曼昆第10版讲义mankiw10e-irm-ch16

|CHAPTER16 AlternativePerspectivesonStabilizationPolicy

LectureNotes|

CHAPTER16

AlternativePerspectivesonStabilizationPolicy

NotestotheInstructor

ChapterSummary

Thischapterdiscussesissuesinmacroeconomicpolicy.AlthoughtheAD–ASmodelsuggeststhatstabilizationpolicyisbothdesirableandstraightforward,inpracticethebenefitsofstabilizationpolicyarelessclear,anditscomplicationsaremuchmoreevident.Thechapteraddressestwokeyquestions.First,shouldpolicymakerstrytostabilizetheeconomyorinsteadbecontentwithdoingnoharm?Andsecond,shouldpolicymakerscommittoaruleormakepolicydecisionsonacase-by-casebasis?Accordingly,thechapterframesitsdiscussionarounddebatesoveractiveversuspassivepolicyanddebatesoverrulesversusdiscretion.

Comments

Thematerialinthischaptercanbecoveredintwolectures.Thetaxonomysetupinthischaptermakesdiscussionofpolicyissuesveryclear,andasaresult,studentslikethismaterial.Iemphasizethatmanyeconomistsbelievethatthereisacaseinprincipleforstabilizingtheeconomybutthatpragmaticdifficultiesmayoverridethiscase.

Thematerialonthepoliticalbusinesscycleisparticularlystrikingtostudentsandobviouslycouldbegivenemphasisinelectionyears.ItmightalsobeworthreferringbacktoRayFair’sworkdiscussedinSupplement1-2.

UseoftheWebsite

Thisisthenaturaltimetodiscussthepresidentialpolicygameintheweb-basedsoftware.Notsurprisingly,studentsseemtolikethisgamealot.Aswellasbeingfun,itisintendedtoteachanumberoflessonsaboutthedifficultyofstabilizationandofhowexpansioncanbebeneficialintheshortrunbutcostlyinthelongrun.Instructorsmightalsochoose(atsomepoint)toexplaintothestudentsaboutthedetailsofthemodel,asexplainedinthedocumentation.

Attheriskofturningfunintowork,thegamecouldbeusedasabasisforhomeworkassignments—forexample,askingstudentstowriteanessayongoodandbadstrategies.Instructorscouldalsopolltheirclassestoseewhowasmostsuccessful(intermsofscoreand/orlengthinoffice)andfindoutwhatstrategytheyused.Itisalsointerestingtodiscusswhatisleftoutofthegame(open-economyconsiderations,forecastsoffutureshocks,elections,independentmonetaryandfiscalpolicymakers)andhowinclusionofthesefeaturesmightchangethings.

UseoftheEWebsite

GototheEwebsiteanddownloaddataforthepastthreeyearsontherateofconsumerpriceinflationfortheeuroarea,theUnitedKingdom,Canada,Australia,andNewZealand.Thesecountriesallhaveexplicitinflationtargetsthattheircentralbanksuseinsettingmonetarypolicy.Visitthecentralbankwebsitesofthesecountries(orseeSupplement16-16)tolearntheactualvalues(orranges)oftheirinflationtargets.Assesstheextenttowhichrecentinflationhasbeenaboveorbelowthetargetsforthesecountries.Incaseswherethetargetshavenotbeenachieved,discussanyunusualcircumstancesorpolicyreasonsthatmayhaveledtheseoutcomes.

ChapterSupplements

Thischapterincludesthefollowingsupplements:

16-1 MenuCosts,ImperfectCompetition,andtheWelfare-ImprovingEffectsofPolicy

16-2 ProfitSharingasanAutomaticStabilizer

16-3 LeadingIndicatorsinAction

16-4 ThePitfallsofForecasting(CaseStudy)

16-5 AreForecastersRational?(CaseStudy)

16-6 MicrofoundationsandAggregation

16-7 SpareaThoughtfortheEmpiricalMacroeconomist(CaseStudy)

16-8 TheResponsetoRomer(CaseStudy)

