Chapter five
Macroeconomic policy debate
Should Policy Be Active or Passive?
To many economists the case for active government policy is clear and simple. Recessions
are periods of high unemployment, low incomes, and increased economic hardship. The
model of aggregate demand and aggregate supply shows how shocks to the economy can
cause recessions. It also shows how monetary and fiscal policy can prevent (or at least soften)
recessions by responding to these shocks. These economists consider it wasteful not to use
these policy instruments to stabilize the economy.
Other economists are critical of the government’s attempts to stabilize the economy. These
critics argue that the government should take a hands-off approach to macroeconomic policy.
At first, this view might seem surprising. If our model shows how to prevent or reduce the
severity of recessions, why do these critics want the government to refrain from using
monetary and fiscal policy for economic stabilization? To find out, let’s consider some of
their arguments.
4.2.1 Lags in the Implementation and Effects of Policies
Economic stabilization would be easy if the effects of policy were immediate. Making policy
would be like driving a car: policymakers would simply adjust their instruments to keep the
economy on the desired path.
Making economic policy, however, is less like driving a car than it is like piloting a large
ship. A car changes direction almost immediately after the steering wheel is turned. By
contrast, a ship changes course long after the pilot adjusts the rudder, and once the ship starts
to turn, it continues turning long after the rudder is set back to normal. A novice pilot is likely
to over steer and, after noticing the mistake, over react by steering too much in the opposite
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direction. The ship’s path could become unstable, as the novice responds to previous
mistakes by making larger and larger corrections.
Like a ship’s pilot, economic policymakers face the problem of long lags. Indeed, the
problem for policymakers is even more difficult, because the lengths of the lags are hard to
predict. These long and variable lags greatly complicate the conduct of monetary and fiscal
policy.
Economists distinguish between two lags that are relevant for the conduct of stabilization
policy: the inside lag and the outside lag. The inside lag is the time between a shock to the
economy and the policy action responding to that shock. This lag arises because it takes time
for policymakers first to recognize that a shock has occurred and then to put appropriate
policies into effect. The outside lag is the time between a policy action and its influence on
the economy. This lag arises because policies do not immediately influence spending,
income, and employment.
A long inside lag is a central problem with using fiscal policy for economic stabilization. This
is especially true in the United States, where changes in spending or taxes require the
approval of the president and both houses of Congress. The slow and cumbersome legislative
process often leads to delays, which make fiscal policy an imprecise tool for stabilizing the
economy. This inside lag is shorter in countries with parliamentary systems, such as the
United Kingdom, because there the party in power can often enact policy changes more
rapidly.
Monetary policy has a much shorter inside lag than fiscal policy, because a central bank can
decide on and implement a policy change in less than a day, but monetary policy has a
substantial outside lag. Monetary policy works by changing the money supply and interest
rates, which in turn influence investment and aggregate demand. Many firms make
investment plans far in advance, however, so a change in monetary policy is thought not to
affect economic activity until about six months after it is made.
The long and variable lags associated with monetary and fiscal policy certainly make
stabilizing the economy more difficult. Advocates of passive policy argue that, because of
these lags, successful stabilization policy is almost impossible. Indeed, attempts to stabilize
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the economy can be destabilizing. Suppose that the economy’s condition changes between
the beginning of a policy action and its impact on the economy. In this case, active policy
may end up stimulating the economy when it is heating up or depressing the economy when it
is cooling off. Advocates of active policy admit that such lags do require policymakers to be
cautious. But, they argue, these lags do not necessarily mean that policy should be completely
passive, especially in the face of a severe and protracted economic downturn, such as the
recession that began in 2008.
Some policies, called automatic stabilizers, are designed to reduce the lags associated with
stabilization policy. Automatic stabilizers are policies that stimulate or depress the economy
when necessary without any deliberate policy change. For example, the system of income
taxes automatically reduces taxes when the economy goes into a recession, without any
change in the tax laws, because individuals and corporations pay less tax when their incomes
fall. Similarly, the unemployment-insurance and welfare systems automatically raise transfer
payments when the economy moves into a recession, because more people apply for benefits.
One can view these automatic stabilizers as a type of fiscal policy without any inside lag.
4.2.2 The Difficult Job of Economic Forecasting
Because policy influences the economy only after a long lag, successful stabilization policy
requires the ability to predict accurately future economic conditions. If we cannot predict
whether the economy will be in a boom or a recession in six months or a year, we cannot
evaluate whether monetary and fiscal policy should now be trying to expand or contract
aggregate demand. Unfortunately, economic developments are often unpredictable, at least
given our current understanding of the economy.
