1 The Policy Debate: Active or Passive? CHAPTER 31 © 2003 South-Western/Thomson Learning

2 Active versus Passive Policy Proponents of the active approach argue that discretionary fiscal or monetary policy can reduce the costs of unstable private sector Proponents of the passive approach counter with the argument that discretionary policy may contribute to the instability of the economy and is therefore part of the problem, not part of the solution

3 Active Approach One possible cost of using discretionary policy to stimulate aggregate demand is an increase in the price level, or inflation Another cost of active fiscal policy is to delay efforts to pay off the national debt

4 Problems with Active Policy The timely adoption and implementation of an appropriate active policy is not easy for a number of reasons Identifying the economy’s potential output and the unemployment rate at that level may not be easy Even if policy makers can accurately estimate the economy’s potential level of output, formulating an effective policy requires detailed knowledge of current and future economic conditions Finally, there are the problems of timing lags

5 Identifying Potential Output Suppose, for example, that the natural rate of unemployment is 5%, but policy makers believe it to be 4% As they pursue the 4% unemployment rate goal, they find that output is constantly pushed beyond its potential, creating higher prices in the long run but no permanent reduction in unemployment

6 Detailed Knowledge Policymakers must be able to forecast what AD and AS would be without government intervention have the tools necessary to achieve the desired result relatively quickly be able to forecast the effects of an active policy on the economy’s key performance measures work together, or at least not work at cross- purposes be able to implement the appropriate policy, even with short-term political costs be able to deal with a variety of timing lags.

7 Problem of Lags Recognition lag Time it takes to identify a problem and determine its seriousness For example, time is required to accumulate evidence that the economy is indeed performing below its potential policy makers must await evidence of trouble rather than risk responding to what may be a false alarm Recall that a recession is not identified until more than six months after it begins since the average recession lasts only 11 months, a typical recession will be more than half over before it is officially recognized as such

8 Problem of Lags Decision-making lag Even after evidence is in, policymakers need additional time to decide what to do In the case of discretionary fiscal policy, Congress and the president must develop and agree upon an appropriate course of action Fiscal legislation can take months and could take more than a year The Fed can decide on the appropriate monetary policy more quickly and does not even have to wait for regular meetings Decision-making lag is longer for fiscal than for monetary policy

9 Problem of Lags Implementation lag Once a decision has been made, the new policy must be implemented Monetary policy has the advantage - after a policy has been adopted, the Fed can immediately buy or sell bonds to influence bank reserves and thereby change the federal funds rate The implementation lag is longer for fiscal policy For example, if tax rates change, new tax forms must be printed and distributed and if spending changes, the appropriate agencies must get involved, which may take more than a year

10 Problem of Lags Effectiveness lag Refers to the time before the full impact of the policy registers on the economy One problem with monetary policy is that the lag between a change in the federal funds rate and the change in aggregate demand and output can take from months to a year or more Fiscal policy, once enacted, usually requires 3 to 6 months to take effect, and between 9 and 18 months to register its full effect

11 Problem of Lags These various lags make active policy difficult to execute The more variable the lags, the harder it is to predict when a particular policy will take hold and what the state of the economy will be at the time To advocates of passive policy, these lags are reason enough to avoid active discretionary policy which simply introduces more instability into the economy

12 Review of Policy Perspectives The active and passive approaches embody different views about the natural resiliency of the economy and the ability of Congress or the Fed to implement appropriate discretionary policies they disagree about the inherent stability of the private sector and the role of public policy Active proponents think the natural adjustments take too long high cost with the failure to pursue discretionary policies

13 Review of Policy Perspectives Passive policy advocates believe that uncertain lags and ignorance about how the economy works prevent policy makers from accurately determining and effectively implementing the appropriate active policy rather than pursuing a misguided activist policy, the natural ability of the economy to adjust is much preferred

14 Role of Expectations The effectiveness of a particular government policy depends in part on what people expect The short-run aggregate supply curve is drawn for a given expected price level reflected in long-term contracts If workers and firms expect continuing inflation, their wage agreements will reflect these inflationary expectations

15 Rational Expectations Argues that people form expectations on the basis of all available information, including information about the probably future actions of policy makers Thus, aggregate supply depends on what sort of macroeconomic course policy makers are expected to pursue For example, if people were to observe policy makers using discretionary policy to stimulate aggregate demand that falls below potential, people would come to anticipate the effects of this policy on the price level and output

