The Fed and the government use different tools to steer the economy. Recall that monetary policy, the toolbox of the Fed, includes performing open market operations, and changing both the reserve requirement and the federal funds interest rate. Recall also that fiscal policy, the toolbox of the government, includes changing both taxes and government spending.
All of these tools can be controlled actively. That is, if the Fed or the government decide to use expansionary policy, they can simply select a tool from the policy toolbox and use it. In this way, active policy is defined as actions by the Fed or by the government that are done in response to economic conditions. That is, the Fed or the government choose to respond to something in the economy by undertaking a specific policy. This is also called discretionary policy.
Active policy, while simple, is open to a number of difficulties. Because it relies on the actions and experiences of the policymakers in the Fed and in the government, the weaknesses or prejudices of these policymakers can be translated into official economic policy. For instance, during election years, a central banker may pursue policy that enables the economy to grow in the short run, regardless of the long-term effects, in order to help a candidate. On the other hand, the central banker may contract the economy to hurt a candidate. Similarly, it would be possible for the policymakers to pursue policies that achieve their selfish ends rather than those that are best for the economy at large. Finally, with active policy, policymakers can say one thing and do another. There may be benefits to making the public believe that something different is occurring in the economy rather than what actually is occurring. For instance, if the Fed wants to increase investment, it could use deception by claiming that it raised interest rates while not actually doing so. In this scenario, private investors would save more but investment would remain at the old level or even increase. Thus, it is reasonable to claim that active policy leaves monetary policy and fiscal policy open to not only accidental human error but also to malicious and self-serving acts.
But there are some advantages to active policy. Active policy allows policymakers to respond to shifts in a complex economy and steer the economy in the optimal direction. For instance, an excellent policymaker may be able to keep the economy growing steadily without inflation if she is given complete control of macroeconomic policy. Similarly, active policy, at least in theory, gives control to those individuals who are considered optimally capable to deal with the fluctuations in the economy. That is, active policy allows the sharpest policymakers of the time to control the economy. Finally, the ability to create different expectations between the policymakers and the public can be an advantageous policy tool, as described in the previous paragraph.
In contrast to active (or discretionary) policy is passive policy (or policy by rule). Under this system, macroeconomic policy is conducted according to a preset series of rules. These rules take into account many macroeconomic variables and dictate the best course of action given these conditions. For instance, a passive policy may follow the rule that in order to stabilize the economy the interest rate must be dropped one point whenever the nominal GDP falls one percent.
The major advantage to passive policy is that it takes the short-term desires of policymakers out of the list of possible goals of macroeconomic policy. Instead, the policymakers are simply present to carry out the macroeconomic policy and to ensure that everything runs smoothly. Policy by rule uses policymakers to implement, rather than design, macroeconomic policy. Similarly, another advantage of passive policy is that the policy rules are based on optimizing the economy in the long run and are less likely to trade short run prosperity for long run growth.
Passive policy is not immune to the problems that plague active policy, however. For instance, passive policy must be written by policymakers at some point. Thus, policy rules can contain the biases of the policymakers of a different time--biases that are perhaps quite inappropriate to the current economic climate. And any outright errors in judgment or theory made by these policymakers will be incorporated into the rules and will thus be present as long as the rules are in effect.
Which method of macroeconomic policy is better? Active policy relies on the judgment and character of policymakers to pursue the optimal long-term policies for the economy. Passive policy takes the power of choice away from policymakers and instead relies on the judgment and character of the writers of the rules. It is not clear that either method of policy is better. The majority of macroeconomic policy in the United States is active.
Whichever method of policy is desired, a major problem exists. This problem is based on the fact that it takes time for economic problems to be noticed and dealt with. Detection lags refer to the amount of time between the onset of an economic problem and its detection. Policy lags, on the other hand, refer to the amount of time between the enactment of macroeconomic policy and the moment when that policy takes effect.
For example, say that the economy is contracting. It must contract for a while before the policymakers recognize the contraction. When it is finally recognized, the policymakers must then decide which policy or policy rule to institute. Finally, once the policy or policy rule is instituted, it takes a fair amount of time for it to affect the economy. In the end, lags create significant delays in the progression from problem to solution in macroeconomic policy.
The delays created by lags can have one final and very important effect. If lags are so long that the economy corrects itself before the macroeconomic policies take effect, then the policies can actually worsen the situation. For instance, if the government uses fiscal policy to stimulate the economy, but the economy begins to correct itself before the policy takes effect, then the economy will be over-stimulated, resulting in possible inflation.
There is little that can be done to correct lags. Because the macroeconomy is constantly fluctuating, it is impossible to simply begin policies when a change is detected. The presence of lags must be acknowledged and accounted for as a necessary evil implicit in macroeconomic policy. By using macroeconomic policy judiciously and in small increments, dangerous situations created by lags can be avoided.