Download chapter summary

CHAPTER 17
MACRO POLICY DEBATE: ACTIVE OR PASSIVE?
In this chapter, you will find:
Chapter Outline with PowerPoint Script
Chapter Summary
Teaching Points (as on Prep Card)
Answers to the End-of-Book Questions and Problems for Chapter 17
Supplemental Cases, Exercises, and Problems
INTRODUCTION
This chapter reduces the policy issues of macroeconomics to a single question: Is the economy inherently
stable and self-correcting, or is it unstable and unable to right itself when thrown off course? Proponents
of the active approach view the private sector, particularly investment, as unstable, requiring government
intervention to return the economy to its potential output. Advocates of the passive approach view the
private sector as inherently stable and able to correct itself through price and wage flexibility when output
departs from the economy’s potential. In addition to the discussion of these differences of opinion between
active and passive policy proponents, this chapter also examines the role of expectations formation in the
analysis of macroeconomic policy. In this context, the concepts of the Phillips curve and the rules versus
discretionary policy debate are addressed.
LEARNING OUTCOMES
1
Compare an active policy and a passive policy
Advocates of active policy view the private sector—particularly fluctuations in investment—as the primary
source of economic instability in the economy. Activists argue that achieving potential output through natural
market forces can be slow and painful, so the Fed or Congress should stimulate aggregate demand when actual
output falls below potential.
Advocates of passive policy argue that the economy has enough natural resiliency to return to potential output within a reasonable period if upset by some shock. They point to the variable and uncertain lags associated
with discretionary policy as reason enough to steer clear of active intervention.
2
Consider the role of expectations
The theory of rational expectations holds that people form expectations based on all available information including past behavior by public officials. According to the rational expectations school, government policies are
mostly anticipated by the public, and therefore have less effect than unexpected policies.
3
Discuss policy rules versus discretion
The active approach views the economy as unstable and in need of discretionary policy to eliminate excess unemployment. The passive approach, however, suggests that discretionary policy is not necessary and may even
be harmful. The passive approach suggests that the government should follow clear and predictable policies and
avoid discretionary intervention to stimulate or dampen aggregate demand. Passive policies are reflected in automatic fiscal stabilizers and in explicit monetary rules, such as keeping inflation below a certain rate.
4
Explain the Phillips curve
At one time, public officials thought they faced a stable trade-off between higher unemployment and higher inflation. More recent research suggests that if there is a trade-off, it exists only in the short run, not in the long
run. The hypothetical Phillips curve illustrates the relationship between inflation and unemployment. Expansionary fiscal or monetary policies may stimulate output and employment in the short run. But if the economy is
already at or near its potential output, these expansionary policies, in the long run, result only in more inflation.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted
in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Chapter 17
Macro Policy Debate: Active or Passive?
234
CHAPTER OUTLINE WITH POWERPOINT SCRIPT
USE POWERPOINT SLIDE 2 FOR THE FOLLOWING SECTION
Active Policy Versus Passive Policy
 Active approach: Discretionary fiscal or monetary policy can reduce the costs of an unstable
economy, such as higher unemployment.
 Passive approach: Discretionary policy may contribute to the instability of the economy and is
therefore part of the problem, not part of the solution.
USE POWERPOINT SLIDES 3-5 FOR THE FOLLOWING SECTION
Closing a Recessionary Gap: Short-run equilibrium is below potential output.
 Passive approach: Assumes that the economy is inherently stable.
 High unemployment causes:
– Wages to fall
– Production costs to fall
– Short-run aggregate supply curve (SRAS) to shift to the right
– The economy will, in a reasonable period of time, move to potential output
 Active approach: Monetary policy, fiscal policy, or a mix can be used to:
– Increase aggregate demand.
– Increase the price level (inflation)
– Increase the budget deficit
– The increase in aggregate demand moves the economy to potential output
USE POWERPOINT SLIDES 6-8 FOR THE FOLLOWING SECTION
Closing an Expansionary Gap: Short-run equilibrium output exceeds the economy’s potential. The
actual price level exceeds the expected price level.
 Passive approach: Assumes that natural market forces:
– Prompt firms and workers to negotiate higher wages
– Cause higher production costs
– Shift the SRAS curve leftward
– Lead to a higher price level
– Lower output to potential output
 Active approach: Discretionary policy can be used to:
– Decrease the aggregate demand curve
– Move the economy back to its potential output without an increase in the price level
USE POWERPOINT SLIDE 9 FOR THE FOLLOWING SECTION
Problems with Active Policy:
 Difficult to identify the economy’s potential output level and the natural rate of unemployment.
