Lecture 14: Policy II – Domestic and International Policy Rules

Lower Bedrock

The panel of economists from Lower Bedrock apologized for not having much to discuss. Their inflation rate was quite low, and their unemployment rate was relatively close to the natural rate. Thus, they had no short turn economic problems. However, candor compelled them to admit that the difference between Lower Bedrock and their neighbors was luck. They wanted to take advantage of their good fortune to focus on what kind of policy rules they should adopt to prevent – or at least reduce – the likelihood of them having similar problems in the future.

At the outset, they agreed that there were important lessons to learn from the experience of Russia and the Pacific Rim. If they mismanaged the basics of the economy, they would have trouble. They wanted to concentrate on the narrower question of stabilizing output and prices.

Their problem was simple. Lower Bedrock had just selected a new head of its Central Bank, who faced a number of problems: how to redecorate his office? What will be the menu in the private dining room? However, the new central banker also faced a more important and more serious policy: managing monetary policy. Three questions had been raised:

· Some of his advisors were arguing for a discretionary monetary policy, to keep aggregate demand and long run aggregate supply in Balance. Others were arguing against a discretionary monetary policy, and instead for a non-intervention policy.

· Questions had been raised about the actual status of the Central Bank. Some were proposing that it be abolished or substantially restructured.

· The Central Bank also had responsibility for international monetary policy, and the head wanted to look at some options.

Domestic Monetary Policy

The basic issue underlying the policy debate was quite simple. Thanks to new technology, capital accumulation and population growth, aggregate supply continued to grow each year in Lower Bedrock. In theory, aggregate demand should grow at the same rate. In practice, there was always some slippage. In some years, aggregate demand would be less than aggregate supply; in yet other years aggregate demand would be more than aggregate supply. Figure 14-1 shows the possibilities.

In the first case, the Central Bank can increase the money supply and move the aggregate demand curve to the left. In the second case, it can decrease the money supply and move the aggregate demand curve to the right.

Figure 14-1 Aggregate Supply and Demand out of Balance
P	AD ASSR ASLR Y	ASSR AD ASLR Y
	Aggregate demand is less than aggregate supply. The unemployment rate will be higher than the natural rate	Aggregate demand is greater than aggregate supply. The unemployment rate will be lower than the natural rate

This is essentially the policy followed in the United States by the Federal Reserve System. Most discussions of monetary policy are generally in terms of what the Federal Reserve System should do now, and in terms of loose or tight monetary policy.

· The Federal Reserve System is following a loose monetary policy if it increases the growth rate of the monetary base or some broader measure such as M₁ or M₂. (Sometimes people talk about a loose monetary policy as one that decreases the federal funds rate.)

· The Federal Reserve System is following a tight monetary policy if it decreases the growth rate of the monetary base or some broader measure such as M₁ or M₂. (Sometimes people talk about a tight monetary policy as one that increases the federal funds rate.)

Policy Rules

The central bank has essentially three choices

· A Simple Policy Rule

· A Discretionary Policy Rule

· A Contingent Policy Rule

Simple Policy Rules

A simple rule, is something like:

Conduct open market operations so that M₁ grows by five percent per year.

There would be arguments about what the right rule is. Many people, for instance, would want a role to stabilize the rate of growth of M₂ at around four percent a year. That qualification aside, the automatic nature would appeal to non-interventionists. Another way of stating this rule is:

Adopt a long-term policy for the money supply. If it turns out that
aggregate demand and aggregate supply are not in balance,
wait for the normal adjustment policies to take effect.

Discretionary Monetary Policy Rules

In the United States, as in most major countries, its central bank, the Federal Reserve System, follows a very simple discretionary policy rule:

We will do what we think best. We will set monetary policy according
to "economic conditions"

Many years ago, the Federal Reserve System conducted discretionary monetary policy in secrecy. The Federal Open Market Committee met in secret and never announced what policy decisions it had taken. A whole generation of "Fed Watchers" grew up who attempted to figure out what the Federal Reserve System was up to. Today the system has become more open and transparent. The FOMC announces its decisions as they make them and gives an indication of the direction in which it is leaning. Thus it might say something like "we are adopting a tight monetary policy, but we see no reason why it might become tighter in the future" or perhaps "we are adopting a tight monetary policy and it is likely that it will become tighter in the future". Nonetheless, Fed Watchers still keep themselves employed for the policy is ultimately discretionary.

