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Posted: July 10th, 2024
The use of fiscal and monetary policy as a means of stabilizing the economy is relatively recent, for the most part a development of the period after World War II. During the 19th century the only stabilization policy was that associated with the international gold standard. Under the gold standard, if a deficit occurred in a country’s balance of payments, gold tended to flow out of the country. To counteract this process, the monetary authorities would raise interest rates and reinforce credit requirements, causing a fall in prices, income, and employment.
A macroeconomic strategy enacted by governments and central banks to keep economic growth stable, along with price levels and unemployment. Ongoing stabilization policy includes monitoring the business cycle and adjusting benchmark interest rates to control aggregate demand in the economy. The goal is to avoid erratic changes in total output, as measured by Gross Domestic Product (GDP) and large changes in inflation; stabilization of these factors generally leads to moderate changes in the employment rate as well.
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A stabilization policy is a defined strategy that is used to correct any factors that have threatened to undermine the financial well-being of a business or the economy of a local area, nation, or even a larger region of the world. In each instance, the purpose of the policy is to identify the reasons for the instability and formulate a strategy that will begin to reverse the ill effects of those underlying causes. Often, a stabilization policy may require an extended period of time to completely accomplish its goal, ranging anywhere from a few months to several years.
Stabilization policies are also used to help an economy recover from a specific economic crisis or shock, such as sovereign debt defaults or a stock market crash. In these instances stabilization policies may come from governments directly through overt legislation, securities reforms, or from international banking groups, such as the World Bank.
As economies become more complex and advanced, top economists believe that maintaining a steady price level and pace of growth is the key to long-term prosperity. When any of the aforementioned variables becomes too volatile, there are unforeseen consequences and effects to the broad economy that keep markets from functioning at their optimum level of efficiency.
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Most modern economies employ stabilization policies, with much of the work being done by central banking authorities like the U.S. Federal Reserve Board. Stabilization policy is largely credited with the moderate but positive rates of GDP growth seen in the United States since the early 1980s.
1. Stable growth of real GDP.
2. Relatively stable level of prices.
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3. High level of employment (low unemployment).
Government policies that involve explicit actions designed to achieve specific goals. A common type of activist policy is that designed to stabilize business cycles, reduce unemployment, and lower inflation, through government spending and taxes (fiscal policy) or the money supply (monetary policy). Activist policies are also term discretionary policies because they involve discretionary decisions by government. A contrast to activist policy is automatic stabilizers that help stabilize business cycles without explicit government actions.
Keynesians advocate activist stabilization policy to reduce the amplitude of the business cycle, which they rank among the most important of all economic problems. Here, however, even some conservative Keynesians part company by doubting either the efficacy of stabilization policy or the wisdom of attempting it.
This does not mean that Keynesians advocate what used to be called fine-tuning-adjusting government spending, taxes, and the money supply every few months to keep the economy at full employment. Almost all economists, including most Keynesians, now believe that the government simply cannot know enough soon enough to fine-tune successfully. Three lags make it unlikely that fine-tuning will work. First, there is a lag between the time that a change in policy is required and the time that the government recognizes this. Second, there is a lag between when the government recognizes that a change in policy is required and when it takes action. In the United States, this lag can be very long for fiscal policy because Congress and the administration must first agree on most changes in spending and taxes. The third lag comes between the time that policy is changed and when the changes affect the economy. This, too, can be many months. Yet many Keynesians still believe that more modest goals for stabilization policy-coarse-tuning, if you will-are not only defensible but sensible.
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It is a government policy which is designed to reduce inflation and unemployment. Following are the types of inflation:
These are policies that Keynesians argued should be used to control the level of demand in the economy. If there was a shortage of demand governments should aim to boost demand (reflationary or expansionary policies), and when there was excess demand they should do the opposite (deflationary or contractionary policies). In other words the government should be aiming to do the opposite to the trade cycle. For this reason these policies were often called ‘counter-cyclical demand management policies’.
Policies that are intended to manage the level of demand. The policy stance is opposite to the point in the economic cycle. In other words, if the economy is booming, then policy is fundamentally deflationary to prevent over-heating. If the economy, however, is in recession then the government’s policy stance should be reflationary to kick-start the economy out of recession.
The pattern of recessions and expansion is called the business cycle by economists. Since the burden of poor economic performance during recessions falls principally on the unemployed, policy aimed at eliminating the fluctuations associated with the business cycle seems desirable to most people. Government policy designed to smooth out the business cycle are called stabilization policies.
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Monetary policy attempts to reduce the fluctuations in nominal GDP and unemployment by manipulating the rate of growth in the money supply. Monetary policy is carried out by Federal Reserve Bank’s open market committee. The general strategy is to increase money growth during periods of higher unemployment (recession) and reduce money growth during periods of inflation (excess expansion).
