ECO209Y1 Lecture : Chapter 14-Stabilization Policy
Chapter 14 Ā± Stabilization Policy
1) Active or Passive?
Adv. Active:
- recessions cause econ. Hardship
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- AD/AS show how fiscal and monetary policy respond to shocks and stabilize econ.
Disadv. Active:
- Lags Ā± hinder effectiveness/impact of policy:
o Inside Ā± time between shock and policy response
o Outside Ā± time takes policy to affect economy
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Automatic Stabilizers Ā± 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 Ā± unemployment insurance reduces fall and drop of
AD), welfare (similar to unemployment insurance)
Forecasting (predictions):
1. Leading econ. Indicators Ā± data that fluctuate in advance of econ.
2. Macroeconometric models Ā± large-scale models w/ estimated parameters; used to forecast response of endogenous
variables to shocks and policies
Lucas Critique Ā± 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 Ā± unemployment may not fall
2) Rules or Discretion?
Rule Ā± set policy in advance
- Adv.:
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not same as interest of society)
o Time Inconsistency of Discretionary Policy Ā± policymakers have incetive to take back previously
announced policy once otKHUHVīKDYHīDFWHGīRQīDQQRXQFHPHQWīīGHVWUR\VīSROLF\PDNHUVĀ¶īFUHGLELOLW\īĀ± reduces
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o M.P. Rules
ī Constant money supply growth rate
ī Target growth rate of nominal GDP
ī Target inflation rate
** B of C announcement must be CREDIBLE (depends on degree of independence of the central bank)
Discretion Ā± use judgment and change policy as events change
SUMMARY
Advocates of active policy believe:
ī frequent shocks lead to unnecessary fluctuations in output and employment
ī fiscal and monetary policy can stabilize the economy
Advocates of passive policy believe:
ī the long & variable lags associated with monetary and fiscal policy render them ineffective and possibly
destabilizing
ī inept policy increases volatility in output, employment
Advocates of discretionary policy believe:
ī discretion gives more flexibility to policymakers in responding to the unexpected
Advocates of policy rules believe:
ī the political process cannot be trusted: politicians make policy mistakes or use policy for their own
interests
ī commitment to a fixed policy is necessary to avoid time inconsistency and maintain credibility
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