Transcript The Art and Science of Economics

The Policy Debate:
Active or Passive?
CHAPTER
31
© 2003 South-Western/Thomson Learning
1
Active versus Passive Policy
Proponents of the active approach
argue that discretionary fiscal or
monetary policy can reduce the costs of
unstable private sector
Proponents of the passive approach
counter with the argument that
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)
High unemployment will cause
wages to fall  production costs
decline  short-run aggregate
supply curve shifts rightward to
SRAS120  the economy moves to its
potential level of output at point b 
little reason for active government
intervention.
Potential output
SRAS130
SRAS120
Price level
Suppose the economy is in short-run
equilibrium at point a, with a real
GDP of $9.8 trillion, which is below
the economy’s potential output of
$10.0 (a contractionary gap) - the
actual unemployment rate is above
the natural rate.
125
120
a
b
AD
0
9.8 10.0
Real GDP
(trillions
of dollars)
3
Exhibit 1b: Closing a Contractionary Gap
(The Active Approach)
We start at point a with a
contractionary gap. Through
some mix of discretionary
monetary and fiscal policy, active
policy attempts to increase
aggregate demand from AD to
AD', moving the economy from
point a to point c and closing the
contractionary gap.
Potential output
SRAS130
Pri c e level
Advocates of the active approach
believe that when adverse supply
shocks or sagging demand result
in unemployment exceeding the
natural rate, the economy does not
quickly adjust to eliminate this
problem  the economy needs an
active stabilization policy to alter
AD.
c
130
a
125
AD'
AD
0
9.8 10.0
Real GDP
(trillions
of dollars)
4
Active Approach
One possible cost of using discretionary
policy to stimulate aggregate demand is
an increase in the price level, or
inflation
Another cost of active fiscal policy is to
delay efforts to pay off the national debt
5
Exhibit 2a: Policy Responses to an
Expansionary Gap (The Passive Approach)
Potential output
Suppose an actual price level of 130,
causing an expansionary gap .
SRAS 140
The passive approach argues
that natural market forces will
prompt firms and workers to
negotiate higher nominal wages
which will increase production
costs  aggregate supply
curve shifts leftward from
SRAS130 to SRAS140. This
increases the price level and
lowers output to the economy’s
potential  a higher price or
inflation at point e.
Price level
SRAS 130
140
e
d
135
130
c
AD"
Real GDP
(trillions
of dollars)
6
Exhibit 2b: Policy Responses to an
Expansionary Gap (The Active Approach)
An active approach sees discretionary policy
as a way of returning the economy to its
potential output without an increase in the
price level.
•Passive approach relies on natural
market forces to close an
expansionary gap through a decrease
in the SRAS curve
•Active approach relies on the right
discretionary policy to close the gap
through a decrease in AD.
SRAS130
Price level
This can occur if aggregate
demand can be reduced from AD"
to AD'  the equilibrium point
will move along the initial
aggregate supply curve from d to c.
Potential output
d
135
130
c
AD"
AD'
0
10.0 10.2
Real GDP
(trillions
of dollars)
7
Problems with Active Policy
The timely adoption and implementation
of an appropriate active policy is not easy
for a number of reasons
Identifying the economy’s potential output
and the unemployment rate at that level may
not be easy
Even if policy makers can accurately estimate
the economy’s potential level of output,
formulating an effective policy requires
detailed knowledge of current and future
economic conditions
Finally, there are the problems of timing lags
8
Identifying Potential Output
Suppose, for example, that the natural
rate of unemployment is 5%, but policy
makers believe it to be 4%
As they pursue the 4% unemployment
rate goal, they find that output is
constantly pushed beyond its potential,
creating higher prices in the long run
but no permanent reduction in
unemployment
9
Detailed Knowledge
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 crosspurposes
be able to implement the appropriate policy,
even with short-term political costs
be able to deal with a variety of timing lags.
