1 The Policy Debate: Active or Passive? Chapter 31 © 2006 Thomson/South-Western

2 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

3 Exhibit 1a: Closing a Contractionary Gap – The Passive Approach Potential output Real GDP (trillions of dollars) SRAS 130 a AD SRAS 120 b  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 SRAS 130 to SRAS 120, moving the economy to its potential output at point b.  The passive approach: there is little reason for active government intervention. Price Level

4 Exhibit 1b: Closing a Contractionary Gap – The Active Approach Potential output Real GDP (trillions of dollars) SRAS 130 a AD c AD'  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

5 Real GDP (trillions of dollars) Exhibit 2a: Policy Responses to an Expansionary Gap – The Passive Approach Potential output  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 SRAS 140.  The new equilibrium at point e results in a higher price level and lower output and employment SRAS 130 d c AD" SRAS 140 e Price Level

6 Exhibit 2b: Policy Responses to an Expansionary Gap (The Active Approach) Potential output Real GDP (trillions of dollars) SRAS 130 d AD " AD ' c  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. Price Level

7 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.

8 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

9 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

10 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

11 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

12 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.

13 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

14 Exhibit 3: Short-Run Effects of an Unexpected Expansionary Monetary Policy Potential output Real GDP (trillions of dollars) AD SRAS 130 a Price level  At point a, workers and firms expect a price level of 130; supply curve SRAS 130 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 long- run effect is just a higher price level AD' 12.2 c b

15 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

16 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, SRAS 152, 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.

17 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

18 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

19 Policy Credibility  Cold turkey: the announcement and execution of tough measures to reduce high inflation

20 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

21 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.

22 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

23 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

24 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.

25 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

26 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

27 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

28 Price level Exhibit 6: Aggregate Supply Curves and Phillips Curves in the Short Run and the Long Run 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 natural rate, 5%. (a) Short-run aggregate supply curve(b) Short-run & long-run Phillips curve Real GDP (trillions of dollars) SRAS 103 AD a a Inflation rate (percent) Unemployment rate Long-run Phillips curve Short-run Phillips curve Potential Output

29 (a) Short-run aggregate supply curve Price level Unemployment rate Exhibit 6: Aggregate Supply Curves and Phillips Curves in the Short Run and the Long Run (b) Short-run & long-run Phillips curve Real GDP (trillions of dollars) SRAS 103 AD AD * AD´ c e b a d d a e Inflation rate (percent) b c 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 c trace the short-run Phillips curve; points a, d, and e depict long-run points. Short-run Phillips curve Potential Output Long-run Phillips curve

30 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

31 Exhibit 7: Short-Run Phillips Curves Since 1960