MACROECONOMICS

Arba Minch University

College of Business and Economics
Department of Economics
by
Zigale Y.(M.Sc.)
1/27/2022 1
 CHAPTER FIVE
MACROECONOMICS POLICY DEBATES-
STABILIZATION POLICY
❖5.1. Introduction
❖ Some economists such as William McChesney Martin, view
the economy as inherently unstable.
❖ They argue that the economy experiences frequent shocks to
aggregate demand and aggregate supply.
❖ Unless policymakers use monetary and fiscal policy to stabilize
the economy.
❖ These shocks will lead to unnecessary and inefficient
fluctuations in output, unemployment, and inflation.
 Cont’d …
✓ According to the popular saying, macroeconomic policy
should “lean against the wind’’, stimulating the economy
when it is depressed and slowing the economy when it is
overheated.

❖ Other economists, such as Milton Friedman, view the

economy as naturally stable.

❖ They blame bad economic policies for the large and inefficient

fluctuations we have sometimes experienced.

❖ They argue that economic policy should not try to fine-tune

the economy. 3
 Cont’d …
✓ Instead, economic policymakers should admit their limited
abilities and be satisfied if they do no harm.

✓ This debate has persisted for decades.

✓ In this chapter, we ask two questions that arise in this debate.

✓ First, should monetary and fiscal policy take an active role in

trying to stabilize the economy, or should policy remain
passive?

✓ Second, should policymakers be free to use their discretion in

responding to changing economic conditions, or should they
be committed to following a fixed policy rule? 4
 5.2. Should Policy Be Active or Passive?
❖ To many economists the case for active government policy is
clear and simple.
❖ It is at a time of Recessions.

❖ The model of AD and AS shows that:

a) how shocks to the economy can cause recessions(periods of

high unemployment, low incomes,).
b) It also shows how monetary and fiscal policy can avoid
recessions by responding to these shock.
❖ so these economists conclude that it’s wasteful not to use
these policy instruments to stabilize the economy 5
 Cont’d …
❖ Other economists are dangerous of the government’s attempts to
stabilize the economy.

❖ These critics argue that the government should take a hands-off

approach to macroeconomic policy.

❖ Reasons why do these critics want the government to refrain from

using monetary and fiscal policy for economic stabilizations are:

I). Lags in the Implementation and Effects of Policies

❖ Economic stabilization would be easy if the effects of policy were
immediate.

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 Cont’d …
❖ However, economic policymakers face the problem of long and

variable lags that greatly complicate the conduct of monetary

and fiscal policy.

❖ Economists distinguish between two lags in the conduct of

stabilization policy:

1).The inside lag is the time b/n a shock to the economy and the
policy action responding to that shock.

❖ This lag arises b/c it takes time for policymakers first to

recognize that a shock has occurred and then to put appropriate

policies into effect.
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 Cont’d …
2).The outside lag is the time b/n 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. But it depends on the legislative process.

✓ If the structure of the government is presidential like the USA,

where changes in spending or taxes require the approval of the
president and both houses of Congress, policy action takes longer
time.
8
 Cont’d …
❖ If the structure of the government is parliamentary system,
like Ethiopia and UK, the inside lag in using Fiscal policy is
shorter.

❖ because 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.

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 Cont’d …
❖ Monetary policy works by changing the money supply and

thereby interest rates, which in turn influence investment.

❖ But many firms make investment plans far in advance.

❖ Therefore, 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.

10
 Cont’d …
❖ Advocates of passive policy argue that, b/c of these lags,

successful stabilization policy is almost impossible.

❖ Indeed attempts to stabilize 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 overheated or depressing the economy

when it is cooling off.

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 Cont’d …
❖ Advocates of active policy admit that such lags do require
policymakers to be cautious(carefulness).
❖ But, they argue, these lags do not necessarily mean that policy
should be completely passive, especially in the face of a
severe and extended 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.
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 Cont’d …
❖ 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.

❖Economic Forecasting –
❖Active Policy Requires Forecasts,

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 Cont’d …
❖ 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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 Cont’d …
❖ 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.

❖ Another way forecasters look ahead is with macro econometric

models developed for forecasting and policy analysis.

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 5.3. Ignorance, Expectations, and the Lucas Critique
❖ Nobel laureate Robert Lucas has emphasized the issue of how
people form expectations of the future.

