should monetary and –scal policy take an active role in...

Notes From �Macroeconomics; Gregory Mankiw�

Part 5 - MACROECONOMIC POLICY DEBATES

Ch14 - Stabilization Policy?

� Should monetary and �scal policy take an active role intrying to stabilize the economy, or should remain passive?

� Should policymakers be free to use their discretion, orshould they be committed to following a �xed policy rule?

� Below we consider some problems with policy making

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Argument 1: The Cause of Crisis

� It depends the cause of crisis, on which Economists areusually disagree

Argument 2: Lags in the Implementation and E¤ects ofPolicies

� The inside lag is the time between a shock to the economyand the policy action responding to that shock

� The outside lag is the time between a policy action and itsin�uence on the economy

�A long inside lag is a central problem with using �scal2

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policy. Because changes in spending or taxes requirethe approval of higher authorities

�Monetary policy has a substantial outside lag. This isbecause monetary policy works by changing the interestrates, which in turn in�uence investment. But many�rms make investment plans far in advance

� Automatic stabilizers stimulate or depress the economywhen necessary without any deliberate policy change

�Income taxes, the unemployment-insurance and welfaresystems



Argument 3: The Di¢ cult Job of Economic Forecasting

� Economic developments are often unpredictable

Argument 4: The Lucas Critique

� Lucas has emphasized that optimal decision rules of eco-nomic agents vary systematically over time

� Hence, it is naive to try to predict the e¤ects of a changein economic policy entirely on the basis of relationshipsobserved in aggregated historical data

� Economists evaluating alternative policies need to considerhow policy a¤ects agents�expectations



Should Policy Be Conducted by Rule or by Discretion?

� Policy is conducted by rule if policymakers announce inadvance how policy will respond to various situations andcommit themselves to those rules

� Policy is conducted by discretion if policymakers are freeto choose whatever policy seems appropriate at the timeof events

�The debate over rules versus discretion is distinct fromthe debate over passive versus active policy (Policy canbe conducted by rule and yet be either passive or active)



�Why commitment could be a better alternative to discre-tion?

...Distrust of Policymakers and the Political Process

� If politicians are incompetent or opportunistic, then wemay not want to give them the discretion to use the pow-erful tools of monetary and �scal policy

�Politicians often do not have su¢ cient knowledge tomake informed judgments, which allows them to pro-pose incorrect but super�cially appealing solutions tocomplex problems



�Manipulation of the economy for electoral gain, calledthe political business cycle

...The Time Inconsistency of Discretionary Policy

� In some situations policymakers may want to announce inadvance the policy they will follow in order to in�uencethe expectations of private decisionmakers. But later, af-ter the private decisionmakers have acted on the basis oftheir expectations, these policymakers may be tempted torenege on their announcement. Hence, to make their an-nouncements credible, policymakers may want to make acommitment to a �xed policy rule.



�Ex: Negotiatingwith terrorists over the release of hostages�Ex: Consider the dilemma of a CB that cares aboutboth in�ation an unemployment. According to thePhillips curve, the trade-o¤ between in�ation and un-employment depends on expected in�ation. To reduceexpected in�ation, the CB might announce that lowin�ation is the paramount goal of monetary policy butdoes not ful�ll it promise then. As a result, CB losescredibility, which leaves the economy with higher in�a-tion rates in the longer run



Rules for Monetary Policy

� CB were to commit to a rule for monetary policy, whatrule should it choose?

� Some economists believe that �uctuations in the moneysupply are responsible for most large �uctuations in theeconomy

�They advocate that the CB keep the money supplygrowing at a steady rate (stabilizes aggregate demandonly if the velocity of money is stable)

�A second policy rule that economists widely advocateis that CB announces a planned path for nominal GDP.



