Chapter 19
Policy in an Uncertain World
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz
Slides prepared by Dr Monica Keneley.
19-1
Objectives
• Explore the limitations of macroeconomic policy
• Understand how uncertainty impacts on the
outcome of policy implementation
• Explain policy lags
• Understand the issue of rules versus discretion
• Analyse the issue of dynamic inconsistency
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz
Slides prepared by Dr Monica Keneley.
19-2
Chapter Organisation
19.1
Policy: Working Backwards
19.2
Lags in the Effects of Policy
19.3
Expectations and Reactions
19.4
Uncertainty and Economic Policy
19.5
Multiplier Uncertainty and Policy: a Formal Analysis
19.6
Targets, Instruments and Indicators: a Taxonomy
19.7
Activist Policy
19.8
Which Target? A Practical Application
19.9
Dynamic Inconsistency and Rules Versus Discretion
19.10
Dynamic Inconsistency: a Formal Approach
19.11
The Positive Theory of Policy Making
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz
Slides prepared by Dr Monica Keneley.
19-3
19.1 Policy: Working Backwards
• The process of studying macroeconomics is:
– Observe a shock or policy change
– Recognise the transmission mechanisms linking the
shock to our AD and AS models
– Analyse how the AD and AS curves shift in terms of
directions and amounts
– Take into account the slopes of the AD and AS curves
– Calculate the output and price level changes.
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz
Slides prepared by Dr Monica Keneley.
19-4
Policy: Working Backwards
• Policy makers use the same tools but run the
exercise in reverse:
– Policy makers ask where output and price levels
should be.
– Then they ask in which direction and how far AS
and/or AD need to shift to hit these targets.
– The final step is to calculate how large a policy
change is required to move AS and/or AD the
necessary distance.
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz
Slides prepared by Dr Monica Keneley.
19-5
Chapter Organisation
19.1
Policy: Working Backwards
19.2
Lags in the Effects of Policy
19.3
Expectations and Reactions
19.4
Uncertainty and Economic Policy
19.5
Multiplier Uncertainty and Policy: a Formal Analysis
19.6
Targets, Instruments and Indicators: a Taxonomy
19.7
Activist Policy
19.8
Which Target? A Practical Application
19.9
Dynamic Inconsistency and Rules Versus Discretion
19.10 Dynamic Inconsistency: a Formal Approach
19.11 The Positive Theory of Policy Making
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz
Slides prepared by Dr Monica Keneley.
19-6
19.2 Lags in the Effects of Policy
• Consider an economy at full employment which
experiences an unexpected adverse AD shock.
• Policy makers must distinguish whether the
disturbance is permanent or transitory:
– If the disturbance is transitory with AD rapidly adjusting
it would be best to do nothing
– Why? Policy actions have lagged effects which may
cause overshooting in the correction process.
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz
Slides prepared by Dr Monica Keneley.
19-7
Lags in the Effects of Policy
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz
Slides prepared by Dr Monica Keneley.
19-8
Lags in the Effects of Policy
• Figure 19.1 highlights the policy intervention
problem:
– Without intervention output declines but then recovers.
– If expansionary policy is implemented output recovers
faster but may overshoot the full employment level.
– Restrictive policy may then have to be applied to
return the economy to it full employment point.
– If the disturbance is permanent (persistent) policy
makers must intervene.
– However, their ability to intervene is made difficult by
lags in the effects of policies.
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz
Slides prepared by Dr Monica Keneley.
19-9
Lags in the Effects of Policy
• There are two types: Inside and Outside lags
• Inside lags
– The time period it takes to undertake policy action
– Are divided into recognition, decision and action lags
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz
Slides prepared by Dr Monica Keneley.
19-10
Lags in the Effects of Policy
• The recognition lag
– The period that elapses between the time a disturbance
occurs and the time the policy makers recognise that
action is required.
• The decision lag
– The delay between the recognition of the need for
action and the policy decision.
– This involves time in formulating an appropriate
policy response.
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz
Slides prepared by Dr Monica Keneley.
19-11
Lags in the Effects of Policy
• The action lag
– The lag between the policy decision and its
implementation
– Usually short for monetary policy as actions can be
undertaken almost as soon as the decision is made
– Fiscal policy actions are relatively slower to implement
– They require legislation drafting and approval by both
houses of parliament
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz
Slides prepared by Dr Monica Keneley.
