Monetary and fiscal Policy Notes

monetary and fiscal policy for internal and external balance and monetary policy vs fiscal policy advantages and disadvantages monetary and fiscal policy effects on economy
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Chapter 23 POLICY AND POLICY MAKERS: WHAT DO WE KNOW? At many points in this book, we have seen how the right mix of fiscal and monetary policy can help a country out of a recession, improve its trade position without increasing activity and igniting inflation, slow down an overheating economy, stimulate investment and capital accu- mulation and so on. These conclusions, however, appear to be at odds with frequent demands that policy makers be tightly restrained: in Europe, the countries that adopted the euro signed the ‘Stability and Growth Pact,’ which requires them to keep their budget deficit under 3% of GDP or else face large fines. Monetary policy is also under fire. For example, the charter of the central bank of New Zealand, written in 1989, defines monetary policy’s sole role as the maintenance of price stability, to the exclusion of any other macroeconomic goal. This chapter discusses the arguments for restraining macroeconomic policy: ● Sections 23.1 and 23.2 look at one line of argument, namely that policy makers may have good intentions, but they end up doing more harm than good. ● Section 23.3 looks at another – more cynical – line, that policy makers do what is best for them, which is not necessarily what is best for the country. On 15 January 2004, the German cartoonist, Horst Haitzinger, took an ironic look (‘It was self-defence, honest’) at the uncomfortable position of Hans Eichel, German Finance Minister, who was attempting to jus- tify the position of the Federal Republic of Germany (FRG) before the Court of Justice of the European Communities regarding its failure to comply with the Stability and Growth Pact. Source: Haitzinger, Horst. Haitzinger Karikaturen 2004. München: Bruckmann, 2004, p. 9. http://www.ena.lu?lang=2&doc=23469.CHAPTER 23 POLICY AND POLICY MAKERS: WHAT DO WE KNOW? 477 23.1 UNCERTAINTY AND POLICY A blunt way of stating the first argument in favour of policy restraints is that those who know little should do little (and the 2009–10 crisis that so few economists had anticipated is a humbling reminder of how little most of us know). The argument has two parts: macroeconomists, and by implication the policy makers who rely on their advice, know little; they should therefore do little. Let’s look at each part separately. How much do macroeconomists actually know? Macroeconomists are like doctors treating cancer. They know a lot, but there is a lot they don’t know. Take an economy with high unemployment, where the central bank is considering the use of monetary policy to increase economic activity. Think of the sequence of links between an increase in money and an increase in output – all the questions the central bank faces when deciding whether and by how much to increase the money supply: ● Is the current high rate of unemployment above the natural rate of unemployment, or has the natural rate of unemployment itself increased (Chapters 9 and 10)? ● If the unemployment rate is close to the natural rate of unemployment, isn’t there a risk that monetary expansion will lead to a decrease in unemployment below the natural rate of unemployment and cause an increase in inflation (Chapters 9 and 10)? ● By how much will the change in the money supply decrease the short-term interest rate (Chapter 4)? What will be the effect of the decrease in the short-term interest rate on the long-term interest rate (Chapter 15)? By how much will stock prices increase (Chapter 15)? By how much will the currency depreciate (Chapter 18)? ● How long will it take for lower long-term interest rates and higher stock prices to affect investment and consumption spending (Chapter 16)? How long will it take for the J-curve effects to work themselves out and for the trade balance to improve (Chapter 18)? What is the danger that the effects come too late, when the economy has already recovered? When assessing these questions, central banks – or macroeconomic policy makers in general – do not operate in a vacuum. They rely in particular on macroeconometric models. The equations in these models show how these individual links have looked in the past. But different models yield different answers. This is because they have different structures, different lists of equations and different lists of variables. We will consider two cases. A fiscal policy and a monetary policy shock. Let us start first with a monetary policy shock. Consider a case where the euro area economy is growing at its normal growth rate; call this the baseline case. Suppose now, that over the period of a year, the ECB increases the nominal short-term interest rate by a 1% point. What will happen to the output in the euro area? Table 23.1 shows the deviation of output from the baseline predicted by each of four macroeconomic models available for the euro area (the characteristics of these models are Table 23.1 The response of output to a monetary shock: predictions from four models Year AWM MULTIMOD III NIGEM QUEST 1 −0.19 −0.20 −0.16 −0.57 2 −0.30 −0.14 −0.22 −0.10 3 −0.28 −0.02 −0.11 −0.03 5 −0.17 −0.02 −0.04 −0.02 10 −0.01 0.02 0.0 −0.01 Note: the first-year monetary policy multipliers are greater in QUEST than in the other three models. Source: Kenneth F. Wallis, ‘Comparing economic models of the euro economy’, Economic Modeling, 21, 735–758, 2004.478 EXTENSIONS SHOULD POLICY MAKERS BE RESTRAINED? described in the Focus box ‘Four macroeconometric models’. All four models predict that output decreases for some time after the increase in the short-term nominal interest rate. What is reported in the table is the value of the monetary policy multipliers you have learned in Chapter 5. The four models predict different impacts of the increase in the short-term interest rate on output. After one year, the average deviation of output from the baseline is negative. The range of answers goes from nearly no change (−0.16% in the NIGEM model) to −0.57%, a range of 0.41%. Two years out, the average deviation is −0.19%; the range is FOCUS Four macroeconometric models There are four major macro models for the euro area: relate to Australasia, Mexico, Norway, South Korea, Switzerland and the Visegrad economies (the Czech ● the Area-Wide Model (AWM) of the European Central Republic, Hungary, Poland). Finally, there are seven Bank (Fagan et al., 2001). The AWM treats the euro simpler trade-and-payments models for China, OPEC, area as a single economy. It corresponds to a con- Developing Europe, Africa, Latin America, other LDCs ventional national economy macro model, with the and the rest of East Asia. rest of the world treated as exogenous. Although this ● The QUEST model of the European Commission includes the three EU members that have not adopted (Roeger and in’t Veld, 1997) separately models the the single currency, and Greece, which did not join the USA and Japan, then describes the rest of the world by third stage of EMU until 1 January 2001, in the current 11 trade-and-payments models. Four of these relate to model the rest of the world is proxied by a four-country the larger remaining OECD countries (Australia, Canada, aggregate, comprising the USA, Japan, the UK and Norway, Switzerland) and seven to various groups of Switzerland. countries, very much as above (Central and Eastern and three well-established multicountry models, namely: Europe, the rest of the OECD, OPEC, the former Soviet Union, ‘dynamic’ Asian economies, the rest of Asia and ● MULTIMOD Mark III, developed in the Research the rest of Africa and Latin America). Department of the IMF in Washington, DC (Laxton et al., 1998). This model contains separate models for All the models describe the economy as you have learned each of the Group of Seven (G7) countries – the USA, in the previous chapters: the economy tends to its Canada, Japan, France, Germany, Italy and the UK – medium-run equilibrium with output equal to the natural and for an aggregate grouping of 14 smaller industrial level of output and employment at the level consistent countries. The remaining economies of the world are with unemployment being at the natural level. All the then aggregated into two separate blocks of develop- models incorporate what you have learned about the ing and transition economies. Each of the industrial behaviour of economic agents, that is they suppose country models has the structure of a complete that financial markets, firms and households take their national-economy model, whereas the two remaining economic decisions based on their ‘rational’ expectations blocks are modelled in much less detail. about the future. References: The following two models – NIGEM and QUEST – are more Fagan, G., Henry, J., Mestre, R., An Area-Wide Model (AWM) for the Euro Area, disaggregated, each having complete country models for Working Paper No.42, European Central Bank, Frankfurt, 2001. each EU member (taking the Belgium–Luxembourg Laxton, D., Isard, P., Faruqee, H., Prasad, E., Turtelboom, B., MULTIMOD Mark Economic Union as a single entity) and a finer division of III: the core dynamic and steady-state models, Occasional Paper No.164, International Monetary Fund, Washington DC, 