Chapter 16

The Policy Debate: Active or Passive?


Active approach views the private sector as relatively unstable and unable to recover from shocks. Economic fluctuations arise primarily from the private sector, particularly investment. To move the economy to potential output, the active approach calls for the use of discretionary fiscal policy.


Passive approach considers the private sector relatively stable. When the economy gets off track, natural forces are enough to move it back on course. Active government intervention is unnecessary, and can often do more harm than good.


I.                   Active Policy v. Passive Policy


Active:  Discretionary policy ΰ reduces costs imposed by unstable private sector

Passive: Discretionary policy ΰ contributes to instability


A.     Closing a Contractionary Gap


Example: Short-run equilibrium with real GDP $7.8 trillion and a contractionary gap of $0.2 trillion.

              Unemployment is above the natural rate.


What should the government do?


a.       Passive approach


-         wages and prices are flexible enough to adjust within a reasonable period of time

-         allow natural forces to close the gap


Exhibit 1a and 1b (pg. 341)



b.      Active approach


-         prices and wages are not very flexible (particularly downwards)

-         economy will not quickly adjust, renegotiations of wages may take a long time

-         the longer the adjustment takes, the greater the economic and social costs of reduced output and unemployment

-         Use active monetary or fiscal policies to close the gap.


One cost of the policy is an increase in inflation. (There is a trade-off between unemployment and inflation.) Another cost is possibly increased federal budget deficit.

B.     Closing an Expansionary Gap


a.       Passive Approach


-         Natural market forces will prompt firms and worker to negotiate higher wages. These higher wages will increase production costs and shift SRAS to the left. This leads to a higher price level and reduced output.


Graph Exhibit 2 (pg. 343)




b.      Active Approach


-         Advocates view discretionary policy as a way to reduce output without inflation.

-         The active approach relies policy to decrease AD to close the expansionary gap.

-         When the Fed attempts to “cool and overheated economy,” it uses active monetary policy to close the expansionary gap.


C.     Problems with Active Policy


1.      Identifying potential output and unemployment at that level.

2.      Forecast what AD and SRAS would be without intervention.

3.      Must have the tools to put the plan into effect relatively quickly.

4.      Must be able to predict the effect of the policy.

5.      Policy makers (Fed and Congress and President) must coordinate their actions.

6.      Must be able to implement policy even if it causes short-term political costs.

7.      Must be able to deal with lags.



D.     The Problem of Lags


 Recognition lag – The time needed to identify a macroeconomic problem and assess its seriousness


Decision-making lag – The time needed to decide what to do once a macroeconomic problem has been identified


Implementation lag – The time needed to introduce a change in monetary or fiscal policy


Effectiveness lag – The time necessary for changes in monetary or fiscal policy to have an effect on the economy


-         Monetary policy can take 3 to 6 months or 3 years to be effective.

-         Fiscal policy can take 3 to 6 months to show any effective and 9 to 18 months to have full effect.



II.                The Role of Expectations


The effectiveness of government policy depends in part on what people expect.


Rational expectations – A school of thought that claims people form expectations based on all available information, including the probably future actions of government policy makers


A.     Monetary Policy and Expectations


Time-inconsistency problem – The problem that arises when policy makers have an incentive to announce one policy to influence expectations but then pursue a different policy once those expectations have been formed and acted upon



-         Given an economy producing at potential output, the Fed announces that it will pursue a policy of price stability (keeping prices constant at the current level).

-         Workers negotiate and renew their contracts with that expectation.

-         If the Fed follows through, the price level will turn out as expected.

-         After workers and firms agree on wages, public officials (dissatisfied with the current level of unemployment) persuade the Fed to stimulate AD.


One solution to this problem is to take discretion away from policy maker so that once a policy is announced, it cannot be changed.


Graph Exhibit 3 (pg. 348)

B.     Anticipation Monetary Policy


If the Fed announces again that they will pursue a policy of price stabilization, this time workers may not believe the news.



-         The Fed announces again that they will keep prices stable at a level of 142.

-         Workers expect the Fed to pursue expansionary policy and expect the price level to be higher (152).

-         Monetary authorities must decide whether or not to follow their planned policy. Their planned policy will result in recession. Only the expected expansionary policy will result in the economy producing potential output.

-         Monetary authorities pursue the expansionary policy to avoid recession and this reinforces the public's belief that the Fed will pursue expansionary policy no matter what.


Economists of the rational expectations school believe that if the economy is already producing its potential output, an expansionary monetary policy, if fully and correctly anticipated, will have no effect on output or employment.



C.     Policy Credibility


For the Fed to pursue a policy consistent with a constant price level, its announcements must be credible.


Congress cannot attempt to influence Fed policy by withholding funds because the Fed earns a profit each year that is turned over to the treasury. So, although the President appoints and the Senate approves members of the Board of Governors, the Fed operates fairly independently.


When central banks for 17 advanced industrial countries were from least independent to most independent, inflation turned out to be lowest in the countries with the most independent banks.


III.             Policy Rules v. Discretion


The passive approach often calls for predetermined rules to guide policy makers. These rules take the form of automatic stabilizers aimed at offsetting the effects of business fluctuations.


A.     Rationale for Rules


“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.”


Example: According to Milton Friedman, although there is a link between money growth and nominal GDP (direct channel- equation of exchange), the exact relationship is hard to pin down because of long lags. To avoid the timing problem, he suggests that the Fed follow a fixed growth rate monetary policy year after year.


B.     Rules and Rational Expectations


Proponents of rational expectations advocate passive rules for a different reason. They believe that people on average have a pretty good idea about how the economy works and what to expect from government policy makers.


“To the extent that monetary policy is fully anticipated by workers and firms, it has no effect on the level of output; it affects only the price level.” They advocate a monetary rule to avoid monetary surprises.