16-9 DistrustofPolicymakers

16-10 ThePoliticalBusinessCycle

16-11 ThePoliticalBusinessCycleatItsWorst

16-12 TheEconomyUnderDemocraticandRepublicanPresidents

16-13 PriceLevelVersusInflationTargeting

16-14 InflationTargeting(CaseStudy)

16-15 Central-BankIndependenceandGrowth(CaseStudy)

16-16 MeasuringCentral-BankIndependence(CaseStudy)

16-17 AdditionalReadings

LectureNotes

Introduction

Ourinterestinmacroeconomicphenomenaismotivatedbyadesiretounderstandnotonlythefunctioningoftheeconomybutalsohowmacroeconomicpoliciesaffecttheeconomy,withaviewtounderstanding,inturn,ifthereisaroleforgovernmentpoliciesdirectedatstabilization.Ultimately,wewishtoanswertwoquestions:Canthegovernmentimprovethefunctioningoftheeconomybypursuingactivestabilizationpolicies?Howshouldawell-designedeconomicpolicybeconducted?Bothareconsideredinthischapter.

Supplement16-1,“MenuCosts,ImperfectCompetition,andtheEconomicWelfare-ImprovingEffectsofPolicy”

Toanswerthesequestions,wefirstneedanswerstotwopriorquestions:Howwouldtheeconomyperformintheabsenceofstabilizationpolicies?Howdogovernmentpoliciesaffecttheoverallfunctioningoftheeconomy?Ouranalysistothispointprovidesanswers.Giventhatflexiblepricesareimportantfortheefficientallocationofresourcesintheeconomy,thepossibilityofpricestickinessintheshortrunsuggeststhatrecessionsandboomsmaybeasignalofinefficientmisallocationsofresources.Totheextentthatwebelievethatpricesandwagesmaynotbeperfectlyflexibleintheshortrun,wehavesomereasontobelievethatawell-designedmacroeconomicpolicycouldimproveoveralleconomicwelfare.Theaggregatedemand–aggregatesupplymodel,meanwhile,explainsthatgovernmentpoliciesaffectthelevelofoutputintheeconomybyalteringaggregatedemand.Givenashort-runaggregatesupplycurve,shiftsinaggregatedemandaffectoutputandemployment.

16-1 ShouldPolicyBeActiveorPassive?

Theaggregatedemand–aggregatesupplymodelindicatesthat,inprinciple,policymakerscouldmanipulateaggregatedemandinordertostabilizetheeconomy.Despitesuchaconclusion,manyeconomistsdonotadvocateanactiveroleforgovernmentpolicy.

Newclassicaleconomistsbelievethatpricesandwagesareflexibleandusuallyarguethatstabilizationpolicyisinappropriate.Theybelievethatfluctuationsariseeitherasanefficientresponsetoshocks(thereal-business-cycleview)orasaresultoftheinformationproblemssummarizedintheimperfect-informationtheoryofshort-runaggregatesupply.Sincetheybelieveinpriceandwageflexibility,theirpresumptionisthatmarketsservetoallocategoodsefficiently.Therewillberoomforpolicymakerstostabilizetheeconomyonlyiftheyarebetterinformedaboutshockstotheeconomythanareindividualsintheeconomy.Ifindividualsknowasmuchabouttheshockshittingtheeconomyaspolicymakersdo,thentheycanformasgoodapredictionofaggregatedemandandhenceofthepricelevel.Thereisnowayforpolicymakerstoimproveeconomicperformanceunlesstheyhaveaninformationadvantage.

LagsintheImplementationandEffectsofPolicies

Ifpricesandwagesaresticky,asKeynesiansbelieve,thenthetheoreticalcaseforinterventionismuchstronger.Nevertheless,someproponentsofnewKeynesianideasarealsoskepticalaboutstabilizationpolicy.Inreality,theeconomyisnotaseasytoinfluenceasourmodelssuggest,andtherearemanypracticaldifficultiesassociatedwitheconomicstabilization.Economistspointinparticulartolagsinthepolicyprocess.

