Stabilisation Policy

Question 1

2 views on the economy and how to respond to shocks

Answer 1

1. economy is inherently UNSTABLE and requires intervention
2. economy is inherently STABLE and government only interferes with natural process.

Question 2

2 forms of approaches to policy

Answer 2

Active (Keynes) vs Passive (Neo) approaches
Rules vs discretion for gov policy

Question 3

Main argument against active policy

Answer 3

Policy lags

Question 4

Policy lags - 2 types of lags

Answer 4

Inside lag - delay between the shock, and the policymakers reaction (time to comprehend and respond)

Outside lag - delay between policy action and impact on economy. (i.e policy effects arent instant)

Question 5

So why are policy lags an issue

Answer 5

State of economy can change in meantime. Then takes time to correct the now ill-fitted policy. Waste of resources if no longer suited/time

Question 6

How to shorten the inside lag (delay between shock and reaction)

Answer 6

Automatic stabilisers - stimulate or contract economy without new policy.

e.g income tax, it is progressive. in a recession, incomes fall so the tax they have to pay falls too.

(So stabilises the economy to help overcome the issue - recession in this case)

Question 7

Importance of economic forecasting - what is forecasting used for.

Answer 7

Very important - current decisions are based on forecasts of future.

Question 8

What is problem with forecasting

Answer 8

Accuracy is mixed - often inaccurate, as key events are unpredictable e.g COVID

Question 9

Example of forecasting failure

Answer 9

GFC , they underpredicted unemployment.

Question 10

What is a crucial factor in policy analysis to consider, and what theory uses this?

Answer 10

Expectations i.e reactions to expected future government policy

Lucas Critique - when analysing policy impacts, we need to account for how agents react.

E.g if aiming to increase tax revenue by 10%, it may not be simple as increasing taxes 10%, as when considering agents reactions, they may reduce hours worked since incentives weaken. So they may have to increase taxes by 20% or even lower tax to boost incentives and hours worked.

Question 11

Recall the sacrifice ratio

Answer 11

The % of GDP needed to lower inflation by 1% , for a given Phillips curve.

Question 12

Sacrificing ratios used to be standard approach for determining whether to pursue or not.

We often got large estimated sacrifice ratios, implying it may be better to tolerate high inflation (since would lose a lot of GDP - costly to reduce inflation)

What if government announces credible plan to reduce inflation, and we also assume RATIONAL EXPECTATIONS? (Pg6)

Answer 12

Economic agents will alter inflation expectations.
Assuming rational expectations…

AD shift is the policy effect. E.g contractionary monetary, increase in interest rates, or fiscal a reduction in g.

If policy is fully credible, since we have rational expectations, Phillips curve includes expected inflation so a fall in expected inflation will shift Phillips curve shifts down at the same time, so we avoid point B.

(So NO SACRIFICE IN TERMS OF OUTPUT, WE GO STRAIGHT TO C, SINCE WE HAVE RATIONAL EXPECTATIONS INSTEAD, NO LAGS ETC)

This shows us the possibility of a costless disinflation (prices/inflation has fallen without the sacrifice of output)

Question 13

This shows us the possibility of a costless disinflation (prices/inflation has fallen without the sacrifice of output).

Even if not fully credible, it can lead to smaller sacrifice ratios. (Loss of Y is not a severe)

Question 14

Discretion vs rules, and whether each is active or passive.

Answer 14

Discretion - “Active” approach. Policymakers set policy on a period-by-period basis as they see fit. (Flexible… but agents are unaware)

Rules - policymakers announce in advance how they will respond to various situations, and commit to that.

Could be active or passive. (Rules are good as puts pressure if they aren’t applied e.g why hasn’t it been executed as intended)

Question 15

Cons of discretion? (3)

Answer 15

Incompetence/ignorance : may not understand economy well enough to stabilise it successfully

Vested interests - pressure groups may influence decision making.

Opportunism - temptation to “grease wheels of economy” prior to an election to get votes e.g expansionary fiscal to reduce unemployment.

(And time lags with active policy as mentioned before)

Question 16

Passive v Active rules examples

Answer 16

Passive - Friedman’s k% rule
Money growth = k% (per year)

So let money growth increase by k% and leave it, no interference.

Active - McCallum rule
Money growth = k% + øu (u% -u to the n%)

Let money growth increase by k% + parameter(current unemployment - natural rate)

E.g if u increases, we should increase money growth to stabilise the economy’s higher unemployment they face.

Question 17

A pro of discretion is flexibility - able to respond to prevailing issues.

