Chapter 23 Should Policy Makers Be Restrained? • • Given the uncertainties about the effects of macroeconomic policies, would it be better not to use policy at all? Can we trust policy makers to carry out the right policy? Should Policy Makers Be Restrained? Arguments for and against restraints on policy Arguments for restraints on policy 1. Policy makers may have good intentions, but they end up doing more harm than good. 2. Policy makers do what is best for themselves, which is not necessarily what is best for the country. The argument against a rigid policy rule • It is not possible to write a policy rule that covers all possible circumstances. Copyright © 2015 Pearson Canada Inc. 23-1 Should Policy Makers Be Restrained? 23-1 | Uncertainty and Policy How Much Do Macroeconomists Actually Know? Consider an economy with high unemployment. Central bank is considering the use of monetary policy to increase economic activity. • • • • Is the current high rate of unemployment a sign that unemployment is above the natural rate or a sign that the natural rate has increased? By how much will the change in money supply decrease the shortterm interest rate? How long will it take for lower long-term interest rates and higher stock prices to affect investment and consumption spending? How will the proposed policy affect expectations of future output and future interest rates? Copyright © 2015 Pearson Canada Inc. 23-2 Should Policy Makers Be Restrained? 23-1 | Uncertainty and Policy Copyright © 2015 Pearson Canada Inc. 23-3 Should Policy Makers Be Restrained? 23-1 | Uncertainty and Policy Should Uncertainty Lead Policy Makers to Do Less? A Scenario: The economy is in a recession What the Bank of Canada knows: • • • • Without changes in monetary policy, unemployment will still be 10.0% next year. The natural rate of unemployment is 8.0%. Okun’s law: 1% more output growth for a year leads to a reduction in the unemployment rate of 0.4%. If it could achieve 5% more output growth over the coming year, the unemployment rate would go down to its natural rate of 8.0%. ο By how much should the Bank of Canada reduce the interest rate? Copyright © 2015 Pearson Canada Inc. 23-4 Should Policy Makers Be Restrained? 23-1 | Uncertainty and Policy Average Response to the Models: • • • A decrease in interest rates of 1% point should increase GDP by 0.4% points. To return the unemployment rate to its natural rate in one year requires 5% more output growth. To increase real GDP growth by the required 5% requires a initial 12.5% reduction in the nominal interest rate. Copyright © 2015 Pearson Canada Inc. 23-5 Should Policy Makers Be Restrained? 23-1 | Uncertainty and Policy • The proposed policy is an enormous reduction in the short-term interest rate. • Short-term interest rates are between 0 and 2% in many countries, including Canada. • Large reductions in the nominal interest rate would hit the zero lower bound on nominal interest rates (liquidity trap). ο Uncertainty reduces the size of policy actions. ο Policy makers should be more cautious. Copyright © 2015 Pearson Canada Inc. 23-6 Should Policy Makers Be Restrained? 23-2 | Expectations and Policy • Macroeconomic policy: a game (strategic interactions) between players. • Policy makers and “the economy”. • What people and firms do depends on what they expect policy makers to do. • What policy makers do depends on what is happening in the economy. Copyright © 2015 Pearson Canada Inc. 23-7 Should Policy Makers Be Restrained? 23-2 | Expectations and Policy Hostage Takings and Negotiations • Should governments discontinue their stated policy of “no negotiation” with plane hijackers? Copyright © 2015 Pearson Canada Inc. 23-8 Should Policy Makers Be Restrained? 23-2 | Expectations and Policy Inflation and Unemployment Revisited Recall the relation between inflation and unemployment π = π π − πΆ π − ππ Suppose the Bank of Canada announces it will follow a monetary policy consistent with zero inflation. • Wage setters believe the announcement: π π = π. The Bank of Canada faces the following relation π = −πΆ π − ππ Copyright © 2015 Pearson Canada Inc. 23-9 Should Policy Makers Be Restrained? 