 Requires detailed knowledge of current and future economic conditions.
 Must have tools needed to achieve desired result relatively quickly.
 Must be able to forecast the effects of active policy on key measures.
 Fiscal and monetary policy makers must work together.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Chapter 17
Macro Policy Debate: Active or Passive?
235
USE POWERPOINT SLIDES 10-11 FOR THE FOLLOWING SECTION
The Problem of Lags: Lags occur because of the time required to implement policy. Passive policy
advocates view these lags as a reason to avoid discretionary policy.
 Recognition lag: The length of time it takes to identify a problem
 Decision-making lag: The length of time required to decide what to do
– Fiscal policy takes months to approve
– Monetary policy is decided more quickly than fiscal policy
 Implementation lag: The length of time before an approved policy is introduced
 Effectiveness lag: The length of time before the full impact of the policy registers on the economy
A Review of Policy Perspectives
 Active policy: Failure to pursue a discretionary policy is costly due to the loss of output and the
prolonged hardship of unemployment. Despite the lags, this approach prefers action through fiscal
policy or monetary policy to inaction.
 Passive policy: Uncertain lags and ignorance about how the economy works undermine active policy.
Prefer to rely on the economy’s natural ability to correct itself using automatic stabilizers.
USE POWERPOINT SLIDES 12-15 FOR THE FOLLOWING SECTION
The Role of Expectations
 The effectiveness of a particular governmental policy depends in part on what people expect.
 Rational expectations: People form expectations on the basis of all available information.
Monetary Policy and Inflation Expectations
 Unexpected expansionary monetary policy causes:
– Output and employment to increase in the short run.
– Price level to increase (inflation) in the long run.
 Time-Inconsistency Problem: Occurs when policy makers have an incentive to announce one policy
to shape expectations but then to pursue a different policy once those expectations have been formed
and acted on.
USE POWERPOINT SLIDES 16-19 FOR THE FOLLOWING SECTION
Anticipating Monetary Policy
 When workers fully expect expansionary monetary policy and inflation, such a policy has no effect on
output or employment, not even in the short run.
 Only unanticipated changes in policy can temporarily push output beyond its potential.
Policy Credibility: Necessary if the Fed is to pursue a policy consistent with a constant price level.
USE POWERPOINT SLIDES 20-22 FOR THE FOLLOWING SECTION
Policy Rules Versus Discretion
The passive approach argues for rules to guide actions of policy makers, for example, allowing the money
supply to grow at a predetermined rate.
Limitations on Discretion: The economy is so complex that active policy cannot be successful.
Rules and Rational Expectations: Advocate a predictable rule to avoid surprises because surprises result
in unnecessary departures from potential output.
Despite support for rules, some claim discretion is the rule of the day. Paul Volcker: “I know of no rule
that can be relied on with sufficient consistency in our complex and constantly evolving economy.”
USE POWERPOINT SLIDES 23-34 FOR THE FOLLOWING SECTION
The Phillips Curve: Shows possible combinations of the inflation rate and the unemployment rate.
The Phillips Framework: Dilemma of 1970s led to reexamination of the Phillips curve.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted
in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Chapter 17
Macro Policy Debate: Active or Passive?
236
 The Short-Run Phillips Curve: Assumes a given expected inflation rate; exhibits an inverse
relationship between inflation and unemployment.
 The Long-Run Phillips Curve: A vertical line at the economy’s natural rate of unemployment; the
unemployment rate is independent of the inflation rate. Policy makers cannot choose between
unemployment and inflation in the long run. They can only choose among alternative rates of
inflation.
The Natural Rate Hypothesis:
 In the long run the economy tends toward the natural rate of unemployment.
 This natural rate of unemployment is independent of any aggregate demand stimulus.
 The optimal long-run policy is one that results in low inflation.
Evidence of the Phillips Curve
 Each short-run Phillips curve is drawn for a given expected inflation rate.
 A change in inflationary expectations shifts the short-run Phillips curve.
CHAPTER SUMMARY
Advocates of active policy view the private sector—particularly fluctuations in investment—as the
primary source of economic instability in the economy. Activists argue that achieving potential output
through natural market forces can be slow and painful, so the Fed or Congress should stimulate aggregate
demand when actual output falls below potential.
