Stabilisation Policy

Policy makers can use demand management policies to minimise deviations of output from
its full employment level (stabilisation policies). For example, policy makers could use
government spending (a fiscal policy instrument) or open market operations (a monetary
policy instrument) to minimise the impact of a recession on the level of output and the
unemployment rate

Uncertainty and Restraints on Policy Maker

There is substantial uncertainty about the effects of macroeconomic policies. This uncertainty
should lead policy makers to be more cautious, and to use less active policies. Policies should
be broadly aimed at avoiding prolonged recessions, slowing down booms and avoiding
inflationary pressure. The higher unemployment or the higher inflation, the more active the
policies should be. But they should stop well short of fine-tuning, of trying to achieve
constant unemployment or constant output growth

Nominal GNP targeting:

1989, popular wisdom held that the U.S. monetary authority was faced with a daunting policy
task: it should not permit too much money growth and cause prices to rise too rapidly, but it
should not allow too little money growth and cause the economy to tip into recession as real
output would fall.

Its argued that monetary policy makers create problems for themselves by attempting to
exploit the possible output-inflation trade off.
nominal income targeting: the monetary authority would ignore the presumed trade-off
between inflation and real output growth; instead, it would simply adjust money stock growth
to achieve some targeted level or growth rate in nominal GNP.

Nominal income targeting yields two potential improvements over policies designed to
stabilize the price level as the level of real output.
1. First, nominal income targeting permits both price and output to adjust
simultaneously; thus, it avoids more extreme movements in either price or output
alone that occur when policy is directed toward stabilizing one of these variables.
2. Second, nominal income targeting also enables the economy to avoid the changes in
nominal wages that produce a second set of adjustments. Nominal wages will not
change because nominal GNP targeting always stabilizes output at the full
information output level, the level firms would choose to produce if they could
recognize and fully adjust to the shocks confronting them. Thus, nominal GNP
targeting responds as well as price or output level targeting to demand shocks and is
superior to either in responding to supply shocks, especially if policy is directed
toward keeping output at the full information level.

Can the Monetary Authority Control Nominal GNP?

Targeting nominal GNP requires that the monetary authority control nominal GNP. That is, a
change in the money stock must lead to a predictable consequent change in nominal GNP.
Few economists doubt that, in broad terms, nominal GNP can be influenced by the monetary
authority. For example, the St. Louis equation, which has been used to aid policy making at
the Federal Reserve Bank of St. Louis and elsewhere, demonstrates the relationship between
changes in the money stock and subsequent changes in nominal GNP over a period of several
quarters.1° Of course, questions about the controllability of nominal GNP are really questions
about the impact of money on the components of spending. They apply equally well to the
price or output level. To see this, assume that policy makers adopt a real GNP target. Policy
makers might proceed with the two-step procedure described recently by Benjamin Friedman
(1988), in which policy makers first choose a target value for real GNP, then estimate the
value of the money stock consistent with their real GNP
goal. The estimated money stock is an intermediate target of policy in lieu of attempting to
hit the real GNP target over periods shorter than a quarter. This procedure works only if
achieving the money target is related to achieving the real GNP target. But such a relationship
between money and nominal GNP is exactly what is required.

A common criticism of policy making is that economists and policy makers do not know
enough about how the economy functions to have a model that describes accurately the
behaviour of macroeconomic variables like real GNP and the price level. In this case, it has
been argued that policy action based on a flawed or incomplete model might cause more
harm than good. To avoid this problem, Milton Friedman and others have advocated policy
rules that do not depend on the state of the economy; these rules are called “non-contingent”
monetary policy rules. Milton Friedman and others have emphasized that “long and variable
lags” exist between changes in money aggregates and the full response of GNP. Because the
variability in these lags is neither predictable nor well understood, Friedman argues that
ignorance of the causes and patterns of variability in the lag structure justifies the use of a
constant money rule, such as having a money aggregate grow at exactly 3 percent per year
forever. This type of money rule is non-contingent; that is, it does not vary even though
nominal GNP, the price level and/or real output varies. In contrast, nominal GNP targeting
can be achieved only with a state-contingent money rule. For example, a rule specifying 3
percent annual nominal GNP growth requires faster money growth when nominal GNP
growth is less than 3 percent and slower money growth when nominal GNP growth is above
3 percent. In practice, nominal GNP targeting is a “feedback” money rule, with the feedback
running from observed GNP changes to money growth.

