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Mankiw Precis
Chapter 13: The Macroeconomic Policy Debate
Should policy be active or passive?
Most economists believe that the economy is “unstable” in the sense that unless
monetary and fiscal policy are properly tuned, output and unemployment and
inflation will exhibit substantial and destructive fluctuations. The economy is
continually being bombarded by shocks to aggregate demand—to the location of
the IS curve and to the transmission mechanism that translates short-term safe
nominal into long-term risky real interest rates—and aggregate supply. Unless
these shocks are damped by the proper policies, they will be amplified by the
multiplier process and generate the fluctuations we call business cycles.
The consensus is that macroeconomic policy should “lean against the wind.”
When unemployment is relatively high, policy should be trying to make it lower.
When unemployment is relatively low, inflation is likely to be on the rise—and
policy should be aiming at contracting aggregate demand and reducing
inflationary pressures.
Other economists agree that appropriate monetary and fiscal policies can go a
long way toward reducing the magnitude of business-cycle fluctuations, but
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focus much more on the limits of stabilization policy.
The history of stabilization policy
The beliefs that the government has an important positive duty to try to stabilize
the macroeconomy is less than a century old. In the United States, the
Employment Act of 1946 serves as a tide-marker for the government’s accepting
responsibility for managing the state of the macroeconomy: to achieve “full
employment and production.”
Lags in implementation and effects
All economists agree that macroeconomic stabilization would be much easier if
policy had immediate effects on output, employment, and inflation. Simply
adjust policy—change the values of the “instruments” that the government
controls—to keep output, employment, and inflation at their desired levels.
But macroeconomic policies do not have immediate effects. Economic
policymakers face the problem of long and variable lags. And these long and
variable lags make it much more difficult to stabilize the economy using
monetary and fiscal policy.
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Economists divide up the lags in stabilization policy. First comes the recognition
lag—the time between when a problem that needs to be corrected by
macroeconomic policy develops, and when policymakers in the government
recognize the existence of the problem. Second comes the formulation lag—the
time it takes for the government to decide what to do and to take action. These
two lags together are sometimes called the inside lag, for they take place inside
the government.
Third comes the implementation lag—the time it takes for the policy to have its full
effect on the economy. This is also called the outside lag, because it takes place
outside the government.
Monetary policy has a substantial implementation lag. Even if the Federal
Reserve reacts immediately and appropriately to a shock to aggregate demand, it
will take about a year (or more) for the shift in Federal Reserve policy to affect
the level of production, and about two years for such a shift to affect the rate of
inflation. This holds true even though interest rates react immediately to Federal
Resrve policy announcements. The source of this substantial implementation lag
is that monetary policy works through the effect of interest rates on investment.
And investment spending is sluggish. Changes in interest rates have to have time
to affect the decisions made by firm investment committees. And decisions made
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by firm investment committees do not have immediate effects on where concrete
is poured and what machines are installed in new factories.
Yet the situation with monetary policy is more complex. Because the interest rate
that matters most in determining aggregate demand is the long-term interest
rate, and because the long-term interest rate is a weighted average of future
short-term interest rates, expected future monetary policy has powerful impacts on
the level of economic activity now. Confidence that the central bank will take
steps in the future to properly manage and stabilize the economy serves to
stabilize the economy now. Thus there is a sense in which the implementation
lag for monetary policy can be thought of as negative.
Discretionary fiscal policy works with even longer lags than does monetary
policy. It has an especially long set of inside lags. In the United States, legislated
changes in spending programs or in tax laws require not just approval by both
houses of Congress but also the signature of the President (or the overriding of a
Presidential veto). This legislative process requires years in order for action to
result. Thus fiscal policy—at least discretionary fiscal policy—is a very poor tool
in the United State for stabilizing the economy.
There is another kind of fiscal policy, however, that has next to no lag of any sort.
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The long and variable lags associated with
The difficult job of economic forecasting
[Example: Forecasting the 1990 recession]
[Example: Forecasting the Great Depression]
[Example: Forecasting the 1982 recession]
Rational expectations and the Lucas critique
Economic history and economic stabilization
[Example: Is the stabilization of the economy a figment of the data?]
[Example: The economy under Republicans and Democrats]
Rules or authorities?
Distrust of government and the process of politics
Time-inconsistency and macroeconomic policy
Rules for making stabilization policy
Rules for fiscal policy.
[Example: The debt-GDP ratio]
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Rules for monetary policy.
Central-bank independence.
