Notes on economic short-run policy.

Two Important Issues:

§  Short Run Economic Policy – what should the government do about the business cycles (economic fluctuations, recessions and expansions)?

§  Problems with Short Run Economic Policy – why short run policies may not be desirable and why laissez faire may be the preferred policy

Short Run Economic Policy:

D.A.S.K.:

§  Discretionary: Government is free to the policies they think are appropriate. This is in contrast to a “rules” policy where government must follow predetermined rules.

§  Activist: Government actively attempts to control the economy as opposed to doing nothing, laissez faire.

§  Stabilization: Short run policy that attempts to eliminate or lessen the cyclical nature (ups and downs) of the economy. Traditionally, this refers to lessening the cyclical nature of income and unemployment (real side of the economy). However, now some people will talk of stabilizing prices (nominal side).

§  Keynesian: Most income and unemployment short run activist policies are based upon the Keynesian theory of business cycles. This means attempting to change Aggregate Demand (AD).

How to Conduct a DASK policy:

Using Keynesian theory, a recession is caused by a drop in AD and the inability of the economy to adjust. To counter this, the government needs to increase AD. Government can attempt to increase AD by using fiscal or monetary policy.

Using Monetary Policy: Increase AD by increasing the money supply. In the short run, if prices don’t fully adjust, the increase in the money supply will increase bank reserves. Banks will attempt to loan this reserves out. With the increase supply of loans, interest rates will drop. This is why increasing the money supply is now often framed as a “decrease in interest rate targets.” With lower interest rates, there will be an increase in consumption and investment which means more AD. Note: the lower interest rate is a short run result based on stickiness in the economy. In the long run, more money should translate to just higher prices.

Using Fiscal Policy: Fiscal policy concerns government spending, taxing, and deficit. To increase AD, the government should spend more (increase in G) and tax less (increase in C or I depending on what tax is reduced). Since the government is spending more and / or taxing less, the budget deficit will increase.

How much?

An important question that must be answered by the government if it is to conduct policy is “how much?” How much are tax rates changed? How much is spending changed? How much money is injected into the economy? This is a complicated question and mathematically models would be needed to answer such a question. For this introductory course, we’ll take an easy out: How much should be done? Just enough!

Problem with a DASK policy:

In the 1970’s, the government was spending a lot and injecting a lot of money. The result was large increases in AD and large increases in inflation. According to traditional Keynesian theory, this should have also been a time of very lower unemployment. However, unemployment was also very high. This unpredicted result was called “stagflation”. Economists starting looking for reasons a DASK policy may not work. I’ve grouped the explanations into 3 groups, DUM: Delays, Unintended Consequences, and Mistakes.

Delays:

The problem of delays is more commonly called the problem of “lags” (but I liked the acronym “DUM” better than “LUM”). Lags are the delays between when the economy enters a cyclical event (a recession or expansion) and when government policy becomes effective to counteract the cycle. Delays can happen for several reasons. Delays occur because it takes time to identify when a recession begins. It then takes time to formulate a policy response (Congress, the Fed, and the President need to make decisions and coordinate plans). It then takes time to implement the policies. Finally, it can take time for the economy to react to the policies.

Lags may be so severe that by the time government responds to a recession, the recession may be over (most recessions last a little more than one year). In which case, the stimulation of AD comes too late and may worsen the business cycle (this has been called “over shooting”). Government then becomes a destabilizing force, not a stabilizing one.

Unintended Consequences:

When the government enacts activist policies, people may change their behavior knowing that the government is enacting these policies. These changes of behavior may make policies ineffective or they may create problems that are worse that the recession that is being cured (cure is worse than the disease).

A football example. A study of football finds that punts are the worst part of the game. Therefore, NFL decided to use an activist policy to get rid of punts. A study shows that punts are always done on fourth down. The NFL eliminates the fourth down, giving teams only three downs. The end results is more punts, not less. The policy made things worse, not better because the policy did not take into account the change in team behavior when the new 3 down policy was put into place.

Rules versus discretion. One of the ways unintended consequences were explored was through the issue of rules versus discretion. What was argued was that there can be unintended consequences if policy makers have discretion instead of following set rules. The unintended consequence is manipulation. Manipulation can happen in either direction. The policy maker can try to manipulate the people who live under the policy. Or the people who live under the policy can try to manipulate the policy maker.

Examples of manipulation: Politicians may change tax rates and spending around the time of elections to make the economy stronger during the election to increase the chance of incumbents getting re-elected. Changing fiscal policy around elections would cause AD to change and thus stimulate the economy around election. Instead of working to lessen the business cycle, politicians would be creating their own economic cycle based around elections. This is referred to as the “political cycle”.

Another example of manipulation is that pressure groups may ask politicians to pass special laws that favor that group with special tax breaks or spending. Politicians can frame these taxes and expenditures as activist fiscal policy, but it’s really just a political pay-off. That pressure groups expend economic resources (time and money) to reap these benefits is called “Political Rent Seeking”.

With monetary policy, the attempted manipulation is the Fed attempting to manipulate the public with surprisingly high inflation. This idea uses the misperception theory of business cycles, not Keynesian. With the misperception theory, unexpectedly high inflation causes lower unemployment because businesses misperceive the inflation as an increase in demand for their product. So the Fed attempts to fool businesses by making inflation higher. The problem is that businesses will expect the Fed policy and expect even higher inflation. The Fed would have to increase inflation even more to reduce unemployment. But then businesses would expect even higher inflation. The end result is that inflation will end up very high with little impact on unemployment. This result is referred to as an “inflation trap” or “inflationary bias”. The only solution is to take away the Fed’s ability to arbitrarily inject money and increase inflation. That is, the Fed should be restricted to follow rules.

Mistakes:

The issue of mistakes recognizes that economists may not know enough to conduct effective policy. There are numerous mistakes that can be made attempting to control the economy. There can be mistakes in understanding the state of the economy. What if we think it’s a demand led recession when it is really a supply led recession?

There can be mistakes in economic theory. DASK policy is built upon the idea that recessions are the result of an economy that doesn’t adjust quickly (sticky prices) and a drop in demand. What if recessions do not happen as Keynesian theory suggests? What if recessions are the result of misperceptions? Or recessions are the result of supply changes?

There can be mistakes in the effects of policy. Deficit spending may increase interest rates and crowd out investment. So AD is not stimulated all that much (or maybe not at all). It’s possible that fiscal policy doesn’t stimulate AD. Some economists thought there could be “multipliers” with fiscal policy. A small increase in government spending would lead to even larger increases in AD (there are all sorts of terms to describe this including “priming the pump” or “jump-starting the economy”). However, if interest rates more, then not only won’t there be a multiplier, there maybe a dampening effect. Mistakes can be made with monetary policy also. Injecting money and increasing inflation won’t help unless inflation increases more than expected under the misperception theory.

If economists are not quite sure what the condition of the economy is, are not quite sure why the economy might be having problems, and are not quite sure what impact policy might have upon the economy, then is it wise to use those policies?