First,ittakestimetorecognizeandtakeactionstorespondtoshocksthathittheeconomy.Asjustnoted,ifpolicymakerscannotrecognizeshocksanymorequicklythanprivateindividualscan,thentheyhavenoscopeforstabilization.Evenafterashockhasbeenidentified,itmaytaketimetochangethecourseofmonetaryandfiscalpolicies.Thisisknownastheinsidelag.Itisrelativelymoreimportantforfiscalpolicythanformonetarypolicy,sinceachangeinmonetarypolicysimplyentailsadecisionbytheFederalReserve,whileachangeinfiscalpolicyrequiresagreementandactionbythecongressionalandexecutivebranchesofgovernment.

Second,thereisanoutsidelag,meaningthetimeittakesforpoliciestoaffecttheeconomy.Fiscalpoliciesaffectspendingandhenceaggregatedemanddirectly,andsodonothaveasignificantoutsidelag.Monetarypolicyhasalongoutsidelag,becausemonetarypoliciesaffectaggregatedemandthroughthemonetarytransmissionmechanism(wherebychangesinthemoneysupplyaffectinterestratesandthusinvestment).Thepresenceofinsideandoutsidelagsmakesactiveuseoffiscalandmonetarypoliciesimprecise.Buttheselagsdonotimplythatpolicyshouldremainpassiveinthepresenceofasevereandlengthyeconomiccontraction,suchasthedownturnthatbeganin2008.

Supplement16-2,“ProfitSharingasanAutomaticStabilizer”

SomefeaturesoftheeconomyhelpkeepGDPclosetothenaturalratewithoutdirectactionbypolicymakers.Whentheeconomyisinaboom,taxrevenuesincreaseandtransferpayments,suchasunemploymentinsuranceandotherwelfarebenefits,decrease.Theoppositeoccurswhentheeconomyisinrecession.Thus,taxesminustransfers(T)areprocyclical:Tautomaticallyincreasesinbooms(decreasingdisposableincome)anddecreasesinrecessions(increasingdisposableincome).Theseareknownasautomaticstabilizers.Intermsofourmodel,theyimplythatagivenshocktoaggregatedemandcausesasmallerchangeinGDPthanwouldbethecaseintheirabsence.

TheDifficultJobofEconomicForecasting

Afundamentaldifficultywithgoodpolicymakingisthatitdependsupontheabilitytoforecastfutureeconomicevents.Thelarge-scalemacroeconometricmodelsdiscussedinChapter12areofsomeusehere,sincetheyhelppredictthebehaviorofkeyeconomicvariables,givenassumptionsaboutthefuturebehaviorofexogenousvariables.Butmanyeventsthathaveasignificanteffectontheeconomy,suchasIraq’sinvasionofKuwaitin1990ortheattacksofSeptember11,2001,areinherentlyunpredictable.

Supplement16-3,“LeadingIndicatorsinAction”

TheIndexofLeadingEconomicIndicators,discussedinChapter10,providessomeinformationonthefutureperformanceoftheeconomy.Thisisasetof10dataseriesthathavehistoricallybeenagoodguidetofutureeconomicbehavior.

CaseStudy:MistakesinForecasting

Figure16-1

Supplement16-4,“ThePitfallsofForecasting”

Supplement16-5,“AreForecastersRational?”

ThedifficultyofeconomicforecastingiswellillustratedbasedonthefailureofforecasterstopredictwithanyaccuracyboththeGreatDepressionandthesevererecessionof2008–2009.AlmostallforecasterspredictedthatthepooreconomicperformanceatthestartoftheDepressionwouldbeshort-livedandthatrecoverywasimminent.Andintheearlystagesoftheeconomicdownturnof2008,forecasterspredictedarelativelymildslowdown,withunemploymentprojectedtoincreaseonlymodestly.Infact,theunemploymentraterosesharplyduring2008and2009.Forecastingisdifficultevenwhenwehaveagoodeconomicmodelbecauseoftheuncertaintyinpredictingthefuturebehaviorofexogenousvariables.

