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Copyright © 2009 Pearson Addison-Wesley. All rights reserved.
Chapter 14
Stabilization Policy in the Closed and Open Economy
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Introduction to Stabilization Policies
• Stabilization policies aim at minimizing changes to real GDP from exogenous Demand Shocks including:– Changes in business and consumer optimism
– Changes in net exports
– Changes in government spending and/or taxes not related to stabilization policy
• Policy Activism purposefully changes the settings of the instruments of monetary and fiscal policy to offset changes in private sector spending.– An alternate approach recommends Policy Rules that call for a
fixed path of a policy instrument like the money supply or a target variable like inflation or unemployment.
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Policy Rules and Monetary Policy
• In the 1930s, University of Chicago economist Henry Simons posed a stark contrast between a totally discretionary monetary policy and a fixed rule.– A Discretionary Policy treats each macroeconomic episode as a
unique event without a common approach to all events.
– A Rigid Rule for policy sets a key policy instrument at a fixed value.
• In the 1950s, Milton Friedman advocated a Constant Growth Rate Rule (CGRR) that stipulated a fixed percentage growth rate for the money supply. He was part of the Monetarism school of thought.
• A Feedback Rule sets stabilization policy to respond in a systematic way to a macroeconomic event (e.g. the “Taylor” Rule).
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Figure 14-1 A Flowchart Showing the Relationship Between Policy Instruments, Policy Targets, and Economic Welfare
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The Positive Case for Rules
• Milton Freidman’s arguments for monetary policy rules:– A rule insulates the Fed from political pressure
– A rule allows the Fed’s performance to be judged
– A rule reduces uncertainty
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The Negative Case for Rules
• Rules are favorable to discretionary policies because of the “long and variable” lags between changes in monetary policy instruments and the ultimate response of target variables like inflation and unemployment.
• Five Types of Lags– The Data Lag
– The Recognition Lag
– The Legislative Lag
– The Transmission Lag
– The Effectiveness Lag
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Figure 14-2 The Percent Change in Real GDP Following a 1 Percentage Point Change in the Treasury Bill Rate, Three Intervals, 1961–2007
Source: See Appendix C-4.
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Multiplier Uncertainty
• The multiplier formulas from Chapters 3 and 4 showed the size of the change in real GDP that would result from a change in a policy instrument.
• Dynamic Multipliers are the amount by which output is raised during each of several time periods after a given change in the policy instrument.
• Multiplier Uncertainty concerns the lack of firm knowledge regarding the change in output caused by a change in a policy instrument.
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The Fed and the “Great Moderation”
• Why has there been a decline in economic volatility since the mid-1980s?– In other words, what caused the “Great Moderation”?
• Possibility 1: Smaller Demand and Supply Shocks– Government military spending fell and was more stable.
– Financial deregulation made residential construction less volatile.
– Computers and improved management practices reduced the volatility of inventory investment.
– The oil and farm prices shocks of the 1970s were absent in the 1980s.
• Possibility 2: Improved Federal Reserve Performance– The Fed moved rapidly and decisively in response to movements in
the log output ratio.
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Figure 14-3 The Log Output Ratio and the Moving Average of its Absolute Value, 1960–2007 (1 of 2)
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Figure 14-3 The Log Output Ratio and the Moving Average of its Absolute Value, 1960–2007 (2 of 2)
Source: See Appendix C-4.
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Figure 14-3 The Log Output Ratio and the Moving Average of its Absolute Value, 1960–2007
Source: See Appendix C-4.
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Figure 14-4 The Federal Funds Interest Rate and the Log Output Ratio, 1980–2007
Source: See Appendix C-4.
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Time Inconsistency and Policy Credibility
• Time Inconsistency describes the temptations of policy makers to deviate from a policy after it is announced and private decision makers have reacted to it.
• Policy Credibility is the belief by the public that policy makers will actually carry out an announced policy.
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The Taylor Rule
• Stanford University economist John Taylor has proposed a simple rule (called the Taylor Rule) for the Fed to follow in setting the real federal funds rate (rFF):
rFF = rFF* + a(p – p*) + b[log(Y/YN)]
(where * represents the desired or target levels of variables and a, b are parameters > 0)
– If the Fed cares about avoiding accelerating inflation, then “a” is large.
– If the Fed cares about avoiding recession and/or high unemployment, then it chooses a large “b.”
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Figure 14-5 The Actual Federal Funds Rate and Interest Rates Calculated by Two Versions of the Taylor Rule, 1980–2007
Source: See Appendix C-4.
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Table 14-1 Assessing Alternative Policy Rules (1 of 2)
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Table 14-1 Assessing Alternative Policy Rules (2 of 2)
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Table 14-1 Assessing Alternative Policy Rules
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MS and Targeting Exchange Rates
• Under flexible exchange rates, an expansionary monetary policy lowers interest rates, leading to a depreciation that boosts NX and therefore output.
• Under fixed exchange rates, monetary policy must be used to maintain the fixed exchange rate, and therefore, is no longer available for stabilization purposes.
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How the Fed Reinvented Instability in Residential Construction
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The Debate About The Euro
• What are the benefits and costs of a single currency for the EU?
• Benefits– Elimination of costs and risks associated with exchange
rates improved intra-EU commerce– Monetary and fiscal discipline lower inflation
• Costs– No independent control over MS
– Prohibition of fiscal deficits over 3% limits automatic stabilization during recessions
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International Perspective: The Debate About the Euro