Should Policy Makers Be Restrained?

1
Should Policy Makers Be Restrained?

• Arguments for Restraints
• Well-intentioned policy makers do more harm than
  good
• The self interest of the policy makers may not be
  in the best interests of the country
• How much do macroeconomists actually know?
• Uncertainty and policy The issues a central bank
  economist must address when considering
  expansionary monetary policy to lower
  unemployment
• Is unemployment gt natural unemployment?
• How much will i fall?
• What is the relationship between short-term and
  long-term i?
• How much will stock prices increase?
• How much will the currency depreciate?
• How long will it take for C and I to respond to
  lower long-term i?
• How long will the J curve effect last?
• What if the economy is already recovering?

2
Should Policy Makers Be Restrained?
Uncertainty and Policy How well do the macro
models work?
3
Should Policy Makers Be Restrained?
Uncertainty and Policy How well do the macro
models work?
The Response of Output to a Monetary Expansion
12 Predictions from 12 Models
Observations

• 1 year out Omitting extremes, the range is
  greater than 1
• 2 years out Average deviation is 1.2
• 6 years out Average deviation is 0.6 and the
  range is -0.5 to 2.5

Conclusion
There is substantial uncertainty about the
effects of policy.

• Should uncertainty lead policy makers to do less?
  
• A Scenario The economy is in a recession - What
  the Bank of Canada knows
• No policy U 9 next year
• Un 7
• Okuns Law 1 more growth ??0.4 U
• 5 more growth ??U to 5 next year

4
Should Policy Makers Be Restrained?
Uncertainty and Policy How well do the macro
models work?

• Average Response to the Models?Ms 4? .85 ?Y
  1st year?Ms 1? .21 ?Y 1st year?Ms 23.8? 5.0
  ?Y 1st year
• The Extremes ?Ms 23.8? 0.0 ?Y ?0?U ?Ms 23.8?
  17.9 ?Y ?7?U
• Conclusion
• Uncertainty and, therefore, risk is high
• A moderate policy is more suitable
• The uncertainty will act as an automatic
  restraint on policy

5
Should Policy Makers Be Restrained?
Expectations and Policy Arguments for
Restraints on Policy Makers
Game Theory and Expectations

• Expectations contribute to the uncertainty of
  macro-policy by influencing the outcome of the
  policy
• Game theory is used to explain how strategic
  interactions influence expectations and their
  impact on the outcome of policy decisions.
• What do you think...
• Should governments discontinue their stated
  policy of no negotiation with plane hijackers?
• Inflation and Unemployment Revisited
• Recall ? ? ?e ? ? (u-un )
• Assume The Bank of Canada announces a policy of
  zero inflation
• Then ? ? ? ? (u-un )
• Outcome Zero inflation with u un

6
Should Policy Makers Be Restrained?
Expectations and Policy

• Given ? ? ? ? (u-un )
• If ? ? 1
• Then The Bank of Canada could lower u 1 below
  un by accepting an inflation rate of 1
• Question What is likely to happen over time if
  the B of C pursues a policy of 1 inflation?
• Conclusion The best policy is for the Bank of
  Canada to make a credible commitment to zero
  inflation and u un
• Establishing Credibility
• Establish, by law, the rate of money growth.
• This would prevent the Central Bank from
  intervening during periods of severe economic
  shocks.
• Make the Central Bank independent and choose a
  conservative central banker.

7
Should Policy Makers Be Restrained?
Expectations and Policy
Inflation Central Bank Independence
8
Should Policy Makers Be Restrained?
Politics and Policy
Games Between Policy Makers and Voters

• Tax cuts and the trade-off between growth today
  and deficits tomorrow.
• Political business cycle
• Systematic Deficit The Evidence
• Ratio of Debt to GDP
• Debt buildup associated with Depression and WWII
• Debt/GDP fell from over 140 in 1949 to 31 in
  1976
• Debt/GDP rose from 1976 to 1996
• Debt/GDP has fallen since 1996

9
Should Policy Makers Be Restrained?
Politics and Policy
The Evidence
The Ratio of Canadian Federal Government Debt to
GDP, 1926-2001
10
Should Policy Makers Be Restrained?
Politics and Policy
The Political Business Cycle
11
Should Policy Makers Be Restrained?
Politics and Policy
The Political Business Cycle
12
Should Policy Makers Be Restrained?
Politics and Policy
Back to the Balanced-Budget Law

• The Case Against
• It would eliminate the use of fiscal policy
• Deficit reduction can be achieved without the
  constraints of a balanced budget law
• The Case For
• Macro policy is not effective
• Running deficits during recessions may adversely
  effect financial markets and hinder an economic
  recovery

13
Should Policy Makers Be Restrained?
What do you think...
Do rules reduce budget deficits?
Debt Per Capita in Ontario, 1970-2000