Chapter 14

Macroeconomic Policy

Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin

14-2

The Role of Stabilization Policy

Recall, the economy can self-correct. When should we act to stabilize the economy? The speed of self-correction matters Factors that slow the self-correcting process:

The size of the output gap Long-term contracts Efficiency and flexibility of labor and product

markets

14-3

Stabilization Policy and Demand Shocks

AD1

AD2

Y2 Output Y

Infla

tion

rate

e

Y*

2

ASLRAS

14-4

Responding to Aggregate Inflation Shocks

What can the Fed do?

Y1Output (Y)

Infla

tion

()

LRAS

Y2

2

AS2

1

AD1

AS1

Y*

14-5

Output (Y)

Infla

tion

()

Rea

l int

eres

t rat

e (r

)

Inflation ()

The Fed adjusts their target level of inflation to 3.

Option 1: Accommodating Policy

3

Y2

2

AS2

AD2

r1*

MPR1

1* Y*

LRAS

1

AD1

AS1

MPR2

3*

14-6

Output (Y)

Infla

tion

()

Option 2: Maintain Original Policy Targets

AS1

Y2

2

AS2

3

LRAS

1

AD1

Y*

14-7

What should the Fed do? Option 2: Maintain Original Policy Targets Return to Y* and the original target inflation At the potential cost of a long recession

Option 1: Accommodating Policy Closes the output gaps relatively fast At the cost of a higher inflation target

Repeated use of Accommodating Policy results in highly volatile inflation.

14-8

What should the Fed do? Central Banks prefer to maintain low inflation targets. This choice depends on the speed of the Aggregate

Supply. This is partially observed in the reaction to the initial

shock. Also depends on the public’s expectations. Anchored inflationary expectations: people’s

expectations of future inflation do not change even if inflation rises temporarily Encourages Fed to maintain its original inflation

target

14-9

Expectation and the Credibility of Monetary Policy Three factors that affect credibility

1. Degree of central bank's independence Removes short-run political influences Indicators of independence: Term length and staggered nature Interference from other branches Federal budgetary obligations

14-10

Expectation and the Credibility of Monetary Policy Three factors that affect credibility

2. The announcements of explicit inflation targets Pros: Improves market function Allocates resources away from inflation protection

Cons: Too rigid? Potentially ignores other factors like

unemployment and output Many countries have seen improvement as a result Others, like the Fed, have done well without it.

14-11

Zero Inflation Target? Zero inflation has several undesirable consequences: Negative inflation (deflation) is likely. Fed may use negative real interest rates at times

Nominal interest rates cannot be negative. Measured inflation overstates actual inflation A small amount of inflation makes markets work

better.

14-12

Expectation and the Credibility of Monetary Policy Three factors that affect credibility

3. Established reputation for fighting inflation Inflation hawk is committed to achieving and

maintaining low inflation Accepts some short-run cost in reduced output

and employment Inflation dove is not strongly committed to achieving

and maintaining low inflation Becoming an inflation hawk

1. Start acting like a hawk and stick with it.

2. Appoint leaders known for being hawks.

14-13

Inflation and the Federal Reserve

1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010

-5%

-3%

-1%

1%

3%

5%

7%

9%

11%

13%

15%

Inflation in the United States

The Changing Volatility of Real GDP

14-15

Fiscal Policy Effects

Government Spending and Taxes can affect: Aggregate Demand, directly Long-run Aggregate Supply, by stimulating

economic growth.

LRAS1

Output (Y)

1

AD1

Y1

Infla

tion

()

AD2

LRAS2

Y2

14-16

Taxes How can taxes affect the economy? AD: Changes disposable income (Y-T) LRAS: Affects expected payoffs from investments LRAS: Work vs. Leisure decision

Opportunity cost of leisure: (Net) Wage Substitution Effect: If taxes increase, leisure is

cheaper Income Effect: If taxes increase, it will take more

work to earn the same amount

Marginal Tax Rate and Hours Worked

Country Relative Hours Worked (US = 100)

Marginal Tax Rate

Japan 104 37%

US 100 40

UK 88 44

Canada 88 52

Germany 75 59

France 68 59

Italy 64 64Prescott, EC. “Why Do Americans Work So Much More Than Europeans?” Federal Reserve Bank on Minneapolis Quarterly Review. July

2004. pgs. 2-13.

14-18

Policymaking: Art or Science?

Macroeconomic policy works best with Accurate knowledge of current economic

conditions Knowledge of the future path of the economy

without policy Precise value of potential output Good control of fiscal and monetary policies Knowledge of how and when the economy will

respond to policy changes

14-19

Barriers to Perfect Policies

Policy is subject to lags The inside lag is the delay between the time a policy

change is needed and the time it is implemented Shorter for monetary policy than for fiscal policy

The outside lag is the delay between policy implementation and the major effects of the policy occur Longer for monetary policy than for fiscal policy