Contingent Policy Rules

Under a contingent policy rule, the money supply varies depending on unemployment, inflation, or other economic variables. A very simple one would be

If the unemployment rate is between four and six percent, let the money supply grow at 3% per year. If the unemployment rate is above six percent, let the money supply grow at 5% per year. If the unemployment rate is below four percent, let the money supply grow at 1% per year.

This is not a good policy rule – in fact, it is a bad one – but it is a good illustration of a contingent policy rule. Note that this rule does not follow something simple like "if aggregate demand is below aggregate supply then…" since aggregate demand and aggregate supply are quite useful concepts, but hard to distinguish in practice.

Debates about monetary policy take up two issues:

· Should the Central Bank do something or should it do nothing?

· If the Central Bank is going to do something, should it follow a discretionary policy or an automatic rule?

The case for doing nothing

Those advocating a non-intervention policy make several points points.

Lincoln's Law Works

The recession came about because of imperfect information. It is not that people are stupid, but merely that people are fallible. Lincoln's Law tells us that people do wise up. Consider the situation in Middle Bedrock. Given time, the short run aggregate supply curve would rotate as shown in Figure 14-2. As it did, the problem would correct itself. For instance, once the short run aggregate supply curve had rotated to AS^SR', the difference between GDP and full employment GDP (measured by long run aggregate supply) would have been cut in half.

Figure 14-2
What would happen if Middle Bedrock
had done nothing

Y₁ Y₂

Y_f

AS_SR'

Full Employment is at Y_f. Middle Bedrock's GDP is currently Y₁. As the short run aggregate supply curve rotates, GDP will increase and move upward. When the short run aggregate supply curve has moved to ASSR', for instance, then half of the gap between Y₁ and Y_f will disappear.

Lags in discretionary policies

It takes time for discretionary policies to come into effect. There are two kinds of lags in the effects of policies.

· Lags in implementing policies because of lags in getting information about the economy. By the time the Central Bank gets information and act upon a situation it may have already resolved itself. For example, the Board of Governors of the Federal Reserve System could get stale information, indicating that the economy is in a recession, and stimulate the economy by raising the money supply. However, it is possible that the economy is already on its way out of the recession. If so, the stimulus actually over stimulates the economy by the time that it actually takes effect, thus, causing a wider fluctuation in the business cycle.

· Lags in effects of discretionary policies. There are also lags in the time for a policy to have an effect once it has been decided. Thus, even with timely information, the economy may already have moved from say recession to boom (say) before the policies begin to take effect.

Lack of Information

Some panelists stressed that economic management was limited by incomplete information. Others pointed out that the problem went well beyond this. People do not always respond the same way to a change in economic conditions, and are conditioned on what they expect the government to do. They pointed to the dilemma in Upper Bedrock. There, people were expecting the government to increase the money supply by 15 percent and thus were expecting 12 percent inflation. The same thing could, of course happen to Middle Bedrock. This was not the first recession to occur in Middle Bedrock, not would it be the last. Suppose, for instance, that Middle Bedrock adopted a policy of always increasing the money supply to deal with the recession. People would then begin to expect an increase in the money supply and hence in the price level whenever a recession began. The effect would be to shift the short run aggregate supply curve up by the expected inflation, and give the government the dilemma shown in Figure 14-3. The shift in the short run aggregate supply curve would just offset the increase in the aggregate demand curve induced by the increased money supply.

Now we can see what happens when the Central Bank increases the money supply and shifts the aggregate demand curve to AD'. The economy will have grown to expect the policy and the net effect will be to leave the economy at Y₁. Indeed the problem is worse than that. Because the economy has come to expect the increase in the money supply, if the Central Bank does not increase the money supply, they will still get the shift in the short run aggregate supply function and the economy will slip back to Y₂. In words, the economy will be worse off. That is, they must increase the money supply just to stay still.

