Chapter four

Macro economic Policy Debates

Learning objectives
In this chapter, you will learn about two policy debates:
1. Should policy be active or passive?
2. Should policy be by rule or by discretion?

Note: rule: a regulation or principle governing conduct or procedure

within a particular sphere
discretion: The freedom to decide what should be done in a particular
situation

For detail reading on:

1 Mankiw 5th ed. P 380-405 & 1234-1290
Mankiw 7th ed. P 443-466
 …
Question 1:
Should policy be active or passive?
Arguments for active policy
➢Recessions are periods of high unemployment, low
incomes, and cause economic hardship for millions of people.
➢To many economists the case for active government policy
is clear and simple.
➢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.
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➢The Employment Act of 1946 was a landmark piece
of legislation in which the government first held itself
accountable for macroeconomic performance. The act
states that “it is the continuing policy and responsibility of
the Federal Government to…promote full employment and
production.”

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Arguments against active policy/ Arguments for Passive
policy
➢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.
➢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:
1. Lags in the Implementation and Effects of Policies
➢Economic stabilization would be easy if the effects of policy were
immediate. 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. 4
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Two types of lags that are central problem for the conduct
of stabilization policy:
➢ inside lag:
✓the time between the shock and the policy response
✓takes time to recognize shock
✓takes time to implement policy, especially fiscal policy
➢outside lag:
✓the time it takes for policy to affect economy. Or it 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.

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 …
➢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.
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➢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.

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 …
➢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. If conditions change before policy’s impact is
felt, then policy may end up destabilizing the economy.
➢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.
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➢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.

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➢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.
Examples:
– income tax
– unemployment insurance
– welfare

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➢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.

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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.

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 ….
➢Because policies act with lags, policymakers must predict
future conditions.
➢Ways to generate forecasts:
1. Leading economic indicators(LEI): data series that
fluctuate in advance of the economy
2. Macro econometric models: Large-scale models
with estimated parameters that can be used to forecast
the response of endogenous variables to shocks and
policies

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➢Here is a list of the Index of Leading Economic Indicators.
➢Can you explain why each of these might help predict changes in real
GDP?
1. Average workweek of production workers in manufacturing.
2. Average initial weekly claims for unemployment insurance. This series
is inverted in computing the index, so that a decrease in the series
raises the index.
3. New orders for consumer goods and materials, adjusted for inflation.
[Link] performance. This is a measure of the number of companies
receiving slower deliveries from suppliers.
5. New orders, nondefense capital goods.
6. New building permits issued.
7. Index of stock prices.
8. Money supply (M2), adjusted for inflation.
9. Interest rate spread: the yield spread between 10-year Treasury
notes and 3-month Treasury bills.
10. Index of consumer expectations. 14
 …
➢The episodes—the Great Depression, the recession and
recovery of 1982, and the recent economic downturn—
show that many of the most dramatic economic events
are unpredictable. And show that the forecasts are
often wrong.
➢This is one reason why some economists oppose
policy activism.

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3. Ignorance, Expectations, and The Lucas Critique
➢Robert Lucas won Nobel Prize in 1995 for “rational
expectations”
➢Forecasting the effects of policy changes has often been
done using models estimated with historical data.
➢ Lucas pointed out that such predictions would not be
valid if the policy change alters expectations in a way
that changes the fundamental relationships between
variables.

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➢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.
➢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 expectations17
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.
➢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 (a humble view of one’s own
importance). Don’t exaggerate the importance of policies. 18
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Inflation, Unemployment, and the Phillips Curve
The Phillips curve states that π depends on:
➢expected inflation, πe
➢cyclical unemployment: the deviation of the actual rate
of unemployment from the natural rate
➢supply shocks, ν
π = πe − β(u −un )+ν
where β > 0 is an exogenous constant.

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Adaptive expectations:
➢Adaptive expectations: an approach that assumes
people form their expectations of future inflation based
on recently observed inflation.
➢A simple example:
Expected inflation = last year’s actual inflation
πe = π-1
Then, the P.C. becomes:
π = π-1 − β(u − un ) + ν

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Inflation inertia:
π = π-1 − β(u − un ) + ν
In this form, the Phillips curve implies that inflation
has inertia:
– In the absence of supply shocks or cyclical
unemployment, inflation will continue indefinitely at
its current rate.
– Past inflation influences expectations of current
inflation, which in turn influences the wages & prices
that people set.

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 Graphing the Phillips curve
In the short
run,
π = π-1 − β(u − un ) + ν
policymakers
face a trade-off π
between π and
u. The short-run
π e +ν Phillips Curve

Slope=B
u
un
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The sacrifice ratio:
Sacrifice ratio = (lost GDP)/(total disinflation)
To reduce inflation, policymakers can contract
aggregate demand, causing unemployment to rise
above the natural rate.
The sacrifice ratio measures the percentage of a
year’s real GDP that must be foregone to reduce
inflation by 1 percentage point.
Estimates vary, but a typical one is 5.