1998. the rest of the world. Barrell, R., Dury, K., Hurst, I., Pain, N., Modelling the World Economy: the National Institute Global Economic Model. Presented at an ENEPRI workshop on ● NIGEM, developed at the National Institute of Eco- Simulation Properties of Macroeconometric Models, CEPII, Paris, 2001. nomic and Social Research, London (Barrell et al., Roeger, W. and in’t Veld, J., QUEST II: a multi country business cycle and growth 2001). NIGEM has six intermediate-size models con- model, Working paper, European Commission DGII, Brussels, 1997. sisting of a very basic description of the domestic eco- Source: This box is taken from an article by Kenneth F. Wallis ‘Comparing nomy (output and prices) together with trade volume economic models of the euro economy’, in Economic Modeling, 21, 735–758, and price equations and the balance of payments; these 2004.CHAPTER 23 POLICY AND POLICY MAKERS: WHAT DO WE KNOW? 479 Table 23.2 The response of output to a fiscal shock (a reduction in G equivalent to 1% of euro area GDP): predictions from two models Year AWM MULTIMOD III 1 −1.35 −1.48 2 −0.52 0.23 3 0.09 0.24 5 0.22 0.11 10 0.03 0.00 Note: the first-year fiscal policy multipliers are well above 1 in both models. Source: Kenneth F. Wallis, ‘Comparing economic models of the euro economy’, Economic Modeling, 21, 735–758, 2004. down to 0.20%. But two models (AWM and NIGEM) predict a higher second-year monetary policy multiplier compared to the first-year multiplier; that is they predict that the largest negative impact on output of an increase in the short-term interest rate happens after two years. On the other hand, QUEST and MULTIMOD III predict that the largest impact on out- put happen in the first year. Five years out, the average deviation is −0.06%, but the answers range from −0.02% to −0.17%. Ten years out, the average deviation is 0%, but the answers range from −0.01% to 0.02%. Admittedly, the range of answers is not as large as is was in macroeconometric models used in the1980s, where the range of answers was much larger than it is now. But still, if we measure uncertainty by the range of answers from this set of models, there is a certain amount of uncertainty about the effects of policy. Now consider a case where the euro area economy is growing at its normal growth rate; call this the baseline case. Suppose now, that over the period of a year, government spend- ing is reduced by 1% of GDP, area-wide. What will happen to the output in the euro area? Table 23.2 shows the effect on GDP of the fiscal contraction. Only two models are included in the table, AWM and MULTIMOD III, which can provide area-wide results. The responses of GDP to the fiscal contraction show wide variation, with impact multipliers well in excess of 1 on AWM and MULTIMOD III, 1.35 and 1.48, respectively. In both cases, the change in investment accounts for most of the reduction in GDP. Should uncertainty lead policy makers to do less? Should uncertainty about the effects of policy lead policy makers to do less? In general, the answer is yes. Consider the following example, which builds on the simulations we just looked at. Suppose the euro area economy is in recession. The ECB is considering using monetary policy to expand output. To concentrate on uncertainty about the effects of policy, let’s assume that the ECB knows everything else for sure. By how much should the ECB decrease the short-term nominal interest rate? Taking the average of the responses from the different models in Table 23.1 (but with the opposite sign), a decrease in short-term nominal interest rate of 1% leads to a 0.28% increase in output in the first year. Suppose the ECB takes this average relation as holding with certainty. What it should then do is straightforward. To achieve 1% more output growth requires the ECB to decrease the short-term interest rate by 1%/0.28 = 3.6%. The ECB should therefore decrease the interest rate by 3.6%. This is clearly impossible, as nominal interest rates in the euro area have been much lower than that for a long time. But our example here serves to make another point. If the economy’s response is equal to the average response from the four models, this decrease in interest rates will achieve 1% higher output growth at the end of the year. Suppose the ECB actually decreases rates by 3.6%. But let’s now take into account uncer- tainty, as measured by the range of responses of the different models in Table 23.2. Recall that the range of responses of output to a 1% decrease in interest rates after one year varies from −0.16% to −0.57%; equivalently, a 1% decrease in interest rates leads to a range of480 EXTENSIONS SHOULD POLICY MAKERS BE RESTRAINED? increases in output from 0.16% to 0.57%. These ranges imply that a decrease in interest rates of 3.6% leads, across models, to an output response anywhere between 0.58% and 2%. This example relies on the notion ➤ The conclusion is clear: given the range of uncertainty about the effects of monetary of multiplicative uncertainty – that policy on output, decreasing interest rates by 3.6% would be irresponsible. If the effects of because the effects of policy are uncer- interest rates on output are as weak as suggested by one of the four models, output growth tain, more active policies lead to more at the end of the year would increase by just around half percentage point. Given this uncer- uncertainty. See William Brainard, tainty, the ECB should consider carefully whether and by how much to decrease the short- ‘Uncertainty and the Effectiveness of Policy’, American Economic Review, term interest rate. (In fact, as the short-term interest rate is much lower than 3.6% in the 1967, 57, 411–425. euro area, the ECB, to help the economy out of the recession of 2007–2010, did not have the option to reduce rates by as much as 3.6%, and had to resort to other forms of monetary policy, i.e. quantitative easing, as you learned in Chapter 20). Uncertainty and restraints on policy makers Let’s summarise: there is substantial uncertainty about the effects of macroeconomic policy. This uncertainty should lead policy makers to be more cautious and to use less active policy. Policies should be broadly aimed at avoiding prolonged recessions, slowing down booms and avoiding inflationary pressure. The higher unemployment or the higher inflation, the more active the policies should be. But they should stop well short of fine-tuning, of try- ing to achieve constant unemployment or constant output growth. Friedman and Modigliani are the same ➤ These conclusions would have been controversial 20 years ago. Back then, there was a two economists who independently heated debate between two groups of economists. One group, headed by Milton Friedman developed the modern theory of con- from the University of Chicago, argued that because of long and variable lags, activist policy sumption we saw in Chapter 16. is likely to do more harm than good. The other group, headed by Franco Modigliani from MIT, had just built the first generation of large macroeconometric models and believed that economists’ knowledge was becoming good enough to allow for increasing fine-tuning of the economy. Today, most economists recognise that there is substantial uncertainty about the effects of policy. They also accept the implication that this uncertainty should lead to less active policies. Differences of opinion are more pronounced on the effects of fiscal than monetary policy. During the financial crisis of 2007–2010 there was widespread agreement on the need to use monetary policy both to offset the shock to aggregate demand and to compensate the shift in the demand for money (the crisis induced people to hold more money and fewer bonds for any given level of the interest rate). Whether to use government spending to offset the shock to aggregate demand was more controversial. In the USA, the UK and Ireland, governments relied extensively on fiscal policy: in the USA the budget deficit increased from 2.2% of GDP in 2006 to 13.6% in 2009; in the UK from 2.7% to 15.5%, in Ireland the budget shifted from a 3% surplus in 2006 to a 12% deficit in 2009. Continental Europe did much less: Germany for instance increased the deficit from 1.5% of GDP in 2006 to 4% in 2009. Underlying these differences in policies lie differences in views about the effects of a fiscal stimulus, with the Europeans less convinced than the Anglo-Saxons that an increase in public spending translates into higher GDP growth. Note, however, that what we have developed so far is an argument for self-restraint by policy makers, not for restraints on policy makers. If policy makers understand the implica- tions of uncertainty – and there is no particular reason to think they don’t – they will, on their own, follow less active policies. There is no reason to impose further restraints, such as the requirement that money growth be constant or that the budget be balanced. Let’s now turn to arguments for restraints on policy makers. 