Figure 14-3
Middle Bedrock's Dilemma, Revisited

Y₂ Y₁ Y_f

AD'

AS^SR

Middle Bedrock finds itself in a recession. GDP is at Y₁. The question of the moment is how it should get out of this dilemma. If it increases the money supply and people expect it, the shift in the short run aggregate supply curve will leave the economy at Y₁.

On the other hand, if it does nothing, people will still be expecting something so the short run aggregate supply curve will shift up and the economy will drift down to Y₂. Things will get worse

Here, the panel reminded everyone of the credibility issue discussed earlier.

The History

There is a fundamental rule in medicine: do no harm. In the case of a discretionary monetary policy, it is possible that "doing something" will actually result in making things worse. The panel reminded everyone how the United States Federal Reserve System had, on many occasions, abused its discretionary authority and made things worse off.

Summary

The panel knew that new head of the Central Bank liked examples, and had tried to recast the problem in terms of running a pizzeria, say Miller's Pizzeria. Suppose a manager hires a new waiter. He hopes and expects the new waiter to make good. However, new waiters often get off to a rocky start. Should the manager intervene and coach the waiter?

One school of thought says the manager should not. Consumers control tipping. A poor waiter will get poor tips, and will shape up on his own, or will quit. Thus, there is something to be said for doing nothing. If the manager does try to intervene, he suffers from two problems. He cannot be everywhere and may not really know what is going on. By the time he gets around to coaching the waiter, he may already have learned the lesson and any advice will be gratuitous and be resented. Further, if the manager is always intervening, the waiter will learn the wrong lesson and stop exercising discretion. Clearly, a successful waiter, as indeed any successful employee should exercise discretion and show initiative. Thus, the process of intervention may be counterintuitive. Moreover, the manager will remember the many cases where is advice was a disaster and he would have been better keeping his mouth shut.

Of course, "never" is a strong word. There are always cases where a manager will intervene, if for no other reason than to fire a hopelessly inept waiter. The right lesson is that intervention should be sparing.

So too should it be with the economy.

The case for a Policy Rule

Discussion usually focuses on discretionary monetary policy. The question is whether the economy is best served by discretionary intervention or by a contingent policy rule.

The case for discretionary policy is obvious. Policy decisions should be made on all the information and any simple rule will fail to take into account all information.

On top of that, the issue is what the policy rule should be. Just saying that you should have a policy rule does not tell you what the "right" policy rule should be.

Policy Rules have their own benefits

A credible rule for actions can lead to better results than even the best actions chosen on a case-by-case (discretionary) basis. Consider, for instance, a rule saying you will never negotiate with terrorists. Never is a very strong word. You can always find examples where negotiating would seem to be the best policy. But the United States government, like many governments, refuses to negotiate with terrorists. It believes that a policy of refusing to negotiate reduces the incentive for terrorists to take hostages. Rules that are announced in advance and that are credible, that people believe the government will follow, can produce better results than policies not based on rules, because credible rules change peoples’ incentives, and decreases uncertainty about the economy. This allows people to make better decisions because they know what to expect.

Fiscal Policy

While the head of the Central Bank has no authority over fiscal policy, the panel also considered discretionary fiscal policy.

They noted that economists spend less and less time worrying about discretionary tax and spending policies as a means of fighting recessions.

Two kinds of lags complicate fiscal policies – lags in implementing policies and lags in the effects of fiscal policies. In the United States, for instance, the Federal Reserve System can alter the money supply relatively quickly. A decision to change tax and spending policies must work its way through Congress and the White House. Though these two agencies can move quickly on occasion, it normally takes a year or two for them to make changes in tax and spending policies. Moreover, in the case of changes in spending policies, it sometimes takes even longer for spending to actually increase even after authorization.

Credible rules for fiscal policy can improve economic performance by changing people's incentives. The best tax and spending policies involve a good deal of constancy. It is much like driving, where good practice calls for maintaining a steady speed and not moving about in the road. A poor driver veers about on the roadway and is constantly accelerating and decelerating.

As an example of the last point, the panel spoke specifically about the tasks of maintaining highways and sport stadiums. While they certainly favored appropriate investments in both, being careful to point out that the appropriate investment might be zero: not all proposed highways should be built. There was a significant body of research suggesting that the trend to publicly financed sports stadia (they could not resist using the correct Latin plural) was essentially a rip-off of the public for the benefit of team owners.

