This Document Contains Chapters 13 to 15 INTRODUCTION Deriving directly from Chapter 12 and leading to 15, this is a ‘payoff’ chapter which draws from (and reinforces) material from other chapters. As a result, the key to teaching this chapter is to make it relevant to students. The material in this section is as up-to-date as possible, but it makes sense to supplement it with current topics in your country. Teaching Tips ALTERNATIVE ROUTES THROUGH THE CHAPTER As little of the material in this chapter is directly required to let students understand later chapters, almost any element can be by-passed though the transmission mechanism and Taylor Rules are probably the easiest to leave out. Combining intermediate targets with the section on credibility in Chapter 16 and final targets and the operation of monetary policy into Chapter 11 would make sense for a shorter course. Opening the lecture with the operation of monetary policy and final targets and then moving to intermediate targets, Taylor rules and the transmission mechanism is a logical route that would lead naturally to a discussion of current issues at the end of the lecture. CHAPTER GUIDE 13.1 The Influence of Central Banks. Although this chapter is all about Central Banks, the reasons for the increased number and independence of Central Banks is covered in Chapters 12 and 15 respectively. The increased number comes largely from the end of commodity-based currencies (the gold standard) and independence stems from the value of credibility in eradicating inflationary bias. 13.2 Monetary Policy and the LM Curve. See case study to chapter 12 for a complete discussion of IS-LM analysis 13.3 What Does Monetary Policy Target? The debate over the appropriate target rate of inflation is still an active one. The Background Material below summarizes a strong argument for positive inflation by Akerlof, Dickens and Perry (1996). 13.4 What Intermediate Targets Should Central Banks use? The increased use of intermediate targets reinforces the popularity of rules over discretion discussed in Chapter 16. Some more detail on intermediate targets for the main economies is given in the Background Material 13.5 Money Supply Targeting. The Case Study “Mrs. Thatcher’s Monetarist Experiment” can be used to bring out most of the arguments in this section. CHAPTER 13: MONETARY POLICY This Document Contains Chapters 13 to 15 13.6 Exchange Rate Targets. This section – though important – is difficult to teach in much detail until Chapters 18 and 19 have been covered. But currency boards are very interesting special cases of money supply targeting. Of course, a further discussion of currency boards later on can be used to help reinforce students’ understanding. 13.7 Inflation Targeting. Given the huge popularity of inflation targets (Norway, Iceland and South Africa are some of the other inflation targeters), it is worth adding a note a caution here with regard to aggregate supply shocks. The argument is simply that a central bank that raises interest rates in a boom and cuts them in recessions has an easy job, but in the face of an aggregate supply shock, they may have to raise interest rates in a recession – something that might dent the popularity of inflation targeting regimes. Certainly, the set-up of the first inflation targeting regime (New Zealand) recognizes this and has a number of get-out clauses covering aggregate supply shocks (see Background Material). 13.8 The Operational Instruments of Monetary Policy. Details on the US, UK and Euro monetary operating procedures can be found in the Background Material. 13.9 Controlling the Money Supply or Interest Rates? This section does not make an explicit distinction between money base control and broad money targeting. Money base control (where the Central Bank supplies a pre-set amount of liquidity into the money market and then lets interest rates move) as formerly practiced in Switzerland and as effectively practiced by many currency boards, is a system in which the Central Bank gives up control of interest rates in return for control of the money supply. Broad money targeting is a little less transparent as Central Banks with broad money targets will tend to control interest rates in the short term but move them in order to hit the longer-term money target. You should judge whether the distinction between these two types of money targeting is one which your students will find useful. 13.10 The Transmission Mechanism. The Background Material on Japan and the liquidity trap can be a useful way of applying some of the ideas in this section to a current economic situation. 13.11 Monetary Policy in Practice. Taylor rules make a good starting point for a discussion of monetary policy in the run up to the crisis. They suggest rates were too low – is this right? If so to what extent was monetary policy responsible for the crisis? 13.12 Quantitative Easing. Clearly, the assessment of QE is still an ongoing research topic with a burgeoning literature on both theoretical and empirical aspects TABLE & CHART TIPS Figure 13.10. Not only is the trend away from no explicit target interesting, but also the extent to which exchange rate targets remain as popular as ever despite the ERM and Asian crises. Figure 13.12 UK Broad money velocity is discussed in the Case Study. Of interest also is the fact that M0 velocity has started falling (i.e. more cash held per head) for the first time in recorded history. The Bank of England likes to argue that this change is due to low and stable inflation that has reduced the opportunity cost of holding cash. CASE STUDY: MRS THATCHER’S MONETARIST EXPERIMENT In 1979 the conservative government of Margaret Thatcher was elected in the UK with a commitment to reduce inflation then running at nearly 15%. The centerpiece of this anti-inflation policy was the Medium Term Financial Strategy (MTFS) which set rigorous targets for the growth of £M3 (UK broad money). The government was fully convinced of the value of credibility and so stated their pre-commitment to these money supply targets in no uncertain terms. “[There can be] no question of departing from the money supply policy, which is essential to the success of any anti-inflationary strategy” they stated in their first budget. The policy soon acquired the acronym TINA (there is no alternative). It didn’t take long to realize that the policy was running into some serious technical problems. The first was a direct consequence of one of the government’s other aims – deregulation of the banking system. Having abolished exchange controls in 1979 (i.e. ending limits on foreign exchange transactions), they moved on to abolish the ’corset’ - a set of quantitative limits on bank lending. Unsurprisingly, once the ‘corset’ had been removed, monetary expansion was dramatic. £M3 jumped 5% in one month alone sending it way out of the target range (see table). What was worse, the sudden surge in money supply growth was not just a one-year wonder but continued. As a result M3 seriously overshot its target for the first two years of the MTFS – not quite the demonstration of credibility the government had hoped for. In 1982, the government adopted a dual strategy to retrieve the situation. First, despite falling inflation (and a crippling recession), they chose to raise the target range for money growth – recognizing that the trend in velocity had changed (see chart). Secondly, they implemented a policy of overfunding. This arcane practice involved selling more government debt to the