INTERMEDIATE MACROECONOMICS-II
B.A.(H) Economics, Semester-IV
Topic-3: Fiscal & Monetary Policy
Reference: Blanchard, Macroeconomics (5th ed.)
CHAPTER 24: Should Policy Maker’s be Restrained
Lecture Notes
Shri Ram College of Commerce
2019-20
Should Policymakers Be Restrained?
There’s substantial uncertainty about the effects of macroeconomic
policies.
Economists argue that this uncertainty should lead to policymakers to
be more careful and use less active policies.
Two different schools of thought regarding macroeconomic policies:
(i) Friedman from Chicago, suggests due to long and variable lags, an
activist policy does more harm than good.
(ii) Modigliani from MIT believed that economists’ have attained
knowledge sufficient enough to allow for increasingly fine-tuning the
economy with active policies.
Shri Ram College of Commerce INTERMEDIATE MACROECONOMICS-II 2019-20 2 / 14
Should Policymakers Be Restrained?
There’s substantial uncertainty about the effects of macroeconomic
policies.
Economists argue that this uncertainty should lead to policymakers to
be more careful and use less active policies.
Two different schools of thought regarding macroeconomic policies:
(i) Friedman from Chicago, suggests due to long and variable lags, an
activist policy does more harm than good.
(ii) Modigliani from MIT believed that economists’ have attained
knowledge sufficient enough to allow for increasingly fine-tuning the
economy with active policies.
Shri Ram College of Commerce INTERMEDIATE MACROECONOMICS-II 2019-20 2 / 14
Should Policymakers Be Restrained?
There’s substantial uncertainty about the effects of macroeconomic
policies.
Economists argue that this uncertainty should lead to policymakers to
be more careful and use less active policies.
Two different schools of thought regarding macroeconomic policies:
(i) Friedman from Chicago, suggests due to long and variable lags, an
activist policy does more harm than good.
(ii) Modigliani from MIT believed that economists’ have attained
knowledge sufficient enough to allow for increasingly fine-tuning the
economy with active policies.
Shri Ram College of Commerce INTERMEDIATE MACROECONOMICS-II 2019-20 2 / 14
Should Policymakers Be Restrained?
There’s substantial uncertainty about the effects of macroeconomic
policies.
Economists argue that this uncertainty should lead to policymakers to
be more careful and use less active policies.
Two different schools of thought regarding macroeconomic policies:
(i) Friedman from Chicago, suggests due to long and variable lags, an
activist policy does more harm than good.
(ii) Modigliani from MIT believed that economists’ have attained
knowledge sufficient enough to allow for increasingly fine-tuning the
economy with active policies.
Shri Ram College of Commerce INTERMEDIATE MACROECONOMICS-II 2019-20 2 / 14
Should Policymakers Be Restrained?
There’s substantial uncertainty about the effects of macroeconomic
policies.
Economists argue that this uncertainty should lead to policymakers to
be more careful and use less active policies.
Two different schools of thought regarding macroeconomic policies:
(i) Friedman from Chicago, suggests due to long and variable lags, an
activist policy does more harm than good.
(ii) Modigliani from MIT believed that economists’ have attained
knowledge sufficient enough to allow for increasingly fine-tuning the
economy with active policies.
Shri Ram College of Commerce INTERMEDIATE MACROECONOMICS-II 2019-20 2 / 14
People and firms try to anticipate what policymakers will do.
This leads to strategic interactions (investment, spending decisions)
between policymakers and people.
Hence, macroeconomic policy should be treated as a game between
policymakers and the public.
An announcement of a policy change induces a change in
firms/households behavior: policy changes are internalized by firms
and households.
In a game of strategic decision making, we also find players getting
higher pay-off by not taking decisions that are optimal to them. (e.g.
In a hostage like situation, govt. negotiate with the hostage-takers
(which is the optimal policy). But to deter hostage-taking situations,
govt. stated the policy of no negotiations.)
Shri Ram College of Commerce INTERMEDIATE MACROECONOMICS-II 2019-20 3 / 14
People and firms try to anticipate what policymakers will do.
This leads to strategic interactions (investment, spending decisions)
between policymakers and people.
Hence, macroeconomic policy should be treated as a game between
policymakers and the public.
An announcement of a policy change induces a change in
firms/households behavior: policy changes are internalized by firms
and households.
