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CHAPTER 18
Alternative Perspectives on
Stabilization Policy
Notes to the Instructor
Chapter Summary
This chapter discusses issues in macroeconomic policy. Even though the AD–AS model suggests
the desirability and simplicity of stabilization policy, in practice the benefits of stabilization
policy are less clear and its complications are much more evident. The chapter addresses two key
questions. First, should policymakers try to stabilize the economy or instead be content with
Comments
The material in this chapter can be covered in two lectures. The taxonomy set up in this chapter
makes discussion of policy issues very clear, and as a result students like this material. I
emphasize that many economists believe that there is a case in principle for stabilizing the
economy but that pragmatic difficulties may override this case.
Use of the Web Site
This is the natural time to discuss the presidential policy game in the Web-based software. Not
surprisingly, students seem to like this game a lot. As well as being fun, it is intended to teach a
number of lessons about the difficulty of stabilization and of how expansion can be beneficial in
the short run but costly in the long run. Instructors might also choose (at some point) to explain
to the students about the details of the model, as explained in the documentation.
Use of the Dismal Scientist Web Site
Go to the Dismal Scientist Web site and download data for the past three years on the rate of
consumer price inflation for the Euro-zone, the United Kingdom, Canada, Australia, and New
Zealand. These countries all have explicit inflation targets that their central banks use in setting
monetary policy. Visit the central bank Web sites of these countries (or see Supplement 18-16)
426 | CHAPTER 18 Alternative Perspectives on Stabilization Policy
Chapter Supplements
This chapter includes the following supplements:
18-2 Profit Sharing as an Automatic Stabilizer
18-4 The Pitfalls of Forecasting (Case Study)
18-5 Are Forecasters Rational? (Case Study)
18-7 Spare a Thought for the Empirical Macroeconomist (Case Study)
18-9 Distrust of Policymakers
18-11 The Political Business Cycle at Its Worst
18-13 Price Level Versus Inflation Targeting
18-15 Central-Bank Independence and Growth (Case Study)
18-17 Additional Readings
Lecture Notes | 427
Lecture Notes
Introduction
Our interest in macroeconomic phenomena is motivated by a desire to understand not only the
functioning of the economy but also how macroeconomic policies affect the economy, with a
view to understanding, in turn, if there is a role for government policies directed at stabilization.
Ultimately, we wish to answer two questions: Can the government improve the functioning of
the economy by pursuing active stabilization policies? How should a well-designed economic
policy be conducted? Both are considered in this chapter.
To answer these questions, we first need answers to two prior questions: How would the
economy perform in the absence of stabilization policies? How do government policies affect
the overall functioning of the economy? Our analysis to this point provides answers. Given that
18-1 Should Policy Be Active or Passive?
The aggregate demand–aggregate supply model indicates that, in principle, policy-makers could
manipulate aggregate demand in order to stabilize the economy. Despite such a conclusion,
many economists do not advocate an active role for government policy.
New classical economists believe that prices and wages are flexible and usually argue that
stabilization policy is inappropriate. They believe that fluctuations arise either as an efficient
response to shocks (the real-business-cycle view) or as a result of the information problems
summarized in the imperfect-information theory of short-run aggregate supply. Since they
believe in price and wage flexibility, their presumption is that markets serve to allocate goods
Lags in the Implementation and Effects of Policies
If prices and wages are sticky, as Keynesians believe, then the theoretical case for intervention is
much stronger. Nevertheless, some proponents of new Keynesian ideas are also skeptical about
stabilization policy. In reality, the economy is not as easy to influence as our models suggest,
and there are many practical difficulties associated with economic stabilization. Economists
point in particular to lags in the policy process.
First, it takes time to recognize and take actions to respond to shocks that hit the economy.
As just noted, if policymakers cannot recognize shocks any more quickly than private
individuals can, then they have no scope for stabilization. Even after a shock has been identified,
it may take time to change the course of monetary and fiscal policies. This is known as the inside
428 | CHAPTER 18 Alternative Perspectives on Stabilization Policy
money supply affect interest rates and thus investment). The presence of inside and outside lags
makes active use of fiscal and monetary policies imprecise. But these lags do not imply that
policy should remain passive in the presence of a severe and lengthy economic contraction, such
as the downturn that began in 2008.
