Chapters 19 and 20. Stabilization
policy: Why and How?
ECON320
Prof Mike Kennedy
Why stabilization?1
• To understand the need for stabilization policy we have to know the
social costs or welfare losses associated with fluctuations in inflation
and unemployment
• The case for stabilization rest on the hypothesis that the public is averse
to fluctuations in their consumption, employment and in inflation
• Since employment and consumption move with GDP we can write out a
formal Social Loss function as
• The equation says that society’s welfare loss from macroeconomic
instability increases with the variances of output and inflation from
their equilibrium levels
1
Note for Chap 19, you are responsible for pp 556-57 and pp 584-585, the
summary
Stabilisation policy: Why? con’t
• Issues raised are:
– Why variability and not average values of y and π?
– What determines the weights ay and aπ?
– Should output be stabilised around its natural level
regardless of the shock?
– What is the appropriate target for π?
– What are the properties of an optimal policy rule if
policy makers want to minimise the social loss
function (SL)?
Stabilisation policy:
The general conclusions of the literature
• Market imperfection prevent people from insuring themselves
against unanticipated income losses from unemployment
• The average level of welfare could be increased if employment
were stabilised around its natural level
• Empirical evidence suggests that the welfare losses of recessions
are large and are borne disproportionately by low-paid and lowskilled workers
• While it is efficient to stabilise output around its potential level
when there are demand shocks, it is not when there are supply
shocks, distinguishing between the two is difficult at best
• High and volatile output and inflation create a number of welfare
losses, due in large part to nominal rigidities and tax distortions
• The other goal of policy then is to stabilise inflation around a
target level which should be low but not zero
Stabilisation policy: How?
• We know that fluctuations cause welfare losses, making a
case for stabilisation policy
• But, is the economy really too complex to manage?
– This is the case for having a policy rule like that suggested by
Friedman (fixed money growth rate) and later Taylor (focussing on
an inflation target but allowing for output changes)
• Rules may help to establish credibility for policy makers
• The case for discretion says that the policy maker should
have leeway to react to the situation as it develops
• In general most economists favour rules
• In practice, policy makers use lots of discretion, sometimes
with poor results as we will see at the end
Optimal monetary policy with limited
information: Inflation targeting
• Assume that the central bank cannot observe the shocks but
it does know the output and inflation gaps
• Also assume that the central bank does not target an output
level above potential – it cares only about the inflation gap
• Since it cannot observe the shocks or their source the bank
assumes that these shocks take their expected values of zero
• The social loss function is that shown on slide 2
• The Marginal Social Loss wrt each gap is
 l yˆ
ˆ
MSLy 
and MSL   
1 
Inflation targeting
• Also assume that inflation expectations are static π = π-1
• With static inflation expectations, we need to take account of the fact
that a change in today’s output and inflation gaps will effect all future
output gaps according to (see Chap 18):
• Assuming a positive social rate of discount, call it ϕ, the discounted
values of all future marginal gains/losses for each are:
Inflation targeting: The optimal Monetary Policy Rule
• From the SRAS curve we have
• Assuming as we must that the forecast of the shocks (s) are zero then
• Next set the (discounted) marginal gains from an increase in the output
gap to the (discounted losses) from an increase in the inflation gap
equal to each other
MPR curve
Inflation targeting: The MPR curve and the policy rule
• Next, write the AD curve in terms of the policy interest rate (ip)
ˆ  r *) 
yˆ  1gˆ  v   2 (i p    
i  r * 
p
1
2
yˆ
ˆ 0
• Where we have assumed that gˆ, v, 
• Now use the MPR curve to eliminate the output gap and we get

