Monetary and Fiscal Policy-makers should try to Stabilize the Economy.

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• Monetary and Fiscal Policy-makers should try to
  Stabilize the Economy.
• Monetary Policy should be made by an Independent
  Central Bank.
• The Central Bank should aim for Zero Inflation.
• The Government should Reduce its Debt.
• The Tax Laws should be Reformed to Encourage
  Saving. CH 17

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EXAM

• Same format as December
• Monday April 18---9AM---Field House
• This week-chapter 17
• Last class Tuesday April 5Review discuss exam
• Office hours after term ends
• April 11 3-430 and
• April 13 and April 14 from 930-11

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US housing-spending down
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Monetary and Fiscal Policy-makers should try to
Stabilize the Economy PRO

• The economy is inherently unstable, and if left
  unchecked, the economy will go through long and
  frequent periods of recession and high
  unemployment.
• With careful timing and proper actions,
  policy-makers can use monetary and fiscal
  stimulation to prevent recessions or at least
  minimize their severity.

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Monetary and Fiscal Policy-makers should try to
Stabilize the Economy PRO

• There is no reason for society to suffer through
  the booms and busts of the business cycle.
• Monetary and fiscal policy can stabilize
  aggregate demand and, thereby, production and
  employment.

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Monetary and Fiscal Policy- CON

• Discretionary monetary policy affects the economy
  with long and unpredictable (variable) lags
  between the need to act and the time that it
  takes for these policies to exert an influence of
  output and employment.
• Many studies indicate that changes in monetary
  policy have little effect on aggregate demand
  until about six months after the change is made.

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Monetary and Fiscal Policy-makers should try to
Stabilize the Economy CON

• Fiscal policy works with a lag because of the
  long political process to change spending and
  taxes.
• All too often these policy initiatives can
  aggravate rather than reduce the ups and downs of
  the economy.
• It might be desirable if policy makers could
  eliminate all economic fluctuations, but this is
  not a realistic goal.
• Instead provide stable environment.

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Policy question

• Would you be more likely to support active
  stabilization policy if wages, prices, and
  expectations adjust quickly in response to
  economic changes, or if they adjust slowly?

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Refers to AD and AS adjustments

• If wages, prices, and expectations adjust slowly,
  it will take longer for the economy to return to
  its natural rates of output and employment.
• In that case, theres a better chance that
  expansionary policy will act in time to alleviate
  the recession, rather than push the economy into
  an inflationary boom.

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Expectations Adjust

• From SRAS, Y deviates from YN when P deviates
  from PE.
• Y YN a(P-PE)
• YN Natural rate of output
• P is actual price level
• PE is expected price level
• Related to SRPC

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US CBO estimate
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GREAT DEPRESSION 1929-1933

• Real GDP declined 30
• Urate increased from 2.9 to gt20
• Almost no 2 income families
• K causes Uncertainty, C, I (AD) decline
• M causes bad mpMS down
• Global international tariff war.

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Monetary Policy Should Be Made By An Independent
Central Bank PRO

• To the extent politicians influence monetary
  policy, economic fluctuations may come to reflect
  the electoral calendar - political business
  cycle.
• That is, politicians may be tempted to use
  monetary policy to affect election results. (SR
  vs LR objectives).

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PRO Independence

• There is a time inconsistency of policy - the
  discrepancy between what policy-makers say they
  will do what they subsequently in fact do.
• This may make people sceptical about inflation
  policyslows adjustment of PE to P.
• Independent BOC has less incentive tio do this.

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PRO

• Keep monetary policy independent of politics.
• Evidence across countries suggests that countries
  with the most independent central banks have the
  lowest inflation rates.

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Monetary Policy Should Be Made By An Independent
Central Bank CON

• Empowering central banks with complete
  independence in conducting monetary policy is a
  problem since it does not limit incompetence and
  abuse of power.
• Changes in aggregate demand translate into
  changes in employment and income, so someone
  should be accountable for monetary policy changes.

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Monetary Policy Should Be Made By An Independent
Central Bank CON

• Despite clear and forceful statements by the B of
  C, it is not obvious that enhancing the
  credibility of inflation targets has resulted in
  reducing the short-run cost of achieving lower
  inflation.
• Elected policy-makers might find fiscal policy
  more useful than monetary policy when trying to
  influence votes.

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Independent bank CON

• Elected officials are more accountable.
• The practical importance of time inconsistency
  has not been shown.
• Question is how much independence.

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Bank of Canada

• How independent??
• US Fed is similar.
• Current bank-related issues in US have drawn Fed
  (Bernanke) more into the political system.
• Usual central bank goal is price stability.

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Obsessing?
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Previously quite stable
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The Central Bank Should Aim for Zero Inflation
PRO

• Inflation confers no benefit to society, but it
  does impose several social costs.
• If inflation is bad, why not 0?
• Reducing inflation is a policy with temporary
  costs and permanent benefits. Once the
  disinflationary recession is over, the benefits
  of zero inflation would persist.

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The Costs of Inflation

• At least six costs of inflation are identified
  as
• . Shoeleather costs
• . Menu Costs
• . Increased variability of relative prices
• . Tax liabilities
• . Confusion and inconvenience
• . Arbitrary redistribution of wealth

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Aim for Zero Inflation NO

• Zero inflation is probably unattainable and
  getting there involves output and unemployment
  costs that are too high.
• The stimulative effect of a little inflation is
  necessary to keep unemployment reasonably low.
• The imperfections of measuring price levels
  result in uncertainty about measuring the
  successful attainment of zero inflation.

