Basic References: Hall and Taylor, Chapter 9; Study Guide, Chapter 9; In chapter 9, HT take a systematic look at the formulation and evaluation of monetary and fiscal policy with the objective of improving the performance of the economy. They will be particularly concerned with appropriate policy responses to shocks to aggregate demand and to the general price level. An economy is said to be #stable# if, starting from a position of internal balance, and subjected suddenly to some kind of shock, the economy tends to return to a position of internal balance without the need for fiscal or monetary policy intervention. Even if an economy is believed to be stable, the expected time for the economy to return to internal balance may be deemed "too long" by policy makers if the adjustment process entails significant economic and/or political costs. In this case, policy makers may wish to undertake a policy intervention to speed up the adjustment process. More generally, policy makers may not believe that the economy is stable, and they may believe that policy intervention is necessary to ensure a return to internal balance. Briefly put -- as a caricature that nevertheless carries the ring of truth -- a belief in the natural stability of the U.S. economy is characteristic of many Republicans. In contrast, Democrats tend to believe that the U.S. economy is capable of becoming stuck at positions of high unemployment for unacceptably long periods of time, so that maintaining internal balance requires active monetary and fiscal policy intervention in the economy. 9.1 Shocks to the Economy Shocks to an economy can arise from a variety of sources. Macroeconomists generally classify shocks into "demand shocks" (shocks to aggregate demand), "supply shocks" (shocks to potential GDP), and "price shocks" (shocks to the general price level). In HT9, Hall and Taylor focus on demand shocks and price shocks; supply shocks were considered in HT4. An #aggregate demand shock# in period T is any unanticipated period T event that displaces the period T aggregate demand curve. By construction, such a change in the aggregate demand curve can only occur if some displacement takes place in the IS curve and/or the LM curve other than a displacement of the LM curve due to a change in the general price level P(T). For example, a change might occur in household tastes for HC or ROW goods, leading to shifts in the coefficients appearing in the consumption function, the money demand function, or the net export demand function. [See HT Figures 9-1, 9-2] A #price shock# in period T is any unanticipated period T event that changes the period T predetermined price level P(T). [See HT Figure 9-3] The HT8 IS-LM model permits users to trace out the successive dynamic movements of key economic variables in response to an aggregate demand shock or a price shock, and to investigate the extent to which alternative monetary and fiscal policies can offset the effects of such shocks. 9.2 Policy Response to Aggregate Demand Shocks Most economists agree with the goal of maintaining as robust a rate of potential GDP growth as possible consistent with minimal unemployment (actual GDP Y close to potential GDP Y*) and a reasonably stable price level. Nevertheless, they differ strongly on the appropriate #means# for achieving this goal. "Keynesian" economists such as James Tobin believe that government needs to employ #countercyclical (or activist) stabilization policy# to counter aggregate demand shocks to the economy that otherwise would cause unacceptably large cyclical fluctuations in real GDP about potential GDP and/or a volatile price level. In particular, Keynesian economists believe that aggregate demand shocks can be offset by an appropriate mix of monetary and fiscal policy, and that such activist intervention is sometimes necessary to prevent the economy from becoming stuck in a situation of low employment and/or high inflation for unacceptably long periods of time. Note that the HT8 IS-LM model is consistent with this latter claim, in the sense that the modelled economy can be unstable under some settings of the exogenous variables. On the other hand, "monetarist" economists such as Milton Friedman believe that the economy is inherently stable. That is, they believe that actual GDP will automatically adjust back to potential GDP after an aggregate demand shock as long as market forces are allowed to work---that is, as long as prices are permitted to adjust freely in response to excess demand and supply. Activist monetary or fiscal policy is not needed. Indeed, monetarist economists believe that attempts in the past to use activist monetary policy for stabilization purposes have actually been harmful. They argue that the impact of monetary policy occurs with a variable and uncertain lag, so that monetary stimulus often takes hold too late and serves only to #increase# the extent of the fluctuations in real GDP and the price level. Moreover, the only ultimate effect of changes in the money supply is on inflation, so the supposed cure can be more costly than the disease itself. To illustrate the type of situation that monetarists fear, consider what happens if government attempts to use the money supply M to stabilize real GDP around some target path that, by mistake, is set #higher# than the path of potential real GDP. Suppose the price adjustment relation is given by the following simple expectations-augmented Phillips curve in which the expected inflation rate from T to T+1 is the actual inflation rate from T-1 to T: (1) INF(T,T+1) = INF(T-1,T) + f[Y(T) - Y*(T)]/Y*(T) . Then, if Y(T) is maintained at some target level Y^o(T) above Y*(T) in each period T, inflation will continually #accelerate#. That is, not only will prices continually increase---they will also increase at a faster and faster pace. This is the "natural