Worth: Mankiw Economics 5e User JoEkA: Job EFFo1430: 6264_ch14: Pg 378: 26544#/eps at 1004g Mon,Feb18,20021:024M
User JOEWA:Job EFF01430:6264_ch14:Pg 378:26544#/eps at 100% *26544* Mon, Feb 18, 2002 1:02 AM
Worth: Mankiw Economics 5e part V Macroeconomic Policy Debates User JoENA: Job EFFo1430: 6264_ch14: Pg 379: 23155#/eps at 100snnI Mon, Feb 18 0021:02
User JOEWA:Job EFF01430:6264_ch14:Pg 379:23155#/eps at 100% *23155* Mon, Feb 18, 2002 1:02 AM part V Macroeconomic Policy Debates
Worth: Mankiw Economics 5e CHAPTER FOURTEEN Stabilization Policy The Federal Reserve 's job is to take away the punch bowl just as the party William McChesney martin tiously turning the steering wheel to adjust to the unexpected irregule ties of the route, but some means of keeping the monetary passenger who is in the back seat as ballast from occasionally leaning over and giving the steering wheel a jerk that threatens to send the car off the road Milton friedman How should government policymakers respond to the business cycle? The two quotations above-the first from a former chairman of the Federal reserve, the econd from a prominent critic of the Fed--show the diversity of opinion over how this question is best answered Some economists, such as William McChesney Martin, view the economy as inherently unstable. They argue that the economy experiences frequent shocks to aggregate demand and aggregate supply. Unless policymakers use monetary and fiscal policy to stabilize the economy, these shocks will lead to unnecessary and inefficient fluctuations in output, unemployment, and inflation. According to the popular saying, macroeconomic policy should "lean against the wind, stimulat ing the economy when it is depressed and slowing the economy when it is over heated Other economists, such as Milton Friedman, view the economy as naturally stable. They blame bad economic policies for the large and inefficient fluctua tions we have sometimes experienced. They argue that economic policy should not try to"fine-tune"the economy. Instead, economic policymakers should dmit their limited abilities and be satisfied if they do no harm This debate has persisted for decades, with numerous prot agonists advan various arguments for their positions. The fundamental issue is how policymak ers should use the theory of short-run economic fluctuations developed in the 380 User JoENA: Job EFFo1430: 6264_ch14: Pg 380: 24427#/eps at 100s Mon,Feb18,20021:024M
User JOEWA:Job EFF01430:6264_ch14:Pg 380:24427#/eps at 100% *24427* Mon, Feb 18, 2002 1:02 AM How should government policymakers respond to the business cycle? The two quotations above—the first from a former chairman of the Federal Reserve, the second from a prominent critic of the Fed—show the diversity of opinion over how this question is best answered. Some economists, such as William McChesney Martin, view the economy as inherently unstable.They argue that the economy experiences frequent shocks to aggregate demand and aggregate supply. Unless policymakers use monetary and fiscal policy to stabilize the economy, these shocks will lead to unnecessary and inefficient fluctuations in output, unemployment, and inflation.According to the popular saying, macroeconomic policy should “lean against the wind,’’ stimulating the economy when it is depressed and slowing the economy when it is overheated. Other economists, such as Milton Friedman, view the economy as naturally stable. They blame bad economic policies for the large and inefficient fluctuations we have sometimes experienced.They argue that economic policy should not try to “fine-tune’’ the economy. Instead, economic policymakers should admit their limited abilities and be satisfied if they do no harm. This debate has persisted for decades, with numerous protagonists advancing various arguments for their positions.The fundamental issue is how policymakers should use the theory of short-run economic fluctuations developed in the Stabilization Policy 14 CHAPTER The Federal Reserve’s job is to take away the punch bowl just as the party gets going. — William McChesney Martin What we need is not a skilled monetary driver of the economic vehicle continuously turning the steering wheel to adjust to the unexpected irregularities of the route, but some means of keeping the monetary passenger who is in the back seat as ballast from occasionally leaning over and giving the steering wheel a jerk that threatens to send the car off the road. — Milton Friedman FOURTEEN 380 |
Worth: Mankiw Economics 5e CHAPTER 14 Stabilization Policy 381 preceding chapters In this chapter we ask two questions that arise in this debate. First, should monetary and fiscal policy take an active role in trying to stabilize the economy, or should policy remain passive? Second, 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 74-1 Should Policy Be Active or Passive? Policymakers in the federal government view economic stabilization as one of their primary responsibilities. The analysis of macroeconomic policy is a regula duty of the Council of Economic Advisers, the Congressional Budget Office, the Federal Reserve, and other government agencies. When Congress or the presi dent is considering a major change in fiscal policy, or when the Federal Reserve is considering a major change in monetary policy, foremost in the discussion are how the change will influence inflation and unemployment and whether aggre demand needs to be stimulated or restrained Although the government has long conducted monetary and fiscal policy, the view that it should use these policy instruments to try to stabilize the economy is more recent. The Employment Act of 1946 was a key piece of legislation in which the government first held itself accountable for macroeconomic perfor mance. The act states that "it is the continuing policy and responsibility of the Federal Government to .. promote full employment and production. "This