In the preceding three chapters, we saw how changes in aggregate demand and aggregate supply can lead to short-run fluctuations in production and employment. We also saw how monetary and fiscal policy can shift aggregate demand and, thereby, influence these fluctuations. But even if policymakers can influence short-run economic fluctuations, does that mean they should! Our first debate concerns whether monetary and fiscal policymakers should use the tools at their disposal in an attempt to smooth the ups and downs of the business cycle.
Pro: Policymakers Should Try to Stabilize the Economy
Left on their own, economies tend to fluctuate. When households and firms become pessimistic, for instance, they cut hack on spending, and this reduces the aggregate demand for goods and services. The fall in aggregate demand, in turn, reduces the pnxluetion of goods and services. Firms lay off workers, and the unemployment rate rises- Real GDP and other measures of income fall. Rising unemployment and falling income help confirm the pessimism that initially generated the economic downturn.
Such a recession has no benefit for society—it represents a sheer waste of resources. Workers who lose their jobs because of declining aggregate demand would rather be working. Business owners whose factories are idle during a recession would rather be producing valuable goods and servicesand selling them at a profit.
There is no reason for society to suffer through the booms and busts of the businesscyde- The development of macrocconomic theory has shown policymakers how to reduce the severity of economic fluctuations. By "leaning against the wind" of economic change, monetary and fiscal policy can stabilize aggregate demand and, thereby, pnxluetion and employment. When aggregate demand is inadequate to ensure full employment, policymakers should boost government spending, cut taxes, and expand the money supply. When aggregate demand is excessive, risking higher inflation, policymakers should cut government spending, raise taxes, and reduce the money supply. Such policy actkms put macroeco-nomic theory to its best use by leading to a more stable economy, which benefits everyone.
Con: Policymakers Should Not Try to Stabilize the Economy
Monetary and fiscal policy can be used to stabilize the eoinomy in theory, but there are substantial obstacles to the use of such policies in practice.
One problem is that monetary and fiscal policy do not affect the economy immediately but instead work with a long lag. Monetary policy affects aggregate demand by changing interest rates, which in turn affect spending, particularly-residential and business investment. But many households and firms set their spending plans in advance. As a result, it takes time for changes in interest rates to alter the aggregate demand for goods and services Many studies indicate that
changes in monetary policy have little effect on aggregate demand until about six months after the change is made.
Fiscal policy works with a lag because of the long political process that governs changes in spending and taxes. To make any change in fiscal policy, a bill must go through congressional committees, pass both the House and the Senate, and be sign«! by the president. It can take years to propose, pass, and implement a major change in fiscal policy.
Because of these long lags, policymakers who want to stabilize the economy need to look ahead to economic conditions that are likely to prevail when their actions will take effect. Unfortunately, economic forecasting is highly imprecise, in part because macroeconomics is such a primitive science and in part because the shocks that cause economic fluctuations arc intrinsically unpredictable. I hus, when policymakers change monetary or fiscal policy, they must rely on educated guesses about future economic conditions.
Poo often, policymakers trying to stabilize the economy do just the opposite. Economic conditwnscan easily change between when a policy actk>n begins and when it takes effect. Because of this, policymakers can inadvertently exacerbate rather than mitigate the magnitude of economic fluctuations- Some economists have claimed that many of the major economic fluctuations in history, including the Great Depression of the l">3lls, can be traced to destabilizing policy actions.
One of the first rules taught to physicians is "do no harm." The human body has natural restorative powers. Confronted with a sick patient and an uncertain diagnosis, often a doctor should do nothing but leave the patient's body to its own devices. Intervening in the absence of reliable knowledge merely risks making matters worse.
The same can be sax! about treating an ailing economy. It might be desirable if polkymakers could eliminate all economic fluctuations, but that is not a realistic goal given the limits of macroeconomic knowledge and the inherent unpredictability of world events. Economic policymakers should refrain from intervening often with monetary and fiscal policy and be content if they do no harm.
QUICK QUIZ Explain why monetary and fiscal policy work with a lag. Why do these lags matter in the choice between active and passive policy?
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