23.2 EXPECTATIONS AND POLICY One of the reasons why the effects of macroeconomic policy are uncertain is the interaction of policy and expectations. How a policy works, and sometimes whether it works at all,CHAPTER 23 POLICY AND POLICY MAKERS: WHAT DO WE KNOW? 481 depends not only on how it affects current variables but also on how it affects expectations about the future. (This was the main theme of Chapter 17.) The importance of expectations for policy, however, goes beyond uncertainty about the effects of policy. This brings us to a discussion of games. Until 30 years ago, macroeconomic policy was seen in the same way as the control of a complicated machine. Methods of optimal control, developed initially to control and guide rockets, were being increasingly used to design macroeconomic policy. Economists no longer think this way. It has become clear that the economy is fundamentally different from a machine, even a very complicated one. Unlike a machine, the economy is composed of people and firms who try to anticipate what policy makers will do, and who react not only to current policy but also to expectations of future policy. Hence, macroeconomic policy must be thought of as a game between the policy makers and ‘the economy’ – more concretely, the people and the firms in the economy. So, when thinking about policy, what we need is not optimal control theory but rather game theory. Game theory has given economists Warning: when economists say game, they do not mean ‘entertainment’; they mean many insights, often explaining how strategic interactions between players. In the context of macroeconomic policy, the some apparently strange behaviour players are the policy makers on one side, and people and firms on the other. The strategic makes sense when one understands interactions are clear: what people and firms do depends on what they expect policy makers the nature of the game being played. to do. In turn, what policy makers do depends on what is happening in the economy. One of these insights is particularly Game theory has become an important tool in all branches of economics. Both the 1994 important for our discussion of re- straints here: sometimes you can do and the 2005 Nobel Prizes in Economics were awarded to game theorists. In 1994, it was better in a game by giving up some of awarded to John Nash, from Princeton; John Harsanyi, from Berkeley; and Reinhard your options. To see why, let’s start Selten, from Germany (John Nash’s life is portrayed in the movie A Beautiful Mind). In with an example from outside eco- 2005, it was awarded to Robert Aumann, from Israel, and Tom Schelling, from Harvard. nomics – governments’ policies toward hostage takers. Hostage takings and negotiations Most governments have stated policies that they will not negotiate with hostage takers. The reason for this stated policy is clear: to deter hostage taking by making it unattractive to take hostages. Suppose that, despite the stated policy, somebody is taken hostage. Now that the hostage taking has taken place anyway, why not negotiate? Whatever compensation the hostage takers demand is likely to be less costly than the alternative – the likelihood that the hostage will be killed. So the best policy would appear to be to announce that you will not negotiate but, if somebody is taken hostage, negotiate. Upon reflection, it is clear that this would in fact be a very bad policy. Hostage takers’ decisions do not depend on the stated policy but on what they expect will actually happen if they take a hostage. If they know that negotiations will actually take place, they will rightly consider the stated policy as irrelevant. And hostage takings will take place. So what is the best policy? Despite the fact that once hostage takings have taken place, negotiations typically lead to a better outcome, the best policy is for governments to commit not to negotiate. By giving up the option to negotiate, they are likely to prevent hostage takings in the first place. Let’s now turn to a macroeconomic example, based on the relation between inflation and This example was developed by Finn Kydland, from Carnegie Mellon, and unemployment. As you will see, exactly the same logic is involved. Edward Prescott, then from Minnesota and now at Arizona State University, in ‘Rules Rather than Discretion: the Inflation and unemployment revisited Inconsistency of Optimal Plans’, Journal Recall the relation between inflation and unemployment we derived in Chapter 9 equation of Political Economy, 1977, 3 85. Kydland and Prescott were awarded (9.9), with the time indexes omitted here for simplicity: the Nobel Prize in Economics in 2004. e π = π − α(u − u ) 23.1 n e Inflation, π, depends on expected inflation, π , and on the difference between the actual unemployment rate, u, and the natural unemployment rate, u . The coefficient α captures n ➤ ➤482 EXTENSIONS SHOULD POLICY MAKERS BE RESTRAINED? the effect of unemployment on inflation, given expected inflation: when unemployment is above the natural rate, inflation is lower than expected; when unemployment is below the natural rate, inflation is higher than expected. Suppose the central bank announces that it will follow a monetary policy consistent with zero inflation. On the assumption that people believe the announcement, expected e inflation, π , as embodied in wage contracts, is equal to zero, and the central bank faces the following relation between unemployment and inflation: A refresher: π=−α(u − u ) 23.2 Given labour market conditions, and n given their expectations of what prices ➤ If the central bank follows through with its announced policy, it will choose an unem- will be, firms and workers set nominal ployment rate equal to the natural rate; from equation (23.2), inflation will be equal to wages. Given the nominal wages firms have to pay, firms then set prices. So, zero, just as the central bank announced and people expected. prices depend on expected prices and Achieving zero inflation and an unemployment rate equal to the natural rate is not a bad labour market conditions. Equivalently, outcome. But it would seem that the central bank can actually do even better: for simpli- price inflation depends on expected city, we assume that the central bank can choose the unemployment rate – and, by implica- price inflation and labour market con- tion, the inflation rate – exactly. In doing so, we ignore the uncertainty about the effects of ditions. This is what is captured in equation (23.1). policy. This was the topic of Section 23.1, but it is not central here. If a 5 1, equation (23.2) implies p 5 ➤ ● Recall from Chapter 9 that in the USA, α is roughly equal to 1. So equation (23.2) (u 2 u ). If p 5 1%, then (u 2 u ) 521%. n n implies that, by accepting just 1% inflation, the central bank can achieve an unemploy- ment rate of 1% below the natural rate of unemployment. Suppose the central bank – and everybody else in the economy – finds the trade-off attractive and decides to decrease unemployment by 1% in exchange for an inflation rate of 1%. This incentive to deviate from the announced policy once the other player has made his move – in this case, once wage setters have set the wage – is known in game theory as the time inconsistency of optimal policy. In our example, the central bank can improve the outcome this period by deviating from its announced policy of zero inflation: by accepting some inflation, it can achieve a substantial reduction in unemployment. Remember that the natural rate of ➤ ● Unfortunately, this is not the end of the story. Seeing that the central bank has increased unemployment is neither natural nor money by more than it announced it would, wage setters are likely to begin to expect best in any sense (see Chapters 7 positive inflation of 1%. If the central bank still wants to achieve an unemployment and 9). It may be reasonable for the rate 1% below the natural rate, it will have to achieve 2% inflation. However, if it does central bank and everyone else in the achieve 2% inflation, wage setters are likely to increase their expectations of inflation economy to prefer an unemployment rate lower than the natural rate of further, and so on. unemployment. ● The eventual outcome is likely to be high inflation. Because wage setters understand the central bank’s motives, expected inflation catches up with actual inflation, and the cen- tral bank will eventually be unsuccessful in its attempt to achieve an unemployment rate below the natural rate. In short, attempts by the central bank to make things better lead in the end to things being worse. The economy ends up with the same unemployment rate that would have prevailed if the central bank had followed its announced policy, but with much higher inflation. How relevant is this example? Very relevant. Go back to Chapter 9: we can read the history of the Phillips curve and the increase in inflation in the 1970s as coming precisely from the central bank’s attempts to keep unemployment below the natural rate of unem- ployment, leading to higher and higher expected inflation, and higher and higher actual inflation. In that light, the shift of the original Phillips curve can be seen as the adjustment of wage setters’ expectations to the central bank’s behaviour. So what is the best policy for the central bank to follow in this case? It is to make a cred- ible commitment that it will not try to decrease unemployment below the natural rate. By giving up the option of deviating from its announced policy, the central bank can achieve unemployment equal to the natural rate of unemployment and zero inflation. The analogy with the hostage taking example is clear: by credibly committing not to do something that would appear desirable at the