Making policy in an uncertain world
Chapter 14: Recent Developments in the Theory
of Economic Fluctuations
Real business cycle theory
Fluctuations in technological prospects
Fluctuations in desired investment
Do these generate fluctuations in unemployment—or in real GDP per
worker?
Monetary neutrality?
Testing for monetary neutrality
Are wages and prices inflexible?
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New Keynesian economics
Menu costs and aggregate-demand externalities
Wage-price staggering
Coordination failures
Chapter 16: The Debates Over Government Debt
The standard view of government debt
Barrovian—or Ricardian—equivalence
The government budget constraint
Who cares about the timing of taxes?
How forward-looking are consumers?
Myopia
Liquidity constraints
[Example: George Bush’s witholding experiment]
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Which deficit?
Adjusting for inflation
Adjusting for investment
Adjusting for off-book liabilities
Adjusting for the state of the business cycle
Generational accounting
Chapter 18: Money Supply and Money Demand
Money supply
100%-reserve banking
Fractional reserve banking
A model of the money supply
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Epilogue
The Most Important Lessons of Macroeconomics
In the long run, a country’s productive capacity determines its citizens’
material well-being.
Material well-being.
The single best estimate of a country’s material well-being is its level of real GDP
per worker: its labor productivity. In the long run the level of real GDP will not
stay far away from the economy’s productive capacity: the level of potential
output. Thus if you want to improve citizens’ well-being in the long run, take
steps to boost the level of potential output per worker.
Potential output per worker depends on two things. First, it depends on the
economy’s capital-output ratio—equal to s/(n+g+), equal to the quotient of the
average savings rate and the sum of the labor force growth, productivity growth,
and depreciation rates. Second, it depends on the level of technology or total factor
productivity in the economy.
Thus if you want to boost potential output per worker, either boost the capitaloutput ratio or raise the level of the technology in use in the economy.
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Raising the capital-output ratio.
The capital-output ratio can be raised by policies that increase the savings rate—
national savings divided by GDP—or reduce the labor force growth rate.
(Policies that reduce the rate of growth of technology raise the capital-output ratio,
but do not increase potential output per worker; the rate of depreciation is much
more a “technical” than an “economic” factor and cannot be significantly
influenced by economic policy.) National savings can either be boosted by
policies—effective policies—to raise private savings by removing constraints that
kept people from saving before, or by policies that change how much the
government saves by reducing the government’s budget deficit or increasing the
government’s surplus. The population growth rate—a factor of much more
concern to poor than rich countries—can be reduced by increasing the degree to
which the government provides social insurance, by increasing female
educational levels, or by taking other steps that accelerate the so-called
demographic transition to relatively low levels of fertility, mortality, and
population growth.
Human capital
Human capital—the educational level and the skills of the labor force—falls in a
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conceptual halfway house between the capital intensity of the economy and the
level of technology.
Bettering technology.
Policies to increase technological progress…
Raising the rate of technological progress is the most important objective for
public policy: persistent growth in living standards does not continue without
technological progress. The worldwide slowdown in productivity growth that
began in the mid-1970s is the worst thing to have happened to the world
economy in the past century.
In the short run, aggregate demand determines production and
employment.
Aggregate Demand and Supply
Although in the long run output per worker depends on aggregate supply—the
level of potential output—in the short run output per worker depends on
aggregate demand.
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Our toolbox.
The IS-MP and Phillips curve framework developed in chapters xxx and yyy
serves as our toolbox to analyze the determinants of aggregate demand, and
calculation how shifts in private spending and changes in government economic
policy affect aggregate demand, and thus the level of output and unemployment.
In the long run, economic policy has a big influence on the rate of inflation
but only a small influence on the rate of unemployment.
Economic policy and unemployment.
In the long run, economic policy has only a small influence on the economy’s rate
of unemployment and on the so-called output gap—the difference between
potential output and the actual level of production of goods and services. Unless
the inflation rate either accelerates or decelerates substantially, the average level
of unemployment in an economy over any extended period of time will be close
to that economy’s natural rate of unemployment. This natural rate is not
independent of macroeconomic policy: changes in economic policy can raise or
lower the natural rate. But the natural rate is not very dependent on
macroeconomic policy. Anyone seeking to alter the average rate of
unemployment through government macroeconomic policy has set themselves a
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very difficult task.
Economic policy and inflation in the long run.
By contrast, economic policy has an enormous influence on the economy’s average
rate of inflation in the long run.
In the short run, economic policymakers face a tradeoff between inflation
and unemployment.
The Phillips curve.