Monetary policy attempts to increase aggregate demand during recession by increasing the growth of the money supply. The theory of liquidity preference suggests that increasing the money supply will cause interest rates to fall. Lower interest rates cause higher investment spending which increases aggregate demand.
When the Federal Reserve Bank increases the money supply through an open market operation, it is buying government bonds from large banks with newly created reserves. The additional reserves allow the banks to create new money through loans to private citizens and companies. As banks compete to make new loans, they will offer loans at lower interest rates. The new lower interest rates attract new borrowers. Most borrowers are using the loans to purchase durable items such as cars, houses, or – in the case of companies – new factories and equipment. As a result, the lower interest rates increase investment spending, and aggregate demand increases.
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While most economists believe that increasing money growth can affect aggregate demand in the short run, in the long run a high rate of growth in the money supply leads to inflation. As a result, the average rate of growth in the money supply should be slowed if inflation develops in the expansionary phase.
If growing the money supply more rapidly during the recessions lowers interest rates and increases investment spending, the slower growth of money during expansions raises interest rates and reduces investment spending and aggregate demand. When one combines the effects on both recessions and recoveries, monetary policy reduces the swings in economic activity – it stabilizes the economy. Rather than growing unusually rapidly during the recovery, with monetary policy GDP should rise at a rate closer to the long-term sustainable growth rate.
The word “fiscal” refers to “budget.” Since most Keynesian economists believe that recession arise from low aggregate demand, the phrase “fiscal policy” amounts to a collection of strategies that manipulate the government’s budget to affect aggregate demand. In practice, fiscal policy involves using one of two strategies:
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Increasing government purchases during recessions should directly raise aggregate demand. Cutting taxes should cause consumer spending to increase, raising aggregate demand indirectly.
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Many factors complicate the use of fiscal policy. One factor that helps the government increase aggregate demand during recessions is called the Keynesian multiplier effect.
The multiplier may be illustrated with an example. Suppose that the government buys $100 million worth of new cars during a recession. The cars companies now have to produce more cars so they are likely to hire back some of the workers that they laid off early in the recession. With new paychecks, these workers will now buy more goods and services, causing an increase in aggregate demand. In the end aggregate demand rises by more than the increase in government spending because of the secondary increase in consumer spending.
The Keynesian multiplier works in similar fashion with a tax cut. When the government cuts taxes, consumers buy more goods and services. Companies need more workers to produce those goods and services so they hire back previously laid off workers. Those workers then purchase more goods and services. Thus the initial effect of the tax cut is multiplied by secondary increases in consumer spending.
One factor that makes fiscal policy less effective is called crowding out. Crowding out suggest that fiscal policy raises interest rates, causing lower investment spending. Lower investment spending partially offsets the increases in aggregate demand that would otherwise occur when taxes are cut or when government has increased its spending. The higher interest rates arise because as aggregate demand increases, so does money demand.
When fiscal policy strategies were first developed, economists and others were very eager to see them tried. Now after about 40 years of experience there is a great deal of heated discussion about how effective it has been at reducing the variations in growth and unemployment in the economy. Most of the concern is over active fiscal policy, which amounts to designing a tax cut or an increase in government spending to match the needs of a particular recession. Perhaps the most critical concern relates to timing. To work, fiscal policy must be done at the right time. With active fiscal policy timing is difficult.
Most economists pin their hopes for fiscal policy to automatic stabilizers. When the economy slips into a recession income tax collections always fall because people get poorer. Similarly, some government spending programs like welfare and unemployment insurance increase as people lose their jobs. Notice that these effects taken together imply that during recessions the government automatically borrows money to cut tax collections and increase government purchases. Without passing a law fiscal policy takes place. The right people get the money and it happens on time. Automatic stabilizers aren’t very dramatic or very visible, but they are widely believed to be the best type of fiscal policy.
They can also help create real jobs and sustainable growth through their positive effect on labor productivity and competitiveness. Increases in competitiveness will also help improve the balance of payments.
Finally, supply-side policy is less likely to create conflicts between the main objectives of stable prices, sustainable growth, full employment and a balance of payments. This partly explains the popularity of supply-side policies over the last 25 years.
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However, supply-side policy can take a long time to work its way through the economy. For example, improving the quality of human capital, through education and training, is unlikely to yield quick results. The benefits of deregulation can only be seen after new firms have entered the market, and this may also take a long time.
2. In addition, supply-side policy is very costly to implement. For example, the provision of education and training is highly labor intensive and extremely costly, certainly in comparison with changes in interest rates.
3. Furthermore, some specific types of supply-side policy may be strongly resisted as they may reduce the power of various interest groups. For example, in product markets, profits may suffer as a result of competition policy, and in labor markets the interests of trade unions may be threatened by labor market reforms.
