Macroeconomic Policy in Practice

ECON3236 International Finance

Girish Bahal

Main reading: Krugman, Obstfeld, and Melitz, Ch 17 pages 508-509

(Output and the Exchange Rate in the Short Run)

Learning Objectives

Understand the various problems of policy formulation:

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Inflation Bias

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Origin of shocks

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Fiscal vs monetary policy

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Lags at which macroeconomic policies operate

Inflation Bias

Lectures 9.1 and 9.2: expansionary policies can raise output in the short-run

These policies give a government the power to raise output during a recession

But these policies can also be used to create politically useful economic booms

Inflation Bias

If workers and firms anticipate such policies in advance → wages ↑ and prices ↑

in the expectation of expansionary policies

In such a case, the government will have to use expansionary policy merely to

prevent a recession that higher domestic prices otherwise would cause!

As a result, macroeconomic policy can display an inflation bias, leading to high

inflation but no average gain in output

Inflation Bias

Example: the increase in inflation that occurred in the United States during the

1970s

The inflation bias problem suggests that central banks should operate

independently of the govt.

If the CB is truly independent, this can help anchor inflation expectations

Many central banks throughout the world now seek to reach announced target

levels of (low) inflation

Inflation Bias

Source: ABS;RBA

Origin of Shocks

Lecture 9.1:

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The type of temporary shock is known with certainty

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The optimal policy response is different for different type of shocks

In reality, it’s hard to know whether a disturbance to the economy originates in

the output or the asset markets

Real-world policy choices are frequently determined by bureaucratic necessities

Fiscal vs Monetary Policy

Changes in fiscal policy take long time in planning, approval and execution

Monetary policy is usually exercised expeditiously by the central bank

There is an incentive for the govt. to respond to disturbances by changing

monetary policy even when a shift in fiscal policy is more appropriate

Fiscal vs Monetary Policy

Another problem with fiscal policy is its impact on the government budget

Eg: the multibillion-dollar fiscal stimulus package sponsored by the Obama

administration in the US in 2009

There is no guarantee that the govt. will synchronize the necessary fiscal

reversals with the state of the economy

The state of the electoral cycle may be more important

The US Govt. Budget Surplus or Deficit, 1950–2019

Source: FederalReserveBankofSt. Louis

Policy Lags

Policies that appear to act swiftly in our simple model operate in reality with

lags of varying lengths

Also, it’s difficult to evaluate the size and persistence of a given shock

→ it’s hard to know precisely how much monetary or fiscal medicine to

administer

These uncertainties force policy makers to base their actions on forecasts (or

even hunches!) that may turn out to be quite wide of the mark