19-12
Lags in the Effects of Policy
• Inside lags are discrete lags.
– There is a period time between each lag from
recognition to action.
• Outside lags are distributed lags.
– Policy effects are spread over time and gradually
accumulate.
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz
Slides prepared by Dr Monica Keneley.
19-13
Lags in the Effects of Policy
• Outside lags
– Are associated with the impact of policy on the economy
 Example: The impact of an increase in money supply
gradually increases spending and GDP over several
quarters
 Implication: A large increase in money supply is needed to
quickly reverse an adverse AD shock
 Problem: This will have large effects on GDP which could
overcorrect and cause inflation
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz
Slides prepared by Dr Monica Keneley.
19-14
Lags in the Effects of Policy
• Monetary versus fiscal policy lags
– Fiscal policy has relatively shorter outside lags but
considerably longer inside lags than monetary policy.
– For this reason fiscal policy is less useful for stabilisation.
• Gradualist versus cold turkey policies
– Gradualist policies more the economy slowly towards
a target.
– Cold turkey policies generate a 'shock effect'. This
shock may have negative as well as positive effects.
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz
Slides prepared by Dr Monica Keneley.
19-15
Chapter Organisation
19.1
Policy: Working Backwards
19.2
Lags in the Effects of Policy
19.3
Expectations and Reactions
19.4
Uncertainty and Economic Policy
19.5
Multiplier Uncertainty and Policy: a Formal Analysis
19.6
Targets, Instruments and Indicators: a Taxonomy
19.7
Activist Policy
19.8
Which Target? A Practical Application
19.9
Dynamic Inconsistency and Rules Versus Discretion
19.10
Dynamic Inconsistency: a Formal Approach
19.11
The Positive Theory of Policy Making
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz
Slides prepared by Dr Monica Keneley.
19-16
19.3 Expectations and Reactions
• Uncertainty about the effects of policies arises
because policy makers do not know:
– The precise values of multipliers
– How the economy will react to policy changes.
• Reaction uncertainties
– Assume that the government decides on a temporary
tax cut.
– The effectiveness of the tax cut depends upon the
reaction of the public.
– If the government is wrong in its estimation of reaction,
a policy change could destabilise the economy.
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz
Slides prepared by Dr Monica Keneley.
19-17
Expectations and Reactions
• If the public knows the tax cut is only temporary:
– Their permanent income will increase by a small margin
– So the increase in spending will be small.
• If the public think that the cut will last longer:
– Their MPC out of the tax cut would be higher
– So a small tax cut may raise spending by a
larger amount.
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz
Slides prepared by Dr Monica Keneley.
19-18
Expectations and Reactions
• Credibility and policy regime
– Policy makers only have credibility when their
announcements are believed by individuals.
– Policy makers have to earn credibility by behaving
consistently over long periods of time.
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz
Slides prepared by Dr Monica Keneley.
19-19
Chapter Organisation
19.1
Policy: Working Backwards
19.2
Lags in the Effects of Policy
19.3
Expectations and Reactions
19.4
Uncertainty and Economic Policy
19.5
Multiplier Uncertainty and Policy: a Formal Analysis
19.6
Targets, Instruments and Indicators: a Taxonomy
19.7
Activist Policy
19.8
Which Target? A Practical Application
19.9
Dynamic Inconsistency and Rules Versus Discretion
19.10 Dynamic Inconsistency: a Formal Approach
19.11 The Positive Theory of Policy Making
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz
Slides prepared by Dr Monica Keneley.
19-20
19.4 Uncertainty and Economic Policy
• Policy makers may go wrong in using active
stabilisation policies because of:
– Uncertainty about expectations
– Difficulty in forecasting shocks, such as the hikes
in the price of oil.
• Economists do not know enough about the true
structure of a dynamic economy.
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz
Slides prepared by Dr Monica Keneley.
19-21
Uncertainty and Economic Policy
• This uncertainty arises because:
– Economists disagree about the correct model of the
economy.
– This is evidenced by the large number of different
macroeconomic models.
– Even with a given model, there are uncertainties about
the correct values of parameters and multipliers.
– Uncertainty about the effects of policy changes due to
incomplete knowledge of the multiplier value is known
as 'multiplier uncertainty'.
