Stabilization policy


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Stabilization policy

  1. 1. Stabilization Policy MSB, Chapter 15, pp. 364-383. 1
  2. 2. What can the government do to reduce business fluctuations? Can the government stabilize the economy by using fiscal and monetary policy? Monetary policy can be implemented through changing money supply or the rate of interest. An expansionary monetary policy implies expanding money supply or directly reducing the rate of interest. A restrictive monetary policy implies reducing money supply or directly increasing the rate of interest. 2
  3. 3. A fiscal policy may be carried out by changing the government expenditure or by changing taxes. An expansionary fiscal policy implies higher government expenditure or lower taxes. This implies a government budget deficit. This deficit can be financed in two ways. The first way consists in the central bank buying government debt bonds issued by the government; in this case the government budget deficit also implies an increase in money supply. The European Central Bank is forbidden in its statute from following this route. This is not the case, for instance, with the US Federal Reserve System (FED). 3
  4. 4. The alternative way is for savers to buy bonds issued by the government to finance its budget deficit. This is the only way that can be followed in the Eurozone. In this case an increase in the government deficit means that more government bonds will be issued, i.e. additional government debt will be created. The excess supply of government bonds will decrease their market price and this will increase the rate of interest. The opposite happens when the government uses a restrictive fiscal policy reducing its deficit by decreasing government expenditure or increasing taxes. 4
  5. 5. P0 Y0Y1 P1 AD AS LRAS A downturn in a business cycle: a negative aggregate demand shock (fall in firms’ investment expectations) reduces real GDP and increases unemployment. 5
  6. 6. P0 Y0Y1 P1 AD AS LRAS The government may bring back the economy to its full employment position by increasing expenditures or reducing taxes. The central bank could achieve the same result by expanding money supply and/or reducing the interest rate. 6
  7. 7. P0 Y0Y1 P1 AD AS LRAS A negative aggregate supply shock (increase in oil price) reduces real GDP and increases the price level (stagflation). 7
  8. 8. P0 Y0Y1 P1 AD AS LRAS The government can try to support a recovery through an expansionary fiscal policy (or the Central Bank could do the same by reducing interest rates). The result will be a higher real GDP but also a higher inflation. 8
  9. 9. The idea that government’s fiscal policy or monetary policy could stabilize the business cycle has been very popular until recently, when it started to be objected by many economists. One objection makes reference to the so called “automatic stabilizers”. The idea is that there is no need of an explicit stabilization policy as to a significant extent government spending and taxes respond automatically to the business cycle. In a recession taxes tend to fall due to falling incomes and private sector spending. Some government expenditures such as transfers for unemployment benefits tend to rise. As a result aggregate demand tends to automatically increase during a recession. 9
  10. 10. A more significant objection concerns the effectiveness of a fiscal stabilization policy, for instance of a fiscal deficit. This kind of objection is summarized in the so called “Ricardian equivalence principle”. In the eighteen century English economist David Ricardo claimed that financing government expenditure by rising taxes or by issuing government debt would have little impact on demand if people were forward-looking. Suppose that in period 1 the government finances a budget deficit by issuing debt (D): 1 1 1G T D 10
  11. 11. In period 2 the government has to repay the debt plus the interests. This means that in period 2 the government must have a budget surplus; the government intertemporal budget constraint is: 2 2 1 1 1T G (1 r)D (1 r) G T If in period 1 consumers have saved, in period 2 they can consume: 2 2 2 1 1 1C Y T 1 r Y T C 2 2 2 1 1 1 C Y T C Y T 1 r 1 r 1 r Dividing both sides by (1+r), we obtain: 11
  12. 12. The present value of consumption equals the present value of pre-tax incomes minus the present value of taxes. 2 2 1 1 1T G (1 r)D (1 r) G T implies 2 2 1 1 G T G T 1 r 1 r The present value of government spending equals the present value of tax revenue. 2 2 2 1 1 1 C Y T C Y T 1 r 1 r 1 r 12
  13. 13. and imply 2 2 2 1 1 1 C Y G C Y G 1 r 1 r 1 r The intertemporal budget constraint for households makes no explicit reference to the fiscal deficit. This is because lower taxes today must be compensated by higher taxes in the future. In this situation a budget deficit is likely to be compensated by lower consumption and higher saving with no real impact on aggregate demand. 2 2 2 1 1 1 C Y T C Y T 1 r 1 r 1 r 2 2 1 1 G T G T 1 r 1 r 13
