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Debate: Policymakers Should Try To Stabilize The Economy
Debate: Policymakers Should Try To Stabilize The Economy
CASE OF POLICY
Active policy (CON)
The Fed and the government use different tools to steer the economy. Recall that monetary
policy, the toolbox of the Fed, includes performing open market operations, and changing both
the reserve requirement and the federal funds interest rate. Recall also that fiscal policy, the
toolbox of the government, includes changing both taxes and government spending.
All of these tools can be controlled actively. That is, if the Fed or the government decide to use
expansionary policy, they can simply select a tool from the policy toolbox and use it. In this way,
active policy is defined as actions by the Fed or by the government that are done in response to
economic conditions. That is, the Fed or the government choose to respond to something in the
economy by undertaking a specific policy. This is also called discretionary policy.
Active policy, while simple, is open to a number of difficulties. Because it relies on the actions
and experiences of the policymakers in the Fed and in the government, the weaknesses or
prejudices of these policymakers can be translated into official economic policy. For instance,
during election years, a central banker may pursue policy that enables the economy to grow in
the short run, regardless of the long-term effects, in order to help a candidate. On the other hand,
the central banker may contract the economy to hurt a candidate. Similarly, it would be possible
for the policymakers to pursue policies that achieve their selfish ends rather than those that are
best for the economy at large. Finally, with active policy, policymakers can say one thing and do
another. There may be benefits to making the public believe that something different is occurring
in the economy rather than what actually is occurring. For instance, if the Fed wants to increase
investment, it could use deception by claiming that it raised interest rates while not actually
doing so. In this scenario, private investors would save more but investment would remain at the
old level or even increase. Thus, it is reasonable to claim that active policy leaves monetary
policy and fiscal policy open to not only accidental human error but also to malicious and selfserving acts.
But there are some advantages to active policy. Active policy allows policymakers to respond to
shifts in a complex economy and steer the economy in the optimal direction. For instance, an
excellent policymaker may be able to keep the economy growing steadily without inflation if she
is given complete control of macroeconomic policy. Similarly, active policy, at least in theory,
gives control to those individuals who are considered optimally capable to deal with the
fluctuations in the economy. That is, active policy allows the sharpest policymakers of the time
to control the economy. Finally, the ability to create different expectations between the
policymakers and the public can be an advantageous policy tool, as described in the previous
paragraph.
Passive policy (PRO)
In contrast to active (or discretionary) policy is passive policy (or policy by rule). Under this
system, macroeconomic policy is conducted according to a preset series of rules. These rules
take into account many macroeconomic variables and dictate the best course of action given
these conditions. For instance, a passive policy may follow the rule that in order to stabilize the
economy the interest rate must be dropped one point whenever the nominal GDP falls one
percent.
The major advantage to passive policy is that it takes the short-term desires of policymakers out
of the list of possible goals of macroeconomic policy. Instead, the policymakers are simply
present to carry out the macroeconomic policy and to ensure that everything runs smoothly.
Policy by rule uses policymakers to implement, rather than design, macroeconomic policy.
Similarly, another advantage of passive policy is that the policy rules are based on optimizing the
economy in the long run and are less likely to trade short run prosperity for long run growth.
Passive policy is not immune to the problems that plague active policy, however. For instance,
passive policy must be written by policymakers at some point. Thus, policy rules can contain the
biases of the policymakers of a different time--biases that are perhaps quite inappropriate to the
current economic climate. And any outright errors in judgment or theory made by these
policymakers will be incorporated into the rules and will thus be present as long as the rules are
in effect. Which method of macroeconomic policy is better? Active policy relies on the judgment
and character of policymakers to pursue the optimal long-term policies for the economy. Passive
policy takes the power of choice away from policymakers and instead relies on the judgment and
character of the writers of the rules. It is not clear that either method of policy is better. The
majority of macroeconomic policy in the United States is active.
Policy lags (CON)
Whichever method of policy is desired, a major problem exists. This problem is based on the fact
that it takes time for economic problems to be noticed and dealt with. Detection lags refer to the
amount of time between the onset of an economic problem and its detection. Policy lags, on the
other hand, refer to the amount of time between the enactment of macroeconomic policy and the
moment when that policy takes effect. For example, say that the economy is contracting. It must
contract for a while before the policymakers recognize the contraction. When it is finally
recognized, the policymakers must then decide which policy or policy rule to institute. Finally,
once the policy or policy rule is instituted, it takes a fair amount of time for it to affect the
economy. In the end, lags create significant delays in the progression from problem to solution in
macroeconomic policy.
The delays created by lags can have one final and very important effect. If lags are so long that
the economy corrects itself before the macroeconomic policies take effect, then the policies can
actually worsen the situation. For instance, if the government uses fiscal policy to stimulate the
economy, but the economy begins to correct itself before the policy takes effect, then the
economy will be over-stimulated, resulting in possible inflation. There is little that can be done to
correct lags. Because the macroeconomy is constantly fluctuating, it is impossible to simply
begin policies when a change is detected. The presence of lags must be acknowledged and
accounted for as a necessary evil implicit in macroeconomic policy. By using macroeconomic
policy judiciously and in small increments, dangerous situations created by lags can be avoided.