{ "cells": [ { "cell_type": "markdown", "metadata": {}, "source": [ "# Part V: Macroeconomic Policy\n", "\n", "We now have all the tools we need to understand business cycles: Part III showed how to analyze business cycles in a flexible-price macroeconomy. Part IV showed how to analyze business cycles in a sticky-price macroeconomy, and how to understand when the flexible-price model and when the sticky-price model is the best one to use.\n", "\n", "Part V uses the tools built up earlier in this book to conduct a tour of the major issues in modern macroeconomics. It considers stabilization policy: how the government attempts to keep unemployment low, growth steady, inflation low and recessions shallow. It moves on to consider fiscal policy and the effects of the government's taxes, spending, and national debt on the level of investment, on growth, and on the state of the business cycle. It analyzes the international economy: how a government tries to manage its economy's interconnections with the other economies of the world.\n", "\n", "Then it takes an even broader view. It discusses how the macroeconomy has changed over the past century, and how the changes in the macroeconomy have affected macroeconomic policy. And it considers the intellectual discipline of macroeconomics: how it has changed in the past, and how it is likely to change in the future.\n", "\n", " " ] }, { "cell_type": "markdown", "metadata": {}, "source": [ "# 13. Stabilization Policy\n", "\n", "**QUESTIONS**\n", "\n", "1. How does the Federal Reserve work?\n", "\n", "2. How does the budget process work?\n", "\n", "3. What are the goals of stabilization policy?\n", "\n", "4. How has the practice of stabilization policy evolved?\n", "\n", "5. What aspects of stabilization policy do economists argue about today?\n", "\n", "6. How does uncertainty affect stabilization policy?\n", "\n", "7. How long are the lags associated with stabilization policy?\n", "\n", " \n", "\n", "**The Budget Process**: The process by which Congress and the president make fiscal policy. It is arcane—byzantine, in fact.\n", "\n", "**inside lag**: The lapse of time between the moment that a shock begins to affect the economy and the moment that economic policy is altered\n", "in response to the shock.\n", "\n", "**Lucas critique** The assertion that much analysis of the effects of economic policy is badly flawed because it does not take proper account of how changes in policies induce changes in people's expectations and thus in their behavior.\n", "\n", "**leading indicators**: A number of variables correlated with future movements in real GDP or inflation.\n", "\n", "**monetary policy lags**: The time between when a monetary policy proposal is made and when it becomes effective in changing the economy in some way.\n", "\n", "**discretionary fiscal policy**: Discretionary fiscal policy is made by Congress's and the president's decisions to change levels of spending and of taxes. It is policy that is not automatic in the sense that automatic stabilizers swing into action without anyone making an explicit decision.\n", "\n", "**automatic stabilizers**: Due to changes in tax revenues and in social insurance spending, the government budget automatically swings toward\n", "a deficit, providing a stimulus to aggregate demand, whenever private demand drops. Similarly, it automatically swings toward a surplus, reducing aggregate demand, whenever private demand rises.\n", "\n", "**rules**: Fixed rules that a central bank must follow for how fast they will allow the money supply to grow.\n", "\n", "**authorities**: Central bank authorities with the discretion to respond to specific circumstances as they see fit. Contrasted with rules in a debate over the best way to conduct policy.\n", "\n", "**discretion**: Leaving policies to be made and adjusted by appointed bodies of experts with discretion to respond to circumstances.\n", "\n", "**political business cycle**: Movements in unemployment and inflation resulting from discretionary policy timed to enhance the political fortunes of an incumbent president.\n", "\n", "**credibility**: The degree to which the public believes in the policy action taken by some institution of government (e.g., the Fed, Congress, or the president).\n", "\n", "**dynamic inconsistency**: A situation where a central bank succumbs to the temptation to make inflation higher than expected and thereby loses its credibility.\n", "\n", " " ] }, { "cell_type": "markdown", "metadata": {}, "source": [ "Part of this book set out the last of our major models, the sticky-price model of the economy, in which short-run changes in real GDP, unemployment, interest rates, and inflation are all driven by changes in the economic environment and by shifts in two kinds of government policy: fiscal policy and monetary policy. Changes in fiscal policy shift the MPRF curve. Central-bank-driven changes in interest rates—monetary policy—move the economy along the MPRF, changing real GDP as well as unemployment and inflation rates.\n", "\n", "These policies and the economic environment together set the level of planned expenditure. They move the economy along the Phillips curve, raising and lower­ ing inflation and unemployment. Changes in expectations of inflation, changes in the natural rate of unemployment, and supply shocks shift the position of the short-run Phillips curve, and thus play a powerful role in determining the options open to the government and the central bank.\n", "\n", "This is the context in which the government tries to manage the macroeconomy, controlling to a certain extent unemployment and inflation. It attempts to stabilize the macroeconomy by minimizing the impact of the shocks that cause business cycles. The first part of this chapter looks at the institutions that make macroeconomic policy: the Federal Reserve, which makes monetary policy, and the Congress, which makes fiscal policy (subject to the president’s veto). After looking at the institutions we will look at how macroeconomic policy is actually made and how well it works.\n", "\n", " " ] }, { "cell_type": "markdown", "metadata": {}, "source": [ "## 13.1 Monetary Policy Institutions \n", "\n", "### 13.1.1 The Federal Reserve\n", "\n", "#### 13.1.1.1 The Structure of the Federal Reserve\n", "\n", "Monetary policy in the United States is made by the Federal Reserve, which is our central bank. (In other countries the central bank bears a different name, most frequently the name of its country: The central bank of country X is probably called the Bank of X.)\n", "\n", "Today the Federal Reserve is and for more than two decades past the Federal Reserve has been the most important organization making American macroeconomic policy. Because monetary policy is the most powerful tool for stabilizing the economy, the Federal Reserve has the power to play the leading role in stabilization policy. Because the Federal Reserve is effectively independent of its political superiors, the Federal Reserve has the discretion to play the leading role in stabilization policy. And it does. \n", "\n", "In normal times, fiscal policy—the decisions about spending levels and tax rates made by the president and the Congress—plays a distinctly second fiddle in stabilization policy. Monetary policy has proved to be more powerful, faster acting, and more reliable than fiscal policy. Moreover, these days the president and the Congress, who could order the Federal Reserve around, rarely like to do so. That’s why White House press releases talking about monetary policy almost always begin with something like:\n", "\n", ">The Federal Reserve is an independent agency, charged with the mission of maintaining price stability, full employment, and maximum purchasing power...\n", "\n", "In strongly non-normal times, like the depths of the Great Recession from 2009-2015 or so, the Federal Reserve needs help in trying to guide the economy to a point near full employment. It is one of trhe puzzles of macroeconomics and political economy that it did not then get that help.\n", "\n", "The Federal Reserve has a central office and 12 regional offices. \n", "\n", "Its central office is the Board of Governors, composed of a chair, a vice chair, and five governors, all of them nominated by the president and confirmed by the Senate. The Board of Governors’ offices are in Washington, DC, on the north side of the Mall between the Lincoln Memorial and the Washington Monument. \n", "\n", "The Federal Reserve’s 12 regional offices are the 12 Federal Reserve banks. They are scattered around the country: San Francisco CA, Minneapolis MN, Dallas TX, Kansas City MO, St. Louis MO, Chicago IL, Cleveland OH, Atlanta GA, Richmond VA, Philadelphia PA, New York NY, and Boston MA. Why two in Missouri? Because when the Federal Reserve Act was passed in 1913, supporters of the bill found that the vote of Senator James A. Reed (D-MO) was esssential to break the deadlock on the Senate Banking Committee and get the bil passed. In addition, the chair of the Senate Banking Committee was Senator Robert Owen (D-OK), and Kansas City was the closest city to Oklahoma that had even a claim to be one of twelve key centers of economic activity.\n", "\n", "Each Federal Reserve Bank has nine directors. Three are appointed by the Federal Reserve Board in Washington DC to represent the public, and are to be selected with \"due but not exclusive consideration to the interests of agriculture, commerce, industry, services, labor and consumers.\" Six are elected by the banks in the regional bank's region that have chosen to join the Federal Reserve sytem. Of those three cannot be bankers, and are also to be elected with \"due but not exclusive consideration to the interests of agriculture, commerce, industry, services, labor and consumers.\" The other three must be bankers, and are elected to represent the interests of the banks that have joined the Federal Reserve system. National banks must join the Federal Reserve. State-chartered banks may join, and so gain an indirect voice through electing directors in the business of the Fed.\n", "\n", "The President of each regional Federal Reserve Bank is elected by the six non-banker directors of the bank, subject to the approval of the Federal Reserve Board in Washington.\n", "\n", " \n", "\n", "#### 13.1.1.2 The Federal Open Market Committee\n", "\n", "The principal policy-making body of the Federal Reserve system is its Federal Open Market Committee (FOMC). The FOMC lowers and raises interest rates, which increases and decreases the money supply. The Federal Reserve’s Board of Governors can and do, independently, alter bank regulations. They can and do raise or lower the interest rate at which the Federal Reserve itself directly lends to banks and businesses—the discount rate. But most of the time the FOMC plays the leading role within the Federal Reserve.\n", "\n", " \n", "\n", "\"DeLong\"DeLong\n", "\n", ">**Structure of the Federal Reserve System**\n", "\n", " \n", "\n", "The members of the Board of Governors and the presidents of the 12 regional Federal Reserve banks together make up the Federal Open Market Committee. The chair, the vice chair, the other five governors, and the president of the Federal Reserve Bank of New York are always voting members of the FOMC. The 11 presidents of the other Federal Reserve banks alternate. At any moment four are voting members and seven are nonvoting members. How do you rotate four voting slots among eleven? The Presidents of the Federal Reserve Banks of Cleveland and Chicago are voting members of the FOMC every other year. Each of the other nine bank presidents is a voting member every third year.\n", "\n", " \n", "\n", "#### 13.1.1.3 The History of the Federal Reserve\n", "\n", "The Federal Reserve was created just before World War I. Its congressional architects feared that a unitary central bank based in Manhattan would pay too much attention to the interests of bankers and financiers and not enough attention to the interests of merchants and producers. A near century of experience, however, suggests that they were wrong: Bankers in St. Louis think like bankers in New York.\n", "\n", "The Federal Reserve failed to handle its first great crisis, the Great Depression that started in 1929. The Federal Reserve did little to help stem the coming of or to cure the Great Depression of the 1930s. Since World War II, however, the Federal Reserve has done a much better job: There has been no repeat of the Great Depression.\n", "\n", "The Federal Reserve’s performance in the 1970s is generally regarded as inadequate. The 1970s were a decade of rising inflation and relatively high unemployment. The start of the 1980s therefore saw the Volcker disinflation: the Federal Reserve, under its Chair Paul Volcker, enforcing a deep recession on the United States to demonstrate that the Federal Reserve would not tolerate high inflation, to break the relatively high inflation expectations of the day, and to re-anchor inflationary expectations and inflation at a level less than 5 percent per year.\n", "\n", "By 2007, after two and a half straight decades of very successful monetary stabilization policy—so successful they were called \"the Great Moderation\"—the prestige of the Federal Reserve was very high. It had almost unlimited freedom to conduct monetary policy as it wishes. And few outside the organization wished to challenge its judgments or decisions.\n", "\n", "Then came the housing bubble, the financial crisis of 2007-8, and the Great Recession of 2008-9. Economist now fiercely debate how well the Federal Reserve handled this tumultuous macroeconomic environment.\n", "\n", " \n", "\n", "### 13.1.2 How the Federal Reserve Operates\n", "\n", "The FOMC meets about every six weeks to set interest rates. It can and occasionally does delegate power to the Chair of the Federal Reserve to alter interest rates between meetings if circumstances require. And it can hold emergency meetings on short notice.