Ignorance,Expectations,andtheLucasCritique

TheeconomistRobertLucashascriticizedtheuseoftraditionaleconomicandeconometricmodelsfortheevaluationofeconomicpolicy.Lucas’spointisthatindividuals’behaviorandactions—andparticularlytheirexpectations—ingeneraldependuponthepolicieschosenbygovernment.Therefore,Lucasargues,itismisleadingtousestandardmodelsforpolicyevaluationunlesswetakeaccountoftheeffectsofpoliciesonexpectations.Forexample,iftheeconomyhasbeenexperiencingmoderateandfairlysteadyinflation,thenpeople’sinflationexpectationsmightbewellapproximatedbyadaptiveexpectations.ButiftheFedthenannouncedthatitwasgoingtostartincreasingthemoneysupplyby100percentperyear,thenindividualswouldcertainlyrevisetheirinflationexpectationsinlightofthisannouncement,andadaptiveexpectationswouldbeaveryunreliableguidetopeople’sbeliefs.

Supplement16-6,“MicrofoundationsandAggregation””

AnotherimplicationoftheLucascritiqueisthatweneedtobecarefultorecognizethatsomeofthebasicequationsofourmodelmightalsochangewhenpolicychanges.Forthisreason,manymacroeconomistsbelievethatitisimportanttopayattentiontothemicrofoundations—thatis,themicroeconomicunderpinnings—ofourmacroeconomicmodel.Thetextbookemphasizessuchmicrofoundationsatvarioustimes.Forexample,Chapter19showsthattheeffectsofataxcutonconsumptionaredifferentdependinguponwhetherindividualsexpectthetaxcuttobetemporaryorpermanent.

TheHistoricalRecord

Onewaytohelpdecideifpolicyshouldbeactiveorpassiveistotrytodeterminewhetherstabilizationpoliciesweresuccessfullypursuedinthepast.Macroeconomistsoftenlooktohistoricaldatatoanswerthisquestion.Casualexaminationofthedatasupportstheideathatstabilizationpoliciesworked.IntheperiodafterWorldWarII,policymakersusedtheinsightsofKeynesianeconomicsasabasisforactivedemandmanagement.ThedataonGDPandothervariablesindicatethatthisperiodwascharacterizedbylessseverefluctuationsthantheprewarperiod.Thisevidenceisnotconclusive,however.Itmayhavebeenthattheeconomywassimplynothitbysuchsevereshocks.Alternatively,thechangingcompositionoftheeconomymayhavelessenedtheimportanceofshocks.Forexample,supposethatthemostimportantshockstotheprewareconomywereweathershocksaffectingagriculturaloutput.ThenastheagriculturalsectorbecamerelativelylessimportantintheU.S.economy,suchshockswouldbelessrelevantforaggregatefluctuations.

OurpreviousdiscussionoftheGreatDepressionillustrateswhysuchanalysisisofteninconclusive.ThespendinghypothesisarguesthattheDepressionwascausedbyafallinconsumptionandinvestmentdemand,whichcouldhavebeencounteredbyexpansionarymonetaryandfiscalpolicies.ThemoneyhypothesisarguesthattheDepressionwascausedbybadlymanagedeconomicpolicymaking—inparticular,aseveremonetarycontraction—andsuggeststhatapassivepolicyofsteadymonetaryexpansioncouldhavelimiteditsseverity.

CaseStudy:IstheStabilizationoftheEconomyaFigmentoftheData?

Supplement16-7,“SpareaThoughtfortheEmpiricalMacroeconomist”

Supplement16-8,“TheResponsetoRomer”

TheeconomistandeconomichistorianChristinaRomerhassuggestedthatitmaynotevenbetruethattheeconomyhasbeenmorestablesinceWorldWarII.Shenotesthattheeconomymaysimplyappearlessvolatileinrecentyearsasaresultofimproveddatacollection.Byattemptingtoacquirebetterolddataandbysubjectingmoremoderndatatothemethodsusedinconstructingolderdataseries,shedemonstratedthatatleastpartofthevolatilityofearlydataisanartifactofthemethodsusedtoconstructthosedata.Someofherworkevensuggeststhatthereisnoevidencethatthepostwareconomyismorestablethanpreviously.Othereconomichistoriansdisputedthisclaim.ThecurrentconsensusappearstobethatRomerisrighttoattributepartofthedifferenceinvolatilitytodataflaws,butthatthisdoesnotexplainallthedifference.