time, policy makers can achieve a better outcome: no hostage takings in our earlier example, no inflation here.CHAPTER 23 POLICY AND POLICY MAKERS: WHAT DO WE KNOW? 483 Establishing credibility How can a central bank credibly commit not to deviate from its announced policy? One way to establish its credibility is for a central bank to give up – or to be stripped by law of – its policy making power. For example, the mandate of the central bank can be defined by law in terms of a simple rule, such as setting money growth at 0% forever. (An alternative, which we discussed in Chapter 19, is to adopt a hard peg, such as a currency board or even dollarisation: in this case, instead of giving up its ability to use money growth, the central bank gives up its ability to use the exchange rate and the interest rate.) Such a law surely takes care of the problem of time inconsistency. But the tight restraint it creates comes close to throwing out the baby with the bathwater. We want to prevent the central bank from pursuing too high a rate of money growth in an attempt to lower unem- ployment below the natural unemployment rate. But – subject to the restrictions discussed in Section 23.1 – we still want the central bank to be able to expand the money supply when unemployment is far above the natural rate, and contract the money supply when unemployment is far below the natural rate. Such actions become impossible under a constant-money-growth rule. There are indeed better ways to deal with time inconsistency. In the case of monetary policy, our discussion suggests various ways of dealing with the problem. A first step is to make the central bank independent. Politicians, who face frequent re-elections, are likely to want lower unemployment now, even if it leads to inflation later. Making the central bank independent, and making it difficult for politicians to fire the central banker, makes it easier for the central bank to resist the political pressure to decrease unem- ployment below the natural rate of unemployment. This may not be enough, however. Even if it is not subject to political pressure, the central bank will still be tempted to decrease unemployment below the natural rate: doing so leads to a better outcome in the short run. So, a second step is to give incentives to central bankers to take the long view – that is, to take into account the long-run costs from higher inflation. One way of doing so is to give them long terms in office, so they have a long horizon and have an incentive to build credibility. A third step may be to appoint a ‘conservative’ central banker, somebody who dislikes inflation very much and is therefore less willing to accept more inflation in exchange for less unemployment when unemployment is at the natural rate. When the economy is at the natural rate, such a central banker will be less tempted to embark on a monetary expansion. Thus, the problem of time inconsistency will be reduced. These are the steps many countries have taken over the past two decades. Central banks have been given more independence. Central bankers have been given long terms in office. And governments typically have appointed central bankers who are more ‘conservative’ than the governments themselves – central bankers who appear to care more about inflation and less about unemployment than the government. (See the Focus box ‘Was Alan Blinder wrong in speaking the truth?’) Figure 23.1 suggests that this approach has been successful. The vertical axis gives the average annual inflation rates in 18 OECD countries for the period 1960–1990. The horizontal axis gives the value of an index of ‘central bank independence,’ constructed by looking at a number of legal provisions in the bank’s charter – for example, whether and how the government can remove the head of the bank. There is a striking inverse relation between the two variables, as summarised by the regression line: more central bank inde- pendence appears to be systematically associated with lower inflation. Time consistency and restraints on policy makers Let’s summarise what we have learned in this section. We have examined arguments for putting restraints on policymakers, based on the issue of time inconsistency.484 EXTENSIONS SHOULD POLICY MAKERS BE RESTRAINED? A warning: ➤ Figure 23.1 shows correlation, not nec- essarily causality. It may be that coun- tries that dislike inflation tend both to give more independence to their cen- tral bankers and have lower inflation. (This is another example of the differ- ence between correlation and causality – discussed in Appendix 2 at the end of the book.) Figure 23.1 Inflation and central bank independence Across OECD countries, the higher the degree of central bank independence, the lower the rate of inflation. Source: Vittorio Grilli, Donato Masciandar, and Guido Tabellini, ‘Political and Monetary Institutions and Public Financial Policies in the Industrial Countries’, Economic Policy, October 1991, 341–392. FOCUS Was Alan Blinder wrong in speaking the truth? In the summer of 1994, President Clinton appointed Alan his words that he was not a conservative central banker, Blinder, an economist from Princeton, Vice-Chairman (in that he cared about unemployment as well as inflation. effect, second in command) of the Federal Reserve Board. With the unemployment rate at the time equal to 6.1%, A few weeks later, Blinder, speaking at an economic con- close to what was thought to be the natural rate of ference, indicated his belief that the Fed has both the unemployment at the time, markets interpreted Blinder’s responsibility and the ability, when unemployment is statements as suggesting that he might want to decrease high, to use monetary policy to help the economy recover. unemployment below the natural rate. Interest rates This statement was badly received. Bond prices fell, and increased because of higher expected inflation – bond most newspapers ran editorials critical of Blinder. prices decreased. Why was the reaction of markets and newspapers The moral of the story: whatever views central bankers so negative? It was surely not that Blinder was wrong. may hold, they should try to look and sound conservative. There is no doubt that monetary policy can and should This is why many heads of central banks are reluctant help the economy out of a recession. Indeed, the Federal to admit, at least in public, the existence of any trade- Reserve Bank Act of 1978 requires the Fed to pursue full off between unemployment and inflation, even in the employment as well as low inflation. short run. The reaction was negative because, in terms of the argument we developed in the text, Blinder revealed by We have looked at the case of monetary policy. But similar issues arise in the context of fiscal policy. For instance, we discussed in Chapter 21 the issue of debt repudiation – the option for the government to cancel its debt obligations – and see that the conclusions there are very similar to those in the case of monetary policy. When issues of time inconsistency are relevant, tight restraints on policy makers – such as a fixed-money-growth rule in the case of monetary policy, or a balanced budget rule inCHAPTER 23 POLICY AND POLICY MAKERS: WHAT DO WE KNOW? 485 the case of fiscal policy – can provide a rough solution. But the solution has large costs because it prevents the use of macroeconomic policy altogether. Better solutions typically involve designing better institutions (such as an independent central bank or a better budget process) that can reduce the problem of time inconsistency while, at the same time, allowing the use of policy for the stabilisation of output. 23.3 POLITICS AND POLICY We have assumed so far that policy makers are benevolent – that they try to do what is best for the economy. However, much public discussion challenges that assumption: politicians or policy makers, the argument goes, do what is best for themselves, and this is not always what is best for the country. You have heard the arguments: politicians avoid the hard decisions, they pander to the electorate, partisan politics leads to gridlock and nothing ever gets done. Discussing the flaws of democracy goes far beyond the scope of this book. What we can do here is to briefly review how these arguments apply to macroeconomic policy and then look at the empirical evidence and see what light it sheds on the issue of policy restraints. Games between policy makers and voters Many macroeconomic policy decisions involve trading off short-run losses against long-run gains – or, conversely, short-run gains against long-run losses. Take, for example, tax cuts. By definition, tax cuts lead to lower taxes today. They are also likely to lead to an increase in activity and, therefore, to an increase in pre-tax income, for some time. But unless they are matched by equal decreases in government spending, they lead to a larger budget deficit and to the need for an increase in taxes in the future. If voters are short-sighted, the temptation for politicians to cut taxes may prove irresistible. Politics may lead to systematic deficits, at least until the level of government debt has become so high that politicians are scared into action. Now move on from taxes to macroeconomic policy in general. Again suppose that From Okun’s law, we know that output growth in excess of normal growth voters are