law was written when the memory of the Great Depression was still fresh. The law- makers who wrote it believed, as many economists do, that in the absence of an active government role in the economy, events such as the great Depression could occur regularly. To many economists the case for active government policy is clear and simple. Recessions are periods of high unemployment, low incomes, and increased eco- nomic hardship. The model of aggregate demand and aggregate supply shows how shocks to the economy can cause recessions. It also shows how monetary and fis- cal policy can prevent recessions by responding to these shocks. These economists consider it wasteful not to use these policy instruments to stabilize the economy. Dther economists are critical of the governments attempts to stabilize the economy. These critics argue that the government should take a hands-off ap- proach to macroeconomic policy. At first, this view might seem surprising. If our model shows how to prevent or reduce the severity of recessions, why do these critics want the government to refrain from using monetary and fiscal policy for economic stabilization? To find out, let's consider some of their arguments Lags in the Implementation and Effects of policies Economic stabilization would be easy if the effects of policy were immediate Making policy would be like driving a car: policymakers would simply adjust heir instruments to keep the economy on the desired path User JoENA: Job EFFo1430: 6264_ch14: Pg 381: 27867#/eps at 100s Mon,Feb18,20021:024M
User JOEWA:Job EFF01430:6264_ch14:Pg 381:27867#/eps at 100% *27867* Mon, Feb 18, 2002 1:02 AM preceding chapters. In this chapter we ask two questions that arise in this debate. First, should monetary and fiscal policy take an active role in trying to stabilize the economy, or should policy remain passive? Second, 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? 14-1 Should Policy Be Active or Passive? Policymakers in the federal government view economic stabilization as one of their primary responsibilities.The analysis of macroeconomic policy is a regular duty of the Council of Economic Advisers, the Congressional Budget Office, the Federal Reserve, and other government agencies.When Congress or the president is considering a major change in fiscal policy, or when the Federal Reserve is considering a major change in monetary policy, foremost in the discussion are how the change will influence inflation and unemployment and whether aggregate demand needs to be stimulated or restrained. Although the government has long conducted monetary and fiscal policy, the view that it should use these policy instruments to try to stabilize the economy is more recent. The Employment Act of 1946 was a key piece of legislation in which the government first held itself accountable for macroeconomic performance.The act states that “it is the continuing policy and responsibility of the Federal Government to . . . promote full employment and production.’’This law was written when the memory of the Great Depression was still fresh.The lawmakers who wrote it believed, as many economists do, that in the absence of an active government role in the economy, events such as the Great Depression could occur regularly. To many economists the case for active government policy is clear and simple. Recessions are periods of high unemployment, low incomes, and increased economic hardship.The model of aggregate demand and aggregate supply shows how shocks to the economy can cause recessions. It also shows how monetary and fiscal policy can prevent recessions by responding to these shocks.These economists consider it wasteful not to use these policy instruments to stabilize the economy. Other economists are critical of the government’s attempts to stabilize the economy. These critics argue that the government should take a hands-off approach to macroeconomic policy.At first, this view might seem surprising. If our model shows how to prevent or reduce the severity of recessions, why do these critics want the government to refrain from using monetary and fiscal policy for economic stabilization? To find out, let’s consider some of their arguments. Lags in the Implementation and Effects of Policies Economic stabilization would be easy if the effects of policy were immediate. Making policy would be like driving a car: policymakers would simply adjust their instruments to keep the economy on the desired path. CHAPTER 14 Stabilization Policy | 381
Worth: Mankiw Economics 5e 382 PART V Macroeconomic Policy Debates Making economic policy, however, is less like driving a car than it is like pilot ing a large ship. car cna anges direction almost immediately after the steering wheel is turned. By contrast, a ship changes course long after the pilot adjusts the dder, and once the ship starts to turn, it continues turning long after the rudder is set back to normal. a novice pilot is likely to oversteer and, after noticing the mistake, overreact by steering too much in the opposite direction. The ship's path could become unstable, as the novice responds to previous mistakes by making larger and larger corrections Like a ship's pilot, economic policymakers face the problem of long lags In- deed, the problem for policymakers is even more difficult, because the lengths of the lags are hard to predict. These long and variable lags greatly complicate the conduct of monetary and fiscal policy Economists distinguish between two lags in the conduct of stabilization policy: the inside lag and the outside lag. The inside lag is the time between a shock to the economy and the policy action responding to that shock. This lag arises be cause it takes time for policymakers first to recognize that a shock has occurred and then to put appropriate policies into effect. The outside lag is the time be tween a policy action and its influence on the economy. This lag