\n", "\n", " \n", "\n", "#### 13.1.2.1 The FOMC as a Consensus-Seeking Committee\n", "\n", "The FOMC currently tries to reach its decisions by consensus. If a consensus cannot be achieved, the members of the FOMC are more likely to postpone the issue than to make a decision that a substantial minority of its members oppose. But a substantial minority almost never opposes. The chair has only one vote of twelve, but almost invariably the FOMC does what the chair wishes. These days questions and dissents from the chair’s view of the economy and proposed path for interest rates are much more likely to be voiced in private in the chair’s office before an FOMC meeting than in the meeting itself. The current chair, since February 2018, is Jay Powell. Before him Janet Yellen (2014-2018) and Ben Bernanke (2006-2014) were consensus-building chairs. Earlier chairs, like Alan Greenspan (1987-2006), Paul Volcker (1979-1987), Arthur Burns (1970-1978), William McChesney Martin (1951-1970), and Marriner Eccles (1934-1948) were frequently very strong chairs. \n", "\n", "Once the FOMC decides on a change in policy, that change is implemented immediately. Interest rates shift within minutes in response to FOMC decisions. Indeed, interest rates often change in advance of the actual FOMC meeting as speculators attempt to make money by betting on what they believe the Federal Reserve will do.\n", "\n", "The chair of the Federal Reserve Board is the chair of the FOMC. Jay Powell was confirmed to his first four-year term as Chair of the Federal Reserve in February 2018. The president of the Federal Reserve Bank of New York is the vice chair of the FOMC; John Williams currently holds the post.\n", "\n", " " ] }, { "cell_type": "markdown", "metadata": {}, "source": [ "#### 13.1.2.2 Open Market Operations\n", "\n", "The FOMC changes interest rates by carrying out open-market operations. In an expansionary open-market operation, the Federal Reserve buys short-term government bonds for cash. Such a transaction reduces the amount of interest-bearing government bonds available for financial investors to hold. This reduction in publicly-available supply raises the price of short-term government bonds, and an increase in the price of a bond is a decline in its interest rate. This transaction also increases the amount of cash—money—in the economy. This increased amount of cash satisfies households' and businesses' higher demand for cash at the now-lower interest rate.\n", "\n", "When the Federal Reserve buys government bonds it pays for them by crediting the purchasers with deposits at the regional Federal Reserve banks. Commercial banks use these deposits to satisfy the reserve requirements imposed on them by bank regulators. The more reserves a bank has, the more deposits it can accept and the more loans it can make. With more banks trying to make more loans, the interest rates that banks charge on loans drop. Thus purchases of short-term government bonds for cash by the Federal Reserve are expansionary open-market operations, which reduce interest rates. Contractionary open-market operations work in reverse, raising interest rates: the Federal Reserve sells short-term government bonds for cash, thus shrinking the amount of cash money in the hands of the public and raising the stock of bonds that they must hold.\n", "\n", "Open-market operations in short-term government bonds are not the only policy tools the Federal Reserve has. The Board of Governors can alter legally required bank reserves. It can lend money directly to financial institutions. It can restrict the types of loans that the financial institutions it regulates can make. It can try to communicate what its future policies will be via so-called \"forward guidance\". It can purchase not short-term safe but long-term risky bonds via so-called \"quantitative easing\". But some of these tools are used rarely, and others are not terribly effective at influencing the state of the economy. Most of the time the FOMC can use open-market operations to set interest rates at whatever it wants them to be. \n", "\n", " " ] }, { "cell_type": "markdown", "metadata": {}, "source": [ "### 13.1.3 The Banking System, Money Demand, and Money Supply\n", "\n", "The wealthy in an economy hold their financial assets in two possible forms: money—assets that do not pay interest or dividends, but that are liquid in that they can immediately be used to purchase other commodities and assets—and other assets that do pay interest or dividends and yield capital gains. We will usually let the term \"bonds\" stand for these assets—even though they include not just bonds but stocks, derivatives, much tradeable real estate, and loans as well.\n", "\n", "Financial markets will be in balance when the configuration of interest rates is such that there is neither excess demand nor excess supply for money or for what we are calling bonds. In fact, we need look at only one of these two asset categories. Since the only forms the wealthy can hold their financial assets in are money and bonds, it follows:\n", "\n", "1. If there is an excess supply of money, there is an excess demand for bonds.\n", "2. If there is an excess demand for money, there is an excess supply of bonds.\n", "3. If the money market is in supply-demand balance, the bond market will be in supply-demand balance as well.\n", "\n", "Let us look at the demand and supply for money.\n", "\n", " " ] }, { "cell_type": "markdown", "metadata": {}, "source": [ "#### 13.1.3.1 The Supply of Money\n", "\n", "The central bank—the Federal Reserve—directly determines what economists call _the monetary base_, the sum of currency in circulation and of deposits at the Federal Reserve’s 12 branches. When the central bank wants to reduce the monetary base, it conducts contractionary open-market operations: it sells short-term government bonds and accepts as payment either currency or, as an alternative, deposits that banks already hold at the Fed’s regional branches.\n", "\n", "When the Federal Reserve sells bonds for currency, the currency it accepts as payment is then removed from circulation, no longer part of the money stock. When the Federal Reserve sells bonds and accepts as payment deposits that national banks hold at the Fed’s regional branches, these deposits are then erased from its books. Thus the monetary base declines.\n", "\n", "The monetary base is not the entire money stock. “Money” includes many other things than just currency and reserve deposits held at the 12 regional Federal Reseme banks: checking account deposits, savings account deposits, small-denomination certificates of deposit, and a number of other assets. There are alternative measures of the money stock: they all attempt to divide financial assets so as to include only those that are held for their liquidity—their holders' ability to spend them immediately—rather than for their return.\n", "\n", "Changes in the monetary base induce changes in these other components of the money stock. For example, banks accept checking deposits. They lend out the purchasing power deposited in the bank, earn interest, and provide the depositor with a claim to wealth in readily spendable form. But those to whom they lend out the purchasing power themselves redeposit it in their own checking accounts, from which it is then lent out again. Thus one dollar of cash deposited and redeposited leaves its mark in a large number of checking account balances of different individuals and organizations. And all of these checking account deposits are as good as readily spendable cash—they are also \"money\".\n", "\n", "Thus out of the monetary base the banking system creates a multiplied total of liquid assets households and businesses are happy to hold. The ratio of the economy's money supply to the monetary base we call the _money multiplier_.\n", "\n", "How large is the money multiplier? It depends on much of the deposits they take in banks then turn around and lend out. The Federal Reserve limits banks’ ability to do this. It regulates and limits their ability to accept deposits, and limits the proportion of the deposits they do accept that national banks can then lend out. The Federal Reserve requires that national banks redeposit at the local regional branch of the Federal Reserve a proportion—currently 10%—of their \"net transaction account\" deposits as reserves. And financial institutions often find it prudent to hold liquid excess reserves in case an unexpectedly large number of depositors seek to withdraw their money. For a financial institution, nothing is worse than being unable to immediately meet depositors’ demands to withdraw their money when they seek to do so. Since these reserves have to be assets included in the monetary base, central banks thus hold the leash of the banking system as far as how much it can create of \n", "\n", "The Federal Reserve's control over the monetary base and the banking system's creation of additional monetary assets via the money multiplier process together determine the money supply.\n", "\n", " " ] }, { "cell_type": "markdown", "metadata": {}, "source": [ "#### 13.1.3.2 Demand for Money and the Equilibrium Interest Rate\n", "\n", "Think about a household or a business trying to figure out in what form to hold its wealth. The household can hold its wealth in the form of interest-bearing or other return-earning assets like real estate, stocks, and bonds—what we lumped all together as “bonds”—or what we call “money”, M, assets that are liquid, can be readily spent, can be easily used to buy things. Wealth held in the form of money earns little or no interest. Wealth held in the form of bonds earns interest at the current short-term nominal interest rate i. \n", "\n", "Wealth held in the form of bonds cannot be readily spent: To transform it into a form in which you can use it to buy things takes some time, and so if too great a proportion of wealth is held in bonds, you may miss opportunities to buy goods and services. Wealth held in the form of money is liquid, and it can be easily spent—that is the important, the defining characteristic of money.\n", "\n", "About the quantity of money that businesses and households demand to hold, which we will call $ M^d $, with the d superscript there to remind ourselves that this is a demand we can say:\n", "\n", "1. Money demand is proportional to total income and spending.\n", "2. Money demand is inversely related to the nominal interest rate—when nominal interest rates go up, demand for money goes down.\n", "\n", "Why does the quantity of money demanded $ M^d$ go up when total income Y goes up? How much wealth you want to hold in readily spendable form as money depends on how large are the purchases you typically make in a unit of time. And the higher the flow of total income, the greater the flow of purchases an average household or business wants to make.\n", "\n", "Why does the quantity of money demanded $ M^d $ go down when the nominal interest rate i goes up? The nominal interest rate is the opportunity cost of holding money: you sacrifice income at the rate of i dollars per year for each extra dollar you hold as money. When the interest rate i is high, you will look for ways to economize on holding money. Hence the quantity of money demanded falls when the nominal interest rate i rises. Note that _nominal_ interest rate. Usually it is the real interest rate that matters, but not in the case of hte demand for money.\n", "\n", "Economists therefore write the money demand function as:\n", "\n", ">$ M^d = (PY)(m_o - m_ii) $\n", "\n", "Money demand is proportional to the overall price level P because what households and businesses really care about is not how many pieces of paper with George Washington’s face they have, but how much in the way of goods and services their money holdings can buy. If the price level P doubles, desired money holdings will double as well. Money demand is proportional to national income for the same reason: a doubling of income and spending requires double the money holdings to make transactions go smoothly.\n", "\n", "At an interest rate of zero, households and businesses want to hold an amount of money equal to the fraction $ m_o $ times the product of the price level and of national income. And as the short-term nominal interest rate increases, this fraction drops by m_i for every unit increase in the short-term nominal interest rate.\n", "\n", "We will have equilibrium in the money market—the supply of money will be equal to demand—when this $ M^d $ is equal to the money stock M determined by the central bank and the banking system:\n", "\n", ">$ M = (PY)(m_o - m_ii) $\n", "\n", "So for this money demand function and the money stock M, the short-term safe interest rate i will be:\n", "\n", ">$ i = \\frac{m_o - \\frac{M}{PY}}{m_i} $\n", "\n", "The central bank will then achieve its interest rate target i via its open-market operations in short-term bonds that will push the money stock M to the necessary level.\n", "\n", " " ] }, { "cell_type": "markdown", "metadata": {}, "source": [ "### 13.1.4 The Zero Lower Bound on Interest Rates\n", "\n", "The Federal Reserve’s power to set interest rates is subject to only one important restriction. Suppose that the Federal Reserve has already conducted so many expansionary open-market operations in short-term bonds that it and the banking system have together increased the economy's money stock to the point where:\n", "\n", ">$ M = m_oPY $\n", "\n", "so that the short-term nominal interest rate is zero:\n", "\n", ">$ i = 0 $\n", "\n", "And suppose it carries out more such operations: keeps buying short-term bonds for cash that it newly prints. What happens?