Some features of the economy help keep GDP close to the natural rate without direct
action by policymakers. When the economy is in a boom, tax revenues increase and transfer
payments, such as unemployment insurance and other welfare benefits, decrease. The opposite
The Difficult Job of Economic Forecasting
A fundamental difficulty with good policymaking is that it depends upon the ability to forecast
future economic events. The large-scale macroeconometric models discussed in Chapter 12 are
of some use here, since they help predict the behavior of key economic variables, given
Case Study: Mistakes in Forecasting
The difficulty of economic forecasting is well illustrated by the failure of forecasters to predict
both the Great Depression and the severe recession of 2008-2009 with any accuracy. Almost all
forecasters predicted that the poor economic performance at the start of the Depression would be
short-lived and that recovery was imminent. And in the early stages of the economic downturn
Ignorance, Expectations, and the Lucas Critique
The economist Robert Lucas has criticized the use of traditional economic and econometric
models for the evaluation of economic policy. Lucas’s point is that individuals’ behavior and
actions—and particularly their expectations—in general depend upon the policies chosen by
government. Therefore, Lucas argues, it is misleading to use standard models for policy
evaluation unless we take account of the effects of policies on expectations. For example, if the
economy has been experiencing moderate and fairly steady inflation, then people’s inflation
expectations might be well approximated by adaptive expectations. But if the Fed then
!Supplement 18-2,
“Profit Sharing as
!Supplement 18-3,
“The Labor
!Figure 18-1
!Supplement 18-5,
“The Pitfalls of
Lecture Notes | 429
The Historical Record
One way to help decide if policy should be active or passive is to try to determine whether
stabilization policies were successfully pursued in the past. Macroeconomists often look to
historical data to answer this question. Casual examination of the data supports the idea that
stabilization policies worked. In the period after World War II, policymakers used the insights of
Keynesian economics as a basis for active demand management. The data on GDP and other
variables indicate that this period was characterized by less severe fluctuations than the prewar
period. This evidence is not conclusive, however. It may have been that the economy was simply
not hit by such severe shocks. Alternatively, the changing composition of the economy may have
Case Study: Is the Stabilization of the Economy a Figment of the
Data?
The economist and economic historian Christina Romer has suggested that it may not even be
true that the economy has been more stable since World War II. She noted that the economy may
simply appear less volatile in recent years as a consequence of improved data collection. By
attempting to acquire better old data and by subjecting more modern data to the methods used in
constructing older data series, she demonstrated that at least part of the volatility of early data is
Case Study: How Does Policy Uncertainty Affect the Economy?
Recent research investigates the effect of policy uncertainty on economic performance. The
researchers developed an index of policy uncertainty that has three components. One component
considers the number of articles in major newspapers during a given month which contain the
words “uncertainty” or “uncertain”, “economic” or “economy, and at least one of the following:
“congress,” “legislation,” “white house,” “regulation,” “federal reserve,” or “deficit.” A second
component considers the number of temporary provisions in the tax code. These provisions are
often extended at the last minute and so create uncertainty in financial planning for businesses
and households. A third component considers the amount of disagreement among private
!Supplement 18-8,
“Spare a Thought
for the Empirical
Macroeconomist”
!Supplement 18-9,
“The Response to
Romer””
18-2 Should Policy Be Conducted by Rule or by Discretion?
Even if economists agreed upon the desirability of active stabilization policies, they would
probably still disagree about exactly how policy should be conducted. One possibility is
Distrust of Policymakers and the Political Process
In practice, the policies enacted by governments need not always be those that are best for the
economy. The idea of a well-informed, benevolent policymaker choosing monetary and fiscal
policy variables to stabilize the economy is a useful fiction for our analysis, but it hardly
describes the realities and complexities of the political process. Policymakers may not be well
The Time Inconsistency of Discretionary Policy
Time inconsistency provides a less pragmatic but perhaps more intriguing argument for favoring
rules over discretion. The insight is that policymakers may want to change their minds about the
appropriate policies to pursue, giving them an incentive to renege on previous policy
announcements. Individuals will understand this incentive and so will not believe the original
announcements. Policymakers’ incentive to deviate from announced policies, in other words,
causes those announcements to not be credible. A fixed-policy rule may be more credible, and
so ultimately better.
