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Chapter 17

Policy
Item Item Item Etc.

McGraw-Hill/Irwin Macroeconomics, 10e

2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 17-2

Introduction

In this chapter we examine how policymakers formulate appropriate policy measures

Must consider:
Timing  Uncertainty  How individuals will respond to specific policies  Role of credibility  Monetary or fiscal policy, or a mix  Different policy instruments  Different intermediate and ultimate targets


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Lags in the Effects of Policy

Suppose the economy is at full employment:

Affected by a negative aggregate demand disturbance p reduces the equilibrium level of income below full employment No advance warning of disturbance p no policy action taken in anticipation of its occurrence

Policymakers must decide: 1. Should they respond to the disturbance? 2. If so, how should they respond?

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Lags in the Effects of Policy

Is the disturbance permanent (or persistent) or temporary?

[Insert Figure 17-1 here]

Figure 17-1 illustrates a temporary aggregate demand shock A one period reduction in consumption p best policy is to do nothing at all Todays policy actions take time to have an effect p would hit economy after back at full-employment level, driving it away from the optimal level
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Lags in the Effects of Policy

Policymaking is a process:
Takes time to recognize and implement a policy action Takes time for an action to work its way through the economy

Inside Lags: the time period it takes to undertake a policy action

Recognition Lag: the period that elapses between the time a disturbance occurs and the time the policymakers recognize that action is required p Lag is negative if the disturbance is predicted and appropriate policy actions considered before it occurs (Ex. Increase money supply prior Christmas) p Lag is typically positive


Each step involves delays or lags:

1.

2.

Inside lags  Recognition lags  Decision lags  Action lags Outside lags

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Lags in the Effects of Policy

Policymaking is a process:
Takes time to recognize and implement a policy action Takes time for an action to work its way through the economy

Inside Lags: the time period it takes to undertake a policy action

Decision Lag: the delay between the recognition of the need for action and the policy decision p Differs between monetary and fiscal policy FOMC meets regularly to discuss and decide on policy


Each step involves delays or lags:

1.

2.

Inside lags  Recognition lags  Decision lags  Action lags Outside lags

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Lags in the Effects of Policy

Policymaking is a process:
Takes time to recognize and implement a policy action Takes time for an action to work its way through the economy

Inside Lags: the time period it takes to undertake a policy action

Action Lag: the lag between the policy decision and its implementation p Also differs for monetary and fiscal policy Monetary policy makers typically act immediately Fiscal policy actions are less rapid p administration must prepare legislation and then get it approved


Each step involves delays or lags:

1.

2.

Inside lags  Recognition lags  Decision lags  Action lags Outside lags

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Lags in the Effects of Policy

Policymaking is a process:
Takes time to recognize and implement a policy action Takes time for an action to work its way through the economy

Outside Lags: time it takes a policy measure to work its way through the economy


Each step involves delays or lags:

1.

2.

Inside lags  Recognition lags  Decision lags  Action lags Outside lags

Inside lags are discrete, but outside lags are typically distributed lags p Once a policy action has been taken, its effects on the economy are spread out over time p Immediate impacts may be small, but other effects occur later

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Lags in the Effects of Policy

Figure 17-2 illustrates the dynamic multiplier

[Insert Figure 17-2 here]

Shows the effects of a once-and-forall 1 percent increase in the money supply in period zero Impact is initially very small, but continues to increase over a long period of time Monetary policy: initially impacts investment via interest rates, not income When AD ultimately affected, increase in spending itself produces a series of induced adjustments in output and spending
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Why are there outside lags?

Monetary Versus Fiscal Policy Lags

Fiscal policy directly impacts aggregate demand

Affect income more rapidly than monetary policy p Shorter outside lags than monetary policy p Longer inside lags than monetary policy

Long inside lags makes fiscal policy less useful for stabilization and used less frequently to stabilize the economy
It takes time to set the policies in action, and then the policies themselves take time to affect the economy. Further difficulties arise because policymakers cannot be certain about the size and the timing of the effects of policy actions.
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Expectations and Reactions

Government uncertainties about the effects of policies on the economy arise because:
1.

2.

Policymakers do not know what expectations firms and consumers have Government does not know the true model of the economy Work with econometric models of the economy in estimating the effects of policy changes


An econometric model is a statistical description of the economy, or some part of it

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Reaction Uncertainties

Suppose the government decides to cut taxes to stimulate a weak economy p temporary tax cut How big of a cut is needed?
 One

possibility: temporary tax cut will not affect long-term income, and thus not long-term spending p Large tax cut needed  Alternatively: consumers may believe tax cut will last longer than announced, and MPC out of tax cut is larger p Smaller tax cut might be sufficient If the government is wrong about consumers reactions, it could destabilize rather than stabilize the economy.
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Uncertainty and Economic Policy

Policymakers can go wrong in using active stabilization policy due to:

Uncertainty about the expectations of firms and consumers Difficulties in forecasting disturbances Lack of knowledge about the true structure of the economy

Uncertainty about the correct model of the economy Uncertainty about the precise values of the parameters within a given model of the economy

Instead of choosing between fiscal and monetary policies when the multipliers are unknown, best to employ a portfolio of policy instruments. DIVERSIFICATION

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Targets, Instruments, and Indicators

Economic variables play a variety of roles in policy discussions

Useful to divide them into targets, instruments, and indicators identified goals of policy

 Targets:

Ultimate targets

Ex. to achieve zero inflation Ex. Targeting money growth Used to achieve ultimate target

Intermediate targets

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Targets, Instruments, and Indicators

Economic variables play a variety of roles in policy discussions

Useful to divide them into targets, instruments, and indicators tools policymakers manipulate directly

 Instruments:

Ex. An exchange rate target

 Indicators:

economic variables that signal us as to whether we are getting closer to our desired targets

Ex. Increases in interest rates (indicator) sometimes signal that the market anticipates increased future inflation (target) Provide useful feedback p policymakers can use to adjust the instruments in order to do a better job of hitting targets
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Rules Versus Discretion

In determining how policymakers should operate, policymakers must answer several questions: Should policymakers actively try to offset shocks? If yes: Should responses be precommitted to specific rules? OR Should policy makers work on a case-by-case basis?
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Rules Versus Discretion

Milton Friedman and others argued:

There should be no use of active countercyclical monetary policy Monetary policy should be confined to making the money supply grow at a constant rate Friedman advocated a simple monetary rule p Fed does not respond to the condition of the economy

Policies that respond to the current or predicted state of the economy = activist policies/discretionary policies Debate over whether fiscal and monetary authorities should follow rules or execute discretionary policy

Activist rules are possible as well

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