Unit 7

Part. II
Unit 7
Uncertainty, Expectations and Economic
Should policymakers be restrained?
- Frequent requests in US and Europe to restrain
i) In US there are frequent calls for the introduction of a
balanced-budget amendment (e.g. this was the
first item in the “contract with America”, the
program drawn by the Republicans in the 1994):
Figure 24 - 1
The Contract with America
ii) In Europe the countries that adopted the Euro signed
the “Stability and Growth Pact”, which required the
government in the Eurozone to put budget deficits
under control or face large fines
- A major point: macroeconomic policymakers in
general do not have all the knowledge required
for solving complex macroeconomic problems
- Furthermore, in market economies there is
substantial uncertainty about the ultimate
effects of policy measures. One of the reasons
is the interaction of policy and expectations
- During the 1960s Keynesian economists (F.
Modigliani, P. Samuelson and others) believed
that economists’ knowledge was becoming
good enough to allow for increasing finetuning of the economy
- M. Friedman: activist, discretionary policy is likely
to do more harm than good
- The interaction of policy and expectations: how
a policy works depends not only on how it
affects current variables but also on how it
affects expectations about the future
- In the past (during the 1960’s) economic policy was
seen as the control of a complicated machine
- Methods of optimal control were being used to
design macroeconomic policy
- However, outcomes in market economies are the result of
the actions of people and firms who try to anticipate
what policymakers will do and who react not only to
current policy but also to expectations of future policy
-Therefore, economic policy can be thought as a game
between policymakers on the one side and the people
and firms in the economy on the other
-We don’t need optimal control theory but rather game
theory, which studies strategic interactions between
- Strategic interaction: what people and firms do
depends on what they expect policymakers to do.
In turn, what policymakers do depends on what is
happening in the economy
Sometimes, you can do better in a game by giving
up some of your options
e.g.: by giving up the option to negotiate,
governments can prevent hostage takings in the
first place
- The same logic is involved in the design of
macroeconomic policy to control inflation and
unemployment and inflation:
   e   (u  un )
Inflation depends on expected inflation and on the
difference between actual unemployment rate
and the natural unemployment rate. The
coefficient α captures the effect of unemployment
on inflation (Time indexes are omitted for
- Let us assume that the Fed announces that it will
follow a policy consistent with zero inflation. If
people believe this announcement, πe = 0
- As a consequence, the Fed faces the following
relation between unemployment and inflation:
    (u  un )
- If the Fed follows through with its announced policy, it
will “choose” an unemployment rate equal to the
natural rate. Inflation would be zero as people
- But the Fed could deviate from its stated policy and
try to achieve an unemployment rate below the
natural rate with just a small increase in the inflation
If  = 1 and  = 0, then (uun) =  1%. This
incentive to deviate from the announced policy
once the other player (in this case wage
setters) has made its move is known as the
time inconsistency of optimal policy.
- However, wage setters revise their expectations and
begin to expect positive inflation of 1%
- If the Fed still wants to achieve an unemployment rate
1% below the natural rate, it will have to achieve
2% inflation
- As a consequence, people revise their expectations
for inflation further
- Eventually, the economy returns to the natural rate of
unemployment, but with higher inflation.
- The best policy for a Central bank is therefore to
make a credible commitment that it will not try to
deviate from its announced target
- By giving up the option of deviating from the
announced policy, the Central bank can achieve
u = un and zero inflation
- How can a Central bank credibly commit not to
deviate from its announced policy?
- One radical way for a Central bank to establish its
credibility is to be stripped by law of its
policymaking power
- The mandate of the Central bank can be defined by
law in terms of a simple rule (e.g. setting money
growth at 1%)
- An alternative is to adopt a currency board
- Of course, a constant money growth rule would
prevent a Central bank to enact discretionary
monetary policy (e.g.: expand money supply
when unemployment is far above the natural
- There are better ways to deal with the problem of
time inconsistency, without totally stripping
policy-making power from the Central bank
These ways include:
i) Make the Central bank independent: in
this case it would be easier for the
monetary authorities to resist political
ii) Give the central bankers long terms in
office, so they have a long horizon and
incentives to build credibility
 iii) Appoint a “conservative” central
banker who utterly dislikes inflation
-Over the past two decades, several
countries adopted these measures,
which on the whole have been quite
- We have assumed so far that policy makers
were benevolent – that they tried to do
what was best for the economy
- However much public discussion challenges
this assumption: many policy decisions
involve trading off
short-run gains
against long-run losses
Tax cuts:
- By definition, tax cuts lead to lower taxes
today. They are also likely to lead to an
increase in activity and income in the short
- However, unless they are matched by
decreases in government spending, tax
cuts lead to larger budget deficit and to the
need for an increase in taxes in the future
- If voters are shortsighted, the temptation for
politicians to cut taxes may prove
- With the right timing and shortsighted voters,
political parties can win elections
- Therefore, politics may lead to systematic
deficits, until the level of government debt
is so high that politicians are forced to act
- More generally, by assuming that voters are
shortsighted, politicians have a clear
incentive to expand demand before an
- Indeed, excess demand cannot be sustained
and eventually the economy should return
to its structural level Yn
- Thus, we might expect a clear political
business cycle, with higher growth on
average before elections than after
How well do these arguments fit the facts?
- An analysis of the evolution of the ratio of
government debt to GDP in the US since
1900 shows that the reality is more
i) the major build-ups in debt were associated
with special circumstances (World War I,
the Great depression, World War II)
ii) since the early 1980s, the argument of
politicians fits the facts much better much
Game theorists refer to situations in which
each side (party) holds out, hoping the
other side will give in, as wars of attrition
E.g.: the party in power wants to reduce
spending but faces opposition to spending
cuts in Parliament
One way of putting pressure on Parliament is
to cut taxes and create deficits
This puts increasing pressure to the
Parliament to adopt measures aimed at
reducing spending
-These “wars” usually result in delays in the
implementation of policy
-This analytical framework explains to a large
extent the rise in the ratio of debt to GDP in
the US since the early 1980
-One of the goals of the Reagan administration
when it decreased taxes from 1981 to 1983
was to create the conditions for spending
cuts (Republicans in the US are traditionally
against “big governments”)
The Stability and Growth Pact
- In 1997 the would-be members of the Euro
area agreed to make permanent some
“convergence criteria” set by the Maastricht
-In particular the members of the Eurozone
i) commit to balance their budget in the
medium run
ii) avoid excessive deficits (deficits in excess of
3% of GDP) except under exceptional
- Substantial sanctions were imposed on
countries that ran excessive deficits
- Indeed from 1993 to 2000 the performance of
the countries in the Eurozone was very
positive. Budget balances went from a
deficit of 5.8% of Euro area GDP to a
surplus of 0.1
- However, whilst the fiscal rules played a
positive role, this performance was
mainly the result of:
i) The decrease in the nominal interest rate,
which decreased the interest payment
on the debt
ii) The strong economic expansion in the late
Since 2000 deficits have increased
Main reason: low output growth which led to
low tax revenue growth
Some countries (Portugal, France, Germany)
faced “excessive deficit”
However, for obvious political reasons it was
impossible to start the excessive deficit
procedure against the latter two countries

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