10
Problem of Lags
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
• policy makers must await evidence of trouble
rather than risk responding to what may be a
false alarm
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
11
Problem of Lags
Decision-making lag
Even after evidence is in, 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
• Fiscal legislation can take months and could take
more than a year
The Fed can decide on the appropriate
monetary policy more quickly and does not
even have to wait for regular meetings
Decision-making lag is longer for fiscal than
for monetary policy
12
Problem of Lags
Implementation lag
Once a decision has been made, the new
policy must be implemented
• Monetary policy has the 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
• For example, if tax rates change, new tax forms
must be printed and distributed and if spending
changes, the appropriate agencies must get
involved, which may take more than a year
13
Problem of Lags
Effectiveness lag
Refers to the time before the full impact of
the policy registers on the economy
• One problem with monetary policy is that 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
14
Problem of Lags
These various lags make active policy
difficult to execute
The more variable the lags, the harder it
is to predict when a particular policy
will take hold and what the state of the
economy will be at the time
To advocates of passive policy, these
lags are reason enough to avoid active
discretionary policy which simply
introduces more instability into the
economy
15
Review of Policy Perspectives
The active and passive approaches
embody different views about the natural
resiliency of the economy and the ability
of Congress or the Fed to implement
appropriate discretionary policies
they disagree about the inherent stability of
the private sector and the role of public policy
Active proponents think the natural
adjustments take too long
high cost with the failure to pursue
discretionary policies
16
Review of Policy Perspectives
Passive policy advocates believe that
uncertain lags and ignorance about how
the economy works prevent policy
makers from accurately determining
and effectively implementing the
appropriate active policy
rather than pursuing a misguided activist
policy, the natural ability of the economy to
adjust is much preferred
17
Role of Expectations
The effectiveness of a particular
government policy depends in part on
what people expect
The short-run aggregate supply curve is
drawn for a given expected price level
reflected in long-term contracts
If workers and firms expect continuing
inflation, their wage agreements will
reflect these inflationary expectations
18
Rational Expectations
Argues that people form expectations
on the basis of all available information,
including information about the
probably future actions of policy makers
Thus, 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
19
Monetary Policy and Expectations
Suppose the economy is producing
potential output and while wage
negotiations are under way, the Fed
announces that its monetary policy will
aim at maintaining the potential level of
output while keeping the price level
stable
This seems the appropriate policy since
unemployment is already at the natural
rate
20
Exhibit 3: Short-Run Effects of an
Unexpected Expansionary Monetary Policy
Here, the short-run aggregate
supply curve is SRAS130, and
aggregate demand is AD 
equilibrium occurs at a, where the
economy is producing at its
potential and the price level is as
expected.
Potential output
SRAS130
135
Suppose that after workers and firms
have agreed on nominal wages,
public officials become dissatisfied
with the prevailing level of
unemployment  they decide to
pursue an expansionary monetary
policy that shifts aggregate demand
from AD to AD'
a
130
AD'
AD
0
10.0
10.2 Real GDP
(trillions
of dollars)
21
Exhibit 3: Short-Run Effects of an
Unexpected Expansionary Monetary Policy
The price level is now higher than
workers expected. At their next
opportunity, workers will negotiate
higher wages which eventually causes the
short-run aggregate supply curve to shift
leftward, intersecting AD' at point c, the
economy’s potential output at a higher
price level .
Potential output
SRAS130
Price level
This unexpected policy stimulates
output and employment in the short run
to equilibrium point b  output
increases to $10.2 trillion, and the price
level increases to 135.
142
c
b
135
a
130
AD'
AD
0
10.0 10.2 Real GDP
(trillions of dollars)
22
Anticipating Monetary Policy
Suppose Fed policy makers become
alarmed by the high inflation with the
result that they announce that it plans a
monetary policy that will hold the price
level constant at 142, a policy aimed at
keeping real GDP at its potential
23
Anticipating Monetary Policy
Based on previous experience, workers
and firms know the Fed is willing to
accept higher inflation in exchange for a
temporary reduction in unemployment
Workers do not want to get caught
again with their real wages down
should the Fed implement a stimulative
monetary policy
a high-wage-increase settlement is reached
24
Exhibit 4: Short-Run Effects of the Fed Pursuing
a More Expansionary Policy than Announced
The SRAS curve reflecting the higher
wage agreements is depicted by SRAS152.
Note that AD' is the aggregate demand
that would result if the Fed’s
unannounced constant-price-level policy
were pursued, and the curve intersects
the potential output at point c, where the
price level is 142.
However, AD" is the aggregate demand
that firms and workers expect based on
an expansionary monetary policy.
Thus, a price level of 152 is based on rational
expectations. In effect, workers and firms
expect the expansionary policy to shift
aggregate demand from AD' to AD"
Potential output
Price
Level
SRAS152
152
e
d
147
c
142
AD"
AD'
0
9.8 10.0
Real GDP
(trillions
of dollars)
25
Exhibit 4: Short-Run Effects of the Fed Pursuing
a More Expansionary Policy than Announced
Monetary authorities must decide whether
to stick with the announced plan (holding
the price level constant) or follow an
expansionary policy.
With the constant-price-level policy,
aggregate demand will turn out to be AD'
and short-run equilibrium will occur at
point d, producing below the economy’s
potential and resulting in unemployment
exceeding the natural rate.