Advocates of passive policy argue that the economy has enough natural resiliency to return to potential
output within a reasonable period if upset by some shock. They point to the variable and uncertain lags
associated with discretionary policy as reason enough to steer clear of active intervention.
The effect of particular government policies on the economy depends on what people come to expect. The
theory of rational expectations holds that people form expectations based on all available information,
including past behavior by public officials. According to the rational expectations school, government
policies are mostly anticipated by the public, and therefore have less effect than unexpected policies.
The passive approach suggests that the government should follow clear and predictable policies and avoid
discretionary intervention to stimulate or dampen aggregate demand over the business cycle. Passive
policies are reflected in automatic fiscal stabilizers and in explicit monetary rules, such as keeping
inflation below a certain rate.
At one time, public officials thought they faced a stable trade-off between higher unemployment and
higher inflation. More recent research suggests that if there is a trade-off, it exists only in the short run, not
in the long run. Expansionary fiscal or monetary policies may stimulate output and employment in the
short run. But if the economy is already at or near its potential output, these expansionary policies, in the
long run, result only in more inflation.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Chapter 17
Macro Policy Debate: Active or Passive?
237
TEACHING POINTS
1. Because this chapter examines the state of debate in macroeconomics today, it has the potential for
leaving students wondering why the course went through all this material when no consensus exists
as to whether such policies can work or should even be tried. Therefore, it is vital to stress at the
outset, the fact that economics is a social rather than a natural science. Students don’t need to be
convinced that policy is important and that this course gives them the tools to form their own
opinions about the efficacy of macroeconomic policy.
2. A basic problem underlying the active–passive debate concerns the question of whether the lags in
implementing discretionary policy are shorter than the natural adjustment period of aggregate supply.
The basis for disagreement lies in notions of information problems, lags, and inherent stability in the
economy. Furthermore, many economists believe that price expectations induced by activist policy
are sufficiently accurate and able to adjust rapidly enough to render such policies ineffective. Thus,
whereas activists endorse discretionary monetary and fiscal policy rules, the nonactivists argue for
automatic, predictable, and stable policy rules.
3. The latter part of this chapter considers the issue of the Phillips curve. Carefully examine Exhibit 6
in this chapter of the text before developing your lecture on this subject. However, that diagram does
not treat the dynamic nature of the adjustment process. You may want to begin the discussion by
going through the adjustment process following a one-time increase in aggregate demand. The selfcorrection process returns the economy to potential output so that both inflation and lower
unemployment are temporary in this case. Be sure the class understands the distinction between the
inflation rate and the price level. A higher, but stable, price level means that inflation has returned to
zero. Now ask the class how policy makers might try to keep the economy above potential output
permanently. They will likely respond that it requires further increases in aggregate demand.
However, the result is further self-correction and permanent inflation. If both demand and supply
curves shift at constant rates, the inflation rate itself is stable. This is the basis of the traditional
Phillips curve.
4. If inflationary expectations develop, self-correction speeds up. With the aggregate supply curve
shifting more rapidly, output will return to potential GDP unless aggregate demand is shifted more
rapidly. The Phillips curve shifts upward, and the result is that lower unemployment requires an
ever-increasing rate of inflation. The class will then want to know what happens if inflationary
expectations continue even when output returns to its potential level. The answer is that the inflation
that accompanies the return of output to its potential level means that inflationary expectations are
likely to remain even after potential output is reached. Therefore, to keep output from falling below
potential GDP, aggregate demand must be increased. The result is a positive stable inflation rate at
potential GDP with the actual and expected inflation rates equal to each other. Lowering of the
actual inflation rate at this point requires a lowering of inflationary expectations. If expectations are
slow to fall, a recession will be unavoidable. Therefore, credibility for anti-inflationary policy is
essential to reducing inflation relatively costlessly once inflationary expectations have developed.
5. Rational expectations have become an important feature of modern macroeconomics. This chapter
explores the basic concept of rational expectations and shows its relevance to the question of policy
formation. The central idea to convey to your students is that the short-run aggregate supply curve
will shift when discretionary policy is undertaken and this will tend to undermine the policy. This
will be true if individuals anticipate the policy but not if the policy is erratic and unpredictable. The
result is that the economy should be at potential output most of the time, apart from supply shocks
and erratic fiscal and monetary policies.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted
in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Chapter 17
Macro Policy Debate: Active or Passive?