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz
Slides prepared by Dr Monica Keneley.
19-22
Chapter Organisation
19.1
Policy: Working Backwards
19.2
Lags in the Effects of Policy
19.3
Expectations and Reactions
19.4
Uncertainty and Economic Policy
19.5
Multiplier Uncertainty and Policy: a Formal Analysis
19.6
Targets, Instruments and Indicators: a Taxonomy
19.7
Activist Policy
19.8
Which Target? A Practical Application
19.9
Dynamic Inconsistency and Rules Versus Discretion
19.10 Dynamic Inconsistency: a Formal Approach
19.11 The Positive Theory of Policy Making
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz
Slides prepared by Dr Monica Keneley.
19-23
19.5 Multiplier Uncertainty and Policy:
a Formal Analysis
• Multipliers measure the quantitative effects
of policy.
• Policy may not always achieve its designated
target.
• There may be a gap between the actual change
in income Y and the desired change in income Y*.
• This gap may be measured through the loss
function.
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz
Slides prepared by Dr Monica Keneley.
19-24
Multiplier Uncertainty and Policy:
a Formal Analysis
• Assume the effect of a change in monetary policy
can be expressed as:
Y = βM
(19.1)
– In this equation Y is output, M is the money supply
and  is the money multiplier
• The loss function measuring the loss due to
any gap between actual and target output is:
L = ½(Y – Y*)2
(19.2)
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz
Slides prepared by Dr Monica Keneley.
19-25
Multiplier Uncertainty and Policy:
a Formal Analysis
• The impact of policy change may also be
measured with reference to the marginal
loss function.
• The marginal loss function measures the
incremental loss or gain due to a change
in policy.
• ML(M) = (βM – Y*) × β
(19.3)
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz
Slides prepared by Dr Monica Keneley.
19-26
Chapter Organisation
19.1
Policy: Working Backwards
19.2
Lags in the Effects of Policy
19.3
Expectations and Reactions
19.4
Uncertainty and Economic Policy
19.5
Multiplier Uncertainty and Policy: a Formal Analysis
19.6
Targets, Instruments and Indicators: a Taxonomy
19.7
Activist Policy
19.8
Which Target? A Practical Application
19.9
Dynamic Inconsistency and Rules Versus Discretion
19.10
Dynamic Inconsistency: a Formal Approach
19.11
The Positive Theory of Policy Making
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz
Slides prepared by Dr Monica Keneley.
19-27
19.6 Targets, Instruments and Indicators:
a Taxonomy
• Targets are identified goals.
– Targets are subdivided into ultimate targets and
intermediate targets.
– We focus on output, prices and unemployment—these
are intermediate targets.
• Instruments are the tools the policy maker
manipulates directly.
– An example is the RBA having an exchange rate target.
– The RBA instrument would be the purchase or sale of
cash or foreign exchange reserves.
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz
Slides prepared by Dr Monica Keneley.
19-28
Targets, Instruments and Indicators:
a Taxonomy
• Indicators are economic variables that indicate
whether we are closer to our desired targets.
– An example: an increase in interest rates (an indicator)
sometimes signals that the market anticipates increased
future inflation (a target).
– Other examples of indicators are consumption
expenditure, changes in inventories, consumer
sentiment and inflationary expectations.
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz
Slides prepared by Dr Monica Keneley.
19-29
Chapter Organisation
19.1
Policy: Working Backwards
19.2
Lags in the Effects of Policy
19.3
Expectations and Reactions
19.4
Uncertainty and Economic Policy
19.5
Multiplier Uncertainty and Policy: a Formal Analysis
19.6
Targets, Instruments and Indicators: a Taxonomy
19.7
Activist Policy
19.8
Which Target? A Practical Application
19.9
Dynamic Inconsistency and Rules Versus Discretion
19.10
Dynamic Inconsistency: a Formal Approach
19.11
The Positive Theory of Policy Making
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz
Slides prepared by Dr Monica Keneley.
19-30
19.7 Activist Policy
• Activist policies are policies that respond
to economic problems and attempt to
stabilise output.
• Is activist monetary and fiscal policy desirable?
– Intervention is necessary when the economy has
suffered a major economic shock.
• The debate revolves around the use of policies
for finetuning an economy.
– The major argument against finetuning is that, in practice,
policy makers try to do too much.
– This can be risky and policy may become destabilising.
