Chapter 14: Stabilization PolicyChapter 14: Stabilization Policy

Policy ActivismEconomy is not self-correcting. We need to implement stabilization policy to correct business cycles.

Use fiscal and monetary policy to prevent recession and control inflation.

Example of active monetary policy:M2 Growth = 3% + (u – 6%) whenever correction is required

Policy PassivismGovernment budgetary actions and stabilization attempts are the source of economic instability.

Government can make matters worse as it did in the Great Depression by implementing concretionary policies of tax and interest rate increases!

Example of passive monetary policy:M2 Growth = 3% annually

Policy Lags

Inside lags: time between a shock to the economy and policy action responding to that shock

Outside lags: time between implementation of a policy action and its effect on the economy

Policy Lags: Inside Lags

Recognition lag: The time it takes for policy makers to recognize the existence of a boom or slump.

Formulation lag: The time it takes to design policy measures to correct a boom or slump.

Policy Limitations: Outside Lags

Implementation lag: The time it takes to put the desired policy measures into effect in correcting a boom or slump.

Response lag: The time it takes for the economy to adjust to new conditions after policy measures are implemented.

Duration of Lags

Monetary policy requires shorter formulation and implementation lags as the FED decides how to correct a boom or slump.

Fiscal policy requires longer formulation and implementation lags as a tax or spending policy must be approved by the Congress and implemented by federal agencies.

Automatic Stabilization Boom: greater employment, inflation, and nominal wage will move workers into higher tax brackets. Paying more taxes reduce disposable income and consumption spending, slowing the economy.

Slump: greater unemployment and lower inflation and nominal wage will move workers into lower tax brackets. Paying less taxes increases disposable income and consumption spending, stimulating the economy.

Forecasting: Leading Indicators 1. Manufacturing production workweek2. Weekly unemployment claims3. New orders for consumer goods and materials4. Vendor performance5. Orders for plants and equipment6. Change in manufactures’ unfilled orders 7. New building permits issued8. Change in sensitive materials prices9. Index of stock prices10. Real money supply (M2)11. Index of consumer expectations

Macroeconomic Forecasting

Economists apply empirical models to macro data to forecast conditions.

While minimizing the forecast error, there still are discrepancies between actual and predicted values because, despite sophistication, models can’t account for all possible effects.

Forecasting Errors

Forecasting Errors

Generating 6-months forecasts, economists could not correctly predict the rapid

– Rise in unemployment rate from 1981.2 to 1982.4– Fall in unemployment rate from 1982.4 to 1984.4

Formation of Expectations

Adaptive expectations: expectations are formed using past information on the indicator being considered

Rational expectations: expectations are formed using past and present information on all possible variables that affect the indicator being considered

Robert Lucas’ Critique

Policy makers must take into account how people’s expectations respond to policy changes

Traditional methods of policy evaluation do not adequately take into account the policy effects on people’s expectations

Sacrifice Ratio & ExpectationsSacrifice Ratio: the percentage of real GDP that must be given up to lower inflation by 1 percent.

Policy makers prefer to live with inflation since they find the Sacrifice Ratio to be too high for the public.

Rational-expectations advocates assert that Sacrifice Ratio estimation is subject to Lucas critique; it assumes expectations are formed adaptively rather than rationally.

Distrust of Policy MakersPolicy can be implemented to manipulate the economy for political purposes (e.g., the short-run Phillips Curve)

Time inconsistency of discretionary policy: promise one policy, but implement another policy; e.g., promise an investment tax credit, but after factories are built increase corporate income tax rate

Political Business Cycle

Business cycle induced by policy makers:– slow the economy in the first two years of a political

administration– stimulate the economy in the last two years to cause

a boom just in time for the next election

Data partly supports this idea for the Republican presidents

Economic Growth and Politics

Rules of Monetary Policy

Respond to policy shocks (e.g., energy crisis)

Target GDP growth to achieve natural unemployment rate

Target inflation to keep it low

Inflation & Central Bank

Rules of Fiscal Policy

Budgetary balance or surplus

Deficit spending to cause growth to shift the burden to the next generation through debt

Tax smoothing to reduce distortions by keeping rates relatively stable