The Short-Run Versus Long-Run Tradeoff in Macroeconomic Policy: An Optimal Control Analysis in the Canadian Context

Abstract

<p>The intertemporal dimension of macroeconomic policy, which has been largely neglected, constitutes the main focus of this study. Two questions are posed: What are the long-run implications of pursuing a short-run myopic policy, and what are the short-run consequences of long-sighted policy? Is there a tradeoff relationship between the performance of the economy in the short run and in the long run? To answer these questions, an optimal control approach is used. The two principles elements of this approach are: a macroeconomic model describing the functioning of the system under control, and an objective function specifying explicitly the targets pursued by the policy maker. A macroeconomic model for Canada is formulated and estimated for the period 1962-1982. Some short-run and long-run features characterize the structure of the model. In particular, a government budget constraint, a capital accumulation identity and a production-function that defines the level of potential output in the long run are integrated with a conventional demand-oriented short-run Keynesian model. The objective function specified is quadratic and penalizes the squared deviations of its arguments from their desired values. The optimal control experiments consist of minimizing the objective function subject to the constraints of the macro model. Two approaches are used. The first consists of varying the relative structure of the weights over time by changing the rate of time preference in the objective function. The second approach aims at measuring and comparing the costs implied by different time horizons used by policy makers. In both cases, tradeoff relationships are derived between the performance of the economy in the short run and the long run, expressed in terms of the weighted squared deviations in the objective function. The major conclusions drawn from this study are that a short-run/long-run tradeoff does exist within the given structure of the economy. In addition, this tradeoff implies that as more emphasis is placed on the near-term, the higher will be the cost incurred in the longer term relative to the gain in the near-term, and vice versa. Other conclusions relate to the existence of inflation-unemployment and inflation-balance-of-payments tradeoffs, and the assignment of particular instruments to particular targets.</p>