rate property" discussed in HT8. [See HT Figures 9-4 and 9-5] 9.3 Policy Response to Price Adjustment Shocks The HT8 IS-LM model yields the Keynesian prediction that the effects of aggregate demand shocks on real GDP and the price level can be offset by an appropriate mix of monetary and fiscal policy. However, this model also predicts that the effects of price shocks cannot be entirely offset. For example, suppose an economy is currently in internal balance with Y(T) equal to Y*(T) and with the price level equal to P(T). Suppose a price shock suddenly raises the price level to some higher level P'(T), which shifts the LM curve to the left. Assuming no policy intervention is undertaken, a new IS-LM equilibrium then results at some point (Y'(T),R'(T)) for which Y'(T) is less than Y*(T), implying that a negative GDP gap opens up. Prices would then tend to fall back to their original level, but this would only occur after a length of time during which the economy would suffer a recession and unemployment. Now suppose, instead, that government intervenes to prevent the initial price shock from leading to a fall in real GDP and employment, even in the short run. In particular, suppose government quickly steps in and increases the money supply from M to some higher level M', which puts downward pressure on the LM curve and thus works to offset the negative effects of the price shock on real GDP. A sufficiently large setting for M' could in principle prevent any negative GDP gap from arising, even in the short run. Unfortunately, this "monetary accommodation" means that the price level will not drop back to its original level P(T) but rather will be maintained at or near the new higher level P'(T). Thus, with price shocks, there is a trade-off between maintenance of a stable price level and maintenance of a stable level of real GDP. [See HT Figure 9-6 and 9-7] 9.4 Monetary Policy as a Rule A #policy rule# is a function that specifies a particular setting for a policy variable for each possible state of the economy. In particular, a #monetary policy rule# is a function that specifies a particular setting for the level or growth rate of the money supply for each possible state of the economy. For example, a monetary policy rule might specify that the growth rate of the money supply is to be set at 2 percent in the current period if actual GDP was greater than potential GDP in the previous period and at 4 percent in the current period if actual GDP was less than potential GDP in the previous period. Alternatively, the rule might specify that the growth rate of the money supply should be set at the constant rate of 3 percent for all possible states of the economy. The latter type of "fixed monetary policy rule" is advocated by monetarists such as Milton Friedman on the grounds that it reduces the uncertainty of private agents regarding the effects of monetary policy. In the HT8 IS-LM model, it is assumed that the money supply is set equal to an exogenously given target level M regardless of the state of the economy. In contrast, when the target level or target growth rate of the money supply is set in response to economic conditions, this target level or target growth rate becomes an endogenous variable of the system. We saw an example of this type of "endogenization" of the money supply in the MacroSolve exercise assigned for the last exercise set, where the money supply was set to accommodate an increase in government spending so as to keep the interest rate constant over time. We saw in that exercise that the #effective# government spending multiplier with monetary accommodation was much larger than the government spending multiplier in the absence of monetary accommodation. Similarly, with accommodative monetary policy in response to price shocks, the #effective# aggregate demand curve is steeper than the actual aggregate demand curve. [See HT Figure 9-8] In recent years, a growing number of economists have agreed with monetarists and rational expectations theorists that government ought to set its policy variables in accordance with publicly announced policy rules. In this way government would be committing itself to a predictable course of behavior, thus reducing the uncertainty of the private sector regarding the effects of government policy. 9.5 Policy Possibilities for Reducing the Rate of Inflation #Disinflation# means that inflation rate is decreasing over time: that is, INF(T,T+1) is less than INF(T-1,T), where T is the current period. Thus, disinflation is a statement about the rate of change of the inflation rate; but it does #not# restrict the #sign# of the inflation rate, which can be positive or negative. For example, an economy with a positive inflation rate is undergoing disinflation if the rate at which the price level is increasing is slowing down over time: In contrast, recall that #deflation# means that the inflation rate is negative, implying that the price level is decreasing. Consider the following simple expectations-augmented Phillips Curve in which the expected inflation rate is taken to be last period's actual inflation rate and potential GDP is taken to be a constant level Y* over time: (2) INF(T,T+1) = INF(T-1,T) + f[Y(T) - Y*]/Y* . Given (2), the #only# way to have disinflation is to have actual GDP Y(T) drop #below# potential GDP Y*---that is, to have a recession. The essential question is therefore #not# whether a recession is inevitable in order to generate disinflation---it is---but rather how long and how deep must the recession be. #Alternative Disinflation Paths# Suppose the economy in some period 0 is in an internal balance E* with a #positive# inflation rate INF(-1,0) = 10. This is the initial situation considered by Hall and Taylor in their discussion of alternative disinflation rates---see Table 9-1. But how could the economy be in internal