If monetary authorities want to keep the
economy performing at its potential, they
must match public expectations, resulting in
aggregate demand of AD'', leading to an
equilibrium at e, where the price level is 152
and output is at its potential.
Potential output
SRAS152
e
152
d
147
c
142
AD"
AD'
0
9.8 10.0
Real GDP
(trillions
of dollars)
26
Rational Expectations
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
27
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 somehow 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
28
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
29
Limitations of Discretion
The rationale for the passive approach
arises from different views on how the
economy works
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 cost
of not intervening are relatively low
we know too little about how the economy
works
30
Limitations of Discretion
Advocates of active policy believe
there can be wide and prolonged
swings in the economy
doing nothing involves significant
risks
31
Phillips Curve
At one time, policymakers thought they
faced a stable long-run tradeoff
between inflation and unemployment
The possible options with respect to
unemployment and inflation are
illustrated by the hypothetical Phillips
curve in Exhibit 5
32
Exhibit 5: Hypothetical Phillips Curve
Suppose we begin at point a,
which depicts one possible
combination of unemployment
and inflation.
Fiscal or monetary policy could
be used to stimulate output and
thereby reduce unemployment,
moving the economy from point
a to point b.
The reduction in unemployment
comes at a cost of higher inflation.
A reduction in unemployment with no change in inflation would be represented
by point c, an option that is not available  policy makers could choose either
lower inflation or lower unemployment, not both.
33
Phillips Curve
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
34
Phillips Curve
The 1970s proved this view wrong for
two reasons
adverse supply shocks - such as those
created by the oil embargoes and worldwide
crop failures which 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
• Both of these outcomes can be represented by an
outcome such as point d in Exhibit 5
35
Exhibit 6: Relationship Between the SRAS Curve and
the Short-Run Phillips Curve
(a) Short-run aggregate supply curve
Potential Output
(b) Short-run & long-run Phillips curve
Long-run
Phillips curve
5
103
Inflation rate
(percent)
Price level
SRAS 103
a
a
3
Short-run
Phillips curve
1
AD
0
10.0
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 natural rate, 5%.
36
Exhibit 6: Relationship Between the Short-Run
Aggregate Supply Curve and the Short-Run Phillips Curve
(a) Short-run aggregate supply curve
Potential Output
105
SRAS 103
a
9.9
AD *
10.0 10.1
b
5
AD´
c
e
0
d
b
103
101
Long-run
Phillips curve
Inflation rate
(percent)
Price level
d
(b) Short-run & long-run Phillips curve
a
3
Short-run
Phillips curve
c
1
e
AD
Real GDP
(trillions of dollars)
0
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 c trace the short-run Phillips curve.
37
Exhibit 6: Relationship Between the Short-Run
Aggregate Supply Curve and the Short-Run Phillips Curve
(a) Short-run aggregate supply curve
Potential Output
d
SRAS 103
d
a
AD´
c
101
e
9.9
AD *
10.0 10.1
b
5
b
103
0
Long-run
Phillips curve
Inflation rate
(percent)
Price level
105
(b) Short -run & long-run Phillips curve
a
3
c
1
e
AD
Real GDP
(trillions of dollars)
Short-run
Phillips curve
0
4
5
6
Unemployment rate
In the long run, the actual price level equals the expected price level, output is at the
potential level $10.0 trillion in panel a, and unemployment is at the natural rate, 5%, in
panel b. Points a, d, and e on the vertical long-run Phillips curve represent this.
38
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 labor contracts that reflect
a given expected price level, which
implies a given expected rate of inflation
39
Long-Run Phillips Curve
When employers and workers have the
time and the ability to adjust fully to
any unexpected change in aggregate
demand, the long-run Phillips curve is a
vertical line drawn at the economy’s
natural rate of unemployment
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
40
Natural Rate Hypothesis
The reexamination of the Phillips curve
led to the natural rate hypothesis
Natural Rate Hypothesis states that in the
long run the economy tends toward the
natural rate of unemployment, which 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
41
Evidence of the Phillips Curve
The clearest trade-off between
unemployment and inflation occurred
between 1960 and 1969
The short-run Phillips curve shifted up
to the right for the period from 1970 to
1973 when inflation and unemployment
both increased
42
Evidence of the Phillips Curve
In 1974, sharp increases in oil prices
and crop failures reduced aggregate
supply and another shift in the Phillips
curve
During the 1974 – 1983 period, inflation
and unemployment were relatively high
and after two recessions in the early
1980s, the short-run Phillips curve
shifted leftward
43
Exhibit 7: Short-Run Phillips Curves since 1960
Data for 1997 –
2001 suggest a
new, lower shortrun Phillips curve
- shifted back to
near where it
started in the
1960s.
44