Worth: Mankiw Economics 5e CHAPTER 14 Stabilization Policy 383 example, the system of income taxes automatically reduces taxes when the economy goes into a recession, without any change in the tax laws, because individuals and corporations pay less tax when their incomes fall. Similarly, the unemployment insurance and welfare systems automatically raise transfer payments when the econ- omy moves into a recession, because more people apply for benefits. One can view these automatic stabilizers as a type of fiscal policy without any inside lag The Difficult Job of Economic Forecasting Because policy influences the economy only after a long lag, successful stabilization policy requires the ability to predict accurately future economic conditions. If we cannot predict whether the economy will be in a boom or a recession in six months or a year, we cannot evaluate whether monetary and fiscal policy should now be try ing to expand or contract aggregate demand. Unfortu nately, economic developments are often unpredictabl at least given our current understanding of the economy. One way forecasters try to look ahead is with lead ing indicators. a leading indicator is a data series that fluctuates in advance of the economy. A large fall in a leading indicator signals that a recession is more likely Another way forecasters look ahead is with macro- conometric models, which have been developed both by overtime ent agencies and by private firms for forecast- It's true. Caesar. Rome is declining but I ing and policy analysis. As we discussed in Chapter 11, expect it to pick up in the next quarter What's in the Index of Leading Economic Indicators? Each month the Conference Board, a private! 3. New orders for consumer goods and materi economics research group, announces the index als, adjusted for of leading economic indicators. This index is made upi 4. Vendor performance. This is a measure of from 10 data series that are often used to fore- the number of companies receiving slower cast changes in economic activity about six to deliveries from suppliers nine months ahead. Here is a list of the series Can you explain why each of these might help 5. New orders, nondefense capital goods predict changes in real GDP? 6. New building permits issued. 1. Average workweek of production workers in 7. Index of stock prices 8. Money supply(M2), adjusted for inflation 2. Average initial weekly claims for unemploy.i 9. Interest rate spread: the yield spread be- ment insurance. This series is inverted in tween 10-year Tr computing the index, so that a decrease Treasury bills the series raises the index 10. Index of consumer expectations User JoENA: Job EFFo1430: 6264_ch14: Pg 383: 27869#/eps at 100sl Mon,Feb18,20021:024M
User JOEWA:Job EFF01430:6264_ch14:Pg 383:27869#/eps at 100% *27869* Mon, Feb 18, 2002 1:02 AM example,the system of income taxes automatically reduces taxes when the economy goes into a recession, without any change in the tax laws, because individuals and corporations pay less tax when their incomes fall. Similarly, the unemploymentinsurance and welfare systems automatically raise transfer payments when the economy moves into a recession, because more people apply for benefits. One can view these automatic stabilizers as a type of fiscal policy without any inside lag. The Difficult Job of Economic Forecasting Because policy influences the economy only after a long lag,successful stabilization policy requires the ability to predict accurately future economic conditions. If we cannot predict whether the economy will be in a boom or a recession in six months or a year,we cannot evaluate whether monetary and fiscal policy should now be trying to expand or contract aggregate demand. Unfortunately, economic developments are often unpredictable, at least given our current understanding of the economy. One way forecasters try to look ahead is with leading indicators.A leading indicator is a data series that fluctuates in advance of the economy. A large fall in a leading indicator signals that a recession is more likely. Another way forecasters look ahead is with macroeconometric models, which have been developed both by government agencies and by private firms for forecasting and policy analysis. As we discussed in Chapter 11, CHAPTER 14 Stabilization Policy | 383 “It’s true, Caesar. Rome is declining, but I expect it to pick up in the next quarter.” Drawing by Dana Fradon; © 1988 The New Yorker Magazine, Inc. FYI Each month the Conference Board, a private economics research group, announces the index of leading economic indicators. This index is made up from 10 data series that are often used to forecast changes in economic activity about six to nine months ahead. Here is a list of the series. Can you explain why each of these might help predict changes in real GDP? 1. Average workweek of production workers in manufacturing. 2. Average initial weekly claims for unemployment insurance. This series is inverted in computing the index, so that a decrease in the series raises the index. What’s in the Index of Leading Economic Indicators? 3. New orders for consumer goods and materials, adjusted for inflation. 4. Vendor performance. This is a measure of the number of companies receiving slower deliveries from suppliers. 5. New orders, nondefense capital goods. 6. New building permits issued. 7. Index of stock prices. 8. Money supply (M2), adjusted for inflation. 9. Interest rate spread: the yield spread between 10-year Treasury notes and 3-month Treasury bills. 10. Index of consumer expectations
