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Lecture

Chapter 14-Stabilization Policy

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Department
Economics
Course Code
ECO209Y1
Professor
Gustavo Indart

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Chapter 14 ± Stabilization Policy
1) Active or Passive?
Adv. Active:
- recessions cause econ. Hardship
- JRDOVRI&GQ*RYWDQG%RI& SURPRWHIXOOHPSSURGQ
- 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
LIFRQGLWLRQVFKDQJHEHIRUHSROLF\VLPSDFWIHOWSROLF\PD\'(67$%,/,=(HFRQ
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.:
o DisWUXVWRISROLF\PDNHUVDQGSROLWLFDOSURFHVVPLVLQIRUPHGSROLWLFLDQVSROLWLFLDQVLQWHUHVWVVRPHWLPHV
not same as interest of society)
o Time Inconsistency of Discretionary Policy ± policymakers have incetive to take back previously
announced policy once otKHUHVKDYHDFWHGRQDQQRXQFHPHQWGHVWUR\VSROLF\PDNHUVFUHGLELOLW\± reduces
HIIHFWLYHQHVVRISROLFLHVHJJRYWDQQRXQFHV12WD[EXWHYHQWPDNHVWKHPFKDQJHWKHLUPLQG
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
SUMMARY
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
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
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Description
Chapter 14 Stabilization Policy 1) Active or Passive? Adv. Active: - recessions cause econ. Hardship - J4,O8413 *4;9,34157424901:OO025 5743 - ADAS show how fiscal and monetary policy respond to shocks and stabilize econ. Disadv. Active: - Lags hinder effectivenessimpact of policy: o Inside time between shock and policy response o Outside time takes policy to affect economy L1.43L9L438.K,3J0-0147054OL.8L25,.910O954OL.2,$%,,=0.43 Automatic Stabilizers policies that stimulatedepress economy when necessary without any deliberate policy change - designed to reduce lags - e.g. income tax (in recessions avrg. Income falls, taxperson 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.: o Dis97:894154OL.2,N078,354OL9L.,O574.088
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