Slide 0Question 1:Arguments for active policyArguments against active policyForecasting the macroeconomyMistakes Forecasting the Recession of 1982Slide 8The Lucas CritiqueAn example of the Lucas CritiqueThe Jury’s Out…Question 2:Rules and Discretion: basic conceptsArguments for RulesSlide 15Examples of Time-Inconsistent PoliciesMonetary Policy RulesThe Taylor RuleSlide 19Does Greenspan follow the Taylor Rule?Central Bank IndependenceInflation and Central Bank IndependenceChapter summarySlide 24macroeconomics fifth editionN. Gregory MankiwPowerPoint® Slides by Ron Cronovichmacro © 2002 Worth Publishers, all rights reservedTopic 12:Stabilization Policy(chapter 14)CHAPTER 14CHAPTER 14 Stabilization Policy Stabilization Policyslide 2Question 1:Question 1:Should policy be Should policy be ______ or _____?______ or _____?Should policy be Should policy be ______ or _____?______ or _____?CHAPTER 14CHAPTER 14 Stabilization Policy Stabilization Policyslide 3Arguments 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.CHAPTER 14CHAPTER 14 Stabilization Policy Stabilization Policyslide 4Arguments 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 Policy Stabilization Policyslide 6Forecasting the macroeconomyForecasting the macroeconomyBecause 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 policiesCHAPTER 14CHAPTER 14 Stabilization Policy Stabilization Policyslide 7Mistakes 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 Policy Stabilization Policyslide 8Forecasting the macroeconomyForecasting the macroeconomyBecause policies act with lags, policymakers must predict future conditions.The preceding slides show that The preceding slides show that the forecasts are often wrong. the forecasts are often wrong. This is one reason why some This is one reason why some economists oppose policy economists oppose policy activism. activism. The preceding slides show that The preceding slides show that the forecasts are often wrong. the forecasts are often wrong. This is one reason why some This is one reason why some economists oppose policy economists oppose policy activism. activism.CHAPTER 14CHAPTER 14 Stabilization Policy Stabilization Policyslide 9The 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 ______________________________________________________________________________.CHAPTER 14CHAPTER 14 Stabilization Policy Stabilization Policyslide 10An 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 Policy Stabilization Policyslide 11The Jury’s Out…The Jury’s 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 Policy Stabilization Policyslide 12Question 2:Question 2:Should policy Should policy be conducted by be conducted by ____ or _______?____ or _______?Should policy Should policy be conducted by be conducted by ____ or _______?____ or _______?CHAPTER 14CHAPTER 14 Stabilization Policy Stabilization Policyslide 13Rules 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 Policy Stabilization Policyslide 14Arguments for RulesArguments for Rules1. __________________________________________________________________misinformed politicianspoliticians’ interests sometimes not the same as the interests of societyCHAPTER 14CHAPTER 14 Stabilization Policy Stabilization Policyslide 15Arguments for RulesArguments for Rules2. The Time Inconsistency of Discretionary Policydef: ______________________________________________________________________________________.Destroys policymakers’ credibility, thereby reducing effectiveness of their policies.CHAPTER 14CHAPTER 14 Stabilization Policy Stabilization Policyslide 16Examples of Time-Inconsistent PoliciesExamples of Time-Inconsistent PoliciesTo encourage investment, To encourage investment, government announces it government announces it won’t tax income from capital. won’t tax income from capital. But once the factories are built, But once the factories are built, the govt reneges in order to the govt reneges in order to raise more tax revenue.raise more tax revenue.CHAPTER 14CHAPTER 14 Stabilization Policy Stabilization Policyslide 17Monetary