CHAPTER 24 © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard Should Policy Makers Be Restrained? Prepared by: Fernando Quijano and Yvonn Quijano

Chapter 24: Should Policy Makers Be Restrained? © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard2 of 22 Figure Should Policy Makers Be Restrained? Is a balanced-budget amendment a good idea? The Contract with America

Chapter 24: Should Policy Makers Be Restrained? © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard3 of 22 Uncertainty and Policy Macroeconomic policy makers in general do not have all the knowledge required for solving economic problems. They rely on macroeconometric models, all of which give different answers for how to solve a particular problem. 24-1

Chapter 24: Should Policy Makers Be Restrained? © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard4 of 22 How Much Do Macroeconomists Actually Know? The Response of Output to a Monetary Expansion: Predictions from 12 Models While all 12 models predict that output will increase for some time in response to a monetary expansion, the range of answers regarding the size and the length of the output response is large. There is substantial uncertainty about the effects of policy. Figure

Chapter 24: Should Policy Makers Be Restrained? © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard5 of 22 Should Uncertainty Lead Policy Makers to Do Less? Should uncertainty about the effects of policy lead policy makers to do less? In general, the answer is: Yes. Twelve Macroeconometric Models Together, the set of models in the Brookings project is representative of the different types of macroeconomic models used for forecasting and policy simulations.

Chapter 24: Should Policy Makers Be Restrained? © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard6 of 22 Uncertainty and Restraints on Policy Makers There is substantial uncertainty about the effects of macroeconomic policies. This uncertainty should lead policy makers to be more cautious, to use less active policies. They should stop well short of fine tuning, of trying to achieve constant unemployment or constant output growth.

Chapter 24: Should Policy Makers Be Restrained? © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard7 of 22 Expectations and Policy Until 20 years ago, the economy was seen as a machine. Methods of optimal control were being used to design macroeconomic policy. People and firms try to anticipate what policy makers will do. Hence, macroeconomic policy is a game between them. We don’t need optimal control theory but rather game theory, which studies strategic interactions between players. 24-2

Chapter 24: Should Policy Makers Be Restrained? © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard8 of 22 Hostage Takings and Negotiations By giving up the option to negotiate, governments can prevent hostage takings in the first place. Exactly the same logic is involved in the design of macroeconomic policy to control inflation and unemployment.

Chapter 24: Should Policy Makers Be Restrained? © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard9 of 22 Inflation and Unemployment Revisited The relation between unemployment and inflation is as follows: Suppose the Fed announces that it will constant inflation, and wage setters believe that expected inflation will be zero. Then: In the U.S.,   1. If  = 0, then the announced policy calls for  =  e = 0, and u=u n.

Chapter 24: Should Policy Makers Be Restrained? © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard10 of 22 Inflation and Unemployment Revisited But the Fed could deviate from its stated policy and achieve an unemployment rate of 1% below the natural rate with just a 1% increase in the inflation rate.  If  = 1 and  = 0, then (u  u n.) =  1%. This incentive to deviate from the announced policy once the other player (in this case wage setters) has made its move is known as the time inconsistency of optimal policy.

Chapter 24: Should Policy Makers Be Restrained? © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard11 of 22 Inflation and Unemployment Revisited  Wage setters wise up and begin to expect positive inflation of 1%. Eventually, the economy returns to the natural rate of unemployment, but with higher inflation.  The eventual outcome is likely to be high inflation. The economy ends up with the same unemployment rate, but with much higher inflation.

Chapter 24: Should Policy Makers Be Restrained? © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard12 of 22 Establishing Credibility Ways to deal with the problem of time inconsistency, without totally stripping policy- making power from the central bank, include: Make the central bank independent. This way, the central bank resists political pressure to decrease unemployment. Give incentives to the central bankers to take the long view-to take into Choose a conservative central banker who dislikes inflation.

Chapter 24: Should Policy Makers Be Restrained? © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard13 of 22 Establishing Credibility Inflation and Central Bank Independence Across OECD countries, the higher the degree of central bank independence, the lower the rate of inflation. Figure

Chapter 24: Should Policy Makers Be Restrained? © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard14 of 22 Politics and Policy We have assumed so far that policy makers were benevolent – that they tried to do what was best for the economy. Politicians or policy makers, however, do what is best for themselves, and this is not always what is best for the country Was Alan Blinder Wrong in Speaking the Truth? Alan Blinder, an economist from Princeton indicated his belief that the Fed has both the responsibility and the ability to use monetary policy to help the economy recover.

Chapter 24: Should Policy Makers Be Restrained? © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard15 of 22 Games Between Policy Makers and Voters If voters are shortsighted, the temptation for politicians to cut taxes may prove irresistible. With the right timing and shortsighted voters, political parties can win elections. Thus, we might expect a clear political business cycle, with higher growth on average before elections than after elections. However, there is little evidence of manipulation of the macroeconomy to win elections.

Chapter 24: Should Policy Makers Be Restrained? © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard16 of 22 Games Between Policy Makers and Voters The Evolution of the Ratio of U.S. Debt to GDP, The three major buildups of debt since 1900 have been associated with World War I, the Great Depression, and World War II. The buildup since 1980 appears different in nature. Figure

Chapter 24: Should Policy Makers Be Restrained? © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard17 of 22 Games Between Policy Makers and Voters Table 24-1 Growth During Democratic and Republican Administrations (Percent per Year) Year FirstSecondThirdFourth Democratic Truman Kennedy/Johnson Johnson Carter Clinton I Clinton II Average: Democratic Republican Eisenhower Nixon Nixon/Ford Reagan I Reagan II Bush (George H.) Bush (George W.) Average: Republican Average

Chapter 24: Should Policy Makers Be Restrained? © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard18 of 22 Games Between Policy Makers Game theorists refer to situations in which each side holds out, hoping the other side will give in, as wars of attrition. These wars usually result in delays in the implementation of policy. Also, each party worries more about either inflation or unemployment. We would expect, for example, to see stronger growth during Democratic administrations.

Chapter 24: Should Policy Makers Be Restrained? © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard19 of 22 The Growth and Stability Pact: a Short History Figure 1 Euro Area Budget Deficits as a Percentage of GDP since 1990

Chapter 24: Should Policy Makers Be Restrained? © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard20 of 22 Politics and Fiscal Restraints A balanced-budget amendment would eliminate the problem of deficits, but it would also eliminate the use of fiscal policy as macroeconomic policy instrument. A constitutional amendment is not the only way to achieve deficit control and reduction.

Chapter 24: Should Policy Makers Be Restrained? © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard21 of 22 Politics and Fiscal Restraints The “Budget Enforcement Act” passed in 1990, and extended by new legislation in 1993 and 1997, introduced two main rules:  It imposed constraints on spending. Constraints, called spending caps, were set on discretionary spending for the following 5 years.  It required that a new transfer program could only be adopted if it could be shown not to increase deficits in the future. This rule is known as the pay-as-you-go or the PAYGO rule.

Chapter 24: Should Policy Makers Be Restrained? © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard22 of 22 Key Terms  fine-tuning  optimal control  game  optimal control theory  game theory  strategic interactions  players  time inconsistency  political business cycle  wars of attrition  spending caps  PAYGO rule