Constant rate of money growth

Friedman's k-percent rule is the monetarist proposal that the money supply should be
increased by the central bank by a constant percentage rate every year, irrespective of
business cycles
According to Milton Friedman "The stock of money [should be] increased at a fixed rate
year-in and year-out without any variation in the rate of increase to meet cyclical needs."
(Friedman 1960) Giving governments any flexibility in setting money growth will lead to
inflation according to Friedman. The main policy to be avoided is countercyclical monetary
policy, the standard Keynesian policy recommendation at the time. For this reason, the
central bank should be forced to expand the money supply at a constant rate, equivalent to the
rate of growth of real GDP
This is not to be confused with the Friedman Rule, which is a policy of zero nominal interest
rate
Milton Friedman argued that because of long and variable lags, activist policy is likely to do
more harm than good. Policy makers should restrain from active use of demand management
policies:

First, there are significant lags in the implementation (inside lag) and effects (outside lag) of
macroeconomic policies. The inside lag is the period it takes for a policy action to be
implemented:
  recognition lag - time between the occurrences of a shock and its perception by the
policy makers
 decision lag – time between the recognition and the policy decision
 action lag – time between the policy decision and its actual implementation

The outside lag is a the period it take for a policy to have its effect on the economy.
Second, there is uncertainty about the structure of the economy, the nature of the shocks and
the effects of stabilisation polices.

Expectations and Credibility: The Lucas Critique

Lucas pointed out that when trying to predict the effects of a major policy change, it could be
very misleading to take as given the relations estimated from past data.
Assuming that wage setters would keep expecting inflation in the future to be the same as it
was in the past, that the way wage setters formed their expectations would not change in
response to the change in policy. This was an unwarranted assumption, Lucas argued: Why
shouldn't wage setters take policy changes into account? If wage setters believed that the Fed
was committed to lower inflation, they might well expect inflation to be lower in the future
than in the past. If they lowered their expectations of inflation, then actual inflation would
decline without the need for a protracted (long lasting) recession.

Lucas' argument can be seen, Phillips curve with the expected inflation on the right:
πt = πt e - α(ut - un)
If wage setters kept forming expectations of inflation by looking at the previous year's
inflation (πt = πt-1 ), then the only way to decrease inflation would be to accept higher
unemployment for some time.
But, if wage setters could be convince that inflation was indeed going to be lower that in the
past, they would reduce actual inflation, without any change in the unemployment rate.
Nominal money growth, inflation, and expected inflation could all be reduced without the
need for a recession. Put it another way, decreases in nominal money growth could be neural
not only in the medium run, but also in the short run.
The essential ingredient of successful disinflation, he argued, was credibility of monetary
policy – the belief by wage setters that the central bank was truly committed to reducing
inflation. Only credibility would cause wage setters to change the ways they formed their
expectations.

Expectations and Policy

One of the reasons why the effects of macroeconomic policy are uncertain is the interaction
of policy and expectations. How a policy works, and sometimes whether it works at all,
depends not only on how it affects current variables but also on how it affects expectations
about the future.
In the context of macroeconomic policy, the players are the policy makers and people and
firms. The strategic interactions are clear. What people and firms do depends on what they
expect policy makers to do. In turn, what policy makers do depends on what is happening in
the economy.
Game theory has given economists many insights, often explaining how some apparently
strange behaviour makes sense when one understands the nature of the game being played.