❖ Expectations play a crucial role in the economy because they

influence all sorts of economic behavior.

❖ These expectations depend on many things, including the

economic policies being pursued by the government.

❖ Thus, when policymakers estimate the effect of any policy

change, they need to know how people’s expectations will

respond to the policy change.
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 Cont’d …
❖ Lucas has argued that traditional methods of policy

evaluation—such as those that rely on standard macro

econometrics models— do not adequately take into account
this impact of policy on expectations.

❖ This criticism of traditional policy evaluation is known as the

Lucas critiques.

❖ Lesson from Lucas critiques:

• Economists evaluating alternative policies need to consider

how policy affects expectations and, thereby, behavior.
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 Question 2:
❖

Should policy be conducted by

rule or discretion?
 Cont’d …
❖5.4. Should policies be conducted by Rule or by
Discretion?
❖ A second topic of debate among economists.

❖ Policy is conducted by rule- if policymakers announce in

advance to the public and policy makers commit themselves to
follow that particular policy.

❖ Policy is conducted by discretion- if policymakers are free to

size up events as they occur and choose whatever policy
seems appropriate at the time.

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 Cont’d …
❖ The debate over rules versus discretion is distinct from the
debate over passive versus active policy.
❖ Policy can be conducted by rule can be either passive or active.
❖ For example, A passive policy rule might specify steady
growth of money supply of 3% per year.
❖ Under this rule money supply grows at 3% per annum
regardless of the state of the economy.
❖ An active policy rule might specify that

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 Cont’d …
❖ Under this rule, the money supply grows at 3% if the

unemployment rate is 6%,

❖ but for every percentage point by which the unemployment

rate exceeds 6%, 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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 Cont’d …
❖ Why policy might be improved by a commitment to a policy
rule?

❖ 1). Distrust of Policymakers and the Political Process

❖ Policy by discretion has its own advantage as it recognizes the

existing macroeconomic situation.
❖ However, it has still its own limitation due to incompetency
and opportunistic behavior of policy makers.
❖ Incompetency in economic policy- arises due to lack of sufficient
knowledge of macroeconomics by politicians /policy makers/to
make informed judgments.
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 Cont’d …
❖ Opportunism in economic policy -arises when the interest of
policymakers conflict with the interest/well-being of the public.

❖ Politicians may use macroeconomic policy to further their own

electoral ends.

❖ Manipulation of the economy for electoral gain, called the Political

Business Cycle.

❖ Distrust of the political process leads economists to propose

constitutional amendments, like a balanced-budget amendment (a
rule preventing the government from spending more than it
receives in revenues).
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 ❖ii. The Time Inconsistency of Discretionary Policy
❖ Discretionary policy is, by its nature, flexible.

❖ Rules over discretion arises from the problem of time

inconsistency of policy.

❖ A scenario in which policymakers have an incentive to renege on a

previously announced policy once others have acted on that
announcement.

❖ Destroys policymakers’ credibility, thereby reducing effectiveness

of their policies.

❖ To encourage investment, the government announces that it will not

tax income from capital. But after factories have been built, the
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 Cont’d …
• Advocates of discretionary policy argue that discretion gives
more flexibility to policymakers in responding to various
unforeseen macroeconomics situations.

• Advocates of policy rules argue that the political process

cannot be trusted. They believe that politicians make frequent
mistakes in conducting economic policy and sometimes use
economic policy for their own political ends.

• In addition, advocates of policy rules argue that a commitment

to a fixed policy rule is necessary to solve the problem of time
inconsistency.
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 5.5. Rules for Monetary Policy
❖Three monetary policy rules that various
economists advocate.
A. Constant money supply growth rate
❖Advocated by monetarists.
❖They argue that slow and steady growth in the money supply
would yield stable output, employment, and prices

❖Steady growth in the money supply stabilizes aggregate

demand only if the velocity of money is stable.

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 Cont’d …
B). Nominal GDP Targeting

❖Under this rule, a central bank announces a planned

path for nominal GDP.

✓If nominal GDP rises above the target, the central bank
reduces money growth to dampen aggregate demand.

✓If GDP falls below the target, the central bank raises
money growth to stimulate aggregate demand.

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 Cont’d …
C. Inflation targeting

❖Under this rule, a central bank would announce a target for the
inflation rate and then adjust the money supply when the
actual inflation deviates from the target.

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 Cont’d …

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