We now consider the debate in macroeconomics about whether macro policy (monetary and fiscal) can be used to effectively stabilize the economic fluctuations of the business cycle.  The debate centers around two different views of policy: activist (Keynesian "fine tuning") vs. nonactivist (passive, rules based policy advocated by Classical school).  Sometimes the debate is referred to as "rules vs. discretion."  Rules = passive approach, Discretion = active approach.

Graphs on page 347 and 349 show the record of economic instability and monetary instability. Possible strong link between these two variables.  What, if anything, can macro policy do to stabilize and smooth out the economic fluctuations, smooth out the business cycle?

There is widespread agreement about the goals of macro policy: low un, high levels of employment, strong output growth, low and stable inflation, etc. The great debate in macro is between the activist strategy vs. nonactivist (passive) strategy - which strategy will more effectively achieve the economic goals stated above and promote a strong economy?

Activist Strategy: Keynesian, activist, "fine-tuning," contercyclical approach to stabilize the economy.  Based on the belief that the self-correcting mechanisms (Classical assumptions) work slowly, and policymakers should continually "fine-tune" the economy through an activist approach to policy.

Passive Strategy: Classical approach, assumes that the self-correcting mechanisms will work well, if not stifled by unnecessary meddling by policymakers.  In fact, advocates of the passive approach believe that erratic, improperly timed activist policies are actually a source of economic instability, and that we would be better off if we maintain stable, predictable fiscal and monetary policy during all phases of the business cycle.

Advocates of the passive approach point to the Great Depression as an example of how perverse monetary and fiscal policy can significantly destabilize the economy, and claim that improper policy turned an ordinary recession into a ten year depression.  See pages 350-351.  We know that the proper policy during a recession is expansionary fiscal and/or monetary policy.  However, the Fed implemented restrictive monetary policy (contracted the money supply) and Congress implemented restrictive fiscal policy by raising taxes and tariffs.
 

THE CONDUCT OF ACTIVIST POLICY

To stabilize the economy, policymakers have to correctly time policy so that they stimulate an economy moving into a recession and slow down an economy heading toward inflationary overheating.  If the timing of policy is not precise, active policy will actually destabilize the economy and make it worse.  In that case, it would be like a doctor making an ailing patient even sicker by giving them the wrong medicine!  What tools are available to potentially help activist policymakers achieve proper timing?

1. Index of Leading Economic Indicators. An index of ten separate economic variables that as a group tend to move AHEAD of economic conditions, and predict the future direction of the economy. See page 353 for a list of the ten variables that make up the index.  The index is released monthly by the Conference Board in NYC, an economic research group.

Example of variables in index: Housing permits are a leading indicator, because they accurately  predict of future housing and construction activity.  Developers take out a building permit several months before construction actually begins.

There are some variables that measure wholesale production activity (new orders, slower deliveries, plant and equipment order) that would predict the future direction of retail sales.

The index of leading of leading economic indicators can be used as a forecasting tool to predict where the economy is headed, and can therefore give policymakers a head start to formulating the correct policy.  If the Index predicts a recession, they could get ready to implement expansionary policy.  Therefore, using the index as a forecasting tool would strengthen the case for activist policymaking.

See page 352. All eight recessions since 1952 were predicted by the Index, which started moving down before the recession actually started. However, the Index also falsely predicted five recessions that never happened, indicated by asterisks on the graph.

2. Forecasting Models- Large econometric (statistical) models of the economy have been developed to forecast future economic trends. Evidence is mixed on the accuracy of forecasting from these computer models. Reason: 1) even the best econometric model can't predict unforeseen events and 2) forecasting models use past performance to predict the future, assumes that people will react the same in the future as in the past. Past can be an imperfect indicator of the future. We live in a dynamic and unpredictable economy, not static - people learn from past mistakes and revise their decisions and behavior.  Computer models can't accurately model dynamic behavior.

To the extent that econometric models are accurate, they could strengthen the case for activist policy.

 3. Market Signals - using changes in market prices like commodity prices and ex-rates to predict future economic activity. More useful for monetary policy than fiscal. Example: changes in the price of gold or a commodity index of several commodity prices can predict future inflation (deflation). If gold prices or commodity prices are increasing, it could signal future inflation - Fed should move to a more restrictive monetary policy.  Allan Greenspan does follow gold prices and commodity prices.

Also, the value of the dollar in the foreign exchange market indicates investors perception of the value of the dollar in the future, which reflects the supply of dollars. If the dollar is depreciating, it could reflect foreigners' unwillingness to hold an asset they expect to depreciate in the future, due to an expectation of higher U.S. inflation. Falling dollar could be a signal to the Fed to move toward tighter monetary policy.

