Chapter 16

Macro Policy Debate: Active or Passive?

Active Vs. Passive Approach

• Active Approach: This approach views the economy as relatively unstable and unable to recover from shocks when they occur.– Economic fluctuations arise primarily from the

private sector, particularly investment, and natural market forces may not help much or may be too slow once the economy gets off track.

– How to get to potential output?• Calls for government intervention and discretionary

policy!!!

Active Vs. Passive Approach

• The passive approach on the other hand, views the economy as relatively stable and able to recover from shocks when they do occur.– If the economy derails, natural market forces and

automatic stabilizers nudge it back on track in a timely manner.

– Active discretionary policy is unnecessary and may do more harm than good.

Active Approach

• Under the active approach, discretionary fiscal or monetary policy can reduce the costs of an unstable economy, such as higher unemployment.

Passive Approach

• Discretionary policy may contribute to the instability of the economy and is therefore part of the problem, NOT the solution.

Closing a Contractionary Gap

• What should public officials do?– Passive Approach: Wages and Prices are flexible

enough to adjust within a reasonable period to labor shortages or surpluses.

• High unemployment causes wages to fall, reducing production costs, and shifting the SRAS to the right

• Little reason for discretionary policy

Closing a Contractionary Gap

• What about the active approach?– They believe that prices and wages are not that

flexible, particularly in the downward direction.– When unemployment is higher than the natural

level, then market forces may be to slow to respond.

• The slower market forces, the greater the lost of output

– They are in favor of discretionary policy• February 2009- $787 Billion stimulus plan

LO1

Clo

sing

a C

ontr

act

ion

ary

G

ap

At a: short-run equilibrium; unemployment > natural rate. Passive approach - panel (a) - high unemployment eventually causes wages to fall, reducing the cost of doing business: shifts the SRAS curve rightward from SRAS130 to SRAS120;potential output at b. Active approach - panel (b) - shift the AD curve from AD to AD'. If the active policy works perfectly, the economy moves to its potential output at c.

Exhibit 1

Pric

e

leve

l

125

130

SRAS130

Potential outputLRAS

Real GDP0 14.013.8

(b) The active approach

AD

SRAS130

a

Potential outputLRAS

Real GDP 0 14.013.8

(a) The passive approach

AD

a

AD’

c

Pric

e

leve

l

125

130

120

SRAS120

b

Closing an Expansionary Gap

• Passive: They argue that natural market forces prompt workers and firms to negotiate higher wages.– Higher wages increase production costs, shifting

the SRAS to the left.– This natural approach results in higher price

levels- inflation and decreases the economy’s potential

Closing an Expansionary Gap

• Active Approach:– The Fed attempted to cool down an overheated

economy by increasing its target interest rate- 17 steps between mid-2004 and mid-2006.

– Under active approach, the price level is lower.

Clo

sing

a E

xp

ansi

on

ary

G

ap

At d – short-run equilibrium; $14.2 trillion >potential output. Unemployment < natural rate. Passive approach - panel (a) - no change in policy; higher negotiated wage; higher costs; shifts SRAS curve to SRAS140. New equilibrium, e: higher price level, lower output and employment. Active policy - reduce aggregate demand - panel (b); new equilibrium - c - closing the expansionary gap without increasing the price level.

LO1

Exhibit 2

SRAS130

Potential outputLRAS

Real GDP0 14.0 14.2

(b) The active approach

AD”

SRAS130

Potential outputLRAS

(a) The passive approach

AD’

AD”c

Pric

e

leve

l

135

140

130

SRAS140

d

c

e

Pric

e

leve

l

135

130

Real GDP0 14.0 14.2

d

Problems with Active Policy• Timely adoption and implementation of an

active policy is not easy.• The Problem of Lags

– Recognition Lag: The time it takes to identify a problem and determine how serious it is.

– Decision-marking lag: Once we know the problem, we now have to decide how to fix it!!!

– Implementation lag: the time needed to introduce a change in monetary or fiscal policy.

– Effective lag: The time needed for changes to affect the economy.

Rational Expectations

• A school of thought that argues people from expectations based on all available information, including the likely future actions of government policy makers.– If discretionary policy is used often, then people

will come to expect the use of it.– This means they will expect to see the effects on

output and price level.

Monetary Policy and Expectations

• Suppose the Fed conducts expansionary monetary policy to increase AD– The price level is now higher than workers

expected– Workers have less purchasing power– Time-inconsistency problem arises when policy

makers have an incentive to announce one policy to shape expectations but then to pursue a different policy once those expectations have been formed and acted on.

Anticipating Monetary Policy

• If firms and workers expect the Fed to do expansionary monetary policy, then they can adjust their wage contracts and cost structure.

Policy Credibility

• The Fed needs some guarantee to do what they said they were going to do. – Some credible threat

• Cold Turkey: the announcement and execution of tough measures to reduce high inflation.

Limitations on Discretion

• The economy is so complex and economic aggregates interact in such obscure ways and with such varied lags that policy makers cannot comprehend what is going on well enough to pursue an active monetary or fiscal policy.– This is one view on why active approach does not

work

Rules and Rational Expectations

• Some Economists are more passive approach, because they believe that people have a pretty good idea of how the economy works and what to expect from government policy makers– Monetary policy is fully anticipated by workers

and firms and it has NO effect on the level of output, the effect is only on price levels.

The Phillips Curve

• A curve showing possible combinations of the inflation rate and the unemployment rate– The opportunity cost of reducing unemployment

was higher inflation. – 1970s changed the view of the Phillips Curve

• Either shifted outward or it was no longer economic reality

Hypothetical Phillips Curve

c

d

a

b

Phillips curve

Unemployment rate (percent)5 100

5

10

Infla

tion

rate

(pe

rcen

t ch

ange

in p

rice

leve

l)

The Phillips curve shows an inverse relation between unemployment and inflation. Points a and b lie on the Phillips curve and represent alternative combinations of inflation and unemployment that are attainable as long as the curve itself does not shift. Points c and d are off the curve.

LO4

Exhibit 5

The Short-Run Phillips Curve

• The short-run Phillips curve is based on labor contracts that reflect a given expected price level, which implies a given expected rate of inflation.

The Long-Run Phillips Curve

• When workers and employers adjust fully to an unexpected change in AD, the long-run Phillips curve is a vertical line drawn at the economy’s natural rate of unemployment– According to this analysis, policy makers cannot,

in the long-run, choose between unemployment and inflation, they choose only among different rates of inflation.

Aggregate Supply Curve and Phillips Curves in the Short Run and Long Run

Expected price level=103 (3% higher than current level) and AD; actual price level=103; potential output; point a; unemployment=natural rate=5%

If AD > expected (AD'): price level=105 > expected; output>potential; higher inflation; lower unemployment.

If AD<expected: (AD“); price level=101<expected; output<potential; lower inflation; higher unemployment.

LO4

Exhibit 6

AD

Potential outputLRAS

Pric

e

leve

l

103

105

101

Real GDP0 14.0 14.113.9

SRAS103

aAD’

b

AD”

c

d

e

3

5

Infla

tion

rate

(pe

rcen

t)

1

Unemployment

rate (percent)4 60 5

Short-run

Phillips curve

d

e

Long-run

Phillips curve

a

c

b

The Natural Rate Hypothesis

• In the long-run, the economy tends toward the natural rate of unemployment

• This natural rate is largely independent of AD

Short-Run Phillips Curves Since 1960LO4

Exhibit 7