Finally, there is the issue of equity. Many supply-side measures have a negative effect on the distribution of income, at least in the short-term. For example, lower taxes rates, reduced union power, and privatization have all contributed to a widening of the gap between rich and poor.
Time lags that occur between the onset of an economic problem and the full impact of the policy intended to correct the problem. Policy lags come in two broad categories–inside lag (getting the policy activated) and outside lag (the subsequent impact of the policy). The three specific inside lags are recognition lag, decision lag, and implementation lag. The one specific outside lag is termed impact lag. Policy lags can reduce the effectiveness of business-cycle stabilization policies and can even destabilize the economy. Policy lags, especially inside lags, are often different for monetary policy than for fiscal policy.
Policy lags arise because government actions are not instantaneous. The use of any stabilization policy encounters time lags between the onset of an economic problem, such as a business-cycle contraction or the onset of inflation, and the full impact of the policy designed to correct the problem. For example, should a business-cycle contraction hit the economy on January 1st, stabilization policy cannot correct the problem by January 2nd. The use of any stabilization policy, especially fiscal policy and monetary policy, takes time to work through the system.
Policy lags are commonly divided between inside lag and outside lag. Let’s take a look at each.
Inside lag is the time it takes between the actual onset of a problem and the launching of the corrective action by government. The wheels of government often spin slowly and deliberately. Three types of inside lag occur.
Recognition Lag: Before any policy action can be pursued, the existence of the actual problem must be identified. It takes time to collect and analyze economic data. Unemployment and inflation data are usually available only a month or so after the fact. That is, the unemployment rate for January is usually available in February. Production and income data are reported quarterly and have an even longer lag. Gross production data for January, February, and March is seldom available until May. Once data are obtained, it must be analyzed and evaluated to ensure that it reflects the onset of an actual problem, such as a business-cycle contraction. This often requires several months of data to document an actual trend and determine that it is not just a temporary statistical aberration.
Decision Lag: Once government policy makers have identified the problem, they need to decide on a suitable course of action, and then pass whatever legislation, laws, or administrative rules are necessary. Often this requires an act of Congress, signed into law by the President. Congress is bound to debate the appropriate policy, make amendments, and promote particular political interests along the way. For example, if a business-cycle contraction is identified, Congress is likely to debate over an expansionary fiscal policy use of increased government spending or decreased taxes. But will the spending go for purchases or transfer payments? If it goes for purchases, then what types of goods or services are purchased? If taxes are decreased, which taxes are cut and who receives the extra income? These decisions could take days, weeks, or months.
Implementation Lag: After a particular policy has been selected, steps then need to be taken to implement the policy. For any change in spending, the appropriate government agencies need to be contacted. More often than not, this involves a change in budget appropriations. The affected agencies then need to actually make changes in their spending. The act of spending is not instantaneous. Most agencies require competitive bids to identify product suppliers before they can make the expenditures. Even the employment, then subsequent payment, of additional workers takes time. The implementation of fiscal and monetary policy is also likely to take weeks if not months.
Inside lags are likely to take several months. A best case scenario involves at least two months. One month to recognize the problem and another month to select and implement the appropriation policy. A more likely scenario is three to six months of inside lags.
The outside lag is the time it takes after a policy is selected and implemented by appropriate government entities, before it works its magic on the economy. Such magic is not instantaneous. The principal outside lag is termed the impact lag.
Impact Lag: This lag is the time it takes any change initiated by a government policy to impact the producers and consumers in the economy. A key part of the impact lag is the multiplier. An initial change in government spending, taxes, the money supply, interest rates must work through the economy, triggering changes in production and income, which induces changes in consumption, which causes more changes in production and income, which induces further changes in consumption. Each “round” of changes (consumption expenditures on production that are induced income) is likely to take a month or two. Several rounds are needed (six to ten or more) before the bulk of this impact is realized.
Against the background of the failures of stabilization policies in most developed countries during the 1970’s, it seems natural that a more critical attitude towards such policies has gradually evolved. The skepticism has usually focused on the Long-run effects of stabilization policy, which is the theme of the conference.
There appear to be two lines along which this critical reevaluation has been pursued. The first emphasizes the effects of short-run stabilization policies on the long-run allocation of resources. The second stresses the consequences for future macroeconomic performance.
Turning first to the long-run allocation effects, an obvious starting point is the new type of shocks which developed countries have been exposed to during the last decade. Traditional Keynesian stabilization policies were designed to smoothen the cyclical swings of aggregate demand around a full-employment growth path. They were not designed to cope with disturbances originating on the supply side of the economy such as oil (or other raw material) shocks and wage disturbances. Given such supply shocks, traditional expenditure policies are faced with a dilemma: expenditure increasing policies may prevent unemployment but intensify inflation; expenditure-reducing policies reduce inflation but intensify unemployment.