private sector than was required to fund government spending. The extra funds were then used to reduce government borrowing direct from the banking system and so reduce the banks’ requirement to raise deposits. In effect, despite rapidly growing bank lending to the private sector (almost 20% p.a. between 1980-4), the cut-back in bank lending to the government meant that total money supply was kept under control (averaging about 12% p.a. between 1980-84). By 1985, the government had overfunded so much that the banking system was beginning to come under strain. As banks had no more government debt to give up, the Bank of England actually acquired £18bn of private sector assets instead – the so-called ‘bill mountain’. In addition to the problem of the bill mountain, the government now realized that the velocity of circulation of £M3 was too unpredictable to be useful. Added to these problems, the fact that unemployment had more than doubled in the early years of the MTFS was a pretty clear indication that the hoped-for credibility benefits had not materialized. Unsurprisingly in 1985, the UK government effectively abandoned monetary targeting. It did not employ a rules-based monetary policy again until 1990 when the UK joined the European Exchange Rate Mechanism (ERM). The UK economy 1978 - 1985 Year £M3 target range £ M3 outurn GDP growth Unemploy ment Inflatio n 197 8 - - 3.40 5.90 8.42 197 9 - - 2.75 5.32 13.75 198 0 7-11 18.5 -2.15 6.99 17.69 198 1 6-10 13 -1.25 10.56 11.90 198 2 8-12 11.5 1.80 12.28 8.24 198 3 7-11 10 3.75 12.13 4.67 198 4 6-10 12 2.45 11.51 4.93 198 5 5-9 15 3.78 11.73 6.04 UK £M3 Velocity of Circulation Discussion Questions 1) Should the Thatcher government have postponed financial liberalization until the monetary targeting regime had been properly established? 2) Since the Thatcher government earned a reputation for being tough on all economic and social issues, did the monetarist experiment benefit the UK in the longer term? 2 2.4 2.8 3.2 3.6 74q1 75q1 76q1 77q1 78q1 79q1 80q1 81q1 82q1 83q1 84q1 85q1 Background Material NEW ZEALAND’S CENTRAL BANK CONTRACT. New Zealand’s Central Banks (the RBNZ) has one of the clearest formulations of an inflation target. It is also unusual in having some ‘get-out’ clauses for aggregate supply shocks such as livestock disease outbreaks. Below is a summary of the RBNZ’s 1990 Policy targets agreement Target Inflation target of 0% to 2% inflation on the All Items CPI by year ending December 1992. Variations to targets 1. If CPI inflation diverges by more than ½% from the RBNZ own core CPI measures, the target may be re-negotiated. 2. Any increase/decrease in GST (sales tax) expected to impact inflation may cause the target to be re-negotiated. 3. A significant change in the terms of trade arising from an increase or decrease in either export prices or import prices may trigger a re-negotiation. 4. A crisis situation - such as a natural disaster or a major disease-induced fall in livestock numbers - may trigger a re-negotiation. ORGANISATION AND OPERATING PROCEDURES FOR THE MAIN CENTRAL BANKS. THE US FEDERAL RESERVE Final Objective of Monetary Policy: “High employment consistent with stable prices” (Humphrey Hawkins Act) Intermediate Target: None that are operationally important. Organizational Structure. The Federal Reserve System consists of 7 members of the Board of Governors in Washington D.C. and 12 Federal Reserve District Banks. Interest rate decisions are made at the Federal Open Market Committee (FOMC) which meets eight times a year and consists of 12 members (The 7 members of the board of governors, the president of the Federal Reserve Bank of New York and 4 other Reserve Bank Presidents, who serve in rotation). Operating Procedures. The Federal Reserve sets two interest rates, the Discount Rate and the Fed Funds rate. The Fed Funds market is an interbank market for bank reserves and is based on an overnight interest rate. The Federal Reserve can therefore influence the Fed Funds rates by injecting or removing liquidity with open market operations (purchase or sale of government securities in exchange for reserves). Banks must maintain their level of reserves above the reserve requirement over a two-week averaging period. The Discount Rate is the interest rate charged on emergency lending of reserves through the discount window. Discount window lending is usually only given in special circumstances. But since the discount rate is below the Fed Funds rate (i.e. offers cheaper funds) the Federal Reserve uses “moral suasion” to ensure that banks do not access the discount window too regularly. THE EUROPEAN CENTRAL BANK Final Objective of Monetary Policy: Price Stability – defined by the ECB itself as inflation below 2%. “Without prejudice to this objective, it shall support the general economic policies in the Community and act in accordance with the principles of an open market economy”. Intermediate Target: An inflation target and an M3 target. Called the “Twin Pillars” approach. Organizational Structure. The European System of Central Banks (ESCB) consists of the 6 members of the executive board and the 15 national Central Banks of the European Union. Interest rate decisions are made at fortnightly council meetings where all executive board members and National Central Banks Presidents in the Euro-Area can vote (Sweden, Denmark and UK are in the ESCB but not in the eurosystem and so cannot vote on Euro interest rates). Operating Procedures. The ECB sets three interest rates, the Repo rate and two marginal lending rates (often called the Discount and Lombard rates). The Repo rate is set in the market for bank reserves and is based on an overnight interest rate. The ECB set this rate through regular Repo auctions where it injects or removes liquidity with open market operations (purchase or sale of securities in exchange for reserves). Banks must maintain their level of reserves above the reserve requirement over a one-month averaging period. The two marginal lending rates are special rates at which commercial banks may either borrow reserves (the discount rate) or deposit surplus reserves (the Lombard rate) at national Central Banks. The discount rate is above the Repo rate and the Lombard rate below. They therefore form a corridor within which the Repo rate can fluctuate. THE BANK OF ENGLAND Final Objective of monetary policy: An inflation objective set by the government, currently 2.5%. Intermediate Target: An Inflation target based on a two-year-ahead inflation forecast. Organizational Structure. The Monetary Policy Committee (MPC) of the Bank of England meets to set interest rates once a month. The MPC consists of 9 members, 5 full time Bank of England employees and 4 external experts. Operating Procedures. The Bank of England sets the overnight Repo rate through daily open market operations. There is no reserve requirement, but commercial banks are not allowed to run overdrafts on their accounts at the Bank of England. There will generally be a daily shortage of liquidity in the interbank market, so commercial banks must enter the Bank of England’s daily operations in order to keep liquidity in balance. Additional Questions Question 1) Read the mini-case below. Having read it , what rate of inflation do you think that Central Banks should target.? Akerlof, Dickens and Perry (1996) give one of the most coherent arguments against targeting zero inflation. They start by reviewing the evidence on downward wage rigidity and then analyze the impact of alternative