Chapter 14: Stabilization Policy
Economy is not self-correcting. We need to implement
stabilization policy to correct business cycles.
Use fiscal and monetary policy to prevent recession and
Example of active monetary policy:
M2 Growth = 3% + (u – 6%) whenever correction is required
Government budgetary actions and stabilization attempts
are the source of economic instability.
Government can make matters worse as it did in the Great
Depression by implementing concretionary policies of tax
and interest rate increases!
Example of passive monetary policy:
M2 Growth = 3% annually
Inside lags: time between a shock to the economy and
policy action responding to that shock
Outside lags: time between implementation of a policy
action and its effect on the economy
Policy Lags: Inside Lags
Recognition lag: The time it takes for policy makers to
recognize the existence of a boom or slump.
Formulation lag: The time it takes to design policy
measures to correct a boom or slump.
Policy Limitations: Outside Lags
Implementation lag: The time it takes to put the desired
policy measures into effect in correcting a boom or slump.
Response lag: The time it takes for the economy to adjust
to new conditions after policy measures are implemented.
Duration of Lags
Monetary policy requires shorter formulation and
implementation lags as the FED decides how to correct a
boom or slump.
Fiscal policy requires longer formulation and
implementation lags as a tax or spending policy must be
approved by the Congress and implemented by federal
Boom: greater employment, inflation, and nominal wage
will move workers into higher tax brackets. Paying more
taxes reduce disposable income and consumption
spending, slowing the economy.
Slump: greater unemployment and lower inflation and
nominal wage will move workers into lower tax brackets.
Paying less taxes increases disposable income and
consumption spending, stimulating the economy.
Forecasting: Leading Indicators
Manufacturing production workweek
Weekly unemployment claims
New orders for consumer goods and materials
Orders for plants and equipment
Change in manufactures’ unfilled orders
New building permits issued
Change in sensitive materials prices
Index of stock prices
Real money supply (M2)
Index of consumer expectations
Economists apply empirical models to macro data to
While minimizing the forecast error, there still are
discrepancies between actual and predicted values
because, despite sophistication, models can’t account for
all possible effects.
Generating 6-months forecasts, economists could not
correctly predict the rapid
– Rise in unemployment rate from 1981.2 to 1982.4
– Fall in unemployment rate from 1982.4 to 1984.4
Formation of Expectations
Adaptive expectations: expectations are formed using past
information on the indicator being considered
Rational expectations: expectations are formed using past
and present information on all possible variables that affect
the indicator being considered
Robert Lucas’ Critique
Policy makers must take into account how people’s
expectations respond to policy changes
Traditional methods of policy evaluation do not adequately
take into account the policy effects on people’s
Sacrifice Ratio & Expectations
Sacrifice Ratio: the percentage of real GDP that must be
given up to lower inflation by 1 percent.
Policy makers prefer to live with inflation since they find the
Sacrifice Ratio to be too high for the public.
Rational-expectations advocates assert that Sacrifice Ratio
estimation is subject to Lucas critique; it assumes
expectations are formed adaptively rather than rationally.
Distrust of Policy Makers
Policy can be implemented to manipulate the economy for
political purposes (e.g., the short-run Phillips Curve)
Time inconsistency of discretionary policy: promise one
policy, but implement another policy; e.g., promise an
investment tax credit, but after factories are built increase
corporate income tax rate
Political Business Cycle
Business cycle induced by policy makers:
– slow the economy in the first two years of a political
– stimulate the economy in the last two years to cause
a boom just in time for the next election
Data partly supports this idea for the Republican
Economic Growth and Politics
Rules of Monetary Policy
Respond to policy shocks (e.g., energy crisis)
Target GDP growth to achieve natural unemployment rate
Target inflation to keep it low
Inflation & Central Bank
Rules of Fiscal Policy
Budgetary balance or surplus
Deficit spending to cause growth to shift the burden to the
next generation through debt
Tax smoothing to reduce distortions by keeping rates