Indexed Treasury bonds now give us a direct measure of the real interest rate.  The spread between a regular T-bond and an Indexed T-bond over the same period, gives us a direct measure of the market's expectation of inflation over that period.  Example: A 5 year regular T-bond has a yield of 5% (fixed nominal rate) and an indexed 5 year T-bond has a yield of 3% (fixed real rate), the expected, average annual, rate of inflation over the next 5 years is 2%. 

Market prices can provide signals about future trends, can be used to supplement other forecasting tools as a guide for policymakers.

SUMMARY:

A major challenge for activist, countercyclical policy is: To be effective, it has to be implemented at the correct time to "counter" the "cycle." (Expansionary policy during recession, Restrictive policy during inflationary overheating).  If forecasting aids (Index of Leading Indicators, econometric models, sensitive market prices) are accurate, the case for discretionary, activist policy is strengthened, since it makes proper timing of policy more likely.  Policymakers may get some advance, early warning signals about future economic conditions.
 

LAGS AND THE PROBLEM OF TIMING

1. Recognition lag - time to recognize that economic conditions have changed.
2. Administrative (policy) lag - time it takes to implement new legislation or new policies, after policymaker recognize the need for a change in policy.  For fiscal policy, how long might this lag be?
3. Impact lag - time for a new policy to actually start to affect the economy.

Estimate of the combined duration of the lags: 12-18 months for monetary policy, much longer for fiscal policy. Nonactivists point to lags as the most serious challenge and obstacle for activist policy, claim that lags seriously weaken the case for discretionary policy.  How likely is it that Congress would ever enact anti-recession fiscal policy 18 months (or more) BEFORE a recession actually starts???

Problems that Lags Present for Activist Policy:
1. Duration of lags is unpredictable.
2. Recessions last 12-18 months.
3. Policymakers can't get organized fast enough to stabilize.
4. Policy can't be reversed or undone.
5. Perfect timing is almost impossible.
6. Without perfect timing, discretionary policy will be destabilizing.

See graph page 355. Nonactivists argue that discretionary policy will usually destabilize, not stabilize, since the perfect timing is impossible.  Mis-timed policy will a) make recessions worse and they will last longer and b) will inappropriately move the economy toward inflationary overheating.

SUMMARY: Because of the problems of Lags, Nonactivists (Classical, New Classical, Monetarists, Public Choice) favor rules and a passive, stable, predictable approach to policymaking.
 

POLITICAL BUSINESS CYCLE PROBLEM

Another potential problem with activist policy from Public-choice economics: Politicians are short-sighted, and want to get re-elected or keep their political party power. There is a strong temptation for shortsighted, political entrepreneurs to use their political influence and power to implement (or apply pressure on the Federal Reserve) expansionary policy before an election. Politicians could use macro policy to stimulate the economy before an election, and therefore further their shortsighted political objectives.  Example: propose a tax cut about a year before the next election, to stimulate output and employment to help get re-elected.  The possible misuse of activist policy for political goals is called the "Political business cycle" (PBC) theory.

What is the evidence of PBC?  International study was conducted of 90 elections in 27 different countries. National income increased in 77% of election years vs. 46% of years without election, showing  evidence of politicians implementing expansionary policy to influence the outcome of the election.

Also, expansionary fiscal policy with tax cuts usually doesn't involve across the board tax cuts. Usually some special tax credit to a special interest group, which could lead to wasteful rent-seeking.

SUMMARY: Public choice analysis presents another case against activist policy: a) the potential misuse of policymaking by politicians to further political goals at the expense of the overall good of the economy and b) the wasteful rent-seeking by special interest groups fighting to be the recipient of a tax cut when expansionary fiscal policy is considered.
 

HOW ARE EXPECTATIONS FORMED AND HOW DOES THAT AFFECT POLICY?

As we have discussed, there is an important difference between Anticipated (Expected) and Unanticipated (Unexpected) changes.  Given the important distinction, we now consider the question: How are expectations formed?

ADAPTIVE EXPECTATIONS (AE) HYPOTHESIS is one theory of how people form expectations.  Adaptive expectations hypothesis assumes that people form expectations of the future based on the recent past, i.e. we adapt (change) our expectations of the next period based on what is occurring in this period.

See page 356 for a graphical explanation of adaptive expectations regarding inflation.  If inflation is 0% in period 1, people expect 0% inflation to continue in the next period.  If inflation is 2% in period 1, people expect 2% inflation in period 2, etc.  Implication of adaptive expectations: People expect the next period to pretty much like the current period, or we expect present trends to continue.  AE assumes people are NOT very rational, or forward looking - a STATIC model of how expectations are formed.

