Lecture Sixteen
Limits of Stabilization Policy; Rules vs.
Discretion
(Economics 100b; Spring 1996)
Professor of Economics J. Bradford DeLong
689 Evans, University of California at Berkeley
Berkeley, CA 94720
(510) 643-4027 phone (510) 642-6615 fax
delong@econ.berkeley.edu
http://www.j-bradford-delong.net
February 26, 1996
Limits of Stabilization Policy
Lags in Implementation and Effect
Automatic Stabilizers and Deposit Insurance
Policies Made According to Discretion, or by Following a
Rule?
Administration
Limits of Stabilization Policy
Let me give an example of why, when you don't know what you are
doing, you might not want to do anything. Suppose unemployment rate
currently forecast to be 8% next year; pretty sure that the natural
rate is 6%; thinking about a government speeding program; don't know
the multiplier--your forecasters shrug their shoulders, and say that
maybe it is one, and maybe it is three, they give 50/50 odds each
way.
- If the multiplier is one: need to boost federal spending next
year by $240 billion, and that will get you to 6% unemployment.
- But if the multiplier is three and you boost spending by $240
billion, your unemployment rate is 2% and inflation is through the
roof.
- If the multiplier is three: need to boost federal spending
next year by $80 billion, and that will get you 6% unemployment.
- But if the multiplier is one and you boost spending by only
$80 billion, you still have 7 1/3% unemployment--1 1/3% more than
you would like
- Split the difference? If the multiplier were 2, you'd boost
spending by $120 billion
- with real multiplier of 3, unemployment at 5%
- with real multiplier of 1, unemployment at 7%
And suppose that you want to minimize the expected absolute
deviation from the natural rate: 8% unemployment is bad, but 4%
unemployment (and rapidly rising inflation) is as bad in a different
way. 10% unemployment is twice as bad as 8%, etc.
Now let's look at our three proposed policies, and how much "bad" is
left:
- Stimulus of $240 billion: 2% of "bad"
- Stimulus of $120 billion: 1% of "bad"
- Stimulus of $80 billion: 2/3% of "bad"
But this leaves you with (6%, 7 1/3%) 50-50 chances. You've
deliberately undershot: done less than may well prove necessary to
reach "full employment"
Why? Because if your policies have uncertain or variable effects,
they are one of the sources of risk and distress that you are trying
to stamp out.
- Note that this argument--that if you do not know precisely the
effects of your policies, do less--applies as strongly to policies
that shift the monetary base to control the money stock as to
anything else.
- Which is why if you read Friedman's writings in depth, you
pretty soon discover calls for something called "100% reserve
banking"--because that makes control of the money stock from the
monetary base much easier.
And this is why, at least I think this is why, Mankiw has gotten
confused: he has taken Friedman's powerful--and correct--critique of
the "limits of stabilization policy" to imply that Friedman's own
policy recommendation involve a passive role.
I think Friedman has gotten tangled up to some degree in the same
confusion: limits of knowledge mean policy should be cautious, yet
what is a cautious policy? Unless you have a good benchmark for what
a "neutral" policy is, it is hard to figure out how to be
cautious.
Lags in Implementation and Effect
- Inside lag (fiscal and monetary); data collection; information
processing; legislative enactment; implementation
- Outside lag (fiscal and monetary); multiplier process takes
time; investment takes time;
- "Long and variable lags"; no reason to assume that investment
response to a shift in interest rates always takes the same amount
of time, or has the same magnitude of effect.
Talk about original draft of 1946 Employment Act, the Full
Employment Act of 1946
Talk about political commentaries and Federal Reserve
appointments...//assumption of the worst as far as motives are
concerned...
Automatic Stabilizers and Deposit Insurance
Any policies to stabilize the economy that don't have the problem of
hitting the economy more than a year from now? (Possible digression
on the trade deficit and Clinton policy)
Yes--automatic stabilizers. What are automatic stabilizers?
Suppose that the consumption function (in billions of dollars)
is:
C = 800 + 0.75(Y-T)
that the investment function and government spending are:
I(r) = 1300 - 100(r) r = 3
and, further, suppose that total net taxes and transfers T are
not a lump sum amount, but that instead:
T = .2 x Y
Then:
- Y = C+I+G = 2100 + 0.75(Y-(.2Y)) + 1300 - 100r + G
Y = C+I+G = 2100 + 0.6Y - 100r + G
(1-0.6)Y = 1800 + G
Y = 4500 + 2.5G
Now the marginal propensity to consume c' in this version
of the model is 0.75; thus the simple multiplier 1/(1-c') in
this version of the model is 4. But the government-spending
multiplier--in fact, the general multiplier applying to all
shocks to the IS curve
- Taxes depend on the level of income. Thus when the multiplier
process starts, an extra $1 of income does not generate an extra
$0.75 in consumption but only an extra $0.60 in consumption,
because a $1 increase in pre-tax income is only a $0.80 increase
in disposable income.
Thus the tax system acts as an "automatic stabilizer" to diminish
the impact of shifts in spending on output--it is as if the
marginal propensity to consume had been lowered from .75 to .6,
and the multiplier lowered from 4 to 2.5
- My strong aversion to the balanced-budget amendment
Remember the "money multiplier" from last time?
Between August 1929 and March of 1933--during the
slide into the biggest Depression America has ever seen--the Federal
Reserve expanded the monetary base--the sum of currency and
reserve deposits--by nearly twenty percent, from $7.1 to $8.4
billion, by buying on net some $1.3 billion of government bonds from
banks and other private firms. This means that monetary policy was
quite expansionary during the slide into the Great Depression,
right?
Milton Friedman would--and did--say no: the problem was that in 1929,
banks wanted to hold $1 in reserves for every $7 in deposits; by 1933
banks wanted to hold $1 in reserves for every $5 in deposits; in 1929
consumers were happy to hold 1/6 of their spendable wealth in
currency, and 5/6 in checking accounts; by 1933 consumers were
terrified that their banks would fail and wanted to hold 40% of their
spendable wealth in currency and 60% in checking accounts.
Thus the money supply fell from $26.5 billion in August 1929 to $19.0
billion in March 1933 because $1 of reserves generated $3.70
of "money" in the first period and only $2.30 of "money" in the
second.
Deposit insurance as a way of avoiding such collapses in the
money multiplier
Policies Made According to Discretion, or by Following a
Rule?
Suppose that the consumption function (in billions of dollars)
is:
C = 800 + 0.75(Y-T)
that the investment function and government spending are:
I(r) = 1300 - 100(r) r = 3
and, further, suppose that total net taxes and transfers T are
not a lump sum amount, but that instead:
T = .2 x Y
Then:
- Y = C+I+G = 2100 + 0.75(Y-(.2Y)) + 1300 - 100r + G
Y = C+I+G = 2100 + 0.6Y - 100r + G
(1-0.6)Y = 1800 + G
Y = 4500 + 2.5G
August 1929:
Monetary Base of $7.1 billion
Money multiplier of 3.7
Money stock of $26.5 billion
March 1933
Monetary Base of $8.4 billion
Money multiplier of 2.3
Money stock of $19.0 billion
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