short-sighted. If the politicians’ main goal is to please voters and get re-elected, leads to a decline in the unemployment what better policy than to expand aggregate demand before an election, leading to rate below the natural rate of unem- higher growth and lower unemployment? True, growth in excess of the normal growth ployment. In the medium run, we know rate cannot be sustained, and eventually the economy must return to the natural level of that the unemployment rate must output: higher growth now must be followed by lower growth later. But with the right increase back to the natural rate of unemployment. This in turn requires timing and short-sighted voters, higher growth can win elections. Thus, we might expect a output growth below normal for some clear political business cycle, with higher growth on average before elections than after time. See Chapter 10. elections. The arguments we have just laid out are familiar; you have heard them before, in one form or another. And their logic is convincing. The question is: how well do they fit the facts? Take first deficits and debt. The argument above would lead you to expect that budget deficits and high government debt have always been and always will be there. Figure 23.2, which gives the evolution of the ratio of government debt to GDP in the UK since 1900, shows that the reality is more complex. Look first at the evolution of the ratio of debt to GDP from 1900–1980. Note that each of the three build-ups in debt was associated with special circumstances: the First World War for the first build-up, the Great Depression for the second and the Second World War for the third. These were times of unusually high military spending or unusual declines in output. Adverse circumstances – not pandering to voters – were clearly behind the large deficit and the resulting increase in debt during each of these three episodes. Note also how, in each case, the build-up was followed by a steady decrease in debt. In particular, note how the ratio of debt to GDP, which was as high as 250% around 1950, was steadily reduced to a post-war low below 50% in the early 1990s. ➤486 EXTENSIONS SHOULD POLICY MAKERS BE RESTRAINED? Figure 23.2 The evolution of the ratio of UK debt-to-GDP since 1900 The three major build-ups of debt since 1900 have been associated with the First World War, the Great Depression and the Second World War. Source: Bank of England Statistical Abstract, Part 1, 2000 edition, Table 15.2 (cited in HM Treasury, Public Finances Databank, October 2001). Table 23.3 Average growth during Labour and Conservative administrations in the UK (per cent per year) Year of First Second Third Fourth Average Conservative Party 1.48 1.26 1.29 1.39 1.35 Labour Party 1.34 1.65 1.89 0.82 1.50 Average 1.40 1.47 1.59 1.16 1.43 Let us now return to the political-business-cycle argument, that policy makers try to get high output growth before the elections so they will be re-elected. If the political business cycle were important, we would expect to see faster growth before elections than after. Table 23.3 gives average output growth rates for each of the first four years of each UK govern- ment from the second Wilson administration in 1974, until the third Blair administration ended in 2007, distinguishing between Conservative and Labour governments. Look at the last line: growth has not been highest on average in the last year of a ministry; actually, average growth in the fourth years of a ministry was the lowest compared to average growth in previous years. Moreover, the average difference across years is small: 1.16% in the fourth year of an administration versus 1.40% in the first year. (We shall return later in this chapter to the other interesting feature in the table – the difference between Conservative and Labour governments.) However, if you look at Conservative and Labour governments separately, you will notice that the former achieved on average higher growth in the fourth year of a ministry with respect to the second and third years, which is not the case with Labour governments. It would seem that the Conservatives, unlike their opponents, tried to stimulate the economy towards the end of their ministries to win elections. Overall, there is still little evidence of manipulation – or at least of successful manipulation – of the economy to win elections. Games between policy makers Another line of argument shifts the focus from games between politicians and voters to games between policy makers. Suppose, for example, that the party in power wants to reduce spending but faces oppo- sition to spending cuts in Parliament. One way of putting pressure both on Parliament and on the future parties in power is to cut taxes and create deficits. As debt increases over time, the increasing pressure to reduce deficits may in turn force Parliament and the future parties in power to reduce spending – something they would not have been willing to do otherwise. Or suppose that, either for the reason we just saw or for any other reason, the country is facing large budget deficits. Both parties want to reduce the deficit, but they disagree aboutCHAPTER 23 POLICY AND POLICY MAKERS: WHAT DO WE KNOW? 487 the way to do it: one party wants to reduce deficits primarily through an increase in taxes; the other wants to reduce deficits primarily through a decrease in spending. Both parties may hold out on the hope that the other side will give in first. Only when debt has increased sufficiently, and it becomes urgent to reduce deficits, will one party give up. Game theorists refer to these situations as wars of attrition. The hope that the other side will give in leads to long and often costly delays. Such wars of attrition happen often in the context of fiscal policy, and deficit reduction occurs long after it should. Wars of attrition arise in other macroeconomic contexts, such as during episodes of hyperinflation. As you saw in Chapter 22, hyperinflations come from the use of money creation to finance large budget deficits. Although the need to reduce those deficits is usually recognised early on, support for stabilisation programmes – which include the elimination of those deficits – typically comes only after inflation has reached such high levels that economic activity is severely affected. Another example of games between political parties is the movements in economic activ- ity brought about by the alternation of parties in power. Conservatives typically worry more than Labour about inflation. They worry less than Labour about unemployment. So we would expect Labour governments to show stronger growth – and thus less unemployment and more inflation – than Conservative governments. This prediction appears to fit the facts quite well. Look at Table 23.3 again. Average growth has been 1.50% during Labour governments, compared to 1.35% during Conservative governments. The most striking contrast is in the third year, 1.89% during Labour governments, compared to 1.29% during Conservative governments. This raises an intriguing question: why is the effect so much stronger in the administra- tion’s third year? The theory of unemployment and inflation we developed in Chapter 10 suggests a possible hypothesis: there are lags in the effects of policy, so it takes more than two years for a new government to affect the economy. And sustaining higher growth than normal for too long would lead to increasing inflation, so even a Labour government would not want to sustain higher growth throughout its term. Thus, differences in growth rates tend to decline in the fourth year of Labour and Conservative governments and to be much closer to each other towards the end of a ministry – more so than in the third year. In fact, during Labour governments, growth actually declined in the fourth year compared to the first three years. SUMMARY ● The effects of macroeconomic policies are always uncer- ● When playing a game, it is sometimes better for a player tain. This uncertainty should lead policy makers to be to give up some of his or her options. For example, when more cautious and to use less active policies. Policies a hostage taking occurs, it is better to negotiate with the must be broadly aimed at avoiding prolonged recessions, hostage takers than not to negotiate. But a government slowing down booms and avoiding inflationary pressure. that credibly commits to not negotiating with hostage The higher the level of unemployment or inflation, the takers – a government that gives up the option of negoti- more active the policies should be. But they should stop ation – is actually more likely to deter hostage takings short of fine-tuning, of trying to maintain constant unem- from occurring. ployment or constant output growth. ● The same argument applies to various aspects of macro- ● Using macroeconomic policy to control the economy is economic policy. By credibly committing not to using fundamentally different from controlling a machine. monetary policy to decrease unemployment below the Unlike a machine, the economy is composed of people natural rate of unemployment, a central bank can allevi- and firms who try to anticipate what policy makers will ate fears that money growth will be high and, in the pro- do, and who react not only to current policy but also to cess, decrease both expected and actual inflation. When expectations of future