Issues in monetary and fiscal policy
• In this lecture we will use our economic models
to study some important issues in the use of
monetary and fiscal policy.
• For monetary policy we will cover the issues of
time inconsistency of monetary policy, choice of
optimal inflation and RBA behaviour rules.
• For fiscal policy we will cover the issues of
government spending and government debt and
the Ricardian equivalence proposition.
Phillips Curve relation
• The Phillips Curve stated that there was a
relationship between current inflation and
current unemployment:
(π – πe) = -α (u – un)
• So that for every 1% that inflation exceeds
expected inflation, current unemployment will be
pushed 1/α below the natural rate of
unemployment.
• If α=0.33 in Australia, then the RBA can get 3%
lower unemployment by pushing current inflation
1% above expectations.
Time inconsistency
• The RBA (and implicitly the Australian
government) has a trade-off between current
inflation and current unemployment at a rate of 1
to 3.
• Most people might think that this trade-off is
worthwhile, as inflation has relatively invisible
social costs whereas the costs of unemployment
are quite plain to see.
• The temptation exists then for the RBA to always
try to push inflation above expected inflation.
Time inconsistency
• Let’s assume that the RBA announces an
inflation target of 2% for next year.
• Expected inflation then will be set at 2% by firms
and workers.
• However after this announcement, the RBA
knows it can choose to push inflation above 2%
and lower unemployment.
• Since the government prefers 3% lower
unemployment to 1% lower inflation, the
government will push inflation above the target
2%.
Time inconsistency
• This is the problem of “time inconsistency”. The
government can not be trusted to keep past
promises.
• No matter what, there is always a short-term
gain to be had by raising inflation by 1%.
• The real trade-off occurs in the long-run. Since
inflation expectations are persistent, a 1% rise in
inflation today typically leads to a 1% rise in
permanent inflation expectations.
Time inconsistency
• However since governments are typically only
concerned with winning the next election which
comes in 1-4 years, governments have very
short horizons. So short-run gains are
emphasized at the expense of long-run costs.
• We expect then that governments can not resist
the temptation to inflate, so people factor this
into their expectations, so expected inflation and
actual inflation are too high.
Optimal inflation rate
• Imagine we were to “choose” an inflation
rate for Australia. What would be the
optimal choice of inflation rate? Would it
be zero?
Optimal inflation rate
• A rational analysis of the inflation rate would say
that we should balance benefits of costs of
inflation until we find the “optimal” rate.
• Benefits of inflation:
– Inflation tax or seignorage- although this is very small
in developed countries
– Scope for monetary policy- since nominal interest
rates can not go below zero, the maximum that
nominal interest rates can fall to combat a recession
is real interest rates plus inflation. The lower is
inflation, the less room for monetary policy.
Benefits of inflation
• Benefits of inflation (continued):
– Money illusion- most workers resist a cut in
nominal wages, even though a 0% rise in
wages with 3% inflation is actually a cut in
wages identical to a 2% rise in wages when
inflation is 5%- so a positive inflation rate
allows firms to cut wages without workers
getting upset- a low positive rate of inflation
makes sense due to this rationale.
Costs of inflation
• Costs of inflation:
– Menu costs- these are the costs of rewriting contracts
and prices as inflation pushes all prices up
– Shoe-leather costs- these are the self-imposed costs
people face from trying to minimize their money
balances
– Redistribution from fixed incomes- people who own
assets that aren’t indexed to inflation suffer an income
loss from inflation (although this loss is redistributed
to the rest who owes the non-indexed debt)
Optimal inflation rate
• The costs that we have mentioned- menu, shoeleather and redistribution- are all very low at low
positive levels of inflation. Of the benefits,
seignorage is very low at low levels of inflation,
but monetary policy scope and avoiding money
illusion are high at low positive levels of inflation.
• The above calculation suggests that a low
positive rate of inflation is probably optimal for
most countries.
RBA behaviour
• We have generally used two models of RBA
behaviour in this class- fixed nominal money and
inflation targeting.
