What is the role of stabilization policy?

In response to changes in spending that create shocks in aggregate demand, fiscal and monetary policy can be applied to return output to potential and inflation to its long run expected rate. Shocks to aggregate supply (such as inflation shocks), however, force the Fed to choose between maintaining inflation and stabilizing output. If inflationary expectations are anchored, however, the return to potential output following an inflation shock will occur more rapidly. By monitoring the core rate of inflation, the Fed can determine whether an inflation shock has led to any second-round effects on inflation and can act accordingly.

Anchored inflationary expectations: when people's expectations of future inflation do not change even if inflation rises temporarily.

Inflationary expectations and credibility

Macroeconomic performance may be improved if expectations of inflation are anchored. Anchored expectations, in turn, depend on the extent to which a central bank's anti-inflation pronouncements are viewed as credible. Several institutional characteristics may help to enhance a central bank's credibility: the extent to which the central bank is independent from the executive and legislative branches of the government, the announcement of a numerical inflation target, and the reputation of the central bank as an “inflation hawk.”

Credibility of monetary policy: degree to which the public believes the central bank's promises to keep inflation low, if even if doing so may impose short-run economic costs.

Central bank independence: when central bankers are insulated from short-term political considerations and are allowed to take long term view of the economy.

Inflation hawk: someone who is committed to achieving and maintaining low inflation, even at some short-run cost in reduced output and employment.
Inflation dove: someone who is not strongly committed to achieving and maintaining low inflation.

Marginal tax rate: amount by which taxes rise when before-tax income rises by one dollar.
Average tax rate: total taxes divided by total before-tax income.

Inside lag (of macro economic policy): delay between the date a policy change is needed and the date it is implemented.

Outside lag (of macroeconomic policy): delay between the date a policy change is implemented and the date by which most of its effects on the economy have occurred.

In response to changes in spending that create shocks in aggregate demand, fiscal and monetary policy can be applied to return output to potential and inflation to its long run expected rate. Shocks to aggregate supply (such as inflation shocks), however, force the Fed to choose between maintaining inflation and stabilizing output. If inflationary expectations are anchored, however, the return to potential output following an inflation shock will occur more rapidly. By monitoring the core rate of inflation, the Fed can determine whether an inflation shock has led to any second-round effects on inflation and can act accordingly.

Anchored inflationary expectations: when people's expectations of future inflation do not change even if inflation rises temporarily.

Macroeconomic performance may be improved if expectations of inflation are anchored. Anchored expectations, in turn, depend on the extent to which a central bank's anti-inflation pronouncements are viewed as credible. Several institutional characteristics may help to enhance a central bank's credibility: the extent to which the central bank is independent from the executive and legislative branches of the government, the announcement of a numerical inflation target, and the reputation of the central bank as an “inflation hawk.”

Credibility of monetary policy: degree to which the public believes the central bank's promises to keep inflation low, if even if doing so may impose short-run economic costs.

Central bank independence: when central bankers are insulated from short-term political considerations and are allowed to take long term view of the economy.

Inflation hawk: someone who is committed to achieving and maintaining low inflation, even at some short-run cost in reduced output and employment.
Inflation dove: someone who is not strongly committed to achieving and maintaining low inflation.

Marginal tax rate: amount by which taxes rise when before-tax income rises by one dollar.
Average tax rate: total taxes divided by total before-tax income.

Inside lag (of macro economic policy): delay between the date a policy change is needed and the date it is implemented.

Outside lag (of macroeconomic policy): delay between the date a policy change is implemented and the date by which most of its effects on the economy have occurred.