Dynamic Macroeconomics


 Monetary and Fiscal Policy with a Full Employment Target


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9-MAVZUGA (KEYNS MODELI VA FILLIPS EGRI CHIZIG\'I) (1)

15.3.2 Monetary and Fiscal Policy with a Full Employment Target
Let us assume that the sole target of macroeconomic policy is to maintain
output at its full employment level. This can be done by using either fiscal
policy, monetary policy, or both to ensure that aggregate demand is equal to
full employment output y
f
. From 
(15.26)
and 
(15.28)
, output and the price
level satisfy
Using 
(15.30)
 to substitute for the price level in 
(15.29)
, we get
From 
(15.31)
, we see that the government can use its aggregate demand
instruments (i.e., m and g) to achieve the target of full employment output. If
m and g satisfy 
(15.31)
 for all periods, then output will always be at its full
employment target under the discretionary policy.
If the monetary instrument of the government is the nominal interest rate
and not the money supply, then 
(15.31)
 would be replaced by
The money supply would then become endogenous, and the price level would
still be determined by 
(15.30)
.
The above analysis is the justification for discretionary aggregate demand
policies in the Keynesian model. In principle, aggregate demand policies can
be used to counteract the effects of both demand and supply shocks on
aggregate output and unemployment. This ability would imply that aggregate
demand policies could in principle be used to stabilize economic activity at
the level of full employment and help avoid the repetition of phenomena such
as the Great Depression.


15.3.3 Monetary and Fiscal Policy with a Full Employment Target and a Price Level
Target
From the preceding analysis, note that if output is stabilized at its full
employment level, then the price level cannot be controlled and depends only
on the exogenous nominal wage and aggregate supply shocks through
equation 
(15.30)
. If the government wanted to achieve a price level target as
well as full employment, it would not be able to do so, as its monetary and
fiscal policy instruments both operate through aggregate demand and are thus
linearly dependent. Effectively, the government has only one instrument,
aggregate demand policy, and thus can only achieve one target. To affect the
price level, it would need an independent instrument (such as an incomes
policy) that would affect the nominal wage in 
(15.30)
. Without such an
additional instrument, it would have to balance deviations from the full
employment target against deviations from the price level target.
Let us assume, following Theil [1964], that the government selects
monetary and fiscal policy to minimize a loss function that depends on
quadratic deviations of output from full employment output and the price
level from a socially desirable fixed price level target. This loss function
takes the form
where is the price level target, and ζ measures the relative marginal social
cost of price deviations relative to output deviations in the social welfare
ranking of the government.
18
The problem of discretionary economic policy can be modeled as the
minimization of the welfare loss 
(15.33)
, subject to the constraint of the
model of the economy described by equations 
(15.26)

(15.28)
. The outcome
of such a policy process is often described as discretionary policy, because
the government chooses its policy instruments in every period to minimize its
one-period loss function.
From the first-order conditions for a minimum, it follows that


At the optimum, the government aggregate demand policies equate the
marginal social cost of deviations of output from full employment to the
marginal welfare cost of deviations of the price level from its target.
If the government possessed enough instruments to eliminate deviations of
both output from its full employment level and the price level from its target,
then 
(15.34)
would be satisfied for zero deviations from the targets of the
government. However, the government essentially has one policy instrument,
as both monetary and fiscal policy operate through aggregate demand. Using
the aggregate supply function 
(15.26)
 to substitute for y − y
f
in 
(15.34)
, we
find that under the optimal policy,
The price level will deviate from the government’s target under the optimal
policy, unless there is a “divine coincidence,” which ensures that the
exogenous nominal wage, the price level target of the government, and the
supply shock are such that the right-hand side of 
(15.35)
adds up to zero.
Aggregate demand policies do not affect 
(15.35)
.
Substituting 
(15.35)
 in 
(15.34)
, we can see that under the optimal policy,
output will also deviate from full employment output, and the deviation is
determined by
Supply shocks will cause positive deviations of output from full employment
output, and wage shocks will cause negative deviations of output from full
employment output. The lower the price level target of the government
relative to the nominal wage is, the smaller the deviation of output from full
employment output will be: Thus, a government with a low price level target,
given nominal wages, will end up with lower output and employment
compared to full employment under the optimal discretionary policy.
In the presence of wage and supply shocks, discretionary aggregate
demand policies can only ensure that the deviation of output from full
employment output satisfies 
(15.34)
, but no more. Wage and supply shocks


induce a trade-off between the employment and price level target of a
government. Full employment is not compatible with the optimal
discretionary macroeconomic policy, because the government has one
instrument (aggregate demand policies) but two targets (output and the price
level). The optimal discretionary policy is thus second best, as the
government just balances, at the margin, the welfare costs associated with
deviations of the price level and output from its targets.
From 
(15.34)
, note that if ζ = 0 (i.e., if the government cares only about
output and not the price level), this trade-off disappears, and we are back to
a full employment equilibrium, as analyzed in sub-section 15.3.2. However,
in such a case, the price level is destabilized.
The problem is that monetary and fiscal policy in Keynesian models (such
as the AD-AS model we analyzed) can only affect aggregate demand. It is
optimal to use them to achieve full employment only if the government cares
about output and employment and not the price level. If the government cares
about both output and the price level, achieving full employment through
discretionary aggregate demand policies is not feasible in the presence of
wage and supply shocks, because the optimal policy is second best. The
government does not have enough instruments to achieve both targets. Thus,
under the optimal discretionary aggregate demand policy, the best a
government could do is to equalize the marginal welfare cost of deviations of
output from full employment to the marginal welfare cost of deviations of the
price level from its target, as suggested by 
(15.34)
.
If the government is to be able to achieve both of its targets fully under the
discretionary policy, it needs another policy instrument in addition to
monetary and fiscal policies. Such an instrument could, for instance, be a
price or incomes policy that would operate through controls of nominal
wages or prices. Note from 
(15.35)
 and 
(15.36)
 that if a government could
control nominal wages, then it would be able to achieve both full
employment and the price level target.
From the 1950s to the 1970s, when many governments tried to implement
discretionary aggregate demand policies, conflicts often arose between the
targets of full employment and price stability. In such cases, many
governments resorted to nominal wage and price controls as an additional
policy instrument that would help resolve the conflicts. These conflicts


became even more acute with the negative supply shocks of the 1970s, which
led to stagflation, a combination of recession with a rise in inflation.
We shall return to the dilemma of rules versus discretion after we discuss
the evolution of Keynesian models since the 1960s, following the emergence
of the Phillips curve.

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