policy. In this sense, macroeco- issues of time inconsistency are relevant, tight restraints nomic policy can be thought of as a game between policy on policy makers – such as a fixed-money-growth rule makers and people in the economy. in the case of monetary policy – can provide a rough 488 EXTENSIONS SHOULD POLICY MAKERS BE RESTRAINED? solution. But the solution can have large costs if it pre- short-sighted electorate by choosing policies with short- vents the use of macroeconomic policy altogether. Better run benefits but large long-term costs – for example, methods typically involve designing better institutions large budget deficits. Political parties may delay painful (such as an independent central bank) that can reduce decisions, hoping that the other party will make the the problem of time inconsistency without eliminating adjustment and take the blame. In cases like this, tight monetary policy as a macroeconomic policy tool. restraints on policy, such as a constitutional amendment to balance the budget, again provide a rough solution. ● Another argument for putting restraints on policy makers Better ways typically involve better institutions and is that policy makers may play games either with the better ways of designing the process through which public or among themselves, and these games may lead policy and decisions are made. to undesirable outcomes. Politicians may try to fool a KEY TERMS fine-tuning 480 optimal control theory 481 players 481 political business cycle 485 optimal control 481 game theory 481 time inconsistency 482 war of attrition 487 game 481 strategic interactions 481 QUESTIONS AND PROBLEMS QUICK CHECK first three years of a prime minister’s administration has little effect on voting behaviour. 1. Using the information in this chapter, label each of the Assume that inflation last year was 10%, and that the unem- following statements true, false or uncertain. Explain briefly. ployment rate was equal to the natural rate. The Phillips curve a. There is so much uncertainty about the effects of is given by monetary policy that we would be better off not using it. π = π − α(u − u ) t t−1 t n b.Elect a Labour government if you want low unemployment. Assume that you can use fiscal and monetary policy to achieve any unemployment rate you want for each of the next four years. c. There is clear evidence of political business cycles in the Your task is to help the prime minister achieve low unemploy- UK: low unemployment during election campaigns and ment and low inflation in the last year of her administration. higher unemployment the rest of the time. a. Suppose you want to achieve a low unemployment rate d. Rules are ineffective in reducing budget deficits. (i.e. an unemployment rate below the natural rate) in the e. Governments would be wise to announce a no- year before the next election (four years from today). negotiation policy with hostage takers. What will happen to inflation in the fourth year? f. If hostages are taken, it is clearly wise for governments b. Given the effect on inflation you identified in part (a), to negotiate with hostage takers, even if the government what would you advise the prime minister to do in the has announced a no-negotiation policy. early years of her administration to achieve low inflation g. When a central bank announces a target inflation rate, in the fourth year? it has no incentive to deviate from the target. c. Now suppose the Phillips curve is given by e π = π − α(u − u ) 2. Implementing a political business cycle t t t n You are the economic adviser to a newly elected prime min- In addition, assume that people form inflation expectations, e ister. In four years she will face another election. Voters want π , based on consideration of the future (as opposed to look- t a low unemployment rate and a low inflation rate. However, ing only at inflation last year), and are aware that the prime you believe that voting decisions are influenced heavily by the minister has an incentive to carry out the policies you values of unemployment and inflation in the last year before identified in parts (a) and (b). Are the policies you described the election, and that the economy’s performance in the in parts (a) and (b) likely to be successful? Why or why not?CHAPTER 23 POLICY AND POLICY MAKERS: WHAT DO WE KNOW? 489 3. Suppose the government amends the constitution to prevent The possible outcomes are represented in the following table: government officials from negotiating with terrorists. Social security cuts What are the advantages of such a policy? What are the Yes No disadvantages? Defence cuts Yes (R = 1, D =−2) (R =−2, D = 3) No (R = 3, D =−2) (R =−1, D =−1) 4. New Zealand rewrote the charter of its central bank in the early 1990s to make low inflation its only goal. The table presents payoffs to each party under the various out- comes. Think of a payoff as a measure of happiness for a given Why would New Zealand want to do this? party under a given outcome. If Labour vote for social security cuts and the Conservatives vote against cuts in military spend- DIG DEEPER ing, the Conservatives receive a payoff of 3 and Labour receive 5. Political expectations, inflation and unemployment a payoff of 22. Consider a country with two political parties, Labour and a. If the Conservatives decide to cut military spending, what Conservative. Labour care more about unemployment than is the best response of Labour? Given this response, what Conservative, and Conservative care more about inflation is the payoff for the Conservatives? than Labour. When Labour are in power, they choose an b. If the Conservatives decide not to cut military spending, inflation rate of π , and when the Conservatives are in power, L what is the best response of Labour? Given this response, they choose an inflation rate of π . We assume that π π . C L C what is the payoff for the Conservatives? The Phillips curve is given by c. What will the Conservatives do? What will Labour do? e π = π − α(u − u ) t t t n Will the budget deficit be reduced? Why or why not? (A game with a payoff structure like the one in this An election is about to be held. Assume that expectations about e problem, and which produces the outcome you have just inflation for the coming year (represented by π ) are formed t described, is known as a prisoner’s dilemma.) Is there a before the election. (Essentially, this assumption means that way to improve the outcome? wages for the coming year are set before the election.) Moreover, Labour and Conservative have an equal chance of EXPLORE FURTHER winning the election. a. Solve for expected inflation, in terms of π and π . 7. Games, pre-commitment and time inconsistency in L C the news b. Suppose Labour win the election and implement their target inflation rate, π . Given your solution for expected Current events offer abundant examples of disputes in which L inflation in part (a), how will the unemployment rate the parties are involved in a game, try to commit themselves to compare to the natural rate of unemployment? lines of action in advance and face issues of time inconsistency. Examples arise in the domestic political process, international c. Suppose the Conservatives win the election and imple- affairs and labour–management relations. ment their target inflation rate, π . Given your solution C for expected inflation in part (a), how will the unemploy- a. Choose a current dispute (or one resolved recently) to ment rate compare to the natural rate of unemployment? investigate. Do an Internet search to learn the issues involved in the dispute, the actions taken by the parties to d. Do these results fit the evidence in Table 23.3? Why or date and the current state of play. why not? b. In what ways have the parties tried to pre-commit to cer- e. Now suppose that everybody expects Labour to win the tain actions in the future? Do they face issues of time election, and Labour indeed win. If Labour implement inconsistency? Have the parties failed to carry out any of their target inflation rate, how will the unemployment their threatened actions? rate compare to the natural rate? c. Does the dispute resemble a prisoner’s dilemma game 6. Deficit reduction as a prisoner’s dilemma game (a game with a payoff structure like the one described in problem 6)? In other words, does it seem likely (or did Suppose there is a budget deficit. It can be reduced by cutting it actually happen) that the individual incentives of the military spending, by cutting social security, or by cutting parties will lead them to an unfavourable outcome – one both. Labour have to decide whether to support cuts in social that could be improved for both parties through coopera- security. The Conservatives have to decide whether to support tion? Is there a deal to be made? What attempts have the cuts in military spending. parties made to negotiate? d. How do you think the dispute will be resolved (or how has it been resolved)?490 EXTENSIONS SHOULD POLICY MAKERS BE RESTRAINED? We invite you to visit the Blanchard page on the Prentice Hall website, at www.prenhall.com/blanchard for this chapter’s World Wide Web exercises. FURTHER READING ● If you want to learn more on these issues, a very useful Deficit: The Political Legacy of Lord Keynes, Academic reference is Alan Drazen, Political Economy in Macroeco- Press, New York, 1977. nomics, Princeton University Press, Princeton, NJ, 2000. ● For an interpretation of the increase in inflation in the 1970s ● A leading proponent of the view that governments misbe- as a result of time inconsistency, see Henry Chappell and have and should be tightly restrained is James Buchanan, Rob McGregor, ‘Did Time Consistency Contribute to from George Mason University. Buchanan received the the Great Inflation?’ Economics & Politics, 2004, 16, Nobel Prize in 1986 for his work on public choice. Read, for 233–251. example, his book with Richard Wagner, Democracy inChapter 24 MONETARY AND FISCAL POLICY RULES AND CONSTRAINTS Nearly every chapter has said something about monetary and fiscal policies. This chapter puts all these things together and ties up the remaining loose ends. Let’s first briefly review what you have learned about monetary policy: ● In the short run, monetary policy affects the level of output as well as its composition: ● An increase in money leads to a decrease in interest rates and a depreciation of the currency. ● Both of these lead to an increase in the demand for goods and an increase in output. ● In the medium run and the long run, monetary policy is neutral: ● Changes in either the level or the rate of growth of money have no effect on output or unemployment. ● Changes in the level of money lead to proportional increases in prices. ● Changes in the rate of nominal money growth lead to corresponding changes in the inflation rate. Let’s also review what you have learned about fiscal policy: ● In the short run, a budget deficit (triggered, say, by a increase in government spending) increases demand and output. What happens to investment spending is ambiguous. ● In the medium run, output returns to the natural level of output. The interest rate and the composition of spending are different, however. The interest rate is higher, and investment spending is lower. ● In the long run, lower investment leads to a lower capital stock and, therefore, a lower level of output. With these effects in mind, this chapter looks at the goals and methods of monetary and fiscal policies today. The chapter is divided in three sections. The first two sections deal with monetary policy rules: ● Section 24.1 discusses what inflation rate central banks should try to achieve in the medium run and the long run, in other words what is the optimal inflation rate. ● Section 24.2 discusses how monetary policy should be designed both to achieve this inflation rate in the medium run and the long run, and to reduce output fluctuations in the short run.492 EXTENSIONS SHOULD POLICY MAKERS BE RESTRAINED? The last section deals with fiscal policy rules and constraints: ● Section 24.3 examines a number of fiscal policy issues where the government budget constraint plays a central role, from the proposition that deficits do not really matter, to tax distortions. It then describes some notable cases of fiscal policy rules around the world: the rules imposed by the Stability and Growth Pact on the members of the European Monetary Union, the Golden Rule recently introduced in the UK and the balanced budget rule in the USA. 24.1 THE OPTIMAL INFLATION RATE At this stage, the debate in OECD countries is largely between those who think some inflation (say 3%) is fine and those who want to achieve price stability – that is, 0% inflation. Those who want an inflation rate around 3% emphasise that the costs of 3% versus 0% inflation are small and that the benefits of inflation are worth keeping. They argue that some of the costs of inflation could be avoided by indexing the tax system and issuing more indexed bonds. They also argue that getting inflation down from its current rate to zero would require some increase in unemployment for some time, and that this transition cost may well exceed the eventual benefits. Those who want to aim for 0% make the point that 0% is a very different target rate from all others: it corresponds to price stability. This is desirable in itself. Knowing that the price level will be roughly the same in ten or 20 years as it is today simplifies a number of complicated decisions and eliminates the scope for money illusion. Also, given the time consistency problem facing central banks (discussed in Chapter 23), credibility and simplicity of the target inflation rate are important. Proponents of 0% inflation believe price stability can achieve these goals better than a target inflation rate of 3%. The debate is not settled. For the time being, most central banks appear to be aiming for low but positive inflation – that is, inflation rates between 2% and 3%. The costs of inflation We saw in Chapter 22 how very high inflation, say a rate of 30% per month or more, can disrupt economic activity. The debate in OECD countries today, however, is not about the costs of inflation rates of 30% per month or more. Rather, it centres on the advantages of, say, 0% versus 3% inflation per year. Within that range, economists identify four main costs of inflation: (1) shoe-leather costs, (2) tax distortions, (3) money illusion and (4) inflation variability. Shoe-leather costs From Chapter 14: in the medium run, ➤ In the medium run, a higher inflation rate leads to a higher nominal interest rate and so to the real interest rate is not affected a higher opportunity cost of holding money. As a result, people decrease their money by inflation. The increase in inflation is balances by making more trips to the bank – thus the expression shoe-leather costs. These reflected one-for-one in an increase in trips would be avoided if inflation were lower and people could be doing other things the nominal interest rate. This is called instead, such as working more or enjoying leisure. the Fisher effect. During hyperinflations, shoe-leather costs can become quite large. But their importance in times of moderate inflation is limited. If an inflation rate of 3% leads people to go to the bank say one more time every month, or to do one more transaction between their money market fund and their current account every month, this hardly qualifies as a major cost of inflation.CHAPTER 24 MONETARY AND FISCAL POLICY RULES AND CONSTRAINTS 493 Tax distortions The second cost of inflation comes from the interaction between the tax system and inflation. Consider, for example, the taxation of capital gains. Taxes on capital gains are typically based on the change in the price of an asset between the time it is purchased and the time it is sold. This implies that the higher the rate of inflation, the higher the tax. An example will make this clear: ● Suppose inflation has been running at π % per year for the past ten years. ● Suppose you bought your house for a50 000 ten years ago, and you are selling it today 10 π %) – so its real value is unchanged. for a50 000 × (1 + ● If the capital gains tax is 30%, the effective tax rate on the sale of your house – defined as the ratio of the tax you pay to the price for which you sell your house – is 10 The numerator of the fraction equals 50 000(1 + π %) − 50 000 (30%) 10 the sale price minus the purchase 50 000(1 + π %) price. The denominator is the sale price. ● Because you are selling your house for the same real price at which you bought it, your real π = 0 – if there has been capital gain is zero, so you should not be paying any tax. Indeed, if no inflation – then the effective tax rate is 0%. But if π = 3%, then the effective tax rate is 7.6%: despite the fact that your real capital gain is zero, you end up paying a high tax. The problems created by the interactions between taxation and inflation extend beyond capital gains taxes. Although we know that the real rate of return on an asset is the real interest rate, not the nominal interest rate, income for the purpose of income taxation includes nominal interest payments, not real interest payments. Or, to take yet another example, until the early 1980s in the USA, the income levels corresponding to different income tax rates were not increased automatically with inflation. As a result, people were pushed into higher tax brackets as their nominal income – but not necessarily their real income – increased over time, an effect known as bracket creep. You might argue that this cost is not a cost of inflation per se, but rather the result of a badly designed tax system. In the house example we just discussed, the government could eliminate the problem if it indexed the purchase price to the price level – that is, if it adjusted the purchase price for inflation since the time of purchase – and computed the tax on the dif- ference between the sale price and the adjusted purchase price. Under that computation, there would be no capital gains and therefore no capital gains tax to pay. But because tax codes rarely allow for such systematic adjustment, the inflation rate matters and leads to distortions. Money illusion The third cost of inflation comes from money illusion – the notion that people appear to make systematic mistakes in assessing nominal versus real changes. A number of computa- tions that would be simple when prices are stable become more complicated when there is inflation. When they compare their income this year to their income in previous years, people have to keep track of the history of inflation. When they choose between different assets or when they decide how much to consume or save, they