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Econ 100b

Created 4/30/1996
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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.


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:

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.

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

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:

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

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:



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


>

Econ 100b

Created 4/30/1996
Go to
Brad De Long's Home Page


Professor of Economics J. Bradford DeLong, 601 Evans
University of California at Berkeley
Berkeley, CA 94720-3880
(510) 643-4027 phone (510) 642-6615 fax
delong@econ.berkeley.edu
http://www.j-bradford-delong.net/