In a game of strategic decision making, we also find players getting
higher pay-off by not taking decisions that are optimal to them. (e.g.
In a hostage like situation, govt. negotiate with the hostage-takers
(which is the optimal policy). But to deter hostage-taking situations,
govt. stated the policy of no negotiations.)
Shri Ram College of Commerce INTERMEDIATE MACROECONOMICS-II 2019-20 3 / 14
People and firms try to anticipate what policymakers will do.
This leads to strategic interactions (investment, spending decisions)
between policymakers and people.
Hence, macroeconomic policy should be treated as a game between
policymakers and the public.
An announcement of a policy change induces a change in
firms/households behavior: policy changes are internalized by firms
and households.
In a game of strategic decision making, we also find players getting
higher pay-off by not taking decisions that are optimal to them. (e.g.
In a hostage like situation, govt. negotiate with the hostage-takers
(which is the optimal policy). But to deter hostage-taking situations,
govt. stated the policy of no negotiations.)
Shri Ram College of Commerce INTERMEDIATE MACROECONOMICS-II 2019-20 3 / 14
People and firms try to anticipate what policymakers will do.
This leads to strategic interactions (investment, spending decisions)
between policymakers and people.
Hence, macroeconomic policy should be treated as a game between
policymakers and the public.
An announcement of a policy change induces a change in
firms/households behavior: policy changes are internalized by firms
and households.
In a game of strategic decision making, we also find players getting
higher pay-off by not taking decisions that are optimal to them. (e.g.
In a hostage like situation, govt. negotiate with the hostage-takers
(which is the optimal policy). But to deter hostage-taking situations,
govt. stated the policy of no negotiations.)
Shri Ram College of Commerce INTERMEDIATE MACROECONOMICS-II 2019-20 3 / 14
People and firms try to anticipate what policymakers will do.
This leads to strategic interactions (investment, spending decisions)
between policymakers and people.
Hence, macroeconomic policy should be treated as a game between
policymakers and the public.
An announcement of a policy change induces a change in
firms/households behavior: policy changes are internalized by firms
and households.
In a game of strategic decision making, we also find players getting
higher pay-off by not taking decisions that are optimal to them. (e.g.
In a hostage like situation, govt. negotiate with the hostage-takers
(which is the optimal policy). But to deter hostage-taking situations,
govt. stated the policy of no negotiations.)
Shri Ram College of Commerce INTERMEDIATE MACROECONOMICS-II 2019-20 3 / 14
Inflation & Unemployment
The relation between unemployment and inflation, is given by the
Phillips Curve:
π = π e − α(u − un )
In the above expression, Inflation π, depends on expected inflation,
π e , and on the difference between the actual and natural rate of
unemployment (u − un ). α captures the effect of unemployment on
inflation.
Suppose the Fed announces a monetary policy to ensure zero
inflation, on the assumption that wage setters believe that expected
inflation will be zero i.e. π e = 0. Then:
π = −α(u − un )
Shri Ram College of Commerce INTERMEDIATE MACROECONOMICS-II 2019-20 4 / 14
Inflation & Unemployment
The relation between unemployment and inflation, is given by the
Phillips Curve:
π = π e − α(u − un )
In the above expression, Inflation π, depends on expected inflation,
π e , and on the difference between the actual and natural rate of
unemployment (u − un ). α captures the effect of unemployment on
inflation.
Suppose the Fed announces a monetary policy to ensure zero
inflation, on the assumption that wage setters believe that expected
inflation will be zero i.e. π e = 0. Then:
π = −α(u − un )
Shri Ram College of Commerce INTERMEDIATE MACROECONOMICS-II 2019-20 4 / 14
Inflation & Unemployment
The relation between unemployment and inflation, is given by the
Phillips Curve:
π = π e − α(u − un )
In the above expression, Inflation π, depends on expected inflation,
π e , and on the difference between the actual and natural rate of
unemployment (u − un ). α captures the effect of unemployment on
inflation.
Suppose the Fed announces a monetary policy to ensure zero
inflation, on the assumption that wage setters believe that expected
inflation will be zero i.e. π e = 0. Then:
π = −α(u − un )
Shri Ram College of Commerce INTERMEDIATE MACROECONOMICS-II 2019-20 4 / 14
If the fed follows through with it’s announced policy, it will choose an
unemployment rate equal to the natural rate, such that
u = un → π = π e = 0.
