Dr. Odile Poulsen Aarhus Business School Department of Economics MACROECONOMICS LECTURE 18: Should Policy Makers be restrained? Read: Blanchard Ch.25. Topics: 1.Uncertainty and Policy. 2. Expectations and Policy. 3.Politics and Policy. 1
1.Uncertainty and Policy. 1.1 How much do Macroeconomists know? Macroeconomists work with models. However when applying these models to the real world there is a lot they don't know. Ex: Take an economy with a high unemployment rate. Suppose the central bank decides to use monetary policy to lower the interest rate to boost the economy. Here are a few questions the Central Bank in a closed economy must answer: -Is the current unemployment rate above the natural level? -By how much will the change in the money supply decrease the interest rate? -How is the price level going to be affected by an increase in the nominal money supply? -What effects is the decrease in interest rate going to have on investment and spending? - and more 2
To answer these questions the central bank will use econometric models. The problem is that different models give different answers to these questions These different answers mirror the uncertainty about the effects on the policy 1.1 Should uncertainty lead policy maker to do less? Consider the following situation: Suppose the U.S economy is in recession. The unemployment rate is 7% and the Fed uses monetary policy to expand output. The Fed has also estimated that the natural rate of unemployment is 5%. So unemployment exceeds its natural rate by 2%. Using Okun's law the Fed forecasts that a 1% output growth will decrease unemployment by 0.4%. Under these assumptions, the Fed wants output to grow by 5% the coming year (so, that it can expect to decrease unemployment by 2%). By how much should the Fed increase the money supply? 3
Suppose that the Fed is using a model that predicts that a 4% increase in the money supply will lead to 0.85% increase in output. If the Fed believes this to be true, it should increase the money supply by 23.8%. If the economy behaves like the econometric model used by the Fed, there is no problem. Unemployment is reduced to its natural rate. Suppose now that the real world does not behave like the model. Suppose that by increasing the money supply by 23.8% the unemployment rate falls to 3%. This rate is below the natural rate. So, according to the Phillips curve this will generate inflation!!! So, the Fed should be cautious and increase the money supply by less than 23.8%. Conclusion: Given the large amount of uncertainty that prevails about the effects of economic policies, policy makers should aim at show self-restraint. They should not use the natural rate as target but rather aim at keeping unemployment within a certain margin. 4
2.Expectations and Policy. 2.1 Inflations and Unemployment revisited. Recall that the relationship between inflation and the deviation in unemployment is given by the Phillips curve: ΠΠe -.X-u n ) ZKHUH DFWXDO LQIODWLRQ ΠGHSHQGV RQ H[SHFWHG LQIODWLRQ Πe and cyclical unemployment u-u n. Suppose that the Fed announces a policy consistent with 0 inflation. If wage setters believe the announcements, then H[SHFWHG LQIODWLRQ Πe will be 0. If the Fed, following its announcement, realizes a 0% inflation rate, then unemployment is at its natural rate. Suppose instead that the Fed decides to surprise the public by creating 1% inflation. Then the Phillips curve tells us that unemployment will be below its natural rate. 5
Next period, wage setters will realize that the real wage as fallen by 1%. They will realize that inflation has increased by 1%. To keep unemployement below its natural rate then the fed must now create even more inflation The story goes on as long as the Fed decides to surprise the public. In the long run the economy returns to its natural rate with a high inflation rate. Conclusion: Unless the Fed credibly commits to a 0 inflation rate it will have a strong incentive to deviate in order to decrease the unemployment below its natural rate. 2.2 Establishing credibility. How can the Fed credibly commit to its announced policy? First, it should become independent. Then it should appoint a "conservative" central banker. 6
3. Politics and Policy. 3.1 Game between Politics and Voters. Politicians care bout being re-elected. To do so, they are for example willing to reduce unemployment below its natural rate below an election If voters are short-sighted as we saw above this is feasible by generating more inflation than the voters expect before the election. The policy will succeed in the short-run. In the long run however, voters will realize that inflation has increased. Unemployment will go back to its natural rate. The inflation rate in the economy will however have increased. This game between the politics and the voters is called "political business cycle". For more example of political business cycles see Blanchard p 492 and 493. 7
3.2 Game between Policy Makers. Ex: The delay in the reduction of the budget deficit in the U.S. In the mid 80's large budget deficits were perceived as one of the main macroeconomic problem facing the US. It took 15 years before the budget deficit was eliminated Why? Because the Democrats and the Republicans were disagreeing about the way it should be done The Democrats wanted higher taxes whereas the Republicans favoured cut in public spending. This kind of situation is referred to as war of attrition. For other example see Blanchard p 494. 8
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