1macroeconomicsfifth editionN. Gregory MankiwPowerPoint®Slides by Ron Cronovichmacro © 2002 Worth Publishers, all rights reservedTopic 12:Stabilization Policy(chapter 14)CHAPTER 14CHAPTER 14 Stabilization PolicyStabilization Policyslide 1Question 1:Question 1:Should policy be Should policy be ______ or _____?______ or _____?CHAPTER 14CHAPTER 14 Stabilization PolicyStabilization Policyslide 2Arguments for active policyArguments for active policy§ Recessions cause economic hardship for millions of people.§ The Employment Act of 1946: “it is the continuing policy and responsibility of the Federal Government to…promote full employment and production.”§ The model of aggregate demand and supply (Chapters 9-13) shows how fiscal and monetary policy can respond to shocks and stabilize the economy.2CHAPTER 14CHAPTER 14 Stabilization PolicyStabilization Policyslide 3Arguments against active policyArguments against active policy1. ________________ __________: the time between the shock and the policy response§ takes time to recognize shock§ takes time to implement policy, especially fiscal policy__________: the time it takes for policy to affect economyIf conditions change before policy ’s impact is felt, then policy may end up destabilizing the economy.CHAPTER 14CHAPTER 14 Stabilization PolicyStabilization Policyslide 4Automatic stabilizersAutomatic stabilizers§ definition: ____________________________________________________________________.§ They are designed to reduce the lags associated with stabilization policy.§ Examples:– income tax– unemployment insurance– welfareCHAPTER 14CHAPTER 14 Stabilization PolicyStabilization Policyslide 5Forecasting the Forecasting the macroeconomymacroeconomyBecause policies act with lags, __________________________________________.Ways to generate forecasts:• ___________________: data series that fluctuate in advance of the economy• Macroeconometric ______:Large-scale models with estimated parameters that can be used to forecast the response of endogenous variables to shocks and policies3CHAPTER 14CHAPTER 14 Stabilization PolicyStabilization Policyslide 6Mistakes Forecasting the Recession of 1982Mistakes Forecasting the Recession of 1982YearUnemploymentrate (percent)1986Actual1983:41983:21982:41982:21981:41981:219851984198319821981198011.010.510.09.59.08.58.07.57.06.56.0CHAPTER 14CHAPTER 14 Stabilization PolicyStabilization Policyslide 7Forecasting the Forecasting the macroeconomymacroeconomyBecause policies act with lags, policymakers must predict future conditions.The preceding slides show that the The preceding slides show that the forecasts are often wrong. forecasts are often wrong. This is one reason why some This is one reason why some economists oppose policy activism. economists oppose policy activism. CHAPTER 14CHAPTER 14 Stabilization PolicyStabilization Policyslide 8The Lucas CritiqueThe Lucas Critique§ Due to Robert Lucaswon Nobel Prize in 1995 for “rational expectations”§ Forecasting the effects of policy changes has often been done using models estimated with historical data. § Lucas pointed out that such predictions would not be valid if the policy change ______________________________________________________________________________.4CHAPTER 14CHAPTER 14 Stabilization PolicyStabilization Policyslide 9An example of the Lucas CritiqueAn example of the Lucas Critique§ Prediction (based on past experience):an increase in the money growth rate will reduce unemployment§ The Lucas Critique points out that increasing the money growth rate may raise expected inflation, ________________________________________________________________. CHAPTER 14CHAPTER 14 Stabilization PolicyStabilization Policyslide 10The JuryThe Jury’’s Outs Out……Looking at recent history does not clearly answer Question 1: • It’s hard to identify shocks in the data,• and it’s hard to tell how things would have been different had actual policies not been used.CHAPTER 14CHAPTER 14 Stabilization PolicyStabilization Policyslide 11Question 2:Question 2:Should policy Should policy be conducted by be conducted by ____ or _______?____ or _______?5CHAPTER 14CHAPTER 14 Stabilization PolicyStabilization Policyslide 12Rules and Discretion: basic conceptsRules and Discretion: basic concepts§ Policy conducted by rule : Policymakers announce in advance how policy will respond in various situations, and commit themselves to following through.§ Policy conducted by discretion:As events occur and circumstances change, policymakers use their judgment and apply whatever policies seem appropriate at the time.CHAPTER 14CHAPTER 14 Stabilization PolicyStabilization Policyslide 13Arguments for RulesArguments for Rules1. __________________________________________________________________§ misinformed politicians§ politicians’ interests sometimes not the same as the interests of societyCHAPTER 14CHAPTER 14 Stabilization PolicyStabilization Policyslide 14Arguments for RulesArguments for Rules2. The Time Inconsistency of Discretionary Policy§ def: ______________________________________________________________________________________.§ Destroys policymakers’ credibility, thereby reducing effectiveness of their policies.6CHAPTER 14CHAPTER 14 Stabilization PolicyStabilization Policyslide 15Examples of TimeExamples of Time--Inconsistent PoliciesInconsistent PoliciesTo encourage investment, To encourage investment, government announces it government announces it wonwon’’t tax income from capital. t tax income from capital. But once the factories are built, But once the factories are built, the the govtgovt reneges in order to reneges in order to raise more tax revenue.raise more tax revenue.CHAPTER 14CHAPTER 14 Stabilization PolicyStabilization Policyslide 16Monetary Policy Rules Monetary Policy Rules c.a.b.d.Target Federal Funds rate based on§ inflation rate§ gap between actual & full-employment GDPCHAPTER 14CHAPTER 14 Stabilization PolicyStabilization Policyslide 17The Taylor RuleThe Taylor Rulewhere: = nominal federal funds rateffiGDP Gap = 100YYY−×= the percent by which real GDP is below its natural rate + 2 + 0.5(2) 0.5(GDP Gap)ffi =−−ππ7CHAPTER 14CHAPTER 14 Stabilization PolicyStabilization Policyslide 18The Taylor RuleThe Taylor Rule§ If π = 2 and output is at its natural rate, then monetary policy targets the nominal Fed Funds rate at 4%.§ For each one-point increase in π, mon.