However what is the issue of this? And what is this known as

Answer 17

Time inconsistency of discretionary policy -

Policymakers may cheat on their policy

May have an incentive to announce particular policy, allow agents to form their expectations, and then cheat on this policy at a later date.

Question 18

Evaluation of cheating through discretionary policy - who can eliminate this risk?

Answer 18

Rational agents will understand this potential to cheat, and will set their expectations with governments true incentives in mind, rather than what they are announcing.

Question 19

So what is the general principle and view of discretion and rules

Answer 19

We should remove discretion from policymakers.
We should impose credible rules in order to achieve objectives. (As in pg6)

Question 20

Non economic example of these uncredible policies

Answer 20

Teacher wants kids to study and be smart, but also doesnt want to mark the work.

Announces an exam, to get them to study and be smart.

Cancels day before, so he doesn’t have to mark, and kids have studied and are smart.

However, if students are rational, they will anticipate exam being cancelled and thus choose not to revise.

General principle For this to be effective, we need a credible rule, perhaps from the uni officially announcing the exam.

Question 21

So we need a rule.

What are 2 rules that can be used in monetary policy (2)

Answer 21

Monetarists - control money supply at a constant rate each year (not used anymore)

Inflation targeting (more used)

Question 22

Scenario to build a model:

The central bank sets monetary policy but the government determines its objective. I.e gov decide inflation target, then central bank act on it (just like UK)

Assume that the central bank can ‘choose’ the actual rate of inflation using its policy instrument.

Answer 22

1. Now have the rate of inflation chosen, we use Phillips curve equation to find unemployment given this.
   u=un - a(π-Eπ)
2. We then create social loss function - shows social cost of inflation+unemployment to society

𝐿(𝑢,𝜋) =𝑢+𝛾𝜋²
(WE SQUARE TO ACCOUNT FOR IF INFLATION IS NEGATIVE (DEFLATION)

y measures society’s aversion to inflation (higher=dislikes inflation more)

Question 23

So social loss is the cost of unemployment inflation to society:

What is minimum loss?

Answer 23

L(0,0) = 0

0 unemployment, 0 inflation.

Question 24

Monetary policy regime 1:

What is unfettered discretion:

Are the public aware?

Answer 24

Gov does not give central bank with any objectives. (Give their full/unfettered discretion)

General public know this.

Question 25

How does the economy work under unfettered discretion (3 steps)

Answer 25

1. Private agents form inflation expectations Eπ
2. Central bank chooses actual level of inflation upon this. π
3. Then unemployment is determined by phillips curve given this level of inflation (as done previously)

Question 26

So how to work out what inflation rate the C.B chooses? What assumption is made?

Answer 26

Assume benevolence acts in best consideration for society, i.e minimise loss function.

Sub unemployment into the loss function.

Then differentiate to F.O.C respect to π
Gets us
-a+2yπ = 0

Then make π (inflation) subject
π=a/2y
Optimal inflation C.B chooses.

Question 27

So what is the formula for inflation rate C.B chooses,

What is important to specify!

Answer 27

π=a/2y

This is independent of expected inflation!!

Question 28

How to rational agents use this?

Answer 28

Since rational, they understand this rate is independent of expected inflation, and so set their expected inflation

Eπ = π =a/2y

And so u=u to the n (current u=natural u) (using Phillips curve u=u to the n - a(π-Eπ)

Question 29

How do we find losses under unfettered discretion

Answer 29

Sub our solutions for π and u to the n into the loss function.

L (u,π) = u to the n + y(a/2y)²

Question 30

Monetary policy regime 2: Inflation target

Gov does provide a target for CB to fulfil (unlike unfettered discretion). Public know this.

What inflation target should the government set for the central bank, if the target is fully credible?

Answer 30

Full credibility so
Eπ=π=π* (expected inflation=inflation=target inflation)

Question 31

What should π* be? Use the loss function to prove why.

Answer 31

As minimises the loss function. So government should set an inflation target of 0.

Recall loss function
L(u,π) = u to the n + yπ*₂

If π* = 0
L= u the n.

Question 32

Now compare these 2 scenarios of different regimes

Which one is better and why

Answer 32

Inflation targeting (latter) is better, because it produces a smaller loss. As under unfettered discretion, π=0 cannot occur. (Time inconstency problem)

Shown by loss from inflation targeting = un
Loss from unfettered discretion = un+y(a/2y)²

un < un+y(a/2y)² (loss smaller)

Question 33

Which country has unfettered discretion / independent central bank

Answer 33

Switzerland