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The Policy Debate: Active or Passive

The Policy Debate: Active or Passive. Summary of Activist Position. Active policy associates a high cost with the failure to pursue a discretionary policy

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The Policy Debate: Active or Passive

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  1. The Policy Debate:Active or Passive

  2. Summary of Activist Position • Active policy associates a high cost with the failure to pursue a discretionary policy • Despite the lags involved, advocates of active policy prefer action—whether through fiscal policy, monetary policy, or some combination of the two—to inaction

  3. Summary of the Passive Position • Passive policy advocates believe that uncertain lags and ignorance about how the economy works prevent the government from accurately determining or effectively implementing the appropriate active policy • Therefore, the passive approach, rather than pursuing a misguided activist policy, relies more on the economy’s natural ability to correct itself and on the government’s automatic stabilizers

  4. Closing a Contractionary Gap--The Passive Approach Potential output Price Level SRAS AD SRAS’ Real GDP contractionary gap

  5. Closing a Contractionary Gap--The Active Approach Potential output Price Level AD’ SRAS AD Real GDP contractionary gap

  6. Policy Response to an Expansionary Gap--The Passive Approach Potential output AD Price Level SRAS’ SRAS Real GDP expansionary gap

  7. Policy Response to an Expansionary Gap--The Active Approach Potential output AD Price Level AD’ SRAS Real GDP expansionary gap

  8. The Problem of Lags • A recognition lag is the time needed to identify a macroeconomic problem and assess its seriousness • A decision-making lag is the time needed to decide what to do after a macroeconomic problem is identified • An implementation lag is the time needed to introduce a change in monetary or fiscal policy • An effectiveness lag is the time necessary for changes in monetary or fiscal policy to have an effect on the economy

  9. The Role of Expectations • Since the short-run aggregate supply curve is drawn for a given expected price level, the effectiveness of particular government policy depends on what people expect

  10. Rational Expectations • Rational expectations is a school of thought that claims people form expectations based on all available information, including the probable future actions of government policy makers • If the population forms expectations rationally, fiscal and monetary policy will be fully anticipated when, for example, long-term labor contracts are negotiated • This make fiscal and monetary policy ineffective, even in the short run

  11. The Phillips Curve Inflation rate • The Phillips Curve show possible combinations of the inflation rate and the unemployment rate • This view was suggested by the research of New Zealand economist A. W. Phillips, who in 1958 published an article that examined the historical relation between inflation and unemployment in the United Kingdom Short-run Phillips curve Unemployment rate

  12. The Foundation for the Short-Run Phillips Curve Potential output AD2 Price Level AD0 SRAS AD1 Real GDP

  13. The Short-Run and Long-Run Phillips Curve Inflation rate • The short-run Phillips curve is based on an expected price level • The long-run Phillips curve is a vertical line drawn at the economy’s natural rate of unemployment • The long-run Phillips curve represents the state of the economy when employers and workers have the time to fully adjust their expectations natural rate Long-run Phillips curve Unemployment rate

  14. The Natural Rate Hypothesis • The natural rate of unemployment is independent of the stimulus by monetary or fiscal policy • The weak version of the natural rate hypothesis implies that policy makers can trade off between unemployment and inflation in the short run but not in the long run • The strong version of the natural rate hypothesis implies that the short-run gains in employment resulting from monetary or fiscal surprises diminish as the public comes to expect as much (closely related to rational expectations)

  15. Evidence of the Phillips Curve Inflation rate • It may be that the Phillips curve has shifted during various periods, as expectations for the price level are adjusted Unemployment rate

  16. Policy Rules Versus Discretion • Advocates of policy rules adopt the passive policy point of view • Uncertain lags and ignorance about how the economy works prevent the government from accurately determining or effectively implementing the appropriate active policy • As a result, policy rules (such as a rule fixing the rate of growth in the money supply) would do best in bringing about a stable macroeconomy • Nobel laureate Milton Friedman, the best-known advocate of such rules, supports a rule of 3% annual growth in the money supply

  17. Rules and Rational Expectations • Rules should be adopted because employers and workers are sophisticated in forming expectations • As a result, the government or the monetary authorities have little opportunity to “surprise” employers or workers by implementing expansionary fiscal or monetary policy • This renders fiscal and monetary ineffective, even in the short run • Rules would function just as well, and would provide the best environment for macroeconomic stability

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