Chapter 31
The Policy Debate: Active or
Passive?
© 2006 Thomson/South-Western
1
Active versus Passive Policy
Active approach: discretionary fiscal or
monetary policy can reduce the costs of
unstable private sector
Passive approach: discretionary policy
may contribute to the instability of the
economy and is therefore part of the
problem, not part of the solution
2
Exhibit 1a: Closing a Contractionary Gap –
The Passive Approach
SRAS130
SRAS120
Price Level
The economy is in short-run
equilibrium at point a, with
unemployment exceeding its
natural rate.
High unemployment
eventually causes wages to
fall, reducing the cost of doing
business. The decline in costs
shifts the short-run aggregate
supply curve rightward from
SRAS130 to SRAS120 , moving
the economy to its potential
output at point b.
The passive approach: there
is little reason for active
government intervention.
Potential
output
a
125
120
b
AD
0
11.8 12.0
Real GDP
(trillions of dollars)
3
Exhibit 1b: Closing a Contractionary Gap –
The Active Approach
Potential
output
The economy is in short-run
equilibrium, with
unemployment exceeding its
natural rate.
The government employs an
active approach to shift the
aggregate demand curve from
AD to AD'.
If the active policy works,
the economy moves to its
potential output at point c.
Price Level
SRAS130
c
130
a
125
AD'
AD
0
11.8 12.0
Real GDP
(trillions of dollars)
4
Exhibit 2a: Policy Responses to an Expansionary
Gap – The Passive Approach
Potential
output
SRAS140
SRAS130
Price Level
At point d the economy is in
short-run equilibrium,
producing $12.2 trillion, which
exceeds the economy’s potential
output. Unemployment is below
its natural rate.
In the passive approach, the
government makes no change in
policy, so natural market forces
eventually bring about a higher
negotiated wage, increasing firm
costs and shifting the short-run
supply curve leftward to
SRAS140.
The new equilibrium at point
e results in a higher price level
and lower output and
employment.
140
e
d
135
130
c
AD"
Real GDP
(trillions of dollars)
5
Exhibit 2b: Policy Responses to an Expansionary Gap
(The Active Approach)
SRAS130
Price Level
At point d the economy is
in short-run equilibrium,
producing $12.2 trillion,
which exceeds the
economy’s potential output.
Unemployment is below its
natural rate.
An active policy reduces
aggregate demand, shifting
the equilibrium from point
d to point c, thus closing the
expansionary gap without
increasing the price level.
Potential
output
d
135
130
c
AD"
AD'
0
12.0 12.2
Real GDP
(trillions of dollars)
6
Problems with Active Policy
Policymakers must
be able to forecast what AD and AS would be without
government intervention
have the tools necessary to achieve the desired result
relatively quickly
be able to forecast the effects of an active policy on the
economy’s key performance measures
work together, or at least not work at cross-purposes
be able to implement the appropriate policy, even with
short-term political costs
be able to deal with a variety of timing lags.
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The Problem of Lags
There may be long, sometimes
unpredictable, lags that reduce the
effectiveness and increase the uncertainty
of active policies:
Recognition lag
Decision-making lag
Implementation lag
Effectiveness lag
8
Recognition Lag
Time it takes to identify a problem and
determine its seriousness
 For example,
time is required to accumulate
evidence that the economy is indeed performing
below its potential
Recall that a recession is not identified until
more than six months after it begins
Since the average recession lasts only 11 months,
a typical recession will be more than half over
before it is officially recognized as such
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Decision Making Lag
Even after a problem is identified,
policymakers need additional time to
decide what to do
 In
the case of discretionary fiscal policy,
Congress and the president must develop and
agree upon an appropriate course of action
The Fed can decide on the appropriate
monetary policy more quickly and does
not have to wait for regular meetings
Decision-making lag is longer for fiscal
than for monetary policy
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Implementation Lag
Once a decision has been made, the new
policy must be implemented
 Monetary
policy has an advantage - after a
policy has been adopted, the Fed can
immediately buy or sell bonds to influence
bank reserves and thereby change the federal
funds rate
The implementation lag is longer for fiscal
policy
11
Effectiveness Lag
The time needed for changes in monetary or
fiscal policy to affect the economy
The lag between a change in the federal funds
rate and the change in aggregate demand and
output can take from months to a year or more.