If nominal GDP rises above the target, the CB reducesmoney growth to dampen aggregate demand

�A third policy rule that is often advocated is in�ationtargeting. Like nominal GDP targeting, in�ation tar-geting insulates the economy from changes in the ve-locity of money. In addition, it is easy to explain to thepublic

� Notice that all these rules are expressed in terms of somenominal variable: the money supply, nominal GDP, or theprice level. One can also imagine policy rules expressed interms of real variables, such as real GDPgrowth rate or theunemployment rate, but this is not a common approach



Ch15 - Government Debt

Problems in Measurement

� The government budget de�cit equals the amount of newdebt (or printing money) the government needs to issue to�nance its operations

Pt(Gt� Tt) +Bt�1it�1 +Bypt�1iypt�1 = Btit +B

ypt i

ypt (+PMt)

� There is a discussion that the budget de�cit does not accu-rately gauge either the impact of �scal policy on today�seconomy or the burden being placed on future generationsof taxpayers



...Measurement Problem 1: In�ation and Real GDPGrowth

� Nominal government debt may rise at the same time withdecline in real government debt

� Real government debt may rise at the a rate lower thanthe real GDP growth

...Measurement Problem 2: Capital Assets

�When a person borrows to buy a house, we do not say thathe is running a budget de�cit

�A budget procedure that accounts for assets as well asliabilities is called capital budgeting



�The major di¢ culty with capital budgeting is that it ishard to decide which government expenditures shouldcount as capital expenditures

...Measurement Problem 3: Uncounted Liabilities

� Some economists argue that the measured budget de�citis misleading because it excludes some important govern-ment liabilities

� For example, consider the pensions of government workers.These workers provide labor services to the governmenttoday, but part of their compensation is deferred to thefuture



...Measurement Problem 4: The Business Cycle

� Many changes in the government�s budget de�cit occurautomatically in response to a �uctuating economy

� For example, when the economy goes into a recession, in-comes fall, so people and �rm pay less taxes. Moreover,more people become eligible for government assistance, sogovernment spending rises

� So, the de�cit can rise or fall either because the economyhas changed direction. To solve this problem, the govern-ment calculates a cyclically adjusted budget de�cit (some-times called the full-employment budget de�cit). It is theestimate of what government spending and tax revenue



would be if the economy were operating at its natural rateof output and employment

The Traditional View of Government Debt

Exchange of letters between a politician and an economist

� (An Economist) Dear Sir: A tax cut �nanced by govern-ment borrowing would have many e¤ects on the economy.The immediate impact of the tax cut would be to stimulateconsumer spending

� In the short run, higher consumer spending would raise thedemand for goods and services and thus raise output and



employment. Interest rates would also rise, as investorscompeted for a smaller �ow of saving. Higher interest rateswould discourage investment and would encourage capitalto �ow in from abroad. The dollar would rise in valueagainst foreign currencies, and U.S. �rms would becomeless competitive in world markets

� In the long run, the smaller national saving caused by thetax cut would mean a smaller capital stock and a greaterforeign debt. Therefore, the output of the nation would besmaller, and a greater share of that output would be owedto foreigners

� Overall, current generations would bene�t fromhigher con-16

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sumption and higher employment, although in�ationwouldlikely be higher as well. Future generations would bearmuch of the burden of today�s budget de�cits: they wouldbe born into a nation with a smaller capital stock and alarger foreign debt

� (The Politician) Thank you for your letter. It made senseto me. But yesterday my committee heard testimony froma prominent economist who called herself a �Ricardian�anwho reached quite a di¤erent conclusion. She said that atax cut by itself would no stimulate consumer spending;hence, it would therefore not have all the e¤ects you listed.What�s going on here?



The Ricardian View of Government Debt

� According to the Ricardian view, consumers are forward-looking and, therefore, base their spending not only ontheir current income but also on their expected future in-come

� A tax cut �nanced by government debt means reschedulingcurrent taxes to the future taxes

� Hence, a tax cut �nanced by government debt does notreduce the tax burden; therefore should not encourage theconsumer to spend more



...Consumers and Future Taxes: Some arguments

� Myopia: It may be that consumers are not forward-lookingbut shortsighted

� Future Generations: A debt-�nanced tax cut gives the cur-rent generation the opportunity to consume at the expenseof the next generation

�The fact that many people leave minimal bequests totheir children is consistent with this hypothesis



Fiscal E¤ects on Monetary Policy

� A high level of debt might also encourage the governmentto create in�ation

� The ends of hyperin�ations almost always coincide with�scal reforms that include large cuts in government spend-ing



...International Dimensions

� The higher the level of the government debt, the greaterthe temptation of default. Thus, as government debt in-creases, international investors may come to fear defaultand curtail their lending. If this loss of con�dence occurssuddenly, the result could be the classic symptoms of cap-ital �ight: a collapse in the value of the currency and anincrease in interest rates


should monetary and –scal policy take an active role in...

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