\n", "\n", "What happens is that financial institutions shrug their shoulders, and nothing happens to the interest rate. At a nominal interest rate of zero, a short-term government bond becomes the same thing as cash: it is a liability of the government—thus you can use it to offset any debts you owe to the government, for example taxes—and it pays zero interest. There is then no difference between cash and short-term government bonds, and open-market operations have no effect on anything. The short-term interest rate stays at zero.\n", "\n", "This inability of the Federal Reserve to push nominal interest rates below zero has destructive consequences, as we saw from 2008-2015. The Federal Reserve wanted even lower interest rates than then prevailed, but it could not generate them. \n", "\n", "Things could have been worse. If prices had been expected to fall—during a time of anticipated deflation, for example, when the expected inflation rate is negative—a nominal interest rate not less than zero would still be a relatively high real interest rate, because the real interest rate r is the difference between the nominal interest rate i and the expected inflation rate. If the expected inflation rate is sufficiently far below zero, the real interest rate will be high, and investment low, no matter what the FOMC does. \n", "\n", "Deflation is greatly feared because it would drive up real interest rates at just the time the Federal Reserve needed to reduce them to stimulate the economy. Yet with nominal interest rates at their minimum of zero, the Federal Reserve’s hands would be even more tied than they were over 2008-2015.\n", "\n", " " ] }, { "cell_type": "markdown", "metadata": {}, "source": [ "#### 13.1.4.1 Japan's Liquidity Trap: Economic Policy\n", "\n", "Before the 1990s, the possibility that monetary policy might lose its power because expected deflation kept real interest rates high used to be dismissed as a theoretical curiosity irrelevant to the real world. But in the mid-1990s the Japanese economy entered into such a “liquidity trap.” Real GDP has been far below potential output. Nominal interest rates on short-term government bonds have been indistinguishable from zero. \n", "\n", "\"DeLong\n", "\n", ">**Japan's Liquidity Trap: Nominal Safe Interest Rates**: The graph shows the official discount rate of the Bank of Japan. Despite a decade of extremely low interest rates on government bonds in Japan, investment has not boomed. Why not? Because risk premiums and expected deflation have made businesses believe that the real interest rates at which they can borrow remain high.\n", "\n", "A combination of expected deflation, high risk premiums, and steep term premiums meant that businesses found that the real interest rate they had to pay to borrow money was quite high. This situation continues today. From banks’ perspective there are few credit-worthy borrowers. Yet from businesses’ perspective there is little affordable capital. Japan’s economic underperformance has dragged on for more than two decades.\n", "\n", "What is to be done? Two obvious policies might improve matters. The first is fiscal expansion: Cut taxes or increase spending to shift the IS curve to the right and the MPRF to the left, raising the level of planned spending even if real interest rates are relatively high. The second is to create expectations of inflation byannouncing that monetary policy will be expansionary not just now but for the indefinite future.\n", "\n", " \n", "\n", "### 13.1.5 RECAP: Monetary Policy Institutions\n", "\n", "The most important kind of stabilization policy is monetary policy, carried out by the Federal Reserve, the United States’ central bank. The principal policymaking body of the Federal Reserve is the Federal Open Market Committee—the FOMC. The FOMC decides what the level of short-term safe nominal interest rates will be, and how fast the money stock will grow. The head of and the most important decision maker in the Federal Reserve is the chair. Jasy Powell was confirmed to a four-year term as Chair of the Federal Reserve in February 2018.\n", "\n", " " ] }, { "cell_type": "markdown", "metadata": {}, "source": [ "## 13.2 Fiscal Policy Institutions\n", "\n", "### 13.2.1 The Budget Cycle in Theory\n", "\n", "Fiscal policy in the United States today is managed by Congress and the president. Congress passes spending and tax bills, which the president then signs or vetoes, and Congress then overrides or fails to override any vetoes. Congress’s tax laws determine the taxes imposed by the federal government. Congress’s spending bills determine the level of government purchases and transfer payments. Together these taxes and government purchases make up the government’s fiscal policy.\n", "\n", "Tax and spending levels are set in a combined bureaucratic-legislative process called the budget cycle, outlined in Figure 13.4 on page 386. The federal government’s year for budget purposes—its fiscal year—runs from October 1 of one year to September 30 of the next. The budget period from October 1, 2018, to September 30, 2019, for example, is called “fiscal 2019.”\n", "\n", "Some broad classes of expenditure, called “mandatory” or \"entitlement\" are the result of open-ended long-term government commitments. They continue whether or not Congress explicitly appropriates money for them in the current year. They involve transfer payments and purchases of goods and services to and devoted to assisting people by virtue of their status which \"entitles\" them to, among other things, have their health care paid by the Medicaid or the Medicare program. Social Security, Medicare, Medicaid, unemployment insurance, food stamps, and so forth fall into this category of so-called mandatory or entitlement spending.\n", "\n", "Other broad classes of expenditure, called “discretionary,” must be explicitly appropriated by Congress in each fiscal year. Defense spending, the National Park Service, NASA, the National Institutes of Health, highway spending, education spending, and so forth fall into this category of so-called discretionary spending.\n", "\n", "Early in one fiscal year the executive branch departments and agencies that administer federal programs begin planning for the next. Throughout the fall they negotiate with the president’s Executive Office—the Office of Management and Budget. The result of these negotiations, modified by the president’s own priorities, becomes the president’s budget submission to Congress in January.\n", "\n", "Congress considers the president’s budget request, conducts its own internal debates, and by the end of April is supposed to have passed a budget resolution giving spending targets for broad classes of expenditure. It rarely does. Using the budget resolution as a guide, Congress is then supposed to alter and amend the laws that control mandatory spending and alter and amend the tax code in a streamlined legislative process called \"Reconciliation\". \n", "\n", "Congress is also supposed to pass the appropriations bills necessary for discretionary spending. By the end of September all of the appropriations bills are supposed to have been passed, so that the new fiscal year can begin with the pieces of the government knowing how much should be spent and on what over the next 12 months. It rarely happens that way. Usually the fiscal year will start with government agencies operating under a \"continuing resolution\"—told to keep spending what they spent in the past year, with perhaps a few changes.\n", "\n", " \n", "\n", "\n", "\n", ">**Major Federal Government Expenditures by Category, 1965-2003**\" The past four decades have seen the level of federal government spending as a share of GDP remain roughly constant, but the composition of federal spending has changed remarkably. Spending on national defense and international affairs has fallen from nearly 10 to between 3 and\n", "4 percent of GDP. Spending on Medicare and Medicaid and Social Security has risen from about 2.5 to over 8 percent of GDP. Net interest, which comprises most other \"mandatory\" spending, rose sharply from 1 to 3 percent of GDP as a result of the deficits of the 1980s, declined in the 1990s, but recently began to climb again. Other social insurance—unemployment insurance, welfare, and so fort— rose from just under 2 percent of GDP in the 1960s to 3.5 percent by the deep recession years of the early 1980s, and has been cut since. And domestic \"discretionary\" spending—everything else the government does, from the FBI to the National Park Service, the National Institutes of Health, and the interstate highway system—rose from 3 to 5 percent of GDP between 1965 and 1980, and has since been cut back to about 3 percent.\n", "\n", " " ] }, { "cell_type": "markdown", "metadata": {}, "source": [ "### 13.2.2 The Budget Cycle in Practice\n", "\n", "More often than not, however, Congress fails to pass or the president vetoes one or more appropriations bills. In that case the government continues more or less on autopilot if Congress passes and the president signs a continuing resolution until the appropriations bill is passed. \n", "\n", "If they don’t, the government “shuts down.” Discretionary spending is cut back to the bone. Nonessential employees are sent home. The Washington Monument and other major tourist attractions are closed. Government office buildings are inhabited by only a skeleton crew of key functionaries and unpaid interns until Congress and the president reach agreement and pass and sign the appropriations bills necessary for the government’s discretionary spending programs to go forward.\n", "\n", "However, even during a so-called government shutdown, most of what the government does continues. Mandatory spending does not have to be explicitly appropriated every year, and it continues even if there is total gridlock in Washington.\n", "\n", " \n", "\n", "\n", ">**Federal Government Domestic Discretionary Spending, 2000**: Every year Congress and the president must pass and sign appropriations bills for those categories of spending that are not mandated by long-run open-ended enabling statutes (like Social Security, Medicare, and unemployment insurance) or required by the Constitution (like net interest). Of this \"discretionary\" spending, defense takes about half. The rest is spread out among a wide variety of activities.\n", "\n", " \n", "\n", "The lesson to draw from this overview is that making fiscal policy in the United States is complicated, baroque, and time-consuming. The inside lag—the time between when an economic shock occurs and when a policy proposal becomes effective—for fiscal policy is measured in years. By contrast, the inside lag asso­ ciated with FOMC-decided changes in monetary policy is measured in days, weeks, or at most two months. The FOMC can turn on a dime. Congress and the president cannot. This is a key advantage that makes the Federal Reserve more effective at undertaking stabilization policy to manage unemployment and inflation.\n", "\n", " \n", "\n", "### 13.2.3 RECAP: Fiscal Policy Institutions\n", "\n", "Fiscal policy in the United States is conducted by Congress, which passes laws, and the president, who signs—or vetoes—them. Most government spending is “mandatory” or \"entitlement\" and takes place each year regardless of whether Congress acts. Other spending is “discretionary,” subject to the whims of politics, lobbying, and, occasionally, economics. Discretionary spending is well less than half of government spending. Defense spending is about half of discretionary spending.\n", "\n", " " ] }, { "cell_type": "markdown", "metadata": {}, "source": [ "## 13.3 The History of Stabilization Policy\n", "\n", "### 13.3.1 The Employment Act of 1946\n", "\n", "The United States government did not always see itself as responsible for stabilizing the economy and taming the business cycle. It accepted this responsibility in the Employment Act of 1946, which did the following:\n", "\n", "* Established Congress’s Joint Economic Committee.\n", "* Established the president’s Council of Economic Advisers.\n", "* Called on the president to estimate and forecast the current and future level of economic activity in the United States.\n", "* Announced that it was the “continuing policy and responsibility” of the federal government to “coordinate and utilize all its plans, functions, and resources... to foster and promote free competitive enterprise and the general welfare; conditions under which there will be afforded useful employment for those able, willing, and seeking to work; and to promote maximum employment, production, and purchasing power.”\n", "\n", "Passage of the Employment Act marked the rout of the belief that the government could not stabilize the economy and should not try to do so. In the old view, common at the beginning of the twentieth century, monetary and fiscal policies to fight recessions would keep workers and firms producing in unsustainable lines of business and levels of capital intensity, thus making the depression less deep only at the price of making it longer.\n", "\n", "This doctrine that in the long run even deep recessions like the Great Depression would turn out to have been “good medicine” for the economy drew anguished cries of dissent even before World War II. John Maynard Keynes tried to ridicule this “crime and punishment” view of business cycles, concluding that he did not see how “universal bankruptcy could do us any good or bring us any nearer to prosperity.” Indeed, it was largely due to Keynes’s writings, especially his _General Theory of Employment, Interest and Money_, that economists and politicians became convinced that the government could halt depressions and smooth out the business cycle. But Keynes was not alone. For example, Ralph Hawtrey, an adviser to the British Treasury and the Bank of England, called worry about government action the equivalent of “crying, ‘Fire! Fire!’ in Noah’s flood.” \n", "\n", "By the end of the Great Depression there was near universal consensus that the government had to take steps to moderate the business cycle to make sure nothing like the Great Depression ever happened again.