RATIONAL EXPECTATIONS (RE) HYPOTHESIS is a more recent advancement in the understanding of how people form expectations, and assumes that people are rational and forward-looking.  RE assumes that people use ALL available information - they consider past information, but they also consider the expected effects of changes in current and future policy.  RE is DYNAMIC model of expectations.

Example: Inflation has been 3% for three years, but now the money supply data shows an acceleration of money growth to 12%, up from 4% before.  According to AE, people would only consider the past and would continue to expect 3% in future periods.  However, according to RE, people rationally consider the change in monetary policy when forming expectations, and would therefore revise their expectations of future inflation upward, perhaps to 6-10%.

RE doesn't assume that all forecasts will be correct, just that people will learn from past mistakes and will therefore NOT make systematic errors when forming expectations.  They might overestimate future inflation in some periods, and underestimate inflation in other periods, but their estimates will be correct on average since they will learn from their past mistakes.

See page 357 for a bio of Robert Lucas, who won the Nobel Prize in 1995 for his role in developing Rational Expectations in the 1970s.
 

AE VS. RE

1. RE assumes that people adjust quickly to changes, AE assumes that people react slowly to changes.

2. RE assumes that people don't make systematic errors when forming expectations, AE assumes that people will make systematic errors.  For example, according to AE, when inflation is accelerating (falling), people will systematically underestimate (overestimate) future inflation, because they are ONLY using past information to predict the future.
 

POLICY IMPLICATIONS OF AE and RE

See graph page 358.  Starting at full employment output (Y_F), assume there is a move towards a more expansionary monetary policy.

Panel a: Under AE, people will not initially correctly anticipate the change in policy, and output and employment will increase to Y₂ for the reasons we discussed previously (Retail prices rise immediately, input costs are fixed by long-term contracts, so profits increase, firm expand output along SRAS, employment increases, etc.).  Eventually, input prices will start to rise, SRAS will decrease, and output will return to Y_F so the increase in output is only temporary.  The expansion in output relies on people with AE being surprised and fooled by the expansionary monetary policy.

Panel b: Under RE, if people form expectations rationally and are forward looking, they won't be surprised by the expansionary policy, and will immediately change their expectations once they learn of the proposed expansionary monetary policy.  Money supply figures are released weekly, so people will realize immediately that there has been a move toward expansionary policy, and will revise their expectations of inflation upward.  Therefore, input prices and wages will be adjusted upward immediately, which will shift the SRAS from SRAS₁ to SRAS₂ immediately, and the economy will move from E₁ to E₂.  Real output will not change in SR, it will remain at Y_F, the only change will be an increase in prices from P₁ to P₂.

The possible results under RE illustrate the Policy-Ineffectiveness Theorem, which states that rational, forward looking people will figure out what policymakers are up to, and will therefore undermine, offset and neutralize any systematic attempt to use discretionary policy to influence the economy.  Activist policy will have no effect on real output, real wages, real interest rates, employment if people form expectations rationally.  Proponents of RE therefore claim that activist policy will fail to achieve its intended outcomes, and suggest that a passive, predictable, rules-based approach to macro policy will better achieve the desired economic goals of economic stability, low unemployment, strong output growth, etc.  According to RE, under the best scenario, activist policy will be neutral (policy ineffectiveness), but could actually be destabilizing (negative).

SUMMARY: 1) Activist policy will only stimulate output in the SR if people have AE, and will NOT work if people have RE.   2) In the LR, both AE and RE predict the same outcome: Expansionary policy in the LR will only increase prices, and will have NO LR effect on output, employment, etc.  See Thumbnail Sketch, page 360.
 

NONACTIVIST STABILIZATION POLICY

Monetarists, Public Choice economists and Rational Expectations (New Classical) economists are generally critical of the Activist (Keynesian) approach to policy and alternatively advocate a nonactivist, passive, predictable, rules-based approach to policy.  The critics of active policy point to the many problems facing discretionary "fine-tuning": timing/lag problems, public choice analysis (politically motivated business cycles) and RE (policy ineffectiveness).  Claiming that the activist approach will backfire and end up destabilizing the economy, they suggest that policymakers could better achieve LONG RUN goals of economic stability if they publicly announced and pursued stable, predictable policies based on predetermined rules.  If macro policies were stable, known and predictable over the business cycle, 1) the public would have greater confidence and certainty about policy, 2) private decision making would be more efficient under policy stability, and 3) the efficiency of the economy would improve, leading to increased economic prosperity and raising our standard of living.
 

NONACTIVIST MONETARY POLICY

Policy conclusions of nonactivists: Use Monetary Policy Rules to Avoid erratic, stop-and-go, unpredictable, or mistimed discretionary policy such as:

1. Monetary growth rule. Milton Friedman has advocated adopting a fixed/constant growth rate of MS at 3%, for example, the growth rate of LRAS.  A fixed growth rule of 3% would provide appropriate countercyclical policy. During a rapid expansion, if real output growth = 5%, monetary policy would be automatically tight/restrictive, creating deflationary pressure.  When economy slows to 1% real output growth or is negative, the fixed growth rate of 3% would be expansionary.

