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Economics "Ask the Instructor" Clip 33 Transcript
Can we count on fiscal and monetary policy to “smooth-out” the business cycle?
You know what Congress can do in terms of fiscal policy: change taxes and/or government
spending. And you know the tools available to the FED in its conduct of monetary policy: Change the
required reserve ratio, the discount rate, or either buy or sell government securities in the open market. But
in practice there are reasons why these policies may not work as intended.
First, Congress and the FED may not coordinate their policies. For example, Congress, being
subject to political influences, may choose to run budget deficits at a time that the FED is pursuing a “tight”
monetary policy in an effort to contain a rising inflation rate. Second, there’s the problem of timing both
fiscal and monetary policy. Consider the so-called recognition lag. This refers to the amount of time that
elapses between the beginning of a macroeconomic problem and the time when policymakers become
aware that the problem exists. For example, if an inflationary gap occurs, it may be months before
Congress becomes aware of it. Next, there is what economists call the decision-making lag. This refers to
the time required for policymakers to decide on an appropriate policy, once the problem has been
identified. For example, if a deflationary gap is identified, Congress will likely debate alternative fiscal
remedies for months. Should taxes be cut or should government spending be increased? If a tax cut is
deemed preferable, then should the tax cut be “across-the-board” or should it be focused on particular
income groups? Should the individual income tax be cut, or payroll taxes?
Next, there is the implementation lag. This refers to the time required for a change in policy to
be implemented, for Congress to enact legislation in the case of fiscal policy. For example, President
George W. Bush proposed a tax cut in 2001 during the first weeks of his administration, but Congress
debated the proposal, revised it, and it was June 2001 before the final legislation passed Congress.
Finally, there is the so-called effectiveness lag. As the name implies, this is the time necessary for
the change in monetary or fiscal policy to have an impact on either aggregate supply or aggregate demand.
Continuing with the tax cut illustration, even though Congress enacted the tax cut legislation in June 2001
retroactive to the first of the year, most taxpayers did not receive a tax refund until months later.
The point is that the cumulative effect of these time lags weakens the case for an activist
macroeconomic policy. An analogy might be made between a recessionary gap and a headache. The case
for taking a pain reliever would be much weaker if the person with a headache was required to debate for
several hours or days the pros and cons of acetaminophen versus aspirin. The case for medicine would be
further weakened if, once taken, the pain reliever did not begin to reduce aches and pains until after several
days had elapsed. By then the headache might have been gone without the medicine.
In summary, stabilization policy is much more difficult to enact and implement in practice than in
theory. This is particularly true in the case of fiscal policy because fiscal policy is done in a political
environment. It is somewhat less true in the case of monetary policy because members of the FED’s
Board of Governors are appointed, not elected.