Worth: Mankiw Economics 5e 384 PART V Macroeconomic Policy Debates ese large-scale computer models are made up of m ing a part of the economy. After making assumptions about the path of the exoge- nous variables, such as monetary policy, fiscal policy, and oil prices, these models yield predictions about unemployment, inflation, and other endogenous variables. Keep in mind, however, that the validity of these predictions is only as good as the model and the forecasters'assumptions about the exogenous variables CASE STUDY Mistakes in Forecasting Light showers, bright intervals, and moderate winds. " This was the forecast of- fered by the renowned British national weather service on October 14, 1987. The next day britain was hit by the worst storm in more than two centuries 1983:2 8.5 1981:4 7.5 7.0 1981:2 1980 1983 1984 Year Forecasting the Recession of 1982 The red line shows the actual unemployment rate from the first quarter of 1980 to the first quarter of 1986. The blue lines show the unemployment rate predicted at six points in time: the second quarter of 1981, the fourth quarter of 1981, the second quarter of 1982, and so on. Fo each forecast, the symbols mark the current unemployment rate and the forecast for the subsequent five quarters. Notice that the forecasters failed to predict both he rapid rise in the unemployment rate and the subsequent rapid decline burce: The unemployment rate is from the Department of Commerce. The predicted Unemployment rate is the median forecast of about 20 forecasters surveyed by the American Statistical Association and the National Bureau of Economic Research User JoEkA: Job EFFo1430: 6264_ch14: Pg 384: 27870#/eps at 1004 Mon,Feb18,20021:024M
User JOEWA:Job EFF01430:6264_ch14:Pg 384:27870#/eps at 100% *27870* Mon, Feb 18, 2002 1:02 AM these large-scale computer models are made up of many equations, each representing a part of the economy.After making assumptions about the path of the exogenous variables, such as monetary policy, fiscal policy, and oil prices, these models yield predictions about unemployment, inflation, and other endogenous variables. Keep in mind, however, that the validity of these predictions is only as good as the model and the forecasters’assumptions about the exogenous variables. 384 | PART V Macroeconomic Policy Debates CASE STUDY Mistakes in Forecasting “Light showers, bright intervals, and moderate winds.”This was the forecast offered by the renowned British national weather service on October 14, 1987. The next day Britain was hit by the worst storm in more than two centuries. figure 14-1 Year Unemployment rate (percent) 1986 Actual 1983:4 1983:2 1982:4 1982:2 1981:4 1981:2 1980 1981 1982 1983 1984 1985 11.0 10.5 10.0 9.5 9.0 8.5 8.0 7.5 7.0 6.5 6.0 Forecasting the Recession of 1982 The red line shows the actual unemployment rate from the first quarter of 1980 to the first quarter of 1986. The blue lines show the unemployment rate predicted at six points in time: the second quarter of 1981, the fourth quarter of 1981, the second quarter of 1982, and so on. For each forecast, the symbols mark the current unemployment rate and the forecast for the subsequent five quarters. Notice that the forecasters failed to predict both the rapid rise in the unemployment rate and the subsequent rapid decline. Source: The unemployment rate is from the Department of Commerce. The predicted unemployment rate is the median forecast of about 20 forecasters surveyed by the American Statistical Association and the National Bureau of Economic Research
Worth: Mankiw Economics 5e CHAPTER 14 Stabilization Policy 385 Like weather forecasts, economic forecasts are a crucial input to private and public decisionmaking. Business executives rely on economic forecasts when de- ciding how much to produce and how much to invest in plant and equipment Government policymakers also rely on them when developing economic poli- cies. Yet also like weather forecasts, economic forecasts are far from precise The most severe economic downturn in U.S. history, the Great Depression of the 1930s, caught economic forecasters completely by surprise. Even after the stock market crash of 1929, they remained confident that the economy would not suffer a substantial setback. In late 1931, when the economy was clearly in bad shape, the eminent economist Irving Fisher predicted that it would recover quickly. Subsequent events showed that these forecasts were much too optimistic. I Figure 14-1 shows how economic forecasters did during the recession of 1982, the most severe economic downturn in the United States since the Great Depres sion. This figure shows the actual unemployment rate(in red) and six attempts to predict it for the following five quarters (in blue). You can see that the forecasters did well predicting unemployment one quarter ahead. The more distant forecasts, how- ever,were often inaccurate. For example, in the second quarter of 1981, forecasters were predicting little change in the unemployment rate over the next five quarters yet only two quarters later unemployment began to rise sharply. The rise in unem- ployment to almost 11 percent in the fourth quarter of 1982 caught the forecasters by surprise. After the depth of the recession became apparent, the forecasters failed to predict how rapid the subsequent decline in unemployment would be These two episodes--the Great Depression and the recession of 1982show that many of the most dramatic economic events are unpredictable. Although private and public decisionmakers have little choice but to rely on economic forecasts, they must always keep in mind that these forecasts come with a large margin of error. Ignorance, Expectations, and the Lucas Critique The prominent economist Robert Lucas once wrote, " As an advice-giving pro- fession we are in way over our heads. Even many of those who advise policy- makers would