LECTURE 9 Limits to stabilization policies

1. LECTURE 9Limits to stabilization policies Øystein Børsum 14th March 2006

2. Overview of forthcoming lectures • Lecture 9: Limits to stabilization policies • Rational expectations and the Policy Ineffectiveness Proposition, the Ricardian Equivalence Theorem and the Lucas Critique • Real business cycles • Policy rules versus discretion: Credibility of economic policy • Lecture 10: Open economy • Features of a small, open economy with perfect capital mobility • Aggregate demand and aggregate supply in the open economy • Long-term macroeconomic equilibrium in the open economy • Lecture 11 and 12: Fixed and floating exchange rate regimes (Prof. Nymoen) • Macroeconomic policy under a fixed exchange rate regime • Macroeconomic policy under a floating exchange rate regime and inflation targeting

3. Overview of issues limiting stabilization policies • Possible consequences of rational expectations: • Monetary policy may be ineffective (Policy Ineffectiveness Proposition) • Tax policy may be ineffective (Ricardian Equivalence Theorem) • Past behavior of economic agents can be a poor guide for assessing the effects of policy changes (Lucas’ critique) • Real business cycle theory demonstrates that business cycle fluctuations can be reproduced in a model with market clearing and a context that is consistent with rational expectations. The new source of fluctuations is shocks to production technology • If economic policy is not credible and expectations are rational, you can achieve better outcomes with rules-based policy than with discretionary (flexible) policy

4. PART 1Rational expectations

5. What is the appropriate assumption about expectations? • So far: Backwards-looking expectations • Allows systematic forecasting errors: Economic agents can be systematically fooled by policy makers • This is hardly a solid foundation for policy analysis “You can fool all of the people some of the time; you can even fool some of the people all of the time, but you can’t fool all of the people all of the time.” (Lincoln) • Rational expectations hypothesis • Use all available information to make forecasts, including knowledge about the structure of the economy • Agents will be make forecast errors, but over time, forecasts will be unbiased • Model-consistent expectations

6. rt = r + h(te - *) + b(yte - y) t = te + (yt - y) + st yt - y = vt - (rt - r) Is there scope for economic policy if agents have rational expectations? • Suppose the central bank has no information advantage compared to other agents in the economy. • Monetary policy is based on expected values of y and  • Standard model with goods market equilibrium and aggregate supply • Assume for simplicity that the shock variables are identically and independently distributed over time, with zero mean and constant variances.

7. yt = y + vt - [h(te - *) + b(yte - y)] t = te - [h(te - *) + b(yte - y)] + vt + st Solving a model with rational expectations • Three-step procedure (cf. textbook) • Solve for the endogenous variables in terms of the exogenous variables (as usual) and the expectations of the endogenous variables • Calculate the expected value of the expressions in 1. Solve for the expected values of the endogenous variables • Insert the results from 2 into 1 • Here: Use the policy rule to substitute for rt - r in the equilibrium condition for the goods market • Use the expression above to substitute for yt - y in the equation for aggregate supply

8. yte = y - [h(te - *) + b(yte - y)] te = te - [h(te - *) + b(yte - y)] yt = y + vt - [h(te - *) + b(yte - y)] t = te - [h(te - *) + b(yte - y)] + vt + st h(te - *) = b(yte - y) yte = y te = * Calculate the expected values of the endogenous variables    

9. yt = y + vt The Policy Ineffectiveness Proposition • In the final solution, inflation and output are unaffected by the parameters of monetary policy • Why? • AS curve: Deviations in output only due to surprise inflation • Agents perfectly anticipate the effect of systematic monetary policy (the policy rule) on inflation • Surprise inflation cannot originate from systematic monetary policy, only from shocks to the economy • Note: Monetary policy does not observe the shocks in time to react to them t = * + vt + st

