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ply curve is flat, stabilization policy is much more effective at combating recession than
inflation. If the supply curve is steep, precisely the reverse is true.
But why does the argument persist? Why can™t economists just measure the slope of the
aggregate supply curve and stop arguing? The answer is that supply conditions in the real

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Chapter 14 289
The Debate over Monetary and Fiscal Policy

D1 S S
D0 D0
110 110
Rise in
Price Level

Price Level
E D1 E
100 100
Fall in
price B
90 D0 D0

Rise in Fall in
output output

6,000 6,100 5,900 6,000
Real GDP Real GDP
(a) Expansionary Policy (b) Contractionary Policy

F I GU R E 6
NOTE: Real GDP in billions of dollars per year.

Stabilization Policy
with a Steep Aggregate
Supply Curve
world are far more complicated than our simple diagrams suggest. Some industries may
have flat supply curves, whereas others have steep ones. For reasons explained in
Chapter 10, supply curves shift over time. And, unlike laboratory scientists, economists
cannot perform controlled experiments that would reveal the shape of the aggregate sup-
ply curve directly. Instead, they must use statistical inference to make educated guesses.
Although empirical research continues, our understanding of aggregate supply re-
mains less settled than our understanding of aggregate demand. Nevertheless, many
economists believe that the outline of a consensus view has emerged. This view holds that
the steepness of the aggregate supply schedule depends on the time period under consideration.
In the very short run, the aggregate supply curve is quite flat, making Figure 5 the more
relevant picture of reality. Over short time periods, therefore, fluctuations in aggregate
demand have large effects on output but only minor effects on prices. In the long run,
however, the aggregate supply curve becomes quite steep, perhaps even vertical. In that
case, Figure 6 is a better representation of reality, so that changes in demand affect mainly
prices, not output.3 The implication is that
Any change in aggregate demand will have most of its effect on output in the short run
but on prices in the long run.

SOURCE: From The Wall Street
Journal”Permission, Cartoon

We have yet to consider what may be the most fundamental and controver-
sial debate of all”the issue posed at the beginning of the chapter. Is it likely
that government policy can successfully stabilize the economy? Or are even
Features Syndicate

well-intentioned efforts likely to do more harm than good?
This controversy has raged for several decades, with no end in sight. In
part, the debate is political or philosophical. Liberal economists tend to be
more intervention-minded and hence more favorably disposed toward an “Daddy™s not mad at you, dear”
activist stabilization policy. Conservative economists are more inclined to Daddy™s mad at the Fed.”

The reasoning behind the view that the aggregate supply curve is flat in the short run but steep in the long run

will be developed in Chapter 16.

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Part 3
290 Fiscal and Monetary Policy

The Fed Fights Recession
From June 2004 until June 2006, the Federal Reserve raised the Federal Funds Rate, 2004“2008
Federal funds rate”at first to bring it up to more “normal” levels
and then because it was worried about inflation. The Fed then left
the funds rate constant (at 5.25%) for more than a year as it pon-
dered what to do next. (See chart.) Then the financial panic which

Federal Funds Rate (%)
erupted in August 2007 changed everything.
Worried that the financial shock might disrupt not only the
financial markets but also the economy, the Fed cut interest rates
by 1„2 percentage point (a large move by Fed standards) on
September 18. But that was just the beginning. It soon followed 3
with several more cuts, including two particularly sharp rate reduc-
tions just eight days apart in January 2008. Yet the financial crisis

SOURCE: Federal Reserve
persisted and, by some measures, got worse. By the end of April 1
2008, the federal funds rate was down to 2%, as the Fed worked
2004 2005 2006 2007 2008
hard to avert a recession. At the time this book went to press, Fed
watchers were guessing that the Fed would stop cutting rates at 2%, Year
but no one was quite sure.