agree with this assessment. Economics is a young science, and there is still much that we do not know. Economists cannot be completely confi- dent when they assess the effects of alternative policies. This ignorance suggests that economists should be cautious when offering policy advice Although economists knowledge is limited about many topics, Lucas has em- of the a crucial role in the economy because they influence all sorts of economic behav- ior. For instance, households decide how much to consume based on expectations Kathryn M. Dominguez, Ray C. Fair, and Matthew D. Shapiro, "Forecasting the Depressio Harvard Versus Yale, "American Economic Review 78( September 1988): 595-612. This article shows how badly economic forecasters did during the Great Depression, and it argues that they could not ave done any better with the modern forecasting techniques available today User JoEkA: Job EFFo1430: 6264_ch14: Pg 385: 27871#/eps at 1004 Mon,Feb18,20021:024M
User JOEWA:Job EFF01430:6264_ch14:Pg 385:27871#/eps at 100% *27871* Mon, Feb 18, 2002 1:02 AM CHAPTER 14 Stabilization Policy | 385 Like weather forecasts, economic forecasts are a crucial input to private and public decisionmaking. Business executives rely on economic forecasts when deciding how much to produce and how much to invest in plant and equipment. Government policymakers also rely on them when developing economic policies.Yet also like weather forecasts, economic forecasts are far from precise. The most severe economic downturn in U.S. history, the Great Depression of the 1930s, caught economic forecasters completely by surprise. Even after the stock market crash of 1929, they remained confident that the economy would not suffer a substantial setback. In late 1931, when the economy was clearly in bad shape, the eminent economist Irving Fisher predicted that it would recover quickly.Subsequent events showed that these forecasts were much too optimistic.1 Figure 14-1 shows how economic forecasters did during the recession of 1982, the most severe economic downturn in the United States since the Great Depression.This figure shows the actual unemployment rate (in red) and six attempts to predict it for the following five quarters (in blue).You can see that the forecasters did well predicting unemployment one quarter ahead.The more distant forecasts, however, were often inaccurate. For example, in the second quarter of 1981, forecasters were predicting little change in the unemployment rate over the next five quarters; yet only two quarters later unemployment began to rise sharply.The rise in unemployment to almost 11 percent in the fourth quarter of 1982 caught the forecasters by surprise.After the depth of the recession became apparent, the forecasters failed to predict how rapid the subsequent decline in unemployment would be. These two episodes—the Great Depression and the recession of 1982—show that many of the most dramatic economic events are unpredictable. Although private and public decisionmakers have little choice but to rely on economic forecasts, they must always keep in mind that these forecasts come with a large margin of error. 1 Kathryn M. Dominguez, Ray C. Fair, and Matthew D. Shapiro, “Forecasting the Depression: Harvard Versus Yale,’’ American Economic Review 78 (September 1988): 595–612.This article shows how badly economic forecasters did during the Great Depression, and it argues that they could not have done any better with the modern forecasting techniques available today. Ignorance, Expectations, and the Lucas Critique The prominent economist Robert Lucas once wrote,“As an advice-giving profession we are in way over our heads.’’ Even many of those who advise policymakers would agree with this assessment. Economics is a young science, and there is still much that we do not know. Economists cannot be completely confi- dent when they assess the effects of alternative policies.This ignorance suggests that economists should be cautious when offering policy advice. Although economists’ knowledge is limited about many topics, Lucas has emphasized the issue of how people form expectations of the future.Expectations play a crucial role in the economy because they influence all sorts of economic behavior. For instance, households decide how much to consume based on expectations
Worth: Mankiw Economics 5e 386 PART V Macroeconomic Policy Debates of future income, and firms decide how much to invest based on expectations of future profitability. These expectations depend on many things, including the eco- nomic policies being pursued by the government. Thus, when policymakers esti- mate the effect of any policy change, they need to know how people's expectations will respond to the policy change. Lucas has argued that traditional methods of policy evaluation- such as those that rely on standard macroeconometric mod- els--do not adequately take into account this impact of policy on expectations This criticism of traditional policy evaluation is known as the Lucas critique o: An important example of the Lucas critique arises in the analysis of disinfla- nAs you may recall from Chapter 13, the cost of reducing inflation is often measured by the sacrifice ratio, which is the number of percentage points of GDP that must be forgone to reduce inflation by 1 percentage point. Because hese estimates of the sacrifice ratio are often large, they have led some econo- mists to argue that policymakers should learn to live with inflation, rather than Incur the large cost of reducing it. According to advocates of the rational-expectations approach, however, these es- timates of the sacrifice ratio are unreliable because they are subject to the Lucas cri- tique. Traditional estimates