inflation rates in a model that reflects these rigidities. One of the many pieces of evidence which they reviewed was a survey that the authors themselves undertook in the Washington area. They asked if the last pay change the respondent had received was positive, negative or no change. Their results are summarized below. Survey of Reported Change in Base Pay (Washington Area) Negative No Change Positive Total 2.7% 30.8% 66.5% Private Sector 2.4% 34% 63.6% Public Sector 3.1% 25.8% 71.1% The table indicates a clear skew in responses, with cuts in wages far rarer than no change. Further questioning revealed that wage cuts were usually only contemplated when a firm was close to bankruptcy. Money illusion seems an important reason for the aversion to wage cuts. Other surveys, for instance, found that workers felt that wage cuts were unfair if a company was in profit even though they felt small wage rises in times of high inflation were acceptable. Putting downward wage rigidity into a simulation model that is subject to heterogeneous demand and supply shocks (i.e. different shocks to different firms calibrated on historical experience), they emerge with a relationship between low inflation and unemployment as shown in the table below. Unemployment and Firms Constrained by Rate of Inflation Inflatio n Unemployment Rate Proportion of firms constrained 5% 5.8% 1% 4% 5.8% 2% 3% 5.9% 5% 2% 6.1% 10% 1% 6.5% 19% 0% 7.6% 33% The table reveals that with inflation at zero, a large number of firms will wish to cut nominal wages but be unable to do so. This constraint makes the equilibrium rate of unemployment higher than it otherwise would be. The implication of this study is that even inflation of 2% is too low a target, and perhaps Central Banks should be happy with inflation of 3% or higher. Source Akerlof, Dickens and Perry(1996) “The Macroeconomics of Low Inflation” Brookings Papers on Economic Activity 1:1996 Answer 1) there is no right answer to this one! Question 2) Should the US Federal Reserve adopt an inflation target? Answer 2) What would inflation targeting mean in the U.S.? If the Fed adopted an inflation target, it would commit to achieve a numerical goal for inflation (a target point or range) within a set time. Inflation targeting would not impose a rigid simple rule for the Fed; instead, policy could employ some discretion to take into account special shocks and situations. However, the organizing principle for monetary policy would be focused on inflation and inflation forecasts. Arguments pro 1. The announcement of an explicit inflation target would provide a clear monetary policy framework that would focus attention on what the Fed actually can achieve. For example, few economists believe that monetary policy can be used to lower the average rate of unemployment permanently, but central banks often are pressured to achieve just that. Explicit inflation targets would help to insulate the Fed from such political pressure. 2. Transparent inflation targets in the U.S. would help anchor inflation expectations in the economy, reducing the size of inflation "surprises" and their associated costs. Inflation targets also likely would boost the Fed's credibility about maintaining low inflation in the long run, in part, because they mitigate the political pressure for expansionary policy. 3. The establishment of inflation targets in the U.S. would help institutionalize good monetary policy. Recent U.S. monetary policy has been generally considered excellent, but some extent, that reflects the skills and attitudes of the people involved rather than the institutional structure. Inflation targets can provide this institutional structure and help ensure that monetary policy is not dependent on always having the good luck to appoint the best people. 4. Inflation targets increase the accountability of Central Bankers. Given forecasts of future inflation, it is easy to compare them to the announced inflation target and. Also, on a retrospective basis, an explicit target allows Fed performance to be easily monitored. Thus, Congress and the public will be able to assess the Fed's performance and hold it accountable. Arguments con 1. The purpose of inflation targeting is to focus the attention of monetary policy on inflation. However, concentrating on numerical inflation objectives (even with caveats or escape clauses) also reduces the flexibility of monetary policy, especially with respect to other policy goals. 2. Because monetary policy actions affect inflation with a lag, inflation targeting means, in practice, that the Fed would need to rely heavily on forecasts of future inflation. Given the uncertainties the Fed faces, an inflexible and undue reliance on inflation forecasts can create policy problems. 3. Proponents of inflation targeting argue that it promotes accountability. However, low inflation is only one of the objectives of monetary policy .For example, it can help to stabilize the economy. Making the Fed publicly accountable for only one policy goal may make it harder for Congress to monitor the Fed's overall contribution 4. Similarly, with regard to the transparency and public understanding of policy, inflation targeting highlights the inflation objective of central banks but tends to obscure the other goals of policy. Source Rudebusch & Walsh, FRBSF economic letter May 1998 Answers to Analytical Questions Chapter 13 Monetary Policy 1. Recall from Chapter 10 that the slope of the IS curve is determined by the responsive of consumption and investment to interest rates. For simplicity lets look at the IS curve in a simple case example with no government sector and when only investment is influenced by interest rates C = 200+.8*Y I = 200 – 10*r Y = C+I So Y = [A+I]/(1-b) or in this caseY = [200 + (200-10*r)]/0.2 Using this we can solve for Y at different levels of r IS curve for I = 200-10*r r Y 1 1950 2 1900 3 1850 4 1800 5 1750 This is the IS curve for our simple economy. Now let’s make investment more responsive to interest rates by changing the Investment equation to 250-20*r IS curve for I = 250-20*r r Y 1 2150 2 2050 3 1950 4 1850 5 1750 2. This is easiest to show graphically (see below). In practice Quantitative easing is used to try to achieve this type of outcome. 3. a r = 2 + 3 + 0.5 x (4 – 2) + 1.5 x (3 – 2) = 7.5% b. With an inflation target of 3% the interest rate is given by r = 3 + 3 + 0.5 x (4 – 2) + 1.5 x (3 – 3) = 7% c. If trend growth has indeed increased to 3.5% the interest rate setting rule implies: r = 2 + 3 + 0.5 x (4 – 3.5) + 1.5 x (3 – 2) = 6.75% so interest rates should be cut by 0.75%, If the central bank is wrong and trend growth has not increased by this much it will have underestimated by how much above trend output is and will have eased monetary monetary policy too much. Inflation is likely to then increase. 