Hostage taking and Negotiations

Most governments have stated the policy that they will not negotiate with hostage takers. The
reason for this is to deter hostage taking by making it unattractive to take hostages. Suppose,
despite the policy somebody taken hostage. Now that the hostage taking occurred anyway,
why not negotiate? Whatever compensation the hostage takers demand are likely to be less
then the alternative – hostages to be killed. So the best policy would be: Announce that you
will not negotiate, but if somebody is taken hostage, negotiate. Upon reflection this would be
a very bad policy. Hostage takers' decisions do not depend on the actual policy but on what
they expect will actually happen if they take hostage. If they know the negotiation will take
place, they will rightly consider the stated policy irrelevant. Hostage taking will take place.
The best policy is for governments to commit not to negotiate. By giving up the option to
negotiate they are likely to prevent hostage takings in the first place.

Inflation and Unemployment revisited

π= πe – α(u – un)
Inflation depends on expected inflation and on the difference between the actual
unemployment rate, and the natural unemployment rate. The coefficient, α captures the effect
of unemployment on inflation, given expected inflation. When unemployment is above the
natural rate, inflation is lower then expected, when unemployment is below the natural rate,
inflation is higher than expected.

Suppose the Fed announces it will follow a monetary policy consistent with zero inflation.
On the assumption that people believe the announcement, expected inflation as embodied in
wage contracts is equal to zero and the Fed faces the following relation between
unemployment and inflation:
π= - α(u – un)
What if the Fed want to achieve better than zero inflation and an unemployment rate equal to
the natural rate?
π= - α(u – un) implies that by accepting just 1% inflation, the Fed can achieve an
unemployment rate of 1% below the natural rate of unemployment. Suppose that the Fed
finds the trade off attractive and decides to decrease unemployment by 1% in exchange for an
inflation rate of 1%. This incentive to deviate from the announced policy once the other
player has made his move - in the case, once wage setters have set the wage is known as the
time inconsistency of optimal policy.

Seeing that the Fed has increased money by more than it announced it would, wage setters
are likely to wise up and begin to expect positive inflation of 1%. If the Fed still wants to
achieve an unemployment rate 1% below the natural rate, it will have to achieve 2% inflation.
However, if it
does that, wage setters are likely to increase their expectations of inflation further, and so on.
The eventual outcome is likely to be high inflation. The wage setters would understand the
Fed's move and expected inflation catches up with actual inflation. The Fed would eventually
be unsuccessful in its attempt to achieve an unemployment rate below the natural rate.

The main solutions that have been proposed for the time inconsistency problem include:
 constitutional rules
 reputation (governments will have in incentive to stick to the announced policies if
they are sufficiently concerned about the future)
 delegation to a independent authority with different preferences or incentives
(argument for independent central bank)

Inflation targeting is a monetary policy in which a central bank attempts to keep inflation in
a declared target range —typically by adjusting interest rates. The theory is that inflation is an
indication of growth in money supply and adjusting interest rates will increase or decrease
money supply and therefore inflation.
Because interest rates and the inflation rate tend to be inversely related, and due to the
projected or declared rate being publicly known, the likely moves of the central bank to raise
or lower interest rates become more transparent. Examples:
 if inflation appears to be above the target, the bank is likely to raise interest rates.
This usually (but not always) has the effect over time of cooling the economy and
bringing down inflation.
 if inflation appears to be below the target, the bank is likely to lower interest rates.
This usually (again, not always) has the effect over time of accelerating the economy
and raising inflation.
Under the policy, investors know what the central bank considers the target inflation rate to
be and therefore may more easily factor in likely interest rate changes in their investment
choices. This is viewed by inflation targeters as leading to increased economic stability
The US Federal Reserves policy setting committee, the FOMC (Federal Open Market
Committee) and its members, regularly publicly state a desired target range for inflation
(usually around 1.5-2%), but do not have an explicit inflation target. This is under debate
within the Fed, since inflation targeting is usually very successful in other countries because
of its transparency and predictability to the markets.
However, some counter that an inflation target would give the Fed too little flexibility to
stabilise growth and/or employment in the event of an external economic shock. Another
criticism is that an explicit target might turn central bankers into what Melvyn King, now
Governor of the Bank of England, had in 1997 colourfully termed "inflation nutters"- that is,
central bankers who concentrate on the inflation target to the detriment (damage) of stable
growth, employment and/or exchange rates. King went on to help design the Bank's inflation
targeting policy and asserts that the nuttery has not actually happened, as does Chairman of
the U.S. Federal Reserve Ben Bernanke who states that all of today's inflation targeting is of
a flexible variety, in theory and practice.
For the moment, the Fed continues without the strict rules of an explicit target. Former
Chairman Alan Greenspan, as well as other former FOMC members such as Alan Blinder,
typically agreed with its benefits, but were reluctant to accept the loss of freedom involved;
Bernanke, however, is a well-known advocate.