10. rt = r + h(t - *) + b(yt - y) yt - y = vt - (rt - r) t = te + (yt - y) + st Scope for economic policy under rational expectations given information advantage • Suppose the central bank has an information advantage compared to other agents in the economy • Monetary policy is based on actual values of y and  • Same standard model with goods market equilibrium and aggregate supply as in the previous example • And same assumption about the shock variables

11. vt - hst 1 + (b + h) yt = y + (1 + b)st +vt t = * + 1 + (b + h) The information advantage makes policy effective • Final solutions for output and inflation depend on the parameters of monetary policy • Why? • AS curve: Deviations in output only due to surprise inflation • Agents know the policy rule and can anticipate the monetary policy response to various shocks, but they do not observe the shocks • Monetary policy observes the shocks and can react to them • Monetary policy will create surprise inflation if that is the appropriate response to the shocks that hit the economy

12. Ricardian equivalence: Ineffectiveness of tax policy • Related to the ideas behind the Policy Ineffectiveness Proposition is the Ricardian Equivalence Theorem (sect. 16.3) • Consumers have rational (forward-looking) expectations about taxes: • They realize that a government tax cut today will necessitate a tax increase in the future (through the intertemporal government budget constraint given no changes in government expenditure) • Consumers experience increased income through the tax cut, but they decide to save it in order to pay the increased taxes in the future • Conclusion: No effect on today’s consumption from a tax cut

13. The Lucas’ critique: Be cautious about historical econometric relationships • The Lucas’ critique is about the stability of econometric relationships: After a policy change, historical econometric relationships may no longer be valid because economic agents change their behavior • Implication for policy makers: Past behavior of economic agents can be a poor guide for assessing the effects of policy changes • Lucas: Should estimate parameters that are invariant to changes in government policy rules (so-called “deep” parameters) such as tastes or technology

14. PART 2Real business cycles

15. Overview of real business cycles theory • Our AS-AD model of the business cycle: • Expectational errors and sluggish price adjustment played key roles • The model assigned an important role to demand shocks • Business fluctuations were associated with fluctuations in involuntary unemployment (cf. microfoundations of the SRAS curve) • Real business cycle theory (basic version): • To explain business cycles, there is no need to postulate nominal and/or real rigidities, backwards-looking expectations or sluggish adjustment • The business cycle could be driven mainly by fluctuations in the rate of productivity growth (a form of supply shock) • The employment fluctuations observed during business cycles reflect voluntary movements in individual labor supply (intertemporal substitution in labor supply, no involuntary unemployment)

16. In the simple RBC model, the production-side resembles a basic growth model • Assume that the production-side of the economy can be described as: • Production function: • Labor productivity: • Trend productivity: • Capital accumulation: ~ where In other words: Stochastic, autoregressive shocks to labor productivity

17. In the simple RBC model, there is market clearing in every period (including the labor market) • Arbitrage • Saving (= investments): • Labor supply: • Profit maximization: • Trend real wage: • Labor market clearing:

18. The solution to the simple RBC model is a ADL model • As shown in the textbook (pages 585-86) the solution to this model is: • Source of impulse in the model: A positive productivity shock raises wages, labor supply and output (income) • Propagation mechanism in the model: Higher output raises savings (investments), thereby increasing the capital stock in the next period. Higher capital stock raises next period’s output (income), thereby raising savings, and so on… • Labor supply in the model:

19. The simple RBC model fits the U.S. economy quite well, except it generates too high persistence Source of data: Economic Outlook Database (OECD) 1. α = 0.33, η = 0.83, ω = 0.1, σc = 0.015 2. Annual data for the business sector Note: The cyclical components of output and employment have been estimated via linear OLS detrending of annual data

20. Some problems with the basic RBC theory • Is technological progress really so time-varying as postulated in the RBC model? • Is it really plausible that recessions are periods of technological regress? • Do the observed fluctuations in employment really reflect intertemporal substitution in labor supply? More generally: Is all recorded unemployment really voluntary? • The RBC model predicts that the real wage is procyclical. This is in line with U.S. data, but not consistent with European data. • Response: Real business cycle theorists have tried to make their models more realistic by allowing for various frictions and rigidities, including (in some cases) nominal rigidities.