• We now get a policy rule in terms of only the inflation gap.
• Note that the concern about the output gap (output and
employment) does enter the rule through the coefficient  l
– The higher is this coefficient, the smaller the weight on the inflation gap
The MPR and the AD curves
• The above is the theoretical underpinnings of inflation targeting
• The general expression for goods market equilibrium is given by
• If we insert the optimum policy rule into this expression we get
the AD curve
• Comparing this to the MPR
we see they are the
same when z = 0
• This shouldn’t be a surprise since inflation targeting is designed
to ensure a socially optimal trade off
A temporary unfavourable supply shock
with optimal policy response
A temporary unfavourable supply shock
with optimal policy response: The details
• In the first period the economy is hit with a negative supply
shock (s > 0) causing the SRAS to shift upwards
• At the new equilibrium, there is a negative output gap and
higher inflation
• In the next period, the shock disappears but the SRAS curve
only shifts down to E2 as inflation expectations are based on
last period’s level of inflation (π-1)
• This yields a new and lower level of π and the SRAS curve
keeps shifting back towards equilibrium
• Since there are no demand shocks, the AD curve remains
unchanged and equal to the MPR curve
A temporary negative demand shock
A temporary negative demand shock: The
details
• The shock (z < 0) pushes the AD curve off the MPR
curve causing inflation to fall below target
• In the next period, the shock disappears and AD is
again equal to MPR but, because inflation
expectations are static the SRAS curve has shifted
• With inflation in period 2 still below target, the
central bank keeps interest rates below their
equilibrium and the economy moves back towards
equilibrium
• As before there is a cycle in output
Time paths of the two shocks
The Taylor rule with inside and outside lags
• Some definitions
– Inside lag, the time it takes to recognize the shock (recognition
lag) and then the time to implement the policy response
(implementation lag)
– Outside lag, the time it takes for policy actions to have an effect
on the economy
• The outside lag is rooted in the structure of the economy
– the delays in responding to policy actions
• For most economies to takes about two years for a change
in interest rates to have the maximum effect on inflation
• To the extent possible, the central bank and/or the
government must take account of these lags in designing
policy responses
Taylor rule when there are lags in the response
of the economy to policy actions
• Suppose we have the following
– The AD curve, assuming it takes 1 year for a change in the policy rate
to affect y
– The SRAS curve, assuming it takes an additional year for output to
affect inflation
• Noting the

 t1   t   (yt  y)  st1 then:

Taylor rule when there are lags con’t
• In its forecast, the central bank cannot know the future shocks (s)
so they are set equal to zero
• The forecast for inflation two periods ahead based on information
today (πet+2,t) is
e
 t2,t
  t   (yt  y )  2 (itp   t r *)
• The bank now chooses the policy rate (ip) so as to achieve its target
(πet+2,t = π*)
• In the end, the central bank targets its forecast of inflation and this
yields the following
• This looks remarkably like the Taylor rule
• Note that monetary policy now reacts to the current output gap
since the gap contains information regarding the future price level –
its part of the forecast
Has using something like a Taylor been
successful?
• From 1960 to 1979 policy makers in both Canada and the
US tended to respond slowly to inflation (h < 0)
• This was a period of both rising inflation as well as more
volatile GDP (see next two slides)
• This changed starting in the 1980s first with Paul Volcker
(US) and in Canada with Gerald Bouey and John Crow
• Once the transition to low inflation was made and
general inflation targeting adopted (implicitly in the US)
GDP, and with it the output gap, became less volatile
Keeping inflation low has not come at the expense of
more GDP volatility, which has declined in the US …
… and in Canada
The recent world wide financial crisis
• Prior to the financial crisis, the US Fed departed from the
Taylor, due in good part to fears about deflation
• The next slides shows the actual US policy interest rate (Fed
funds rate) and that implied by the Taylor rule
• Actual interest rates were far below what would have been
suggested by that rule
• As slide 24 shows, these low interest rates seem to be linked
to the housing boom, driving up US housing starts
– Housing starts would have been much lower if interest rates had been
higher
• There is also evidence, provided in an OECD Working Paper,
that interest rates below what would be suggested by the
Taylor rule contributed to rising housing investment in OECD
countries in general (slide 25)
The Taylor rule versus actual US monetary
policy leading up to the crisis
Actual and estimated US housing starts
A look at other countries
Fiscal policy
• The AD curve already allows for the effect of changes in
government spending
• We now need to modify that curve to allow for tax changes
• From the above we see that an interest rate change equal to
α1/α2 percentage points would have the same effect on the
economy as a one per cent change in g
Fiscal versus monetary policy
• If the government and the central bank have the same
information the question becomes: who should be
responsible for stabilisation?
• Each has the same recognition lag but monetary policy
has a shorter implementation lag
– There is no need to go through the political process
• That said, the outside lag for fiscal policy is shorter –
changes in spending and taxes have immediate effects on
the economy
• Tax changes require a little more analysis since they will
have an effect on aggregate supply (SRAS) through its
effect on pre-tax wage claims
Modifying the SRAS for tax changes
• If the union bargains for after-tax wages (and denoting bu is the
after-tax unemployment benefits), then the wage setting equation
becomes
W(1  )  P m b  W  P m b  0 m
e
w
• The SRAS is now
u
e
wn
u
wn
mw