In the U.S., α ≈ 1. Therefore, the Fed could deviate from its stated
policy and achieve an unemployment rate of 1% below the natural
rate with just a 1% increase in the inflation rate. i.e. if
α = 1, π e = 0 and π = 1, then (u − un ) = −1%.
This incentive to deviate from the announced policy once the other
player (in this case wage setters) has made its move is known as time
inconsistency.
Shri Ram College of Commerce INTERMEDIATE MACROECONOMICS-II 2019-20 5 / 14
If the fed follows through with it’s announced policy, it will choose an
unemployment rate equal to the natural rate, such that
u = un → π = π e = 0.
In the U.S., α ≈ 1. Therefore, the Fed could deviate from its stated
policy and achieve an unemployment rate of 1% below the natural
rate with just a 1% increase in the inflation rate. i.e. if
α = 1, π e = 0 and π = 1, then (u − un ) = −1%.
This incentive to deviate from the announced policy once the other
player (in this case wage setters) has made its move is known as time
inconsistency.
Shri Ram College of Commerce INTERMEDIATE MACROECONOMICS-II 2019-20 5 / 14
If the fed follows through with it’s announced policy, it will choose an
unemployment rate equal to the natural rate, such that
u = un → π = π e = 0.
In the U.S., α ≈ 1. Therefore, the Fed could deviate from its stated
policy and achieve an unemployment rate of 1% below the natural
rate with just a 1% increase in the inflation rate. i.e. if
α = 1, π e = 0 and π = 1, then (u − un ) = −1%.
This incentive to deviate from the announced policy once the other
player (in this case wage setters) has made its move is known as time
inconsistency.
Shri Ram College of Commerce INTERMEDIATE MACROECONOMICS-II 2019-20 5 / 14
But, this leads to wage setters revising their expectations with positive
inflation i.e. π e = 1%. Therefore, in order to ensure (u − un ) = 1%,
Fed will have to achieve 2% inflation. This will further lead to a
revision of expected inflation and eventually leads to higher inflation.
Overtime, as wage setters understand the Fed’s motives, expected
inflation catches up with actual inflation, and eventually economy
returns to the natural rate of unemployment, but with higher inflation.
Shri Ram College of Commerce INTERMEDIATE MACROECONOMICS-II 2019-20 6 / 14
But, this leads to wage setters revising their expectations with positive
inflation i.e. π e = 1%. Therefore, in order to ensure (u − un ) = 1%,
Fed will have to achieve 2% inflation. This will further lead to a
revision of expected inflation and eventually leads to higher inflation.
Overtime, as wage setters understand the Fed’s motives, expected
inflation catches up with actual inflation, and eventually economy
returns to the natural rate of unemployment, but with higher inflation.
Shri Ram College of Commerce INTERMEDIATE MACROECONOMICS-II 2019-20 6 / 14
Establishing Credibility
To deal with the problem of time inconsistency, without totally
stripping the central bank of policy-making power include, the
following measures are taken:
Making the central bank independent. This way, the central bank
resists political pressure to decrease unemployment by increasing
money growth.
Give incentives to the central banker to take the long-term view; that
is, to take into account the long-run costs of higher inflation.
Choose a “conservative” central banker; i.e., one who dislikes inflation.
Shri Ram College of Commerce INTERMEDIATE MACROECONOMICS-II 2019-20 7 / 14
Establishing Credibility
To deal with the problem of time inconsistency, without totally
stripping the central bank of policy-making power include, the
following measures are taken:
Making the central bank independent. This way, the central bank
resists political pressure to decrease unemployment by increasing
money growth.
Give incentives to the central banker to take the long-term view; that
is, to take into account the long-run costs of higher inflation.
Choose a “conservative” central banker; i.e., one who dislikes inflation.
Shri Ram College of Commerce INTERMEDIATE MACROECONOMICS-II 2019-20 7 / 14
Establishing Credibility
To deal with the problem of time inconsistency, without totally
stripping the central bank of policy-making power include, the
following measures are taken:
Making the central bank independent. This way, the central bank
resists political pressure to decrease unemployment by increasing
money growth.
Give incentives to the central banker to take the long-term view; that
is, to take into account the long-run costs of higher inflation.