of the sacrifice ratio are based on adaptive expectations, that is, on the assumption that expected inflation depends on past inflation. Adaptive expectations may be a reasonable premise in some circumstances, but if the policy makers make a credible change in policy, workers and firms setting wages and prices will rationally respond by adjusting their expectations of inflation appropriately. This change in inflation expectations will quickly alter the short-run tradeoff between fation and unemployment. As a result, reducing inflation can potentially be much less costly than is suggested by traditional estimates of the sacrifice ratio The Lucas critique leaves us with two lessons. The narrow lesson is that econo- mists evaluating alternative policies need to consider how policy affects expecta- nd, thereby, behavior. The broad lesson is that policy evaluation is hard,so economists engaged in this task should be sure to show the requisite humility. The historical record In judging whethe er government po olicy should play an active or passive role in the economy, we must give some weight to the historical record. If the economy has experienced many large shocks to aggregate supply and aggregate demand, and if policy has successfully insulated the economy from these shocks, then the case for active policy should be clear. Conversely, if the economy has experienced few rge shocks, and if the fuctuations we have observed can be traced to inept eco- omic policy, then the case for passive policy should be clear. In other words,our view of stabilization policy should be influenced by whether policy has histori- cally been stabilizing or destabilizing. For this reason, the debate over macroeco- nomic policy frequently turns into a debate over macroeconomic history. Yet history does not settle the debate over stabilization policy. Disagree ments over history arise because it is not easy to identify the sources of Robert E. Lucas, Jr, "Econometric Policy Evaluation: A Critique, " Carnegie Rochester Conference on Public Policy 1(Amsterdam: North-Holland, 1976), 19-46. User JoENA: Job EFFo1430: 6264_ch14: Pg 386: 27872#/eps at 100s Mon,Feb18,20021:024M
User JOEWA:Job EFF01430:6264_ch14:Pg 386:27872#/eps at 100% *27872* Mon, Feb 18, 2002 1:02 AM of future income, and firms decide how much to invest based on expectations of future profitability.These expectations depend on many things, including the economic policies being pursued by the government.Thus, when policymakers estimate the effect of any policy change,they need to know how people’s expectations will respond to the policy change. Lucas has argued that traditional methods of policy evaluation—such as those that rely on standard macroeconometric models—do not adequately take into account this impact of policy on expectations. This criticism of traditional policy evaluation is known as the Lucas critique. 2 An important example of the Lucas critique arises in the analysis of disinflation. As you may recall from Chapter 13, the cost of reducing inflation is often measured by the sacrifice ratio, which is the number of percentage points of GDP that must be forgone to reduce inflation by 1 percentage point. Because these estimates of the sacrifice ratio are often large, they have led some economists to argue that policymakers should learn to live with inflation, rather than incur the large cost of reducing it. According to advocates of the rational-expectations approach, however, these estimates of the sacrifice ratio are unreliable because they are subject to the Lucas critique.Traditional estimates of the sacrifice ratio are based on adaptive expectations, that is,on the assumption that expected inflation depends on past inflation.Adaptive expectations may be a reasonable premise in some circumstances, but if the policymakers make a credible change in policy,workers and firms setting wages and prices will rationally respond by adjusting their expectations of inflation appropriately.This change in inflation expectations will quickly alter the short-run tradeoff between inflation and unemployment.As a result, reducing inflation can potentially be much less costly than is suggested by traditional estimates of the sacrifice ratio. The Lucas critique leaves us with two lessons.The narrow lesson is that economists evaluating alternative policies need to consider how policy affects expectations and, thereby, behavior.The broad lesson is that policy evaluation is hard, so economists engaged in this task should be sure to show the requisite humility. The Historical Record In judging whether government policy should play an active or passive role in the economy, we must give some weight to the historical record. If the economy has experienced many large shocks to aggregate supply and aggregate demand, and if policy has successfully insulated the economy from these shocks, then the case for active policy should be clear. Conversely, if the economy has experienced few large shocks, and if the fluctuations we have observed can be traced to inept economic policy, then the case for passive policy should be clear. In other words, our view of stabilization policy should be influenced by whether policy has historically been stabilizing or destabilizing. For this reason, the debate over macroeconomic policy frequently turns into a debate over macroeconomic history. Yet history does not settle the debate over stabilization policy. Disagreements over history arise because it is not easy to identify the sources of 386 | PART V Macroeconomic Policy Debates 2 Robert E. Lucas, Jr., “Econometric Policy Evaluation: A Critique,’’ Carnegie Rochester Conference on Public Policy 1 (Amsterdam: North-Holland, 1976), 19–46