\n", "\n", " " ] }, { "cell_type": "markdown", "metadata": {}, "source": [ "### 13.3.2 Keynesian Overoptimism and the Monetarist Correction\n", "\n", "The high-water mark of confidence that the government could and would manage to use its macroeconomic policy tools to stabilize the economy came in the 1960s. In that decade President Lyndon Johnson’s chief economic adviser, Walter Heller, wrote of the “New Dimensions of Political Economy” that had been opened by the Keynesian revolution. The Department of Commerce changed the title of its _Business Cycle Digest_ to the _Business Conditions Digest_—because, after all, the business cycle was dead.\n", "\n", "The 1970s, however, erased that confidence. Economists Milton Friedman and Edward Phelps had warned that attempts to keep the economy at the upper left corner of the Phillips curve would inevitably cause an upward shift in inflation expectations—that even if expectations had truly been static during the 1950s and early 1960s, they would become adaptive if unemployment were pushed too low for too long.\n", "\n", "Friedman and Phelps were correct: The 1970s saw a sharp upward shift in the Phillips curve as people lost confidence in the commitment of the Federal Reserve to keep inflation low and raised their expectations of inflation. (See Figure 13.7.) The result was stagflation: a combination of relatively high unemployment and relatively high inflation. The lesson learned was that attempts to keep unemployment low and the level of output stable were counterproductive if they tried to keep unemployment below the natural rate and so eroded public confidence in the central bank’s commitment to keep inflation low and prices stable.\n", "\n", " \n", "\n", "\n", "\n", ">**The U.S. Phillips Curves, 1955-1980**: Between the mid-1950s and the late 1960s, unemployment and inflation in the United States were low and stable, and productivity growth was rapid. Economists in government and their politician bosses thought that the new tools of economic policy had licked the business cycle. They were wrong. Between 1967 and 1975 expected inflation nearly tripled, the natural rate of unemployment rose by 2 percentage points, and stagflation set in.\n", "\n", " " ] }, { "cell_type": "markdown", "metadata": {}, "source": [ "### 13.3.3 Monetary Management in the 1980s and Beyond\n", "\n", "The 1970s ended with many economists convinced that “activist” monetary policy did more harm than good, and that the United States might be better off with an “automatic” monetary policy that fixed some control variable like the money stock on a stable long-run growth path. But the sharp instability of monetary velocity since the start of the 1980s (see Figure 13.8) greatly reduced the number of advo­ cates of an automatic central bank that lets the money stock grow by a fixed pro­ portional amount every year.\n", "\n", "Thus today the Federal Reserve acts as outlined in Chapters 10 and 12. As in Chapter 10, the Federal Reserve estimates what level of real GDP will correspond to full employment and where the IS curve will be in a year to a year and a half, and it tries to set a real interest rate today that will produce an appropriate level of output, of capacity utilization, and of the unemployment rate. What is an “appropriate level”? That is where Chapter 12 comes in. \n", "\n", "When inflation is above the Federal Reserve’s target for where it should be, the appropriate level of demand has a certain amount of economic slack built into it to produce downward pressure on inflation. When inflation is below the Federal Reserve’s target, it aims for a level of output above potential, all according to the Taylor rule and monetary policy reaction function (MPRF) of Chapter 12. This is the operating procedure that the Federal Reserve has been following for more than two decades. And it is widely judged to have been highly successful.\n", " \n", " \n", "\n", "\n", "\n", ">**The Velocity of Money**: Before 1980 monetarists argued that the velocity of money was stable and predictable. It had a constant upward trend as new technology was introduced into the banking system, and nearly no other fluctuations. Keep the money supply growing smoothly, they argued, and the smooth trend of velocity will keep the economy stable. They too were wrong. After 1980 the velocity of money became unstable indeed.\n", "\n", " " ] }, { "cell_type": "markdown", "metadata": {}, "source": [ "### 13.3.4 RECAP: The History of Stabilization Policy \n", "\n", "Before the Great Depression, the government viewed the business cycle much like people today view hurricanes and tornadoes: They are catastrophes, and the government should help those who suffer, but it makes no sense to ask the government to prevent or manage them. Largely as a result of the writings of the British economist John Maynard Keynes, this attitude vanished during the Great Depression and World War II. After World War II, economists and politicians believed that the government could and should prevent great depressions and smooth out the business cycle.\n", "\n", "Overconfidence in the government’s ability to manage the macroeconomy vanished in the 1970s, a decade of both relatively high unemployment and relatively high inflation. Today we have a more limited confidence in the government’s ability to stabilize and manage the business cycle.\n", "\n", " " ] }, { "cell_type": "markdown", "metadata": {}, "source": [ "## 13.4 The Power and Limits of Stablization Policy\n", "\n", "### 13.4.1 Economists' Disagreements\n", "\n", "Economists today arrange themselves along a line with respect to their views as to how the central bank (the Federal Reserve) and fiscal authorities (the president and Congress) should manage the economy. \n", "\n", "At one end are economists like Milton Friedman, who holds that activist attempts to manage the economy are likely to do more harm than good. Government should settle on a policy that does not produce disaster no matter what the pattern of shocks or the structure of the economy This end of the spectrum holds that most of the large business cycles and macroeconomic disturbances experienced in the past century were the result of well-intentioned but destructive economic policy decisions based on faulty models of the economy.\n", "\n", " " ] }, { "cell_type": "markdown", "metadata": {}, "source": [ "### 13.4.1.1 The Structure of the Economy and the Lucas Critique: Some Details\n", "\n", "Economist Robert Lucas has argued that most of what economists thought they knew about the structure of the economy was false. Expectations of the future have major effects on decision making in the present: Workers’ nominal wage demands, managers’ investment decisions, households’ consumption decisions, and practically every other economic decision hinge, in one way or another, on what is expected to happen in the future. And expectations depend on many things — including the policies followed by the government. Change the policies followed by the government, and you change the structure of the economy as well.\n", "\n", "Thus, Lucas argued, the use of economic models to forecast how the economy would respond to changes in government policy is an incoherent and mistaken exercise. Changes in policy would induce changes in the structure of the economy and its patterns of behavior that would invalidate the forecasting exercise. Economic forecasts based on a period in which inflation expectations were adaptive would turn out to be grossly in error if applied to a period in which inflation expectations were rational. Forecasts of consumption spending based on estimates of the marginal propensity to consume when changes in national income were permanent would lead policy makers astray if used to forecast the effects of policies that cause transitory changes in national income.\n", "\n", "This Lucas critique is an important enough insight that for it Robert Lucas was awarded the Nobel Prize in 1995.\n", "\n", "At the other end of the spectrum are those who hold that shocks to the economy are frequent and substantial. They believe that appropriate government policy can do a lot to stabilize the economy—to avoid both high unemployment and high inflation.\n", "\n", "This economic policy debate has been going on for generations. It will never be resolved, for the differences are inevitably differences of emphasis rather than sharp lines of division. Even the most “activist” economists recognize the limits imposed on stabilization policy by uncertainty about the structure of the economy and the difficulties of forecasting. Even the greatest believer in the natural stability of the economy—Milton Friedman—believes that the economy is naturally stable only if government policy follows the proper policy of ensuring the smooth growth of the money stock.\n", "\n", " " ] }, { "cell_type": "markdown", "metadata": {}, "source": [ "### 13.4.2 The Implications of Uncertainty\n", "\n", "Because economic policy works with long and variable lags, stabilization policy requires that we first know where the economy is and where it is going. If future conditions cannot be predicted, policies initiated today are as likely to have destructive as constructive effects when they affect the economy 18 months or two years from now.\n", "\n", "In general, economists take two approaches in trying to forecast the near-term future of the economy. The first approach is to use large-scale macroeconometric models—more complicated versions of the models of this book. The second approach is to search for leading indicators: one or a few economic variables not necessarily noted in this book that experience tells us are strongly correlated with future movements in real GDP or inflation. Taking over a former U.S. government task, a private economics research group called the Conference Board now publishes a monthly index of leading economic indicators—10 factors averaged together that many economists believe provide a good guide to economic activity nine or so months in the future.\n", "\n", " \n", "\n", "#### 13.4.2.1 What Are Leading Indicators?: Some Details\n", "\n", "The index of leading indicators contains 10 different components. The index used to be constructed by the Commerce Department’s Bureau of Economic Analysis. As a cost-saving move, it was privatized: It is now compiled and reported by the Conference Board, a nonprofit economic research group. The Conference Board weights all 10 of these components to try to create the best possible index of leading indicators.\n", "\n", " \n", "\n", ">**Components of the Leading Indicators Index**\n", "\n", " \n", "\n", "Of the components that go into the index of leading indicators, perhaps the most broadly watched is the stock market. The level of the stock market is a good indicator of the future of investment spending because the same factors that make corporate investment committees likely to approve investment projects—optimism about future profits, cheap sources of financing, willingness to accept risks—make investors eager to buy stocks and to buy stocks at higher prices. We can read likely future decisions of corporate investment committees from the current value of the stock market. But the stock market is far from perfect as a leading indicator: As economist Paul Samuelson likes to say, the stock market has predicted nine of the past five recessions.\n", "\n", " \n", "\n", "#### 13.4.2.2 The Money Supply as a Leading Indicator\n", "\n", "A second leading indicator that has been closely watched is the money supply. Before the instability of the 1980s monetarists used to claim that the appropriate measure of the money stock was the only leading indicator worth watching. If the central bank can guide the money stock to the appropriate level through open- market operations, then success at managing the economy will immediately and automatically follow.\n", "\n", "As we saw in Chapter 8, no sharp, bright line separates assets that are easy to spend from other assets. A dollar bill is clearly “money” in economists’ sense of being readily spendable purchasing power. But what about a 90-day certificate of deposit with an interest penalty if it is cashed in before it matures? Each place you draw the line gives you a particular total dollar amount of the assets that make up the economy’s “money”— a different monetary aggregate. In order from the smallest to the largest, with each a superset of the one before, the most frequently used measures are called by the shorthand names Ml, M2, and M3.\n", "\n", "These monetary aggregates do not behave the same. At the start of the 1990s the Federal Reserve faced an especially fierce conundrum. During 1992, for example, M l — the narrow measure — grew by more than 14 percent while M3, the broad measure, grew by only 0.3 percent.\n", "\n", "Different measures of the money stock say different things about monetary policy. Republican Party critics of Alan Greenspan continue to blame his tight money policies for George H. W. Bush’s defeat in the presidential election of 1992, with op-ed columnists like Robert Novak and Fred Barnes being the least forgiving of Greenspan, pointing to 1992’s M3 growth of only 0.3 percent. The Federal Reserve was keeping M3 stable, pushing up interest rates and deepening the 1990-1992 recession. What Novak and Barnes do not tell you—and what supporters of Greenspan do—is 1992 also saw extraordinarily rapid growth of M l (and short-term real interest rates of less than zero). While those looking at M3 call 1992’s monetary policy extraordinarily contractionary, those looking at Ml take its 14 percent growth rate as evidence of a recession-fighting monetary policy that was strongly stimulative.