CaseStudy:HowDoesPolicyUncertaintyAffecttheEconomy?

Figure16-2

Recentresearchinvestigatestheeffectofpolicyuncertaintyoneconomicperformance.Theresearchersdevelopedanindexofpolicyuncertaintythathasthreecomponents.Onecomponentconsidersthenumberofarticlesinmajornewspapersduringagivenmonthwhichcontainthewordsuncertaintyoruncertain,economicoreconomy,andatleastoneofthefollowing:congress,legislation,whitehouse,regulation,federalreserve,ordeficit.Asecondcomponentconsidersthenumberoftemporaryprovisionsinthetaxcode.Theseprovisionsareoftenextendedatthelastminuteandsocreateuncertaintyinfinancialplanningforbusinessesandhouseholds.Athirdcomponentconsiderstheamountofdisagreementamongprivateforecastersconcerningthefuturepricelevelandthefutureamountofgovernmentspending.Moredisagreementamongforecastersistakenasevidenceofmoreuncertainty.

Theresearchersthenstudiedwhethertheindexwasassociatedwiththelevelofeconomicactivity.Theyfoundthathigheruncertaintyabouteconomicpolicytendstodepresstheeconomy.Whenpolicyuncertaintyrises,investment,production,andemploymentaremorelikelytodeclinerelativetotheirusualgrowthoverthenextyear.

Apossiblereasonforthiseffectmaybethatuncertaintyreducesaggregatedemandforgoodsandservices.Anincreaseinpolicyuncertaintymayleadfirmsandhouseholdstoputofflargepurchasesuntiltheuncertaintyhasbeenreducedoreliminated.Whilesomeamountofpolicyuncertaintyisunavoidable,someisunderpolicymakers’control.Reducingthepolicyuncertaintypolicymakerscontrolmayhavepayoffsinimprovedmacroeconomicperformance.

16-2 ShouldPolicyBeConductedbyRuleorDiscretion?

Evenifeconomistsagreeduponthedesirabilityofactivestabilizationpolicies,theywouldprobablystilldisagreeaboutexactlyhowpolicyshouldbeconducted.Onepossibilityisdiscretionarypolicy,wherebypolicymakersrespondtochangingeconomiccircumstances.Anotherpossibilityisapolicyrule,wherebypolicymakerscommitthemselvesinadvancetofollowaparticularpolicy.Atfirstsight,discretionarypolicymightseemthebetteroption,forhowcouldlimitationsontheconductofpolicyimproveeconomicoutcomes?Infact,thereareanumberofreasonsforfavoringpolicyrules.

DistrustofPolicymakersandthePoliticalProcess

Inpractice,thepoliciesenactedbygovernmentsneednotalwaysbethosethatarebestfortheeconomy.Theideaofawell-informed,benevolentpolicymakerchoosingmonetaryandfiscalpolicyvariablestostabilizetheeconomyisausefulfictionforouranalysis,butithardlydescribestherealitiesandcomplexitiesofthepoliticalprocess.Policymakersmaynotbewellinformed,sincegoodmacroeconomicanalysisisnoteasy.Andpolicymakersmaynotbebenevolent,butmayinsteadbeinterestedinmanipulatingtheeconomyfortheirownpoliticalends.Theideathatgovernmentsusemacroeconomicpolicytohelptheirreelectionchancesisknownasthepoliticalbusinesscycle.Underthesecircumstances,simplefixedrulesmaydotheleastharm.

TheTimeInconsistencyofDiscretionaryPolicy

Supplement16-9,“DistrustofPolicymakers”

Supplement16-10,“ThePoliticalBusinessCycle”

Supplement16-11,“ThePoliticalBusinessCycleatItsWorst”

Timeinconsistencyprovidesalesspragmaticbutperhapsmoreintriguingargumentforfavoringrulesoverdiscretion.Theinsightisthatpolicymakersmaywanttochangetheirmindsabouttheappropriatepoliciestopursue,givingthemanincentivetorenegeonpreviouspolicyannouncements.Individualswillunderstandthisincentiveandsowillnotbelievetheoriginalannouncements.Policymakers’incentivetodeviatefromannouncedpolicies,inotherwords,causesthoseannouncementstonotbecredible.Afixed-policyrulemaybemorecredible,andsoultimatelybetter.

