Chapter 14: Stabilization Policy
Policy Activism
Economy is not self-correcting. We need to implement
stabilization policy to correct business cycles.
Use fiscal and monetary policy to prevent recession and
control inflation.
Example of active monetary policy:
M2 Growth = 3% + (u – 6%) whenever correction is required
Policy Passivism
Government budgetary actions and stabilization attempts
are the source of economic instability.
Government can make matters worse as it did in the Great
Depression by implementing concretionary policies of tax
and interest rate increases!
Example of passive monetary policy:
M2 Growth = 3% annually
Policy Lags
Inside lags: time between a shock to the economy
and policy action responding to that shock
Outside lags: time between implementation of a
policy action and its effect on the economy
Policy Lags: Inside Lags
Recognition lag: The time it takes for policy
makers to recognize the existence of a boom or
slump.
Formulation lag: The time it takes to design policy
measures to correct a boom or slump.
Policy Limitations: Outside Lags
Implementation lag: The time it takes to put the
desired policy measures into effect in correcting a
boom or slump.
Response lag: The time it takes for the economy
to adjust to new conditions after policy measures
are implemented.
Duration of Lags
Monetary policy requires shorter formulation and
implementation lags as the FED decides how to
correct a boom or slump.
Fiscal policy requires longer formulation and
implementation lags as a tax or spending policy
must be approved by the Congress and
implemented by federal agencies.
Automatic Stabilization
Boom: greater employment, inflation, and nominal wage
will move workers into higher tax brackets. Paying more
taxes reduce disposable income and consumption
spending, slowing the economy.
Slump: greater unemployment and lower inflation and
nominal wage will move workers into lower tax brackets.
Paying less taxes increases disposable income and
consumption spending, stimulating the economy.
Forecasting: Leading Indicators
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Manufacturing production workweek
Weekly unemployment claims
New orders for consumer goods and materials
Vendor performance
Orders for plants and equipment
Change in manufactures’ unfilled orders
New building permits issued
Change in sensitive materials prices
Index of stock prices
Real money supply (M2)
Index of consumer expectations
Macroeconomic Forecasting
Economists apply empirical models to macro data
to forecast conditions.
While minimizing the forecast error, there still are
discrepancies between actual and predicted
values because, despite sophistication, models
can’t account for all possible effects.
Forecasting Errors
Forecasting Errors
Generating 6-months forecasts, economists could
not correctly predict the rapid
– Rise in unemployment rate from 1981.2 to 1982.4
– Fall in unemployment rate from 1982.4 to 1984.4
Formation of Expectations
Adaptive expectations: expectations are formed
using past information on the indicator being
considered
Rational expectations: expectations are formed
using past and present information on all possible
variables that affect the indicator being considered
Robert Lucas’ Critique
Policy makers must take into account how
people’s expectations respond to policy changes
Traditional methods of policy evaluation do not
adequately take into account the policy effects on
people’s expectations
Sacrifice Ratio & Expectations
Sacrifice Ratio: the percentage of real GDP that must be
given up to lower inflation by 1 percent.
Policy makers prefer to live with inflation since they find
the Sacrifice Ratio to be too high for the public.
Rational-expectations advocates assert that Sacrifice
Ratio estimation is subject to Lucas critique; it assumes
expectations are formed adaptively rather than rationally.
Distrust of Policy Makers
Policy can be implemented to manipulate the
economy for political purposes (e.g., the short-run
Phillips Curve)
Time inconsistency of discretionary policy:
promise one policy, but implement another policy;
e.g., promise an investment tax credit, but after
factories are built increase corporate income tax
rate
Political Business Cycle
Business cycle induced by policy makers:
– slow the economy in the first two years of a political
administration
– stimulate the economy in the last two years to cause
a boom just in time for the next election
Data partly supports this idea for the Republican
presidents
Economic Growth and Politics
Rules of Monetary Policy
Respond to policy shocks (e.g., energy crisis)
Target GDP growth to achieve natural
unemployment rate
Target inflation to keep it low
Inflation & Central Bank
Rules of Fiscal Policy
Budgetary balance or surplus
Deficit spending to cause growth to shift the
burden to the next generation through debt
Tax smoothing to reduce distortions by keeping
rates relatively stable