In the short run there is a significant tradeoff between inflation and
unemployment: the Phillips curve. The government can use monetary and fiscal
policy to move down the Phillips curve, lowering inflation and raising
unemployment; or it can use monetary and fiscal policy to move up the Phillips
curve, lowering unemployment at the price of raising inflation.
The location of the Phillips curve.
The tradeoff between inflation and unemployment, however, is not fixed. Supply
shocks—like the sudden increases in oil prices in 1973 and 1979 or the sudden
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decrease in oil prices in 1986—change the terms of the short-run Phillips curve
tradeoff between inflation and unemployment. Changes in the natural rate of
unemploymetn alter the terms of the short-run Phillips curve tradeoff.
Inflation expectations.
Changes in expectations of inflation are the most important factor shifting the
Phillips curve. When expectations of inflation rise, the Phillips curve shifts up:
the same unemployment rate is associated with a higher inflation rate. When
expectations of inflation fall, the Phillips curve shifts down: the same
unemployment rate is associated with a lower inflation rate.
Moreover, the principal determinant of what expectations of inflation are is what
actual inflation has been. If past inflation has been low and stable, individuals in
the economy will hold static expectations and expected inflation will be low and
stable. If past inflation has shown significant variation but been persistent form
year to year, individuals will hold adaptive expectations and this year’s expected
inflation will be equal to last year’s actual inflation. If inflation in the past has
shown significant variation and if changes in economic policy affecting inflation
have been substantial and abrupt, then individuals will hold rational
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expectations—and expectations of inflation will shift in response to changes in
policies even before those changes in economic policies have been implemented.
These facts carry an important messsage for those who seek to use the Phillips
curve tradeoff to generate lower unemployment. There are strong limits to their
ability to do so—and too-aggressive a pursuit of low unemployment through
stimulating aggregate demand is likely, as in the U.S. in the 1970s, to lead not to
low unemployment but to high and stubbornly-persistent inflation.
The Most Important Unresolved Questions of Macroeconomics
What should be done to increase potential output?
What should be done to diminish the size of the business cycle?
Almost all economists believe that monetary and fiscal policies should be used to
diminish the size of business-cycle fluctuations in employment and output. They
disagree, however, over how important it is to reduce the size of such businesscycle fluctuations. And they disagree on what is an appropriate countercyclical
policy.
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How important are business cycles?
What is an “appropriate” countercyclical policy?
What and how large are the social costs of inflation?
When American inflation approached ten percent per year in the late 1970s, the
public viewed inflation as a major problem. Politicians, too, viewed inflation as a
major problem: presiding over high rates of inflation led them to loose elections.
However, when economists try to identify the social costs of inflation they
usually come up with relatively low numbers. Only the interaction of tax laws
with inflation seems to have the possibility of generating large social costs from
the levels of inflation that have been seen in the industrial core since 1950.
Some think that the public is confused about the costs of inflation…
Others think that the public has a right to dislike inflation…
Costs of reducing inflation: can credible disinflation reduce them?
Sacrifice ratio…
Hysteresis…
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How large a problem are government budget deficits?
George Bush regarded the federal government budget deficit as a serious
problem. He was even willing in 1990, the second year of his presidency, to break
his convention speech pledge—“read my lips! No new taxes!”—in order to
obtain a bipartisan agreement to reduce the deficit and impose procedural
constraints upon congress that greatly limited its ability to increase spending in
the future. In 1993, the first year of his presidency, Bill Clinton made reducing
the federal budget deficit a central goal of his administration. (However, after the
Republicans won control of the congress Clinton and the Republican leadership
agreed to slow down the speed with which the gap between spending and taxes
was to be reduced.) Today the federal government has a budget surplus. (It still,
however, faces long-term problems of funding the social insurance system: Social
Security and Medicare expenditures are both projected to vastly outrun their
financing sources over the next generation.)
How important an achievement was this elimination of the federal deficit? Most
economists see a budget deficit as a reduction in national savings, that leads in
the long run to a lower capital-output ratio and a poorer economy. The Reagan
deficits of 4% of GDP—if sustained indefinitely—would have reduced the long-
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run steady-state capital-output ratio by about 0.6, and reduced real GDP per
worker by about 10% (or $6,000 per worker at current levels of productivity).
Dangers of hyperinflation from deficits…
Still others… Reagan deficits as an unsuccessful strategic move…
Still others believe that the budget defricit is such a poor measure of fiscal policy
that using it does more harm than good. They call for “generational accounts”
instead…