23-2 | Expectations and Policy π = −πΆ π − ππ ο If the Bank of Canada follows its announced policy of zero inflation, π = π π = π, and π − ππ = 0. ο Bank of Canada can actually do even better. • By accepting just 1% inflation (and α=2.5), the Bank of Canada can achieve an unemployment rate of 0.4% point below un. • The time inconsistency of optimal policy. Copyright © 2015 Pearson Canada Inc. 23-10 Should Policy Makers Be Restrained? 23-2 | Expectations and Policy • Wage setters will notice that the Bank of Canada has increased money by more than it announced. • “The economy” will expect positive inflation of 1%. • If the BofC still wants to achieve an unemployment rate 0.4% point below the natural rate, it now has to accept π = 2%. ο Attempts by the Bank of Canada to make things better lead to things being worse. ο The economy ends up with the same unemployment rate as would have prevailed if the Bank of Canada had followed its announced policy, but with much higher inflation . Copyright © 2015 Pearson Canada Inc. 23-11 Should Policy Makers Be Restrained? 23-2 | Expectations and Policy Establishing Credibility 1. Make the central bank independent. • Appointing central bankers for longer terms will make them more likely to resist political pressure. 2. Choose a “conservative” central banker. • somebody who dislikes inflation and is unwilling to accept more inflation in exchange for less unemployment. 3. Make central banks more “transparent.” • Reveal to the public as much as possible concerning the information that the central bank uses to make its decisions and the process by which the decisions are made. Copyright © 2015 Pearson Canada Inc. 23-12 Should Policy Makers Be Restrained? 23-2 | Expectations and Policy Copyright © 2015 Pearson Canada Inc. 23-13 Should Policy Makers Be Restrained? 23-2 | Expectations and Policy Copyright © 2015 Pearson Canada Inc. 23-14 Should Policy Makers Be Restrained? 23-3 | Politics and Policy Games between Policy Makers and Voters • Tax cuts • Trade-off: growth today and deficits tomorrow. • Short versus Longsighted voters • Political business cycle Copyright © 2015 Pearson Canada Inc. 23-15 Should Policy Makers Be Restrained? 23-3 | Politics and Policy Some Evidence ο Ratio of Debt to GDP ο Debt buildup associated with Depression and World War II ο Debt/GDP fell from over 140% in 1949 to 31% in 1976 ο Debt/GDP rose from 1976 to 1996 ο Debt/GDP has fallen since 1996 ο 2009 recession and the following years of large deficits, the debt-to-GDP ratio began to rise again. Copyright © 2015 Pearson Canada Inc. 23-16 Should Policy Makers Be Restrained? 23-3 | Politics and Policy Copyright © 2015 Pearson Canada Inc. 23-17 Should Policy Makers Be Restrained? 23-3 | Politics and Policy Games between Policy Makers Budget deficit reduction in Canada. • When first elected, the Conservative government of Brian Mulroney had a clear mandate to reduce the deficit. It did not succeed. • Some of its failure: normal electoral and political process. • Wars of attrition. • Some Conservatives wanted less government spending. Others did not. • The hope that the other side will give in leads to long and often costly delays. Copyright © 2015 Pearson Canada Inc. 23-18 Should Policy Makers Be Restrained? 23-3 | Politics and Policy Back to a Balanced-Budget Law The Case Against: ο It would eliminate the use of fiscal policy ο Deficit reduction can be achieved without the constraints of a balanced budget law The Case For: ο Macro policy is not effective ο Micro perspective: A new spending program should be accompanied by a discussion on funding it. Copyright © 2015 Pearson Canada Inc. 23-19 Should Policy Makers Be Restrained? Summary • Uncertainty about the effects of macroeconomic policies should lead policy makers to be more cautious, use less active policies. • Using macroeconomic policy to control the economy is fundamentally different from controlling a machine. • Macroeconomic policy can be thought of as a game between policy makers and the economy. • By credibly committing to not using monetary policy to decrease unemployment below its natural rate, a central bank can alleviate fears that money growth will be high and, in the process, decrease both expected and actual inflation. Copyright © 2015 Pearson Canada Inc. 23-20 Should Policy Makers Be Restrained? Summary • Policy makers may play games either with the public or among themselves, leading to undesirable outcomes. • The evidence is that balanced-budget laws are ineffective and easily sidestepped in practice. Copyright © 2015 Pearson Canada Inc. 23-21