4. a. Using a spreadsheet we can calculate the path of interest rates, inflation and output under the two regimes. With the Taylor rule: interest rate = 5% + 0.75 x output gap + 1 x (inflation – target inflation) the path of the economy is Y r LM IS Target Income With the Taylor rule: interest rate = 5% + 0.25 x output gap + 2 x (inflation – target inflation) the path of the economy is b. Interest rates, output and inflation are significantly more variable under the second rule where interest rates respond weakly to movements in the output gap but respond powerfully to movements in actual in inflation. The first rule is more forward looking because it responds much more to the output gap which is the determinant of inflation in the next period. By looking ahead there is less need for sharp movements in interest rates. c. Now consider a different economy in which inflation is more sensitive to the output gap so that the slope of the Phillips curve doubles and: Inflation = inflation target + 1 x output gap At the same time the impact of interest rates on inflation also doubles so that: Output gap = -1 x (interest rates last period – 5) Now with the Taylor rule: interest rate = 5% + 0.75 x output gap + 1 x (inflation – target inflation) the path of the economy is interest rates output gap inflation year 1.00 7.50 2.00 3.00 2.00 5.06 -1.25 3.00 3.00 4.35 -0.03 1.38 4.00 5.23 0.32 1.98 5.00 5.08 -0.11 2.16 means 5.44 0.19 2.30 variances 1.44 1.38 0.49 interest rates output gap inflation year 1.00 7.50 2.00 3.00 2.00 6.69 -1.25 3.00 3.00 3.54 -0.84 1.38 4.00 4.34 0.73 1.58 5.00 5.81 0.33 2.37 means 5.58 0.19 2.26 variances 2.67 1.68 0.59 With the Taylor rule: interest rate = 5% + 0.25 x output gap + 2 x (inflation – target inflation) the path of the economy is There is a dramatic increase in the variability of output, inflation and interest rates for both sets of Taylor rules. As before volatility is much greater with the second rule that has interest rates less sensitive to the output gap and more responsive to current inflation. d. Finally we amend the inflation equation to: Inflation = last year’s inflation + 0.5 x output gap last year. The output gap equation reverts to: Output gap = -0.5 x (interest rates last period – 5) Once again we consider two Taylor rules. First consider A = 0.75 and B = 1 Now consider A = 0.25 and B = 2 interest rates output gap inflation year 1.00 7.50 2.00 3.00 2.00 5.13 -2.50 4.00 3.00 2.41 -0.13 -0.50 4.00 6.82 2.59 1.88 5.00 6.23 -1.82 4.59 means 5.62 0.03 2.59 variances 3.98 5.08 4.06 interest rates output gap inflation year 1.00 7.50 2.00 3.00 2.00 8.38 -2.50 4.00 3.00 -0.84 -3.38 -0.50 4.00 -0.29 5.84 -1.38 5.00 18.01 5.29 7.84 means 6.55 1.45 2.59 variances 59.25 18.31 13.76 interest rates output gap inflation year 1.00 7.50 2.00 3.00 2.00 6.06 -1.25 4.00 3.00 5.98 -0.53 3.38 4.00 5.74 -0.49 3.11 5.00 5.59 -0.37 2.87 means 6.17 -0.13 3.27 variances 0.59 1.53 0.20 Once again we find that variables are more variable under the second Taylor rule. The most significant change, however, is that inflation is more sluggish ands remains above the target for nearly the whole period in both regimes. In fact the second set of parameters for the Taylor rule now do better in bringing inflation down to the target by the end of the period. The first rule never gets inflation down to 2% with the inertia implied by the backward looking inflation expectations rule. 5. The inflation mechanism is: Inflation = inflation expectations + 0.5 * (natural rate unemployment - unemployment) Which is: Inflation = 5% + 0.5 x ( 5 – unemployment rate) a. when U, the unemployment rate, is 5 inflation is 5% b. when U falls to 3% inflation is 6% c. The answer , of course, depends on whether the central bank is right to think that the natural rate of unemployment has fallen. If it is right then it will expect inflation to remain at 5% and will not tighten monetary policy and indeed inflation will not rise. If the natural rate has not fallen to 3% while unemployment does move to 3% inflation will rise unless interest rates are increased. d. In case b interest rates will be increased; in case c the central bank will not raise rates assuming it is certain that the natural rate has fallen. e.If the aim is to have inflation at 5% or less we have an asymmetric target for inflation – inflation being above 5% is more serious than inflation being under 5%. In this case the central bank should not gamble that it is right in its hunch that the natural rate has fallen. Instead it should act as if there has been no change in the natural rate, raise interest rats as unemployment falls and be prepared to cut them if inflation actually falls (as it will if the natural rate has moved down to 3%). Under the other two goals – keep inflation and unemployment stable or keep inflation in the range 4.5% to 5.5% - the central bank will want to take account of its evidence that the natural rate has fallen. But because it will be wary of inflation moving up sharply it will probably want to hedge its bets. That is it will not assume that unchanged interest rates is the right policy (as it would if the natural rate had indeed moved down to 3% in line with actual unemployment). Instead it will probably be optimal to increase interest rates slightly interest rates output gap inflation year 1.00 7.50 2.00 3.00 2.00 8.69 -1.25 4.00 3.00 7.29 -1.84 3.38 4.00 5.62 -1.14 2.45 5.00 4.68 -0.31 1.88 means 6.76 -0.51 2.94 variances 2.54 2.27 0.67 because there is a chance that the natural rate has not moved down to 3%. It can then proceed in cautious steps by either raising rates further (if inflation edges up) or cut them gradually (if inflation edges down). f. In the economy the inflation process is: inflation = inflation last year + 0.5 x (natural rate of unemployment – unemployment) Here is the evolution of inflation and unemployment when the policy is to keep inflation at 2% each year from years 1 to 4: Year unemployment inflation 0 5% 5% 1 11% 2% 2 5% 2% 3 5% 2% 4 5% 2% Here is the evolution of inflation and unemployment when the policy is to keep inflation falling by 1% each year down to 2%. Year unemployment inflation 0 5% 5% 1 7% 4% 2 7% 3% 3 7% 2% 4 5% 2% In both cases we need cumulative unemployment over the four years to be 6% higher. Policy 1 gets the pain over quickly with a big rise in unemployment of 6% (from 5% to 11%) immediately which brings inflation right back to 2%. The gradualist strategy has unemployment rise by 2% (from 5% to 7%) and stay there for 3 years as inflation moves smoothly down to 2%. INTRODUCTION This chapter covers a lot of material though not all of it need be covered since fiscal policy is sometimes seen as a ‘dry’ subject. The material here leads naturally on to Chapter 16. Teaching Tips ALTERNATIVE ROUTES THROUGH THE CHAPTER As this chapter relates to many others, almost any subject covered can be used elsewhere. Tax smoothing, can be combined into a lecture on stabilization policy. Debt and Deficits could be included in a lecture on sovereign debt. CHAPTER GUIDE 14.1 Government Spending. These data set the scene and can be presented in as much or as little detail as desired. Some further data on US government spending is included in the additional questions 14.2 The rationale for government’s role and the failure of the invisible hand. This discussion of governments’ role in reducing corruption omits to mention that governments often induce corruption. The Background Material contains further evidence. 14.3 Taxation and distortions. Material on the structure of government revenue in developing and developed countries is included in the Background Material. It is also worth noting that the amount of distortion is related to the elasticity of demand and supply. Inelastically demanded goods such as tobacco make excellent targets for taxation. The Case Study “Reaganomics” gives an example of how the Laffer Curve was used to guide fiscal policy. 14.4 Deficits and Taxes. More data on gross and net debt (as well as a definition) appear in the background material. 14.5 Intergenerational Redistribution and Fiscal Policy. The case study on pensions gives further material on this issue. 