1. CHAPTER 24 Should Policymakers Be Restrained? Should Policymakers Be Restrained? CHAPTER 24 Prepared by: Fernando Quijano and Yvonn Quijano Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall Macroeconomics, 5/e Olivier Blanchard

2. Chapter 24: Should Policymakers Be Restrained? Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall Macroeconomics, 5/e Olivier Blanchard 2 of 25 Should Policy Makers Be Restrained? Is a balanced-budget amendment a good idea? The Contract with America Figure 24 – 1

3. Chapter 24: Should Policymakers Be Restrained? Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall Macroeconomics, 5/e Olivier Blanchard 3 of 25 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 Uncertainty and Policy

4. Chapter 24: Should Policymakers Be Restrained? Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall Macroeconomics, 5/e Olivier Blanchard 4 of 25 There is substantial uncertainty about the effects of policy. 24-1 Uncertainty and Policy How Much Do Macroeconomists Actually Know? Although 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. The Response of Output to a Monetary Expansion: Predictions from 12 Models Figure 24 – 2

5. Chapter 24: Should Policymakers Be Restrained? Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall Macroeconomics, 5/e Olivier Blanchard 5 of 25 Should uncertainty about the effects of policy lead policy makers to do less? In general, the answer is: Yes. 24-1 Uncertainty and Policy Should Uncertainty Lead Policymakers to Do Less? 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. Uncertainty and Restraints on Policymakers

6. Chapter 24: Should Policymakers Be Restrained? Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall Macroeconomics, 5/e Olivier Blanchard 6 of 25 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. Thanks to more and more powerful computers, researchers are building larger and larger models with rational expectations. The modern versions of these models are called dynamic stochastic general equilibrium—(DSGE) models.

7. Chapter 24: Should Policymakers Be Restrained? Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall Macroeconomics, 5/e Olivier Blanchard 7 of 25 Until 30 years ago, the economy was seen as a complicated 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 Expectations and Policy

8. Chapter 24: Should Policymakers Be Restrained? Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall Macroeconomics, 5/e Olivier Blanchard 8 of 25 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. 24-2 Expectations and Policy Hostage Takings and Negotiations

9. Chapter 24: Should Policymakers Be Restrained? Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall Macroeconomics, 5/e Olivier Blanchard 9 of 25 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. 24-2 Expectations and Policy Inflation and Unemployment Revisited

10. Chapter 24: Should Policymakers Be Restrained? Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall Macroeconomics, 5/e Olivier Blanchard 10 of 25 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. 24-2 Expectations and Policy Inflation and Unemployment Revisited

11. Chapter 24: Should Policymakers Be Restrained? Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall Macroeconomics, 5/e Olivier Blanchard 11 of 25  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. 24-2 Expectations and Policy Inflation and Unemployment Revisited

12. Chapter 24: Should Policymakers Be Restrained? Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall Macroeconomics, 5/e Olivier Blanchard 12 of 25 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 that is, to take into account the long run costs from higher inflation. –Choose a “conservative” central banker who dislikes inflation. 24-2 Expectations and Policy Establishing Credibility

13. Chapter 24: Should Policymakers Be Restrained? Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall Macroeconomics, 5/e Olivier Blanchard 13 of 25 24-2 Expectations and Policy Establishing Credibility Across OECD countries, the higher the degree of central bank independence, the lower the rate of inflation. Inflation and Central Bank Independence Figure 24 – 3

14. Chapter 24: Should Policymakers Be Restrained? Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall Macroeconomics, 5/e Olivier Blanchard 14 of 25 When issues of time inconsistency are relevant, tight restraints on policymakers— such as a fixed-money-growth rule in the case of monetary policy, or a balanced budget rule in the case of fiscal policy—can provide a rough solution. But the solution has large costs because it prevents the use of macroeconomic policy altogether. Better solutions typically involve designing better institutions (such as an independent central bank or a better budget process) that can reduce the problem of time inconsistency while, at the same time, allowing the use of policy for the stabilization of output. 24-2 Expectations and Policy Time Consistency and Restraints on Policymakers

15. Chapter 24: Should Policymakers Be Restrained? Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall Macroeconomics, 5/e Olivier Blanchard 15 of 25 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. 24-3 Politics and Policy

16. Chapter 24: Should Policymakers Be Restrained? Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall Macroeconomics, 5/e Olivier Blanchard 16 of 25 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.

17. Chapter 24: Should Policymakers Be Restrained? Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall Macroeconomics, 5/e Olivier Blanchard 17 of 25 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. There is little evidence of manipulation—or at least of successful manipulation—of the economy to win elections. 24-3 Politics and Policy Games between Policymakers and Voters

18. Chapter 24: Should Policymakers Be Restrained? Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall Macroeconomics, 5/e Olivier Blanchard 18 of 25 24-3 Politics and Policy Games between Policymakers and Voters 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 to be different in nature. The Evolution of the Ratio of U.S. Debt to GDP since 1900 Figure 24 – 4

19. Chapter 24: Should Policymakers Be Restrained? Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall Macroeconomics, 5/e Olivier Blanchard 19 of 25 24-3 Politics and Policy Games between Policymakers and Voters Table 24-1 Average Growth During Democratic and Republican Administrations (percent per year) Year of the Administration FirstSecondThirdFourthAverage Democratic3.45.54.43.54.2 Republican2.90.92.24.02.5 Average3.22.93.23.73.3

20. Chapter 24: Should Policymakers Be Restrained? Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall Macroeconomics, 5/e Olivier Blanchard 20 of 25 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. Republicans typically worry more than Democrats about inflation. They worry less than Democrats about unemployment. We would expect, for example, to see stronger growth during Democratic administrations. 24-3 Politics and Policy Games between Policymakers

21. Chapter 24: Should Policymakers Be Restrained? Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall Macroeconomics, 5/e Olivier Blanchard 21 of 25 The Stability and Growth Pact: A Short History The Stability and Growth Pact (SGP), signed in 1997, required members of the Euro Area to follow these fiscal rules:  That countries commit to balance their budget in the medium run.  That countries avoid excessive deficits, except under exceptional circumstances.  That sanctions be imposed on countries that ran excessive deficits.

22. Chapter 24: Should Policymakers Be Restrained? Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall Macroeconomics, 5/e Olivier Blanchard 22 of 25 The Stability and Growth Pact: A Short History Figure 1 Euro Area Budget Deficits as a Percentage of GDP since 1990

23. Chapter 24: Should Policymakers Be Restrained? Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall Macroeconomics, 5/e Olivier Blanchard 23 of 25 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. 24-3 Politics and Policy Politics and Fiscal Restraints

24. Chapter 24: Should Policymakers Be Restrained? Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall Macroeconomics, 5/e Olivier Blanchard 24 of 25 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. 24-3 Politics and Policy Politics and Fiscal Restraints

25. Chapter 24: Should Policymakers Be Restrained? Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall Macroeconomics, 5/e Olivier Blanchard 25 of 25 Key Terms  dynamic stochastic general equilibrium (DSGE) models  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