The supply shocks of the 1970’s have to a large degree have been permanent real shocks that require real adjustments. These must be preceded by appropriate changes in relative prices and real wages. To the extent that traditional expenditure policies prevent or slow down these price adjustments, the long-run allocation of resources will be affected adversely. In order to evaluate the welfare effects of stabilization policy, these long-run allocation losses must be weighted against short-run gains.
Fiscal expansion leads to fiscal deficits which add to the public debt. Obviously, debt is sustainable only up to a limit.
Public has little tolerance to cuts in government expenditure and increases in tax rates, and this limits the operations of fiscal policy in restricting the unsustainable recovery/prosperity. In other words, fiscal policy is asymmetric.
Against the background of the failures of stabilization policies in most developed countries during the 1970’s, it seems natural that a more critical attitude towards such policies has gradually evolved. The skepticism has usually focused on the Long-run effects of stabilization policy, which is the theme of the conference.
There appear to be two lines along which this critical reevaluation has been pursued. The first emphasizes the effects of short-run stabilization policies on the long-run allocation of resources. The second stresses the consequences for future macroeconomic performance.
Turning first to the long-run allocation effects, an obvious starting point is the new type of shocks which developed countries have been exposed to during the last decade. Traditional Keynesian stabilization policies were designed to smoothen the cyclical swings of aggregate demand around a full-employment growth path. They were not designed to cope with disturbances originating on the supply side of the economy such as oil (or other raw material) shocks and wage disturbances. Given such supply shocks, traditional expenditure policies are faced with a dilemma: expenditure increasing policies may prevent unemployment but intensify inflation; expenditure-reducing policies reduce inflation but intensify unemployment.
The supply shocks of the 1970’s have to a large degree have been permanent real shocks that require real adjustments. These must be preceded by appropriate changes in relative prices and real wages. To the extent that traditional expenditure policies prevent or slow down these price adjustments, the long-run allocation of resources will be affected adversely. In order to evaluate the welfare effects of stabilization policy, these long-run allocation losses must be weighted against short-run gains.
The government should increase its spending to make up for the shortfall in private spending. Indeed, this was a main motivation for the $800 billion stimulus package proposed by President Obama and passed by Congress in early 2009. The logic behind this policy should be familiar to anyone who has taken a macroeconomics principles course anytime over the past half century.
Unlike traditional Keynesian analysis of fiscal policy, modern macro theory begins with the preferences and constraints facing households and …firms and builds from there. This feature of modern theory is not a mere idol for microeconomic foundations. Instead, it allows policy prescriptions to be founded on the basic principles of welfare economics. This feature seems particularly important for the case at hand, because the Keynesian recommendation is to have the government undo the actions that private citizens are taking on their own behalf. Figuring out whether such a policy can improve the well-being of those citizens is the key issue, a task that seems impossible to address without some reliable measure of welfare.
The model we develop to address this question fits solidly in the new Keynesian tradition. That is, the starting point for the analysis is an intertemporal general equilibrium model with prices that are assumed to be sticky in the short run. This temporary price rigidity prevents the economy from reaching an optimal allocation of resources, and it gives a possible role for monetary and fiscal policy to help the economy reach a better allocation through their influence on aggregate demand. The model yields several significant conclusions about the best responses of policymakers under various economic conditions and constraints on the set of policy tools at their disposal.
To be sure, by the nature of this kind of exercise, the validity of any conclusion depends on whether the model captures the essence of the problem being examined. Because all models are simplifications, one can always question whether a conclusion is robust to generalization. Our strategy is to begin with a simple model that illustrates our approach and yields some stark results. We then generalize this baseline model along several dimensions both to check robustness and to examine a broader range of policy issues.
Our baseline model is a two-period general equilibrium model with sticky prices in the …first period. The available policy tools are monetary policy and government purchases of goods and services. Like private consumption goods, government purchases yield utility to households. Private and public consumption are not, however, perfect substitutes. (If they were, public consumption would be an irrelevant instrument.) Our goal is to examine the optimal use of the tools of monetary and fiscal policy when the economy finds itself producing below potential because of insufficient aggregate demand.
We have summarized the theme underlying much of that the new Keynesian research program as follows: Keynes and his followers got it right, but they just did not have the tools. What Keynes “got right” was the notion that the fluctuations in the level of economic activity that we observe in industrial economies–and, most prominently, the recurrent episodes of recession and high unemployment-are, to some extent, undesirable and avoidable and that policy can be effective in limiting their negative effects. What Keynes did not have were the analytical tools that are available to us now and, in particular, the flexible dynamic general equilibrium that are at the heart of much recent research on optimal policy in the presence of frictions of all sorts. The interest that such research has raised in policy institutions like, the Federal Reserve or the IMF suggests that we may be getting closer to establishing a strong connection between economic theory and macroeconomic policy.
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