238
ANSWERS TO END-OF-BOOK QUESTIONS AND PROBLEMS
1.1
(Active Versus Passive Policy) Discuss the role each of the following plays in the debate between the
active and passive approaches:
a. The speed of adjustment of the nominal wage
b. The speed of adjustment of expectations about inflation
c. The existence of lags in policy creation and implementation
d. Variability in the natural rate of unemployment over time
This question addresses the effectiveness of discretionary policy. Recall that the issue largely comes
down to the speed of self-correction forces, the speed (and accuracy) of expectations adjustment, the
information requirements for policy, and the lags inherent in policy decision and implementation.
Accordingly,
a. Faster nominal wage adjustment means less need for active policy and strengthens the passive
position.
b. Faster expectations adjustment means faster short-run aggregate supply adjustments and
therefore less need for active policy.
c. Longer lags reduce the effectiveness of active policy.
d. More variability in the natural rate makes it harder to determine good policy, thus
strengthening the passive position.
1.2
(Problems with Active Policy) Use an AD-AS diagram to illustrate and explain the short-run and
long-run effects on the economy of the following situation: Both the natural rate of unemployment
and the actual rate of unemployment are 5 percent. However, the government believes that the
natural rate of unemployment is 6 percent and that the economy is overheating. Therefore, it
introduces a policy to reduce aggregate demand.
Suppose that the economy is initially producing real GDP level Ya with price level Pa. The
government policy reduces aggregate demand from AD to AD*. In the short run, the economy
moves along the SRAS curve to point b. Real GDP falls to Yb , the price level falls to Pb , and
unemployment rises above the natural rate of unemployment. In the long run, real wages drop in
response to the recessionary gap created by the government policy. Therefore, the short-run
aggregate supply curve shifts outward to SRAS*. With the increase in short-run aggregate supply,
the price level falls further to Pc , real GDP returns to Ya , and the actual unemployment rate returns
to the natural rate.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Chapter 17
Macro Policy Debate: Active or Passive?
239
2.1 (Rational Expectations) Using an AD–AS diagram, illustrate the short-run effects on prices, output, and employment of an increase in the money supply that is correctly anticipated by the public. Assume that the economy is initially at potential output.
3.1
(Policy Lags) What lag in discretionary policy is described in each of the following statements? Why
do long lags make discretionary policy less effective?
a. The time from when the government determines that the economy is in recession until a tax cut
is approved to reduce unemployment
b. The time from when the money supply is increased until the resulting effect on the economy is
felt
c. The time from the start of a recession until the government identifies the existence and severity
of the recession
d. The time from when the Fed decides to reduce the money supply until the money supply actually
declines
a.
b.
c.
d.
Decision-making lag
Effectiveness lag
Recognition lag
Implementation lag
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted
in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Chapter 17
Macro Policy Debate: Active or Passive?
240
Long lags mean that by the time the impact of discretionary policy is felt, the problem it was meant
to correct may already have been alleviated by natural market forces. Then the discretionary policy
is no longer the appropriate policy and serves to increase instability in the economy.
4.1 (Long-Run Phillips Curve) Suppose the economy is at point d on the long-run Phillips curve
shown in Exhibit 6. If that inflation rate is unacceptably high, how can policy makers get the inflation rate down? Would rational expectations help or hinder their efforts?
To get inflation down, it is necessary to lower the expected inflation rate. This means getting actual
inflation below expected inflation, thereby pulling expected inflation down. Expectations that are slow
to adjust require moving down the short-run Phillips curve and pushing the economy below potential
GDP. If expectations are formed rationally, such a recession may not be necessary so long as policy
makers are credible in their stated goal of reducing inflation.
SUPPLEMENTAL CASES, EXERCISES, AND PROBLEMS
Case Studies
These cases are available to students online at www.cengagebrain.com.
Active Versus Passive Presidential Candidates
During the third quarter of 1990, after what at the time had become the longest peacetime economic
expansion of the century, the U.S. economy slipped into a recession, triggered by Iraq’s invasion of oilrich Kuwait. Because of large federal deficits at the time, policy makers were reluctant to adopt
discretionary fiscal policy to revive the economy. That task was left to monetary policy. The recession
lasted only eight months, but the recovery was sluggish—so sluggish that unemployment continued to
edge up in what was derisively called a “jobless recovery.”