Fiscal policy, once enacted, usually requires 3 to
6 months to take effect and between 9 and 18
months to register its full effect.
These various lags make active policy difficult to
execute.
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The Role of Expectations
Rational expectations: people form expectations
on the basis of all available information,
including information about the probable future
actions of policy makers
Aggregate supply depends on what sort of
macroeconomic course policy makers are expected to
pursue
For example, if people were to observe policy makers
using discretionary policy to stimulate aggregate
demand that falls below potential, people would come
to anticipate the effects of this policy on the price level
and output
13
Exhibit 3: Short-Run Effects of an
Unexpected Expansionary Monetary Policy
At point a, workers and firms
expect a price level of 130;
supply curve SRAS130 reflects
that expectation.
If the Fed unexpectedly
pursues an expansionary
monetary policy, the aggregate
demand curve becomes AD'
rather than AD.
Output in the short run (point
b) exceeds its potential, but in
the long run costs increase,
shifting SRAS leftward until the
economy produces its potential
output at point c.
The short-run effect of an
unexpected monetary expansion
is greater output, but the longrun effect is just a higher price
level.
Potential
output
SRAS130
c
142
b
135
a
130
AD'
AD
0
12.0
12.2
Real GDP
(trillions of dollars)
14
Time-Inconsistency Problem
Occurs when policy makers have an
incentive to announce one policy to
influence expectations but then pursue a
different policy once those expectations
have been formed and acted on
15
Exhibit 4: Short-Run Effects of the Fed Pursuing
a More Expansionary Policy than Announced
The Fed announces it plans to
keep prices stable at 142. Workers
and firms, based on their
experience, expect monetary policy
to be expansionary. The short-run
aggregate supply curve, SRAS152,
reflects their expectations.
If the Fed follows the stable-price
policy, aggregate demand will be
AD', and short-run output at point
d will be less than the economy’s
potential output of $12.0 trillion.
To keep the economy performing
at its potential, the Fed must
stimulate aggregate demand as
much as workers and firms expect,
but this is inflationary.
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Anticipating Monetary Policy
Economists of the rational expectations believe
that if the economy is already producing its
potential, an expansionary monetary policy, if
fully and correctly anticipated, will have no
effect on output or employment
Only unanticipated or incorrectly anticipated
changes in policy can temporarily influence
output and employment
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Policy Credibility
If the economy is producing its potential, an
unexpected expansionary monetary policy would
increase output and employment temporarily
The costs include not only inflation in the long
run, but also a loss of credibility the next time
around
its announcements must be credible or believable
firms and workers must believe that when the time
comes to make a hard decision, the Fed will follow
through as promised
may be more effective if their discretion is taken away
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Policy Credibility
Cold turkey: the announcement and
execution of tough measures to reduce high
inflation
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Rules versus Discretion
In place of discretionary policy, the passive
approach often calls for predetermined rules to
guide the actions of policy makers
In fiscal policy, these rules take the form of
automatic stabilizers
In monetary policy, passive rules might be
the decision to allow the money supply to grow at a
predetermined rate,
maintain interest rates at some predetermined level, or
keep inflation below a certain rate
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Policy Rules vs. Discretion
Inflation target: central bankers commit
not to exceed a certain inflation rate for
the next year or two
Advocates of inflation targets say this
would encourage workers, firms, and
investors to plan on a low and stable
inflation rate.
Opponents of inflation targets worry that
the Fed would pay less attention to
economic growth.