\n", "\n", "To say that the money stock is the single most important leading indicator is not helpful if different measures of “the” money stock say different things. And 1992 is not alone. In 2000 — as the stock market reached its peak and started rapidly down — M3 grew by 8.6 percent and M l shrank by 3.3 percent. In 1996 M3 grew by 7.5 percent and Ml shrank by 4.3 percent. Easy money or tight money?\n", "\n", "All in all, being a monetary economist is much harder than it used to be \n", "\n", " \n", "\n", ">**Different Measures of the Money Stock Behave Differently**: The graph shows the annual growth rates of different money stock measures. Since 1980 these different measures have ceased to move together. A year like 1996 in which M1 falls can also see M3 grow, with a difference between the two of more than 10 percentage points per year.\n", "\n", " \n", "\n", "#### 13.4.2.3 The Money Multiplier: Some Details\n", "\n", "The Federal Reserve’s open-market operations change the monetary base: One more dollar’s worth of Treasury bills sold to the public means one dollar of cash or reserve deposits fewer in the hands of the public. The effects of Federal Reserve open-market operations on the money supply are less direct, and less certain. Changes in the monetary base cause amplified changes in the money supply through a process called the money multiplier process.\n", "\n", "When someone deposits $100 in cash in a bank, the Federal Reserve requires the bank to set aside some portion of that deposit as a reserve to satisfy the Fed that the bank is liquid and can meet its daily demands for funds. Suppose—for simplicity’s sake—that the current reserve requirement is 10 percent, so the bank takes $10 of the newly deposited cash and itself deposits it in the nearest regional Federal Reserve Bank as a reserve deposit. The bank then loans out the remaining $90 to collect inter­ est. The borrower receiving the $90 loan typically redeposits it into some other banks. That second wave of banks set aside 10 percent of what they have received—$9—as their reserves, and loan out the remaining $81. This cycle repeats over and over.\n", "\n", "In the end, the 10 percent reserve requirement means that an initial injection of 100 in cash into the banking system leads to an increase in total banking systemwide deposits of 100/10% = 1,000, and an increase in banks’ own reserve deposits at the Federal Reserve of $100. Thus if the Federal Reserve injects, say, $10 billion into the economy in an open-market operation—by purchasing bonds for cash—it triggers a potential increase of as much as 100 billion in the total money supply. We then say that the economy has a money multiplier of 10.\n", " \n", "In practice, the increase in the money supply will be less. Borrowing households and businesses who seek to keep a fixed currency-to-deposits ratio will keep some of the money in cash, so not all money loaned out by banks in one wave will be redeposited in the next. And banks will keep some excess reserves—not all that they could legally lend will be. The money multiplier depends on three factors: the reserve requirements the Federal Reserve imposes on banks, the proportional amount of excess reserves to deposits that banks seek to keep, and the ratio of currency to deposits in which households and businesses prefer to hold their money. \n", "\n", "If you know these three factors, then you can calculate that the money multiplier m is:\n", "\n", "> $ m = \\frac{\\frac{curr}{dep} + 1}{\\frac{curr}{dep} + \\frac{req}{dep} + \\frac{exc}{dep}} $\n", "\n", "where (curr/dep) is households’ and businesses’ desired ratio of currency-to-deposits, (req/dep) is the ratio of required reserves imposed by the Fed, and (exc/dep) is the ratio of excess reserves that banks desire to hold to total deposits.\n", "\n", "Once you know the money multiplier, you can calculate the economywide stock of liquid money assets M by multiplying the monetary base B directly controlled by the Fed by the money multiplier:\n", "\n", ">$ M = mB $\n", "\n", " \n", "\n", ">**Changes in the Currency-to-Deposits Ratio**: The currency-to-deposits ratio was fairly stable up until the late 1970s. Since then it has first risen and then fallen substantially. Its sharp increase and decrease mean that changes in the money stock are not highly correlated with changes in the monetary base produced by Federal Reserve open-market operations.\n", "\n", " \n", "\n", "If any of the three factors determining the money multiplier changes, the money multiplier will change as well—and the money supply will change even if the Federal Reserve has not undertaken any open-market operations and has left the monetary base completely alone:\n", "\n", ">$ \\Delta{M} = \\Delta{m}B $\n", "\n", "Do the factors determining the money multiplier shift? Yes, they do. \n", "\n", " \n", "\n", "#### 13.4.2.4 Long Lags and Variable Effects\n", "\n", "Even if economists have good, reliable forecasts, changes in macroeconomic policy affect the economy with long lags and have variable effects. Estimates of the slope of the IS curve are imprecise: This isn’t rocket science, after all. Economists are estimating the reactions of human beings to changes in the incentives to under­ take different courses of action. They are not calculating the motions of particles that obey invariant and precisely known physical laws.\n", "\n", "Moreover, changes in interest rates take time to affect the level of planned expenditure and real GDP. It takes time for corporate investment committees to meet and evaluate how changes in interest rates change the investment projects they wish to undertake. It takes time for changes in the decisions of corporate investment committees to affect the amount of work being done that builds up the country’s capital stock. It takes time for the changes in employment and income generated by changes in investment to feed through the multiplier process and have their full effect on equilibrium aggregate demand. Thus the level of total prod­ uct now is determined not by what long-term real risky interest rates are now, but by what they were more than a year and a half ago.\n", "\n", "As more than one member of the FOMC has said, making monetary policy is like driving a car that has had its windshield painted black. You guess which way you want to go by looking in the rearview mirror at the landscape behind.\n", "\n", " \n", "\n", "##### 13.4.2.4.1 The Limits of Stabilization: Economic Policy \n", "\n", "Suppose that the target level of real GDP that the central bank hopes to attain is 10,000 billion, but that the central bank staff forecasts that if interest rates are kept at their current levels the real GDP will be only 9,500 billion. Reducing the interest rate will boost real GDP. But how far it will be boosted is uncertain. Suppose that there is one chance in four that a 1-percentage-point reduction in the interest rate will not boost real GDP at all, one chance in two that a 1-percentage- point reduction in the interest rate will boost real GDP by $200 billion, and one chance in four that a 1-percentage-point reduction in the interest rate will boost real GDP by 400 billion.\n", "\n", "What should the central bank do? In this particular example, the answer is that it should do only about half as much as it would if there were no uncertainty about the effects of its policies. The point is general: If the effects of policy are uncertain, do less than you otherwise would, and be cautious.\n", " \n", "Assume that the central bank tries to make the expected value (in billions) of $ (Y - 10000)^2 $ as small as possible: The best situation is to actually have real GDP equal to 10000 billion, and bigger deviations are proportionately worse. Then we can solve the central bank’s problem. We can calculate the amount Ar by which it should reduce the real interest rate.\n", "\n", "If the central bank reduces the real interest rate by $ {\\Delta}r $, there is:\n", "\n", "* One chance in four that $ Y = 9500 $\n", "* One chance in two that $ Y = 9500 + 20000({\\Delta}r) $\n", "* One chance in four that $ Y = 9500 + 40,000({\\Delta}r) $\n", "\n", "In the first case, the squared deviation of Y from 10000 is\n", "$ (-500)^2 $ = 250000$\n", "\n", "In the second case, the squared deviation of Y from 10000 is\n", "$ [20000({\\Delta}r) - 500]^2 = 250000 - 20000000({\\Delta}r) + [400000000({\\Delta}r)^2] $\n", "\n", "In the third case, the squared deviation of Y from 10000 is\n", "$ [40000({\\Delta}r) - 500]^2 = 250000 - 40000000({\\Delta}r) 4 + [ 1600000000({\\Delta}r)^2] $\n", "\n", "Since there is one chance in four of each of the first and third cases, and one chance in two of the second case, the total expected value (in billions) of $ (Y - 10000)^2 $ is:\n", "\n", ">$ 0.25(250000) + 0.50(250000 - 20000000({\\Delta}r) + [400000000({\\Delta}r)^2]) + 0.25(250000 - 40000000({\\Delta}r) 4 + [ 1600000000({\\Delta}r)^2]) $\n", "\n", "When $ {\\Delta}r = 0 $, this expected value is 250000. When $ {\\Delta}r = 0.01 $, this expected value is 110000. When $ {\\Delta}r = 0.015 $, this expected value is 85000. And when $ {\\Delta}r = 0.02 $, this expected value is 90,000. The minimum value of the expected square of the deviation of Y from 10000 billion comes for a value of $ {\\Delta}r = .0167 $, which makes the expected square of the deviation of Y from 10000 equal to 83000.\n", "\n", "Suppose that we didn’t take any account of uncertainty. Suppose that we simply said that the expected value of the increase in real GDP produced by a 1-percentage- point cut in interest rates is 200 billion, and that we have a 500 billion output gap to close. Then we would have set Ar at 2.5 percent—a larger change in the interest rate than the 1.67 percent that turned out to be the best a central bank trying to get real GDP as close as possible to 10000 billion could do.\n", "\n", "Why the difference once one recognizes the uncertainty in the effects of policy? Because active policy to close the output gap has the additional effect of adding yet more variation to real GDP. The stronger the shift in policy, the more uncertain are its effects and the more likely it is that the policy will be counterproductive. This extra risk is the reason that the best thing for the central bank to do in this example is to cut interest rates not by 2.5 percent but by only 1.67 percent.\n", "\n", "The point, however, is quite general. When the effects of your policies are uncertain, do less, and be cautious about undertaking bold policy moves.\n", "\n", " \n", "\n", "### 13.4.3 RECAP: The Power and Limits of Stabilization Policy\n", "\n", "Economists and policy makers have recognized that the ability of the govern­ ment to successfully conduct stabilization policy is limited. Uncertainty about the actual state of the economy combined with the long and variable lags with which economic policies take effect means that monetary and fiscal policy must be slow to respond to sudden falls in production and rises in unemployment. Beyond that, because economic policies have uncertain effects, policies to aggressively fight recessions may well wind up being counterproductive. Good policy makers must be cautious policy makers.\n", "\n", " " ] }, { "cell_type": "markdown", "metadata": {}, "source": [ "## 13.5 Monetary versus Fiscal Policy \n", "\n", "### 13.5.1 Relative Power\n", "\n", "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 Monetary policy had proved to be of little use during the Great Depression: Risk premiums and term premiums were too high and too unstable for changes in the short-term nominal safe interest rates controlled by central banks to have reliable effects on production and employment. In contrast, changes in government spending and in taxes were seen as having rapid and reliable effects on aggregate demand. But over the past 50 years opinion has shifted. Today the overwhelming consensus is that monetary policy has proved itself faster acting and more reliable than discretionary fiscal policy.\n", "\n", "When Congress tries to stabilize the economy by fiscal policy—by passing laws to change levels of taxes and spending—it cannot realistically hope to see changes in the level of output and employment in less than two years after the bill is first introduced into Congress. It takes time for the bill to move through the House of Representatives. It takes more time for the bill to move through the Senate, and for the conference committee to reconcile the different versions. Yet more time must pass before the operating departments in the executive branch of government can change actual spending or write new rules for administering the tax system once Congress has authorized the fiscal change. And it takes more time for the change in government purchases or in net taxes to have its full effect through the multiplier process.\n", "\n", "Monetary policy lags are shorter. The FOMC can move rapidly; once its decisions are made they affect long-term real interest rates on the same day. Substantial lags occur between an interest rate change and output reaching its new equilibrium value: Monetary policy still takes more than a year to work. But monetary policy lags are shorter than those associated with discretionary fiscal policy.\n", "\n", "The fact that the Federal Reserve’s decision and action cycle is shorter than that of the president and Congress means that the Federal Reserve can, if it wishes, neutralize the effects of any change in fiscal policy on planned expenditure. As a rule, today’s Federal Reserve does routinely neutralize the effects of changes in fiscal policy. Swings in the budget deficit produced by changes in tax laws and spending appropriations have little impact on real GDP unless the Federal Reserve wishes them to.