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Macroeconomic Policy
Macroeconomic Policy

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Chapter 25 McGrawHillIrwin Copyright 2015 by McGrawHill Education Asia All rights reserved Learning Objectives Discuss the policy options available to the central bank in response to demand shocks and inflation shocks ID: 564979 Download Presentation

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Slide1

Macroeconomic Policy

Chapter 25

McGraw-Hill/Irwin

Copyright ©

2015

by

McGraw-Hill Education (Asia).

All rights reserved.Slide2

Learning Objectives

Discuss the policy options available to the central bank in response to demand shocks and inflation shocksExplain the roles played by the anchored inflationary expectations and central bank credibility in keeping inflation lowDescribe how fiscal policy can affect both aggregate demand and aggregate supplyAddress why macroeconomic policy is as much art as a scienceSlide3

Stabilization Policy and Demand Shocks

 

Output Y

AD

1

Y

1

Inflation rate

 

e

 

AD

2

Y

*

1

 

AS

2Slide4

Responding to Aggregate Inflation Shocks

The economy begins in long-run equilibrium at Y1, 1Adverse inflation shock shifts aggregate supply to AS2Central bank follows its monetary policy rule and raises interest ratesRecessionary gap at Y2 with higher inflation, 2The central bank chooses Close the recessionary gap Restore target inflation rate

LRAS

Output (Y)

1

AD

1

Y

1

Inflation (

)

AS

1

Y

2

2

AS

2Slide5

Accommodating an Aggregate Inflation Shock

Suppose the central bank moves to close the recessionary gapEases monetary policy, lowering interest rates at 2Resets target inflation rate to 3Lower interest rates stimulate consumption and investment spendingAD shifts to AD2Long-run equilibrium is nowat Y1 and 3Aggregate inflation shock leads to higher long-run

inflation

LRAS

Output (Y)

1

AD

1

Y

1

Inflation (

)

AS

1

3

Y

2

2

AD

2

AS

2Slide6

Responding to An Aggregate Inflation Shock

Suppose the central bank decides to maintain inflation at 1Inflation is 2, above expected inflation of 1The central bank raises interest ratesAlong AS2, expected inflation is 3When the central bank fails

to respond with looser

monetary policy, expected

inflation decreasesAS2 shifts back to AS

1

Original long-run equilibrium

is restored

LRAS

Output (Y)

1

AD

1

Y

1

Inflation (

)

AS

1

Y

2

2

AS

2

3Slide7

Anchored Inflationary Expectations

Anchored inflationary expectations means people's expectations of future inflation do not change even if inflation rises temporarilyInflation anchoring dampens response to an aggregate inflation shockBusinesses and consumers believe the central bank will reestablish its target inflation rateShortens the time required to close the recessionary gap from the shockEncourages central bank to maintain its original inflation targetSlide8

1980s Inflation – Act 1

U.S. Inflation was 13.5% in 19803.2% by 1983; stayed 2 – 5% for rest of the decade2 – 3% in the 1990sMonetary policy defeated inflationShort recession in 1980Deeper recession 1981 – 1982Negative GDP growth in 1980 and 1982Unemployment peaked at 9.7% in 1982Inflation unresponsive 1979 – 1981Slide9

The Changing Volatility of Real GDPSlide10

Declining Macroeconomic Variability

Variation in the growth rate in the U.S. down by half since 1960Inflation declined by two-thirdsRelative stability has benefitsBusiness and economic planning easierMarkets function betterFewer resources devoted to adjusting to inflation and other economic instabilitiesFed is usually credited with causing the increased stability by its consistent actionsSlide11

An Alternative View Explaining Stability

Structural changes in the economy may have made it more adept at absorbing changesChanges in technologyBusiness practicesBetter management of inventoriesDeregulationShift toward services and away from manufacturingIncreased openness to tradeFreer international capital flowsSlide12

Credibility of Monetary Policy

Credibility of monetary policy is the degree to which the public believes the central bank will defend its target inflation rateThe more credible policy is, the more inflation is anchoredFactors that affect credibilityDegree of central bank's independenceThe announcements of explicit inflation targetsEstablished reputation for fighting inflatioSlide13

