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nority of economists used precisely this reasoning to argue against a fiscal stimulus after the
September 11, 2001, terrorist attacks and again after the financial panic of 2007“2008.
Although extreme advocates of rules argue that this is indeed what happens, most
economists agree that the economy™s self-correcting mechanism is slow and not terribly
reliable, even when supplemented by the automatic stabilizers. On this count, then, a
point is scored for discretionary policy.

How Long Are the Lags in Stabilization Policy?
We just explained why long and unpredictable lags in monetary and fiscal policy make it
hard for stabilization policy to do much good. Short, reliable lags point in just the oppo-
site direction. Thus advocates of fixed rules emphasize the length of lags while propo-
nents of discretion tend to discount them.
Who is right depends on the circumstances. Sometimes policy makers take action
promptly, and the economy receives at least some stimulus from expansionary policy
within a year after slipping into a recession. The tax reductions and sharp cuts in interest
rates that followed both the 9/11 tragedy and the financial crisis of 2007“2008 are the most
recent examples. Although far from perfect, the effects of such timely actions were cer-
tainly felt soon enough to do some good. But, as we have seen, very slow policy responses
may actually prove destabilizing. Because history offers examples of each type, we can
draw no general conclusion.

How Accurate Are Economic Forecasts?
One way to compress the policy-making lag dramatically is to forecast economic events
accurately. If we could see a recession coming a full year ahead of time (which we
certainly cannot do), even a rather sluggish policy response would still be timely. In terms
of Figure 7, this would be a case in which the recession is predicted well before point A.
Over the years, economists in universities, government agencies, and private busi-
nesses have developed a number of techniques to assist them in predicting what the econ-
omy will do. Unfortunately, none of these methods is terribly accurate. To give a rough
idea of magnitudes, forecasts of either the inflation rate or the real GDP growth rate for
the year ahead typically err by 6 3„4 to 1 percentage point. But, in a bad year for forecasters,
errors of 2 or 3 percentage points occur.
Is this forecasting record good enough? That depends on how the forecasts are used. It
is certainly not good enough to support so-called fine-tuning”that is, attempts to keep the
economy always within a hair™s breadth of full employment. But it probably is good
enough for policy makers interested in using discretionary stabilization policy to close
persistent and sizable gaps between actual and potential GDP.

The Size of Government
One bogus argument that is sometimes heard is that active fiscal policy must inevitably
lead to a growing public sector. Because proponents of fixed rules tend also to be oppo-
nents of big government, they view this growth as undesirable. Of course, others think
that a larger public sector is just what society needs.
This argument, however, is completely beside the point because, as we pointed out
in Chapter 11: One™s opinion about the proper size of government should have nothing to do
with one™s view on stabilization policy. For example, President George W. Bush is as con-
servative as they come and, at least rhetorically, he is devoted to shrinking the size of
the public sector.4 But his tax-cutting initiatives in 2001“2003 constituted an extremely

In fact, the size of the federal government has expanded rapidly during his presidency, in part because of

national security concerns, but also because of domestic spending.

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Chapter 14 293
The Debate over Monetary and Fiscal Policy

activist fiscal policy to spur economic growth. Furthermore, most stabilization policy
these days consists of monetary policy, which neither increases nor decreases the size of

Uncertainties Caused by Government Policy
Advocates of rules are on stronger ground when they argue that frequent changes in tax
laws, government spending programs, or monetary conditions make it difficult for firms
and consumers to formulate and carry out rational plans. They argue that the authorities
can provide a more stable environment for the private sector by adhering to fixed rules so
that businesses and consumers know exactly what to expect.
No one disputes that a more stable environment is better for private planning. But sup-
porters of discretionary policy emphasize that stability in the economy is more important
than stability in the government budget (or in Federal Reserve operations). The whole idea
of stabilization policy is to prevent gyrations in the pace of economic activity by causing
timely gyrations in the government budget (or in monetary policy). Which atmosphere is
better for business, they ask: one in which fiscal and monetary rules keep things peaceful on
Capitol Hill and at the Federal Reserve while recessions and inflations wrack the economy,
or one in which government changes its policy abruptly on occasion but the economy
grows more smoothly? They think the answer is self-evident. The question, of course, is
whether stabilization policy can succeed in practice.

