Power and Limits of Stabilization Policy and Lucas Critique

The Power and Limits of Stabilization Policy:

For the reason that economic policy works with long and variable lags stabilization policy requires that we first know where the economy is and where it is going. If future conditions can’t be predicted policies initiated today are as probable to have destructive as constructive effects when they affect the economy eighteen months or two years from now.

There are generally two approaches that economists take in trying to forecast the near-term future of the economy. The first approach is to utilize large-scale macro-econometric models--more complicated versions of the models of this book. The subsequent approach is to search for leading indicators- one or a few economic variables not inevitably noted in this book that experience tells us are strongly correlated with future movements in real GDP or inflation. The U.S. government utilized to and a private economics research group called the Conference Board now publishes a monthly index of leading economic indicators--eleven factors averaged together that many economists believe provide a good guide to economic activity nine or therefore months in the future.

Of the components that go in to the index of leading indicators perhaps the most broadly-watched is the stock market. The level of the stock market is a excellent indicator of the future of investment spending for the reason that the same factors that make corporate investment committees likely to approve investment projects--optimism about future profits cheap sources of financing willingness to accept risks--make investors eager to buy stocks and to buy stocks at higher prices. We can read probable future decisions of corporate investment committees off of the current value of the stock market. However the stock market is far from perfect as a leading indicator: as economist Paul Samuelson likes to say the stock market has ‘predicted’ nine of the past five recessions.

Details: The Structure of the Economy and the Lucas Critique

Economist Robert Lucas disagree that most of what economists thought they knew about the structure of the economy was false. Prospect of the future have major effects on decision-making in the present- managers' investment decisions, workers' nominal wage demands, households' consumption decisions and practically each other economic decision hinge in one way or another on what is expected to happen in the future. And expectations depend on various things--including the policies followed by the government. Alter the policies followed by the government and you change the structure of the economy as well.

Therefore Lucas argued the utilization of economic models to forecast how the economy would respond to changes in government policy was an incoherent and mistaken exercise. Changes in policy would persuade changes in the structure of the economy and its patterns of behavior that would invalidate the forecasting exercise. Economic forecasts on the basis of a period in which inflation expectations were adaptive would turn out to be grossly in error if applied to a period in which inflation expectations were rational. Forecasts of consumption spending is on the basis of estimates of the marginal propensity to consume from a period in which changes in national income were permanent would lead policy makers astray if applied to forecast the effects of policies that caused transitory changes in national income.

This Lucas Critique was a significant enough insight that for it Robert Lucas was awarded the Nobel Prize.

The leading indicator that has been the majority closely watched is the money supply. Previous to the instability of the 1980s monetarists used to claim that the appropriate measure of the money stock is the only leading indicator worth watching. If the central bank could direct the money stock to the appropriate level through open market operations then success at managing the economy will immediately and automatically follow.
Various measures of the money stock say different things about monetary policy. Republican Party critics of Alan Greenspan continue to censure his tight money policies for George H.W. Bush’s beat in the presidential election of 1992: throughout that year M3 grew by less than one percent. Supporters of Greenspan’s point to the extraordinarily-rapid growth of M1 as well as short-term real interest rates of less than zero as evidence of extraordinarily simulative recession-fighting monetary policy. To say that the money stock is the single most significant leading indicator is unhelpful if various measures of the money stock say different things.

Different Measures of the Money Stock Behave Differently:

1876_money stock measures.jpg

Legend: Since 1980 the various measures of the money stock have ceased to move together. A year (like 1996) in which M1 falls can as well see M3 grow with a dissimilarity between the two of more than ten percentage points per year.

It is a lot harder to be a monetary economist than it used to be.

Even if economists have good dependable forecasts changes in macroeconomic policy affect the economy with long lags and have variable effects. Estimates of the incline of the IS curves are imprecise: this is not rocket science finally. Economists are approximation the reactions of human beings to changes in the incentives to undertake different courses of action. They aren’t calculating the motions of particles that abide by invariant and precisely-known physical laws.

Furthermore changes in interest rates take time to affect the level of aggregate demand and real GDP. It acquires time for corporate investment committees to meet and evaluate how changes in interest rates change the investment projects they wish to undertake. It acquires time for changes in the decisions of corporate investment committees to affect the amount of work being done in building up the country’s capital stock. It acquires time for the changes in employment and income generated by changes in investment to feed through the multiplier process and have their full effect on equilibrium aggregate demand. Therefore the level of total product now is determined not by what long-term real risky interest rates are now but by what long-term real risky interest rates was more than a year and a half ago.

Since more than one member of the FOMC has said creation of monetary policy is like driving a car that has had its windshield painted black. You guess which way you want to go by looking in the rear-view mirror at the landscape behind.

The fact that the Federal Reserve’s decision as well as action cycle is shorter than that of the President and Congress means that the Federal Reserve can if it wishes neutralize the effects of any change in fiscal policy on aggregate demand. In general today’s Federal Reserve does routinely neutralize the effects of changes in fiscal policy. Swings in the budget shortage produced by changes in tax laws as well as spending appropriations have little impact on real GDP unless the Federal Reserve wishes them to.

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