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Macroeconomic Policy
Monday, May 2, 2016

1:11 PM

What is the Role of Stabilization Policy?

• Self correcting property: output gaps will be closed by rising or falling inflation
rates
○ Assumes that firms change their prices in response to output gaps
○ Long term contracts and market imperfections slow this process
○ The greater the output gap, the longer it will take the self-correction
process to return the economy to long run equilibrium
• Accommodating Policy: a policy that allows the effects of a shock to occur
○ In the short run, the economy experiences a period of recession and
higher inflation, then an increase in output
○ In the long run, the economy returns to potential output with a higher
inflation rate
• Anchored Inflationary Expectations: when people's expectations of future
inflation do not change even if inflation rises temporarily
○ Leads to shorter recessions because people expect the Fed to bring levels
back to normal
• Inflation steady due to improvement in Fed monetary policy

Inflationary Expectations and Credibility

• Credibility of Monetary Policy: the degree to which the public believes the
central bank's promises to keep inflation low, even if doing so may impose
short-run economic costs
○ Affected by central bank independence, announcement of inflation
targets, and reputation for fighting inflation
• Central Bank Independence: when central bankers are insulated from shortterm political considerations and are allowed to take a long-term view of the
economy
○ Can pursue anti-inflationary policy when it is necessary
• Factors that contribute to independence:
○ More independent if central bankers are appointed for longer terms
○ More independent if actions not subject to frequent review
○ More independent if not obligated to buy government bonds
○ More independent if allowed to set and control own budgets
• Fed is relatively independent
○ Daily policy actions of Fed not subject to review

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○ More independent if actions not subject to frequent review
○ More independent if not obligated to buy government bonds
○ More independent if allowed to set and control own budgets
Fed is relatively independent
○ Daily policy actions of Fed not subject to review
○ Under no obligation to buy bonds
○ Controls own budget
Countries where central banks are independent have lower rates of inflation
○ Not accompanied by lower output or unemployment
Central banks that announce their targets typically provide additional
information to the public
○ Reduces uncertainty
○ Anchors inflationary expectations
Not strategic to announce a long-run target because these can be influence by
factors no under the Fed's control
The Fed does not announce an explicit target because it limits its flexibility to
deal with unexpected circumstances
Inflation Hawk: someone who is committed to achieving and maintaining low
inflation, even at some short-run cost in reduced output and employment
○ Central banks with this reputation make is easier to anchor inflationary
expectations
Inflation Dove: someone who is not strongly committing to achieving and
maintaining low inflation

Fiscal Policy and the Supply Side

• Supply-Side Policy: policy that affects potential output
• Interstate highway -- lowered costs of long-distance transportation and
increased productivity and output
○ Spending on capital can affect aggregate demand and supply
• Reducing the federal funds rate increases aggregate demand
• A lower tax rate on interest income may increase people's
willingness to save --> more investment in the long run and increase in output
• Reductions in tax rates may increase the number of hours people want to work
due to higher opportunity cost
• Marginal Tax Rate: the amount by which taxes rise when before-tax income
rises by one dollar
○ Lower tax rate --> people risker with investments, work more hours
• Average Tax Rate: total taxes/before-tax income

Policymaking: Art or Science?

• Perfect policy requires knowing:
○ Accurate knowledge of state of economy
○ Knowledge of future path
○ Value of potential output to determine output gaps
○ Control over fiscal and monetary policy

Policymaking: Art or Science?

• Perfect policy requires knowing:
○ Accurate knowledge of state of economy
○ Knowledge of future path
○ Value of potential output to determine output gaps
○ Control over fiscal and monetary policy
○ Knowledge of how economy will react to changes
• Inside Lag: the delay between the date a policy change is needed and the date it
is implemented
○ Shorter for monetary policy than fiscal policy
• Outside Lag: the delay between the date a policy change is implemented and
the date by which most of its effects on the economy have occurred
○ Shorter for fiscal policy than monetary policy



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