Notes on Chapter 14 - Stabilization Policy

Chapter 14 - Stabilization Policy

We learned about the business cycle in Chapter 9. We also learned about shocks to the economy, both demand shocks which shift the aggregate demand curve and supply shocks which shift the aggregate supply curve. We also discussed ways in which policymakers can react to these shocks in order to dampen their effects and return the economy to natural levels.

In this chapter, we discuss stabilization policy in more detail to answer some fundamental questions about how government policymakers should respond to the business cycle:

1. Should monetary and fiscal policy take an active role in trying to stabilize the economy, or should policy remain passive?
2. Should policymakers be free to use their discretion in responding to changing economic conditions, or should they be committed to following a fixed policy rule?

Should Policy Be Active or Passive?

Monetary and fiscal policy have a significant impact on aggregate demand, inflation and unemployment. Use of monetary and fiscal policy to stabilize the economy is relatively recent, beginning with the Employment Act of 1946. Economists differ in their opinions as to whether government should actively use policy to stabilize the economy or whether they should take a hands-off approach.

There are three major criticisms of active government intervention in using monetary and fiscal policy to stabilize the economy:

1. Lags in the Implementation and Effect of Policy
2. Difficulty in Economic Forecasting
3. Lucas Critique

Policy Implementation and Effect Lags. Implementation lag, also called inside lag, occurs when there is a lag in time between the economic shock and the implementation of policy. This lag occurs because it takes some time for economists to recognize the shock and for government to implement the policy. Policy effect lag, also called outside lag, occurs when there is a lag in time between the implementation of a policy and the effect that it has on the economy. Both inside and outside lag can be long and variable in length.

Fiscal policy suffers from a long inside lag because it takes a significant amount of time for Congress to pass legislation that affects taxes or government spending. Mankiw recently posted an article that noted that changes in fiscal policy, specifically through government spending, also suffer from an inside lag between the time the policy is passed by Congress and when it is implemented by the funds becoming available.

Although the central bank can adjust its policies quickly, monetary policy suffers from a long outside lag. Changes to money supply and interest rates influence investment and aggregate demand. Since many investment decisions are planned in advance, changes to monetary policy generally have a lag of about 6 months before their effect is felt in the general economy.

Automatic stabilizers are policies which stabilize the economy automatically without any changes to monetary or fiscal policy. Examples of automatic stabilizers are taxes and transfer payments. Taxes increase when the economy grows and income increases, thus having a dampening effect on the growing economy. Transfer payments increase as unemployment increases and income falls, thereby having a stimulating effect on the economy.

Economic Forecasting is Difficult
Because of the outside lags noted above, setting economic policy requires governments and central banks to forecast economic conditions six months in the future or more. Economists use both leading indicators and economic models to forecast economic conditions.

By their nature, economic models are limited in their ability to predict the future. In this respect, they are similar to the models that weather forecasters use to predict the weather and are often inaccurate. Two examples are the Great Depression of the 1930s and the recession of 1982.

The Lucas Critique
Robert Lucas is a Nobel Prize-winning economist who is currently associated with the University of Chicago. Lucas developed a theory, known as the Lucas Critique, which posits that the economy is influenced by people's expectations and those expectations are influenced by economic policy. Therefore, the very act of changing economic policy may influence the economy to more or less of a degree than anticipated by economic models due to the effect of the policy change on the public's expectations. In order to account for these effects, economic models should be modified to account for the influence of policy on expectations and economic activity.

The History of Stabilization Policy
In trying to determine whether stabilization policy should be active or passive, you would think that we could look back at history and see whether active or passive policy has been more successful. A few reasons are given why historical review doesn't give us a definitive answer.

1. When examining policy failures, i.e. large shocks, it's not always clear which policy would have been better. For example, concerning the Great Depression, some economists believe that a more active policy would have been the best way to address the situation. Other economists believe that a passive policy may have avoided the Great Depression in the first place.

2. Some economists look at the long term economic data and note that the economic shocks after the 1930s, when Keynes's theory was published and governments started instituting active policy, have been much less severe than the shocks prior to that time. This would seem to point in favor of active stabilization policy. However, Christina Romer, a UC-Berkeley professor and currently nominated for Chair of the Council of Economic Advisors, has noted that since the 1930s we have been gathering more and better economic data. Therefore, it may just be that we have better data in recent years, not that the active policy has made the shocks less severe.

Recent Stability
Throughout the 1990s and 2000s the GDP growth and inflation have been relatively less volatile than in prior years. Mankiw attributes this stability to 3 factors:
1. The US economy is now more service-based which is more stable.
2. Shocks just happen to have been less severe.
3. Fed Chairman Greenspan's management of interest rates and money supply stabilized the economy.