COMPILED POINTS AND RESEARCH

Monetary and Fiscal Policymakers Should Try to Stabilize the Economy

Pro: Policymakers Should Try to Stabilize the Economy
Left on their own, economies fluctuate.
In some instances there may be painful recessions. Recessions have no benefit to society.
Resources sit idle and are wasted.
There is no reason for society to suffer through the booms and busts of the business cycle when
government can use monetary and fiscal policy to ameliorate some of the suffering.
Con: Policymakers Should Not Try to Stabilize the Economy
Monetary and fiscal policy affect the economy with a substantial lag.
The fiscal policy lag is the result of a long political process. Because of these lags, policymakers
are forced to use crystal balls to determine the future and they may be wrong.
If so, the effects are more devastating than the original problem.
Policymakers should adopt a "do no harm" philosophy and restrain themselves from intervening.
Should Policymakers Stabilize the Economy?
Changes in aggregate demand and aggregate supply
Short-run fluctuations in production and employment
Monetary and fiscal policy
Can shift aggregate demand
Influence these fluctuations
Should policymakers influence short-run economic fluctuations?
Pro: policymakers should try to stabilize the economy
When aggregate demand is too small
Policymakers
Boost government spending
Cut taxes
Expand the money supply
When aggregate demand is excessive
Policymakers
Cut government spending
Raise taxes
Reduce the money supply
Lead to more stable economy
Benefits everyone
Con: policymakers should not try to stabilize the economy
Monetary and fiscal policy
Do not affect the economy immediately
Work with a long lag
Economic forecasting is highly imprecise
Policymakers trying to stabilize the economy
Can do just the opposite
Economic conditions can easily change

Pro: Policymakers should try to stabilize the economy

The economy is inherently unstable, and left on its own will fluctuate.
Policy can manage aggregate demand in order to offset this inherent instability and reduce
the severity of economic fluctuations.
There is no reason for society to suffer through the booms and busts of the business cycle.
Monetary and fiscal policy can stabilize aggregate demand and, thereby, production and
employment.
Con: Policymakers should not try to stabilize the economy
Monetary policy affects the economy with long and unpredictable lags between the need to
act and the time that it takes for these policies to work.
Many studies indicate that changes in monetary policy have little effect on aggregate
demand until about six months after the change is made.
Fiscal policy works with a lag because of the long political process that governs changes in
spending and taxes.
It can take years to propose, pass, and implement a major change in fiscal policy.
All too often policymakers can inadvertently exacerbate rather than mitigate the magnitude
of economic fluctuations.
It might be desirable if policy makers could eliminate all economic fluctuations, but this is
not a realistic goal.
Advocates of active monetary and fiscal policy view the economy as inherently unstable
and believe policy can be used to offset this inherent instability.
Critics of active policy emphasize that policy affects the economy with a lag and our ability
to forecast future economic conditions is poor, both of which can lead to policy being
destabilizing.

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.

PROBLEMS WITH IMPLEMENTING MONETARY AND FISCAL POLICY (CON)

Monetary policy and fiscal policy under a system of fixed output
Initially, monetary policy and fiscal policy were introduced in an economy where changes in
these policies would affect output. In reality, there is no real link between monetary policy and
real variables. That is, changes in monetary policy and fiscal policy cannot affect the total level
of output because the total level of output is determined by the factors of production and not by
monetary variables. This is called the neutrality of money.
What really happens, then, when the Fed and the government use monetary policy and fiscal
policy? If we recall the equation for output of Y = C(Y - T) + I + G + NX we can begin this
analysis. Given that Y is fixed by the factors of production, a change in G or T--that is, fiscal
policy--must result in a change in another variable to maintain a constant Y. This change in Y
works directly though the interest rate.
Each of the variables in the output equation is tied to the interest rate. Consumption tends to fall
as the interest rate rises because the incentive for saving increases. Investment tends to fall as the
interest rate rises because the cost of borrowing money increases. Government spending is not
really affected by the interest rate. Net exports tend to rise as interest rates rise because domestic
investment is relatively more attractive to both domestic and foreign investors.
When monetary policy and fiscal policy are used the interest rate is affected. Expansionary
monetary policy directly lowers the interest rate by making money easier and cheaper to obtain.
Contractionary monetary policy directly raises the interest rate by making money harder and
more expensive to obtain. Expansionary fiscal policy increases the interest rate by decreasing the
savings rate through lower taxes and higher government spending. Contractionary fiscal policy
decreases the interest rate by increasing the savings rate through higher taxes and lower
government spending. Thus, monetary policy and fiscal policy both directly affect consumption,
investment, and net exports through the interest rate.
For example, say the Fed uses expansionary monetary policy such as purchasing government
bonds, decreasing the reserve requirement, or decreasing the federal funds interest rate. This
causes the interest rate to fall, which then causes consumption to rise and investment to rise. But,
in order for the total level of output to remain fixed, net exports must fall the same amount that
consumption and investment rise. In this way, total output does not change from monetary policy,
but the division of total output is affected. Another example is needed. Say the Fed uses
contractionary monetary policy such as selling government bonds, increasing the reserve
requirement, or increasing the federal funds rate. This causes the interest rate to rise which
causes consumption to fall and investment to fall. But, in order for the total level of output to
remain fixed, net exports must rise by the same amount that consumption and investment fall. In
this way, total output does not change from monetary policy, but the division of total output is
affected.

Fiscal policy and crowding out

Fiscal policy has a very important affect on the division of total output. This is one major
negative effect of fiscal policy. Recall that the tools of fiscal policy are taxes and government
spending. When the government increases government spending, there should be an indirect
increase in output, as mitigated by the government spending multiplier. In reality, government
spending does not change output as the government spending multiplier would seem to indicate.
It does, instead, significatly change the interest rate. A rise in the interest rate has a strong affect
on investment. That is, as the interest rate rises, investment falls. This is because the interest rate
is the opportunity cost of holding money, and as this increases, taking out loans becomes
relatively less attractive.
When the government increases spending, the interest rate rises and investment falls. This is
called crowding out. That is, increases in government spending tend to replace, or crowd out,
private investment. This works because the total level of output is fixed by the factors of
production, thus causing there necessarily to be an equal and opposite change from an increase in
government purchases. Because investment is more sensitive to interest rates than either
consumption or net exports, investment takes the primary hit from the fiscal policy change. For
this reason, crowding out always occurs when expansionary fiscal policy is used. In the long run,
this crowding out may hamper economic growth since investment affects the factors of
production, which do affect total output.
When taxes decrease, consumption immediately rises because disposable income rises. But,
since total output is fixed by the factors of production and government spending is fixed by fiscal
policy, a change in consumption is met by and equal and opposite change in investment. Here
again the case exists where a change in fiscal policy crowds out investment. In this way, a
tradeoff is created between the short run and long run effects of fiscal policy upon the economy
due to government spending and taxes replacing, or crowding out, private investment.