Chapter
16 / macroeconomic policy challengesOutline
What Can Policy Do?
A.From 1991 to 1999, the U.S. economy performed well, but slowed in 2000, and stopped in 2001 with unemployment increasing
B.All major industrial countries had slowing economies in 2001; leaders began to speak of stimulus packages, but not everybody agreed any stimulus was needed
C.What can and should policy makers do to achieve desirable macroeconomic performance?
I.Policy Goals
A.The domestic goals of macroeconomic policy are to
1.Achieve the highest sustainable rate of growth of potential GDP.
2.Smooth out avoidable business cycle fluctuations.
3.Maintain low unemployment.
4.Maintain low inflation.
B.Potential GDP Growth
1.Rapid sustained real GDP growth can make a profound contribution to economic well being.
2.From 1990 to 2000, the growth rate of real GDP per person was 2 percent a year, at which rate output per person doubles every 35 years. If it grew at 2.5 percent a year, doubling would take only 28 years; 4 percent would mean 18 years. Increasing the long-term growth rate is very important.
C.The Business Cycle
1.Deviations of output from potential GDP are costly; their extent is unknown because RBC suggests most business cycles are fluctuations in potential GDP, but eliminating such deviations as do exist is desirable.
D.Unemployment
1.High unemployment is wasteful and costly; low unemployment causes bottlenecks and inefficiencies.
2.Keeping unemployment at the natural rate is desirable; but its level is not known with certainty.
3.Lowering the natural rate if it is high is also a goal.
E.Inflation
1.Predictability of inflation is a consensus goal; most economists favor a measured rate of 0 to 3 percent per annum, roughly equivalent to price stability given measurement bias.
F.The Two Core Policy Indicators: Real GDP Growth and Inflation
1.The first three of these goals are linked to the growth rate of real GDP; the trend inflation rate is independent. Hence the growth rate of real GDP and the inflation rate are the core policy targets.
2.Figure 31.1 (page 733/387) graphs their performance 1961–2001.
II.Policy Tools and Performance
A.Fiscal policy is the use of the federal budget to achieve macroeconomic objectives.Monetary policyis the adjustment of the quantity of money in circulation and interest rates by the Fed to achieve macroeconomic objectives.
B.Fiscal Policy since 1961
1.Fiscal policy was mildly expansionary during the Kennedy years, more strongly expansionary during the Vietnam War, expansionary during the first Reagan administration, and less expansionary during the Clinton years.
2.Figure 31.2 (page 734/388) graphs spending, taxes, and deficit/surplus for 1961–2001.
C.Monetary Policy since 1961
1.Conducted by the Federal Reserve, monetary policy involves changing interest rates and the quantity of money to achieve macroeconomic objectives.
2.Figure 31.3 (page 735/389) graphs these three measures for 1961–2001.
3.The thrust of monetary policy can be measured by M2 growth, the federal funds rate, and/or the real federal funds rate.
4.The growth rate of M2 and the federal funds rate move in opposite directions: when the Federal Reserve cuts the federal funds rate, M2 growth increases and vice versa.
5.Monetary growth was highest in the 1970s, when inflation was highest.
6.Monetary policy tends to be expansionary before a presidential election and contractionary after the election. Exceptions were the terms of Jimmy Carter and George Bush, Sr., both of whom failed to be reelected.
7.M2 growth increased during the late 1990s and remained high through 2002.
III.Long-Term Growth Policy
A.Policies that aim at increasing long-term growth must increase
1.National saving
2.Investment in human capital
3.Investment in new technologies.
B.National Saving
1.National saving equals private saving plus government saving.
2.In the United States, after fluctuating around an average of 20 percent of GDP between 1960 and 1982, national saving fell to a low of 16 percent of GDP in 1993. It increased until 1998 when it began to fall again.
3.Figure 31.4 (page 737/391) shows national saving, government saving, and net national saving for 1961–2001.
