Should Policy Be Active or Passive

Should Policy Be Active or Passive?
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.
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
Lags in the Implementation and Effects of Policies
Economists distinguish between two lags that are relevant for 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.
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 example, the system of income taxes automatically reduces taxes
when the economy goes into a recession, without any change in the tax laws,
because individuals and corporations pay less tax when their incomes fall. Similarly,
the unemployment-insurance and welfare systems automatically raise transfer
payments when the economy moves into a recession, because more people
apply for benefits. One can view these automatic stabilizers as a type of fiscal policy
without any inside lag.
When policymakers estimate theeffect of any policy change, therefore, they need to know how peoples
expectationswill respond to the policy change. Lucas has argued that traditional methods of policyevaluationsuch
as those that rely on standard macroeconometric modelsdonot adequately take into account the impact of policy
on expectations. This criticism
of traditional policy evaluation is known as the Lucas critique
the cost of reducing inflation is often measured

by the sacrifice ratio, which is the number of percentage points of GDP that must
be forgone to reduce inflation by 1 percentage point. Because estimates of the sacrifice
ratio are often large, they have led some economists to argue that policymakers
should learn to live with inflation, rather than incur the large cost of reducing it.
Should Policy Be Conducted

by Rule or by Discretion?
Policy is conducted by rule if policymakers

announce in advance how policy will respond to various situations and
commit themselves to following through on this announcement. Policy is conducted
by discretion if policymakers are free to size up events as they occur and
choose whatever policy they consider appropriate at the time.
The debate over rules versus discretion is distinct from the debate over passive
versus active policy. Policy can be conducted by rule and yet be either passive or
active. For example, a passive policy rule might specify steady growth in the
money supply of 3 percent per year. An active policy rule might specify that
Money Growth = 3% + (Unemployment Rate 6%).
Under this rule, the money supply grows at 3 percent if the unemployment rate
is 6 percent, but for every percentage point by which the unemployment rate
exceeds 6 percent, money growth increases by an extra percentage point. This
rule tries to stabilize the economy by raising money growth when the economy
The Time Inconsistency of Discretionary Policy

Yet a case for rules over discretion arises from the problem of time inconsistency
of policy. In some situations policymakers may want to announce in
advance the policy they will follow to influence the expectations of private decisionmakers.
But later, after the private decisionmakers have acted on the basis of
their expectations, these policymakers may be tempted to renege on their
announcement. Understanding that policymakers may be inconsistent over time,
private decisionmakers are led to distrust policy announcements. In this situation,
to make their announcements credible, policymakers may want to make a commitment
to a fixed policy rule.
Conclusion: Making Policy

in an Uncertain World
Summary
1. Advocates of active policy view the economy as subject to frequent shocks
that will lead to unnecessary fluctuations in output and employment unless
monetary or fiscal policy responds. Many believe that economic policy has
been successful in stabilizing the economy.
2. Advocates of passive policy argue that because monetary and fiscal policies
work with long and variable lags, attempts to stabilize the economy are
likely to end up being destabilizing. In addition, they believe that our
present understanding of the economy is too limited to be useful in formulating
successful stabilization policy and that inept policy is a frequent
source of economic fluctuations.
3. Advocates of discretionary policy argue that discretion gives more flexibility
to policymakers in responding to various unforeseen situations.
4. Advocates of policy rules argue that the political process cannot be trusted.
They believe that politicians make frequent mistakes in conducting
economic policy and sometimes use economic policy for their own political
ends. In addition, advocates of policy rules argue that a commitment to
a fixed policy rule is necessary to solve the problem of time inconsistency.
C H A P T E R 1 5 Stabilization Policy | 461
KEYCONCEPTS
Inside and outside lags
Automatic stabilizers
Lucas critique
Political business cycle
Time inconsistency
Monetarists
Inflation targeting

Should Policy Be Active or Passive

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Should Policy Be Active or Passive

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Should Policy Be Active or Passive?

Some economists, such as William McChesney Martin, view the economy as

Lags in the Implementation and Effects of Policies

the cost of reducing inflation is often measured

Should Policy Be Conducted

Policy is conducted by rule if policymakers

The Time Inconsistency of Discretionary Policy

Conclusion: Making Policy

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