ECO Topic 4 Stabilization Policy PDF

STABILIZATION POLICY John Maynard Keynes famously said, “…in the long run, we are all dead.” In the long run, output and employment at their full employment levels. This period is therefore desirable as there is no need for policies to manage demand. The reality however is that we live in an unst...

STABILIZATION POLICY John Maynard Keynes famously said, “…in the long run, we are all dead.” In the long run, output and employment at their full employment levels. This period is therefore desirable as there is no need for policies to manage demand. The reality however is that we live in an unstable, short-run world where economies have to contend with various kinds of unexpected events, disturbances, and shocks. E.g. the COVID-19 pandemic which affected both global demand and supply. The short run adjustment period, following a shock such as COVID-19 can be long, with challenges such as high unemployment, high inflation, and high interest rates. It therefore falls upon policymakers to formulate policies that will help the economy adjust following a shock. We distinguish between demand and supply shocks. Demand shocks: these are shocks that cause a shift in the AD curve, e.g. an expansionary monetary policy or a decrease in the government’s budget deficit. Supply shocks: these occur on the supply-side, they are shocks to the labour market and pricing decisions of firms.  Sources of instability within the economy There are two ways in which a shock can occur in the economy: 1. When there is a change in the value of one or more variables within the model. For instance, a change in exports or autonomous investment. This will have various multiplier effects throughout the economy. 2. When there is a change in one or more of behavioral parameters within the model. For instance, society may choose to be thrifty leading to a decline in the marginal propensity to consume.  Should policymakers intervene? There are different views regarding the potential role of policy in the face of shocks. 1. There are those who believe in policy intervention when faced with shocks, e.g. stimulating the economy during times of subdued economic activity and slowing it down to guard against overheating in economic booms. 2. Others believe that there is little need for policy intervention as the economy is naturally stable. Here, any large and inefficient fluctuations are thought to be the result of bad economic policies. To further understand the role of policy in the management of short-run economic fluctuations, there are two more questions which must be answered: a.Should monetary and fiscal policy take an active role in trying to stabilize the economy or should policy remain passive? b.Should policy makers be free to use their discretion in responding to changing economic conditions or should they be committed to following a fixed policy rule? Should policy be Passive or Active? The active approach: This approach supports government intervention in the economy. Recall that in Topic 2 under the AS-AD model, we saw how fiscal and monetary policy can be used to increase output in a recession. These were examples of active policy interventions in the economy. The passive approach on the other hand advocates for a “hands off approach” to stabilization. This is based on a number of reasons which we will look at next. Arguments for the Passive Approach a. Lags in policy implementation and policy impact The economy typically responds with a time lag to changes in policy. i.e. the effects of stabilization policies are not immediate. There is also a possibility of unanticipated responses to a policy change i.e. the effects of stabilization polices on the economy can be unpredictable. Arguments for the Passive Approach a. Lags in policy implementation and policy impact We distinguish between two types of lags in the conduct of policy: The inside lag: this refers to the time between the shock occurring and the policy response. This may be the result of a delay in policymakers’ recognition of the shock. The outside lag: this is the time between the policy action and when its effect becomes evident in the economy. This lag is due to the fact that it takes time for changes in spending, income, and employment to be evident following the policy change. Arguments for the Passive Approach Typically fiscal policy has a longer inside lag than monetary policy. This is due to bureaucratic processes e.g. the need to obtain parliamentary approval before the policy can be implemented. Monetary policy though tends to have a longer outside lag. E.g. it takes time for households and businesses to respond to changes in the interest rate. Naysayers of the active approach point to these lags as being potentially destabilizing, especially in stances where economic conditions change between the time of policy action and the effects on the economy. a. Lags in policy implementation and policy impact Automatic stabilizers These are policies that automatically respond to economic conditions either to slow down or stimulate the economy, without need for intervention by policymakers. They reduce the lags associated with stabilization policy. Examples include progressive taxes, which reduce taxes automatically when incomes are low. Arguments for the Passive Approach b. Challenges in Economic Forecasting For policy action to be successful, authorities have to be able to reliably and accurately predict future economic conditions. This requires forecasters to look ahead using leading indications to determine future conditions. The success of the predictions depends on the forecasters’ ability to model. Arguments for the Passive Approach c. Expectations and the Lucas Critique Economists have to be reasonably certain about changes in economic agents’ expectations in response to policy action. i.e. households make their consumption decisions based on expectations of future income, similarly, firms’ investment decisions are determined by prospects of future profitability. These expectations are informed by policy action. We saw this argument earlier when we discussed the Lucas Critique. It is therefore important for policymakers to adequately anticipate how their policies will affect the expectations formed by households and businesses. Arguments for the Passive Approach d. Historical record This refers to the use of historical record to determine whether the government should intervene or not. i.e. if historically, government policies had successfully stabilized the economy, then a case is to be made for an active approach. Similarly, if inept policies have failed or even made economic problems worse, then, the passive approach is better. However, the fact that there can be different sources of shocks hitting the economy at one time implies that a particular policy may not always be successful in fully eliminating the problem.  2. Should policy be conducted by rule or by discretion? Suppose that the central bank announces that from year t+1, it is committed to keeping inflation at a particular range, and then they do everything possible to ensure that inflation stays within that range. This is an example of conducting policy by a rule. Here, policymakers announce their policy stance ahead of time and commit to following through with the announcement. Discretionary policy implies that policymakers are free to choose the appropriate response based on prevailing conditions.  The advantages of a policy by rule a. Distrust of policymakers and the political process Policy by rule is a good option when policymakers are incompetent or opportunistic, which can lead to a feeling of distrust among the population. b. Time inconsistency/ lack of credibility If policymakers are inconsistent over time in terms of how they respond to economic situations, this makes decision makers lose confidence in them.  Rules for monetary policy Even if we are convinced that rules are superior to discretion, there is still a question of which rule to adopt. Below are three policy rules that economists advocate: i. Maintaining a steady growth rate of money supply. Monetarists believe that economic fluctuations are a result of fluctuating money supply. On the other hand, those opposed to this belief argue that AD can only be stabilized if velocity of money is stable. However, shocks that shift money demand result in an unstable velocity, implying a need for money supply to fluctuate in response to shocks. Therefore this is not the best rule. ii. Nominal GDP targeting. Here, monetary authorities set a planned path of nominal GDP. Any deviations of nominal GDP from this path prompts policy action. E.g. if nominal GDP rises above target, the central bank responds by reducing money growth to reduce aggregate demand. iii. Inflation targeting Recall that under inflation targeting, the central bank announces an inflation target and stands ready to respond to any deviations from the set target.