4.Increasing the government’s surplus would increase the government saving component of national saving.
5.Tax policies that increase the after-tax rate of return on saving would boost the private saving part of national saving.
6.Monetary policy that preserves stable prices and minimizes uncertainty about the future price level also increases private saving.
C.Investment in Human Capital
1.Human capital can be obtained through formal schooling and through on-the-job experience.
2.Improving the quality of schooling and enlarging access to advanced training are policies the government can undertake to spur the formation of human capital.
D.Investment in New Technologies
1.Investment in new technologies benefits the nation because new technologies are not subject to diminishing returns and because they can spill over to benefit all sectors of the economy.
2.The government’s research and experiment tax credit reduces the taxes of firms that conduct research and development and helps generate new technologies.
IV.Business Cycle and Unemployment Policy
A.Stabilization policies fall into three broad categories:
1.Fixed-rule policies
2.Feedback-rule policies
3.Discretionary policies
B.Fixed-Rule Policies
1.A fixed-rule policy specifies an action to be pursued independently of the state of the economy.
2.Milton Friedman proposed a fixed rule that sets the monetary growth rate at a level to achieve zero average inflation.
C.Feedback-Rule Policies
1.A feedback-rule policy specifies how policy actions respond to changes in the state of the economy.
2.The Fed’s policy of raising the interest rate in 1994 in response to a falling unemployment rate and lowering the interest rate during 2001 in response to a rising unemployment rate is an example of a feedback-rule policy.
D.Discretionary Policies
1.A discretionary policy responds to the economy in a possibly unique way that uses all available information including perceived lessons from past “mistakes.”
2.Though all policies have some element of discretion, for the most part discretionary policy is a form of sophisticated feedback rule policy.
E.Stabilizing Aggregate Demand Shocks
1.Figure 31.5 (page 740/394) illustrates the economy in a recession. In this situation, either a fixed rule or a feedback rule might be used.
2.Fixed-Rule: Monetarism.
a)A monetarist is an economist who believes that fluctuations in the quantity of money are the main source of economic fluctuations.
b)A monetarist advocates a fixed rule in which neither fiscal policy nor monetary policy respond to the depressed state of the economy.
c)Figure 31.6a (page 741/395) shows that under a fixed rule, if the decrease in aggregate demand is temporary, the economy returns to potential GDP and full employment when aggregate demand recovers.
d)Figure 31.6b (page 741/395) shows that under a fixed rule, if the decrease in aggregate demand is permanent, the economy returns to potential GDP and full employment when the money wage rate falls and the SAS curve shifts rightward.
3.Feedback Rule: Keynesian Activism
a)A Keynesian activist is an economist who believes that fluctuations in aggregate demand combined with sticky wages (and/or sticky prices) are the main source of economic fluctuations.
b)Figure 31.6c (page 741/395) shows that under a feedback rule that uses fiscal or monetary stimulation of aggregate demand, the AD curve shifts rightward and real GDP increases to restore full employment.
4.The Two Rules Compared
a)Under a fixed rule, the economy goes into recession and remains there for as long as it takes the economy under its own steam to return to full employment.
b)Under a feedback rule, the policy action pulls the economy out of recession.
F.So Feedback Rules are Better?
1.Despite the apparent superiority of feedback rules many economists say that fixed rules do a better job of stabilizing aggregate demand. Three reasons are advanced:
a)Potential GDP is not known
b)Policy lags are longer than the forecast horizon
c)Feedback rule policies are less predictable than fixed rule policies
2.Knowledge of Potential GDP
a)Proper use of feedback rules requires that policymakers know whether policy should be expansionary or contractionary.
b)But that requires knowledge of what is the potential level of real GDP, which no one knows with certainty.
3.Policy Lags and the Forecast Horizon
a)The effects of policy actions operate with lags.
b)These lags may be longer than policymakers can forecast so that actions taken in response to actual or forecasted events may have their maximum effects only when the economy faces new problems.
c)This is illustrated with a discussion of Fed policy.
