Chapter 14
The Macroeconomic Policy Debate
Two Issues
• Should stabilization policy be carried out?
• If so, how?
– Active vs. passive
– Rule vs. discretion
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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.