Advanced Lecture Notes for Hall and Taylor, Chapter 9

Course Instructor: Professor Leigh Tesfatsion
Email: tesfatsi@iastate.edu
Last Updated: 6 April 1996


HT9: Macroeconomic Policy---A First Look


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.