14.6 Long-Run Sustainability The algebra in this section could be challenging to some students. However, the essential point is that debt sustainability depends crucially on interest rates and growth rates and this should be easy to communicate. Some simple exercises like the one below could also help. CHAPTER 14: FISCAL POLICY AND THE ROLE OF GOVERNMENT In recent years, Argentina is a good example of a country that has run into fiscal problems due to low growth and high interest rates. Japan is another good example (although there, the primary deficit is large too). See Background Material for further information on Japanese debt sustainability. 14.7 The Intertemporal Budget Constraint. This section is largely just reinforcing the message on the previous section and so could be skipped (especially for more maths-adverse students) 14.8 Optimal Budget Deficits. The fact that constant taxes are less distortionary than volatile taxes results from the non-linear relationship between the level of taxes and the welfare loss from taxes. CASE STUDY: REAGANOMICS Reagan’s supply-side miracle After the slow growth and high inflation of the Carter administration, Ronald Reagan began his presidency with promises of a supply-side revolution. At the core of this approach was the idea that low inflation and lower taxes (smaller government) would boost growth. Thanks to the Laffer curve, he hoped that lower taxes could increase tax revenue and help balance the budget. It didn’t take long for those hopes to be dashed. In August 1981, soon after Reagan came into office, the Economic Recovery Tax Act (ERTA) was passed. This implemented major tax cuts for individuals and businesses (e.g. reducing the average tax rate for the median family to 17% from 20%). On the spending side, although Reagan tried (unsuccessfully) to persuade Congress to make some cutbacks, he himself instigated a large increase in defense spending (such as the “star wars” program). As a result, although economic growth did eventually help scale back social security spending (transfers), rising debt interest costs meant that total spending was barely changed as tax revenue fell (see table). US Central Government Spending and Receipts (% of GNP)* 198 0 198 1 198 2 198 3 198 4 198 5 198 6 Total Spending 22.0 22.8 24.0 25.0 23.7 24.4 24.6 Debt Interest 1.9 2.0 2.6 2.7 3.0 3.3 3.2 Non-Interest Spending 20.1 20.6 21.4 22.3 20.7 21.1 21.3 Defense 5.1 5.4 6.0 6.3 6.2 6.5 6.5 Transfers 8.8 9.2 9.7 10.2 9.3 9.1 9.4 Other 6.2 6.0 5.7 5.8 5.2 5.5 5.5 Total Receipts 20.2 20.8 20.5 19.4 19.2 19.6 19.8 Personal Tax 9.4 9.6 9.9 8.8 8.2 8.7 8.6 Corporate Tax 2.6 2.3 1.6 1.6 2.0 1.7 2.1 Social Insurance 6.8 7.1 7.3 7.4 7.5 7.7 7.8 Other 1.4 1.8 1.7 1.6 1.5 1.5 1.3 BALANCE -1.8 -2.0 -3.5 -5.6 -4.5 -4.8 -4.8 * Fiscal years. The Fed’s response Even before Ronald Reagan had been elected President, the Federal Reserve under Chairman Paul Volker had decided to bring inflation under control. However, Reagan’s expansionary fiscal policy made this task all the harder and the Fed were forced to raise interest rates sharply in the early days of the Reagan Presidency. At the time , the Fed were using money supply targets as part of their disinflation program which – in common with most other developed countries – they missed more often than they hit (see Case Study). However, in the Fed’s case, the adherence to money supply targets was more window-dressing than the centerpiece of policy. They needed an excuse to raise interest rates without coming under too much political pressure. Possibly for the same reason, the Fed followed reserve targets much more strongly in the early eighties than they do now. This meant that if the demand for reserves rose too quickly they let interest rates rise rather than simply supplying that demand in order to keep interest rates steady. As a result, interest rates (the Fed Funds Rate in particular) were quite volatile over this period (see table and compare with the average volatility since 1955 of about 0.8). This was useful to the Fed as it allowed them to portray rising interest rates as simply the result of an automatic process rather than as a deliberate policy action. US Monetary Policy 1979 1980 1981 1982 1983 1984 1985 1986 Interest rates 10.0 11.5 14.0 10.6 8.6 9.5 7.5 5.9 Interest Rate Volatility* 1.6 3.8 2.3 2.6 0.4 1.1 0.3 0.6 Growth of M1b Target Range 1.5- 4.5 4.0- 6.5 3.5- 6.0 2.5- 5.5 4.0-8.0 4.0- 8.0 4.0- 7.0 3.0- 8.0 Actual 5.0 7.3 5.7 8.5 7.2 5.2 11.9 15.3 Growth of M2 Target Range 5.0- 8.0 6.0- 9.0 6.0- 9.0 6.0- 9.0 7.0- 10.0 6.0- 9.0 6.0- 9.0 6.0- 9.0 Actual 9.0 9.8 9.4 9.8 8.3 7.7 8.6 9.1 Growth of M3 Target Range 6.0- 9.0 6.5- 9.5 6.5- 9.5 6.5- 9.5 6.5-9.5 6.0- 9.0 6.5- 9.5 6.0- 9.0 Actual 9.8 9.9 11.4 10.3 9.7 10.5 7.4 9.0 * Standard deviation of end-month Fed Funds Rate. The Economic Consequences of Reaganomics The combination of Reagan and Volker led to a classic tight money-loose fiscal policy mix – a recipe for exchange rate appreciation. Unsurprisingly, the dollar started to appreciate – rising by about 30% on a trade-weighted basis by 1983. More surprisingly, it didn’t stop. It kept going until 1985, (well after the Fed had cut rates and Reagan’s fiscal boost was coming to an end), sending the dollar up to 50% higher than it was before Reagan came to power. US Trade-weighted real exchange rate USA Real effective exchange rate Source: EcoWin 78 79 80 81 82 83 84 85 86 87 88 110 120 130 140 150 160 170 180 190 200 In the early stages of the Reagan supply side program, the worsening current account deficit was more than explained by the worsening fiscal deficit (see chart), but as the dollar continued to soar, US competitiveness became a problem in its own right. The current account deficit continued to worsen despite some improvement in the government accounts (see Chapter 18 for further detail). The US “Twin Deficits” US Current Account Deficit (% of GDP) US Fiscal Deficit (% of GDP) Source: EcoWin 7778798081828384858687888990 -6 -5 -4 -3 -2 -1 0 1 Despite their free market principles, the Reagan economic team was gradually convinced that the market had got it wrong and the dollar was significantly over-valued. As a result, a G-5 meeting (Finance Ministers and Central Bank Governors of US, Japan, Germany France and UK) in 1985 at the Plaza Hotel in New York agreed to weaken the dollar or, as they put it, “an orderly appreciation of non-dollar currencies is desirable”. This statement was accompanied by large- scale foreign exchange intervention by all the major central banks to sell dollars and buy other currencies. Within a year, the dollar had fallen back below where it had been under President Carter. The Plaza accord seemed to have worked. Source: “Reaganomics” O. Blanchard, Economic Policy 1987 Discussion Questions 1) Was Reagan’s economic experiment a failure? 