Chapter 14 Stabilization Policy.ppt

Chapter 14: Stabilization Policy Policy Activism Economy is not self-correcting. We need to implement stabilization policy to correct business cycles. Use fiscal and monetary policy to prevent recession and control inflation. Example of active monetary policy: M2 Growth = 3% + (u – 6%) whenever correction is required Policy Passivism Government budgetary actions and stabilization attempts are the source of economic instability. Government can make matters worse as it did in the Great Depression by implementing concretionary policies of tax and interest rate increases! Example of passive monetary policy: M2 Growth = 3% annually Policy Lags Inside lags: time between a shock to the economy and policy action responding to that shock Outside lags: time between implementation of a policy action and its effect on the economy Policy Lags: Inside Lags Recognition lag: The time it takes for policy makers to recognize the existence of a boom or slump. Formulation lag: The time it takes to design policy measures to correct a boom or slump. Policy Limitations: Outside Lags Implementation lag: The time it takes to put the desired policy measures into effect in correcting a boom or slump. Response lag: The time it takes for the economy to adjust to new conditions after policy measures are implemented. Automatic Stabilization Boom: greater employment, inflation, and nominal wage will move workers into higher tax brackets. Paying more taxes reduce disposable income and consumption spending, slowing the economy. Slump: greater unemployment and lower inflation and nominal wage will move workers into lower tax brackets. Paying less taxes increases disposable income and consumption spending, stimulating the economy. Forecasting: Leading Indicators Manufacturing production workweek Weekly unemployment claims New orders for consumer goods and materials Vendor performance Orders for plants and equipment Change in manufactures’ unfilled orders New building permits issue