\n", "A recent partial exception is provided by the George W. Bush tax cuts of 2001 and 2003. Because the Federal Reserve had already cut interest rates so low, it would have been unable to keep demand stable by lowering interest rates if those tax cuts had not taken place. Near the edge of such a liquidity trap—when the Federal Reserve runs out of room to cut interest rates further—fiscal policy can have powerful effects. \n", "\n", " \n", "\n", "#### 13.5.1.1 Tax Cuts as Stimulus: Economic Policy\n", "\n", "Proponents of discretionary fiscal policy claim the 1964 Kennedy-Johnson tax cut as a success: It stimulated consumption spending and the economy. It was widely perceived as a permanent tax cut that would raise everyone’s permanent income. But critics see it as a fiscal policy failure. Discussed in 1961 and proposed in 1962, it was not enacted until 1964 and had little effect on the economy until 1965-1967.\n", "\n", "In 1961-1962 the unemployment rate was in the range of 5.5 to 6.7 percent. Maybe there was a case for thinking that unemployment was above its natural rate. But by 1965-1966 the unemployment rate was in the range of 3.8 to 4.5 percent, inflation was about to become a serious problem, and Johnson’s advisers were already calling for tax increases to try to reduce aggregate demand and control inflation.\n", "\n", "What about the Reagan tax cuts? The deficits that followed the 1981 Reagan tax cut certainly shifted out the IS curve. But did they raise the level of national product? Almost surely not. The Federal Reserve did not want to see national product expanding so fast as to set inflation rising again. Thus the Reagan deficits led to tighter monetary policy, higher interest rates, and lower investment — not to higher employment and total product. The rule that prevails today and probably will prevail for the next generation is that the Federal Reserve offsets shifts in aggregate demand created by the changing government deficit.\n", "\n", "There is, however, one exception. Stanford’s Michael Boskin argues that the George W. Bush tax cuts of the early 2000s hit the economy at exactly the right moment to cushion the shock to business confidence generated by the September 11, 2001, terror attack on the World Trade Center and the Pentagon. It was not by design—it was by luck—but it was very good luck to have the tax cut taking effect at that exact moment.\n", "\n", " \n", "\n", "#### 13.5.1.2 Fiscal Policy: Automatic Stabilizers\n", "\n", "One kind of fiscal policy works rapidly enough to be important. The so-called fiscal automatic stabilizers swing into action within three months to dampen business cycle-driven swings in disposable income and so moderate the business cycle.\n", "\n", "Whenever the economy enters a recession or a boom, the government’s budget surplus or deficit begins to swing in the opposite direction. As the economy enters a boom, tax collections and withholdings automatically rise because incomes rise. Spending on social welfare programs like food stamps falls because higher employment and higher wages mean that fewer people are poor. Thus the government budget moves toward surplus, without Congress passing or the president signing a single bill. And if the economy enters a recession, tax collections fall, social welfare spending rises, and the government’s budget swings into deficit.\n", "\n", "As unemployment rises and national income falls, taxes fall by about 30 cents for every dollar fall in national product. Government spending rises by about 7 cents for every dollar fall in national product. As a result, a 1 fall in national product produces a fall of only 63 cents in consumers’ disposable income. Thus automatic stabilizers provide more than a dollar's worth of boost to planned expenditure for every 3 dollar fall in production.\n", "\n", "Such fiscal automatic stabilizers would be large enough to reduce the marginal propensity to spend from about 0.6 to about 0.4. This would imply a reduction in the size of the multiplier from about 2.5 to about 1.67. Business cycles could be considerably larger if these automatic stabilizers did not exist, if the Federal Reserve found itself unable to compensate for their disappearance, and if their disappearance did not lead to counteracting changes in the marginal propensity to spend.\n", "\n", " \n", "\n", "#### 13.5.2 How Monetary Policy Works\n", "\n", "For monetary policy to work, the Federal Open Market Committee must first recognize that there is a problem. It takes three to six months for statistical agencies to collect and process the data, for the Federal Reserve to recognize the state of the economy, and for it to conclude that action is needed. To this recognition lag add a policy formulation lag. The FOMC is a committee that moves by con­ sensus. Members who have taken positions out on various limbs need time to climb down. More than six months can elapse between the start of a recession and decisive FOMC action to lower interest rates to try to increase planned expenditure.\n", "\n", "Once the Federal Reserve acts, the response of financial markets is immediate. At the latest, interest rates shift the very day the trading desk at the New York Federal Reseiwe Bank receives new instructions. Often interest rates change in advance of the policy change. Because the Federal Reserve moves by consensus, traders can often guess what it is going to do beforehand. However, for changes in interest rates to change real GDP and unemployment takes more than a year. This means that the Federal Reserve is essentially powerless to smooth out fluctuations in less than a year. The average recession in the post-World War II United States has lasted less than 18 months. This means that by the time monetary policy changes initiated at the beginning of the recession and aimed at reducing its size have their effect on the economy, the recession is likely to be nearly over.\n", "\n", " \n", "\n", "#### 13.5.2.1 Central Bank Instruments of Control: Economic Policy\n", "\n", "Today the Federal Reserve focuses on controlling interest rates to control the economy. In the past it occasionally let interest rates be more volatile and focused on controlling the rate of growth of the money stock, the economy’s total supply of liquid assets.\n", "\n", "Should the Federal Reserve target real interest rates—try to keep them stable, perhaps allowing them to climb when inflation threatens and to fall during a recession? Or should it focus on keeping the money stock growing smoothly because the money stock is a good leading indicator and stabilizing the growth path of this indicator is a good way to stabilize the economy as a whole?\n", "\n", "It depends.\n", "\n", "If the principal instability in the economy is found in a shifting IS curve, then targeting interest rates will do little or nothing to reduce the magnitude of shocks to the economy. Better to have the growth of the money supply react to leading indicators and outcomes. But if the instability lies instead in the relationship between the money stock and real output (the result of volatile money demand) or in a shifting relationship between the monetary base and the money supply (because the currency-to-deposits and reserves-to-deposits ratios vary), then targeting interest rates is wiser.\n", "\n", "In recent years instability has been primarily in the velocity of money and the size of the money multiplier. The money multiplier fluctuated unexpectedly and widely in the 1980s and 1990s, chiefly because of unexpected fluctuations in the currency-to-deposits ratio. Since 1980, the Federal Reserve’s control over the mon­ etary base has not been enough to allow the Federal Reserve to exercise control over the money supply. And the velocity of money has fluctuated as well. By con­ trast, the position of the IS curve has been relatively stable.\n", "\n", "Thus in the past quarter century the Federal Reserve has been more suc­ cessful targeting the level of interest rates than the growth of the money supply.\n", "\n", " \n", "\n", "#### 13.5.3 RECAP: Monetary Versus Fiscal Policy\n", "\n", "Policy affects the economy with a lag. Months or often years elapse from the time a problem occurs, to when policy makers recognize the problem exists, to when they finally reach agreement on a policy solution, to when the solution is put into place, to when the policy solution actually solves the problem. Monetary policy lags are shorter than fiscal policy lags, and that is why economists typically believe monetary policy solves macroeconomic problems better than does fiscal policy. But one type of fiscal policy does work rapidly: automatic stabilizers.\n", "\n", " " ] }, { "cell_type": "markdown", "metadata": {}, "source": [ "## 13.6 Making Good Stabilization Policy: Rules versus Authorities\n", "\n", "In the late 1940s Chicago School economist Henry Simons set the terms for a debate over macroeconomic policy that continues to this day. He asked, Should macroeconomic policy be conducted “automatically,” according to rules that would be followed no matter what? Or should macroeconomic policy be left to authorities — bodies of appointed officials — provided with wide discretion over how to use their power and given general guidance as to what goals to pursue?\n", "\n", " \n", "\n", "### 13.6.1 Competence and Objectives\n", "\n", "The first reason for automatic rules is that we fear that the people appointed to authorities will be incompetent. If people are appointed because of friendships from the past, or because of their ability to rally campaign contributions for a particular cause, there is little reason to think that they will be skilled judges of the situation or insightful analysts. Better then to constrain them by automatic rules. Even if those appointed to authorities are well intentioned, they may fail to find good solutions to macroeconomic problems. The stream of public discourse about macroeconomics is polluted by a large quantity of misinformation.\n", "\n", "A second reason for fixed rules is that authorities might not have the right objectives. To institute a good rule it is only necessary for the political process to make the right decision once—at the moment the rule is settled. But an authority making decisions every day may start pursuing objectives that conflict with the long-run public interest. The state of the economy at the moment of the election is a powerful influence on citizens’ votes. Thus politicians in office have a powerful personal incentive to pursue policies that will sacrifice the health of the economy in the future in order to obtain good reported economic numbers during the election year, thus creating a political business cycle (see Box 13.8).\n", "\n", "#### 13.6.1.1 The Political Business Cycle and Richard Nixon: Economic Policy\n", "\n", "The most famous example of the political business cycle at work comes from the American politician Richard Nixon’s episodic autobiography, Six Crises, published in 1962. Looking back on his defeat in the 1960 presidential election by John E Kennedy, Nixon wrote:\n", "\n", ">Two other developments [that] occurred before the [Republican Party] Convention... [had] far more effect on the election outcome....\n", "\n", ">Early in March [1960], Dr. Arthur Burns.... called on me.... [He] expressed great concern about the way the economy was then acting.... Burns’ conclusion was that unless some decisive government action were taken, and taken soon, we were heading for another economic dip, which would hit its low point in October, just before the elections. He urged strongly that everything possible be done to avert this development... by loosening up on credit and... increasing spending for national security. The next time I saw the President, I discussed Burns’ proposals with him, and he in turn put the subject on the agenda for the next cabinet meeting.\n", "\n", ">The matter was thoroughly discussed by the Cabinet.... Several of the Administration’s economic experts who attended the meeting did not share [Burns’] bearish prognosis.... There was strong sentiment against using the spending and credit powers of the Federal Government to affect the economy, unless and until conditions clearly indicated a major recession in prospect.\n", "\n", ">In supporting Burns’ point of view, I must admit that I was more sensitive politically than some of the others around the cabinet table. I knew from bitter experience how, in both 1954 and 1958, slumps which hit bottom early in October contributed to substantial Republican losses in the House and Senate....\n", "\n", ">Unfortunately, Arthur Burns turned out to be a good prophet. The bottom of the 1960 dip did come in October.... In October... the jobless rolls increased by 452,000. All the speeches, television broadcasts, and precinct work in the world could not counteract that one hard fact.\n", "\n", "By 1972 Richard Nixon was president, and he had appointed Arthur Burns to be chair of the Federal Reserve. The year 1972 saw very good economic statistics—at the price of a sharp acceleration of inflation in subsequent years. Given the smoking gun provided by Nixon in Six Crises, many have diligently searched for evidence that the Federal Reserve made economic policy in 1971 and 1972 not in the public interest but to enhance the private political interest of Richard Nixon.\n", "\n", "However, things are more complicated. Economist Herbert Stein pointed out that Nixon administration economic policy was in fact less expansionary than many Democratic politicians and economic advisers wished: The claim that Burns was leaning to the expansionary side of the center of gravity of opinion is simply not correct. And once Arthur Burns had become chair of the Federal Reserve, Nixon administration officials found him to be truly and annoyingly independent.\n", "\n", "The verdict is that Richard Nixon dearly wished for the Federal Reserve to tune economic policies in a way that would enhance his reelection chances, but that the institutional independence of the Federal Reserve worked. White House political pressure in 1971-1972 led to little if any change in Federal Reserve policy.