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CHAPTER
17
Policy
Learning objectives



Understand that uncertainty about the economy places
limits on the reach of successful policy.
Understand that imperfect knowledge of the economy
sometimes argues for a “go-slow” approach in the
application of economic policy.
Understand that the choice of policy targets should be
influenced by the limits of our knowledge as well as by the
extent of our knowledge.
PowerPoint® slides prepared by Marc Prud’Homme, University of Ottawa
Copyright 2005 © McGraw-Hill Ryerson Ltd.
Lags in the Effects of Policy
Copyright 2005 © McGraw-Hill Ryerson Ltd.
Chapter 17: Policy
o Permanent disturbance: An exogenous
change that shifts, say, the aggregate
demand curve to a new position
permanently.
o Transitory disturbance: An exogenous
change that shifts, say, the aggregate
demand curve, but the disturbance is
short-lived and the curve shifts back to its
original position.
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Lags in the Effects of Policy
Copyright 2005 © McGraw-Hill Ryerson Ltd.
Chapter 17: Policy
Figure 17-1: Lags and Destabilisation Policy
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Lags in the Effects of Policy
o The inside lag is a discreet lag
o Outside Lag: The timing of the effects of
the policy action on the economy.
Chapter 17: Policy
o Inside Lag: The time period it takes to
undertake a policy action.
o The outside lag is a distributed lag
o Recognition Lag: The period that elapses
between the time a disturbance occurs
and the time the policy makers recognize
that action is required.
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Lags in the Effects of Policy
o Monetary policy
o Fiscal Policy
:
:
Short decision lag
Long decision lag
Chapter 17: Policy
o Decision Lag: The delay between the
recognition of the need for action and the
policy decision.
o Action Lag: The lag between the policy
decision and its implementation.
o Monetary policy:
o Fiscal Policy:
Short decision lag
Long decision lag
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Lags in the Effects of Policy
Copyright 2005 © McGraw-Hill Ryerson Ltd.
Chapter 17: Policy
Figure 17-2: Dynamic Multipliers for the Effects of a Change in the Monetary
Base on GDP.
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Lags in the Effects of Policy
o Fiscal policy affects income more
rapidly then monetary policy.
o Fiscal policy has a shorter outside lag.
o Fiscal policy has a longer inside lag.
Copyright 2005 © McGraw-Hill Ryerson Ltd.
Chapter 17: Policy
o Monetary versus Fiscal Policy Lags
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Expectations and Reactions
o Small effect on permanent income. OR
o Large propensity to spend out of the tax cut will be large.
Chapter 17: Policy
o Reaction uncertainties: If the government wants to
stimulate the economy by temporarily cutting taxes. It must
guess about public reaction.
o Changes in Policy Regime: A special problem emerges
when governments change the way it traditionally
responded to disturbances.
o Credibility: Announcements by policy makers are believed by
policymakers.
o Econometric Policy Evaluation Critique: Existing
macroeconomic models cannot be used to study the effects
of policy changes because the way private agents respond
to changes in income and prices depends on the types of
policy being followed.
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Uncertainty and Economic Policy
o Uncertainty about the expectations of firms and
consumers.
o Difficult to forecast disturbances.
o Ignorance about the true structure of the economy.
Chapter 17: Policy
o Policy makers go wrong in using active
stabilization policy because:
o Uncertainty about the correct model of the economy.
o Uncertainties about the values of the parameters and
multipliers.
o Multiplier Uncertainty: Uncertainty about the size
of the effects that will result from any particular
policy action.
o Portfolio of Policy Instruments: A weaker dose of
both monetary and fiscal policy.
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Activist Policy
Copyright 2005 © McGraw-Hill Ryerson Ltd.
Chapter 17: Policy
o Milton Friedman: “By setting itself a
steady course and keeping to it, the
monetary authority could make a major
contribution to promoting economic
stability.”
o Activist Policies: Policies that react to the
current or predicted state of the economy.
o Fine-tuning: Policy variables are
continually adjusted in response to small
disturbances in the economy.
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BOX
Rules, Discretion and Governors of the BOC
17-2
o 1975 Monetary Gradualism designed to be nondiscretionary policy.
o Early 1980s More discretionary policy with higher
nominal and real interest rates, which lead to the
recession but lower inflation.
o
o
o
o
1987 Stock market crash on October 19.
Early 1990s Recession
1998 Depreciating dollar
2001 September 11
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Activist Policy
M
 4.0  2(u  5.5)
M
Copyright 2005 © McGraw-Hill Ryerson Ltd.
Chapter 17: Policy
o Rules versus discretion: A policy is
set according to a rule if policy does
not change in observed changes in the
economy. A policy is set according to
discretion if policy changes in
response to observed changes in the
economy.
o Example of a rule: Constant-growthrate rule for monetary policy.
(8)
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Activist Policy
Chapter 17: Policy
o Activist Rules: Rules that have
countercyclical features without
having any discretion about their
actions to policy makers.
o Two practical issues arise in the rulesversus-discretion debate:
1) Where is the authority to change the rule
located.
2) Should the policy makers announce in
advance the policies they will be following
in the near future.
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Slide 13
Dynamic Inconsistency
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Chapter 17: Policy
o Dynamic Inconsistency: Policy makers
who have discretion will be tempted to
take short run actions that are
inconsistent with the economy’s best
long run interests.
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Dynamic Inconsistency
1) The policy maker announces a policy, say, zero
percent inflation.
2) Economic decision makers choose a level of
anticipated inflation consistent with the
announced policy, implying the economy will be
positioned on the short run Phillips curve at full
employment.
3) The policy maker implements the best possible
policy. Since the short run Phillips curve is now
fixed, the policy maker can reduce unemployment
at the expense of little inflation. The policy is
optimal, although it is inconsistent with the policy
announced in step 1.
Copyright 2005 © McGraw-Hill Ryerson Ltd.
Chapter 17: Policy
o Three steps to modelling the interaction between
policy maker and the economy:
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Dynamic Inconsistency
INFLATION
π
Economy starts at point
A: Inflation = 0
Equilibrium short run
Phillips curve
B
Chapter 17: Policy
Figure 17-3: The Phillips Curve and Economic Policy
If policy moves the
economy to B to reduce
unemployment…
C
Marginal loss from inflation =
marginal loss from
unemployment
…Expectations will
bring the economy to C.
Best short run
Phillips curve
0
A
u*
Attempts to bring
the economy back
to A = credibility
problem.
UNEMPLOYMENT
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Chapter Summary
Chapter 17: Policy
• The potential need for stabilizing policy actions
arises from economic disturbances.
• Wise policy makers work with what we know
about the economy while also recognizing the
limits of our knowledge.
• The three key difficulties of stabilization policy
are:
– Policy works with lags
– The outcome depends on expectations.
– The uncertainty about the structure of the economy.
• When forming economic policy, policy makers
must choose between sudden policy changes and
gradual changes.
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Slide 17
Chapter Summary (cont’d)
Copyright 2005 © McGraw-Hill Ryerson Ltd.
Chapter 17: Policy
• For the purpose of policy, economic variables
can be classifies as targets, instruments, and
indicators.
• There are occasions on which active monetary
policy and fiscal policy actions should be
taken to stabilize the economy.
• Fine-tuning is more controversial.
• In the rules-versus-discretion debate, it is
important to recognize that activist rules are
possible.
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The End
Chapter 17: Policy
Copyright 2005 © McGraw-Hill Ryerson Ltd.
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