Advantage: creates predictable, stable money policy and eliminates possible political influence problems (political business cycle). Avoids problems with lags. Creates confidence in monetary policy - everybody knows what to expect. No possibility of hyperinflation, or other abuses by central bank.

Disadvantage: Financial deregulation and innovation may have reduced the effectiveness of fixed rule policy in the 1980s and 1990s. Starting in 1980, interest could legally be paid on checking, dramatically changing M1. M1 has grown rapidly, and has been somewhat volatile and unpredictable. The rapid growth was not indicative of expansionary monetary policy. For example, M1 grew at 12% during 1992 and 1993, but inflation was very low. M2 grew at only 1.5%. People were shifting money balances from saving accounts to checking accounts. Possible solution to the variability of M1 - target M2 growth instead of M1.

2. Price Level Rule or Inflation Target -Instead of fixing the MS, directly target the inflation rate (CPI or GDP Deflator). Example: target inflation rate = 2.5% (UK), or = 0%, or some range 1-2%, and direct the central bank to meet the inflation target. Since money is neutral in the long run, and only influences the price level (not real output, employment, income, etc.), why not target the one variable that MS growth actually determines?

New Zealand used to have erratic and high inflation. They adopted a Price Level Rule in 1990, currently at 0-2% inflation. If not met, the chairman of the central bank can be fired. Has been very successful there, is now being use elsewhere (European Central Bank has a 2% inflation target, Canada, UK have inflation targets). Price Level Rule forces the central bank to focus on its main goal: Price Level Stability.

NONACTIVIST FISCAL POLICY

1. Balanced Budget Amendment is an example of a fixed rule for fiscal policy - force Congress and President to balance the budget annually (G = T).  However, this would require 1) tax increases or decreases in govt. spending during recessions to prevent budget deficits, and 2) tax decreases or increases in govt. spending during an expansion to prevent surpluses.  Therefore, fiscal policy would be constantly fluctuating and changing over the business cycle, which would contradict the nonactivist goal of stable (unchanged) fiscal policy.  A balanced budget rule would not force policymakers to follow a steady course.

2. Amendment (rule) limiting government spending and budget deficits is another approach advocated by nonactivists to limit discretionary fiscal power.  For example, a supermajority (e.g. 60%) could be required to pass legislation that a) resulted in a deficit or b) increased govt. spending more than the growth rate of GDP.

3. Term Limits would be another way to limit the potential abuse of shortsighted politicians.

4. Expiration Dates for Legislation (sunset laws) has also been proposed as a way to limit politically motivated politicians, and was common in the 19th Century.  Rationale: forces programs to have to be periodically reviewed, puts the burden on those who want to maintain the status quo.
 

EMERGING CONSENSUS VIEW (pages 362-363).

1. Monetary Policy should focus on Price Level Stability - low and stable inflation.

2. Activist expansionary policies cannot reduce the rate of unemployment below the natural level in the long run, and may not even be able to reduce it in the short run, especially if people have rational expectations (policy ineffectiveness theorem).

3. Stable monetary and fiscal policies are desirable, and erratic policies will destabilize the economy.  Too much "Fine-tuning," too often, by policymakers will usually destabilize the economy.

4. Discretionary fiscal policy will probably not work effectively very often, due to the major problems of lags/timing.  Political realities dictate that implementing fiscal policy is extremely time-consuming (e.g. it may take years to make major changes in tax laws), and therefore mean that fiscal policymakers are incapable of changing fiscal policy fast enough to be effectively used to stabilize the economy.
 

RECENT STABILITY OF THE U.S. ECONOMY

Up until the 1970s, the activist Keynesian approach was generally accepted by most economists and all politicians.  Because of: 1) the two severe recessions and stagflation of the 1970s and 2) the development of Rational Expectations in the 1970s, the activist approach fell out of favor and the nonactivist approach gained support, especially in monetary policy.  At least partly as a result of the switch to a more passive approach, there was greater economic stability (fewer recessions, longer expansions) in the 80s and 90s than at any other time this century, see graph page 364.

Especially during Alan Greenspan's term (since 1987) as Fed chairman, there has been an increased emphasis on price level stability.  The low and stable inflation of the last 16 years has been one of the major factors in the current economic expansion, giving support to the Classical model -  as long prices are stable, the self-correcting mechanisms of the market economy work as "shock absorbers" and help stabilize and protect the economy from recessions.  

Questions: 8 and 10