1. Issues in monetary and fiscal policy In this lecture we will use our economic models to study some important issues in the use of monetary and fiscal policy. For monetary policy we will cover the issues of time inconsistency of monetary policy, choice of optimal inflation and RBA behaviour rules. For fiscal policy we will cover the issues of government spending and government debt and the Ricardian equivalence proposition.

2. Phillips Curve relation The Phillips Curve stated that there was a relationship between current inflation and current unemployment: (π – π e ) = -α (u – u n ) So that for every 1% that inflation exceeds expected inflation, current unemployment will be pushed 1/α below the natural rate of unemployment. If α=0.33 in Australia, then the RBA can get 3% lower unemployment by pushing current inflation 1% above expectations.

3. Time inconsistency The RBA (and implicitly the Australian government) has a trade-off between current inflation and current unemployment at a rate of 1 to 3. Most people might think that this trade-off is worthwhile, as inflation has relatively invisible social costs whereas the costs of unemployment are quite plain to see. The temptation exists then for the RBA to always try to push inflation above expected inflation.

4. Time inconsistency Let’s assume that the RBA announces an inflation target of 2% for next year. Expected inflation then will be set at 2% by firms and workers. However after this announcement, the RBA knows it can choose to push inflation above 2% and lower unemployment. Since the government prefers 3% lower unemployment to 1% lower inflation, the government will push inflation above the target 2%.

5. Time inconsistency This is the problem of “time inconsistency”. The government can not be trusted to keep past promises. No matter what, there is always a short-term gain to be had by raising inflation by 1%. The real trade-off occurs in the long-run. Since inflation expectations are persistent, a 1% rise in inflation today typically leads to a 1% rise in permanent inflation expectations.

6. Time inconsistency However since governments are typically only concerned with winning the next election which comes in 1-4 years, governments have very short horizons. So short-run gains are emphasized at the expense of long-run costs. We expect then that governments can not resist the temptation to inflate, so people factor this into their expectations, so expected inflation and actual inflation are too high.

7. Optimal inflation rate Imagine we were to “choose” an inflation rate for Australia. What would be the optimal choice of inflation rate? Would it be zero?

8. Optimal inflation rate A rational analysis of the inflation rate would say that we should balance benefits of costs of inflation until we find the “optimal” rate. Benefits of inflation: –Inflation tax or seignorage- although this is very small in developed countries –Scope for monetary policy- since nominal interest rates can not go below zero, the maximum that nominal interest rates can fall to combat a recession is real interest rates plus inflation. The lower is inflation, the less room for monetary policy.

9. Benefits of inflation Benefits of inflation (continued): –Money illusion- most workers resist a cut in nominal wages, even though a 0% rise in wages with 3% inflation is actually a cut in wages identical to a 2% rise in wages when inflation is 5%- so a positive inflation rate allows firms to cut wages without workers getting upset- a low positive rate of inflation makes sense due to this rationale.

10. Costs of inflation Costs of inflation: –Menu costs- these are the costs of rewriting contracts and prices as inflation pushes all prices up –Shoe-leather costs- these are the self-imposed costs people face from trying to minimize their money balances –Redistribution from fixed incomes- people who own assets that aren’t indexed to inflation suffer an income loss from inflation (although this loss is redistributed to the rest who owes the non-indexed debt)

11. Optimal inflation rate The costs that we have mentioned- menu, shoe- leather and redistribution- are all very low at low positive levels of inflation. Of the benefits, seignorage is very low at low levels of inflation, but monetary policy scope and avoiding money illusion are high at low positive levels of inflation. The above calculation suggests that a low positive rate of inflation is probably optimal for most countries.

12. RBA behaviour We have generally used two models of RBA behaviour in this class- fixed nominal money and inflation targeting. Fixed nominal money supply assumed that the RBA kept the nominal money supply constant. Inflation targeting assumed that the RBA sets the cash rate so as to keep inflation equal to the target rate of inflation. Most reserve banks in developed countries have shifted from a fixed money supply rule to an inflation target rule.

13. RBA behaviour John Taylor, in a very influential paper, suggested another rule that reserve banks could follow- the Taylor rule: i t = i n + a (π t - π T ) – b (u t – u n ) Where in the medium-run, the bank aims for π t = π T and i t = i n = r n + π T. So if inflation is above the target rate, the RBA will raise interest rates. If unemployment is above the natural rate, the RBA will lower interest rates.

14. RBA behaviour The factors a and b then tell us how important excess inflation and excess unemployment are in RBA calculations. If b is zero, then we have a bank that purely targets inflation, so the inflation-targeting RBA is also following a form of the Taylor rule. We could then look at the evolution of i, u, and π over time to try to estimate what a and b are for different reserve banks.

15. Government debt One problem that economic commentators always point to is the level of government debt- “Our debt is too high.” How do we evaluate the level of government debt? How do we know is it is “too high”. Government debt is like any other form of debt. You evaluate the debt relative to the income/wealth of the person incurring the debt. A $500,000 debt might be high to you and me, but it might mean nothing to Kerry Packer.

16. Government debt So we need to evaluate government debt relative to “government income”. But what is the appropriate form of “government income”, as the government doesn’t earn or produce anything. Generally we use the income of the country as the comparison, since the government is free to tax or claim any part of GDP.

17. Government debt So our criterion for “too much” is debt (B t, since typically government debt is issued in government bonds) over GDP (Y t ): B t / Y t Banks would make much the same calculation when considering whether to issue someone a home loan. In general debt is growing at the rate of interest each year, r, while GDP is growing at the growth rate of the economy, g.

18. Government debt As long as g > r, then debt is shrinking relative to income, so debt is becoming less important. But each year, government might be creating new debt if G t – T t < 0, so we might also be worried about: (G t – T t )/ Y t So deciding whether we have too much debt is not a simple matter, much as whether $0.5m is “too much debt” for a person.

20. Government debt Another point to consider about government debt is that it is not like a bond issued by a company, there is no asset behind the bond. Government debt is a promise to pay someone an amount in the future, backed entirely by the taxation power of the government. Higher debt then is just a transfer from future taxpayers to people who hold bonds. If both people are Australians, government debt is just a transfer from one Australian to another.

21. Ricardian equivalence Ricardian equivalence takes this thinking one step further. Suppose the government raises $1 in taxes today versus the government raises $1 in bonds today. In the tax case, taxpayers are $1 worse off. In the bond case, taxpayers know they have to repay the bond in one year’s time with increased taxes.

22. Ricardian equivalence How much will the taxpayers have to put aside today to pay the extra $1 in government debt? If government debt has a real interest rate of r, and people earn a real interest rate of r on investments, then taxpayers will have to put aside $1 today to pay for the extra future taxes. In this case, $1 in new taxes and $1 in new debt are identical to the taxpayers. This is called “Ricardian equivalence.”