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz
Slides prepared by Dr Monica Keneley.
19-31
Activist Policy
• Rules versus discretion
– Should the authorities conduct policy in accordance
with pre-announced rules (publicised policy responses
to certain shocks)?
– Or should policy makers be allowed to use their
discretion?
– Given the economy and our understanding of it is
always changing, there is no economic case for
supporting permanent policy rules.
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz
Slides prepared by Dr Monica Keneley.
19-32
Chapter Organisation
19.1
Policy: Working Backwards
19.2
Lags in the Effects of Policy
19.3
Expectations and Reactions
19.4
Uncertainty and Economic Policy
19.5
Multiplier Uncertainty and Policy: a Formal Analysis
19.6
Targets, Instruments and Indicators: a Taxonomy
19.7
Activist Policy
19.8
Which Target? A Practical Application
19.9
Dynamic Inconsistency and Rules Versus Discretion
19.10
Dynamic Inconsistency: a Formal Approach
19.11
The Positive Theory of Policy Making
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz
Slides prepared by Dr Monica Keneley.
19-33
19.8 Which Target? A Practical Application
• Real GDP targeting requires the use of monetary
and fiscal policy to achieve a particular rate of
growth in real GDP.
– If we know what potential GDP is, and we are able to
hit potential GDP, then real GDP targeting is optimal.
– The Phillips curve relationship implies that hitting
potential GDP is consistent with low actual and
anticipated inflation.
– The problem with targeting real GDP is that guessing
too high as to the growth of potential GDP creates
inflationary problems.
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz
Slides prepared by Dr Monica Keneley.
19-34
Which Target? A Practical Application
• Nominal GDP targeting
– Suppose that the nominal GDP target is 4% but real
GDP is actually 2%.
– In the long run, the 4% nominal GDP growth will split
into 2% real growth and 2% inflation.
– This has the advantage over real GDP targeting as
inflation won’t be unlimited, which may occur through
targeting real GDP.
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz
Slides prepared by Dr Monica Keneley.
19-35
Which Target? A Practical Application
• Inflation targeting
– This is the opposite to real GDP targeting.
– This may be easier to achieve than targeting
unemployment or real output.
– Economists who believe the economy is largely
self-correcting prefer nominal targets like inflation.
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz
Slides prepared by Dr Monica Keneley.
19-36
Chapter Organisation
19.1
Policy: Working Backwards
19.2
Lags in the Effects of Policy
19.3
Expectations and Reactions
19.4
Uncertainty and Economic Policy
19.5
Multiplier Uncertainty and Policy: a Formal Analysis
19.6
Targets, Instruments and Indicators: a Taxonomy
19.7
Activist Policy
19.8
Which Target? A Practical Application
19.9
Dynamic Inconsistency and Rules Versus Discretion
19.10
Dynamic Inconsistency: a Formal Approach
19.11
The Positive Theory of Policy Making
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz
Slides prepared by Dr Monica Keneley.
19-37
19.9 Dynamic Inconsistency and Rules
Versus Discretion
• Dynamic inconsistency
– Refers to the tendency of optimal policy to be different
a different points in time.
– Policy makers who have discretion will be tempted to
take short-run actions that are inconsistent with the
economy’s best long-run interests.
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz
Slides prepared by Dr Monica Keneley.
19-38
Dynamic Inconsistency and Rules
Versus Discretion
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz
Slides prepared by Dr Monica Keneley.
19-39
Dynamic Inconsistency and Rules
Versus Discretion
– The policy maker announces a policy of zero inflation.
– Economic agents choose a level of anticipated inflation
consistent with the announced policy.
– The economy will be at point A at full employment.
– Since the short-run Phillips curve is now fixed, the
policy maker may reduce unemployment at the
expense of a little inflation.
– The economy moves to point B.
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz
Slides prepared by Dr Monica Keneley.
19-40
Dynamic Inconsistency and Rules
Versus Discretion
– At point B, the policy may be optimal because people’s
marginal loss from more inflation equals the marginal
benefit from lower unemployment.
– However, at point B, inflation is greater than expected.
– Economic agents will come to anticipate higher inflation
and the short-run Phillips curve will shift up.
– The economy moves to point C.
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz
Slides prepared by Dr Monica Keneley.