Establishing Credibility
How can a central bank credibly commit not to deviate from its announced policy?
One way to establish its credibility is for the central bank to give up - or to be striped by law
of - its policy making power. For example, the mandate of the central bank can be defined by
law in terms of a simple rule, such as setting money growth at 0 % forever. (An alternative, is
to adopt a hard peg, such as a currency board or even dollarisation, in this case, instead of
giving up its ability to use money growth, the central bank gives up its ability to use the
exchange rate and the interest rate.
We want to prevent the central bank from pursuing too high a rate of money growth in an
attempt to lower unemployment below the natural unemployment rate. But still want the
central bank to be able to expand the money supply when unemployment is far below the
natural rate. Such actions become impossible under a constant money growth rule.

1. A first step is to make the central bank independent. Politicians, who face frequent re-
elections, are likely to want lower unemployment now, even if it leads to inflation
later. Making the central bank independent, and making it difficult for politicians to
 fire the central banker, makes it easier for the central bank to resist the political
pressure to decrease unemployment below the natural rate of unemployment.

2. Second, give incentives to central bankers to take the long view – that is, to take into
account the long-run costs from higher inflation. One way of doing so is to give them
long terms in office, so they have a long horizon and have the incentives to build
credibility.
3. Thirdly, is to appoint a conservative central banker, somebody, how dislikes inflation
very much and is therefore less willing to accept more inflation in exchange for less
unemployment when unemployment is at the natural rate.

