Active policy
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.
Passive policy
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.
Policy lags
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.
