©2012 The McGraw-Hill Companies, All Rights Reserved 1 Chapter 24: Macroeconomic Policy.

©2012 The McGraw-Hill Companies, All Rights Reserved

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Chapter 24: Macroeconomic Policy


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Learning Objectives

1.Analyze the effects of anti-inflationary monetary policy

2.Discuss the policy options available to the central bank in response to an aggregate demand shock

3.Discuss the policy options available to the central bank in response to an aggregate supply shock

4.Explain the roles of core rate of inflation, anchored inflationary expectation, and central bank credibility in keeping inflation low

5.Describe how fiscal policy can affect both AD and AS

6.Address the question: why is macroeconomic policy as much an art as a science?


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Using Monetary Policy To Reduce High Inflation: The Short Run

Monetary policy can be used to reduce short-run and long-run inflation

Start at potential output, Y1, and 1 Increase the interest rate

at each level of inflation Shifts AD left to AD2

Recessionary gap and short-run equilibrium at Y2, 2

Cyclical unemploymentoccurs

LRAS

Y 1

AD1

Output (Y)

Infla

tion

()

AS1

1

AD2

Y2

2


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Using Monetary Policy To Reduce High Inflation: The Long Run

Start at short-run equilibrium with a recessionary gap at Y2, and 2

Actual inflation, 2, is below expected inflation of 1

Expected inflation decreases

Lower expected inflation shifts AS to AS2

Economy moves down AD2

New equilibrium at Y1, 3

Short-term pain gets long-term gain

LRAS

Y 1

AD1

Output (Y)

Infla

tion

()

AS1

AD2

1

Y2

2

3

AS2


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Responding to Shocks in Spending

Aggregate demand shifts from either an increase in government spending or other exogenous changes Suppose changes are permanent To maintain expected rate of inflation,

central bank tightens monetary policy Suppose military spending increases

sharply Aggregate demand increases, opening an

expansionary gap Inflation exceeds expectations central bank must decide whether to

maintain monetary policy or fight inflation


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Accommodating Monetary Policy

Accommodating monetary policy allows the effects of a shock to occur When exogenous spending

goes up, the central bank does not change monetary policy

AD shift to AD2 and the economy moves to an expansionary gap at Y2, 2 The central bank holds it MPR and AS shifts to AS2 Economy settles at Y1, 3

LRAS

Output (Y)

1

AD1

Y 1

Infla

tion

()

AS1

3

AD2

Y2

2

AS2


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Maintains Low Inflation After A Change in Spending

The central bank can choose to enforce its inflation target, 1

central bank tightens monetary policy, shifting MPR left

AD shift to AD2 and the economy moves to an expansionary gap at Y2, 2

central bank tightens monetary policy Interest rates increase

more than if the central bank had accommodated the change AD shifts back to AD1

Economy returns to Y1, 1

LRAS

Output (Y)

1

AD1

Y 1

Infla

tion

()

AS1

AD2

Y2

2


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Defending Target Inflation Rate

When aggregate demand increases, the central bank shifts its MPR Each inflation rate is now associated

with a higher interest rate Increase in spending reduces spending

and increases interest rates in the long run

To fight inflation, the central bank raises its interest rates to the new, long-run level


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Responding to Shocks In Aggregate Supply

The economy begins in long-run equilibrium at Y1, 1

Adverse supply shock shifts aggregate supply to AS2 central bank follows its monetary policy rule and

raises interest rates Recessionary gap at Y2

with higher inflation, 2

The central bank must choose Close the recessionary gap Restore target inflation rate

LRAS

Output (Y)

1

AD1

Y 1

Infla

tion

()

AS1

Y2

2

AS2


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Accommodating an Aggregate Supply Shock

Suppose the central bank moves to close the recessionary gap Eases monetary policy, lowering interest

rates at 2 Resets target inflation rate to 3

Lower interest rates stimulate consumption and investment spending

AD shifts to AD2

Long-run equilibrium is nowat Y1 and 3

Aggregate supply shock leadsto higher long-run inflation

LRAS

Output (Y)

1

AD1

Y 1

Infla

tion

()

AS13

Y2

2

AD2

AS2


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Responding to An Aggregate Supply Shock

Suppose the central bank decides to maintain inflation at 1 Inflation is 2, above expected inflation of 1 The central bank raises interest rates Along AS2, expected

inflation is 3 When the central bank fails to respond with looser

monetary policy, expected inflation decreases

AS2 shifts back to AS1 Original long-run equilibrium

is restored

LRAS

Output (Y)