Supplement16-12,“TheEconomyUnderDemocraticandRepublicanPresidents”

WediscussedtheimportanceofcredibilitywhenweconsideredthepotentialforpainlessdisinflationinChapter14.Supposethattheeconomyisexperiencinghighinflationandunemployment.TheFederalReserve,inordertoreduceinflationaryexpectations,mightannounceatightmoneypolicy.Ifthisannouncementisbelieved,thenthePhillipscurveteachesusthatinflationwillfall.ButtheFedthenhasanincentivetocheat—thatis,toengineeranunexpectedincreaseinthemoneysupplyinordertobringunemploymentdown.If,asaconsequence,individualsfailtobelievetheFed’sannouncement,theninflationaryexpectationsandhenceinflationwillnotfallafterall.

CaseStudy:AlexanderHamiltonVersusTimeInconsistency

Chapter16appendix

Intheprocessofachievingindependence,theUnitedStatesincurredasubstantialpublicdebt.TheSecretaryoftheTreasury,AlexanderHamilton,stronglyopposedsuggestionsthatthegovernmentdefaultonitsdebtsinordertoavoidlevyingtaxestopaythemoff.Suchapolicywastemptingatthetime,butitwouldhavecertainlymeantthatthegovernmentwouldhavefounditverydifficulttoborrowinthefuture.Thedecisiontohonorthegovernmentdebtcouldbethoughtofasaninvestmentincredibility.

RulesforMonetaryPolicy

Variousrulesformonetarypolicyhavebeenproposed.PerhapsthesimplestandmostfamousisMiltonFriedman’smonetaristviewthatthegrowthrateofthemoneysupplyshouldbekeptconstant.Theargumentforsucharuleisthatchangesinthemoneysupplymaybeacauseoffluctuations(as,forexample,inthemoney-hypothesisexplanationoftheGreatDepression).Ifthevelocityofmoneyisconstant,thenstablemoneygrowthwillavoidoutputfluctuations.Ifvelocityisunstable,though,suchapolicywillnotleadtostableoutput.EconomistswhobelievethatthevelocityofmoneyispronetovariationoftenadvocatenominalGDPtargetinginstead.Inthiscase,theFedmanipulatesthemoneysupplytotrytokeepnominalGDPonsomeannouncedpath.Athirdpossiblepolicyruleisaninflationtarget.Inthiscase,theFedadjustsmonetarypolicyinanattempttomaintainsomeannouncedtargetforinflation.

Supplement16-13,“PriceLevelVersusInflationTargeting”

Allthesepoliciesareexpressedintermsofnominalvariables.Whilerealvariablesultimatelyareabettermeasureofeconomicwelfare,thereisadangerindirectingmonetarypolicytowardrealvariables.SupposethattheFedismisinformedandbelievesthenaturalrateofunemploymenttobelowerthanitactuallyis.SupposealsothattheFedusesmonetarypolicyinanattempttokeepunemploymentatthisincorrectlevel.Ifunemploymentisatthetruenaturalrate,theFedwillincreasethemoneysupply.ThePhillipscurvetellsusthatthiswouldleadtolowerunemploymentandhigher(demand-pull)inflationintheshortrun.Overtime,expectedinflationrisesandtheeconomyreturnstothenaturalrate.This,inturn,inducestheFedtoinflatefurther.Theconsequencewillbeever-increasinginflation.Targetingnominalvariablesavoidssuchproblems.

CaseStudy:InflationTargeting:RuleorConstrainedDiscretion?

Supplement16-14,“InflationTargeting”

Inflationtargeting,whichstartedtobecomeapopularpolicyobjectiveforcentralbanksinthelate1980s,isnotastrictcommitmenttoapolicyrule.Inflationtargetsareusuallyarange(e.g.,1to3percent),leavingcentralbankswithafairamountofdiscretion.Inaddition,inthefaceoftemporaryshocks,inflationisallowedtodeviatefromthetargetrangewithoutinvokingactionbythecentralbank.Evenwithsuchflexibility,inflationtargetingincreasesthetransparencyofmonetarypolicyandmakesiteasierforthepublictojudgethecentralbank’sperformance.

