The Policy Debate: Active or Passive?

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

SRAS 120 b 120 Exhibit 1a: Closing a Contractionary Gap(The Passive Approach) 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. Potential output SRAS 130 l e a v e 125 l 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. e c i r P AD 0 Real GDP 9.8 10.0 (trillions of dollars)

c 130 AD' Exhibit 1b: Closing a Contractionary Gap(The Active Approach) Potential output 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. SRAS 130 l e a v e 125 l e c i r 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. P AD Real GDP 0 9.8 10.0 (trillions of dollars)

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

SRAS 140 140 e 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 130 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. l e v e l e d 135 c i r P 130 c AD" 0 Real GDP 10.2 10.0 (trillions of dollars)

c 130 AD' 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. Potential output SRAS 130 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. l e v e d 135 l e c i r P AD" • 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. 0 Real GDP 10.0 10.2 (trillions of dollars)

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

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

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 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.

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

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

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

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

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

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

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

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

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

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

135 AD' 10.2 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 SRAS 130 Price level a 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' 130 AD 0 Real GDP 10.0 (trillions of dollars)

142 c Exhibit 3: Short-Run Effects of an Unexpected Expansionary Monetary Policy 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. Potential output SRAS 130 Price level 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 . b 135 a 130 AD' AD 0 10.2 Real GDP 10.0 (trillions of dollars)

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

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

SRAS 152 e 152 d 147 AD" 9.8 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. Potential output Price Level However, AD" is the aggregate demand that firms and workers expect based on an expansionary monetary policy. c 142 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" AD' 0 Real GDP (trillions of dollars) 10.0

SRAS 152 e 152 d 147 AD" 9.8 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. Potential output 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. Price Level c 142 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. AD' 0 Real GDP 10.0 (trillions of dollars)

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

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

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

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

Limitations of Discretion • Advocates of active policy believe • there can be wide and prolonged swings in the economy • doing nothing involves significant risks

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

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.

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

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

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 SRAS 103 5 Price level Inflation rate (percent) 103 a a 3 Short-run Phillips curve 1 AD 0 0 Real GDP (trillions of dollars) 10.0 Unemployment rate 5 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%.

Exhibit 6: Relationship Between the Short-Run Aggregate Supply 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 SRAS 103 d d b 5 105 b Price level Inflation rate (percent) 103 a a 3 AD´ Short-run Phillips curve c 101 c 1 e e AD AD * 0 0 Real GDP (trillions of dollars) 9.9 10.1 10.0 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.

Exhibit 6: Relationship Between the Short-Run Aggregate Supply 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 SRAS 103 d d b 5 105 b Inflation rate (percent) 103 a a 3 AD´ Short-run Phillips curve c Price level 101 c 1 e e AD AD * 0 0 Real GDP (trillions of dollars) 9.9 10.0 10.1 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.

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

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

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

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

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

Exhibit 7: Short-Run Phillips Curves since 1960 Data for 1997 – 2001 suggest a new, lower short-run Phillips curve - shifted back to near where it started in the 1960s.

The Policy Debate: Active or Passive?