11Stabilization Policy• Introduction to Stabilization Policy.¾ Goals,¾ Framework, and¾ Challenges.2Stabilization Policy• Goal: Dampen the business cycle, i.e., to keep Ye close to Yn.¾ Less volatility is “better” because of less uncertainty.¾ Success!• Volatility since 1984 has been about ½ of what it was between 1959- 84.3Stabilization PolicyReal Gross Domestic Product-4048121960 1965 1970 1975 1980 1985 1990 1995 2000Year-on-Year Percent Change4Stabilization PolicyOutput Ratio-8-40481960 1965 1970 1975 1980 1985 1990 1995 2000Percent: Actual to Potential GDP5Stabilization Policy• Goal: Dampen the business cycle. ¾ Reasons for Success:• Better application of technology,• Deregulation,¾ Financial markets,¾ Transportation, energy, etc.• Better policy implementation, and• Luck.6Stabilization Policy• Framework:¾ Identify the target variables:• Economic output,• Unemployment rate, and• Inflation.27Stabilization Policy• Framework (continued):¾ Use (major) policy variables:• Monetary policy, and• Fiscal policy.8Stabilization Policy• Framework (continued):¾ Use (minor) policy variables:• Miscellaneous policies:¾ Regulatory policy,¾ Wage and price policies, and¾ Employment policies.• International policies:¾ Trade treaties,¾ Tariffs and quotas, and¾ Exchange rates.9Stabilization Policy• Stabilization Challenges:¾ Unrealistic precision of models and data,¾ Structural uncertainties,¾ Multiplier uncertainties,¾ Time (or policy) lags,¾ Asymmetries, and¾ Expectations.10Stabilization Challenges• Unrealistic precision and simplicity of models & data.¾ Models imply a precision that does NOT exist in the real world.¾ Models imply a simplicity that does NOTexist in the real world.• Interest rates and the yield curve.¾ Unrealistic precision of data.• Particularly, potential output, Yn and• Productivity growth.11Stabilization Challenges• Structural uncertainties:¾ Structure of the economy is more complicated.¾ Structure of the economy is not stable.• Financial deregulation.• Production deregulation.• Globalization.¾ Transmission mechanisms are more complicated and subtle.12Stabilization Challenges• Multiplier Uncertainties:¾ Multiplier effects are not instantaneous.¾ There is often more than 1 change taking place.¾ Multipliers change with changes in the economy.• Housing finance.• Consumer finance.• Flexible exchange rates. ¾ Asymmetries; the importance of initial conditions.313Stabilization Challenges• Fiscal Policy Multipliers:¾ Start large, grow, then fade.• Large initial impact.• Multiplier effects.14Fiscal Policy MultipliersTime2.01.51.00.50.0-0.5Government Spending MultiplierWithout r responseWith r response15Stabilization Challenges• Fiscal Policy Multipliers:¾ Start large, grow, then fade.• Fade because:¾ Higher r crowds out Ip,¾ Higher r raises $ which reduces ( X – M ),¾ Higher r increases debt burdens,¾ Higher r reduces wealth, and¾ Higher inflation.16Stabilization Challenges• Monetary Policy Multipliers:¾ Start small, build, then fade.• No direct spending effect.• Multiplier effect.17Monetary Policy MultipliersTimeMoney Multiplier4.03.02.01.0018Stabilization Challenges• Monetary Policy Multipliers:¾ Start small, build, then fade.• Fade because:¾ Higher r (after initial drop), and¾ Higher inflation.419Stabilization Challenges• Time (or policy) lags:¾ Changes in policy variables do not happen instantaneously (i.e., the inside lag).¾ Changes in policy variables do not have an instantaneous impact on the economy (i.e., the outside lag).20Stabilization Challenges• Time (or policy) lags:¾ The Inside Lag (Time to policy action).• The data lag,• The recognition lag,• The decision/legislative lag, and• The action/implementation lag.21Stabilization Challenges• Time (or policy) lags:¾ The Outside Lag (Time to effect the economy).• The transmission lag¾ Change in policy instrument to initial change in Ep• The effectiveness lag¾ Initial change in Ep until ½ of change is complete22Stabilization Challenges• Policy Lags in Fiscal Policy:¾ Lags can be long.• Up to 2 years.• Long inside lag but short outside lag.• Initial conditions important for outside lag.¾ Asymmetry.¾ Makes policymaking more difficult.• Must forecast effects.¾ Size and timing are difficult to estimate.• Must forecast other influences on the economy.23Stabilization Challenges• Policy Lags in Monetary Policy:¾ Lags can be long and variable.• 3 months to 2 years.• Short inside lag but long and variable outside lag.• Initial conditions important for outside lag.¾ Asymmetry.¾ Makes policymaking more difficult.• Must forecast effects.¾ Size and timing are difficult to estimate.• Must forecast other influences on the economy.24Stabilization Challenges• Asymmetries: ¾ Between economic conditions.¾ Between expansionary and contractionary policy.¾ Between monetary and fiscal policy.525Stabilization Challenges• Expectations:¾ Economic behavior may or may not change in anticipation of policy changes.• Do expectations then match actual policy change?• If not, this can generate a dynamic feedback loop.26Stabilization Policy Summary• The Role of Monetary and Fiscal Policy:¾ Theoretically, equally capable of achieving Yn.• But at different r’s.¾ In the real world,• Monetary policy is better at achieving Yn.¾ Faster, more flexible (easily reversible).¾ But it is an indirect influence on spending.• Fiscal policy becomes responsible for setting r.¾ Slower, less flexible (not easily reversible).¾ But it has a direct influence on spending.¾ This gives it a long-run growth orientation.27Stabilization Policy Summary• Dealing with Stabilization Challenges.¾ Don’t try to “fine tune” the economy.¾ Make use automatic stabilizers.¾ Be humble about your abilities to forecast and control the