A Political Business Cycle?
A final argument put forth by advocates of rules is political rather than economic. Fiscal pol-
icy decisions are made by elected politicians: the president and members of Congress. When
elections are on the horizon (and for members of the House of Representatives, they always

Between Rules and Discretion
interest rate in proportion to any excess of inflation above 2 per-
In recent years, a number of economists and policy makers have
cent (which is the Fed™s presumed inflation goal). No central bank
sought a middle ground between saddling monetary policy makers
uses the Taylor rule as a mechanical rule; nor did Taylor intend it
with rigid rules and giving them complete discretion, as the Federal
that way. But many central banks around the world, including the
Reserve has in the United States.
Fed, find the Taylor rule useful as a benchmark to guide their deci-
One such approach is called “inflation targeting.” As practiced in
sion making”thus blending, once again, features of both rules and
the United Kingdom, for example, inflation targeting starts when an
elected official (the Chancellor of the Exchequer, who is roughly
equivalent to the U.S. Secretary of the Treasury) chooses a numeri-
cal target for the inflation rate”currently, this target is 2 percent
for consumer prices. The United Kingdom™s central bank, the Bank
of England, is then bound by law to try to reach this target. In that
sense, the system functions somewhat like a rule. However, mone-
tary policy makers are given complete discretion as to how they go
about trying to achieve this goal. Neither the Chancellor nor Parlia-
ment interferes with day-to-day monetary policy decisions. The
Federal Reserve™s current chairman, Ben Bernanke, was a big advo-
SOURCE: © David Devins/newscast

cate of inflation targeting when he was a professor at Princeton
University. But the Fed has not adopted it officially.
Another approach is called the “Taylor rule,” after Professor John
Taylor of Stanford University. More than a decade ago, Taylor no-
ticed that the Fed™s interest rate decisions during the chairmanship
of Alan Greenspan could be described by a simple algebraic equa-
tion. This equation, now called the Taylor rule, starts with a 2 per-
cent real interest rate, and then instructs the Fed to lower the rate
The Bank of England™s Monetary Policy Committee
of interest in proportion to any recessionary gap and to raise the

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Licensed to:
Part 3
294 Fiscal and Monetary Policy

are), these politicians may be as concerned with keeping their jobs as with doing what is right
for the economy. This situation leaves fiscal policy subject to “political manipulation””
lawmakers may take inappropriate actions to attain short-run political goals. A system of
purely automatic stabilization, its proponents argue, would eliminate this peril.
It is certainly possible that politicians could deliberately cause economic instability to
help their own reelection. Indeed, some observers of these “political business cycles” have
claimed that several American presidents have taken full advantage of the opportunity.
Furthermore, even without any insidious intent, politicians may take the wrong actions
for perfectly honorable reasons. Decisions in the political arena are never clear-cut, and it
certainly is easy to find examples of grievous errors in the history of U.S. fiscal policy.
Taken as a whole, then, the political argument against discretionary fiscal policy seems
to have a great deal of merit. But what are we to do about it? It is unrealistic to believe that
fiscal decisions could or should be made by a group of objective and nonpartisan techni-
cians. Tax and budget policies require inherently political decisions that, in a democracy,
should be made by elected officials.
This fact may seem worrisome in view of the possibilities for political chicanery. But it
should not bother us any more (or any less) than similar maneuvering in other areas of
policy making. After all, the same problem besets international relations, national
defense, formulation and enforcement of the law, and so on. Politicians make all these
decisions for us, subject only to sporadic accountability at elections. Is there really any
reason why fiscal decisions should be different?
But monetary policy is different. Because Congress was concerned that elected officials
focused on the short run would pursue inflationary monetary policies, it long ago gave
day-to-day decision-making authority over monetary policy to the unelected technocrats
at the Federal Reserve. Politics influences monetary policy only indirectly: The Fed must
report to Congress, and the president has the power to appoint Federal Reserve governors
whose views are to his liking. For the most part, however, the Fed is apolitical.

