Notes on economic short-run policy.
Two Important Issues:
 Short Run Economic Policy – what should the government do about the business
cycles (economic fluctuations, recessions and expansions)?
 Problems with Short Run Economic Policy – why short run policies may not be
desirable and why laissez faire may be the preferred policy
Short Run Economic Policy:
D.A.S.K.:
 Discretionary: Government is free to the policies they think are appropriate. This
is in contrast to a “rules” policy where government must follow predetermined
rules.
 Activist: Government actively attempts to control the economy as opposed to
doing nothing, laissez faire.
 Stabilization: Short run policy that attempts to eliminate or lessen the cyclical
nature (ups and downs) of the economy. Traditionally, this refers to lessening the
cyclical nature of income and unemployment (real side of the economy).
However, now some people will talk of stabilizing prices (nominal side).
 Keynesian: Most income and unemployment short run activist policies are based
upon the Keynesian theory of business cycles. This means attempting to change
Aggregate Demand (AD).
How to Conduct a DASK policy:
Using Keynesian theory, a recession is caused by a drop in AD and the inability of the
economy to adjust. To counter this, the government needs to increase AD. Government
can attempt to increase AD by using fiscal or monetary policy.
Using Monetary Policy: Increase AD by increasing the money supply. In the
short run, if prices don’t fully adjust, the increase in the money supply will
increase bank reserves. Banks will attempt to loan this reserves out. With the
increase supply of loans, interest rates will drop. This is why increasing the
money supply is now often framed as a “decrease in interest rate targets.” With
lower interest rates, there will be an increase in consumption and investment
which means more AD. Note: the lower interest rate is a short run result based on
stickiness in the economy. In the long run, more money should translate to just
higher prices.
Using Fiscal Policy: Fiscal policy concerns government spending, taxing, and
deficit. To increase AD, the government should spend more (increase in G) and
tax less (increase in C or I depending on what tax is reduced). Since the
government is spending more and / or taxing less, the budget deficit will increase.
How much?
An important question that must be answered by the government if it is to conduct
policy is “how much?” How much are tax rates changed? How much is spending
changed? How much money is injected into the economy? This is a complicated
question and mathematically models would be needed to answer such a question.
For this introductory course, we’ll take an easy out: How much should be done?
Just enough!
Problem with a DASK policy:
In the 1970’s, the government was spending a lot and injecting a lot of money. The result
was large increases in AD and large increases in inflation. According to traditional
Keynesian theory, this should have also been a time of very lower unemployment.
However, unemployment was also very high. This unpredicted result was called
“stagflation”. Economists starting looking for reasons a DASK policy may not work.
I’ve grouped the explanations into 3 groups, DUM: Delays, Unintended Consequences,
and Mistakes.
Delays:
The problem of delays is more commonly called the problem of “lags” (but I liked
the acronym “DUM” better than “LUM”). Lags are the delays between when the
economy enters a cyclical event (a recession or expansion) and when government
policy becomes effective to counteract the cycle. Delays can happen for several
reasons. Delays occur because it takes time to identify when a recession begins.
It then takes time to formulate a policy response (Congress, the Fed, and the
President need to make decisions and coordinate plans). It then takes time to
implement the policies. Finally, it can take time for the economy to react to the
policies.
Lags may be so severe that by the time government responds to a recession, the
recession may be over (most recessions last a little more than one year). In which
case, the stimulation of AD comes too late and may worsen the business cycle
(this has been called “over shooting”). Government then becomes a destabilizing
force, not a stabilizing one.
Unintended Consequences:
When the government enacts activist policies, people may change their behavior
knowing that the government is enacting these policies. These changes of
behavior may make policies ineffective or they may create problems that are
worse that the recession that is being cured (cure is worse than the disease).
A football example. A study of football finds that punts are the worst part of the
game. Therefore, NFL decided to use an activist policy to get rid of punts. A
study shows that punts are always done on fourth down. The NFL eliminates the
fourth down, giving teams only three downs. The end results is more punts, not
less. The policy made things worse, not better because the policy did not take into
account the change in team behavior when the new 3 down policy was put into
place.
Rules versus discretion. One of the ways unintended consequences were explored
was through the issue of rules versus discretion. What was argued was that there
can be unintended consequences if policy makers have discretion instead of
following set rules. The unintended consequence is manipulation. Manipulation
can happen in either direction. The policy maker can try to manipulate the people
who live under the policy. Or the people who live under the policy can try to
manipulate the policy maker.
Examples of manipulation: Politicians may change tax rates and spending around
the time of elections to make the economy stronger during the election to increase
the chance of incumbents getting re-elected. Changing fiscal policy around
elections would cause AD to change and thus stimulate the economy around
election. Instead of working to lessen the business cycle, politicians would be
creating their own economic cycle based around elections. This is referred to as
the “political cycle”.
Another example of manipulation is that pressure groups may ask politicians to
pass special laws that favor that group with special tax breaks or spending.
Politicians can frame these taxes and expenditures as activist fiscal policy, but it’s
really just a political pay-off. That pressure groups expend economic resources
(time and money) to reap these benefits is called “Political Rent Seeking”.
With monetary policy, the attempted manipulation is the Fed attempting to
manipulate the public with surprisingly high inflation. This idea uses the
misperception theory of business cycles, not Keynesian. With the misperception
theory, unexpectedly high inflation causes lower unemployment because
businesses misperceive the inflation as an increase in demand for their product.
So the Fed attempts to fool businesses by making inflation higher. The problem
is that businesses will expect the Fed policy and expect even higher inflation. The
Fed would have to increase inflation even more to reduce unemployment. But
then businesses would expect even higher inflation. The end result is that
inflation will end up very high with little impact on unemployment. This result is
referred to as an “inflation trap” or “inflationary bias”. The only solution is to
take away the Fed’s ability to arbitrarily inject money and increase inflation. That
is, the Fed should be restricted to follow rules.
Mistakes:
The issue of mistakes recognizes that economists may not know enough to
conduct effective policy. There are numerous mistakes that can be made
attempting to control the economy. There can be mistakes in understanding the
state of the economy. What if we think it’s a demand led recession when it is
really a supply led recession?
There can be mistakes in economic theory. DASK policy is built upon the idea
that recessions are the result of an economy that doesn’t adjust quickly (sticky
prices) and a drop in demand. What if recessions do not happen as Keynesian
theory suggests? What if recessions are the result of misperceptions? Or
recessions are the result of supply changes?
There can be mistakes in the effects of policy. Deficit spending may increase
interest rates and crowd out investment. So AD is not stimulated all that much (or
maybe not at all). It’s possible that fiscal policy doesn’t stimulate AD. Some
economists thought there could be “multipliers” with fiscal policy. A small
increase in government spending would lead to even larger increases in AD (there
are all sorts of terms to describe this including “priming the pump” or “jumpstarting the economy”). However, if interest rates more, then not only won’t there
be a multiplier, there maybe a dampening effect. Mistakes can be made with
monetary policy also. Injecting money and increasing inflation won’t help unless
inflation increases more than expected under the misperception theory.
If economists are not quite sure what the condition of the economy is, are not
quite sure why the economy might be having problems, and are not quite sure
what impact policy might have upon the economy, then is it wise to use those
policies?