2) Should the Fed have supported the Reagan Program by cutting interest rates? Background Material US GOVERNMENT SPENDING. US government spending, which had remained roughly constant at around 32% of percent of GDP since the 1960’s, has recently began to decline. However, this decline is almost entirely due to the “peace dividend” of declining defenses expenditure. US Government Spending (% of GDP) Total Government Spending (% of GDP) Government Spending exc. defense (% of GDP) Source: EcoWin 48 50 52 54 56 58 60 62 64 66 68 70 72 74 76 78 80 82 84 86 88 90 92 94 96 98 00 02 04 12.5 15.0 17.5 20.0 22.5 25.0 27.5 30.0 32.5 35.0 GOVERNMENTS AND CORRUPTION Although the government’s role in enforcing the rule of law should make it an agent against corruption, in certain countries corruption is centered around government activities. Overall however, the chart below indicates that larger governments tend to induce lower levels of corruption (a high score on the corruption index indicates low levels of corruption). Of course, it may also be the case that richer countries can afford bigger governments and have less corruption. Studies of government and corruption show how corrupt governments tend to spend more on non-productive areas such as defense and less on health, education and infrastructure. Governments and Corruption 5 15 25 35 0 2 4 6 8 10 Corruption Index Government Consumption (% of GDP) . TAX STRUCTURE IN DEVELOPED AND DEVELOPING COUNTRIES The table below shows average government revenue as a percent of GDP. Developing countries not only have smaller overall revenues but the share of revenue from broad-based taxes is also very small. They rely more on non-tax revenue and trade taxes. Expanding the tax base of poorer countries to a broader range of goods and individuals is one of the major issues in their development. Average tax structure as % of GDP Developed Countries Developing Countries Total Revenue 33.3% 24.4% Tax Revenue 29.7% 18.7% Income, profit and capital gains taxes 9.7% 6.1% Social Security tax 8.0% 2.6% Payroll tax 0.3% 0.3% Property tax 0.7% 0.4% Sales, VAT Turnover taxes 5.8% 3.6% Excise 3.0% 1.9% Import taxes 0.8% 3.7% Export taxes 0.0% 0.5% Non-Tax revenue 3.5% 5.7% Source: IMF HISTORIC DEBT GDP RATIOS The charts below show estimated debt to GDP ratios for the major economies (other than the US which is shown in Figure 1.11) German Government Debt to GDP ratio 0% 10% 20% 30% 40% 50% 1930 1935 1940 1945 1950 1955 1960 1965 1970 1975 1980 1985 Japanese Government Debt to GDP ratio 0% 20% 40% 60% 80% 1880 1890 1900 1910 1920 1930 1940 1950 1960 1970 1980 Sources OECD, Mitchell and Deane(1962) “Abstract of British Historical Statistics” Additional Questions Question 1) Look at the following charts, which good should face a higher tax? Why? S D Price Quantity S D Price Quantity GOOD 1 GOOD 2 Answer) Good 2 since a high tax rate will result in a smaller distortion in this case (see figure 14.4) Answers to Analytical Questions Chapter 14 Fiscal Policy and the Role of Government 1. a. People who are purely self-interested will reason thus. If I have to pay the amount I reveal on the questionnaire as being my valuation I might as well say my valuation is zero. In that case if the police are provided I pay nothing and the chance that my answer actually makes a difference to whether the police are provided is virtually zero. The second type of questionnaire is one where if the police are provided everyone pays the same. Suppose I know the cost to the government is going to be $50 million if the police are provided. Shared equally among the population this means the cost is $7.14 a person. If my own valuation is less than $7.14 I definitely do not want the police to be provided so I should do whatever I can to reduce the chance of the total of all valuations exceeding $75million. The way to do this is to put a valuation of zero. But if my valuation is greater than $7.14 I now have an incentive to put down a very high valuation. Either way I will not want to reveal my true valuation. So neither form of questionnaire will get anyone to reveal a true valuation. b. The first survey gets everyone to say the police are worth nothing to them. The second gets a proportion to say the police are worth nothing and for all others to exaggerate the value of the police. At least the second survey reveals some information (the proportion who place a value above $7.14 on the extra police). c. Both surveys mean that nearly everyone will lie, assuming they are self-interested. d. Here is one questionnaire that could work. The government announces that the cost per person of the police is to be $7.14 if the police are provided. The provision of extra police will simply depend on whether more people place a valuation above $7.14 than place a value below $7.14. The government says that it will pay no attention to the sum of the valuations. In this case people might as well answer the valuation question honestly. All that matter is whether the valuation is above $7.14 or below. The paradox here is that if people think the government will pay attention to the sum of the valuations as well as the proportion one side of $7.14 or the other, then people have an incentive to lie. But if people do not lie the government probably should look at the total valuations and not just whether the percentage above $7.14 is more than 50%. 2. Initially we have incomes which look like this: Poorest citizens (one third of population) earn 1/3w Medium citizens (one third of population) earn 2/3w Richest citizens (one third of population) earn 2w Where w is the average wage in the initial situation. Now we introduce a tax and benefit system. The tax is only paid by the rich. They each contribute 0.25 x 2. The make up 1/3 of the population and the people who get benefits make up 2/3 of the population. This means each rich person has their tax revenue split between two people earning less than average wages. The distribution of income is: Poorest citizens (one third of population) earn 1/3w + 0.125 x 2w = 58% of w Medium citizens (one third of population) earn 2/3w + 0.125 x 2w = 92% of w Richest citizens (one third of population) earn (1-0.25)2w = 150% of w Income is clearly much more equal. Now assume 1/2 of the rich leave the country. If there is no change in the pre-tax wage this means that the numbers paying tax fall in half and the amount of the benefit is also cut by 1/2. The incomes after the tax/benefit system look like this: Poorest citizens (40% of population) earn 1/3w + 0.0625 x 2w = 46% of w Medium citizens (40% of population) earn 2/3w + 0.0625 x 2w = 79% Richest citizens (20% of population) earn (1-0.25) 2w = 150% of w Income is more equal than without a tax benefit system but not as equal as it was before tax induced migration. 3. Let us assume the extra spending is to be financed out of taxes. For each extra $billion of spending on education we might have an estimate of the enhancement to productivity. We need to know when the enhancement happens and how great it is and how long it lasts. If we know those things we can work out the present discounted value of extra output from the extra $billion spending today. We can do something similar with crime, but here we need to know not only by how much crime might fall, and when it falls and for how long, but also the money value of a fall in crime. (Obviously relevant here is what sort of crime is reduced). Valuing the money value of reducing crime is tricky, but one approach is to ask people how they value crime reduction. Another is to work out the cost of crime prevention spending that yields an equivalent reduction in crime. Once we have the benefits side worked out we need to calculate the present value of the distortions form the extra taxes levied and add to that the actual resources used in providing extra spending (this is just the $1 billion). To calculate the size of the tax distortions we need to know what sorts of tax are to be raised and how they affect labor supply and other spending decisions. Clearly we need to know a lot to work out the optimal level of government spending on education! 