LECTURE 8 Stabilization policy

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LECTURE 8Stabilization policy
Øystein Børsum 7th March 2006
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Overview of forthcoming lectures

• Lecture 8 Stabilization policies
• Goals for stabilization policies Stable output
  and inflation
• Optimal policy rule Demand and supply shocks
• Lecture 9 Limits to stabilization policies
• Rational expectations and the Policy
  Ineffectiveness Proposition, the Ricardian
  Equivalence Theorem and the Lucas Critique
• Policy rules versus discretion Credibility of
  economic policy
• Real business cycles (section 19.4)
• Lecture 10 Open economy
• Features of a small, open economy with perfect
  capital mobility
• Aggregate demand and aggregate supply in the open
  economy
• Long-term macroeconomic equilibrium in the open
  economy

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Overview of stabilization policy in the AS-AD
model with a Taylor rule

• Stable output and stable inflation are popular
  policy goals
• In the case of demand shocks, the adequate policy
  response with respect to output and inflation
  stabilization is the same
• In the case of supply shocks, there is a clear
  trade-off between the two goals
• The priorities of monetary policy are represented
  by the choice of parameters in the Taylor rule
• The optimal policy rule depends on whether supply
  or demand shocks are dominant, as well as policy
  preferences
• Within a framework of rules-based policies,
  activist fiscal policy and monetary policy are
  essentially the same Demand management
  Therefore, they lead to the same outcomes and
  have the same limitations

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Presumption A desire for stabilization policies

• Hypothesis The observed aversion to fluctuations
  in output and inflation can be represented by a
  social loss function

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Motivating output stability as a policy goal

• Consumers prefer to smooth consumption over time,
  but may not be able to do so Credit constraints,
  insurance market imperfections
• High consumer risk aversion?
• Stable income (output) may help consumers to
  smooth consumption
• Labor market inefficiencies probably increase
  when employment fluctuates
• Uneven distribution of the cost of recession
  (low-paid, unskilled and young workers suffer
  most) Successful stabilization policy may help
  to improve the distribution of income and welfare

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Motivating stable inflation as a policy goal

• Surprisingly hard to motivate in theory
• A fluctuating rate of inflation generates
• Inflation forecast errors Households will regret
  saving, investment and labor supply decisions
• Arbitrary redistribution of real income and
  wealth between creditors and debtors
• Protection against unanticipated inflation
  Indexation of nominal contracts
• Indexation is rare in real life, probably because
  the contracting parties (e.g., employers and
  employees) focus on different price indices

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The inflation target should be low and positive

• Costs of a fully anticipated inflation
• Shoe-leather costs
• Menu costs
• Distortion of relative prices (due to
  unsynchronized price setting)
• Tax distortions (due to a non-indexed tax system)
• The case for a positive target inflation rate
• Lower bound on the nominal interest rate
  (liquidity trap)
• Downwards nominal wage and price rigidity
• Quality improvements of goods and services are
  not fully captured by official price indices
• Most OECD countries aim at Low and stable
  inflation with a target rate of 2 2½

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Policy based on rules vs. discretionary policy

• Examples of policy rules
• The Taylor rule (flexible inflation targeting)
• A fixed exchange rate policy
• The Friedman rule (constant money growth)
• Discretionary policy Policy makers react in an
  ad-hoc manner to the specific circumstances of
  the situation, using all relevant available
  information
• Trade-off Credibility vs. flexibility
• Credibility anchors inflation expectations The
  legacy of stabilization policies in the 70s and
  80s

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AS-AD model (restated)
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Policy problem Find the monetary policy that
minimizes the social loss function

• At first, we disregard fiscal policy
• AD curve
• AS curve
• Social loss function
• Decision variables (in the Taylor rule) h and b

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Deriving the variances of output and inflation in
the general case

• Demand shock variable z (see chapter 17)
• The asymptotic (long-run) variances of output and
  inflation become (see appendix chapter 20)

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Case 1 An economy with only demand shocks

• Only demand shocks
• The variances of output and inflation simplify
• Higher values of h and b reduce both variances
  No trade-off between the inflation gap and the
  output gap

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Higher weight on the output stabilization (higher
b) reduces both the output gap and the inflation
gap
Illustration of the short-run effects of a
negative demand shock under different weights on
the monetary policy parameter b
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Conclusion No policy trade-off in an economy
with only demand shocks

• The central bank should react to demand shocks by
  pursuing a countercyclical monetary policy (b gt
  0).
• There is no trade-off between stabilizing output
  and stabilizing inflation when business cycles
  are driven by demand shocks.
• When faced with demand shocks, the central bank
  should react as strongly as possible to the
  output and inflation gaps.

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Case 2 An economy with only supply shocks

• Only supply shocks
• The variances of output and inflation simplify
• A low variance of output can only be achieved at
  the expense of a high variance of inflation, and
  vice versa A clear trade-off between the
  inflation gap and the output gap

where
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With supply shocks, there is a clear trade-off
between the inflation gap and the output gap
Illustration of the short-run effects of a
negative supply shock under different designs of
monetary policy
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Conclusion Clear policy trade-off in an economy
with only supply shocks

• If policy makers primarily seek to stabilize
  output, b should be positive and high
  (countercyclical policy) and h should be close to
  zero so that the AD curve becomes steep.
• If policy makers primarily seek to stabilize
  inflation, b should be negative (procyclical
  policy) and h should be high so that the AD curve
  becomes flat.

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The general case In optimum, there is a
trade-off between the output gap and the
inflation gap

• Minimize the social loss function
• First-order conditions with respect to h and b
• Implications In a social optimum, a smaller
  variance of output can only be achieved at the
  expense of a larger variance of inflation, and
  vice versa

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Optimal monetary policy design depends on which
shocks are dominant and the policy preferences
Optimal monetary policy under the Taylor rule
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Rules-based fiscal stabilization policy work in
the same way as rules-based monetary policy

• Fiscal policy rule
• Monetary policy follows the Taylor rule
• The AD curve with activist fiscal policy

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Decreased interest in fiscal stabilization policy

• Policy lags are seen to disadvantage fiscal
  policy relative to monetary policy
• Recognition lag (data measurement)
• Decisions lag (political system)
• Implementation lag (administrative process)
• Effectiveness lag (from change in instrument to
  effect in target)
• Direct constraints on the room for fiscal policy
• EU Maastricht treaty (1992) and the Stability
  and Growth Pact (1997)
• Credibility problems (cf. lecture 10) are likely
  to be more pronounced for fiscal than for
  monetary policy