One way forecasters try to look ahead is with leading indicators. A leading indicator is a data
series that fluctuates in advance of the economy. A large fall in a leading indicator signals
that a recession is more likely to occur in the coming months.
Another way forecasters look ahead is with macro econometric models, which have been
developed both by government agencies and by private firms for forecasting and policy
analysis. These large-scale computer models are made up of many equations, each
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representing a part of the economy. After making assumptions about the path of the
exogenous variables, such as monetary policy, fiscal policy, and oil prices, these models yield
predictions about unemployment, inflation, and other endogenous variables. Keep in mind,
however, that the validity of these predictions is only as good as the model and the
forecasters’ assumptions about the exogenous variables.
1.2.3 Ignorance, Expectations, and the Lucas Critique
The prominent economist Robert Lucas once wrote, “As an advice-giving profession we are
in way over our heads.” Even many of those who advise policymakers would agree with this
assessment. Economics is a young science, and there is still much that we do not know.
Economists cannot be completely confident when they assess the effects of alternative
policies. This ignorance suggests that economists should be cautious when offering policy
advice.
In his writings on macroeconomic policymaking, Lucas has emphasized that economists need
to pay more attention to the issue of how people form expectations of the future. Expectations
play a crucial role in the economy because they influence all sorts of behavior. For instance,
households decide how much to consume based on how much they expect to earn in the
future, and firms decide how much to invest based on their expectations of future
profitability. These expectations depend on many things, but one factor, according to Lucas,
is especially important:
the policies being pursued by the government. When policymakers estimate the effect of any
policy change, therefore, they need to know how people’s expectations will respond to the
policy change. Lucas has argued that traditional methods of policy evaluation—such as those
that rely on standard macro econometric models—do not adequately take into account the
impact of policy on expectations. This criticism of traditional policy evaluation is known as
the Lucas critique.
An important example of the Lucas critique arises in the analysis of disinflation. The cost of
reducing inflation is often measured by the sacrifice ratio, which is the number of percentage
points of GDP that must be forgone to reduce inflation by 1 percentage point. Because
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estimates of the sacrifice ratio are often large, they have led some economists to argue that
policymakers should learn to live with inflation, rather than incur the large cost of reducing it.
According to advocates of the rational-expectations approach, however, these estimates of the
sacrifice ratio are unreliable because they are subject to the Lucas critique. Traditional
estimates of the sacrifice ratio are based on adaptive expectations, that is, on the assumption
that expected inflation depends on past inflation. Adaptive expectations may be a reasonable
premise in some circumstances, but if the policymakers make a credible change in policy,
workers and firms setting wages and prices will rationally respond by adjusting their
expectations of inflation appropriately. This change in inflation expectations will quickly
alter the short-run tradeoff between inflation and unemployment. As a result, reducing
inflation can potentially be much less costly than is suggested by traditional estimates of the
sacrifice ratio.
The Lucas critique leaves us with two lessons. The narrow lesson is that economists
evaluating alternative policies need to consider how policy affects expectations and, thereby,
behavior. The broad lesson is that policy evaluation is hard, so economists engaged in this
task should be sure to show the requisite humility.
The Historical Record
In judging whether government policy should play an active or passive role in the economy,
we must give some weight to the historical record. If the economy has experienced many
large shocks to aggregate supply and aggregate demand, and if policy has successfully
insulated the economy from these shocks, then the case for active policy should be clear.
Conversely, if the economy has experienced few large shocks, and if the fluctuations we have
observed can be traced to inept economic policy, then the case for passive policy should be
clear. In other words, our view of stabilization policy should be influenced by whether policy
has historically been stabilizing or destabilizing. For this reason, the debate over
macroeconomic policy frequently turns into a debate over macroeconomic history.
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Yet history does not settle the debate over stabilization policy. Disagreements over history
arise because it is not easy to identify the sources of economic fluctuations. The historical
record often permits more than one interpretation.
The Great Depression is a case in point. Economists’ views on macroeconomic policy are
often related to their views on the cause of the Depression. Some economists believe that a
large contractionery shock to private spending caused the Depression. They assert that
policymakers should have responded by using the tools of monetary and fiscal policy to
stimulate aggregate demand. Other economists believe that the large fall in the money supply
caused the Depression. They assert that the Depression would have been avoided if the Fed
had been pursuing a passive monetary policy of increasing the money supply at a steady rate.
Hence, depending on one’s beliefs about its cause, the Great Depression can be viewed either
as an example of why active monetary and fiscal policy is necessary or as an example of why
it is dangerous.
