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
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Chapter Equations
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Chapter Equations
r FF  r FF *  a  p  p *  bYˆ
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(14.1)
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