Should Policy
Makers Be
Restrained?
Is a balanced-budget amendment a good idea?
Uncertainty and Policy
Macroeconomic policy makers in general
do not have all the knowledge required for
solving economic problems.
 They rely on macroeconometric models, all
of which give different answers for how to
solve a particular problem.

How Much Do
Macroeconomists Actually
Know?
The Response of
Output to a
Monetary
Expansion:
Predictions from
12 Models
There is substantial uncertainty about the effects of policy.
Uncertainty and Restraints
on Policy Makers

There is substantial uncertainty about the
effects of macroeconomic policies. This
uncertainty should probably lead policy
makers to be more cautious, and to use less
active policies.
Expectations and Policy


Until 20 years ago, the economy was seen as a
machine. Methods of optimal control were being
used to design macroeconomic policy.
People and firms try to anticipate what policy
makers will do. Hence, macroeconomic policy is
a game between them. We don’t need optimal
control theory but rather game theory, which
studies strategic interactions between players.
Hijackings and Negotiations
By giving up the option to negotiate,
governments can prevent hijackings in the
first place.
 Exactly the same logic is involved in the
design of macroeconomic policy to control
inflation and unemployment.

Inflation and Unemployment
Revisited

The relation between unemployment and
inflation is as follows:
π = πe - α( u - un )
 Suppose the Fed announces that it will
constant inflation, and wage setters believe
that expected inflation will be zero. Then:
π = - α( u - un )
 In the U.S.,   1. If  = 0, then the announced
policy calls for  = e = 0, and u=un.
Inflation and Unemployment
Revisited

But the Fed could deviate from its stated
policy and achieve an unemployment rate of
1% below the natural rate with just a 1%
increase in the inflation rate.
π = - α( u - un )
 If  = 1 and  = 0, then (uun.) =  1%.
 This incentive to deviate from the announced
policy once the other player (in this case wage
setters) has made its move is known as the
time inconsistency of optimal policy.
Inflation and Unemployment
Revisited

Wage setters wise up and begin to expect
positive inflation of 1%. Eventually, the
economy returns to the natural rate of
unemployment, but with higher inflation.
 By credibly committing not to do something
that would appear desirable at the time, policy
makers can achieve a better outcome—no
inflation.
Establishing Credibility

Ways to deal with the problem of time
inconsistency, without totally stripping policymaking power from the central bank, include:
1. Make the central bank independent. This
way, the central bank resists political
pressure to decrease unemployment.
2. Choose a conservative central banker who
dislikes inflation.
Establishing Credibility
Inflation and
Central Bank
Independence
Politics and Policy
If voters are short-sighted, the temptation for
politicians to cut taxes may prove irresistible.
 With the right timing and short-sighted
voters, political parties can win elections.
Thus, we might expect a clear political
business cycle, with higher growth on
average before elections than after elections.
 However, there is little evidence of
manipulation of the macroeconomy to win
elections.

Games Between
Policy Makers and Voters
The
Evolution
of the
Ratio of
U.S. Debt
to GDP,
19002000
Growth During Democratic and Republican Administrations
GDP Growth (% per Year)
First
Second
Third
Fourth
Truman
0.0
8.5
10.3
3.9
Kenney/Johnson
2.6
5.3
4.1
5.3
Johnson
5.8
5.8
2.9
4.1
Carter
4.7
5.3
2.5
0.2
Clinton I
2.7
4.0
2.7
3.6
Clinton II
4.4
4.3
4.1
4.1
3.4
5.5
4.4
3.5
Eisenhower
4.0
1.3
5.6
2.1
Nixon
2.4
0.3
2.8
5.0
Nixon/Ford
5.2
0.5
1.3
4.9
Reagan I
1.9
2.5
3.6
6.4
Reagan II
3.6
3.0
2.7
3.0
Bush
2.5
1.2
0.7
2.6
Bush (George W)
1.1
0.1
2.1
4.0
Democratic
Average: Democratic
Republican
Average: Republican
3.3
Games Between Policy Makers


Game theorists refer to situations in which each
side holds out, hoping the other side will give in,
as wars of attrition. These wars usually result in
delays in the implementation of policy.
Also, each party worries more about either
inflation or unemployment. We would expect, for
example, to see stronger growth during
Democratic administrations.
The Case Against a
Balanced-Budget Amendment
A balanced-budget amendment would
eliminate the problem of deficits, but it
would also eliminate the use of fiscal policy
as macroeconomic policy instrument.
 A constitutional amendment is not the only
way to achieve deficit control and
reduction.

The Case For a
Balanced-Budget Amendment



Economists in favor of a balanced-budget
amendment are more skeptical of the usefulness of
macroeconomic policy in general, and of fiscal
policy in particular.
Lags in the legislative process prevent Congress
from changing fiscal policy in time to stabilize the
economy.
Rules that Congress may impose on itself can be
changed by a vote later on.