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INFLATION COSTS

• Not all inflations are the same.
• Little inflation becomes hyperinflation only with
  political instability.
• 5 inflationgtgtgtP doubles in 14 years.
• Inflation variability more costly
• 3 per year for five years (15 total) versus
  5,0,5,0,5 (15 total)

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Measuring inflation ch 6

• CPIfixed market basket3 biases
• Substitution biasbuy less of things that go up
  more in price but basket is fixed.
• New products-greater utility from variety
• Unmeasured quality changereal price lower.
  Computing power

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Government Debt Should Be Reduced PRO

• Budget deficits impose an unjustifiable burden on
  future generations by raising their taxes and
  lowering their incomes.
• When the debts and accumulated interest come due,
  future taxpayers will face a difficult choice
• They can pay higher taxes, enjoy less government
  spending or both.

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The Government Should Balance Its Budget PRO

• By shifting the cost of current government
  benefits to future generations, there is a bias
  toward too large a public sector.
• Deficits reduce national saving, thereby
  retarding capital formation, causing lower
  productivity, and limiting real growth.
• Series of deficits leads to debt.

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Budget deficit reduces S
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The Government Should Balance Its Budget CON

• The deficit is only one small part of fiscal
  policy. The problem with the deficit and debt is
  often exaggerated.
• Intergenerational transfers may be justified and
  some government purchases produce benefits well
  into the future (i.e. reducing budget deficit by
  cutting spending on education).

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The Government Should Balance Its Budget CON

• A balanced budget requirement would limit the
  policy options available to deal with emergencies
  and future economic crises.
• The government debt can continue to rise.
  Population growth and technological progress
  increase the nations ability to pay the interest
  on the debt.

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Key is debt/GDP
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The Tax Laws Should Be Reformed To Encourage
Saving

• A nations productive capability is determined
  largely by how much it saves and invests for the
  future.
• S Y-C-G (simple closed economy)
• Farm exampleeat corn vs seed

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The Tax Laws Should Be Reformed To Encourage
Saving PRO

• A nations saving rate is a key determinate of
  its long-run economic prosperity.
• When the saving rate is higher, more resources
  are available for investment in new plant and
  equipment.

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Tax Laws Should Encourage Saving PRO

• Our society discourages saving in too many ways,
  such as by taxing the income from capital heavily
  and by reducing benefits for those who have
  accumulated wealth and capital.
• The consequences of high interest income tax
  policies are reduced saving, reduced interest
  accumulation, lower labour productivity, and
  reduced economic growth.

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Reform Tax Laws To Encourage Saving PRO

• An alternative to current tax policies, advocated
  by many economists is a consumption tax like the
  GST-HST.
• A person pays taxes only on the basis of what
  they consume (spend) not on what they produce
  (earn). Income that is saved is exempt from
  taxation until the saving is later withdrawn and
  spent on consumption goods.

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Tax Laws Should Encourage Saving CON

• Most of the proposed changes in the tax policies
  to stimulate saving would benefit primarily the
  wealthy at the expense of lower income groups.
• High-income households save a higher fraction of
  their income than low-income households. Any tax
  change that favors people who save will also tend
  to favor people with high income.

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Taxes

• US
• Top 1 of taxpayers pay 37 of taxes
• Top 10 pay 68 (100K and more)
• Top 50 pay 97 of all taxes
• Tax cuts must be on those who pay.

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Tax Laws Should Encourage Saving CON

• Reforms would be either regressive or would
  further the inequality of income in our society.
• Raising public saving by eliminating the
  governments budget deficit would provide a more
  direct and equitable way to increase national
  saving.

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Summary-17

• Advocates of active monetary and fiscal policy
  view the economy as inherently unstable and
  believe policy can be used to offset this
  inherent instability.
• Critics of active policy emphasize that policy
  affects the economy with a lag and our ability to
  forecast future economic conditions is poor, both
  of which can lead to policy being destabilizing.

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Summary-17

• Advocates of an independent central bank argue
  that
• such independence guards against politicians
  using monetary policy to try to influence voters.
• A lower rate of inflation and a more favourable
  short-run tradeoff between inflation and
  unemployment is possible.
• Critics of an independent central bank argue that
  because it has large and lasting influences on
  aggregate demand, output, and employment,
  citizens should have a say on monetary policy

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Summary-17

• Advocates of a zero-inflation target emphasize
  that inflation has many costs and few if any
  benefits.
• Critics of a zero-inflation target claim that
  moderate inflation imposes only small costs on
  society, whereas the recession necessary to
  reduce inflation is quite costly.

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Summary-17

• Advocates of reducing the government debt argue
  that the debt imposes a burden on future
  generations by raising their taxes and lowering
  their incomes.
• Critics of reducing the government debt argue
  that the debt is only one small piece of fiscal
  policy.

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Summary-17

• Advocates of tax incentives for saving point out
  that our society discourages saving in many ways
  such as taxing income from capital and reducing
  benefits for those who have accumulated wealth.
• Critics of tax incentives argue that many
  proposed changes to stimulate saving would
  primarily benefit the wealthy and also might have
  only a small effect on private saving.
  (Elasticity issue)