4. Half the population just saves the tax cut because they want to bequeath extra wealth equal to the future higher tax burden. But half the population spends the tax cut. Thus saving rises by half the tax cut, that is by $25 billion. b. Spending rises by half the tax cut, that is by $25 billion c.Half of the $50 billion of debt is sold to domestic residents; the remaining $25 billion is sold to overseas residents. d. Because of the tax cut saving only rises by $25 billion but the government needs to borrow $50 billion. The extra government borrowing would crowd out private sector investment. Bond prices would probably fall and interest rates rise so that people are induced to save a bit more and investment is scaled back. INTRODUCTION This chapter is about how governments can use monetary and fiscal policy to help stabilize the economy. It focuses on the issues of expectations and credibility and how these influence policy. This chapter is relatively theoretical and quite difficult in places. However, the concepts, once understood, are useful and interesting to most students. Teaching Tips ALTERNATIVE ROUTES THROUGH THE CHAPTER The core of this chapter, which moves from the Phillips curve to the role of expectations, is a logical progression that is hard to split up. However, the discussion of stabilization policy at the beginning is reasonably self-contained and so could be by-passed or added to a fiscal policy lecture. In a shorter course, the material in this chapter could be combined with the material in Chapter 15 or even Chapter 14 CHAPTER GUIDE 15.1 Output Fluctuations and the Tools of Macroeconomic Policy. IS-LM analysis is discussed in more detail in the case study to Chapter 12.Up-to-date numbers for the output gap are available in the latest OECD Economic Outlook. The numbers are useful for discussing the present cyclical position of the major economies. Note that the distinction between the short-run upward sloping and the long-run vertical aggregate supply curve already hints at the Phillips curve analysis later in this chapter. 15.2 General Arguments against Stabilization Policy. Recent US policy gives a good example of the relative implementation lags of monetary and fiscal policy. Fed Chairman Greenspan at first disapproved of presidential candidate George W. Bush’s proposed tax cuts on the grounds that they would stimulate an already fast growing economy. By the end of the 2000 presidential campaign, Chairman Greenspan had not only changed his view of the economy but had already cut interest rates. 15.3 The Inflation Output Tradeoff. The US Phillips curve is shown in the Background Material below. 15.4 The Phillips Curve and Shifting Expectations. This section is quite difficult - take it slowly! 15.5 Credibility. The Case Study discusses New Zealand’s attempt to gain credibility for its disinflation policy. 15.6 Time Inconsistency. Although this is another difficult section, most students will have already come across the Prisoner’s Dilemma so it may be worth highlighting the parallels with that game. CHAPTER 15: STABILIZATION POLICY 15.7 Rules versus Discretion. The Background Material outlines the Euro-area fiscal rules in detail. CASE STUDY: NEW ZEALAND’S DISINFLATION In the ten years before 1986, New Zealand inflation averaged 13% - high for an OECD country. As a result, the New Zealand government instituted a number of reforms aimed not only at bringing inflation down but doing so with maximum credibility. The key credibility enhancing reform was the Reserve Bank of New Zealand (RBNZ) Act that gave the Central Bank full independence and a clear mandate to reduce inflation. The key components of the RBNZ Act were ➢ Inflation target of 0% to 2% by 1992 with interim targets for each year of the disinflation (with some get-out clauses for extreme events such as livestock disease outbreaks– see Background Material for Chapter 17) ➢ A facility to sack the RBNZ Governor if the inflation target was not achieved. In fact inflation fell faster than the act suggested (see chart) and had hit the target range by 1991 (despite the fact that a new government had already deferred the objective to 1993). Was this due to the benefits of credibility? Unfortunately, not all the faster-than-expected fall in inflation can be ascribed to the credibility benefits of the RBNZ Act because, not only had inflation fallen faster than expected, unemployment had risen faster than expected too (see table). Unemployment rose from a 1977- 86 average of 4.3% to around 11% by 1991 and so most of the fall in inflation was probably due the disinflationary effects of high unemployment. In fact, during the disinflation, a popular comment predicted that by 1992, there would only be one person in New Zealand left with a job - the Governor of the RBNZ! Although the RBNZ achieved its aim of reducing inflation, the RBNZ Act was perceived to have failed in terms of enhancing credibility. Estimates of the sacrifice ratio in New Zealand do not indicate an improved inflation output trade-off after the act was passed. However, there is some evidence that the trade-off has improved since inflation was brought under control. This implies that credibility is built by actions not words. Inflation and Unemployment in New Zealand New Zealand Inflation (Left Hand Scale) New Zealand Unemployment rate (Right Hand Scale) Source: EcoWin 8687888990919293949596 0.0 2.5 5.0 7.5 10.0 12.5 15.0 17.5 20.0 3 4 5 6 7 8 9 10 11 12 Discussion Questions 1) Was New Zealand’s disinflation process worth undertaking? 2) Would a quicker (or slower) disinflation worked better? Background Material FISCAL RULES IN THE UK AND EURO AREA. THE EURO-AREA’S GROWTH AND STABILITY PACT At the EU Dublin and Amsterdam summits of 1996 and 1997, the prospective members of the Euro agreed on a number of guidelines for “excessive” fiscal deficits. The main reason for these guidelines was that low deficit countries like Germany feared that they may at some time be required to bail out high deficit countries like Italy. Even though there is a “no bail out” clause in the Maastricht Treaty, Germany wished to make doubly sure that they would not be presented with a potential bankruptcy in the Euro-area. The essence of the excessive deficit procedure is that a fiscal deficit of over 3% can only be run in exceptional circumstances. The circumstances laid down by the pact are 1. Natural Disasters 2. Temporary overshooting (e.g. associated with a one-off payment) 3. Serious economic decline. (GDP decline of 0.75% or more with declines between 0.75% and 2% subject to the discretion of the Council of Ministers) If the deficit is not justified by one of these three conditions, then the offending country must make a non-interest bearing deposit of 0.2% of GDP with a further 0.1% for every percentage point above the 3% mark in subsequent years. If the deficit is still excessive after two years, the deposit becomes a fine. In practice, this pact has been ignored for many years now. Ironically, Germany was the first country to openly flout the pact. THE US PHILLIPS CURVE The chart below shows the US Phillips curve before the inflation of the 1970s and ‘80s. The US Phillips Curve 1949-1970 2 3 4 5 6 7 8 0 2 4 6 8 10 Wage inflation. Unemployment. Additional Questions Question 1) The chart below shows UK inflation and unemployment during the disinflation instituted in the first Thatcher Government. Looking at the chart do you think it was a credible disinflation? UK Inflation and Unemployment in the Thatcher Disinflation Inflation Unemployment Rate Source: EcoWin 80 81 82 83 84 85 86 