That sluggish recovery was the economic backdrop for the presidential election of 1992 between
Republican President George H. W. Bush and Democratic challenger Bill Clinton. Because monetary
policy did not seem to be providing enough of a kick, was additional fiscal stimulus needed? With the
federal budget deficit in 1992 already approaching $300 billion, a record amount to that point, would a
higher deficit do more harm than good?
Bush’s biggest political liabilities during the campaign were the sluggish recovery and growing federal
deficits; these were Clinton’s biggest political assets. Clinton argued that (1) Bush had not done enough to
revive the economy; (2) Bush and his predecessor, Ronald Reagan, were responsible for the sizable federal
deficits; and (3) Bush could not be trusted because he broke his 1988 campaign pledge of “no new taxes”
by signing a tax increase in 1990 to help cut federal deficits. Clinton promised to raise tax rates on the rich
and cut them for the middle class. He also promised to create jobs through government spending that
would “invest in America.”
Bush tried to remind voters that, technically, and the economy was growing again, so the recession was
over. But that was a hard sell with unemployment averaging 7.6 percent during the six months leading up
to the election (remember that the unemployment rate is a lagging indicator).
Clinton saw a stronger role for government, and Bush saw a stronger role for the private sector.
Clinton’s approach was more active and Bush’s more passive. In the end, high unemployment rates during
the campaign made people more willing to gamble on Clinton. Apparently, during troubled times, an
active policy has more voter appeal than a passive one. Ironically, the economy at the time was stronger
than conveyed by the media and by challenger Clinton (“It’s the economy, stupid” became Clinton’s
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Chapter 17
Macro Policy Debate: Active or Passive?
241
rallying cry). Real GDP in 1992 grew 3.4 percent, which would turn out to exceed the average annual
growth rate during Clinton’s first term.
George W. Bush was not about to make the same mistake as his father. Shortly after taking office in
2001, he proposed the first of three tax cuts to stimulate a weak economy. These cuts, along with growth
in government spending combined with the Fed’s interest rate cuts for the greatest stimulus of aggregate
demand to that point since World War II. Although the recession was over by the end of 2001, the
unemployment rate continued to rise to a peak of 6.3 percent in June 2003. Then, as if on cue, in the final
12 months before the election of 2004, the economy added 2 million jobs. Despite an unpopular war in
Iraq, the additional jobs helped Bush get reelected.
The 2008 presidential election was like no other in at least the last half century. President Bush was
presiding over two unpopular wars, a financial crisis, and an economy sinking fast. But Bush was not on
the ballot. Republican John McCain faced Democrat Barack Obama. Soon after the financial crisis of
September 2008, the two candidates issued a joint statement supporting the TARP measure, the most
significant legislative action prior to the November election—so, no policy difference between the two
candidates on that one.
But the candidates differed on other issues. For example, McCain favored extending the Bush tax cuts,
which were set to expire in 2011. Obama would extend the Bush tax cuts but only for those making less
than $250,000 a year. Obama proposed broad health care reform with more government regulations.
McCain favored tax incentive to increase health coverage, saying he preferred “choices” to “mandates.”
Obama proposed creating millions of new jobs with “green energy” programs. Not McCain.
More generally, Obama blamed Bush and, by association, McCain, for the financial crisis, arguing that
they had stripped away regulations that would have prevented it (though the critical 1999 bank
deregulation act was signed by President Clinton).
A presidential poll taken a month before the election found that those whose top concern was the
economy preferred Obama over McCain by 2 to 1. When the economy is in trouble, voters seem to support
a more active approach. That’s what they got.
Sources: “Obama, McCain Lay Out Contrasts Before Undecided Voters,” CNN, 8 October 2008 at
http://www.cnn.com/2008/POLITICS/10/07/presidential.debate/index.html; David Wessel, “Wanted:
Fiscal Stimulus Without Higher Taxes,” Wall Street Journal, 5 October 1992; Economic Report of the
President, February 2010; Bob Woodward, The Agenda (New York, 1994); and the St. Louis Federal
Reserve Bank’s database at http://research.stlouisfed.org/fred2/.
