See opening quote by Robert. Gordon, p. 327.
We now consider the debate in macroeconomics about whether macro policy (monetary and fiscal) can
be used to effectively stabilize the economic fluctuations of the business cycle. The debate centers
around two different views of policy: activist (Keynesian "fine tuning") vs. nonactivist (passive, rules
based policy advocated by Classical school). Sometimes the debate is referred to as "rules vs.
discretion." Rules = passive approach, Discretion = active approach.
Graph on page 328, Exhibit 1, shows the record of economic instability. What, if anything, can macro
policy do to stabilize and smooth out the economic fluctuations, smooth out the business cycle?
There is widespread agreement about the goals of macro policy: low un, high levels of employment,
strong output growth, low and stable inflation, etc. The great debate in macro is between the
strategy vs. nonactivist (passive) strategy
- which strategy will more effectively achieve the
economic goals stated above and promote a strong economy?
Keynesian, activist, "fine-tuning," contercyclical approach to stabilize the
economy. Based on the belief that the self-correcting mechanisms (Classical assumptions) work
slowly, and policymakers should continually "fine-tune" the economy through an activist approach to
Classical approach, assumes that the self-correcting mechanisms will work well, if
not stifled by unnecessary meddling by policymakers. In fact, advocates of the passive approach
believe that erratic, improperly timed activist policies are actually a source of economic instability, and
that we would be better off if we maintain stable, predictable fiscal and monetary policy during all
phases of the business cycle.
Advocates of the passive approach point to the Great Depression as an example of how perverse
monetary and fiscal policy can significantly destabilize the economy, and claim that improper policy
turned an ordinary recession into a ten year depression. See pages 340-341. We know that the proper
policy during a recession is expansionary fiscal and/or monetary policy. However, the Fed
implemented restrictive monetary policy (contracted the money supply) and Congress implemented
restrictive fiscal policy by raising taxes and tariffs.
THE CONDUCT OF ACTIVIST POLICY
To stabilize the economy, policymakers have to correctly time policy so that they stimulate an
economy moving into a recession and slow down an economy heading toward inflationary
overheating. If the timing of policy is not precise, active policy will actually destabilize the economy
and make it worse. In that case, it would be like a doctor making an ailing patient even sicker by
giving them the wrong medicine! What tools are available to potentially help activist policymakers
achieve proper timing?
MGT 551: BUSINESS ECONOMICS CH – 15