Percent 3 4 5 6 7 8 9 10 11 Percent 2.5 5.0 7.5 10.0 12.5 15.0 17.5 20.0 22.5 Answer 1) Although the disinflation was successful in bring inflation down, the sharp rise in unemployment suggests that the approach was not credible (in the sense that unions and employers believed that inflation would fall and so no rise in unemployment was required to bring about a new Philips Curve). In fact even after inflation had stabilized at a new lower level, unemployment stayed high. Question 2) Look at the chart of actual and perceived inflation in Germany (perceived inflation taken from surveys). What does it tell you about the credibility of the European Central Bank Actual and perceived inflation in Germany Answer 2) the rise in perceived inflation around the introduction of the euro is not good news for the ECB. Of course the widely held belief that the introduction of euro notes and coins was accompanied by a price hikes didn’t help. However, the fact that perceived inflation has been above actual throughout the existence of the ECB suggests that its credibility is well below that of its predecessor (the Bundesbank) and may go some way to explain the poor performance of the German economy since EMU. 0.0 1.0 2.0 3.0 4.0 5.0 6.0 7.0 85Q1 86Q1 87Q1 88Q1 89Q1 90Q1 91Q1 92Q1 93Q1 94Q1 95Q1 96Q1 97Q1 98Q1 99Q1 00Q1 01Q1 02Q1 03Q1 04Q1 Actual Inflation Perceived Inflation Answers to Analytical Questions Chapter 15 Stabilization Policy 1. With no shocks and constant interest rates the economy settles down to an equilibrium in which demand is constant. At this equilibrium Yt = Yt-1 = Y. With r unchanging and et = 0 we then have: Y = A + bY – c r So Y = A/(1-b) – c r / (1-b) With A = 200; b = 0.7 ; c = 10 and r = 6 then Y = 466.7 b. The pattern of output following a shock in period t=1 of –30 is: c. If interest rates are cut to 3% at the same time as the shock and are kept at that level the evolution of demand is: The cut in interest rates at time 1 is just enough to keep output from falling in that period and exactly offsets the negative shock. But keeping interest at that lower level generates higher demand once the one-off shock passes. d. A better strategy would be to cut interest rates to 3% at the time of the shock of –30 but then return interest rates to 6% after the shock. This would keep demand at the equilibrium level of 466.67 throughout. 2. The inflation outcomes look like this: time Y -1.00 466.67 -2.00 466.67 0.00 466.67 1.00 436.67 2.00 445.67 3.00 451.97 4.00 456.38 5.00 459.46 time Y -1.00 466.67 -2.00 466.67 0.00 466.67 1.00 466.67 2.00 496.67 3.00 517.67 4.00 532.37 5.00 542.66 Table 1 The levels of inflation plotted against unemployment are shown in figure 1 Figure 1 Inflation and Unemployment 1 2 3 4 5 0 1 2 3 4 5 6 7 8 Unemployment Inflation There is a general negative relation between unemployment and inflation but the relation is far from tight. We see that there are different levels of inflation for the same level of unemployment – at 5% unemployment in year 1 inflation is 3% but in year 4 is 4%. c) What explains the failure of the points in the figure to lie on the same line is that both the natural rate of unemployment and the expected rate of inflation change over time. For a given natural rate of unemployment and a given rate of expected inflation the levels of inflation and of unemployment lie on a straight line. Thus there is a Philips curve for each pair of expected inflation and natural rate combinations. 3. Figures 2 and 3 show the two Phillips curves. Year Expected Natural Unemployment Inflation Inflation Rate Rate 1 3 5 5 3 2 3 5 3 4 3 4 5 4 4.5 4 4 5 5 4 5 4 5 5.2 3.9 6 4 6 5.7 4.15 7 3 6 6.1 2.95 8 3 6 6.4 2.8 9 3 7 6.8 3.1 10 3 7 7.2 2.9 Figure 2 The Phillips Curve: logarithmic version 3.8 4 4.2 4.4 4.6 4.8 5 5.2 1 2 3 4 5 6 7 8 9 10 unemployment inflation Figure 3 The Phillips Curve: linear version 0 1 2 3 4 5 1 2 3 4 5 6 7 8 9 10 unemployment inflation b. The effect of a given fall in unemployment upon inflation is the same at all levels of unemployment in the linear version of the Phillips curve. With the logarithmic version there is a larger impact of a given fall in unemployment upon inflation at low levels of unemployment. It is plausible that a further fall in unemployment from already low levels (eg. from 2% to 1%) is more inflationary than a decline from, say, 18% unemployment to 17%. Because of this the logarithmic version of the Phillips curve is more plausible. c. The sacrifice ratio is the cost in terms of unemployment of reducing inflation by one percent. In the linear version of the model the sacrifice ratio is constant at (1/0.3) = 3.33. In the logarithmic version the sacrifice ratio depends upon the level of unemployment. The change in inflation for a given change in the unemployment rate , U, is –0.3/U. Thus a change in unemployment from a low level has a bigger impact on inflation than the same size change from a high level. If unemployment is at 0.2% and inflation is at 5.48% it takes a rise in unemployment to about 5.6% to reduce inflation to around 4.48%. The sacrifice ratio is about 5.4 (ie a rise in unemployment from 0.2% to 5.6% is needed to cut inflation by 1%). But if unemployment starts at 2% and inflation is 4.79% it takes a rise in unemployment rate to a staggering 56% to get inflation down by 1% to 3.79%. Now the sacrifice ratio is 54 (ie, the difference between unemployment of 56% and 2%). 4. a. The payoffs are: Governments Private Sector Inflation Expectations Choice High Inflation Low Inflation High Inflation -3, -1 3, -2 Low Inflation -5, –3 0, 1 Whatever the inflation expectations of the private sector the payoff to the government (the first number of each pair in the cell) is greater with high inflation. The result is that we get locked into the high inflation and high expected inflation equilibrium. b. If the central bank determines policy its preferences over outcomes become important. If the central bank chairman hates inflation the payoffs might look like this: Central Bank Private Sector Inflation Expectations Choice High Inflation Low Inflation High Inflation -100, -1 -100, -2 Low Inflation 4, –3 5, 1 Whatever the inflation expectations of the private sector the payoff to the central bank (the first number of each pair in the cell) is much greater with low inflation. The result is that we get locked into the low inflation and low expected inflation equilibrium. c. It is not clear what the preferences of a trade union leader would be as chairman of the central bank. It is likely that the dislike of inflation is less than considered in case b. The trade union leader might also particularly dislike the outcome of low inflation and high expected inflation, when unemployment would be high. Furthermore the public may believe the trade union chairman is likely to attach a strong weight to high employment. If this is so we may well fall back to the bad equilibrium of case a. In this case the chairman wants to avoid the private sector expecting inflation to be higher than it is and we end up with permanent high inflation which benefits no-one. In this case it is in everyone’s interest to have the chairman have a pathological hatred of inflation, even though the private sector sees the benefit of having more jobs. The point is there is no benefit to high inflation as an equilibrium outcome. Solution Manual for Macroeconomics: Understanding the Global Economy David Miles, Andrew Scott, Francis Breedon 9781119995715
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