Fiscal and monetary policy lags • Automatic stabilizers ...

Unfortunately, the automatic stabilizers reduce the size of the fiscal policy multiplier and therefore theeffectiveness of fiscal stabilization policies. Chapter 9 mathematically derives the government spendingmultiplier, and instructors may want to postpone a more in-depth discussion of how the fiscal policymultiplier is affected by automatic stabilizers until later.Instructors should clearly point out the distinction between inside and outside lags. Inside lagstend to be discrete, that is, of a specified length, whereas outside lags are distributed over time. The insidelag, which is a combination of the recognition, decision, and action lags, is much longer for fiscal policythan for monetary policy. Fiscal policy has to be initiated and passed by both houses of Congress, whichcan be a lengthy process, as can be seen in the ongoing debate on tax reform or any Social Securityreform. Monetary policy can be implemented much more quickly since the FOMC meets on a regularbasis to discuss and decide on monetary policy actions. On the other hand, the outside lag, which isgenerally a distributed lag, which takes account of the effects of a policy action over time, is much shorterfor fiscal policy than for monetary policy. A change in government spending affects aggregate demandimmediately, leading to a further series of induced changes in output and spending. But monetary policyactions must first change short-term interest rates, then long-term interest rates, and then the level ofinvestment spending before its full effects are felt.The reluctance of the government to make hard choices reflects the difficulties encountered inachieving successful discretionary fiscal policy. On the other hand, the successful record of thediscretionary monetary policy approach taken by the Fed for most of the past two decades appears toindicate that an activist monetary policy can be effective.Based on the argument that the lags for monetary policy are long and variable and that ourknowledge of the workings of the economy is fairly limited, some economists favor some form of amonetary growth rule. They argue that a strict monetary growth rule with announced targets wouldgreatly reduce the uncertainty the private sector faces when forming inflationary expectations. Noteveryone agrees with this assessment, however, and the discussion of whether to follow a rule or topursue discretionary policy centers around the tradeoff between credibility and flexibility. Whilediscretionary policy has the advantage of giving policy makers the flexibility to react to disturbances,policy rules allow for more certainty about future policy actions. This creates more rational expectationsin the private sector and a quicker return to full employment. In addition, these rules reduce all kinds ofpolitical pressure. It should be noted that policy makers have a hard time earning credibility and thatcredibility is easily lost if policies are changed frequently.In the debate over rules versus discretion, it is important to note that policy rules do not have tobe passive. An active monetary policy rule is represented in Equation (8), which suggests that the moneysupply growth rate should be increased by two percent for every one percent increase in theunemployment rate over the natural rate. In this case, an anticyclical monetary policy is achieved withoutdiscretion, allowing the public to anticipate the government's action.Government policies affect private sector expectations and actions. But at the same time, privatesector expectations and actions affect the success of government policies. The government must beconsistent enough in its policy decisions to enable the private sector to anticipate fairly accurately whatthe government will do in a particular situation. If policy actions can be correctly anticipated, markets willclear more quickly, and stabilization policy will be much more effective.Econometric models, which consist of a set of equations that are based on past economic behavior,are generally used to forecast the effects of various policy options. It is important to emphasize that suchmodels come in all shapes and sizes. One cannot generalize that the more comprehensive models alwaysproduce better forecasts. No model is a perfect image of the economy and we still do not really know howthe economy works. Therefore we should view forecasts only as best guesses, based on incompleteinformation and subject to modifications as unexpected events take place.107