have to keep track of the difference between the real interest rate and the nominal interest rate. Casual evidence sug- gests that many people find these computations difficult and often fail to make the relevant distinctions. Economists and psychologists have gathered more formal evidence, and it sug- gests that inflation often leads people and firms to make incorrect decisions (see the Focus box ‘Money illusion’). If this is the case, then a simple solution is to have zero inflation. Inflation variability The fourth cost comes from the fact that higher inflation is typically associated with more variable inflation. And more variable inflation means financial assets such as bonds, which promise fixed nominal payments in the future, become riskier. ➤494 EXTENSIONS SHOULD POLICY MAKERS BE RESTRAINED? Take a bond that pays a1000 in ten years. With constant inflation over the next ten years, not only the nominal value but also the real value of the bond in ten years is known with certainty – we can compute exactly how much a euro will be worth in ten years. But with variable inflation, the real value of a1000 in ten years becomes uncertain. The more variability there is, the more uncertainty it creates. Saving for retirement becomes more difficult. For those who have invested in bonds, lower inflation than they expected means a A good and sad movie about surviving ➤ better retirement; but higher inflation may mean poverty. This is one of the reasons retirees, on a fixed pension in Italy after the for whom part of their income is fixed in money terms, typically worry more about inflation Second World War is Umberto D, made by Vittorio de Sica in 1952. than other groups in the population. You might argue, as in the case of taxes, that these costs are not due to inflation per se, but rather to the financial markets’ inability to provide assets that protect their holders against inflation. Rather than issuing only nominal bonds (bonds that promise a fixed nominal amount in the future), governments or firms could also issue indexed bonds – bonds that promise a nominal amount adjusted for inflation, so people do not have to worry about the real value of the bond when they retire. Indeed, as we saw in Chapter 15, a number of countries, including the UK, France and Sweden, have now introduced such bonds, so people can better protect themselves against movements in inflation. FOCUS Money illusion There is a lot of anecdotal evidence that many people ● During the time Carl owned the house, there was a fail to adjust properly for inflation in their financial com- 25% inflation – the prices of all goods and services putations. Recently, economists and psychologists have increased by approximately 25%. A year after Carl started looking at money illusion more closely. In a recent bought the house, he sold it for 246 000 (23% more study, two psychologists, Eldar Shafir from Princeton Uni- than what he had paid). versity and Amos Tversky from Stanford University, and Please rank Adam, Ben and Carl in terms of the success one economist, Peter Diamond from MIT, designed a sur- of their house transactions. Assign ‘1’ to the person who vey aimed at finding how prevalent money illusion is and made the best deal and ‘3’ to the person who made the what causes it. Among the many questions they asked of worst deal. people in various groups (people at Newark International In nominal terms, Carl clearly made the best deal, Airport, people at two New Jersey shopping malls and a followed by Ben, followed by Adam. But what is relevant group of Princeton undergraduates) is the following. is how they did in real terms – adjusting for inflation. In Suppose Adam, Ben and Carl each received an real terms, the ranking is reversed: Adam, with a 2% real inheritance of 200 000 and each used it immediately gain, made the best deal, followed by Ben (with a 1% to purchase a house. Suppose each sold his house one loss), followed by Carl (with a 2% loss). year after buying it. Economic conditions were, however, The survey’s answers were as follows: different in each case: ● During the time Adam owned the house, there was a Rank Adam Ben Carl st 25% deflation – the prices of all goods and services 1 37% 15% 48% nd decreased by approximately 25%. A year after Adam 2 10% 74% 16% rd 3 53% 11% 36% bought the house, he sold it for 154 000 (23% less than what he had paid). ● During the time Ben owned the house, there was no Carl was ranked first by 48% of the respondents, and inflation or deflation – the prices of all goods and Adam was ranked third by 53% of the respondents. These services did not change significantly during the year. answers suggest that money illusion is very prevalent. A year after Ben bought the house, he sold it for In other words, people (even Princeton undergraduates) 198 000 (1% less than what he had paid). have a hard time adjusting for inflation.CHAPTER 24 MONETARY AND FISCAL POLICY RULES AND CONSTRAINTS 495 The benefits of inflation Inflation is actually not all bad. One can identify three benefits of inflation: (1) seignorage, (2) the option of negative real interest rates for macroeconomic policy and (3) (somewhat paradoxically) the use of the interaction between money illusion and inflation in facilitating real wage adjustments. Seignorage Money creation – the ultimate source of inflation – is one of the ways in which the govern- ment can finance its spending. Put another way, money creation is an alternative to borrowing from the public or raising taxes. As you saw in Chapter 22, the government typically does not ‘create’ money to pay for its spending. Rather, the government issues and sells bonds and spends the proceeds. But if the bonds are bought by the central bank, which then creates money to pay for them, the result is the same: other things being equal, the revenues from money creation – that is, seignorage – allow the government to borrow less from the public or to lower taxes. Let H denote the monetary base – the How large is seignorage in practice? When looking at hyperinflations in Chapter 22, you money issued by the central bank. saw that seignorage is often an important source of government finance in countries with Then very high inflation rates. But its importance in OECD economies today, and for the range of inflation rates we are considering, is much more limited. Take the case of the USA. The ratio Seignorage VH VH H 55 Y PY H PY of the monetary base – the money issued by the ECB (see Chapter 4) – to GDP is about 6%. An increase in nominal money growth of 3% per year (which eventually leads to a 3% where DH/H is the rate of growth of the monetary base, and H/PY is the ratio of increase in inflation) would lead therefore to an increase in seignorage of 3% × 6%, or the monetary base to nominal GDP. 0.18% of GDP. This is a small amount of revenues to get in exchange for 3% more inflation. Therefore, while the seignorage argument is sometimes relevant (for example, in economies that do not yet have a good fiscal system in place), it hardly seems relevant in the discussion of whether OECD countries today should have, say, 0% versus 3% inflation. The option of negative real interest rates The seignorage argument follows from our discussion of the liquidity trap and its macro- From Chapter 14: the natural real inter- est rate is the real interest rate implied economic implications in Chapter 5. A numerical example will help here. Consider two by equilibrium in the goods market economies, both with a natural real interest rate equal to 2%. when output is equal to its natural level. ● In the first economy, the central bank maintains an average inflation rate of 3%, so the nominal interest rate is, on average, equal to 2% + 3% = 5%. ● In the second economy, the central bank maintains an average inflation rate of 0%, so the nominal interest rate is, on average, equal to 2% + 3% = 5%. ● Suppose both economies are hit by a similar adverse shock, which leads, at a given inter- est rate, to a decrease in spending and a decrease in output in the short run. ● In the first economy, the central bank can decrease the nominal interest rate from 5% to 0%, a decrease of 5%. Under the assumption that expected inflation does not change immediately and remains equal to 3%, the real interest rate decreases from 2% to −3%. This is likely to have a strong positive effect on spending and help the economy recover. ● In the second economy, the central bank can only decrease the nominal interest rate from 2% to 0%, a decrease of 2%. Under the assumption that expected inflation does not change right away and remains equal to 0%, the real interest rate decreases only by 2%, from 2% to 0%. This small decrease in the real interest rate may not increase spending by very much. In short, an economy with a higher average inflation rate has more scope to use monet- ary policy to fight a recession. An economy with a low average inflation rate may find itself unable to use monetary policy to return output to the natural level of output. This possibility is far from being just theoretical. Japan faced precisely such a limit on monetary policy, and its recession turned into a slump. In the early 2000s, many economists worried that other countries may also be at risk. Many countries, including the USA, had low inflation and low ➤ ➤

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