1

AD1

Y 1

Infla

tion

()

AS1

Y2

2

AS2

3


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Anchored Inflation

Anchored inflationary expectations means people's expectations of future inflation do not change even if inflation rises temporarily Inflation anchoring dampens response to an

aggregate supply shock Businesses and consumers believe the

central bank will reestablish its target inflation rate

Shortens the time required to close the recessionary gap from the shock

Encourages central bank to maintain its original inflation target


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An Alternative View Explaining Stability

Structural changes in the economy may have made it more adept at absorbing changes Changes in technology Business practices Better management of inventories Deregulation Shift toward services and away from

manufacturing Increased openness to trade Freer international capital flows


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Oil Price Increases of 2003-2005

Crude oil price was $3 in 1972 $12 at the end of 1974 $35 in 1981

Oil shocks were followed by stagflation Prices fell gradually after 1981, reaching $23

in 2002 Some exceptions to this trend Oil prices increased dramatically beginning in

2002 By late 2004, oil was more than $40 and

reached $65 in August 2005 BUT… oil price shocks of 2003 – 2005 did not

create stagflation


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Real GDP growth and Inflation, 2002-2006


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One explanation for avoiding stagflation is the changes in the real price of oil While the nominal price was $65 in August

2005, the real price (adjusted for inflation) was below the 1981 price

The 1981 nominal price of $35, adjusted to 2005 prices, would have been $460 in Egypt and $99 in Morocco

Another contributing factor was the legacy of previous oil shocks The 1973 oil shock caused factories that

were energy inefficient to close Factories were ready for higher priced

energy


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Most economies are less reliant on energy than previously Shift to services from manufacturing Energy efficient homes, appliances, and

vehiclesThe central bank's history of defeating

inflation and sustaining a low target rate of inflation helped avoid stagflation Inflation is more firmly anchored than in

the earlier oil shocks


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Core Rate of Inflation

Core inflation excludes energy and food Shows the effects of a supply shock

separate from the change in the price of the good causing the shock

Food and energy are the most volatile elements of the CPI and most likely to cause a supply shock

Core inflation lets the central bank prevent the inflation from a supply shock from becoming permanent


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Core Rate of Inflation

Central banks in the Middle East and North Africa do not focus on the core rate of inflation.

1. Most of these central banks already face a daunting task in regularly reporting accurate CPI figures.

2. Food and energy represent a large proportion of the CPI basket (e.g., 67 percent in Morocco) and excluding them would not be meaningful.

3. Most of these countries have consistently faced high inflation and have yet to consider setting inflation targets.

A small number of countries, including Tunisia, Morocco, and Egypt, have started reporting their core rate of inflation.


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Inflationary Expectations And Credibility

Credibility of monetary policy is the degree to which the public believes the central bank will defend its target inflation rate The more credible policy is, the more

inflation is anchoredFactors that affect credibility

Degree of central bank's independence The announcements of explicit inflation

targets Established reputation for fighting inflation


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Central Bank’s Independence

Central banks insulated from short-term issues are better able to stabilize the economy

Indicators of independence are Length of appointments to the central bank Whether the central bank's actions are

subject to frequent interference Whether the central bank has obligation to

finance the national deficit The degree to which the central bank's

budget is controlled by the legislative or executive branch

Countries with independent central banks have lower inflation


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Central Bank's Independence

The central bank is a relatively independent central bank Monetary policy is generally in the

central bank's hands The central bank is not obligated to

finance the national debt The central bank is self-funding, largely

through its holdings of different securities

When the central bank has a budget surplus, it returns it to the government


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Announcing Inflation Target

Proponents argue announced target adds to credibility of monetary policy and strengthens anchoring Reduce uncertainty in the financial markets

Some countries use announced targets or a narrow range for inflation These central banks provide additional

economic data to support their target Targets must be consistently met

Announced targets have been successful in industrialized and developing countries Highly successful in Brazil, Chile, Mexico, and

Peru Not very successful in Turkey due to frequent

target revisions


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Zero Inflation Undesirable Target

Zero inflation has several undesirable consequences Imperfect control over inflation mean

periods of deflation are possible Central bank may use negative real

interest rates at times Can only be achieved if nominal rates are less

than inflation, so nominal rates would be negative

Measured inflation overstates actual inflation

A true inflation of zero means measured inflation of about 1%

A small amount of inflation makes labor markets work better


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US Inflation 2002 - 2003

Inflation in September, 2002 was 1.5% -- and falling Federal funds rate was 1.75% Further declines would make monetary policy

difficult to implement if there were an adverse supply shock

Consumption and planned investment respond to real interest rates In September 2002, the real interest rate was

