Chapter 14-Stabilization Policy

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2 Aug 2010
Chapter 14 ± Stabilization Policy
1) Active or Passive?
Adv. Active:
- recessions cause econ. Hardship
- AD/AS show how fiscal and monetary policy respond to shocks and stabilize econ.
Disadv. Active:
- Lags ± hinder effectiveness/impact of policy:
o Inside ± time between shock and policy response
o Outside ± time takes policy to affect economy
Automatic Stabilizers ± policies that stimulate/depress economy when necessary without any deliberate policy change
- designed to reduce lags
- e.g. income tax (in recessions avrg. Income falls, tax/person falls), unemployment insurance (in recession
unemployment rises, income falls, spending falls, AD falls ± unemployment insurance reduces fall and drop of
AD), welfare (similar to unemployment insurance)
Forecasting (predictions):
1. Leading econ. Indicators ± data that fluctuate in advance of econ.
2. Macroeconometric models ± large-scale models w/ estimated parameters; used to forecast response of endogenous
variables to shocks and policies
Lucas Critique ± using models estimated with historical data as predictions would not be valid if policy change alters
expectations in way that changes fundamental relationships between variables
- e.g. Prediction: increase in money growth rate = reduce unemployment
o CRITIQUE: increasing money growth may raise expected inflation ± unemployment may not fall
2) Rules or Discretion?
Rule ± set policy in advance
- Adv.:
not same as interest of society)
o Time Inconsistency of Discretionary Policy ± policymakers have incetive to take back previously
o M.P. Rules
Constant money supply growth rate
Target growth rate of nominal GDP
Target inflation rate
** B of C announcement must be CREDIBLE (depends on degree of independence of the central bank)
Discretion ± use judgment and change policy as events change
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
inept policy increases volatility in output, employment
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
commitment to a fixed policy is necessary to avoid time inconsistency and maintain credibility
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