Chapter 14 The Macroeconomic Policy Debate Two Issues • Should stabilization policy be carried out? • If so, how? – Active vs. passive – Rule vs. discretion • • • • In principle, we should carry out stabilization policy. Difficult to achieve in practice. Automatic stabilizers (tax and transfer system). Passive policy is generally preferred. Why Stabilization Policy is Difficult to Achieve in Practice • Timely information is necessary in order to be successful. • Problem with lags – Lag in recognition – Inside lag: the time between recognizing a shock to the economy and taking policy action – Outside lag: the time between policy action and its impact on the economy • Monetary policy has short inside lag but long outside lag. • Fiscal policy has long inside lag but shorter outside lag. The Historical Record • The economy in post WWII appear to be more stable, shorter recessions and longer expansions. • May not be the result of stabilization policy. • The economy may be more stable after WWII because of fewer shocks • Pre-WWII data may not be reliable. Rule vs. Discretion • Rule: policy makers commit themselves in advance to follow a particular policy. • Discretion: policy makers respond to changing economic conditions on a case-by-case basis. The Case for Policy Rule • Distrust of policymakers and the political process i.e., the political business cycles. • Time inconsistency of discretionary policy and the credibility of policymakers. Rule for Monetary Policy • A constant money supply growth (good only if velocity is stable). • Nominal GDP target. • Price level (or inflation) target. • Note all are nominal variables because real variables such as unemployment or real output cannot be controlled by monetary policy. Rule for Fiscal Policy • Balanced budget is desirable but a strict rule is not. • Destroy the automatic stabilizers. • Budget deficits are a means of intergenerational redistribution. For example, government investment which will benefit future generations can be financed by a bond and repay with taxes of the future generation. Summary and Conclusion • The appropriate stabilization policy is difficult to determine and implement in a dynamic economy.