16 Monetary Policy and Expectations Suppose the economy is producing potential output and while wage negotiations are under way, the Fed announces that its monetary policy will aim at maintaining the potential level of output while keeping the price level stable This seems the appropriate policy since unemployment is already at the natural rate

17 Anticipating Monetary Policy Suppose Fed policy makers become alarmed by the high inflation with the result that they announce that it plans a monetary policy that will hold the price level constant at 142, a policy aimed at keeping real GDP at its potential

18 Anticipating Monetary Policy Based on previous experience, workers and firms know the Fed is willing to accept higher inflation in exchange for a temporary reduction in unemployment Workers do not want to get caught again with their real wages down should the Fed implement a stimulative monetary policy a high-wage-increase settlement is reached

19 Rational Expectations Economists of the rational expectations believe that if the economy is already producing its potential, an expansionary monetary policy, if fully and correctly anticipated, will have no effect on output or employment Only unanticipated or incorrectly anticipated changes in policy can temporarily influence output and employment

20 Policy Credibility If the economy is producing its potential, an unexpected expansionary monetary policy would increase output and employment temporarily The costs include not only inflation in the long run, but also a loss of credibility the next time around its announcements must somehow must be credible or believable firms and workers must believe that when the time comes to make a hard decision, the Fed will follow through as promised may be more effective if their discretion is taken away

21 Rules versus Discretion In place of discretionary policy, the passive approach often calls for predetermined rules to guide the actions of policy makers In fiscal policy, these rules take the form of automatic stabilizers In monetary policy, passive rules might be the decision to allow the money supply to grow at a predetermined rate, maintain interest rates at some predetermined level, or keep inflation below a certain rate

22 Limitations of Discretion The rationale for the passive approach arises from different views on how the economy works the economy is so complex and economic aggregates interact in such obscure ways and with such varied lags that policy makers cannot comprehend what is going on well enough to pursue an active monetary or fiscal policy the economy is inherently stable - the cost of not intervening are relatively low we know too little about how the economy works

23 Limitations of Discretion Advocates of active policy believe there can be wide and prolonged swings in the economy doing nothing involves significant risks

24 Phillips Curve At one time, policymakers thought they faced a stable long-run tradeoff between inflation and unemployment The possible options with respect to unemployment and inflation can be illustrated by the hypothetical Phillips curve

25 Phillips Curve The Phillips curve was based on an era when inflation was low and the primary disturbances in the economy were shocks to aggregate demand Changes in aggregate demand can be traced as movements along a given short-run aggregate supply curve If aggregate demand increased, the price level increased, but unemployment fell If aggregate demand decreased, the price level decreased, but unemployment increased

26 Phillips Curve The 1970s proved this view wrong for two reasons adverse supply shocks - such as those created by the oil embargoes and worldwide crop failures which shifted the aggregate supply curve leftward higher inflation and higher unemployment stagflation expansionary gap - when short-run equilibrium output exceeds potential output, as this gap is closed by a leftward shift of the SRAS curve, greater inflation and higher unemployment result

27 Short-Run Phillips Curve The short-run Phillips curve is generated by the intersection of alternative aggregate demand curves along a given short-run aggregate supply curve It is based on labor contracts that reflect a given expected price level, which implies a given expected rate of inflation

28 Long-Run Phillips Curve When employers and workers have the time and the ability to adjust fully to any unexpected change in aggregate demand, the long-run Phillips curve is a vertical line drawn at the economy’s natural rate of unemployment As long as prices and wages are flexible, the rate of unemployment, in the long run, is independent of the rate of inflation  policy makers can only choose among alternative rates of inflation

29 Natural Rate Hypothesis The reexamination of the Phillips curve led to the natural rate hypothesis Natural Rate Hypothesis states that in the long run the economy tends toward the natural rate of unemployment, which is largely independent of the level of the aggregate demand stimulus provided by monetary or fiscal policy regardless of policy makers’ concerns about unemployment, the policy that results in low inflation is generally going to be the optimal policy in the long run

30 Evidence of the Phillips Curve The clearest trade-off between unemployment and inflation occurred between 1960 and 1969 The short-run Phillips curve shifted up to the right for the period from 1970 to 1973 when inflation and unemployment both increased

31 Evidence of the Phillips Curve In 1974, sharp increases in oil prices and crop failures reduced aggregate supply and another shift in the Phillips curve During the 1974 – 1983 period, inflation and unemployment were relatively high and after two recessions in the early 1980s, the short-run Phillips curve shifted leftward