21. The most influential contribution of real business cycle theory is methodological • At the methodological level, RBC theorists have made a lasting contribution by pointing out that: • Supply shocks may play an important part in the explanation of business cycles • A satisfactory theory of the business cycle should consist of a dynamic stochastic general equilibrium model which is able to reproduce the most important stylized facts of the business cycle • The Nobel committee on Kydland and Prescott’s business cycle models: • “The Laureates laid the groundwork for more robust models by regarding business cycles as the collective outcome of countless forward-looking decisions made by individual households and firms regarding consumption, investments, labor supply, etc. Kydland and Prescott's methods have been widely adopted in modern macroeconomics.”

22. PART 3Rules versus discretion

23. Policy rules versus discretion: a credibility problem • Discretionary policy: Policy makers react in an ad-hoc manner to the specific circumstances of the situation, using all relevant available information • Intuitive advantage of discretionary policy: Flexibility to adopt the optimal policy at all times • Seminal article: Kydland and Prescott (1977) “Rules rather than discretion: The inconsistency of optimal plans” • Conclusion: Under plausible conditions, the government may achieve better results by committing to follow a rule for monetary policy • Provides a rationale for explicit inflation targets

24. yt - y = - (rt - r) t = te + (yt - y) y* = y +  The setup is a standard AS-AD model where the government wishes to increase y above y • Assume a simplified standard AS-AD model setup without shocks • Monetary policy tries to minimize a social loss function • Assume that the socially optimal level of output is above the trend level of output SLt = (yt - y*)2 + t2  SLt = (t - te - )2 + t2

25. rt = r + ht + b(yt - y) t = te = * = 0 and yt = y The Taylor rule is a benchmark for the performance of discretionary policy • Suppose the central bank follows a Taylor rule with an inflation target equal to zero and no attempt to increase output above its trend value • The solution to this model is • The social loss under the Taylor rule is only due to  SLR = 2

26. Incentives for discretionary monetary policy to disregard the inflation target • Suppose the central bank announces that it will stick to an inflation target * = 0 (as in the benchmark case with the Taylor rule) and the public believes it (te = 0) • What is optimal policy given these inflation expectations? • At zero inflation, output is at y. A small increase in inflation would: • Give a small increase in the social loss from inflation (small because inflation is at its optimal level) • Give a large decrease in the social loss from output (large because output is far – the distance is  – from its optimal level • Conclusion: A small increase in inflation would be desirable. The discretionary central bank will not want to stick to its promise ( = * = 0)

27. dSLt / dt= 0  2(t - te - ) + 2t = 0  t = > 0 and yt = y +   1 +  1 +  1 +  SLC = 2 - < SLR Optimal monetary policy with given inflation expectations • Minimize the social loss function in order to find the optimal level of inflation for the central bank (with given inflation expectations te) • If te = 0 then the solution would be • The social loss is

28.   te - te -  + te = 0 te =    t = te= and yt = y 1 +   SLD = 2 + > SLR In the time-consistent rational expectations equilibrium, the social loss is higher • Rational expectations about inflation must be consistent with the central bank’s optimality condition for monetary policy: • Rational expectations: • Given this expected inflation, the solution and the social loss are 2(t - te - ) + 2t = 0

29. Illustration of the different model equilibriums

30. Central bank independence coupled with rules and/or reputation cures the inflation bias • Delegating monetary policy to the central bank keeps it at a distance from political incentives • Instrument independence is common (operational indep.) • Goal independence is more rare • Building reputation • Repeated games: If the central bank can only brake its promise once, the incentive to stick to the inflation target is increased • Choose a “hawkish” central bank governor (tough on inflation)