Should Policy Be Conducted by Rule or by Discretion?
A second topic debated among economists is whether economic policy should be conducted
by rule or by discretion. Policy is conducted by rule if policymakers announce in advance
how policy will respond to various situations and commit themselves to following through on
this announcement. Policy is conducted by discretion if policymakers are free to size up
events as they occur and choose whatever policy they consider appropriate at the time.
The debate over rules versus discretion is distinct from the debate over passive versus active
policy. Policy can be conducted by rule and yet be either passive or active. For example, a
passive policy rule might specify steady growth in the money supply of 3 percent per year.
An active policy rule might specify that
Money Growth = 3% + (Unemployment Rate − 6%).
Under this rule, the money supply grows at 3 percent if the unemployment rate is 6 percent,
but for every percentage point by which the unemployment rate exceeds 6 percent, money
growth increases by an extra percentage point. This rule tries to stabilize the economy by
raising money growth when the economy is in a recession.
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We begin this section by discussing why policy might be improved by a commitment to a
policy rule. We then examine several possible policy rules.
Distrust of Policymakers and the Political Process
Some economists believe that economic policy is too important to be left to the discretion of
policymakers. Although this view is more political than economic, evaluating it is central to
how we judge the role of economic policy. If politicians are incompetent or opportunistic,
then we may not want to give them the discretion to use the powerful tools of monetary and
fiscal policy.
Incompetence in economic policy arises for several reasons. Some economists view the
political process as erratic, perhaps because it reflects the shifting power of special interest
groups. In addition, macroeconomics is complicated, and politicians often do not have
sufficient knowledge of it to make informed judgments. This ignorance allows charlatans to
propose incorrect but superficially appealing solutions to complex problems. The political
process often cannot weed out the advice of charlatans from that of competent economists.
Opportunism in economic policy arises when the objectives of policymakers conflict with the
well-being of the public. Some economists fear that politicians use macroeconomic policy to
further their own electoral ends. If citizens vote on the basis of economic conditions
prevailing at the time of the election, then politicians have an incentive to pursue policies that
will make the economy look good during election years. A president might cause a recession
soon after coming into office to lower inflation and then stimulate the economy as the next
election approaches to lower unemployment; this would ensure that both inflation and
unemployment are low on election day. Manipulation of the economy for electoral gain,
called the political business cycle, has been the subject of extensive research by economists
and political scientists.
Distrust of the political process leads some economists to advocate placing economic policy
outside the realm of politics. Some have proposed constitutional amendments, such as a
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balanced-budget amendment, that would tie the hands of legislators and insulate the economy
from both incompetence and opportunism.
Do you think that monetary policy suffers from time inconsistency problem associated with
giving too much discretionary power for policy makers?
4.3.1The Time Inconsistency of Discretionary Policy
If we assume that we can trust our policymakers, discretion at first glance appears superior to
a fixed policy rule. Discretionary policy is, by its nature, flexible. As long as policymakers
are intelligent and benevolent, there might appear to be little reason to deny them flexibility
in responding to changing conditions.
Yet a case for rules over discretion arises from the problem of time inconsistency of policy.
In some situations policymakers may want to announce in advance the policy they will follow
to influence the expectations of private decision makers. But later, after the private decision
makers have acted on the basis of their expectations, these policymakers may be tempted to
renege on their announcement. Understanding that policymakers may be inconsistent over
time, private decision makers are led to distrust policy announcements. In this situation, to
make their announcements credible, policymakers may want to make a commitment to a
fixed policy rule.
Time inconsistency is illustrated most simply with a political rather than an economic
example—specifically, public policy about negotiating with terrorists over the release of
hostages. The announced policy of many nations is that they will not negotiate over hostages.
Such an announcement is intended to deter terrorists: if there is nothing to be gained from
kidnapping hostages, rational terrorists won’t kidnap any. In other words, the purpose of the
announcement is to influence the expectations of terrorists and thereby their behavior.
But, in fact, unless the policymakers are credibly committed to the policy, the announcement
has little effect. Terrorists know that once hostages are taken, policymakers face an
overwhelming temptation to make some concession to obtain the hostages’ release. The only
way to deter rational terrorists is to take away the discretion of policymakers and commit
them to a rule of never negotiating. If policymakers were truly unable to make concessions,
the incentive for terrorists to take hostages would be largely eliminated.
