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Chapter 17 Five Debates over Macroeconomic Policy

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ECN 204
Paul Missios

Chapter 17: Five Debates over Macroeconomic Policy Should Monetary and Fiscal Policymakers try to Stabilize Economy?  Pro: should Left on their own, economies tends to fluctuate. Pessimism of households and firms causes a fall in aggregate demand which causes a recession = no benefit for society and waste of resources. Policymakers reduce the severity of economic fluctuations by leaning against the wind of economic change- use monetary and fiscal policy to stabilize aggregate demand, output, and employment. A more stable economy benefits everyone  Con: should NOT Monetary and fiscal policy work with long lags, so policy must act in advance of economic changes. But the shocks that cause fluctuations are unpredictable, and forecasting is highly imprecise. If policy takes effect too late, it will worsen fluctuations. So leave economy to its own devices. Exercise: Active Policy Stabilization Would you be more likely to support active stabilization if wages, prices, and expectations adjust quickly in advance in response to economic changes, or if they adjust slowly? Answer: If wages, prices, and expectations adjust slowly, it will take longer for the economy to return to its natural rates of output and employment. In that case, there’s a better chance that expansionary policy will act in time to alleviate the recession, rather than push the economy into an inflationary boom. Should Monetary Policy be made by an Independent Central Bank?  Pro: should Allowing elected officials to have influence in conducting monetary policy has two problems. Politicians are sometimes tempted to use monetary policy to affect the outcome of elections thus leading to fluctuations that reflect the electoral calendar – the political business cycle. Such influence might lead to more inflation that is desirable. One way to avoid these difficulties is to conduct monetary policy independent of political influence.  Cons: should NOT An important advantage of elected officials having a say in conducting monetary policy is accountability. The practical importance of time inconsistency is far from clear. The supposedly enhanced credibility of monetary policy announcements that comes from central bank independence seems to yield few dividends. The idea that elected policymakers might use monetary policy to generate political business cycles seems at odds with the concept of rational expectations.Should the Central Bank aim for Zero Inflation?  Pro: should The costs of inflation (shoeleather, menu, etc) can be substantial even for low inflation. Achieving zero inflation would have temporary costs (higher unemployment) but permanent benefits and these costs could be reduced if the commitment to zero inflation is credible if it reduces the rate of inflation people expect.  Con: should NOT The benefits of moving from moderate to zero inflation are small, but the costs are large: Estimates: must sacrifice 5% of a year’s GDP for each 1% reduction in inflation. A disinflation would leave permanent scars: investment falls, lowering the future capital stock, workers skill diminish while unemployed. Some of inflation’s cost could be reduce through more widespread indexation. Exercise: Zero Inflation Debate Suppose a structural change has reduced the demand for university administrators, lowering their equilibrium real wage by 3%. A: If th
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