TheFederalReservewasalatecomerinadoptingapolicyofinflationtargeting.Notuntil2012didtheFedsetaninflationtargetof2percent.Inexplainingitsreasoningforadoptingatarget,theFedarguedthatarateof2percentwasconsistentwithitsmandateforpricestabilityandmaximumemployment.TheFednotedthatahigherrateriskedhinderingthepublic’sabilitytomakeaccurateeconomicandfinancialdecisions,andthatalowerrateincreasedthechanceofdeflation.

Someeconomistshaverecentlyquestionedwhether2percentistheoptimaltargetforinflation.AftertheGreatRecessionof2008–2009,theFedkeptthefederalfundsrateatitslowerboundofzeroandonlygraduallyraisedittoastillhistoricallylowlevelof1.25by2017.TheseeconomistsfearthattheFedwillnothavemuchleewaytoreduceinterestratestostimulateaggregatedemandiftheeconomywerehitbyacontractionaryshock.TheyarguethatiftheFedsetahighertargetforinflation,perhaps4percent,thenthenormallevelofinterestrateswouldbehigher,andtheFedwouldhavemoreroomtooffsetarecession.Butproponentsofthecurrent2percentinflationtargetarguetheFedwouldlosecredibilityifitswitchedafterspendingsomucheffortsignalingitscommitmenttoa2percenttarget.

CaseStudy:Central-BankIndependence

Figure16-3

Supplement16-15,“CentralBankIndependenceandGrowth”

Supplement16-16,“MeasuringCentralBankIndependence”

Countriesvaryinthedegreetowhichtheircentralbanksareindependentfromthegovernment.Forexample,insomecountriesthecentralbankisunderthejurisdictionofthefinanceortreasurydepartmentwhileinothercountriesthecentralbankisseparatefromthegovernment.

Researchershavestudiedtherelationshipbetweenthedegreeofindependenceofacountry’scentralbankandtheperformanceofthemacroeconomy.Akeyfindingisthatcountrieswithmore-independentcentralbankshaveloweraverageinflationrates.Furthermore,thislowerinflationratedoesnotcomeatthepriceoflowerormorevolatilegrowth.Thesefindingshaveledsomecountriestopasslegislationincreasingthedegreeofindependenceoftheircentralbanks.

16-3 Conclusion

Thebestandmostcarefuleconomistsareawareofthelimitationsofourunderstandingofthemacroeconomyandarecorrespondinglycautiousaboutgivingadvice.Butanimperfectunderstandingisbetterthannounderstandingatall,andsoeconomistscannotabdicateresponsibilityforthedesignofmacroeconomicpolicy.Ifpolicyisnotformulatedonthebasisofourbestknowledgeoftheeconomy,thenitwillbedesignedinsteadonthebasisofalesserunderstanding.

Appendix:TimeInconsistencyandtheTradeoffBetweenInflationandUnemployment

Thisappendixcontainsananalytictreatmentofthetime-inconsistencyproblem.SupposethattheFed’spreferencesoverinflationandunemploymentcanberepresentedbythelossfunction

L(u,π)=u+γπ2.

TheFedlikesinflationtobeasclosetozeroaspossibleandalsolikesunemploymenttobeaslowaspossible,sotheFedwantstominimizethisfunction.Forsimplicity,wesupposethattheFedcansimplychoosetheinflationrate.ThebehavioroftheeconomyintheshortrunisdescribedbyaPhillipscurve,

u=un–α(π–Eπ).

Giventhepublic’sexpectationsofinflation(Eπ),theFedchoosesπsoastominimizethelossfunction.Wecanbeshow(bysubstitutingforuinthelossfunctionandusingcalculustominimizetheloss)thattheFedwillalwayschoose

π=α/(2γ).

Butifthepublichasrationalexpectations,itwillanticipatetheFed’s