Policy

.IntroductionInthischapterweexaminehowpolicymakersformulateappropriatepolicymeasuresConsider:TimingUncertaintyHowindividualswillrespondtospecificpoliciesRoleofcredibilityMonetaryorfiscalpolicy,oramixDifferentpolicyinstrumentsDifferentintermediateandultimatetargets18-2LagsintheEffectsofPolicySupposetheeconomyisatfullemployment:Affectedbyanegativeaggregatedemanddisturbance

reducestheequilibriumlevelofincomebelowfullemploymentNoadvancewarningofdisturbancenopolicyactiontakeninanticipationofitsoccurrencePolicymakersmustdecide:Shouldtheyrespondtothedisturbance?Ifso,howshouldtheyrespond?18-3LagsintheEffectsofPolicyIsthedisturbancepermanent(orpersistent)ortemporary?Figure18-1illustratesatemporaryaggregatedemandshockAoneperiodreductioninconsumptionbestpolicyistodonothingatallToday’spolicyactionstaketimetohaveaneffectwouldhiteconomyafterbackatfull-employmentlevel,drivingitawayfromtheoptimallevel18-4LagsintheEffectsofPolicy

InsideLags:thetimeperiodittakestoundertakeapolicyactionRecognitionLag:theperiodthatelapsesbetweenthetimeadisturbanceoccursandthetimethepolicymakersrecognizethatactionisrequiredLagisnegativeifthedisturbanceispredictedandappropriatepolicyactionsconsideredbeforeitoccurs(Ex.IncreasemoneysupplypriorChristmas)Lagistypicallypositive18-5Policymakingisaprocess:TakestimetorecognizeandimplementapolicyactionTakestimeforanactiontoworkitswaythroughtheeconomyEachstepinvolvesdelaysorlags:InsidelagsRecognitionlagsDecisionlagsActionlagsOutsidelagsLagsintheEffectsofPolicy

18-6InsideLags:thetimeperiodittakestoundertakeapolicyactionDecisionLag:thedelaybetweentherecognitionoftheneedforactionandthepolicydecisionDiffersbetweenmonetaryandfiscalpolicyFOMCmeetsregularlytodiscussanddecideonpolicyPolicymakingisaprocess:TakestimetorecognizeandimplementapolicyactionTakestimeforanactiontoworkitswaythroughtheeconomyEachstepinvolvesdelaysorlags:InsidelagsRecognitionlagsDecisionlagsActionlagsOutsidelagsLagsintheEffectsofPolicy

18-7Policymakingisaprocess:TakestimetorecognizeandimplementapolicyactionTakestimeforanactiontoworkitswaythroughtheeconomyEachstepinvolvesdelaysorlags:InsidelagsRecognitionlagsDecisionlagsActionlagsOutsidelagsInsideLags:thetimeperiodittakestoundertakeapolicyactionActionLag:thelagbetweenthepolicydecisionanditsimplementationAlsodiffersformonetaryandfiscalpolicyMonetarypolicymakerstypicallyactimmediatelyFiscalpolicyactionsarelessrapidLagsintheEffectsofPolicy

OutsideLags:timeittakesapolicymeasuretoworkitswaythroughtheeconomyInsidelagsarediscrete,butoutsidelagsaretypicallydistributedlagsOnceapolicyactionhasbeentaken,itseffectsontheeconomyarespreadoutovertimeImmediateimpactsmaybesmall,butothereffectsoccurlater18-8Policymakingisaprocess:TakestimetorecognizeandimplementapolicyactionTakestimeforanactiontoworkitswaythroughtheeconomyEachstepinvolvesdelaysorlags:InsidelagsRecognitionlagsDecisionlagsActionlagsOutsidelagsLagsintheEffectsofPolicyFigure18-2illustratesthedynamicmultiplierShowstheeffectsofaonce-and-for-all1percentincreaseinthemoneysupplyinperiodzeroImpactisinitiallyverysmall,butcontinuestoincreaseoveralongperiodoftime18-9Whyarethereoutsidelags?

Monetarypolicy:initiallyimpactsinvestmentviainterestrates,notincomeWhenADultimatelyaffected,increaseinspendingitselfproducesaseriesofinducedadjustmentsinoutputandspendingMonetaryVersusFiscalPolicyLagsFiscalpolicydirectlyimpactsaggregatedemandAffectincomemorerapidlythanmonetarypolicyShorteroutsidelagsthanmonetarypolicyLongerinsidelagsthanmonetarypolicyLonginsidelagsmakesfiscalpolicylessusefulforstabilizationandusedlessfrequentlytostabilizetheeconomyIttakestimetosetthepoliciesinaction,andthenthepoliciesthemselvestaketimetoaffecttheeconomyFurtherdifficultiesarisebecausepolicymakerscannotbecertainaboutthesizeandtimingoftheeffectsofpolicyactions18-10ExpectationsandReactionsGovernmentuncertaintiesabouttheeffectsofpoliciesontheeconomyarisebecause:PolicymakersdonotknowwhatexpectationsfirmsandconsumershaveGovernmentdoesnotknowthetruemodeloftheeconomyWorkwitheconometricmodelsoftheeconomyinestimatingtheeffectsofpolicychangesAneconometricmodelisastatisticaldescriptionoftheeconomy,orsomepartofit18-11ReactionUncertaintiesSupposethegovernmentdecidestocuttaxestostimulateaweakeconomytemporarytaxcutHowbigofacutisneeded?Onepossibility:temporarytaxcutwillnotaffectlong-termincome,andthusnotlong-termspendingLargetaxcutneededAlternatively:consumersmaybelievetaxcutwilllastlongerthanannounced,andMPCoutoftaxcutislargerSmallertaxcutmightbesufficientIfthegovernmentiswrongaboutconsumers’reactions,itcoulddestabilizeratherthanstabilizetheeconomy.18-12UncertaintyandEconomicPolicyPolicymakerscangowronginusingactivestabilizationpolicydueto:UncertaintyabouttheexpectationsoffirmsandconsumersDifficultiesinforecastingdisturbancesLackofknowledgeaboutthetruestructureoftheeconomyUncertaintyaboutthecorrectmodeloftheeconomyUncertaintyabouttheprecisevaluesoftheparameterswithinagivenmodeloftheeconomy18-13Targets,Instruments,andIndicatorsEconomicvariablesplayavarietyofrolesinpolicydiscussionsUsefultodividethemintotargets,instruments,andindicatorsTargets:identifiedgoalsofpolicyUltimatetargetsEx.“toachievezeroinflation”IntermediatetargetsEx.TargetingmoneygrowthUsedtoachieveultimatetarget18-14Targets,Instruments,andIndicatorsEconomicvariablesplayavarietyofrolesinpolicydiscussionsUsefultodividethemintotargets,instruments,andindicatorsInstruments:toolspolicymakersmanipulatedirectlyEx.AnexchangeratetargetIndicators:economicvariablesthatsignalusastowhetherwearegettingclosertoourdesiredtargetsEx.Increasesininterestrates(indicator)sometimessignalthatthemarketanticipatesincreasedfutureinflation(target)Provideusefulfeedbackpolicymakerscanusetoadjusttheinstrumentsinordertodoabetterjobofhittingtargets18-15RulesVersusDiscretionIndetermininghowpolicymakersshouldoperate,policymakersmustanswe