CHAPTER 5: MACROECONOMIC POLICY DEBATES
5.1. Should policy be active or passive?
Policymakers in the federal government view economic stabilization as one of their
primary responsibilities.
The analysis of macroeconomic policy is a regular duty of the Council of Economic
Advisers, the Congressional Budget Office, the Federal Reserve, and other
government agencies.
When Congress or the president is considering a major change in fiscal policy, or
when the Federal Reserve is considering a major change in monetary policy,
foremost in the discussion are how the change will influence inflation and
unemployment and whether aggregate demand needs to be stimulated or restrained.
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Cont.…
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.
Italso 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 hands off approach to macroeconomic
policy.
5.1.1. Lags in the Implementation and Effects of Policies
Economic stabilization would be easy if the effects of policy were immediate.
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.
Cont.….
The outside lag is the time between a policy action and its influence oa, and
employment.
A long inside lag is a central problem with using fiscal policy for economic
stabilization
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.
Therefore, so a change in monetary policy is thought not to affect economic
activity until about six months after it is made.
Cont.….
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 the economy can be destabilizing.
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.
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.
5.1.2. The Difficult Job of Economic Forecasting
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.
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.
5.2. Ignorance, Expectation 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.
Although economists knowledge is limited about many topics, 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.
Cont.…
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.
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.
Cont.…
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.
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.
5.3. Should policies 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.
5.3.1. Distrust of Policymakers and the Political Process
Some economists believe that economic policy is too important to be left to the
discretion of policymakers.
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.
Cont.….
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.
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 balanced-budget
amendment, that would tie the hands of legislators and insulate the economy
from both incompetence and opportunism.
5.4. Rules for monetary policy
Even if we are convinced that policy rules are superior to discretion, the debate
over macroeconomic policy is not over.
Some economists, called monetarists, advocate that the Fed keep the money
supply growing at a steady rate. Monetarists believe that fluctuations in the
money supply are responsible for most large fluctuations in the economy.
They argue that slow and steady growth in the money supply would yield stable
output, employment, and prices. Most economists believe that a policy rule needs to allow
the money supply to adjust to various shocks to the economy.
Cont.…
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 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.
Cont.…
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.