0.25% Additional stimulus might require negative real

interest rates Hard to achieve when inflation is low

Federal funds rate fell to 1.0% by June 2003


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US Inflation 2002 - 2003

Fed has options even at 0% inflation Long-term interest rates are higher than

the federal funds rate If the Fed needed additional stimulus, it could

buy long-term US Treasury securities• Increased demand for bonds increases the price

and lowers the interest rate

Fed is not allowed to buy stocks, but some other central banks are allowed

Fed could commit to a low federal funds rate, stimulating investment spending


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Central Bank Reputation

A central bank's success at stabilizing the economy depends on whether its acts align with its reputation Inflation hawk is committed to achieving

and maintaining low inflation, Accepts some short-run cost in reduced output

and employment Inflation dove is not strongly committed to

achieving and maintaining low inflation Inflation hawks are more successful in

maintaining stable output and employment, even in the short run Stronger anchoring of inflation expectations


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Fiscal Policy Effects

Tax rates reduction increase aggregate spending through the consumption function Shifts aggregate demand to

the right Supply-side effects shift long-

run aggregate supplyWhether inflation increases,

decreases, or stays constantdepends on the relative sizes

of the shifts in AD and LRAS

LRAS1

Output (Y)

1

AD1

Y 1

Infla

tion

()

AD2

LRAS2

Y 2


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Tariq, Single Self-Employed Person's Taxes

Tax and transfer policies also affect potential output by affecting the supply of labor Lower tax rates on earnings may increase

potential output by inducing people to work more hours

A reduction in Tariq’s tax rate from 40 percent to 30 percent increases his after-tax wage from $6 to $7 per hour


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Marginal Tax Rates

Cost – Benefit Principle says individual make labor supply decisions based on the added costs and added benefits of an action Marginal tax rate is the tax rate on an

additional dollar Average tax rate is total taxes divided

by total pre-tax incomeMany taxes are not based on income

Property tax, gasoline tax, sales tax


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Taxes in the MENA

Egypt Total taxes collected in Egypt were about 15.4 percent

of GDP and many of these taxes, such as property taxes, do not depend on income.

The highest marginal tax rate was 20 percent in 2008. Morocco

Total taxes collected in Morocco were about 27.4 percent of GDP in 2008.

The highest marginal tax rate was 42 percent in 2008 (lowered to 38 percent in 2009).

UAE, Qatar, and Saudi Arabia There are no taxes on personal income. These governments rely primarily on oil and natural

gas revenues and to a lesser degree on taxes on profits.

Taxes on profits are estimated at around 14 percent, 11 percent, and 15 percent in the UAE, Qatar, and Saudi Arabia, respectively.


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The Potential Effects of Tax Rate Reductions on Aggregate Demand and

Aggregate Supply


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Americans Work More than Europeans

CountryRelative Hours

Worked (US = 100)Marginal Tax

Rate

Japan 104 37%

US 100 40

UK 88 44

Canada 88 52

Germany 75 59

France 68 59

Italy 64 64


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Americans Work More than Europeans

US average work week is longer US takes fewer vacations and holidays Retire later Less unemployment

Marginal interest rates matter When European marginal rates were

lower, they worked moreOther factors matter

More unionization in Europe Government regulations regarding hours

per week More generous social security systems


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Policymaking: Art or Science?

Economy is complex Actors learn, adapt, and change

Macroeconomic policy works best with Accurate knowledge of current economic

conditions Knowledge of the future path of the

economy without policy Precise value of potential output Good control of fiscal and monetary

policies Knowledge of how and when the economy

will respond to policy changes


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Barriers to Perfect Policies

Policy makers act with an approximate understanding of the economy

Policy is subject to lags The inside lag is the delay between the

time a policy change is needed and the time it is implemented

Shorter for monetary policy than for fiscal policy

The outside lag is the delay between policy implementation and the major effects of the policy occur

Longer for monetary policy than for fiscal policy

©2012 The McGraw-Hill Companies, All Rights Reserved 1 Chapter 24: Macroeconomic Policy.

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Transcript of ©2012 The McGraw-Hill Companies, All Rights Reserved 1 Chapter 24: Macroeconomic Policy.