Case Study: Alexander Hamilton Versus Time Inconsistency
In the process of achieving independence, the United States incurred a substantial public debt.
The Secretary of the Treasury, Alexander Hamilton, strongly opposed suggestions that the
Rules for Monetary Policy
Various rules for monetary policy have been proposed. Perhaps the simplest and most famous is
Milton Friedman’s monetarist view that the growth rate of the money supply should be kept
constant. The argument for such a rule is that changes in the money supply may be a cause of
!Supplement 18-11,
“The Political
Business Cycle”
!Supplement 18-12,
“The Political
Business Cycle at
Its Worst”
!Chapter 18
Lecture Notes | 431
announced path. A third possible policy rule is an inflation target. In this case, the Fed adjusts
monetary policy in an attempt to maintain some announced target for inflation.
such problems.
Case Study: Inflation Targeting: Rule or Constrained
Discretion?
Inflation targeting, which started to become a popular policy objective for central banks in the
late 1980s, is not a strict commitment to a policy rule. Inflation targets are usually a range (e.g.,
1 to 3 percent), leaving central banks with a fair amount of discretion. In addition, in the face of
temporary shocks, inflation is allowed to deviate from the target range without invoking action
Case Study: Central-Bank Independence
Countries vary in the degree to which their central banks are independent from the government.
For example, in some countries the central bank is under the jurisdiction of the finance or
treasury department while in other countries the central bank is separate from the government.
18-3 Conclusion: Making Policy in an Uncertain World
The best and most careful economists are aware of the limitations of our understanding of the
macroeconomy and are correspondingly cautious about giving advice. But an imperfect
understanding is better than no understanding at all, and so economists cannot abdicate
Appendix: Time Inconsistency and the Tradeoff Between
Inflation and Unemployment
This appendix contains an analytic treatment of the time-inconsistency problem. Suppose that
the Fed’s preferences over inflation and unemployment can be represented by the loss function
L(u, π) = u + γπ2.
!Supplement 18-15,
“Inflation Targeting”
!Figure 18-2
!Supplement 18-16,
“”Central Bank
Independence and
432 | CHAPTER 18 Alternative Perspectives on Stabilization Policy
The Fed likes inflation to be as close to zero as possible and also likes unemployment to be as
low as possible, so the Fed wants to minimize this function. For simplicity, we suppose that the
Fed can simply choose the inflation rate. The behavior of the economy in the short run is
described by a Phillips curve,
u = un – α(π – Eπ).
Given the public’s expectations of inflation (Eπ), the Fed chooses π so as to minimize the
loss function. We can be show (by substituting for u in the loss function and using calculus to
minimize the loss) that the Fed will always choose
Figure 1 illustrates the problem in a diagram with inflation and unemployment on the axes.
The Fed’s loss function can be illustrated using indifference curves familiar from
microeconomics: all points on a given indifference curve are equivalent as far as the Fed’s
preferences are concerned. Indifference curves further to the left are preferred. Given an
expectation of inflation, we can draw the corresponding Phillips curve (passing through the point
{un, Eπ}). The Phillips curve represents the constraint faced by the Fed, taking expected inflation
as given, and so the Fed will choose the point on the Phillips curve where it is tangent to the loss
function. For the simple loss function in the example, this point of tangency is always at π =
α/(2γ), regardless of the value of expected inflation.1
To see the time-inconsistency problem, suppose that the Fed announced that it was going
433
ADVANCED TOPIC
18-1 Menu Costs, Imperfect Competition, and the Welfare-Improving
Effects of Policy
The presence of menu costs in the situation where firms set prices in imperfectly competitive markets
provides scope for monetary policy to have large effects on economic welfare. This framework thus gives
some support to an active role for policy in stabilizing the economy.
The essential insight of menu costs is disarmingly simple—so much so that it is quite surprising that it
was noted only very recently. Consider a price-setting firm that wants to maximize its profits. We can
graph its profits against the price it charges as shown in Figure 1. The price that maximizes the firm’s
profits is pm. But, as shown in Figure 1, there may be a wide range of prices, between p' and p'', that the
2.