arises because policies do not immediately influence spending, income, and employment. A long inside lag is a central problem with using fiscal policy for economic stabilization. This is especially true in the United States, where changes in spend- ing or taxes require the approval of the president and both houses of Congress The slow and cumbersome legislative process often leads to delays, which make fiscal policy an imprecise tool for stabilizing the economy. This inside lag is shorter in countries with parliamentary systems, such as the United Kingdom, because there the party in power can often enact policy changes more rapidly c Monetary policy has a much shorter inside lag than fiscal policy, because tral bank can decide on and implement a policy change in less than a day, but monetary policy has a substantial outside lag. Monetary policy works by chang- ing the money supply and thereby interest rates, which in turn influence invest- ment. But many firms make investment plans far in advance. Therefore, a change in monetary policy is thought not to affect economic activity until about six months after it is made The long and variable lags associated with monetary and fiscal policy certainly make stabilizing the economy more difficult. Advocates of passive policy argue that, because of these lags, successful stabilization policy is almost impossible. Indeed, at npts to stabilize the economy can be destabilizing. Suppose that the economy's condition changes between the beginning of a policy action and its impact on the economy. In this case, active policy may end up stimulating the economy when it is overheated or depressing the economy when it is cooling off. Advocates of active policy admit that such lags do require policymakers to be cautious. But, they argue, these lags do not necessarily mean that policy should be completely passive, espe cially in the face of a severe and protracted economic downturn Some policies, called automatic stabilizers, are designed to reduce the lags as- sociated with stabilization policy. Automatic stabilizers are policies that stimulate or depress the economy when necessary without any deliberate policy change. For User JOENA: Job EFF01430: 6264_ch14: Pg 382: 27868 #/eps at 100s Mon,Feb18,20021:024M
User JOEWA:Job EFF01430:6264_ch14:Pg 382:27868#/eps at 100% *27868* Mon, Feb 18, 2002 1:02 AM Making economic policy, however, is less like driving a car than it is like piloting a large ship. A car changes direction almost immediately after the steering wheel is turned. By contrast, a ship changes course long after the pilot adjusts the rudder, and once the ship starts to turn, it continues turning long after the rudder is set back to normal.A novice pilot is likely to oversteer and, after noticing the mistake, overreact by steering too much in the opposite direction.The ship’s path could become unstable, as the novice responds to previous mistakes by making larger and larger corrections. Like a ship’s pilot, economic policymakers face the problem of long lags. Indeed, the problem for policymakers is even more difficult, because the lengths of the lags are hard to predict.These long and variable lags greatly complicate the conduct of monetary and fiscal policy. Economists distinguish between two lags in the conduct of stabilization policy: the inside lag and the outside lag.The inside lag is the time between a shock to the economy and the policy action responding to that shock.This lag arises because it takes time for policymakers first to recognize that a shock has occurred and then to put appropriate policies into effect.The outside lag is the time between a policy action and its influence on the economy.This lag arises because policies do not immediately influence spending, income, and employment. A long inside lag is a central problem with using fiscal policy for economic stabilization.This is especially true in the United States, where changes in spending or taxes require the approval of the president and both houses of Congress. The slow and cumbersome legislative process often leads to delays, which make fiscal policy an imprecise tool for stabilizing the economy. This inside lag is shorter in countries with parliamentary systems, such as the United Kingdom, because there the party in power can often enact policy changes more rapidly. Monetary policy has a much shorter inside lag than fiscal policy, because a central bank can decide on and implement a policy change in less than a day, but monetary policy has a substantial outside lag. Monetary policy works by changing the money supply and thereby interest rates, which in turn influence investment. But many firms make investment plans far in advance.Therefore, a change in monetary policy is thought not to affect economic activity until about six months after it is made. The long and variable lags associated with monetary and fiscal policy certainly make stabilizing the economy more difficult.Advocates of passive policy argue that, because of these lags, successful stabilization policy is almost impossible. Indeed, attempts to stabilize the economy can be destabilizing. Suppose that the economy’s condition changes between the beginning of a policy action and its impact on the economy. In this case, active policy may end up stimulating the economy when it is overheated or depressing the economy when it is cooling off. Advocates of active policy admit that such lags do require policymakers to be cautious. But, they argue, these lags do not necessarily mean that policy should be completely passive, especially in the face of a severe and protracted economic downturn. Some policies, called automatic stabilizers, are designed to reduce the lags associated with stabilization policy.Automatic stabilizers are policies that stimulate or depress the economy when necessary without any deliberate policy change. For 382 | PART V Macroeconomic Policy Debates