • Mostly case studies, but very useful general chapters 1-3.