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CHAPTER 16
MACRO POLICY DEBATE: ACTIVE OR PASSIVE?
In this chapter, you will find:
Learning Outcomes
Chapter Outline with PowerPoint Script
Chapter Summary
Teaching Points (as on Prep Card)
Solutions to Problems Appendix
Experiential Assignments
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
16-1 Outline the difference between active policy and passive policy, and explain how the two approaches differ in their assumptions about how well the economy works on its own.
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.
16-2 Describe how expectations can influence the effectiveness of discretionary policy.
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.
16-3 Summarize why some economists prefer that policy be shaped by predictable rules rather than
by the discretion of policy makers.
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
© 2015 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.
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234
demand. According to the passive approach, a lack of knowledge about how the economy works and
uncertainty about lags make discretionary policy risky. Passive policies are reflected in automatic
fiscal stabilizers and in explicit monetary rules, such as keeping inflation below a certain rate.
16-4 Explain the shape of the short-run Phillips curve and the long-run 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. And federal deficits from expansionary fiscal
policy can create a huge federal debt, which itself can create uncertainty and instability.
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
© 2015 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.
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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.
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.
© 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted
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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.
 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.
© 2015 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.
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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 clear 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.
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 everincreasing 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.
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in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
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SOLUTIONS TO PROBLEMS APPENDIX
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.
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.
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3. (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.
4.
(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
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a.
b.
c.
d.
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240
Decision-making lag
Effectiveness lag
Recognition lag
Implementation lag
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.
5. (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.
Experiential Assignment
1. The Federal Reserve Bank of Minneapolis’s The Region, at
http://www.minneapolisfed.org/publications_papers/ , 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.
© 2015 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.