  14. 14. These implications of the Ricardian equivalence are too drastic. For example, there is no reason to believe that the expectation of higher future taxes should necessarily reduce the current private demand. If the expansionary fiscal policy is successful, the increase in future GDP will provide the basis for the future required increase in taxes. This requires: • that the multiplier effects of fiscal deficits are sizeable and predictable, • that the fiscal deficit is temporary, which makes less likely that future taxes should be levied in order to face future higher public debt. 14
  15. 15. Another objection to the effectiveness of fiscal stabilization policy is the “crowding out effect”. We have seen that when the government follow an expansionary fiscal policy by increasing its deficit because of higher expenditures or lower taxes two things can happen. Either the central bank finances this higher deficit by issuing more money to buy the newly issued government bonds corresponding to the additional public debt. Or, when this is forbidden as in the Eurozone, savers must buy the newly issued government bonds. In this second case the rate of interest will increase. 15
  16. 16. When an expansionary government deficit is financed by the Central Bank thorugh new money supply, this implies that both the IS and the LM curves will shifts outwards. The effect will be that of expanding the aggregate demand with no effect on the rate of interest. r Y IS LM r Y Y 16
  17. 17. If the government expands its expenditure or cuts taxes, and expands its budget deficit creating new government debt, only the IS curve shifts outwards. Given money supply, the rate of interest increases. The increase of the rate of interest reduces the initial increase in aggregate demand. r Y IS LM r Y r Y The expansionary effect of the budget deficit is lower than in the case than it is when accompanied by an expansionary monetary policy. 17
  18. 18. The case where expansionary fiscal policy is not accompanied by monetary policy means that the new created government debt to finance the government deficit must be absorbed by the market. In this case the rate of interest increases and this has a negative effect on the private investment expenditure. This means that the government expenditure, or more generally the government deficit, “crowds out” private expenditure. The result is a lower expansionary effect on the level of aggregate demand. 18
  19. 19. The Inflation-Output Trade-off. Expansionary fiscal and monetary policies increase the aggregate demand and reduce unemployment, but the price level rises, so that they also produce inflation. The British economist Bill Phillips found a decreasing empirical regularity between unemployment and inflation: the lower the unemployment, the higher inflation tended to be; and viceversa. This is called “Phillips curve”. 19
  20. 20. 2 3 4 5 6 7 8 0 2 4 6 8 10 Wage inflation. Unemployment. U.S. Phillips curve 1945-1970 20
  21. 21. 21 The Nobel prize winners in Economics, Edmund Phelps and Milton Friedman, provided a formal expression for the Phillips curve by introducing the role of expected inflation. Suppose that in the labor market the natural rate of unemployment prevails, with a corresponding real wage. Suppose that expected inflation is 3%. If wages and prices increase at the same rate as the expected inflation, real wages will remain constant and the rate of unemployment would remain at the natural rate. Suppose now that prices increase by more than 3%, while expected inflation remains at 3% so that money wages (governed by inflation expectations) increase only by 3%. Real wages would fall and firms would hire more workers: the unemployment rate would fall below the natural level.
  22. 22. = rate of inflation e = expected rate of inflation u = rate of unemployment uN = natural rate of unemployment Define: The Phillips curve is 22 e Nu u e Nu u e Nu u e Nu u
  23. 23. e Nu u The Phillips curve 23 e Nu u e Nu u e Nu u e Nu u
  24. 24. The Phillips curve derives from some assumption leading wages to adjusting not as rapidly as prices. This is because inflation expectations do not immediately adjust to current inflation. When the government through expansionary fiscal and monetary policies increases the price level, money wages increase less than the price level, and the real wages fall. Unemployment falls as firms will demand more labor at lower real wages. When the government through restrictive fiscal and monetary policies reduces the price level, money wages fall less than the price level, and the real wages increase. Unemployment increases as firms will demand less labor at higher real wages. 24
  25. 25. The Phillips curve can be adjusted to take into account supply shocks: e Nu u x where x represents a supply shock; for instance an increase in the oil price. The Phillips curve shifts: • if the natural rate of unemployment changes; • if the expected inflation changes; • if there are supply shocks. All these events characterized the development of the advanced economies from the eighties of the last century. From that period the relation between inflation and unemployment does not fully and always correspond to a Phillips curve. 25
  26. 26. -2 0 2 4 6 8 10 12 14 16 0 2 4 6 8 10 12 Inflation(%) Unemployment (%) United States Inflation and unemployment in the United States , 1980-2009 26 MSB, p.376
