Monetary
and Fiscal Policy-makers
should try to Stabilize the Economy.
Monetary Policy should be made by
an Independent Central Bank.
The Central Bank should aim for
Zero Inflation.
The Government should Reduce its
Debt.
The Tax Laws should be Reformed
to Encourage Saving.
CH 17
EXAM
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Same format as December
Monday April 18---9AM---Field House
This week-chapter 17
Last class Tuesday April 5—Review
+discuss exam
• Office hours after term ends:
• April 11: 3-4:30 and
• April 13 and April 14 from 9:30-11
US housing-spending down
Monetary and Fiscal Policy-makers
should try to Stabilize the Economy: PRO
• The economy is inherently unstable,
and if left unchecked, the economy
will go through long and frequent
periods of recession and high
unemployment.
• With careful timing and proper
actions, policy-makers can use
monetary and fiscal stimulation to
prevent recessions or at least
minimize their severity.
Monetary and Fiscal Policy-makers
should try to Stabilize the Economy: PRO
• There is no reason for society to
suffer through the booms and
busts of the business cycle.
• Monetary and fiscal policy can
stabilize aggregate demand
and, thereby, production and
employment.
Monetary and Fiscal Policy- CON
• Discretionary monetary policy affects the
economy with long and unpredictable
(variable) lags between the “need to act”
and the time that it takes for these policies
to exert an influence of output and
employment.
• Many studies indicate that changes in
monetary policy have little effect on
aggregate demand until about six months
after the change is made.
Monetary and Fiscal Policy-makers
should try to Stabilize the Economy: CON
• Fiscal policy works with a lag
because of the long political process
to change spending and taxes.
• All too often these policy initiatives
can aggravate rather than reduce
the ups and downs of the economy.
• It might be desirable if policy makers
could eliminate all economic
fluctuations, but this is not a
realistic goal.
• Instead provide stable environment.
Policy question
• Would you be more likely to
support active stabilization
policy if wages, prices, and
expectations adjust quickly in
response to economic changes,
or if they adjust slowly?
Refers to AD and AS
adjustments
If wages, prices, and expectations
adjust slowly, it will take longer for
the economy to return to its natural
rates of output and employment.
In that case, there’s a better chance
that expansionary policy will act in
time to alleviate the recession,
rather than push the economy into
an inflationary boom.
Expectations Adjust
From SRAS, Y deviates from YN
when P deviates from PE.
•
Y = YN +a(P-PE)
YN =Natural rate of output
P is actual price level
PE is expected price level
Related to SRPC
US CBO estimate
GREAT DEPRESSION
1929-1933
• Real GDP declined 30%
• Urate increased from 2.9% to
>20%
• Almost no 2 income families
• K causes: Uncertainty, C, I (AD)
decline
• M causes –bad mp—MS down
• Global: international tariff war.
Monetary Policy Should Be Made
By An Independent Central Bank:
PRO
• To the extent politicians influence
monetary policy, economic
fluctuations may come to reflect the
electoral calendar - political
business cycle.
• That is, politicians may be tempted
to use monetary policy to affect
election results. (SR vs LR
objectives).
PRO Independence
• There is a time inconsistency of
policy - the discrepancy between
what policy-makers say they will do
what they subsequently in fact do.
• This may make people sceptical
about inflation policy—slows
adjustment of PE to P.
• Independent BOC has less incentive
tio do this.
PRO
• Keep monetary policy
independent of politics.
• Evidence across countries
suggests that countries with
the most independent central
banks have the lowest inflation
rates.
Monetary Policy Should Be
Made By An Independent
Central Bank: CON
• Empowering central banks with
complete independence in
conducting monetary policy is a
problem since it does not limit
incompetence and abuse of power.
• Changes in aggregate demand
translate into changes in
employment and income, so
someone should be accountable for
monetary policy changes.
Monetary Policy Should Be
Made By An Independent
Central Bank: CON
• Despite clear and forceful
statements by the B of C, it is not
obvious that enhancing the
credibility of inflation targets has
resulted in reducing the short-run
cost of achieving lower inflation.
• Elected policy-makers might find
fiscal policy more useful than
monetary policy when trying to
influence votes.
Independent bank : CON
• Elected officials are more
accountable.
• The practical importance of
time inconsistency has not been
shown.
• Question is how much
independence.
Bank of Canada
• How independent??
• US Fed is similar.
• Current bank-related issues in
US have drawn Fed (Bernanke)
more into the political system.
• Usual central bank goal is price
stability.
Obsessing?
Previously quite stable
The Central Bank Should Aim
for Zero Inflation: PRO
• Inflation confers no benefit to society, but
it does impose several social costs.
• If “inflation is bad”, why not 0?
• Reducing inflation is a policy with
temporary costs and permanent benefits.
Once the disinflationary recession is over,
the benefits of zero inflation would persist.
The Costs of Inflation
• At least six costs of inflation
are identified as:
1
2
3
4
5
6
. Shoeleather costs
. Menu Costs
. Increased variability of relative
prices
. Tax liabilities
. Confusion and inconvenience
. Arbitrary redistribution of wealth
Aim for Zero Inflation: NO
• Zero inflation is probably unattainable and
getting there involves output and
unemployment costs that are too high.