Central Bank Independence and Price Stability
Some economists argue that the Fed would do better in the long run if it committed to the single goal of
price stability rather than also worry about achieving potential output. But to focus on price stability, a
central bank should be insulated from political influence, because price stability may involve some painful
remedies. When the Fed was established, several features insulated it from politics, such as the 14-year
terms with staggered appointments of Board members. Also, the Fed has its own income source (interest
earned from securities and fees earned from bank services), so it does not rely on Congress for a budget.
Does central bank independence affect performance? When central banks for 17 advanced industrial
countries were ranked from least independent to most independent, inflation during the 15-year span
examined turned out to be the lowest in countries with the most independent central banks and highest in
countries with the least independent central banks. The least independent banks at the time were in Spain,
New Zealand, Australia, and Italy. The most independent central banks were in Germany and Switzerland.
Countries with the least independent central banks experienced inflation that averaged four times higher
than countries with the most independent central banks. The U.S. central bank is considered relatively
independent; U.S. inflation was double that of the most independent countries and half that of the least
independent countries.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted
in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Chapter 17
Macro Policy Debate: Active or Passive?
242
The trend around the world is toward greater central bank independence. For example, the Central Bank
of New Zealand has adopted a monetary policy of inflation rate targeting, with price stability as the
primary goal. Chile, Colombia, and Argentina—developing countries that suffered hyperinflation—have
legislated more central bank independence. The Maastricht agreement, which defined the framework for a
single European currency, the euro, identified price stability as the main objective of the new European
Central Bank. That bank has a policy of not reducing the interest rate if inflation exceeds 2.0 percent. In
fact, the European Central Bank came under criticism before the recent financial crisis for not cutting
interest rates even though a recession loomed and unemployment topped 8 percent. The Bank of England
and Swiss National Bank also have a inflation target of no higher than 2.0 percent. Many central banks
have adopted low inflation targets. The Federal Reserve does not have an explicit inflation target, but Fed
head Bernanke has favored one in the past. Some Fed watchers claim the Fed has an informal inflation
target of 1.5% to 2.0%.
Sources: Natasha Brereton, “U.K. Inflation Eases in May,” Wall Street Journal, 15 June 2010; Sarah
Lynch and Tom Barkley, “Jobless Claims Decline,” Wall Street Journal, 15 July 2010; Alberto Alesina
and Lawrence Summers, “Central Bank Independence and Macroeconomic Performance: Some
Comparative Evidence,” Journal of Money, Credit and Banking, 25 (May 1993): 151–162; Ben Bernanke,
“A Perspective on Inflation Targeting: Why It Seems to Work,” Business Economics, 38 (July 2003): 7–
15; Stefano Eusepi and Bruce Preston, “Central Bank Communication and Expectations Stabilization.”
American Economic Journal: Macroeconomics, 2 (July 2010): 235–271; and Ben Bernanke, “Inflation
Targeting,” Federal Reserve Bank of St. Louis Review, 86 (July/August 2004): 165–168. For online links
to more than 160 central banks, including all those discussed in this case study, go to
http://www.bis.org/cbanks.htm.
Experiential Exercises
1. The Federal Reserve Bank of Minneapolis’s The Region, at http://www.minneapolisfed.org/
publications_papers/issue.cfm?id=296, features an ongoing series of interviews with prominent U.S.
policy makers. Ask students to choose a Fed governor or a regional Reserve Bank president and try to
determine whether that person leans more toward an active or a passive policy view. What specific
policy views does that person advocate?
2. The Bank for International Settlements maintains a list of links to central banks around the world at
http://www.bis.org/cbanks.htm. Many central banks maintain English-language Web pages. Have
students choose one or two nations and explore their central bank Web pages. How much
independence do those banks have? To what extent are their functions and goals similar to those of the
U.S. Federal Reserve System?
3. A good source for the latest information regarding macroeconomic policy is the “Economy” column
that appears in the daily Wall Street Journal. Have students look at today’s issue and review the latest
hot topics. They should next turn to the editorial pages, where the Journal’s editorial board,
contributors, and letter writers have their say about the latest hot topics.
4. (Global Economic Watch) Go to the Global Economic Crisis Resource Center. Select Global Issues in
Context. In the Basic Search box at the top of the page, enter the phrase "policy credibility." On the
Results page, go to the News Section. Click on the link for the September 24, 2010, article "Research
Conducted at Chongqing University Has Provided New Information About Economic Psychology."
Does the research described support the importance of policy credibility?
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Chapter 17
Macro Policy Debate: Active or Passive?
