Ohio Wesleyan University Goran Skosples 11. Stabilization Policy

1. Ohio Wesleyan UniversityGoranSkosples11. Stabilization Policy

2. Two debates: • Should policy be active or passive? • Should policy be by rule or discretion?

3. Growth rate of U.S. real GDP Average growth rate Percent change from 4 quarters earlier Should we smooth it?

4. Increase in unemployment during recessions Increase from 12/2007 thru 12/2009: 8 million!!!

5. Arguments for active policy Q1: Should policy be active or passive? • Recessions  econ. hardship for millions of people • The Employment Act of 1946: “it is the continuing policy and responsibility of the Federal Government to…promote full employment and production.” Arguments against active policy • Long and variable lags ( _____ and _______ lags) • Automatic stabilizers (______________________ ____________) • Poor __________ models

6. The Jury’s Out… • Looking at recent history does not clearly answer Question 1: • It’s hard to identify shocks in the data, • and it’s hard to tell how things would have been different had actual policies not been used. • Example: Great Depression • a large contractionary shock to private spending? • a large fall in the money supply?

7. Volatility of GDP Volatility of Inflation The stability of the modern economy 4.0 3.5 Standard deviation 3.0 2.5 2.0 1.5 1.0 0.5 0.0 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005

8. Q2: Rules or Discretion: basic concepts • Policy conducted by ______: Policymakers announce in advance how policy will respond in various situations, and commit themselves to following through. • Policy conducted by __________: As events occur and circumstances change, policymakers use their judgment and apply whatever policies seem appropriate at the time.

9. Arguments for Rules • ______ of policymakers and the political process • The Time __________ of Discretionary Policy • Ex: To encourage investment, gov’t announces it will not tax income from capital. But once the factories are built, gov’t reneges in order to raise more tax revenue.

10. Monetary Policy Rules • ____________ growth rate • stabilizes aggregate demand only if velocity is stable (advocated by Monetarists) • Target growth rate of ___________ • automatically increase/decrease money growth whenever nominal GDP grows slower/faster than targeted nominal GDP • Target the ___________ • automatically reduce money growth whenever inflation rises above the target rate. • _____ rule • target the federal funds rate

11. The Taylor Rule Target the federal funds rate based on • inflation rate • gap between actual & full-employment GDP iff =  + 2 + 0.5( – 2) – 0.5(GDP gap) where iff = nominal federal funds rate target GDP gap = 100 x =

12. Actual Taylor’s Rule The federal funds rate: Actual and suggested 12 Percent 10 8 6 4 2 0 1987 1990 1993 1996 1999 2002 2005

13. “The Great Moderation”

14. Example: Shock to the IS curve Assume that in a certain economy : • LM curve: Y = 2,000r – 2,000 +2(M/P), • IS curve : Y = 8,000 – 2,000r + u, • u is a shock that is equal to +200 half the time and -200 half the time. • The price level is fixed at P = 1.0. • The natural rate of output is 4,000. • The government wants to keep output as close as possible to 4,000 and does not care about anything else. Consider the following two policy rules.

15. Example: Shock to the IS curve (cont) • set the money supply M equal to 1,000 and keep it there (let r fluctuate) • manipulate M from day to day to keep the interest rate (r) constant at 2 percent • Under rule i, what will Y be when u = +200? How about when u = -200? • Under rule ii, what will Y be when u = +200? How about when u = -200? • Which rule will keep output closer to 4,000?

16. Example: Shock to the IS curve (cont) i. IS: Y=8,000– 2,000r+u LM: – 2,000r =–2,000–Y– 2*1000 ii. r = 2  a) u = +200: b) u = +200: c) u = – 200: u = – 200:

17. Exercise: Shock to the LM curve How would things change is the shock u was occurring to the LM curve instead to the IS curve? • LM curve: Y = 2,000r – 2,000 +2(M/P)+ u, • IS curve : Y = 8,000 – 2,000r, Repeat the previous exercise with the new IS and LM curves. • Under rule i, what will Y be when u = +200? How about when u = -200? • Under rule ii, what will Y be when u = +200? How about when u = -200? • Which rule will keep output closer to 4,000?

18. Answers i. IS: LM: ii. r = 2  a) u = +200: b) u = +200: c) u = – 200: u = – 200:

19. Advocates of active policy believe: • frequent shocks lead to unnecessary fluctuations in output and employment • fiscal and monetary policy can stabilize the economy • Advocates of passive policy believe: • the long & variable lags associated with monetary and fiscal policy render them ineffective and possibly destabilizing • inept policy increases volatility in output, employment

20. Advocates of discretionary policy believe: • discretion gives more flexibility to policymakers in responding to the unexpected • Advocates of policy rules believe: • the political process cannot be trusted: politicians make policy mistakes or use policy for their own interests • commitment to a fixed policy is necessary to avoid time inconsistency and maintain credibility