A Nobel Prize for the Rules-versus-Discretion Debate
In 2004, the economists Finn Kydland of regularly, students would soon stop
Carnegie-Mellon University and Edward studying for exams. So actually giving
Prescott of Arizona State University were the exam is the better long-run policy.
awarded the Nobel Prize for a fascinating One way to solve this time inconsis-
contribution to the rules-versus-discretion tency problem is to adopt a simple
debate. They called attention to a general rule stating that announced exams will
SOURCE: © AFP/Getty Images

problem that they labeled “time inconsis- always be given, rather than allowing
tency,” and their analysis of this problem individual faculty members to cancel
led them to conclude that the Fed should exams at their discretion.
follow a rule. Kydland and Prescott argued that
A close-to-home example will illus- monetary policy makers face a similar
trate the basic time inconsistency prob- time inconsistency problem. They first
lem. Suppose your instructor announces announce a stern anti-inflation policy
in September that a final exam will be (analogous to giving an exam). But
given in December. The main purpose of the exam is to ensure then, when the moment of truth (December) arrives, they may
that students study and learn the course materials, and the exam relent because they don™t want to cause unemployment (all that
itself creates both work for the faculty and stress for the students. work and stress). Their suggested solution: The Fed and other
So, when December rolls around, it may seem “optimal” to call central banks should adopt rules that remove period-by-period
off the exam at the last moment. Of course, if that happened discretion.

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Chapter 14 295
The Debate over Monetary and Fiscal Policy

So where do we come out on the question posed at the start of this chapter?
On balance, is it better to pursue the best discretionary policy we can, know-
ing full well that we will never achieve perfection? Or is it wiser to rely on
fixed rules and the automatic stabilizers?
In weighing the pros and cons, your basic view of the economy is crucial.
Some economists believe that the economy, if left unmanaged, would generate
a series of ups and downs that would be difficult to predict, but that it would correct
each of them by itself in a relatively short time. They conclude that, because of long lags
and poor forecasts, our ability to anticipate whether the economy will need stimulus or
restraint by the time policy actions have their effects is quite limited. Consequently, they
advocate fixed rules.
Other economists liken the economy to a giant glacier with a great deal of inertia.
Under this view, if we observe an inflationary or recessionary gap today, it will likely
still be there a year or two from now because the self-correcting mechanism works
slowly. In such a world, accurate forecasting is not imperative, even if policy lags are
long. If we base policy on a forecast of a 4 percent gap between actual and potential
GDP a year from now, and the gap turns out to be only 2 percent, we still will have
done the right thing despite the inaccurate forecast. So holders of this view of the econ-
omy tend to support discretionary policy.
There is certainly no consensus on this issue, either among economists or politicians.
After all, the question touches on political ideology as well as economics, and liberals
often look to government to solve social problems, whereas conservatives consistently
point out that many efforts of government fail despite the best intentions. A prudent
view of the matter might be that
The case for active discretionary policy is strong when the economy has a serious defi-
ciency or excess of aggregate demand. However, advocates of fixed rules are right that it
is unwise to try to iron out every little wiggle in the growth path of GDP.
But one thing seems certain: The rules-versus-discretion debate is likely to go on for
quite some time.

trast, monetary policy operates mainly on investment, I,
1. Velocity (V) is the ratio of nominal GDP to the stock of
money (M). It indicates how quickly money circulates. which responds slowly to changes in interest rates.
2. One important determinant of velocity is the rate of inter- 6. However, the policy-making lag normally is much
est (r). At higher interest rates, people find it less attractive longer for fiscal policy than for monetary policy. Hence,
to hold money because money pays zero or little interest. when the two lags are combined, it is not clear which
Thus, when r rises, money circulates faster, and V rises. type of policy acts more quickly.
3. Monetarism is a type of analysis that focuses attention 7. Because it cannot control the demand curve for money,
the Federal Reserve cannot control both M and r. If the
on velocity and the money supply (M). Although mone-
tarists realize that V is not constant, they believe that it demand for money changes, the Fed must decide whether
it wants to hold M steady, hold r steady, or adopt some
is predictable enough to make it a useful tool for policy
analysis and forecasting. compromise position.
4. Because it increases the volume of transactions, and 8. Monetarists emphasize the importance of stabilizing the
hence increases the demands for bank deposits and growth path of the money supply, whereas the predomi-
therefore bank reserves, expansionary fiscal policy nant Keynesian view puts more emphasis on keeping in-
pushes interest rates higher. Higher interest rates reduce terest rates on target.
the multiplier by deterring some types of spending, es- 9. In practice, the Fed has changed its views on this issue
pecially investment. several times. For decades, it attached primary im-
5. Because fiscal policy actions affect aggregate demand portance to interest rates. Between 1979 and 1982, it
either directly through G or indirectly through C, the stressed its commitment to stable growth of the money


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