1、CHAPTER 13Stabilization Policy1Copyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.Questions What principles should guide stabilization policy?What aspects of stabilization policy do economists argue about today?Is monetary policy or fiscal policy more effective as a stabilization po
2、licy?How does uncertainty affect the way stabilization policy should be made?2Copyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.Questions How long are lags associated with stabilization policy?Is it better for stabilization policy to be conducted according to fixed rules or to be c
3、onducted by authorities with substantial discretion?3Copyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.Government Policy There are two kinds of government policyfiscal policy shifts the IS curvemonetary policy shifts the LM curve The government uses policy to stabilize the macroeco
4、nomy by minimizing the impact of shocks4Copyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.Monetary Policy Institutions Monetary policy in the U.S.is made by the Federal Reserve which is the central bankthe principal policy-making body of the Federal Reserve system is the Federal Op
5、en Market Committee(FOMC)the FOMC lowers and raises interest rates and increases and decreases the money supply5Copyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.Monetary Policy Institutions The Federal Reserve has a central office and 12 regional officesthe central office is the B
6、oard of Governors in Washington,DCthe 12 regional offices are the 12 Federal reserve banks scattered around the U.S.the members of the Board of Governors and the Presidents of the regional Federal Reserve Banks make up the FOMC6Copyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.Figu
7、re 13.1-Structure of the FederalReserve System7Copyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.Figure 13.2-Composition of the Federal Open Market Committee8Copyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.Monetary Policy Institutions The FOMC meets approximatel
8、y once a month to set interest ratesemergency meetings can also be scheduled on short notice When the FOMC decides on a policy change,it is implemented immediatelyit takes only minutes for interest rates to shift in response to FOMC actions9Copyright 2002 by The McGraw-Hill Companies,Inc.All rights
9、reserved.Monetary Policy Institutions The FOMC changes interest rates by carrying out open-market operationsin an expansionary open-market operation,the Federal Reserve buys government bonds,increasing bank reserves,and lowering interest ratesin a contractionary open-market operation,the Federal Res
10、erve sells government bonds,decreasing bank reserves,and raising interest rates10Copyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.Monetary Policy Institutions The Federal Reserve can also alter interest rates in two other waysthe Board of Governors can alter legally required bank
11、reservesthe Board of Governors can lend money directly to financial institutions These tools are used very rarely11Copyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.Fiscal Policy Institutions Fiscal policy in the U.S.is managed by Congressthe Congress creates the tax laws that dete
12、rmine the amount of taxes imposed by the federal governmentthe Congresss spending bills determine the level of government purchases Tax and spending levels are set through a process called the budget cycle12Copyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.Figure 13.4-The Budget Pr
13、ocess13Copyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.Government Expenditures Mandatory expenditures include spending for Social Security,Medicare,Medicaid,unemployment insurance,and food stamps Discretionary expenditures must be appropriated each year by Congressthese include d
14、efense spending,NASA,highway spending,education spending,and so forth 14Copyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.Figure 13.5-Major Federal Government Expenditures by Category,1960-200015Copyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.Figure 13.6-Federal
15、 Government Discretionary Spending,Excluding Defense(2000)16Copyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.Fiscal Policy Institutions Because of the way the budget process is set up,making fiscal policy in the U.S.is complicated and time-consumingthe time between when a policy p
16、roposal is made and when it becomes effective(the inside lag)can take yearsthe inside lag associated with monetary policy changes can be measured in days or weeks17Copyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.The History of Economic Policy The Employment Act of 1946established
17、 Congresss Joint Economic Committee and the Presidents Council of Economic Advisorscalled on the President to estimate and forecast the current and future level of economic activity in the U.S.announced that it was the responsibility of the federal government to foster and promote free enterprise an
18、d the general welfare18Copyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.The History of Economic Policy Before the Great Depression,the general belief was that the government could not stabilize the economy and should not try to do so It was largely due to the writings of John Mayn
19、ard Keynes that economists and politicians became convinced that governments could halt depressions and smooth out the business cycle19Copyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.The History of Economic Policy Because of the low and stable inflation and unemployment rates of
20、the 1960s,economists and politicians thought that the business cycle was dead However,in the 1970s,expected inflation rose and the Phillips curve shifted upthe result was stagflation20Copyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.Figure 13.7-The U.S.Phillips Curve(s),1955-19802
21、1Copyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.The History of Economic Policy By the end of the 1970s,many economists were convinced that active monetary policy did more harm than goodthey argued that the U.S.would be better off with an“automatic”monetary policy one idea is to
22、fix the money stock to a stable long-run growth path the instability of velocity has reduced the number of advocates of this policy22Copyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.Figure 13.8-The Velocity of Money before 198023Copyright 2002 by The McGraw-Hill Companies,Inc.All
23、rights reserved.The Power and Limits of Stabilization Policy Economists today have varied views as to how the central bank and fiscal authorities should manage the economysome(such as Milton Friedman)feel that activist attempts to manage the economy are likely to do more harm than goodsome believe t
24、hat the appropriate government policy can do a lot to stabilize the economy after shocks occur24Copyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.The Power and Limits of Stabilization Policy Even the most activist of economists recognize the limits of stabilization policystabilizat
25、ion policy requires us to know where the economy is and where it is going use large-scale macroeconomic models to forecast the future search for leading indicators the level of the stock market is often used25Copyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.The Lucas Critique Expe
