How should government policymakers respond to the business cycle? Some economists, such as William McChesney Martin, view the economy as inherently unstable. hey 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 fluctua- tions 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. It became especially relevant as economies around the world sank into recession in 2008. The fundamental issue is how policymakers should use the theory of short-run economic fluctuations devel- oped in the 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?
Should Policy Be Active or Passive?
To many economists the case for active government policy is clear and sim- ple. 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 (or at least soften) 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 pol- icy for economic stabilization? To find out, let’s consider some of their arguments. 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 econ- omy. This lag arises because policies do not immediately influence spending, income, and employment. 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 chang- ing the money supply and interest rates, which in turn influence investment and aggregate demand. Many firms make investment plans far in advance, however, so 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 cer- tainly make stabilizing the economy more...