Choose a “conservative” central banker; i.e., one who dislikes inflation.
Shri Ram College of Commerce INTERMEDIATE MACROECONOMICS-II 2019-20 7 / 14
Establishing Credibility
To deal with the problem of time inconsistency, without totally
stripping the central bank of policy-making power include, the
following measures are taken:
Making the central bank independent. This way, the central bank
resists political pressure to decrease unemployment by increasing
money growth.
Give incentives to the central banker to take the long-term view; that
is, to take into account the long-run costs of higher inflation.
Choose a “conservative” central banker; i.e., one who dislikes inflation.
Shri Ram College of Commerce INTERMEDIATE MACROECONOMICS-II 2019-20 7 / 14
Central bank independence and credibility
Across OECD countries, the higher the degree of central bank
independence, the lower the rate of inflation.
Shri Ram College of Commerce INTERMEDIATE MACROECONOMICS-II 2019-20 8 / 14
Time Consistency and Restraints on Policymakers
When time inconsistency is a concern, tight restraints on
policymakers, such as a fixed-money-growth rule in the case of
monetary policy, or a balanced budget rule in the case of fiscal
policy-can provide a rough solution.
But these solutions carry costs because it limits the role of
macroeconomic policy.
Better solutions typically involve designing better institutions (such as
an independent central bank or a better budget process) that can
reduce the problem of time inconsistency while, at the same time,
allowing the use of policy to manage the economy.
Shri Ram College of Commerce INTERMEDIATE MACROECONOMICS-II 2019-20 9 / 14
Time Consistency and Restraints on Policymakers
When time inconsistency is a concern, tight restraints on
policymakers, such as a fixed-money-growth rule in the case of
monetary policy, or a balanced budget rule in the case of fiscal
policy-can provide a rough solution.
But these solutions carry costs because it limits the role of
macroeconomic policy.
Better solutions typically involve designing better institutions (such as
an independent central bank or a better budget process) that can
reduce the problem of time inconsistency while, at the same time,
allowing the use of policy to manage the economy.
Shri Ram College of Commerce INTERMEDIATE MACROECONOMICS-II 2019-20 9 / 14
Time Consistency and Restraints on Policymakers
When time inconsistency is a concern, tight restraints on
policymakers, such as a fixed-money-growth rule in the case of
monetary policy, or a balanced budget rule in the case of fiscal
policy-can provide a rough solution.
But these solutions carry costs because it limits the role of
macroeconomic policy.
Better solutions typically involve designing better institutions (such as
an independent central bank or a better budget process) that can
reduce the problem of time inconsistency while, at the same time,
allowing the use of policy to manage the economy.
Shri Ram College of Commerce INTERMEDIATE MACROECONOMICS-II 2019-20 9 / 14
Politics and Policy
We have assumed so far that policymakers are benevolent, i.e. that
they try to do what is best for the economy.
Politicians or policymakers, however, often do what is best for
themselves, and this is not always what is best for the economy.
Shri Ram College of Commerce INTERMEDIATE MACROECONOMICS-II 2019-20 10 / 14
Politics and Policy
We have assumed so far that policymakers are benevolent, i.e. that
they try to do what is best for the economy.
Politicians or policymakers, however, often do what is best for
themselves, and this is not always what is best for the economy.
Shri Ram College of Commerce INTERMEDIATE MACROECONOMICS-II 2019-20 10 / 14
Games between Policymakers and Voters
If voters are shortsighted, the temptation for politicians to cut taxes
may prove irresistible.
With the right timing and shortsighted voters, political parties can
win elections. Thus, we might expect a clear political business cycle,
with higher growth on average before elections than after elections.
In that context, debt cycles would be closely related to political cycles.
Shri Ram College of Commerce INTERMEDIATE MACROECONOMICS-II 2019-20 11 / 14
Games between Policymakers and Voters
If voters are shortsighted, the temptation for politicians to cut taxes
may prove irresistible.
With the right timing and shortsighted voters, political parties can
win elections. Thus, we might expect a clear political business cycle,
with higher growth on average before elections than after elections.
In that context, debt cycles would be closely related to political cycles.
Shri Ram College of Commerce INTERMEDIATE MACROECONOMICS-II 2019-20 11 / 14
Games between Policymakers and Voters
If voters are shortsighted, the temptation for politicians to cut taxes
may prove irresistible.