• The stimulative effect of a little inflation is
necessary to keep unemployment
reasonably low.
• The imperfections of measuring price
levels result in uncertainty about
measuring the successful attainment of
zero inflation.
INFLATION COSTS
• Not all inflations are the same.
• Little inflation becomes
hyperinflation only with political
instability.
• 5% inflation>>>P doubles in 14
years.
• Inflation variability more costly:
• 3% per year for five years (15
total) versus 5,0,5,0,5 (15 total)
Measuring inflation ch 6
• CPI—fixed market basket:3 biases
• Substitution bias—buy less of things
that go up more in price but basket
is fixed.
• New products-greater utility from
variety
• Unmeasured quality change—real
price lower. Computing power
Government Debt Should Be
Reduced: PRO
• Budget deficits impose an unjustifiable
burden on future generations by raising
their taxes and lowering their incomes.
• When the debts and accumulated interest
come due, future taxpayers will face a
difficult choice:
• They can pay higher taxes, enjoy less
government spending or both.
The Government Should
Balance Its Budget: PRO
• By shifting the cost of current
government benefits to future
generations, there is a bias toward
too large a public sector.
• Deficits reduce national saving,
thereby retarding capital formation,
causing lower productivity, and
limiting real growth.
• Series of deficits leads to debt.
Budget deficit reduces S
The Government Should
Balance Its Budget: CON
• The deficit is only one small part of
fiscal policy. The problem with the
deficit and debt is often
exaggerated.
• Intergenerational transfers may be
justified and some government
purchases produce benefits well into
the future (i.e. reducing budget
deficit by cutting spending on
education).
The Government Should
Balance Its Budget: CON
• A balanced budget requirement
would limit the policy options
available to deal with emergencies
and future economic crises.
• The government debt can continue
to rise. Population growth and
technological progress increase the
nation’s ability to pay the interest on
the debt.
Key is debt/GDP
The Tax Laws Should Be
Reformed To Encourage
Saving
A nation’s productive capability is
determined largely by how
much it saves and invests for
the future.
S = Y-C-G
(simple
closed
economy)
Farm example—eat corn vs seed
The Tax Laws Should Be
Reformed To Encourage
Saving: PRO
• “A nation’s saving rate is a key
determinate of its long-run economic
prosperity.”
• When the saving rate is higher, more
resources are available for
investment in new plant and
equipment.
Tax Laws Should Encourage
Saving: PRO
• “Our society discourages saving in too
many ways, such as by taxing the income
from capital heavily and by reducing
benefits for those who have accumulated
wealth and capital.”
• The consequences of high interest income
tax policies are: reduced saving, reduced
interest accumulation, lower labour
productivity, and reduced economic
growth.
Reform Tax Laws To
Encourage Saving: PRO
• An alternative to current tax policies,
advocated by many economists is a
consumption tax like the GST-HST.
• A person pays taxes only on the basis of
what they consume (spend) not on what
they produce (earn). Income that is
saved is exempt from taxation until the
saving is later withdrawn and spent on
consumption goods.
Tax Laws Should Encourage
Saving: CON
• Most of the proposed changes in the
tax policies to stimulate saving
would benefit primarily the wealthy
at the expense of lower income
groups.
• High-income households save a
higher fraction of their income than
low-income households. Any tax
change that favors people who save
will also tend to favor people with
Taxes
• US:
• Top 1% of taxpayers pay 37% of
taxes
• Top 10% pay 68% ($100K and
more)
• Top 50% pay 97% of all taxes
• Tax cuts must be on those who
pay.
Tax Laws Should Encourage
Saving: CON
• Reforms would be either regressive or
would further the inequality of income in
our society.
• Raising public saving by eliminating the
government’s budget deficit would provide
a more direct and equitable way to
increase national saving.
Summary-17
• Advocates of active monetary and
fiscal policy view the economy as
inherently unstable and believe
policy can be used to offset this
inherent instability.
• Critics of active policy emphasize
that policy affects the economy with
a lag and our ability to forecast
future economic conditions is poor,
both of which can lead to policy
being destabilizing.
Summary-17
• Advocates of an independent central
bank argue that
• such independence guards against
politicians using monetary policy to try
to influence voters.
• A lower rate of inflation and a more
favourable short-run tradeoff between
inflation and unemployment is possible.
• Critics of an independent central
bank argue that because it has large
and lasting influences on aggregate
demand, output, and employment,
citizens should have a say on
monetary policy
Summary-17
• Advocates of a zero-inflation
target emphasize that inflation
has many costs and few if any
benefits.
• Critics of a zero-inflation target
claim that moderate inflation
imposes only small costs on
society, whereas the recession
necessary to reduce inflation is
Summary-17
• Advocates of reducing the
government debt argue that the
debt imposes a burden on future
generations by raising their
taxes and lowering their
incomes.
• Critics of reducing the
government debt argue that the
debt is only one small piece of
Summary-17
• Advocates of tax incentives for
saving point out that our society
discourages saving in many ways
such as taxing income from capital
and reducing benefits for those who
have accumulated wealth.
• Critics of tax incentives argue that
many proposed changes to stimulate
saving would primarily benefit the
wealthy and also might have only a
small effect on private saving.
(Elasticity issue)