That point notwithstanding, the panel certainly favored public investment in all sorts of facilities. However, they argued that the best way to build these projects was on a steady basis. A project should be selected because its benefits exceeded its costs, and not be held hostage to the business cycle. Thus it made no sense to argue, "Build this road as a means of fighting a recession" or to argue "Do not build this road now: delay building it until we are in a recession".[1]

As to tax cuts and increases, the panel noted that, at one time, they had been much in vogue in the United States as a means of dealing with business cycles, but had passed out of favor in recent years. In 1981, for instance, President Reagan enacted a significant tax cut, but did so on the grounds that it would promote economic growth. In 1993, President Clinton, increased taxes during a recession, but did so on the grounds that the tax increase would promote economic growth by reducing the deficit. The irony of the inconsistency was noted, but not commented on.

Ricardian Equivalence

Indeed there is a controversy about whether tax cuts are of any value in fighting a recession. The demand and supply of loans graphs shown in Figure 14-4 illustrate the concept. Suppose we cut taxes by $100 billion. We increase the demand for loans to finance government spending by $100 billion. At the same time, we know that individuals will not spend the entire balance of the tax cut. Thus there will be an increase in the supply of loans. One view, shown in the upper left-hand corner, is that the increase in demand is greater than the increase in supply. If so, interest rates rise and aggregate demand increases, as shown in the lower left-hand panel.

The other view, sometimes labeled Ricardian Equivalence, is that the increase in the supply of loans equals the increase in the demand for loans.

Figure 14-4
Deficit Financing, the Loan Market and
Aggregate Demand: Two Views

This graph illustrates the two views of deficit financing. Suppose the government, initially running a balance budget, cuts taxes and runs a deficit. The demand for loans increases by the amount of the deficit. There is also an increase in the supply of loans, for people save at least part of the tax cut.

One view, shown in the upper left-hand corner, is that the increase in demand is less than the increase in supply. If so, interest rates rise and aggregate demand increases, as shown in the lower left-hand panel.

The other view is that the increase in supply equals the increase in supply. If so, interest rates remain constant. Aggregate demand does not increase. This view is represented by the right hand side of the graphs

If so, interest rates remain constant and aggregate demand does not increase. The right hand side of Figure 14-4 represents this view.

Impact on Aggregate Demand

Figure 14-4 also illustrates the controversy over aggregate demand. If people save less than $100 billion, the supply of loans increases by less than $100 billion, and there is not an exact offset to the increase in the demand for loans. Further, there is an increase in aggregate demand. For example, if the supply of loans increases by (say) $90 billion, then consumption spending is rising by $10 billion, which means a $10 billion increase in aggregate demand.

Once we know what is happening to the supply of loans, we know what is happening to aggregate demand. If people save the entire $100 billion, the supply of loans increases by $100 billion, and there is an exact offset to the increase in the demand for loans. Further, there is no increase in aggregate demand. Government spending is not increasing; and, if there is no increase in consumption spending, then there is no increase in aggregate demand.

The Economist General warned that the view that there is no shift in aggregate demand, formally known as Ricardian Equivalence, is highly controversial. Most economists do not believe in Ricardian Equivalence. Partial Ricardian Equivalence, the view that the shift in the supply of loans will offset the bulk of the increase in the demand for loans is not controversial.

Summing Up

Discretionary fiscal policy is so cumbersome that any management of business cycles is best left to the Central Bank.

Restructuring the Central Bank

As in many countries, the Central Bank is relatively independent of the government. This independence mirrors that of the Federal Reserve System. In the United States, the President and Congress have only limited power to control the System. There, the Federal Reserve System is very different from (say) the Department of Agriculture, who must do as directed by its boss, the President. To be sure, Congress has forced the Chairman of the Federal Reserve System to meet twice a year with the Joint Economic Committee to discuss economic policy. These sessions have become famous for statements like “the economy will continue to grow unless it contracts” and the like.