• Fixed nominal money supply assumed that the
RBA kept the nominal money supply constant.
• Inflation targeting assumed that the RBA sets
the cash rate so as to keep inflation equal to the
target rate of inflation.
• Most reserve banks in developed countries have
shifted from a fixed money supply rule to an
inflation target rule.
RBA behaviour
• John Taylor, in a very influential paper,
suggested another rule that reserve banks could
follow- the Taylor rule:
it = in + a (πt - πT) – b (ut – un)
• Where in the medium-run, the bank aims for πt =
πT and it = in = rn + πT.
• So if inflation is above the target rate, the RBA
will raise interest rates. If unemployment is
above the natural rate, the RBA will lower
interest rates.
RBA behaviour
• The factors a and b then tell us how important
excess inflation and excess unemployment are
in RBA calculations.
• If b is zero, then we have a bank that purely
targets inflation, so the inflation-targeting RBA is
also following a form of the Taylor rule.
• We could then look at the evolution of i, u, and π
over time to try to estimate what a and b are for
different reserve banks.
Government debt
• One problem that economic commentators
always point to is the level of government debt“Our debt is too high.”
• How do we evaluate the level of government
debt? How do we know is it is “too high”.
• Government debt is like any other form of debt.
You evaluate the debt relative to the
income/wealth of the person incurring the debt.
• A $500,000 debt might be high to you and me,
but it might mean nothing to Kerry Packer.
Government debt
• So we need to evaluate government debt
relative to “government income”. But what
is the appropriate form of “government
income”, as the government doesn’t earn
or produce anything.
• Generally we use the income of the
country as the comparison, since the
government is free to tax or claim any part
of GDP.
Government debt
• So our criterion for “too much” is debt (Bt, since
typically government debt is issued in
government bonds) over GDP (Yt):
Bt / Yt
• Banks would make much the same calculation
when considering whether to issue someone a
home loan.
• In general debt is growing at the rate of interest
each year, r, while GDP is growing at the growth
rate of the economy, g.
Government debt
• As long as g > r, then debt is shrinking relative to
income, so debt is becoming less important.
• But each year, government might be creating
new debt if Gt – Tt < 0, so we might also be
worried about:
(Gt – Tt )/ Yt
• So deciding whether we have too much debt is
not a simple matter, much as whether $0.5m is
“too much debt” for a person.
Country
Australia
United States
European Union
Japan
OECD
Net Debt/GDP (%)
1985 1995 2000
15.0 23.5 9.7
41.9 58.9 43.0
34.1 53.8 48.0
69.7 24.8 58.6
41.4 48.8 44.1
2003
2.9
47.1
49.4
80.2
48.7
Primary Surplus/GDP (%)
2000 2003
2.4 1.7
4.1 -2.7
4.1 0.6
-6.1 -6.3
.
2.6 -1.5
Government debt
• Another point to consider about government
debt is that it is not like a bond issued by a
company, there is no asset behind the bond.
• Government debt is a promise to pay someone
an amount in the future, backed entirely by the
taxation power of the government.
• Higher debt then is just a transfer from future
taxpayers to people who hold bonds. If both
people are Australians, government debt is just
a transfer from one Australian to another.
Ricardian equivalence
• Ricardian equivalence takes this thinking one
step further.
• Suppose the government raises $1 in taxes
today versus the government raises $1 in bonds
today.
• In the tax case, taxpayers are $1 worse off.
• In the bond case, taxpayers know they have to
repay the bond in one year’s time with increased
taxes.
Ricardian equivalence
• How much will the taxpayers have to put aside
today to pay the extra $1 in government debt?
• If government debt has a real interest rate of r,
and people earn a real interest rate of r on
investments, then taxpayers will have to put
aside $1 today to pay for the extra future taxes.
• In this case, $1 in new taxes and $1 in new debt
are identical to the taxpayers. This is called
“Ricardian equivalence.”