243
Yes, the research support the importance of policy credibility. The article includes the following quotation: "The perceived policy credibility as well as inflation perceptions and education plays an important role in the individuals' inflationary expectations."
5. (Global Economic Watch) Go to the Global Economic Crisis Resource Center. Select Global Issues in
Context. In the Basic Search box at the top of the page, enter the phrase "inflation target." Write a brief
summary of one article published within the past three years.
Student answers will vary and should focus on whether a central bank uses an explicit inflation target
or an interest-rate target and on how well the bank is adhering to its target, if any.
Additional Questions and Problems
(From student Web site at www.cengagebrain.com)
1. (Active Versus Passive Policy) Contrast the active policy view of the behavior of wages and prices
during a recessionary gap to the passive policy view.
The passive and active approaches differ in terms of the speed at which they believe wages and
prices will adjust to a recessionary gap. Proponents of the passive approach believe that real wages
will fall within a reasonable period, increasing short-run aggregate supply, lowering the price level,
and moving the economy to the potential output level. However, proponents of the active approach
believe that wages and prices are not very flexible in the downward direction. Therefore, natural
market forces may take a very long time, even years, to return the economy to the potential output
level. This increases the costs of a recessionary gap to the point that it is better for the government
to intervene to close the gap.
2. (Active Policy) Why do proponents of active policy recommend government intervention to close an
expansionary gap?
Proponents of the active approach recommend government intervention in order to close the gap
without creating inflation. A reduction in aggregate demand through government action, rather than
a drop in short-run aggregate supply, closes the gap while lowering the price level. The passive
approach to an expansionary gap leads to decreases in short-run aggregate supply and, thus, higher
prices.
3. (Active Versus Passive Policy) According to advocates of passive policy, what variable naturally
adjusts in the labor market, shifting the short-run aggregate supply curve to restore unemployment to
the natural rate? Why does the active policy approach assume that the short-run aggregate supply
curve shifts leftward more easily and quickly than it shifts rightward?
The real wage rate is the variable that adjusts to bring equilibrium in the labor market and to shift
the aggregate supply curve.
Advocates of the active approach believe that wage contracts reduce the flexibility of wages,
especially in the rightward direction. When the unemployment rate rises above the natural rate, the
renegotiation of long-term wage contracts may take months or years because workers are reluctant
to make concessions. It is easier to adjust wages leftward during an expansion.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted
in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Chapter 17
Macro Policy Debate: Active or Passive?
244
4. (Review of Policy Perspectives) Why might an active policy approach be more politically popular
than a passive approach, especially during a recession?
The advocates of an active approach do not wish to wait for the natural adjustment of wages and
prices to bring the economy back to potential output. Active policy advocates view the failure to
pursue a discretionary policy as having a high cost due to lost production and the personal hardship
of prolonged unemployment. A case could also be made for lower potential output if the prolonged
unemployment discourages workers from staying in the labor force. During recessionary times, an
active policy has more voter appeal than a passive one.
5. (The Role of Expectations) Some economists argue that only unanticipated increases in the money
supply can affect real GDP. Explain why this may be the case.
The basic reason is that increases in the money supply cause the aggregate demand curve to shift
rightward along the short-run aggregate supply curve, thus raising the price level. However, if the
monetary increase and the reduction in the real wage are foreseen, the short-run aggregate supply
curve will shift leftward by just enough to offset completely the shift in aggregate demand; there will
be no change in equilibrium output. Wage earners therefore use changes in money supply, among
other variables, as an indicator of future movements in the price level.
6. (Anticipating Monetary Policy) In 1995 the Fed began announcing its interest rate targets
immediately following each meeting of the FOMC. Prior to that, observers were left to draw
inferences about Fed policy based on the results of that policy. What is the value of this greater
openness?
This greater openness about the direction of monetary policy increases the Fed’s credibility and
decreases the probability of a time-inconsistency problem. Since Fed policy influences international
economies as well as the U.S. economy, this openness facilitates international coordination among
central banks in pursuit of price stability.
7. (Policy Credibility) What is policy credibility and how is it relevant to the problem of reducing high
inflation? How is credibility related to the time-inconsistency problem?