The panel noted that some Americans advocate placing the Federal Reserve System under the direct control of the President and the Congress. While the idea has some logic – the Federal Reserve System has essentially become a fourth branch of government – most economists would disagree. The data indicate that countries with independent monetary authorities have lower inflation rates than countries without independent monetary authorities. Why? When the elected government directly controls the monetary authority, the temptation to print money is hard to resist. Independent monetary authorities have more credibility than political monetary authorities.

Indeed the panel noted that in the United Kingdom, one of the first steps of the new Blair administration had been to strengthen the independence of the Bank of England, the British Central Bank. They also noted that the new European Central Bank enjoyed broad autonomy from the governing councils of the European Community. In short, the case for independence seemed clear.

No Central Bank

At the other extreme, the panel also noticed the proposal, made from time to time in the United States to abolish the Federal Reserve System and letting the banks compete among themselves. Each bank would have complete independence to issue its own money. Of course, a dollar issued by Key Bank might be worth more or less than a dollar issued by Bank One, but this might be one of the benefits of the system. The American banking system is hobbled by a number of rules and regulations, and complete independence would allow them to compete and issue the best type of financial products. Certainly political control would end.

In some sense, this idea has already come about. Major banks issue short term certificates of deposit that many corporations and money market funds hold like money. (The denominations are quite large, so forget about acquiring these personally.)

The drawback to going whole hog with this idea is that it might be very inefficient. If an American writes a check on Bank One say, the recipient may worry about his credit worthiness, but not about Bank One’s. And, if Americans constantly had to compare how much a Key Bank dollar was worth in terms of Bank One dollars, financial transactions would be quite complicated.

Relations to International Currencies

Lower Bedrock has a floating exchange rate, where the value of its currency, the Pebble, fluctuates relative to the American dollar ($), the European Euro (€) and the Japanese Yen (¥). The value of the Pebble is set each day by the laws of supply and demand.

Many economists were suggesting that Lower Bedrock reconsider its monetary system. Some of the proposals on the table were

· A return to the gold standard

· A return to fixed exchange rates

· Establish a Currency Board

A Brief Monetary History

Most industrial nations have used either a gold standard, fixed exchange rates or floating exchange rates.

The Gold Standard

The gold standard prevailed from the 19^th century, until just before World War II. Each country pledged to convert its currency into gold, upon demand, at a fixed exchange rate. This system broke down in 1931 when Britain stopped buying and selling gold. As an example of how the gold standard worked, the US government offered to buy or sell gold at the set rate of $20.67 an ounce. The British offered to buy or sell gold at the set rate of £4.30 an ounce. That guaranteed that 1£ = $4.80, the exchange rate between the dollar and the pound for many years. If the rate differed, buying and selling gold could make money. Remember that gold is a traded good and any other exchange rate guaranteed arbitrage opportunities.

The system, suspended during World War I, and reinstated at the end of that war, broke down, for good, under the pressures of the Great Depression. The first blow was when the British suspended convertibility in 1931 (which is a polite way for saying they stopped buying and selling gold).

Fixed Exchange Rates

After World War II, the major industrial nations replaced the gold standard with fixed exchange rates. The agreement leading to fixed exchange rates is called the Bretton Woods system, after the small New Hampshire town where economists met during World War II to plan the system. (There is a great hotel there, with elegant rooms, a great restaurant, and prices to match. When economists are planning to meet for several weeks on an expense account, they are not stupid). The Bretton Woods agreement ran from the end of World War II until 1971. Under this system, the countries of the world agreed to act jointly to maintain fixed exchange rates. All of the currencies in the world were pegged to the US dollar. The monetary authorities were supposed to consult and act responsibly. If a country did expand its money supply too much, then there were several ways to correct this:

· The US government could agree to purchase the additional foreign currency, and thus reduce the foreign currency money supply.

· The foreign authorities could agree to take steps to reform their monetary policy.

· The foreign government could adopt restrictive trade policies. For example, they could restrict the purchase of foreign goods for domestic use. If they did, they reduce the gains from trade.

· The foreign government could devalue their currency to the dollar. This last step was inconsistent with the basic notion of fixed exchange rates. When it looked like devaluation might occur, there was a lot of exchange speculation. People would begin to unload foreign currency for dollars. If the devaluation occurred, they would make money; if it did not, they would lose nothing.

The Bretton Woods syst