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Suppose policymakers wish to reduce inflation from 6
to 2 percent.
If the sacrifice ratio is 5, then reducing inflation by 4
points requires a loss of 4×5 = 20 percent of one year’s
GDP.
This could be achieved several ways, e.g.
– reduce GDP by 20% for one year
– reduce GDP by 10% for each of two years
– reduce GDP by 5% for each of four years
The cost of disinflation is lost GDP. One could use
Okun’s law to translate this cost into unemployment.

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Rational expectations:
Ways of modeling the formation of expectations:
1. adaptive expectations: (discussed above)
✓People base their expectations of future inflation on
recently observed inflation.
2. rational expectations:
✓People base their expectations on all available
information, including information about current and
prospective future policies.

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Painless disinflation?
Proponents of rational expectations believe
that the sacrifice ratio may be very small:
Suppose u = un and π = πe = 6%, and suppose
the Fed announces that it will do whatever is
necessary to reduce inflation from 6 to 2 percent
as soon as possible.
If the announcement is credible, then πe will fall,
perhaps by the full 4 points.
Then, π can fall without an increase in u.
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 The History of the Modern Phillips Curve
The Phillips curve is named after • Second, the modern Phillips curve
New Zealand–born economist A. W. includes expected inflation. This
Phillips. In 1958. Phillips observed a addition is due to the work of Milton
negative relationship between the Friedman and Edmund Phelps. In
unemployment rate and the rate of developing early versions of the
wage inflation in data for the United imperfect information model in the
Kingdom. 1960s, these two economists
The Phillips curve that economists emphasized the importance of
use today differs in three ways from expectations for aggregate supply.
the relationship Phillips examined. • Third, the modern Phillips curve
First, the modern Phillips curve includes supply shocks. Credit for this
substitutes price inflation for wage addition goes to OPEC, the
inflation. This difference is not Organization of Petroleum Exporting
crucial, because price inflation and Countries. In the 1970s OPEC caused
wage inflation are closely related. In large increases in the world price of
periods when wages are rising oil, which made economists more
quickly, prices are rising quickly as aware of the importance of shocks to
well. aggregate supply. 27
 Question 2: Should policy be conducted by rule or
discretion?
Rules and Discretion: basic concepts
Policy conducted by rule:
✓Policymakers announce in advance how policy will
respond in various situations, and commit themselves to
following through.
Policy conducted by discretion:
✓As events occur and circumstances change, policymakers
use their judgment and apply whatever policies seem
appropriate at the time.
Arguments for Rules:
1. Distrust of policymakers and the political process
✓misinformed politicians
✓politicians’ interests sometimes not the same as the
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interests of society
 ….
[Link] Time Inconsistency of Discretionary
Policy:
✓A scenario in which policymakers have an
incentive to renege /go back on/ or break a
promise on a previously announced policy once
others have acted on that announcement.
✓Destroys policymakers’ credibility, thereby
reducing effectiveness of their policies.

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Examples of Time-Inconsistent Policies
To encourage investment, government announces it
won’t tax income from capital. But once the factories are
built, the govt reneges in order to raise more tax revenue.
To reduce expected inflation, the Central Bank
announces it will tighten monetary policy. But faced with
high unemployment, Central Bank may be tempted to cut
interest rates.
Aid to poor countries is contingent on fiscal reforms. The
reforms don’t occur, but aid is given anyway, because the
donor countries don’t want the poor countries’ citizens to
starve.
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Monetary Policy Rules:
a. Constant money supply growth rate
✓advocated by Monetarists
✓stabilizes aggregate demand only if velocity is stable
b. Target growth rate of nominal GDP
automatically increase money growth whenever nominal
GDP grows slower than targeted; decrease money growth
when nominal GDP growth exceeds target.
c. Target the inflation rate
✓automatically reduce money growth whenever inflation
rises above the target rate.
✓Many countries’ central banks now practice inflation
targeting, but allow themselves a little discretion.
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d. The “Taylor Rule”
Target Federal Funds rate based on
✓inflation rate
✓gap between actual & full-employment GDP

Central Bank Independence

✓A policy rule announced by Central Bank will work only
if the announcement is credible.
✓Credibility depends in part on degree of independence of
central bank.

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3. Advocates of discretionary policy believe:
✓discretion gives more flexibility to policymakers in
responding to the unexpected
4. Advocates of policy rules believe:
✓the political process cannot be trusted: politicians make
policy mistakes or use policy for their own interests
✓commitment to a fixed policy is necessary to avoid time
inconsistency and maintain credibility

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