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The same problem arises less dramatically in the conduct of monetary policy. Consider the
dilemma of a Federal Reserve that cares about both inflation and unemployment. According
to the Phillips curve, the tradeoff between inflation and unemployment depends on expected
inflation. The Fed would prefer everyone to expect low inflation so that it will face a
favorable tradeoff. To reduce expected inflation, the Fed might announce that low inflation is
the paramount goal of monetary policy.
But an announcement of a policy of low inflation is by itself not credible. Once households
and firms have formed their expectations of inflation and set wages and prices accordingly,
the Fed has an incentive to renege on its announcement and implement expansionary
monetary policy to reduce unemployment. People understand the Fed’s incentive to renege
and therefore do not believe the announcement in the first place. Just as a president facing a
hostage crisis is sorely tempted to negotiate their release, a Federal Reserve with discretion is
sorely tempted to inflate in order to reduce unemployment. And just as terrorists discount
announced policies of never negotiating, households and firms discount announced policies
of low inflation.
The surprising outcome of this analysis is that policymakers can sometimes better achieve
their goals by having their discretion taken away from them. In the case of rational terrorists,
fewer hostages will be taken and killed if policymakers are committed to following the
seemingly harsh rule of refusing to negotiate for hostages’ freedom. In the case of monetary
policy, there will be lower inflation without higher unemployment if the Fed is committed to
a policy of zero inflation.
The time inconsistency of policy arises in many other contexts. Here are some examples:
■ To encourage investment, the government announces that it will not tax income from
capital. But after factories have been built, the government is tempted to renege on its
promise to raise more tax revenue from them.
■ To encourage research, the government announces that it will give a temporary monopoly
to companies that discover new drugs. But after a drug has been discovered, the government
is tempted to revoke the patent or to regulate the price to make the drug more affordable.
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■ To encourage good behavior, a parent announces that he or she will punish a child
whenever the child breaks a rule. But after the child has misbehaved, the parent is tempted to
forgive the transgression, because punishment is unpleasant for the parent as well as for the
child.
■ To encourage you to work hard, your professor announces that this course will end with an
exam. But after you have studied and learned all the material, the professor is tempted to
cancel the exam so that he or she won’t have to grade it.
In each case, rational agents understand the incentive for the policymaker to renege, and this
expectation affects their behavior. And in each case, the solution is to take away the
policymaker’s discretion with a credible commitment to a fixed policy rule.
4.4Rules for Monetary Policy
Even if we are convinced that policy rules are superior to discretion, the debate over
macroeconomic policy is not over. If the Fed were to commit to a rule for monetary policy,
what rule should it choose? Let’s discuss briefly three policy rules that various economists
advocate.
Some economists, called monetarists, advocate that the Fed keep the money supply growing
at a steady rate. They argue that slow and steady growth in the money supply would yield
stable output, employment, and prices.
A monetarist policy rule might have prevented many of the economic fluctuations we have
experienced historically, but most economists believe that it is not the best possible policy
rule. Steady growth in the money supply stabilizes aggregate demand only if the velocity of
money is stable. But sometimes the economy experiences shocks, such as shifts in money
demand that cause velocity to be unstable. Most economists believe that a policy rule needs
to allow the money supply to adjust to various shocks to the economy.
A second policy rule that economists widely advocate is nominal GDP targeting. Under this
rule, the Fed announces a planned path for nominal GDP. If nominal GDP rises above the
target, the Fed reduces money growth to dampen aggregate demand. If it falls below the
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target, the Fed raises money growth to stimulate aggregate demand. Because a nominal GDP
target allows monetary policy to adjust to changes in the velocity of money, most economists
believe it would lead to greater stability in output and prices than a monetarist policy rule.
A third policy rule that is often advocated is inflation targeting. Under this rule, the Fed
would announce a target for the inflation rate (usually a low one) and then adjust the money
supply when the actual inflation rate deviates from the target. Like nominal GDP targeting,
inflation targeting insulates the economy from changes in the velocity of money. In addition,
an inflation target has the political advantage of being easy to explain to the public.
Notice that all these rules are expressed in terms of some nominal variable— the money
supply, nominal GDP, or the price level. One can also imagine policy rules expressed in
terms of real variables. For example, the Fed might try to target the unemployment rate at 5
percent. The problem with such a rule is that no one knows exactly what the natural rate of
unemployment is. If the Fed chose a target for the unemployment rate below the natural rate,
the result would be accelerating inflation. Conversely, if the Fed chose a target for the
unemployment rate above the natural rate, the result would be accelerating deflation. For this
reason, economists rarely advocate rules for monetary policy expressed solely in terms of real
variables, even though real variables such as unemployment and real GDP are the best
measures of economic performance.
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