\n", "\n", " \n", "\n", "#### 13.6.1.2 Is There Now a Political Business Cycle?: Soem Details\n", "\n", "Few would dispute that politicians seek to tune the macroeconomy to their political advantage. The George H. W. Bush administration tried to persuade Federal Reserve Chair Alan Greenspan to pursue a more expansionary monetary policy in 1991 to produce better economic numbers for the George H. W. Bush reelection campaign in 1992, going so far as threatening not to nominate Greenspan for a second term as Federal Reserve chair. \n", "\n", "But it was unsuccessful. \n", "\n", "Richard Nixon certainly believed when he appointed Arthur Burns to be Fed chair that Burns would still be the loyal partisan supporter he had been in 1960—contemplating this appointment, Nixon referred to the “myth of the autonomous Fed” and laughed.\n", "\n", "But how successful are governments at manipulating the political business cycle? It is not clear. It is true that in the United States since 1948, the fourth year of a president’s term—the presidential election year—has seen annual real GDP growth average 0.6 percent more than the average of nonpresidential election years. But there is a 15 percent probability that at least that large a difference would emerge from random chance and sampling variation alone. Faster growth in presidential election years is suggestive, but not conclusive.\n", "\n", "Moreover, other ways of looking at the data deliver even less evidence. Out of 13 post-1948 presidential terms, fully six— Johnson, Nixon-Ford, Carter, Reagan II, Bush 41, and Clinton I—saw slower economic growth in the politically relevant second half of the term than in the first half of the term. This alternative way of looking at the data provides not even a suggestion of evidence one way or another. And it is important when analyzing any situation not to choose to look at the data in only the way that makes one’s preferred conclusion appear the strongest.\n", "\n", "There is, however, stronger evidence not of a politically motivated component to the business cycle but of a politically influenced component to the business cycle. In seven of the last eight post-WWII presidential terms in which Republicans occupied the White House, growth in the second year of a presidential term has been lower than average real GDP growth over that term. By contrast, in only one of the six terms in which Democrats occupied the White House has second-year growth been lower than average.\n", "The odds against this pattern happening by pure chance are astronomical: There is less than one chance in a thousand that it could be the result of random sampling variation.\n", "\n", "Economists Alberto Alesina and Nouriel Roubini interpret this pattern as showing that the political parties have—or had, for Clinton is the Democratic president for whom the pattern of growth fits the Republican model and George W. Bush is the Republican president for whom the pattern fits the Democratic model—different views of the relative costs of unemployment and inflation. Republicans have more tolerance for unemployment and less tolerance for inflation than Democrats do. Hence when Republicans come into office the Federal Reserve feels freer to try to push inflation down to a lower level. Because a considerable por­ tion of inflation expectations relevant for the second year of a presidential term were formed back before the result of the election was known, actual inflation in the second year of a term is less than expected inflation and so economic growth is relatively low.\n", "\n", " \n", "\n", ">**The Politically Influenced Business Cycle: Relative Growth in the Second Year of Presidential Terms**: Economic growth (real GDP) tends to be relatively rapid in the second year of the term of a Democratic president. Economic growth tends to be relatively slow—or negative—in the second year of the term of a Republican president. Data from the 2004 edition of The Economic Report of the President (Washington, DC: Government Printing Office); replicating an analysis conducted by Alberto Alesina and Nouriel Roubini, \"Political Business Cycles in OECD Economies\" (NBER: Working Paper 3478, 1990), subsequently published in the Review of Economic Studies 59, October 1992, pp. 663-688.\n", "\n", " \n", "\n", "#### 13.6.1.3 Technocracy and Independence \n", "\n", "The substitution of technocratic authorities—like the Federal Reserve—in the place of presidents, prime ministers, and finance ministers provides some insu­ lation. The fear that politicians will have objectives different from the long-run public interest has led many to advocate that monetary policy be made by independent central banks. If stabilization policy is to be made by authorities, it should be made by authorities placed at least one remove from partisan politics. And there is some reason to think that the more independent, the better.\n", "\n", " \n", "\n", "### 13.6.2 Credibility and Commitment\n", "\n", "A central bank is always tempted to pursue a more expansionary monetary policy: More expansionary policy raises national product and reduces the unemployment rate. Moreover, it has little impact on inflation in the short run in which expectations of inflation are more or less fixed. In the short run, expansionary monetary policy always seems to be a central bank’s best option.\n", "\n", "Suppose firms and unions agree on large nominal wage and price increases. Then the best short-run policy for the central bank is to accommodate inflation and expand the money supply. To fight inflation by raising interest rates would generate a recession, and inflation would continue anyway. Suppose instead that firms and unions decide on wage and price restraint. Expansionary monetary policy is still better — inflation will be low, and the economy will boom. In either case, pursuing a more expansionary monetary policy produces a better short-run outcome.\n", "\n", " " ] }, { "cell_type": "markdown", "metadata": {}, "source": [ "#### 13.6.2.1 Central Bank Independence: Economic Policy\n", "\n", "A number of economists have investigated the relationship between macroeconomic performance and the degree to which central banks are insulated from partisan politics. They have examined the legal and institutional framework within which central banks in different countries operate, and constructed indexes of the extent to which their central banks are independent.\n", "\n", "Alberto Alesina and Lawrence Summers concluded that the more independent a central bank, the better its inflation performance. More independent central banks presided over lower average inflation and less variable inflation. Moreover, countries with independent central banks did not pay any penalty. Countries with independent central banks did not have higher unemployment, lower real GDP growth, or larger business cycles.\n", "Interpreting this correlation is not straightforward. Perhaps the factors that lead countries to have independent central banks lead them to have low infla­ tion. Perhaps independent central banks do reduce economic growth, but only countries likely to have high economic growth for other reasons are likely to have independent central banks. Nevertheless, at least the post-1950 experience of the industrialized countries strongly suggests that insulating central banks from partisan politics delivers low inflation without any visible macroeconomic cost.\n", " \n", "At the same time, announcing that monetary policy will be more restrictive in the near future produces a better short-run outcome as well, for by announcing that fighting inflation is job one, the central bank may influence the expectations of workers, managers, investors, and households.\n", "\n", "But why—given the obvious short-run benefits of a more expansionary monetary policy—should anyone ever believe that a central bank will actually implement restrictive monetary policy and aim for low inflation? Because, in the long run, a central bank is wiser to keep low inflation as its top priority. Central banks benefit if workers, firms, and investors all believe that future inflation will be low. A central bank that succumbs to the temptation to make inflation higher than expected loses its credibility. All will soon recognize that the central bank’s talk is cheap, and that it has a strong incentive once expec­ tations for a period are formed to make inflation and money growth higher than expected. So the central bank will find that its words about future policy are ignored in the process of setting expectations. And expectations of inflation will be sky-high.\n", "\n", "Economists give this conflict the awkward name “dynamic inconsistency”: What it is good to have workers, managers, investors, and employers believe that you will do in the future is not what seems best to do when the future becomes the present. Many economists have argued that this dynamic inconsistency prob­ lem is a strong point on the side of rules rather than authorities: You don’t have to worry about a rule breaking its word. Others have pointed out that central banks that are concerned with their long-term reputation and credibility appear to have little problem resisting the temptation to make inflation and money growth higher than the firms and workers in the economy had expected. And they have little problem acquiring credibility if they really want to do so, which they do in many ways, including:\n", "\n", "* Complaining that inflation may be rising.\n", "* Refusing to admit even the possibility that monetary expansion might reduce unemployment.\n", "* Repeatedly declaring that price stability is the primary objective.\n", "The most important way to acquire credibility is to possess a history of past successful control of inflation.\n", "\n", " \n", "\n", ">**Inflation and Central Bank Insulation from Politics**: Countries whose central banks are more independent — rate higher on an average index of independence—have lower average inflation rates. Source: J. Bradford DeLong and Lawrence H. Summers, \"Macroeconomic Policy and Long-Run Growth,\" in Policies for Long-Run Economic Growth (Kansas City: Federal Reserve Bank of Kansas City, 1993), pp. 93-128; replicating an analysis carried out by Alberto Alesina, \"Macroeconomics and Politics,\" NBER Macroeconomics Annual 1988 (Cambridge, MA: MIT Press, 1988).\n", "\n", " " ] }, { "cell_type": "markdown", "metadata": {}, "source": [ "### 13.6.3 Modern Monetary Policy\n", "\n", "Whether monetary policy is guided by strict and rigid rules or made by authorities using their discretion to come up with the best policy for the particular—unique—situation, one question remains: What sort of rule should be adopted, or how should the authority behave? What sort of guidelines for monetary policy should those who set the rules or those who staff the authorities follow?\n", "\n", "Economists believe that one set of rules to avoid are those that command the central bank to attain values for real economic variables, like the rate of growth of real GDP or the level of the unemployment rate. The rate of growth of real GDP is limited in the long run by the rate of growth of potential output. The level of the unemployment rate is controlled in the long run by the natural rate of unemployment. A central-bank target of too high a rate of real GDP growth, or too low a level of the unemployment rate, is likely to end in upward-spiraling inflation. A policy that targets nominal variables—like the nominal money stock, or nominal GDP, or the inflation rate—is robust, in the sense that it does not run the risk of leading to disaster if our assessment of the macroeconomic structure of the economy turns out to be wrong.\n", "\n", "Stanford University macroeconomist John Taylor has put forward his Taylor rule as a description of how the Federal Reserve has typically operated, and as a way of adding some structure and order to the process by which the Federal Reserve discusses and makes monetary policy. The Federal Reserve picks a target for inflation. Whenever inflation is higher than the target (and perhaps when unemployment is lower than the Fed’s judgment of the natural rate), it raises interest rates to levels above their normal values to diminish output and employment and put downward pressure on inflation. Whenever inflation is lower than the target (and perhaps when unemployment is higher than its judgment of the natural rate), it lowers interest rates to levels below their normal values to boost output and employment.\n", "\n", "We’ve seen this before: It is the MPRF from Chapter 12 u=u0+ — ttl)\n", "which assumed that the Fed set interest rates according to the Taylor rule\n", "r=»o+»v(7r- rf)\n", "\n", " This is a version of the Taylor rule for interest rates (one that has the central bank reacting only to the inflation rate; in other versions it reacts to unemploy­ ment as well).\n", " \n", "Former Federal Reserve Vice Chair Alan Blinder said he found the framework set out by John Taylor to be extremely helpful in making monetary policy. Taylor did not intend for the rule to be followed exactly. For example, if fiscal policy is unusually tight (or loose) then the federal funds rate should be lower (or higher) than the Taylor rule prescribes. The Taylor rule provides a way to think about how strongly the Federal Reserve should move to counter shocks to the economy. Do you believe that the Federal Reserve should act more aggressively to boost the economy when unemployment is high? Then you are arguing for a larger parame­ ter rv in the Taylor rule. Do you believe that the Federal Reserve reacts too strongly to cool the economy when inflation rises? Then you are arguing for a smaller param­ eter in the Taylor rule.