Chapter 17

Policy

17-2

Introduction

• In this chapter we examine how policymakers formulate appropriate policy measures

• Must consider: Timing Uncertainty How individuals will respond to specific policies Role of credibility Monetary or fiscal policy, or a mix Different policy instruments Intermediate vs ultimate targets

17-3

Lags in the Effects of Policy

• Suppose the economy is at full employment:• A negative aggregate demand disturbance reduces the

equilibrium level of income below full employment• No advance warning of disturbance no policy action taken

in anticipation of its occurrence

Policymakers must decide:

1. Should they respond to the disturbance?

2. If so, how should they respond?

17-4

Lags in the Effects of Policy

• Is the disturbance permanent (or persistent) or temporary?

• Figure 17-1 illustrates a temporary aggregate demand shock

• A one period reduction in consumption best policy is to do nothing at all

• Today’s policy actions take time to have an effect would hit economy after back at full-employment level, driving it away from the optimal level

[Insert Figure 17-1 here]

17-5

Lags in the Effects of Policy

• Policymaking is a process:• Takes time to recognize need

and implement a policy action• Takes time for an action to work

its way through the economy

• Each step involves delays or lags:

1. Inside lags Recognition lags Decision lags Action lags

2. Outside lags

• Inside Lags: the time period it takes to undertake a policy action Recognition Lag: the period that

elapses between the time a disturbance occurs and the time the policymakers recognize that action is required

Lag is negative if the disturbance is predicted and appropriate policy actions considered before it occurs (Ex. Increase money supply prior Christmas)

Lag is typically positive

17-6

Lags in the Effects of Policy

• Policymaking is a process:• Takes time to recognize and

implement a policy action• Takes time for an action to work

its way through the economy

• Each step involves delays or lags:

1. Inside lags Recognition lags Decision lags Action lags

2. Outside lags

• Inside Lags: the time period it takes to undertake a policy action Decision Lag: the delay between

the recognition of the need for action and the policy decision

Differs between monetary and fiscal policy

• FOMC meets regularly to discuss and decide on policy

17-7

Lags in the Effects of Policy

• Policymaking is a process:• Takes time to recognize and

implement a policy action• Takes time for an action to work

its way through the economy

• Each step involves delays or lags:

1. Inside lags Recognition lags Decision lags Action lags

2. Outside lags

• Inside Lags: the time period it takes to undertake a policy action Action Lag: the lag between the

policy decision and its implementation

Also differs for monetary and fiscal policy

• Monetary policy makers typically act immediately

• Fiscal policy actions are less rapid administration must prepare legislation and then get it approved

17-8

Lags in the Effects of Policy

• Policymaking is a process:• Takes time to recognize and

implement a policy action• Takes time for an action to work

its way through the economy

• Each step involves delays or lags:

1. Inside lags Recognition lags Decision lags Action lags

2. Outside lags

• Outside Lags: time it takes a policy measure to work its way through the economy Once a policy action has been

taken, its effects on the economy are spread out over time

Immediate impact may be small, but other effects occur later

17-9

Lags in the Effects of Policy

• Figure 17-2 illustrates the dynamic multiplier

• Shows the effects of a once-and-for-all 1 percent increase in the money supply in period zero

• Impact is initially very small, but continues to increase over a long period of time

• Why are there outside lags? • Monetary policy: initially impacts

investment via interest rates, not income

• When AD ultimately affected, increase in spending itself produces a series of induced adjustments in output and spending

[Insert Figure 17-2 here]

17-10

Monetary Versus Fiscal Policy Lags

• Fiscal policy directly impacts aggregate demand • Affects income more rapidly than monetary policy Shorter outside lags than monetary policy Longer inside lags than monetary policy

• Long inside lags makes fiscal policy less useful for stabilization and used less frequently to stabilize the economy

It takes time to set the policies in action, and then the policies themselves take time to affect the economy.

Further difficulties arise because policymakers cannot be certain about the size and the timing

of the effects of policy actions.

17-11

Expectations and Reactions

• Government uncertainties about the effects of policies on the economy arise because:

1. Policymakers do not know what expectations firms and consumers have

2. Government does not know the true model of the economy Works with econometric models of the economy in estimating

the effects of policy changes An econometric model is a statistical description of the economy, or

some part of it

17-12

Reaction Uncertainties

• Suppose the government decides to cut taxes to stimulate a weak economy temporary tax cut

How big a cut is needed? One possibility: temporary tax cut will not affect long-term

income, and thus not long-term spending Large tax cut needed

Alternatively: consumers may believe tax cut will last longer than announced, and MPC out of tax cut is larger Smaller tax cut might be sufficient

If the government is wrong about consumers’ reactions, it could destabilize rather than stabilize the economy.

