Suppose the actual unemployment rate for Sun country has been one of the lowest

Question

Suppose the actual unemployment rate for Sun country has been one of the lowest at 2.5% over the last one year. The Central bank and the policy makers have decided to maintain the level of real GDP at the current level.

If the Parliament of Sun country passes a $60 billion increase in personal taxes, what action, if any, would the Central bank have to take?

Describe the effect of the action on Parliament and Central bank on:

The real interest rate

Composition of output

The future growth of real GDP

Explanation / Answer

ANSWER:

The great depression of the 1930s has had a profound influence on both economic and political thinking. The consequences of this event turned out to be of such a dimension that broad consensus emerged on governments doing their best to prevent such disasters from happening again. But even beyond this extreme case, there is general agreement that a stable and predictable economic environment contributes substantially to social and economic welfare. In the short-run, households prefer to have economic stability with continuous employment and stable incomes, allowing them to maintain stable consumption over time. In the long-run, unnecessary economic fluctuations can reduce growth, for example by increasing the riskiness of investments. A highly volatile economic environment might also have a negative impact on the choice of education profiles and career paths. In short, by maintaining a stable macroeconomic environment, economic policy can thus contribute to economic growth and welfare.

2. A need for stabilisation?

But what needs to be stabilised and how? Moreover, to what extent are cyclical fluctuations “acceptable”? What is a “feasible” degree of stabilisation? And what are “effective” stabilisation tools?

These questions have long been debated by economists and – without surprise – the answers provided have changed considerably over time. Back in the 1960’s, the heydays of Keynesian economics, economists spoke optimistically of an end to the business cycle. A book written in 1969 and titled ‘Is the Business Cycle Obsolete?’[2]quotes Hyman P. Minsky, at the time a leading authority on monetary theory and financial institutions, saying:

‘It was felt that if the policy prescription of the New Economics were applied, business cycles as they had been known would be a thing of the past’ (p. vi)

In the late 1960’s the Keynesian view became increasingly challenged by Monetarism. The debate between Keynesians and monetarists often focused on the effectiveness of policy instruments, with monetarists arguing for the ineffectiveness of fiscal tools and Keynesians believing in the superiority of fiscal stabilisation policy.[3] In the context of this discussion, Milton Friedman addressed the question of whether and how much to stabilise at his 1967 Presidential Address to the American Economic Association. Concerned about the possibility that monetary policy actions may themselves be a source of economic instability, Friedman argued that macroeconomic stability is best achieved using an “unconditional” policy rule: his famous “k-percent” money growth rule.

While nowadays nobody seems to support the use of such rigid rules, Friedman’s basic underlying idea remains relevant. His view on stabilisation policy was grounded in the firm belief that the economic system is eventually self-stabilising whereas available knowledge about the economic system is too limited for effectively addressing short-run fluctuations.

Even if one would subscribe to Friedman’s view of an eventually self-stabilising economy, the question of whether reliance on self-stabilising forces alone generates economic fluctuations of politically and economically acceptable magnitudes remains open. From a purely economic viewpoint, the optimal degree of stabilisation depends on whether observed macroeconomic fluctuations constitute efficient responses of the economy to shocks or whether these fluctuations are partly due to economic frictions, to be addressed with the tools of stabilisation policy. However, from a political economy viewpoint, self-stabilisation may lead to short-term fluctuations of an intolerable size and even seriously undermine agents’ trust in a market-based economic system, as several historical episodes have shown.

In an article published only two years ago, Robert E. Lucas confirmed his long-held view that the welfare gains from stabilisation policy must be fairly modest.[4] According to his findings, the potential welfare gains from improved stabilisation policy going beyond stability of monetary aggregates and nominal spending is likely to be small. While this result rests on important simplifying assumptions, it seems to have proven to be a fairly robust finding.

In recent times the overall stabilisation problem has become much less severe. In particular, economic volatility – measured by the standard deviation of quarterly output growth – seems to have fallen considerably in many industrialised countries when comparing the recent two decades to the preceding post World War II experience. Some economists, including David and Christina Romer, suggested this to be due to a fundamental change in the understanding among policymakers about what aggregate demand policy can accomplish. This possibly validates the view that, in the past, severe recessions have been partly caused by over-ambitious macroeconomic policies.[5] Whether this optimistic view about the source of business cycles is the final word on the issue remains to be seen. Clearly other views have been expressed, including the one that the recent experience is simply due to a fortunate sequence of extraordinarily small economic shocks.[6]Whatever viewpoint will ultimately turn out to be correct, they both request discussing the role of monetary and fiscal stabilisation policies, be it to educate our minds and to avoid the mistakes of the past, or be it for effectively counteracting larger disturbances should these reappear.

Related Questions

Navigate

• Browse (All)
• Browse S
• Subjects

Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.