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Limitations of Discretion
Rationale for the passive approach
 The
economy is so complex and economic aggregates
interact in such obscure ways and with such varied
lags that policy makers cannot comprehend what is
going on well enough to pursue an active monetary
or fiscal policy
the economy is inherently stable - the costs of not
intervening are relatively low
we know too little about how the economy works
Advocates of active policy believe
there can be wide and prolonged swings in the
economy
doing nothing involves significant risks
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Phillips Curve
 Phillips curve: a curve showing possible combinations of
the inflation rate and the unemployment rate
 The Phillips curve was based on an era when inflation
was low and the primary disturbances in the economy
were shocks to aggregate demand
 Changes in aggregate demand can be traced as
movements along a given short-run aggregate supply
curve
 If aggregate demand increased, the price level increased, but
unemployment fell
 If aggregate demand decreased, the price level decreased, but
unemployment increased
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Exhibit 5: Hypothetical Phillips Curve
The Phillips curve shows
an inverse relation between
unemployment and
inflation.
Points a and b lie on the
Phillips curve and
represent alternative
combinations of inflation
and unemployment that
are attainable as long as
the curve itself does not
shift. Fiscal or monetary
policy could be used to
stimulate output and
thereby reduce
unemployment moving the
economy from point a to
point b
Points c and d are off the
curve.
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Phillips Curve
The 1970s proved this view wrong for
two reasons
Adverse supply shocks shifted the aggregate
supply curve leftward
higher inflation and higher unemployment
stagflation
Expansionary gap - when short-run
equilibrium output exceeds potential output
as this gap is closed by a leftward shift of the
SRAS curve, greater inflation and higher
unemployment result
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Short-Run Phillips Curve
The short-run Phillips curve is generated by the
intersection of alternative aggregate demand
curves along a given short-run aggregate supply
curve
It is based on an expected inflation rate, a
curve that reflects an inverse relationship
between the inflation rate and the
unemployment rate
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Long-Run Phillips Curve
A vertical line drawn at the economy’s natural
rate of unemployment that traces equilibrium
points that can occur when workers and
employers have the time to adjust fully to any
unexpected change in aggregate demand
As long as prices and wages are flexible, the rate
of unemployment, in the long run, is independent
of the rate of inflation
Policy makers can only choose among alternative
rates of inflation
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Exhibit 6: Aggregate Supply Curves and Phillips Curves in
the Short Run and the Long Run
(a) Short-run aggregate supply curve
10
3
Long-run
Phillips curve
SRAS 103
Inflation rate
(percent)
Price level
Potential
Output
(b) Short-run & long-run Phillips curve
a
5
a
3
Short-run
Phillips curve
1
AD
0
12.0
Real GDP
(trillions of dollars)
0
5
Unemployment rate
If people expect a price level of 103, which is 3% higher than the current level, and if AD is
the aggregate demand curve, then the price level will actually be 103 and output will be at
the potential rate. This is represented by point a in both panels. Unemployment is at the
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natural rate, 5%.
Exhibit 6: Aggregate Supply Curves and Phillips Curves in
the Short Run and the Long Run
(a) Short-run aggregate supply curve
Potential
Output
b
a
AD´
c
Inflation rate
(percent)
Price level
105
101
Long-run
Phillips curve
d
SRAS 103
d
103
(b) Short-run & long-run Phillips curve
5
b
a
3
c
1
e
e
AD
Short-run
Phillips
curve
AD *
0
11.9
12.0
Real GDP
12.11
0
(trillions of dollars)
4
5
6 Unemployment rate
If aggregate demand is higher than expected, at AD', the economy in the short run will be at point b in
both panels. If aggregate demand is lower than expected, at AD*, short-run equilibrium will be at
point c, the price level (101) will be lower than expected, and output will be below the potential rate.
The lower inflation rate and higher unemployment rate are shown as point c in panel b. Points a, b, and
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c trace the short-run Phillips curve; points a, d, and e depict long-run points.
Natural Rate Hypothesis
States that the natural rate of unemployment is
largely independent of the level of the aggregate
demand stimulus provided by monetary or fiscal
policy
Regardless of policy makers’ concerns about
unemployment, the policy that results in low
inflation is generally going to be the optimal
policy in the long run
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Exhibit 7: Short-Run Phillips Curves
Since 1960
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