With the right timing and shortsighted voters, political parties can
win elections. Thus, we might expect a clear political business cycle,
with higher growth on average before elections than after elections.
In that context, debt cycles would be closely related to political cycles.
Shri Ram College of Commerce INTERMEDIATE MACROECONOMICS-II 2019-20 11 / 14
Is debt build up related to policy cycles?
The graph represents the evolution of the U.S. Debt-to-GDP ratio
since 1900. The three major buildups of US debt since 1900 have
been associated with World War I, the Great Depression, and World
War II. The buildup since 1980 appears to be different in nature.
Shri Ram College of Commerce INTERMEDIATE MACROECONOMICS-II 2019-20 12 / 14
Games between Policymakers
Game theorists refer to wars of attrition the situations in which each
side holds out, hoping that the other side will give in. These wars
usually result in delays in the implementation of the policy.
Republicans arguably worry more than Democrats about inflation and
less than Democrats about unemployment. We would then expect to
see stronger growth during Democratic administrations.
Shri Ram College of Commerce INTERMEDIATE MACROECONOMICS-II 2019-20 13 / 14
Games between Policymakers
Game theorists refer to wars of attrition the situations in which each
side holds out, hoping that the other side will give in. These wars
usually result in delays in the implementation of the policy.
Republicans arguably worry more than Democrats about inflation and
less than Democrats about unemployment. We would then expect to
see stronger growth during Democratic administrations.
Shri Ram College of Commerce INTERMEDIATE MACROECONOMICS-II 2019-20 13 / 14
Politics and Fiscal Restraints
A balanced-budget amendment would eliminate the problem of
deficits, but it would also eliminate the use of fiscal policy as
macroeconomic policy instrument.
The “Budget Enforcement Act” passed in 1990, and extended in 1993
and 1997, introduced two main rules:
(i) It imposed constraints on spending. Constraints, called spending
caps, were set on discretionary spending for a period of 5 years.
(ii) It required that a new transfer program could only be adopted if it
could be shown not to increase deficits in the future. This rule is
known as the pay-as-you-go or the PAYGO rule.
Shri Ram College of Commerce INTERMEDIATE MACROECONOMICS-II 2019-20 14 / 14
Politics and Fiscal Restraints
A balanced-budget amendment would eliminate the problem of
deficits, but it would also eliminate the use of fiscal policy as
macroeconomic policy instrument.
The “Budget Enforcement Act” passed in 1990, and extended in 1993
and 1997, introduced two main rules:
(i) It imposed constraints on spending. Constraints, called spending
caps, were set on discretionary spending for a period of 5 years.
(ii) It required that a new transfer program could only be adopted if it
could be shown not to increase deficits in the future. This rule is
known as the pay-as-you-go or the PAYGO rule.
Shri Ram College of Commerce INTERMEDIATE MACROECONOMICS-II 2019-20 14 / 14
Politics and Fiscal Restraints
A balanced-budget amendment would eliminate the problem of
deficits, but it would also eliminate the use of fiscal policy as
macroeconomic policy instrument.
The “Budget Enforcement Act” passed in 1990, and extended in 1993
and 1997, introduced two main rules:
(i) It imposed constraints on spending. Constraints, called spending
caps, were set on discretionary spending for a period of 5 years.
(ii) It required that a new transfer program could only be adopted if it
could be shown not to increase deficits in the future. This rule is
known as the pay-as-you-go or the PAYGO rule.
Shri Ram College of Commerce INTERMEDIATE MACROECONOMICS-II 2019-20 14 / 14
Politics and Fiscal Restraints
A balanced-budget amendment would eliminate the problem of
deficits, but it would also eliminate the use of fiscal policy as
macroeconomic policy instrument.
The “Budget Enforcement Act” passed in 1990, and extended in 1993
and 1997, introduced two main rules:
(i) It imposed constraints on spending. Constraints, called spending
caps, were set on discretionary spending for a period of 5 years.
(ii) It required that a new transfer program could only be adopted if it
could be shown not to increase deficits in the future. This rule is
known as the pay-as-you-go or the PAYGO rule.
Shri Ram College of Commerce INTERMEDIATE MACROECONOMICS-II 2019-20 14 / 14