\n", "\n", " " ] }, { "cell_type": "markdown", "metadata": {}, "source": [ "### 13.6.4 RECAP: Making Good Stabilization Policy\n", "\n", "Economists disagree over whether, the centtaT bank, should be: tightly con-: strained by policy rules. Automatic rules are favored by thdse who believe the authorities are incompetent or misguided. In the United States, the central bank is at least somewhat removed from partisan politics and is given wide discretion/ A central bank which, at its discretion, pursues a goal of long-run price stability will have more credibility,than one that succumbs to pressure to use short-run expansionary monetary policy to boost employment. The Taylor rule describes how the Federal Reserve typically operates. Despite its name, the Taylor rule is not a rule that the FOMC must follow but a frame­ work for understanding the choices made by monetary authorities operating with discretion.\n", "\n", " " ] }, { "cell_type": "markdown", "metadata": {}, "source": [ "## 13.7 Financial Crises\n", "\n", "Perhaps the most important policy tools of central banks are those that we almost never see used. A huge danger to economies is the possibility of a large- scale financial crisis—like those the U.S. suffered in 1933, 1929, 1907, 1893, 1884, and 1873, and 2007-8; like that East Asia suffered in 1997-1998; like that Mexico suffered in 1994-1995; like that the European Union suffered in 2009-11. \n", "\n", "For nearly 400 years market economies have undergone financial crises—episodes when the prices of stocks or of other assets crash, everyone tries to move their wealth into safer forms at once, and the consequent panic among investors can lead to a prolonged and serious depression. Managing such financial crises has been one of the responsibilities of monetary policy makers for more than a century and a half.\n", "\n", "A financial crisis sees investors as a group suddenly (and often not very rationally) become convinced that their investments have become overly risky. As a result, they try to exchange their investments for high-quality bonds and cash. But as everyone tries to do this at once, they create the risk that they hoped to avoid: Stock and real estate prices crash, and interest rates spike upward as investors try to increase their holdings of relatively safe, liquid assets.\n", "\n", "The sharp rise in real interest rates that occurs in a financial crisis can severely reduce investment, sending the economy into a deep depression. Moreover, once the crisis gathers force, the ability of monetary policy tools to boost investment may well be limited. Financial crises are accompanied by steep rises in risk pre­ miums. They are often accompanied by sharp rises in term premiums as well, as investors decide that they want to hold their wealth in as liquid a form as possi­ ble. And financial crises frequently generate deflation as well.\n", "\n", "All of these drive a large wedge between the short-term nominal safe interest rates that the central bank controls and the long-term real risky interest rate relevant for the determination of investment and planned expenditure. The central bank may have done all it can via open-market operations to reduce short-term safe nominal interest rates to their lowest possible level, but it may not be enough: Long-term real risky interest rates may well remain very high indeed.\n", "\n", "But central banks have powerful (albeit rarely visibly used) tools to stem financial crises. They can make direct loans to institutions in trouble — act as what MIT economist Charles Kindleberger called a “lender of last resort” in order to restore confidence that making new loans even in a time of crisis is not unduly risky. And since the Great Depression governments have provided deposit insurance to keep savers from pulling their money out of the financial system in a crisis, thus generating a collapse of the banking and payments system for no reason other than their fear that the banking and payments system might collapse.\n", "\n", " " ] }, { "cell_type": "markdown", "metadata": {}, "source": [ "### 13.7.1 Lenders of Last Resort\n", "\n", "What can a central bank do in a financial crisis? In such a situation a central bank can do a lot of good easily by rapidly expanding the money supply, so that the increase in the demand for liquid assets to hold doesn’t lead to a spike in interest rates and a crash in other asset prices.\n", "\n", "It can also do a lot more good by lending directly to institutions that are fundamentally solvent—that will, if the crisis is stemmed and resolved rapidly, be able to function profitably—but that are temporarily illiquid in the sense that no one is willing to lend to them because no one is confident that the crisis will be resolved. Such a lender of last resort can rapidly reduce risk and term premiums as it reduces safe short-term nominal interest rates, and it can end the financial crisis.\n", "\n", "The problem is that a central bank can also do a lot of harm if it bails out institutions that have gone bankrupt, by encouraging others in the future to take excessive risks hoping that the central bank will bail them out. Thus the central bank has to (1) expand the money supply and lend freely to institutions that are merely illiquid—that is, caught short of cash but fundamentally sound—while (2) forcibly liquidating institutions that are insolvent, those that could never repay what they owe even if the panic were stemmed immediately. This is a neat trick, to save one without saving the other.\n", "\n", "A central bank can take institutional steps in advance to reduce the chance that the economy will suffer a financial crisis and reduce the damage that a financial panic will do. The first and most obvious step is to do a good job as a supervising regulator over the banking system. Depositors will panic and pull their money out of a bank when they fear that it is bankrupt—that it no longer has enough capital, and that the capital plus the value of the loans that it has made are together lower than the value of the money it owes to its depositors. If banks are kept well capitalized, and if banks that fail to meet standards for capital ade­ quacy are rapidly taken over and closed down, then the risk of a full-fledged financial panic is small.\n", "\n", "The potential problem with this strategy of supervision and surveillance is that it may be politically difficult to carry out. Bankers are, after all, often wealthy and influential people with substantial political connections. Bank regulators are midlevel civil servants, subject to pressure and influence from politicians.\n", "\n", " " ] }, { "cell_type": "markdown", "metadata": {}, "source": [ "### 13.7.2 Deposit Insurance and Moral Hazard\n", "\n", "The most recent major financial crisis in the United States was long ago. It took place during the Great Depression, and it was not only the last major but also the most destructive financial crisis the United States ever saw.\n", "\n", "Banks closed; at the beginning of 1933, more than one in three of the banks that had existed in 1929 had closed its doors. When banks failed, people who had their money in them were out of luck; years might pass before any portion of their deposits would be returned. Hence fear of bank failure led to an immediate increase in households’ and businesses’ holdings of currency relative to deposits. In the Great Depression this flight from banks reduced the money supply.\n", "\n", "With 6,000 banks failing in the first three years of the Depression, more and more people felt that putting their money in a bank was not much better than throwing it away. Since a rise in the currency-to-deposits ratio carries with it a fall in the money multiplier, fear of bank failures shrank the money stock. That only deepened the Depression. Something had to be done to prop up depositors’ confidence.\n", "\n", "One of the reforms of President Franklin D. Roosevelt’s New Deal program in the 1930s was the institution of deposit insurance provided by the Federal Deposit Insurance Corporation—the FDIC. If your bank failed, the government would make sure your deposits did not disappear. The aim was to diminish monetary instability by eliminating bank failure-driven swings in the money supply and interest rates.\n", "\n", "Since the 1930s, federal deposit insurance has acted as a monetary automatic stabilizer. A financial panic gathers force when investors conclude that they need to pull their money out of banks and mutual funds because such investments are too risky. Deposit insurance eliminates the risk of keeping your money in a bank—even if the bank goes belly-up, your deposit is still secure. Thus there is no reason to seek to move your money to any safer place. Deposit insurance has broken one of the important links in the chain of transmission that used to make finan­ cial panics so severe.\n", "\n", "The availability of deposit insurance and the potential existence of a lender of last resort do not come for free. These institutions create potential problems of their own—problems that economists discuss under the heading of moral hazard. If depositors know that the Federal Deposit Insurance Corporation has guaranteed their deposits, they will not inquire into the kinds of loans that their bank is making. Bank owners and managers may decide to make deliberately risky high-interest loans. If the economy booms and the loans are repaid, then they make a fortune. If the economy goes into recession and the risky firms to which they have loaned go bankrupt, they declare bankruptcy too and leave the FDIC to deal with the depositors. It becomes a classic game of heads-I-win-tails- you-lose.\n", "\n", "The principal way to guard against moral hazard is to make certain that decision makers have substantial amounts of their own money at risk. Making risky loans using government-guaranteed deposits as your source of funding is a lot less attractive if your personal wealth is the first thing that is taken to pay off depositors if the loans go bad. Hence deposit insurance and lenders of last resort function well only if there is adequate supervision and surveillance: only if the central bank and the other bank regulatory authorities are keeping close watch on banks, and making sure that every bank has adequate capital, so that it is the shareholders’ and the managers’ funds, rather than those of the FDIC, that are at risk if the loans made go bad.\n", "\n", " " ] }, { "cell_type": "markdown", "metadata": {}, "source": [ "### 13.7.3 RECAP: Financial Crises\n", "\n", "In the extreme situations of financial crises, economic policy makers face a choice between large-scale bankruptcy, the possible unraveling of the financial system, and deep depression on the one hand; and rewarding those who have made overspeculative and overleveraged bets on the other.\n", "\n", " " ] }, { "cell_type": "markdown", "metadata": {}, "source": [ "### Chapter Summary\n", "\n", "1. Macroeconomic policy should attempt to stabilize the economy: to avoid extremes of high unemployment and also of high and rising inflation.\n", "2. Long and variable lags make successful stabilization policy difficult.\n", "3. Economists arrange themselves along a spectrum, with some advocating more aggressive management of the economy and others concentrating on establishing a stable framework and economic environment. But compared to differences of opinion among economists in the past, differences of opinion today are minor.\n", "4. In today’s environment, monetary policy is the stabilization policy tool of choice, largely because it operates with shorter lags than does discretionary fiscal policy.\n", "5. Nevertheless, the fiscal “automatic stabilizers” built into the tax system play an important role in reducing the size of the multiplier.\n", "6. Uncertainty about the structure of the economy or the effectiveness of policy should lead policy makers to be cautious: Blunt policy tools should be used carefully and cautiously lest they do more harm than good.\n", "7. The advantage of having economic policy made by an authority is that the authority can use judgment to devise the best response to a changing — and usually unforeseen—situation.\n", "8. The advantages of having economic policy made by a rule are threefold: First, rules do not assume competence in authorities where it may not exist; second, rules reduce the possibility that policy will be made not in the public interest but in some special interest; third, rules make it easier to avoid so-called dynamic inconsistency.\n", "9. Dynamic inconsistency arises whenever a central bank finds that it wishes to change its previously announced policy in an inflationary direction: It is always in the central bank’s short-term interest to have money growth be higher, interest rates lower, and inflation a little higher than had been previously expected.\n", "10. Today, however, central banks are by and large success­ ful in taking a long-term view. They pay great attention to establishing and maintaining the credibility of their policy commitments.\n", "11. Monetary authorities are vitally important during a fi­ nancial crisis. They can expand the money supply or serve as a lender of last resort. But they must be wise, for a bluntly applied policy can hurt as readily as it helps during a financial crisis.\n", "\n", " " ] }, { "cell_type": "markdown", "metadata": {}, "source": [ "## Catch Our Breath\n", "\n", "\n", "\n", "* Ask me two questions…\n", "* Make two comments…\n", "\n", " \n", "\n", "* Further reading…\n", "\n", "
\n", "\n", "----\n", "\n", "Lecture Support: <> \n", "Keynote: <>\n", "\n", " \n", "\n", "----" ] } ], "metadata": { "kernelspec": { "display_name": "Python 3", "language": "python", "name": "python3" }, "language_info": { "codemirror_mode": { "name": "ipython", "version": 3 }, "file_extension": ".py", "mimetype": "text/x-python", "name": "python", "nbconvert_exporter": "python", "pygments_lexer": "ipython3", "version": "3.6.6" } }, "nbformat": 4, "nbformat_minor": 2 }