Notesale: Turn your study into money

Document Preview

Extracts from the notes are below, to see the PDF you'll receive please use the links above

---

Institutions and Economic Policy
Inflation Bias
According to the theory presented in Chapters 8 and 9, wages and prices change slowly, and more
expansionary monetary policy leads to higher production and employment
...
This means that in the short run, policymakers face a trade-off: higher employment
can be bought at the price of somewhat higher inflation
...
This implies that, in the long run, monetary
policy is ineffective as a policy for raising employment because employment will return to the
natural level independent of inflation
...
Let us assume that expected
inflation is equal to the inflation in the previous period: 𝜋 𝑒 𝑡 = 𝜋 𝑡−1 , so the Philips curve is:
𝜋 𝑡 = 𝜋 𝑡−1 − ̂ (𝑢 𝑡 − 𝑢 𝑡𝑛 ) + 𝑧 𝑡 , 𝑤h𝑒𝑟𝑒 ̂ =
𝑏
𝑏

𝜆𝑏
1−𝜆

According to the theory presented in Chapter 9, the slope of the Philips curve depends on the slope
of the wage-setting function, 𝑏, and the fraction of wages that are flexible, λ
...
e
...

When policymakers are short-sighted, say politicians are concerned with winning the next election
for example, then their objectives can be summarized as an attempt to minimize the following loss
function:
𝐿 (𝜋 𝑡 , 𝑢 𝑡 ) = 𝜋 2 + 𝜆𝑢2
...
The further away from
that the point, the bigger the losses from unemployment and inflation
...
We can illustrate
this using indifference curves with each curve representing a different combination of inflation and
unemployment and the associated level of loss
...
3
...
This is
the point along the Philips curve where the level curve of the loss function is tangent to the Philips
curve
...
Faced
with a trade-off between inflation and unemployment the policymaker decides to reduce
unemployment below the natural level, although this leads to an increase in inflation
...
This shifts up the Philips curve and means that both unemployment and inflation will be
higher in the second period
...

𝜋
Solutions to the inflation bias problem:
A fixed norm for inflation: One way to avoid the equilibrium with high inflation is to pass a law
whereby inflation should be zero, or some other low number, and make the central bank obliged to
follow that law
...

A rule for monetary policy: We could allow for more flexibility if we pass a law whereby the central
bank should follow a specific decision rule for monetary policy
...

Delegation to a 'conservative' central banker: That is to say that if delegate responsibility for
monetary policy to a 'conservative' who puts a lot of weight on inflation and little on employment
then we can make sure that we have low average inflation
...
This highlights the credibility-flexibility
trade-off: the less weight the central bank puts on employment the more credible its inflation target
and the more we reduce inflation bias, but at the same time the central bank will be less flexible in
allowing temporary variations in inflation in order to stabilize output
...

A contract for the central bank: Another idea is to delegate monetary policy to an independent
board
...

The contract would tilt the indifference curves so that the inflation bias problem is eliminated while
still allowing a flexible response to shocks
...
Individuals take account of the utility of future generations
...
In reality, we do not have full Ricardian Equivalence and
we can think of at least three types of effect of deficits and high debt
...
For these reasons, people will s[end some of the increase in disposable income
that they get from tax cuts and government spending increases
...

Even with a fully integrated financial system which can prevent a fall in the capital stock there will be
a reduction in the level of net foreign assets held
...
In this way, running a government deficit allows individuals living today to borrow at the
expense of future generations
...

Distortions and tax smoothing: Taxes have distortionary effects; as a result of income taxation the
labour supply is below the socially efficient level, and the distortion will increase more than
proportionally with the level of taxes
...
The tax smoothing argument is an argument
for temporary deficits if government consumption varies over time
...
e
...
This can
explain why countries involved in war will often finance large parts of the increased expenditure
through increased borrowing
...
Whenever the real interest rate on government debt exceeds the real growth rate this is
indeed the case, however if the real growth rate is higher than the real interest rate then there is a
greater level of flexibility and it may only be necessary to keep the primary budget balanced, or
possibly even run a small primary deficit if growth is very robust
...
This can push the tax rate
ever higher in order to raise the revenue required to pay the interest on accumulated debt
...

Deficit bias can occur for several reasons including political Myopia, Political Fragmentation and
occasionally strategic reasons
...
Some parties may believe it to be strategic to spend
now in order to prevent their opposition from having the same spending power when they are
elected
...
Debt targets and ceilings: By setting relatively permanent commitments on debt should act as
a constraint to day to day policy restrictions
...
Budgetary procedures: By making sure that the effects of fiscal policy are fully considered
before any measures are passed and sufficient time is given for due consideration then policy
may be more constrained
...
Delegation: Fiscal policy could be delegated to some independent body, similar to the central
bank
...

4
...




---