The firm sets its price (pm) where marginal revenue (MR) equals marginal cost (MC) and produces the
quantity q. The area under the demand curve and above the marginal cost curve can be divided into three
areas. The firm earns profits (∏) equal to pm – k on every unit. (These profits are sometimes referred to as
producer surplus.) The area above the price and below the demand curve (labeled CS) is consumer
surplus—it represents the difference between the amount consumers would be willing to pay and the
amount they actually pay and so is a measure of the gain of consumers.22 The final area is the deadweight
loss (DW), which measures the cost to society of the firm’s monopoly behavior. Perhaps the easiest way to
set a real price equal to pm and so sets a nominal price (Pm) on the basis of its expectation of the price
the firm will not bother to change its price. This is shown in Figure 3.
The firm’s loss in profits from charging the price p' rather than the optimal price pm is equal to (A –
C) (in other words, if it changed its real price, it would lose an amount equal to the area C and gain an
amount equal to the area A). As Figure 3 shows, this may be a small difference (this is because a hill is flat
at the top). If A – C is smaller than the menu cost associated with changing prices, the firm will elect to
435
ADDITIONAL CASE STUDY
18-2 Profit Sharing as an Automatic Stabilizer
Economists often propose policies to improve the automatic-stabilizing powers of the economy. The
economist Martin Weitzman has made one of the most intriguing suggestions: profit sharing. Today, most
labor contracts specify a fixed wage.1 For example, General Motors might pay assembly-line workers $20
an hour. Weitzman recommends that the workers’ total pay should depend on their firm’s profits. A profit-
sharing contract for General Motors might pay workers $10 for each hour of work, but in addition the
workers would divide among themselves a share of the firm’s profit.
Weitzman argues that profit sharing would act as an automatic stabilizer. Under the current wage
system, a fall in demand for a firm’s product causes the firm to lay off workers: it is no longer profitable to
employ them at the old wage. The firm will rehire these workers only if the wage falls or if demand
recovers. Under a profit-sharing system, Weitzman argues, firms would be more likely to maintain
employment after a fall in demand. Under our hypothetical profit-sharing contract with General Motors,
for example, an additional hour of work would cost the firm only $10; the rest of the compensation for
additional workers would come from the workers’ share of profits. Because the marginal cost of labor
would be so much lower under profit sharing, a fall in demand would not normally cause a firm to lay off
workers.
A second argument for profit sharing is that it may make wages more flexible. Under profit sharing,
wages will fall with profits in recessions and rise with profits in booms. Thus firms might be more willing
to retain workers in recession, rather than laying them off. If wage rigidity is a cause of cyclical
unemployment, profit sharing might therefore be desirable. Many economists are uncomfortable with this
argument, however, because it simply takes wage rigidity as exogenously given.3 Without an explanation
of why wages are rigid, we cannot be confident that the introduction of profit sharing would really make
wages more flexible. For example, suppose that wages are rigid because of the power of insider workers.
Such workers would be likely to oppose the introduction of profit sharing.
Weitzman’s argument for profit sharing is more subtle than either of these and is often misunderstood.
He contends that under profit sharing, firms are less likely to lay workers off in recessions because firms
possess excess demand for labor. Under profit sharing, increases in employment reduce profits per worker
and so reduce compensation. Weitzman thus argues that the marginal product of labor will exceed its
marginal cost and firms will always hire all available workers. Contracts with profit sharing, according to
Weitzman, will lead to less employment fluctuation than contracts that specify fixed wages, and so
policies should be enacted to encourage profit sharing.
437
ADDITIONAL CASE STUDY
18-3 Leading Indicators in Action
Figure 1 shows the percentage change in real GDP and the percentage change in the index of leading
economic indicators for the period 1960–2014.
CASE STUDY EXTENSION
18-4 The Pitfalls of Forecasting
The case study in Chapter 18 documents some of the difficulties of economic forecasting. Making
economic forecasts is a good way to look foolish. For example, the following statements are from the
eminent economist Irving Fisher.1