1 

• A temporary tax cut driving τ below its trend value will act like a
favourable supply shock
• The figure on the following slide illustrates the effect of a
temporary tax cut, where the economy is assumed to be in
recession at point E0
• In this case, fiscal policy shifts both the AD and SRAS curves,
something that monetary policy cannot do
The effect of a temporary tax cut
The effect of a temporary tax cut
• The tax cut will shift the aggregate demand curve
• But it also shift the supply curve as more work is
supplied – it acts as a temporary favourable
supply shock
• The effect on inflation is ambiguous
• The government’s budget balance will fall and
debt rise
• There could be Ricardian effects
Summing up fiscal versus monetary policy
• While government spending has important supply side effects,
these work over the long run
– In the short run, the effects are felt mainly through aggregate demand
• To that extent, these policies cannot achieve anything that could not
be achieved by monetary policy acting alone
• Tax changes, however, can have important effects on both AD and
SRAS
• That said, the implementation lag tends to be long (and sometimes
painful – witness the US debt on stimulus during the crisis)
• For this reason, many economists conclude that short-run
stabilisation should be left to central banks – in normal
circumstances!
• An important exception is when interest rates hit the “zero bound”
and monetary policy becomes impotent – the “liquidity trap”
In the wake of the great recession, many countries
pushed interest rates close to the zero bound …
Short-term interest rates
9
The Great
Recession
8
7
6
AUS
CAN
5
EUR
4
JAP
3
KOR
2
GBR
USA
1
0
-1
Dec-97
Dec-98
Dec-99
Dec-00
Dec-01
Dec-02
Dec-03
Dec-04
Dec-05
Dec-06
Dec-07
Dec-08
Dec-09
… with a great many of them still there,
suggesting a role for fiscal policy
Fiscal policy when interest rates are at zero
• From the previous two slides we see that the liquidity trap is back
• When the economy is at the zero lower bound, the AD curve
becomes:
• Note that AD is now upward sloping!
  
   1  
( y  y )  s,
1  
m p  m W  ln* B/ B )
1  
where s  ln  p  ln  W 
 ln 

1 
m  m  1 
• The SRAS remains unchanged
The dynamics of fiscal expansion when ip = 0
• The initial equilibrium is E0 where the economy is in a liquidity
trap (see figure next slide)
• A fiscal expansion shifts the AD curve to the right (and down)
where it intersects the SRAS at E1 a new short-run equilibrium
• Both output and inflation have increased (an unusual result!)
• The rise in output has driven up MCs, which raises π
• With the policy rate stuck at zero, real interest rates fall, and this
boosts demand
• To satisfy the increased demand, output increases from E1’ to E1
• With static inflation expectations, the SRAS curve will shift
upwards, triggering further drops in the real interest rate due to
rising inflation
• Eventually the original slope of the AD curve will be restored
Fiscal policy in a liquidity trap
Has fiscal policy been stabilising?
• Active fiscal policy was no doubt responsible for lessening the
economic effects of the financial crisis of 2008-09
• But has fiscal policy been actively counter cyclical over long periods
of time?
• We can test this proposition by examining the structural budget
balance, which is defined as
• Variables with bars are structural measures which are measured as
follows
Has fiscal policy been stabilising?
• The OECD has estimated the elasticities in the last two
equations on the previous slide
• Based on this information Fatas and Mihov (2009) have
estimated the following
• The idea is that the coefficient a1 should be negative and
significant if governments are pursuing active counter-cyclical
policy
• The results, shown in Table 20.1, suggest that the answer is no,
with the US and the UK being important exceptions
• This is the reason why economists are sceptical about using fiscal
policy for counter cyclical reasons