keep the government™s hands off the economy and hence advise adhering to fixed rules.
Such political differences are not surprising. But more than ideology propels the debate.
We need to understand the economics.
Critics of stabilization policy point to the lags and uncertainties that surround the opera-
tion of both fiscal and monetary policies”lags and uncertainties that we have stressed repeat-
edly in this and earlier chapters. Will the Fed™s actions have the desired effects on the money
supply? What will these actions do to interest rates and spending? Can fiscal policy actions be
taken promptly? How large is the expenditure multiplier? The list could go on and on.
These skeptics look at this formidable catalog of difficulties, add a dash of skepticism
about our ability to forecast the future state of the economy, and worry that stabilization
policy may fail. They therefore advise both the fiscal and monetary authorities to pursue
a passive policy rather than an active one”adhering to fixed rules that, although inca-
pable of ironing out every bump and wiggle in the economy™s growth path, will at least
keep it roughly on track in the long run.
Advocates of active stabilization policies admit that perfection is unattainable. But they
are much more optimistic about the prospects for success, and they are much less opti-
mistic about how smoothly the economy would grow in the absence of demand manage-
ment. They therefore advocate discretionary increases in government spending (or
decreases in taxes) and lower interest rates when the economy has a recessionary gap”
and the reverse when the economy has an inflationary gap. Such policies, they believe,
will help keep the economy closer to its full-employment growth path.
Each side can point to evidence that buttresses its own view. Activists look back with
pride at the tax cut of 1964 and the sustained period of economic growth that it ushered
in. They also point to the tax cut of 1975 (which was quickly enacted at just about the
trough of a severe recession) and the even speedier fiscal stimulus packages enacted after
9/11 and then again in February 2008. Advocates of using discretionary monetary policy
extol the Federal Reserve™s switch to “easy money” in 1982, its expert steering of the econ-
omy between 1992 and 2000, and its quick responses to the threats to the economy after
9/11 and again after the financial panic in August 2007. Advocates of rules remind us
of the government™s refusal to curb what was obviously a situation of runaway demand
during the 1966“1968 Vietnam buildup, its overexpansion of the economy in 1972, the mon-
etary overkill that helped bring on the sharp recession of 1981“1982, and the inadequate

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Chapter 14 291
The Debate over Monetary and Fiscal Policy

antirecession policies of the early 1990s. Some also argue that the Fed helped fuel the
housing “bubble” by holding interest rates too low in 2003“2005.
The historical record of fiscal and monetary policy is far from glorious. Although the
authorities have sometimes taken appropriate and timely actions to stabilize the economy,
at other times they clearly either took inappropriate steps or did nothing at all. The ques-
tion of whether the government should adopt passive rules or attempt an activist stabi-
lization policy therefore merits a closer look. As we shall see, the lags in the effects of
policy discussed earlier in this chapter play a pivotal role in the debate.

Lags and the Rules-versus-Discretion Debate
Lags lead to a fundamental difficulty for stabilization policy”a
difficulty so formidable that it has prompted some economists
Potential GDP
to conclude that attempts to stabilize economic activity are
likely to do more harm than good. To see why, refer to Figure 7, E

Potential GDP
which charts the behavior of both actual and potential GDP

Actual and
over the course of a business cycle in a hypothetical economy
with no stabilization policy. At point A, the economy begins to D
slip into a recession and does not recover to full employment
until point D. Then, between points D and E, it overshoots Actual GDP
potential GDP and enters an inflationary boom.
The argument in favor of stabilization policy runs something A C
like this: Policy makers recognize that the recession is a serious
problem at point B, and they take appropriate actions very soon.
These actions have their major effects around point C and there- Time
fore limit both the depth and the length of the recession.
But suppose the lags are really longer and less predictable F I GU R E 7
than those just described. Suppose, for example, that actions do not come until point C A Typical Business Cycle
and that stimulative policies do not have their major effects until after point D. Then pol-
icy will be of little help during the recession and will actually do harm by overstimulating
the economy during the ensuing boom. Thus:
In the presence of long lags, attempts at stabilizing the economy may actually succeed
in destabilizing it.
For this reason, some economists argue that we are better off leaving the economy
alone and relying on its natural self-corrective forces to cure recessions and inflations.
Instead of embarking on periodic programs of monetary and fiscal stimulus or restraint,
they advise policy makers to stick to fixed rules that ignore current economic events.
For monetary policy, we have already mentioned the monetarist policy rule: The Fed
should keep the money supply growing at a constant rate. For fiscal policy, proponents of
rules often recommend that the government resist the temptation to manage aggregate
demand actively and rely instead on the economy™s automatic stabilizers, which we dis-
cussed in Chapter 11 (see page 225).

Are the critics right? Should we forget about discretionary policy and put the economy on
autopilot”relying on automatic stabilizers and the economy™s natural, self-correcting
mechanisms? As usual, the answer depends on many factors.

How Fast Does the Economy™s Self-Correcting
Mechanism Work?
In Chapter 10, we emphasized that the economy has a self-correcting mechanism. If that
self-correcting mechanism is fast and efficient, so that recessions and inflations will dis-
appear quickly by themselves, the case for policy intervention is weak. Indeed, if such

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Part 3
292 Fiscal and Monetary Policy

problems typically last only a short time, then lags in discretionary stabilization policy might
mean that the medicine has its major effects only after the disease has run its course. In terms
of Figure 7, this is a case in which point D comes very close to point A. In fact, a distinct mi-


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