balance with a #positive# inflation rate? To maintain the internal balance at E*, the LM curve must remain stable, implying that the real money supply M/P is constant over time. But a positive inflation rate means the price level is increasing. Consequently, government must be "accommodating" the inflation rate by continually increasing M. For example, suppose P(T+1) = [1+10]P(T), T = -1, 0, 1, ... , implying that the inflation rate INF(T,T+1) is 10 in each period T. And suppose the government sets the money supply in accordance with the policy rule M(T+1) = [1+10]M(T), T = -1, 0,1,2,... , implying that the money supply growth rate is equal to the inflation rate, i.e., M(T+1)-M(T) ----------- = 10 = INF(T,T+1). M(T) Then M(T+1) M(T) M(-1) ------- = ------ = ... = ------- , P(T+1) P(T) P(-1) i.e., real money balances are constant over time. Moreover, by the price adjustment relation, the zero real GDP gap at E* implies that INF^e(-1,0) = INF(-1,0), i.e., the inflation rate from period -1 to 0 is correctly anticipated. Consequently, to wring inflation out of the economy, the goverment must engineer a #negative# real GDP gap. One way to do this is simply to #reduce# the #growth rate# of the money supply below the inflation rate. In this case, the real money supply M/P would begin to #fall# and the LM curve would shift up. This opens up a negative real GDP gap, which in turn leads to disinflation, assuming relation (2). The extent and timing of the cut in the growth rate of M/P then determines how quickly disinflation takes place. NOTE: In the real world, the growth rate of the money supply tends to be positive to accommodate a growing population's transactions needs, if for no other reason. Thus, monetary policy is often said to be #contractionary# or #tight# if it implies a reduction in the #growth rate# of the money supply, even if the #level# of the money supply is not itself reduced. More generally: Expansionary (looser) fiscal policy = increase in G or in transfers, or a decrease in tax rates, or in their growth rates Expansionary (looser) monetary policy = increase in the money supply, or in the growth rate of the money supply Contractionary (tighter) fiscal policy = decrease in G or in transfers, or an increase in tax rates, or in their growth rates Contractionary (tighter) monetary policy = decrease in the money supply or in the growth rate of the money supply Hall and Taylor consider two alternative possibilities for bringing down inflation by engineering a negative GDP gap: a) Engineer a #modestly# negative GDP gap in period 0, and maintain it over a long time to bring down the inflation rate. b) Engineer a sharply negative GDP gap in period 0 by sharply reducing the growth rate of M, followed by a return to a higher, more "reasonable" growth rate for M in the near future. [Note that this does not reduce the inflation rate to zero.] Inflation is lowered much more quickly using the latter alternative, but of course the magnitude of the negative real GDP gap is greater. [See HT Figures 9-11A, 9-11B, and 9-12] Short-Run Policy Impacts for Given Price Level P: Expansionary fiscal policy stimulates spending #directly#, which causes the interest rate to #rise#. Investment and net exports are then depressed (crowding out). In contrast, monetary expansion #lowers# the interest rate. Investment and net exports then increase, which increases GDP and consumption through the multiplier effect. Thus, both fiscal and monetary policy can be used to affect real GDP and the price level in the short run, but they have opposite impacts on the interest rate. Fiscal expansion #discourages# investment and net exports whereas monetary expansion #favors# investment and net exports. The reverse is true in the case of contractionary policy: Long-Run Policy Impacts With Price Adjustment: In the long-run, #assuming that Y* does not change#, a one-time increase in the money supply M^o simply leads to a higher price level at the same level of real GDP Y* and the same interest rate R* as before the increase. In the long-run, #assuming that Y* does not change#, a one-time increase in government expenditure G^o leads to a higher price level at the same level of GDP Y* as before, but at a #higher# interest rate R. Thus the increase in G^o replaces ("crowds out") private investment and net export expenditures. Question: What is the long-run impact on potential GDP of an increase in M^o or in G^o, assuming Y*(T) can change over time? As we saw in HT4, potential GDP Y*(T) for any period T is a function F(N*,K(T),A(T)) of the potential employment level N*(T), the current capital stock K(T), and the current level of technology A(T). Thus, Y*(T) will change in response to a change in government policy if and only if that policy affects N*(T), K(T), or A(T). Since the increase in G^o leads to a #higher# interest rate R, the level I(T) of (gross) investment that results will be lower than it otherwise would have been. But, by equation (10) in the HT8 IS-LM model, K(T+1) = K(T) + I(T) - xK(T) , where xK(T) denotes depreciation expenditure. [In particular, note that all investment spending in the economy comes from the private sector; all government outlays are assumed to consist entirely of consumption spending or transfers.] Consequently, the capital stock K(T+1) for the next period T+1 will be lower than it otherwise would have been, implying that potential GDP in period T+1 will also be lower than it otherwise would have been. The increase in M^o eventually leads to an increase in prices, but in the interim the interest rate is #lowered#, which encourages investment. Thus, the degree of impact on potential GDP will depend on the speed with which the price level adjusts. Only with instantaneous perfectly flexible prices will there be no impact on investment and hence no long-run impact on potential GDP.