4.Predictability of Policies
a)Fixed rules are more predictable; feedback rules inflict more uncertainty on the economy.
b)When determining interest rates and wage contracts, people need to forecast future inflation rates.
c)They can do so more easily and accurately when policies are predictable.
G.Stabilizing Aggregate Supply Shocks
1.Real business cycle economists suggest another reason for the failure of feedback rules: Fluctuations in GDP are caused by fluctuations in productivity growth, that is, by shifts in the aggregate supply curve.
2.According to this view, the short-run and long-run aggregate supply curves are identical.
3.A slowdown in productivity growth shifts the aggregate supply curve leftward.
4.With a fixed rule, a decrease in LAS has no effect on policy, so AD does not change, and the result of the decrease in LAS is a fall in real GDP and an increase in the price level.
5.Because the aggregate supply curve is vertical, changes in aggregate demand do not change the level of GDP, so policy changes in aggregate demand have no useful effect on real GDP. Figure 31.7 (page 744/398) illustrates.
H.Natural Rate Policies
1.There are no costless ways to lower the natural rate.
2.Two possibilities are
a)Reducing the generosity of unemployment compensation, thus making the opportunity cost of unemployment higher and reducing search times;
b)Reducing the minimum real wage rate, increasing the demand for labor.
V.Anti-Inflation Policy
A.Avoiding demand-pull inflation is like to avoiding demand-deficiency recession and is achieved by stabilizing aggregate demand. Avoiding cost-push inflation and slowing inflation if it does occur raise special problems.
B.Avoiding Cost-Push Inflation
1.Cost-push inflation originates when cost increases decrease short-run aggregate supply and shift the SAS curve s leftward. Figure 31.8 (page 746/400) illustrates responding to an OPEC price increase.
2.Monetarist Fixed Rule
a)In the face of a leftward shift in the SAS curve, fixed rules for monetary policy allows the economy to suffer stagflation whereby real GDP falls and the price level rises.
b)Eventually, the SAS curve returns to its original position, and the level of output returns to full employment.
3.Keynesian Feedback Rule
a)If the SAS curve shifts leftward, feedback rules increase the money supply and government spending and cut taxes.
b)The policies shift the AD curve rightward, increasing real GDP and the price level.
4.Incentives to push up costs
a)With fixed rules, a boost in, say, money wages results in unemployment; with feedback rules, unemployment is more temporary.
b)Hence workers have a greater incentive to demand higher wages under a feedback rule; that is, the incentive to seize a temporary gain by boosting the price of a resource is greater under a feedback rule.
c)This incentive is a disadvantage of feedback rules.
B.Slowing Inflation
1.A Surprise Inflation Reduction
a)If a reduction in the inflation rate is a surprise, a recession results as the economy moves along a short-run Phillips curve.
b)Alternatively, the AD curve unexpectedly moves leftward, with the price level and real GDP falling as a recession hits the economy.
c)Figure 31.9 (page 748/402) illustrates with AD-AS and Phillips curves.
2.A Credible Announced Inflation Reduction
a)If the Fed credibly announces its goal to reduce the inflation rate, inflation slows and real GDP does not change.
C.Inflation Reduction in Practice
In practice, most reductions in inflation cause recessions because people do not believe Fed announcements; rather they base their expectations on Fed actions.
D.Balancing the Inflation and Real GDP Objective: The Taylor Rule
1.The Taylor Rule suggests targeting inflation, say a target of 2 percent inflation a year, but then being explicit about the target for the federal funds rate if inflation deviates from its target rate.
2.This is intended to reduce the uncertainties produced by Fed-watching to divine the Fed’s intentions from its behavior rather than its pronouncements.
3.Figure 31.10 (page 749/403) compares actual Federal Funds Rate to the Taylor rule for 1971 to 2001, and shows that they are close but not identical.