For the Fed to pursue a policy consistent with low inflation, its announcements must be credible, or
believable. People must feel certain that when the time comes to make a tough decision about
fighting inflation, the Fed will follow through as planned. If the Fed realizes that its credibility is
difficult to develop but easy to undermine, it will be reluctant to pursue policies that go against its
stated policy objectives and ultimately would increase inflation. A Fed concerned about its
credibility would never be tempted to cause a time-inconsistency problem by announcing one policy
with the express purpose of influencing people’s expectations and in a few months reversing its
position to take advantage of those expectations.
8. (Rationale for Rules) Some economists call for predetermined rules to guide the actions of
government policy makers. What are two contrasting rationales that have been given for such rules?
The passive approach to policy argues that the economy is too complex for policy makers to pursue
an appropriate discretionary policy. This argument for rules rests on the difficulty of understanding
the interactions of the economic aggregates and the long lags involved in active policy.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Chapter 17
Macro Policy Debate: Active or Passive?
245
Proponents of rational expectations argue that the public, on average, predicts changes in
government policy with reasonable accuracy. Therefore, discretionary policy affects only the price
level, not real variables such as real GDP. Policy rules reduce surprises that generate departures
from the natural rate of unemployment.
9. (Rational Expectations and Policy) Suppose that people in an election year believe that public
officials are going to pursue expansionary policies to enhance their reelection prospects. How could
such expectations put pressure on officials to pursue expansionary policies even if they hadn’t
planned to?
If expectations of inflation increase, failure to accommodate such expectations will push the
economy into recession. To avoid this, policy makers may well go ahead with inflationary policies,
making such expectations an example of a self-fulfilling prophecy.
10. (Potential GDP) Why is it hard for policymakers to decide if the economy is operating at its
potential output level? Why is this uncertainty a problem?
Potential output occurs when unemployment is at the natural rate. Thus, even at potential output, we
know that there will be some structural, frictional, and seasonal unemployment.
If policy makers are unable to determine the economy’s potential output level, they are more likely
to develop inappropriate active policies. For example, if policy makers incorrectly estimate that the
actual rate of unemployment is above the natural rate, they will introduce policies to increase
aggregate demand—possibly creating an expansionary gap.
11. (Phillips Curve) Describe the different policy trade-offs implied by the short-run Phillips curve and
the long-run Phillips curve. What forces shift the long-run Phillips curve?
The adjustment speed along the short-run Phillips curve is relatively low, implying that the trade–off
between inflation and unemployment suggested by the short-run Phillips curve is relevant for policy.
The long-run Phillips curve is a framework in which price expectations have responded to
differences between expected and actual price levels. The result is that unemployment can stay
below the natural rate only with ever-increasing inflation.
The position of the vertical long-run Phillips curve is determined by the level of potential output,
which occurs at the natural rate of unemployment. Thus, anything that shifts potential output also
shifts the long-run Phillips curve. A decrease in the supply of a key resource, for example, would
shift the curve to the left. In contrast, a reduction in frictional unemployment would shift the curve to
the right.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted
in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Chapter 17
Macro Policy Debate: Active or Passive?
246
ANSWERS TO ONLINE CASE STUDIES
1.
(CaseStudy: Central Bank Independence and Price Stability) One source of independence for the
Fed is the length of term for members of the Board of Governors. In the chapter before last, we
learned that the Fed is a “money machine.” Does this suggest another source of Fed independence
from Congress?
The Fed does not have to rely on Congress for its budget. The Fed’s major assets are U.S.
government securities. The interest earnings on these securities far exceed the Fed’s operating
expenses. In fact, the Fed typically returns most of its interest earnings to the U.S. Treasury.
2.
(CaseStudy: Active versus Passive Presidential Candidates) What were the main differences
between candidates Bush and Clinton in the 1992 presidential campaign? Illustrate their ideas using
the aggregate supply and demand model.
Clinton saw a stronger role for government, an approach that was, therefore, more activist. He
advocated raising the marginal tax rate on the top 2 percent of taxpayers and cutting taxes for the
middle class. He also promised a government spending program that would create jobs. Clinton’s
policy involved using discretionary policy to increase aggregate demand from AD1 to AD2, causing
the economy to move from point a to point b, and allowing it to reach potential output while causing
the price level to rise from P1 to P2.
Bush saw a stronger role for the private sector. His approach was more passive. He would have let
the natural forces in the economy continue the recovery that he claimed was already underway. He
saw the economy steadily approaching potential output by moving from point a to point c as the
aggregate supply curve shifted to the right from SRAS1 to SRAS2. He also promised to cut taxes
and reduce government spending.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.