17-13

Uncertainty and Economic Policy

• Policymakers can go wrong in using active stabilization policy due to:

• Uncertainty about the expectations of firms and consumers• Difficulties in forecasting disturbances• Lack of knowledge about the true structure of the economy

• Uncertainty about the correct model of the economy• Uncertainty about the precise values of the parameters within a

given model of the economy

Instead of choosing between fiscal and monetary policies when themultipliers are unknown, best to employ a portfolio of policy instruments.

DIVERSIFICATION

17-14

Uncertainty and Economic Policy: Example

• Assume output, Y, determined by money supply, M

Y=βM• Objective of policy is to minimize output gap, (Y-Y*)• Loss function

L=½(Y-Y*)²

=½(βM-Y*)²• Optimal monetary policy depends on β – and uncertainty about it• FOC:

(βM-Y*)β=0

M=Y*/β• Suppose we know with certainty β=1 optimal policy sets

M=Y*

17-15

Uncertainty and Economic Policy: Example

• Suppose instead that β=0.5 and β=1.5 are equally likely• Expected value of β is still 1 but setting β=1 is not necessarily

optimal • Loss function now becomes:

L=½[½(0.5M-Y*)²+½(1.5M-Y*)²]• FOC:

½(0.5M-Y*)×0.5+½(1.5M-Y*)×1.5=0

(0.5M-Y*)+(1.5M-Y*)×3=0

M=4/5×Y*

• Uncertainty results in more cautious policy• This is because the loss function is quadratic it penalizes

overshooting more than undershooting

17-16

Targets, Instruments, and Indicators

• Economic variables play a variety of roles in policy discussions

• Useful to divide them into targets, instruments, and indicators

Targets: identified goals of policy• Ultimate targets

• Ex. “to achieve inflation rate of 2%”

• Intermediate targets• Ex. Targeting money growth• Used to achieve ultimate target

17-17

Targets, Instruments, and Indicators

• Economic variables play a variety of roles in policy discussions

• Useful to divide them into targets, instruments, and indicators

Instruments: tools policymakers manipulate directly• Ex. An exchange rate target

Indicators: economic variables that signal us whether we are getting closer to our desired targets

• Ex. Increases in interest rates (indicator) sometimes signal that the market anticipates increased future inflation (target)

• Provide useful feedback policymakers can use to adjust the instruments in order to do a better job of hitting targets

17-18

Rules Versus Discretion

In determining how policymakers should operate, policymakers must answer several questions:

Should policymakers actively try to offset shocks?

If yes:

Should responses be precommitted to specific rules?

OR

Should policy makers work on a case-by-case basis?

17-19

Rules Versus Discretion

• Milton Friedman and others argued:• There should be no use of active countercyclical monetary

policy • Monetary policy should be confined to making the money

supply grow at a constant rate• Friedman advocated a simple monetary rule: constant growth

rate of money supply Fed does not respond to the condition of the economy

17-20

Rules Versus Discretion

• Policies that respond to the current or predicted state of the economy = activist/discretionary policies

• Activist rules are possible as well• Taylor Rule: CB sets interest rate so as to respond to output gap

and deviation of inflation from target

17-21

Dynamic Inconsistency

• In the LR, there is no trade-off between inflation and unemployment

• Therefore, optimal policy should aim for unemployment at natural rate along with low inflation

• Yet, most countries display bias towards inefficiently high inflation

• Dynamic inconsistency: policy makers face an incentive to deviate from announced policy to lower unemployment in the short term

• Rational expectations: public will see through this and will expect non-zero inflation

Kydland and Prescott (1977); Barro and Gordon (1983)

17-22

Dynamic Inconsistency: Model

• SR Philips curve: π = πe – ε(u-u*)• Loss function: L = a(u-u*) + π2

• We can solve for (u-u*) from the PC and substitute to LL = -a/ε×(π - πe ) + π2

• FOC: -a/ε + 2π = 0π = a/2ε

• Hence, the optimal policy for the CB is to generate non-zero inflation as long as a ≠ 0

• Under rational expectations, public will expect this and therefore it will expect non-zero inflation as well

17-23

Dynamic Inconsistency: Solutions?

1. CB may pursue low-inflation policy to establish credibility reputation effect

2. Government appoints a conservative CB governor, i.e. one with low value of a

3. CB governor given contract that rewards low inflation and/or punishes high inflation

4. CB mandate that dictates a policy rule for the CB and disallows discretion

• Politicians are subject to re-election constraint face strong incentive to pursue short-term employment objectives

• Independent and conservative CB reduces the inflation bias• Empirical evidence suggests that independent CBs

associated with lower inflation