ECONOMICS U$A


Episode 14

STABILIZATION POLICY

PURPOSE:
To discuss the arguments for and against active government counter-stabilization policy.

OBJECTIVES:
1. Classical economists believe that there is little that the government can do to reduce unemployment and increase GNP growth, especially in the long run. They maintain that in the long run fiscal stimulus raises interest rates and monetary stimulus raises prices without affecting real growth.

2. Expectations may reduce the effectiveness of government stabilization policies.
a) expectations that the government will reverse an anti-inflation policy will keep the policy from being effective
b) "rational expectations’ may keep a stimulative policy from lowering unemployment because individuals and firms may simply demand higher wages and prices.

3. It is difficult to determine exactly what monetary policy to pursue because neither interest rates nor the money supply are perfect indicators of the restrictiveness of monetary policy.

4. Government fiscal policy has often been complicated by political problems, and large structural deficits make it even more difficult to use discretionary fiscal policies.

KEY ECONOMIC CONCEPTS:
Classical perspective, rational expectations, credibility of government policies, constant growth rate rule, interest rates vs. money supply, structural deficits, inside and outside policy lags

Contemporary Issues Stabilization Policy

During the 1990s, the Fed moved toward a more activist monetary policy, pushing up interest rates to cool down the economy (in 1994 and 2000), and pushing down interest rates to counter financial, economic and geopolitical shocks (in 1998 and 2001). The long boom of the 1990s and the shallow recession of 2001 might suggest that the Fedís attempts at fine-tuning have been successful. However, how much of this was due to luck and other developments, such as the technology boom, and how much to adept policies?


For a complete transcript of this video program download TVpdf#14 




Unemployment on the Rise For many years after the Great Depression, the basic
goal of national economic policy was to minimize unemployment. But the winter of 1982 saw 12 million men and women unemployed, and many complained bitterly
that they were the victims of a needlessly cruel government policy. This time public enemy number one was inflation and the jobless workers were the casualties
in the war.
From Richard Nixon through Jimmy Carter, President
after President set out to fight inflation. But when that fight threatened to increase
unemployment, President after President reversed course, opting for stimulative
policies to keep the economy growing and unemployment low.
When the Federal Reserve began once again to tighten the money supply, workers and businessmen alike refused to believe that the
government was serious about ending inflation. Wages and prices continued
upwards, growing faster than the money supply. Finally, as unemployment passed10%, the inflation rate began to drop. In August, Fed Chairman Paul Volcker announced that the time had come to ease monetary policy. Wall Street was the first to respond. But the bitter memories of the recession lingered on…and faith in counter-cyclical policy was one of the casualties. By 1985, after 2 years of recovery, inflation remained at 4%...but the economy still
bore the scars of the recession. Millions of manufacturing jobs were gone for good... and unemployment remained stuck at 7%. Fifteen years of entrenched inflationary expectations had been sharply reduced, but only after the government had finally proven its willingness to pay the price necessary to wring inflation out of the economic system.

Comment and Analysis by Richard Gill One could argue that the difficult times of the early 1980s were really a reflection of the success of our past policies. The very success of these policies, however, undoubtedly contributed to the recent inflationary tendencies of the economy and, perhaps more significantly, to the expectation of future inflation. By 1980, they had created a general sense that the government would back down in the inflation fight as soon as it began to create serious costs in terms of recession and unemployment. People, in short, began
betting on continued inflation. And this made the government’s task infinitely
more difficult. The government had to act strongly enough to break the back of these well entrenched inflationary expectations. It not only had to fight inflation,
but to fight a general belief that it would not fight inflation that hard. Expectations are important in economics. They made the task of monetary policy much harder in the early 1980s.

Foreign Trade Effects In 1983 America came bouncing out of the recession with a boisterous recovery. However, out of all those billions of dollars of consumer spending, too much seemed to be pouring overseas. At the same time, foreigners had a high percentage of our
national debt. By 1985, economists both here and abroad were asking, "Is our
domestic economy the hostage of international forces?" Those international forces had been building throughout the 1970s. During that decade, the percentage of our economy devoted to foreign trade doubled. 1983 was a year of vigorous growth for America as the economic recovery surged ahead. It soon became obvious that many Americans were being left behind. While millions of jobs were being created in the service industries, millions more in manufacturing appeared gone for good…lost to overseas competition. In the 60s and 70s, expansive economic policies had created jobs for American workers. Now these same policies were creating jobs overseas while Americans remained unemployed. The situation was causing severe
problems for American policymakers You may want to expand the economy…let
us say by budget deficit or easier money…but some of this demand goes abroad.
People buy Japanese cars and so you get expansion in Japan but not in Detroit. For
instance, we’ve got a 200-odd billion dollar budget deficit, but half of the money is going abroad and so we’re getting stimulation only from alf. Fiscal policy is losing much of its power."
No one in the Reagan administration had foreseen this effect in 1981 when the administration first embarked on its expansive course…But
as our trade deficit shot past the 100 billion dollar mark, economists and politicians
alike began to search for a solution. Most economists agreed that the trade deficit
was caused by the overly strong American dollar, which was in turn caused by the
runaway budget deficit. But many politicians began to argue for trade barriers to
keep out the flood of imports. The Reagan administration resisted this approach.
Five months after the Bonn summit, the U.S., Japan,
France, Britain and Germany announced a coordinated effort to reduce the value of
the U.S. dollar. The move was a promising effort to ease the U.S. international trade dilemma and possibly create more jobs for American workers. But major problems remained. By 1985, the United States was running 200 billion dollar budget deficits. But half the economic stimulus, the amount of the U.S. trade deficit, was going overseas and any effort to contain this deficit or to promote continued growth had a major impact around the world

Comment and Analysis by Richard Gill
The main reason the international aspect is so important today is that the numbers are so big. In 1971 the deficit was a little over $2 billion. By 1984, it was over $105 billion. And what these numbers mean is that we can’t separate our domestic
stabilization policies from our international trade policies.
Counter-cyclical Policy
The Employment Act of 1946 created a Council of Economic Advisors to give the president the benefit of the best economic advice. For almost 40 years the essence of this advice was to manipulate the economy to prevent inflation and to promote growth. It was called counter-cyclical policy. But, by 1985, the man who occupied this office was urging a receptive president to keep his hands off. By 1985, the man who held this office sharply rejected the idea that the government could fine tune the economy. Monthly fine-tuning of monetary policy created havoc in the economy,
When Paul Volcker initiated a new monetary policy designed to quell inflation once and for all, he made much of the fact that the new policy was on for the duration. No more starts and stops. When Ronald Reagan embarked on the most expansive fiscal policy in history, he locked his policy in place three years in advance. No turning back. 1983 and 1984 were years of growth in the American economy, but, as the economy grew, the budget deficit grew even faster. By 1985, many economists felt that fiscal policy was dead…a casualty of the towering deficit.
In 1985, the sour notes in our economic performance
warned that problems of inflation and unemployment were still with us. But the
consensus of the economic community was that the most effective response was a
policy of coarse-turning rather than the more active management of an earlier
generation.

Comment and Analysis by Richard Gill
Back in the 1950s and 1960s, the Keynesian view was dominant. With slight turns of the rudder of monetary and especially fiscal policy, one could, most economists felt, steer the economic ship past inflation and of unemployment. But today even Neo-Keynesians concede that economic navigation may be less of an exact science than was once imagined. In general, the shift of emphasis from fine-tuning to coarse-tuning has been a shift in time perspective from the short to the longer run. Active intervention in the short run, many economists now feel, may only intensify our longer-run problems.
Unfortunately, there is no real agreement as to what the truly important long-run factors are.