Politics and Policy

Even if one were to agree that policy makers should actively use stabilisation policies,a
number of arguments would suggest that, rather than using full discretion in setting their
policy actions, they should follow pre-determined policy rules.
Games between Policy makers and Voters
Many macroeconomic policy decisions involve trading off short run losses against long run
gains, or conversely, short run gains against long run losses.
Take for example tax cuts. By definition, tax cuts lead to lower taxes today. They are also
likely to lead to an increase in activity and therefore to an increase in pre tax income for some
time. But unless they are matched by equal decreases in government spending they lead to a
larger budget deficit and to the need for an increase in taxes in the future. If voters are short-
sighted, the temptation for politicians to cut taxes may prove irresistible. Politics may lead to
systematic deficits, at least until the level of government debt has become so high that
politicians are scared into action.
If the politicians main goal is to please voters and get re-elected, what better policy than to
expand aggregate demand before an election, leading to higher growth and lower
unemployment. Growth in excess of the normal growth rate cannot be sustained, and
eventually the economy must return to the natural level of output. Thus, we might expect a
clear political business cycle, with higher growth, on average, before elections than after
elections.
If political business cycle was important, we would expect to see faster growth before
elections than after.
Games between Policy Makers
Suppose, for example, that the party in power wants to reduce spending but faces opposition
to spending cuts in Congress. One way of putting pressure on both Congress as well as on the
future parties in power is to cut taxes and create deficits. As debt increases over time, the
increasing pressure to reduce deficits may well in turn force Congress and the future parities
in power to reduce spending. Or suppose that, the country is facing large budget deficits.
Both parties in Congress want to reduce the deficit, but they disagree about the way to do it.
One party wants to reduce deficits primarily through an increase in taxes, the other wants to
reduce deficits primarily through a decrease in spending. Both parties may hold out on the
hope that the other side will give in first. Only when debt has increase sufficiently and it
becomes urgent to reduce deficits will one party give up. Game theorist refer to these
situation as wars of attrition. The hope that the other side will give in leads to long and often
costly delays. Such wars of attrition happen often in the contract of fiscal policy, and deficit
reduction occurs long after it should.
Politics and Fiscal Restraints
If politics sometimes leads to long and lasting budget deficits, can rules be put in place to
limit these adverse effects?
A better approach is to put in place rules that put limits either on deficits or on debt. This is,
however, harder than it sounds. Rules such as limits on the ratio of the deficit to GDP are
more flexible than a balanced budget requirement, but they may still not be flexible enough if
the economy is affected by particularly bad shocks.
The focus on spending rather than on the deficit itself had one important implication. If there
was a recession, hence, a decrease in revenues, the deficit could increase without triggering a
decrease in spending. This happened in 1991 and 1992 when, because of the recession, the
deficit increased – despite the fact that spending satisfied the constraints imposed by the caps.
Expectations and Policy Effectiveness
Phillips curve suggests that policy makers face a short run trade off between inflation and
unemployment. An important point to understand is the relevance for this trade off and
therefore for macroeconomic policy of the mechanism by which expectations are formed.
Under adaptive expectations (agents are backward looking using past values of observed
economic variables to form their forecasts), there is a trade off between inflation and
unemployment in the short run: reducing inflation requires higher unemployment (or a
positive supply shock). Under rational expectations (agents are forward looking and use
information efficiently: they can make mistakes, but they do not make systematic forecasting
errors), there is no trade off even in the short run.
The rational expectations hypothesis has both positive and negative implication for policy
makers. On the one hand, under rational expectations, price flexibility and symmetric
information, anticipated policies are irrelevant for the economy, since only unanticipated
changes in policy can affect the level of output: this is the essence of the policy
ineffectiveness proposition. On the other hand, disinflation can be less costly: a credible
announcement of a monetary restriction can reduce inflation without causing higher
unemployment through its impact on expected inflation.
Expectations
Rational expectations theory defines this kind of expectations as being identical to the best
guess of the future (the optimal forecast) that uses all available information. However,
without further assumptions, this theory of expectations determination makes no predictions
about human behaviour and is empty. Thus, it is assumed that outcomes that are being
forecast do not differ systematically from the market equilibrium results. As a result, rational
expectations do not differ systematically or predictably from equilibrium results. That is, it
assumes that people do not make systematic errors when predicting the future, and deviations
from perfect foresight are only random. In an economic model, this is typically modelled by
assuming that the expected value of a variable is equal to the value predicted by the model,
plus a random error term representing the role of ignorance and mistakes.
For example, suppose that P is the equilibrium price in a simple market, determined by
supply and demand. The theory of rational expectations says that the actual price will only
deviate from the expectation if there is an 'information shock' caused by information
unforeseeable at the time expectations were formed. In other words ex ante the actual price is
equal to its rational expectation.:
P = P* + e
E(P) = P*
where P* is the rational expectation and e is the random error term, which has an expected
value of zero, and is independent of P*.
Rational expectations theories were developed in response to perceived flaws in theories
based on adaptive expectations. Under adaptive expectations, expectations of the future
value of an economic variable are based on past values. For example, people would be
assumed to predict inflation by looking at inflation last year and in previous years. Under
adaptive expectations, if the economy suffers from constantly rising inflation rates (perhaps
due to government policies), people would be assumed to always underestimate inflation.
This may be regarded as unrealistic - surely rational individuals would sooner or later realise
the trend and take it into account in forming their expectations? it assumes that agents may
repeatedly make systematic errors and can only revise their expectations in a backward-
looking way. Further, models of adaptive expectations never attain equilibrium, instead only
moving toward it asymptotically.
The hypothesis of rational expectations addresses this criticism by assuming that individuals
take all available information into account in forming expectations. Though expectations may
turn out incorrect, they will not deviate systematically from the expected values.
The rational expectations hypothesis has been used to support some radical conclusions about
economic policy making. An example is the Policy Ineffectiveness Proposition developed by
Thomas Sargent. According to the policy ineffectiveness proposition, the government could
not successfully intervene in the economy if attempting to manipulate output. If the
government employed monetary expansion in order to increase output, agents would foresee
the effects, and wage and price expectations would be revised upwards accordingly. Real
wages and prices remain constant and therefore so does output, no money illusion occurs.
Only stochastic shocks to the economy can cause deviations in employment from its natural
level.