26、ctations of the future affect decision-making in the present Robert Lucas argued that,because expectations of the future include expectations of government policies,if policies are changed the structure of the economy may change as welleconomic models from the past may not be useful in forecasting t
27、he future effects of policy26Copyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.Leading Indicators The index of leading indicators contains ten components The leading indicator that has been most closely watched is the money supplythere are four measures of the money supply(M1,M2,M3
28、,and L)these four monetary aggregates do not behave in the same way27Copyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.Figure 13.9-Different Measures of the Money Stock Behave Differently28Copyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.The Money Multiplier Open
29、 market operations change the monetary basethe effects on the money supply are less direct and less certain Changes in the monetary base cause changes in the money supply through a process called the money multiplier()29Copyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.The Money Mu
30、ltiplier The money multiplier can be affected by the the currency-to-deposits ratio that households and businesses keep and the level of excess reserves held by banks(exc/dep)(req/dep)(curr/dep)1(curr/dep)(curr/dep)=currency-to-deposits ratio(req/dep)=ratio of required reserves(exc/dep)=excess reser
31、ves-to-deposits30Copyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.Figure 13.10-Changes in the Currency-to-Deposits Ratio31Copyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.Long Lags&Variable Effects Even with reliable forecasts,changes in policy affect the econom
32、y with long lags and have variable effectsChanges in interest rates take time to affect investment,aggregate demand,and real GDPThe level of GDP today is determined by what long-run risky interest rates existed more than a year and a half ago32Copyright 2002 by The McGraw-Hill Companies,Inc.All righ
33、ts reserved.Monetary vs.Fiscal Policy At the end of the World War II era,most economists and policy makers believed that the principal stabilization policy tool would be fiscal policy Today,the overwhelming consensus is that monetary policy has proven itself to be faster acting and more reliable tha
34、n fiscal policy33Copyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.Monetary vs.Fiscal Policy Fiscal policy takes a longer amount of time to workdelays due to the political process This means that the Federal Reserve can neutralize the effects of any change in fiscal policy on aggre
35、gate demandswings in tax laws and appropriations have little effect on real GDP unless the Federal Reserve wishes them to34Copyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.Automatic Stabilizers Automatic stabilizers include tax collections and social transfer programs such as food
36、 stamps and unemployment insurance These work without new policies having to be created and therefore can moderate the business cycle much more quickly than can discretionary policy35Copyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.How Monetary Policy Works Monetary policy takes t
37、ime to work as wellthe Federal Open Market Committee must first recognize that there is a problem and then formulate a policywhile changes in interest rates will occur almost immediately,it takes over a year for changes in interest rates to change national output and unemployment36Copyright 2002 by
38、The McGraw-Hill Companies,Inc.All rights reserved.How Monetary Policy Works The Federal Reserve can either target real interest rates or keep the money stock growing smoothlyif the principal instability in the economy is a shifting IS curve,targeting interest rates will not stabilize the economyif t
39、he instability in the economy occurs because money demand is unstable or because the currency-to-deposits and the reserves-to-deposits ratios vary,then targeting interest rates is wiser37Copyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.Rules vs.Authorities Should monetary policy b
40、e conducted“automatically”according to rules or should it be left to the discretion of authorities?the first reason for automatic rules is that we fear that the people appointed to authorities will be incompetentthe second reason for fixed rules is that authorities might not have the right objective
41、s political business cycle38Copyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.Figure 13.11-The Politically-Influenced Business Cycle:Relative Growth in the Second Year of Presidential Terms39Copyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.Central Bank Independen
42、ce Research has suggested that the more independent a central bank,the better its performancemore independent central banks presided over lower average inflation and less variable inflationcountries with independent banks did not have higher unemployment rates,lower real GDP growth,or larger busines
43、s cycles40Copyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.Figure 13.12-Inflation and Central Bank Insulation from Politics41Copyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.Credibility&Commitment In the short run,pursuing a more expansionary monetary policy can
44、 seem to have great benefitshigher real GDP,lower unemployment,little impact on inflation In the long run,however,a central bank is wiser to keep low inflation as its top prioritykeeps expected inflation low and maintains credibility42Copyright 2002 by The McGraw-Hill Companies,Inc.All rights reserv
45、ed.Credibility&Commitment Economists call this conflict between short-run and long-run interests dynamic inconsistencysome economists have argued that this is another reason to have a fixed set of rules for monetary policyothers believe that central banks are concerned with their long-term reputatio
46、n and will resist the temptation to make inflation and money growth higher than expected43Copyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.Modern Monetary Policy What guidelines for monetary policy should the central bank follow?Economists believe that the central bank should not
47、target real economic variables such as the growth rate of real GDP or the unemployment rate these are determined in the long run by the growth of potential output and the natural rate of unemploymentPolicies which target nominal variables will work better44Copyright 2002 by The McGraw-Hill Companies
48、,Inc.All rights reserved.Modern Monetary Policy The Taylor rule provides a policy proposal for the central bankthe central bank chooses a target for the inflation rate and then raises interest rates when inflation is above and lowers interest rates when inflation is below this target)-(*rr45Copyrigh
49、t 2002 by The McGraw-Hill Companies,Inc.All rights reserved.Financial Crises The Federal Reserve has other important tools that can be used to try to stem depressionsdeposit insurance insulates bank depositors from the effects of financial crisesif a financial crisis is severe enough,the Federal Res
50、erve will act as a lender of last resort46Copyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.Financial Crises A financial crisis sees investors as a group suddenly become convinced that their investments have become overly riskythey try to exchange their investments for relatively s
