Mankiw: Macroeconomics
Main Points of Chapter 14
1.
This chapter deals with issues in macroeconomic stabilization policy. "Stabilization policy" involves
using fiscal policy (changes in T or G) or monetary policy (changes in M) to shift the AD curve trying
to reduce fluctuations in output (Y).
2.
If private sector forces are shifting the AD curve to the right so that the economy moves to the right of
the LRAS curve, the (theoretically) correct policy response is to shift AD back to the left -- or even
keep it from shifting in the first place. This prevents the price level from rising, as would be necessary
to move the economy back to long-run equilibrium.
3.
If private sector forces are shifting the AD curve to the left so that the economy moves to the left of the
LRAS curve, the (theoretically) correct policy response is to shift the AD back to the right -- or even
keep it from shifting in the first place. This prevents output from falling (in the short-run) and the
price level from falling in the long-run.
4.
Thus, ideally, stabilization policy will make the AD curve more stable, and hence output more stable.
The goal of stabilization policy is to offset fluctuations in AD that originate in the private sector.
5.
This ideal stabilization policy may be more difficult to implement in theory rather than in practice.
There are time lags in the recognition that a policy is necessary (inside lag) and in implementing a
policy once the need is recognized (outside lag). There are uncertainties as to how much the AD curve
will shift with any given policy and the length of time it will take for the shift to occur.
6.
Some economists believe that because of the uncertainties outlined in #5 above, attempts to stabilize
the economy can actually do more harm than good. Other economists think that stabilization policies,
while not perfect, do more good than harm. The proper role of stabilization policy efforts is therefore
an unresolved issue in macroeconomics.
7.
A related issue is the rules versus discretion debate. Some economists believe that policymakers need
to be able to follow any policy they think necessary -- i.e., they need to have discretion. Other
economists think that policy is best made by following a rule. While the rule limits the ability of the
policymaker to respond to some circumstances in the best possible way, it also limits the damage they
can do with bad policies.
8.
One example of a fiscal policy rule is a constitutional amendment calling for federal government
receipts to match outlays -- a "balanced budget amendment." The advantage of this rule is that it
would prevent the government from running deficits, which would raise national saving on average
and therefore lead to higher values of k* and y*. The disadvantage is that it might make the business
cycle worse. If the economy falls into recession, for example, incomes go down and tax revenues fall.
This would make the federal government run a deficit, which would require either a rise in T or a fall
in G -- either one of which would cause a further leftward shift in AD, worsening the recession.
9.
Possible monetary policy rules include a constant money growth rule, a gold standard, and a fixed
exchange rate system.
10. A constant money growth rule makes the money supply grow at a constant rate -- 3% per year,
perhaps. The advantage of this rule is that it prevents the central bank from expanding the money
supply rapidly and thereby causing inflation. The disadvantage is that the central bank cannot respond
to offset changes in AD arising from other sources. An exogenous rise in money demand, for example,
would decrease AD and cause Y to fall. The central bank could prevent this without causing inflation
by increasing the money supply at a faster rate for a while, but the rule would not let them.
11. A gold standard fixes the nominal price of gold. The central bank stands ready to buy or sell gold in
unlimited amounts at the fixed price. The advantage is that it prevents inflation. If the central bank
begins to increase the money supply rapidly, the price level will begin to rise. Most prices in the
economy will rise, and there will therefore be upward pressure on the market price of gold. The fixed
price charged for gold by the central bank will look like a better and better deal, so people will start
buying gold from the central bank. When they do that, money goes out of circulation and the money
supply falls, reversing the inflation. (In effect, the central bank makes an open market sale of gold.)
One disadvantage of a gold standard is (as with a constant money growth rule) that the central bank
cannot respond to offset changes in AD arising from other sources. Another disadvantage is that it
links monetary policy to gold market conditions. If there is a major gold discovery, for example, this
will cause overall inflation. The rise in gold supply will put downward pressure on the gold price.
This will make people sell gold to the central bank, which pays for the gold by increasing the money
supply. The increased money supply causes inflation.
12. A fixed exchange rate system fixes the exchange rate between the home country currency and another
currency. The advantage of this system is that the central bank cannot print money excessively, so it
prevents high and sustained inflation. If a central bank starts printing its money rapidly, it will become
less scarce relative to the other money. This reduced scarcity will put downward pressure on the
exchange rate. To prevent the exchange rate from falling, the central bank will have to buy its own
currency back, in effect taking it out of circulation and "undoing" the original money supply increase.
The major disadvantage of a fixed exchange rate is that sometimes the policy required to keep the
exchange rate fixed is not the policy that is best for the domestic economy. If a country's currency is
losing value during a recession for example, the exchange rate policy implies the central bank should
tighten policy (reduce M to make it more scarce and hence increase its value), while the recession
implies that the central bank should ease policy (increase M to increase AD and raise Y).