19-41
Dynamic Inconsistency and Rules
Versus Discretion
– At point C the marginal loss from inflation is high enough
that the policy maker is unwilling to increase inflation
further to reduce unemployment
– The economy is at point C although the preferred position
is A.
• A promise by the policy maker to return to point A
may not be credible.
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz
Slides prepared by Dr Monica Keneley.
19-42
Dynamic Inconsistency and Rules
Versus Discretion
• How can dynamic inconsistency be reduced?
– The policy maker may follow a (monetary) rule.
– However, this rule may become outdated or
inappropriate.
– If the policy maker is independent of political pressures
then it is more likely to be consistent.
– An independent central bank with a clearly- identified
charter is an example.
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz
Slides prepared by Dr Monica Keneley.
19-43
Chapter Organisation
19.1
Policy: Working Backwards
19.2
Lags in the Effects of Policy
19.3
Expectations and Reactions
19.4
Uncertainty and Economic Policy
19.5
Multiplier Uncertainty and Policy: a Formal Analysis
19.6
Targets, Instruments and Indicators: a Taxonomy
19.7
Activist Policy
19.8
Which Target? A Practical Application
19.9
Dynamic Inconsistency and Rules Versus Discretion
19.10
Dynamic Inconsistency: a Formal Approach
19.11
The Positive Theory of Policy Making
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz
Slides prepared by Dr Monica Keneley.
19-44
19.10 Dynamic Inconsistency: a
Formal Approach
• Assume that policy makers choose the level of
inflation.
• The associated level of unemployment is given
by the short-run Phillips curve.
•  = e – ε(u – u*)
(19.9)
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz
Slides prepared by Dr Monica Keneley.
19-45
Dynamic Inconsistency: a
Formal Approach
• The policy maker prefers low unemployment
and zero inflation.
• The loss function for this policy is specified by:
L = a(u – u*) + 2
(19.10)
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz
Slides prepared by Dr Monica Keneley.
19-46
Dynamic Inconsistency: a
Formal Approach
•
The three steps in the 'game' played by the policy
maker are:
1. The policy maker chooses and announces and inflation
policy (point A in Figure 19.3).
2. The economy 'picks' anticipated policye (point B).
3. The policy maker implements actual policy that
minimises the loss function (point C).
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz
Slides prepared by Dr Monica Keneley.
19-47
Dynamic Inconsistency: a
Formal Approach
• The final score is calculated by inserting the
actual policy and anticipated inflation into the
loss function.
(19.11)
• The loss is minimised by setting the marginal loss
function equal to zero.
(19.12)
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz
Slides prepared by Dr Monica Keneley.
19-48
Dynamic Inconsistency: a
Formal Approach
• The optimal policy is:
(19.13)
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz
Slides prepared by Dr Monica Keneley.
19-49
Chapter Organisation
19.1
Policy: Working Backwards
19.2
Lags in the Effects of Policy
19.3
Expectations and Reactions
19.4
Uncertainty and Economic Policy
19.5
Multiplier Uncertainty and Policy: a Formal Analysis
19.6
Targets, Instruments and Indicators: a Taxonomy
19.7
Activist Policy
19.8
Which Target? A Practical Application
19.9
Dynamic Inconsistency and Rules Versus Discretion
19.10
Dynamic Inconsistency: a Formal Approach
19.11
The Positive Theory of Policy Making
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz
Slides prepared by Dr Monica Keneley.
19-50
19.11 The Positive Theory of
Policy Making
• The positive theory of policy making focuses on
how policy makers actually behave.
– In the short run policy makers have to decide how
accommodate an inflationary shock knowing that
any policy will impact on unemployment.
– In the long run policy makers have to decide whether
to aim for very low, zero or positive inflation.
• The political business cycle theory studies the
interaction between economic policy decisions
and political consideration.
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz
Slides prepared by Dr Monica Keneley.
19-51
The Positive Theory of Policy Making
• The political business cycle hypothesis suggests
that politicians:
– Use restrictive policies early in the government's term
raising unemployment to reduce inflation.
– As the election approaches expansionary policies are
used to reduce unemployment to gain voter approval.
• The approach suggests a systematic cycle in
unemployment rising in the early part of the
government's term and falling in the latter.
– Empirical evidence to support this hypothesis is mixed.
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz
Slides prepared by Dr Monica Keneley.
19-52