  27. 27. -2 0 2 4 6 8 10 0 1 2 3 4 5 6 Inflation(%) Unemployment (%) Japan Inflation and unemployment in Japan, 1908-2009 27 MSB, p.376
  28. 28. -1 0 1 2 3 4 5 6 7 0 2 4 6 8 10 12 Inflation(%) Unemployment (%) Germany Inflation and unemployment in Germany, 1980-2009 28 MSB, p.376
  29. 29. 0 2 4 6 8 10 12 14 16 18 0 2 4 6 8 10 12 14 Inflation(%) Unemployment (%) United Kingdom Inflation and unemployment in UK, 1980-2009 29 MSB, p.377
  30. 30. In particular, there is a different Phillips curve for each level of inflation expectations. In UK in the period between 1957 and 1997 inflation was higher that in the period between 1856 and 1957; and so were inflation expectations. 30 MSB, p.378
  31. 31. Nu u Suppose that initially the unemployment equals its natural (equilibrium) level, with actual and expected inflation of 2%. e 0 0 2% A B 1 4% 1u The government wishes to achieve lower unemployment and increases government spending. Inflation moves to 4%. Because of nominal wage sluggishness, real wages fall and unemployment falls. 31
  32. 32. Nu u Sooner or later inflation expectations will be revised upwards to react to the higher inflation: the Phillips curve shifts upwards. e 0 2% A Be 1 24% 1u Higher inflation expectations mean that wages will adjust upwards; unemployment increases back to the natural level. C The new inflation rate has increased to 4%. The long run effect of the expansionary policy is only higher inflation. e e N Nu u u u 32
  33. 33. Nu u If the government wants to keep unemployment below the natural rate it must increase demand again. Inflation will jump to 6%. e 0 2% A Be 1 24% 1u e 2 36% C D E When inflation expectations will have adjusted to 6%, the Phillips curve shifts again upwards. Unemployment will increase to its natural level. But the inflation rate will now higher: 6% instead of 4%. 33
  34. 34. If individuals adapt their inflation expectations in response to changes in observed inflation, expansionary government policies will have short run effects in terms of lower unemployment, but they will eventually produce only higher inflation. In the long run there is only a vertical Phillips curve: there in no trade off between inflation and output. The only way to reduce permanently the rate of unemployment is to reduce the natural rate of unemployment through supply and not through demand policies. The question of the way and of at which speed individual agents adjust their inflation expectations is crucial. 34
  35. 35. Nu u Suppose initially the unemployment equals its natural (equilibrium) level, with actual and expected inflation of 6%. 1 2% A 0 6% 1u Monetary policy is tightened to reduce inflation to 2%. If inflation expectations are not revised downwards, real wages increase, the demand for labor falls, unemployment rises and the economy goes to point B. B 35
  36. 36. Nu u Eventually the private sector will adjust its inflation expectations to 2%: the Phillips curve will shift downwards. e 1 1 2% A 0 6% 1u With lower inflation expectations, wages will fall, the demand for labor will increase and the unemployment will go back to its natural level. The inflation will be lower but at the price of a period of unemployment. B C 36
  37. 37. But suppose now that people are rational in forming their expectations: they anticipate and believe that the government will be successful in reducing inflation at 2%. They immediately revise downwards their inflation expectations when the monetary authority announces its willingness to reduce inflation. The Phillips curve shifts immediately downwards as there is no need that unemployment increases to induce people to revise their inflation expectations downwards. 37
  38. 38. Nu u e 1 1 2% A 0 6% C 38 With rational expectations, the simple announcement of the monetary authority will be enough to move the economy to point C (inflation at 2% and natural rate of unemployment). Rationality of expectations and credibility of the monetary authority are crucial.
  39. 39. To be credible both fiscal and monetary stabilization policies should be consistent, and particularly they should be “time consistent”. Suppose the Central Bank has followed an monetary policy to lower inflation and this has succeeded in lowering inflation expectations, shifting down the Phillips curve and allowing the economy to be at its natural unemployment rate. Now suppose that after some time the government decides to follow an expansionary fiscal policy: the unemployment rate falls along the Phillips curve. People should now immediately revise inflation expectations upwards; but they may be reluctant to do it, in presence of an inconsistent behavior from the Central Bank. 39
  40. 40. Nu u e 1 1 Ae 0 0 B e 0PC( ) e 1PC( ) 1u C Suppose the economy starts at A with high expected and actual inflation. Monetary policy has been successful in lowering inflation expectations and shifting the economy at B. Now the government uses a fiscal policy to move to C. People should shift up inflation expectations again; the economy would go back to A with a higher inflation. They may be reluctant to do so. 40 To avoid time inconsistency it has been proposed that the central bank should always control inflation and the government always follow a balanced-budget rule.