Central Bank Independence

Central banks insulated from short-term issues are better able to stabilize the economyIndicators of independence are Length of appointments to the central bankWhether the central bank's actions are subject to frequent interferenceWhether the central bank has obligation to finance the national deficitThe degree to which the central bank's budget is controlled by the legislative or executive branchCountries with independent central banks have lower inflationSlide14

The Fed's Independence

The Fed is a relatively independent central bankGovernors serve 14 year termsAppointments by the executive subject to Congressional approvalMonetary policy is generally in the Fed's handsSome Congressional oversightThe Fed is not obligated to finance the national debtThe Fed is self-funding, largely through its holdings of US Treasury securitiesThe Fed generally has a budget surplus which it returns to the TreasurySlide15

Announcing Numerical Inflation Target

Proponents argue announced target adds to credibility of monetary policy and strengthens anchoringReduce uncertainty in the financial marketsSome countries use announced targets or a narrow range for inflationThese central banks provide additional economic data to support their targetTargets must be consistently metAnnounced targets have been successful in industrialized and developing countriesHighly successful in Brazil, Chile, Mexico, and PeruSlide16

Zero Inflation Undesirably Target

Zero inflation has several undesirable consequencesImperfect control over inflation mean periods of deflation are possibleCentral bank may use negative real interest rates at timesCan only be achieved if nominal rates are less than inflation, so nominal rates would be negativeMeasured inflation overstates actual inflation A true inflation of zero means measured inflation of about 1%A small amount of inflation makes labor markets work betterSlide17

Central Bank Reputation

A central bank's success at stabilizing the economy depends on whether its acts align with its reputationInflation hawk is committed to achieving and maintaining low inflation,Accepts some short-run cost in reduced output and employmentInflation dove is not strongly committed to achieving and maintaining low inflationInflation hawks are more successful in maintaining stable output and employment, even in the short runStronger anchoring of inflation expectationsSlide18

Marginal Tax Rates

Cost – Benefit Principle says individual make labor supply decisions based on the added costs and added benefits of an actionMarginal tax rate is the tax rate on an additional dollarAverage tax rate is total taxes divided by total pre-tax incomeMany taxes are not based on incomeProperty tax, gasoline tax, sales taxU.S. average tax rate on income is 30%Slide19

Fiscal Policy Effects

Tax rates reduction increase aggregate spending through the consumption functionShifts aggregate demand to the rightSupply-side effects shift long-run aggregate supplyWhether inflation increases,decreases, or stays constant depends on the relative sizes of the shifts in AD and LRAS

LRAS

1

Output (Y)

1

AD

1

Y

1

Inflation (

)

AD

2

LRAS

2

Y

2Slide20

Americans Work More than Europeans

CountryRelative Hours Worked (US = 100)Marginal Tax RateJapan10437%US 100 40UK 88

44Canada

88

52Germany 75

59

France

68

59

Italy

64

64Slide21

Americans Work More than Europeans

U.S. average work week is longerU.S. takes fewer vacations and holidaysRetire laterLess unemploymentMarginal interest rates matterWhen European marginal rates were lower, they worked moreOther factors matterMore unionization in EuropeGovernment regulations regarding hours per weekMore generous social security systemsSlide22

Policymaking: Art or Science?

Macroeconomic policy works best withAccurate knowledge of current economic conditionsKnowledge of the future path of the economy without policyPrecise value of potential outputGood control of fiscal and monetary policiesKnowledge of how and when the economy will respond to policy changesSlide23

Barriers to Perfect Policies

Policy makers act with an approximate understanding of the economyPolicy is subject to lagsThe inside lag is the delay between the time a policy change is needed and the time it is implementedShorter for monetary policy than for fiscal policyThe outside lag is the delay between policy implementation and the major effects of the policy occurLonger for monetary policy than for fiscal policySlide24

Macroeconomic Policy

Monetary Policy

Fiscal

Policy

Inflation

Exogenous Spending Shocks

Aggregate Supply Shocks

Credibility

Independent Central Bank

Anchored Inflation

Core Rate

Supply-Side

Effects

Marginal

Tax Rates

Shom More....
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