Policy tools and performance
Fiscal policy (use of the federal budget to achieve macroeconomic objectives) and monetary policy (the Fed adjusting the quantity of money and interest rates) are the tools used to try to bring about improved macroeconomic performance. Parkin provides a nice, brief summary of the record of what has happened since 1960.
As represented by government spending and the budget balance, in particular, we see an upward trend in spending (relative to GDP), and "political cycles" in the deficit. That is, the deficit often gets larger (i.e., fiscal policy is more expansionary) in the year prior to a Presidential election (evident for the elections of 1968, 1972, 1976, 1984, and 1992), and smaller (contractionary) in the year following an election.
That was not the case this year, however. Further, the political push to balance the budget has effectively weakened the impulse to use fiscal policy to influence the economy -- the emphasis now is on wiping out the deficit.
Monetary policy also shows evidence of a political cycle, roughly along the same lines as fiscal policy (except that sharp M2 growth was not evident prior to the 1992 election).
Long-term growth policy
As we noted earlier in the course, increasing national saving, investment in human capital, and investment in new technologies are key means of stimulating long-term growth. National saving has been on a downward trend since about 1980, falling from the roughly 17 percent of GDP that it had averaged during the 1960s and 1970s to only 12 percent of GDP in the early 1990s. Foreign saving has helped to finance U.S. investment, but increased U.S. saving would increase world investment (and hence, growth) because of the significance of the U.S. in the world economy (boosting our saving would lower interest rates worldwide). Parkin also suggests that increased saving might spur increased investment in high-risk/high-return new technologies.
Increased national saving could come from increased private saving and/or increased gov't saving. To stimulate increased private saving, policy can increase the after-tax return on such saving, by reducing taxes on interest income. Related policies to stimulate saving would include a consumption or value-added tax (national sales tax). Increased gov't saving requires reducing the budget deficit; and again, this highlights the argument that the major cost of the chronic deficit is the crowding out of productive investment via increased interest rates.
Investment in human capital is already subsidized to a large degree in the U.S. and elsewhere. However, student loan programs that ease capital market constraints for students from lower-income families provide a means of promoting growth and enhancing efficiency while at the same time contributing to greater equity. Similarly, tax breaks for provision of on-the-job training would be another means of encouraging more investment in human capital.
In the same vein, tax incentives for research and development expenditures as well as direct government funding of basic research have the potential for increasing investment in new technologies.
The business cycle and policy to combat unemployment
In considering policies to stabilize the business cycle and combat unemployment, we may distinguish three types: fixed-rule policies, feedback-rule policies, and discretionary policies. Fixed-rule policies refer to policy actions that are taken independently of the state of the economy. The balanced-budget amendment is an example of a fixed-rule policy, as is Milton Friedman's proposal to have the money supply grow steadily at the same rate as long-term growth in real GDP. Such policies are clear and easy to anticipate, but they are rarely adopted, in part because they renounce the option of discretionary efforts to "set things right."
Feedback-rule policies are those that spell out policy actions as a consequence of the state of the economy. For example, the Fed might choose to influence the money supply and interest rates as a direct consequence of recent changes in inflation or unemployment -- e.g., if unemployment rises expansionary open market operations might be initiated, while if unemployment falls contractionary OMOs might be pursued. Feedback-rule policies can also be automatic, like the automatic stabilizers of fiscal policy.
Discretionary policies also respond to the state of the economy, but in a more flexible (and possibly unique) manner than that which results from following a set rule. Most macroeconomic policy actions are in fact discretionary, in part because each situation is regarded as being somewhat unique and in part because policymakers typically believe that it is possible to learn from past mistakes. Because they respond to the state of the economy, discretionary policies are feedback policies.
Now let's consider fixed vs. feedback rules in efforts to stabilize the economy. We'll look at a shock to aggregate demand in the form of an unanticipated decrease in demand causing real GDP to fall below potential GDP. The fixed-rule policy will be to make no response to the economic downturn, while the feedback-rule policy will be to stimulate AD so as to return to full employment. (Parkin distinguishes between a temporary and permanent demand shock; here we'll only worry about a temporary shock.)
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In the fixed-rule case, we eventually get back to full employment, but it takes some time for this to occur. During this period, the economy is in recession and unemployment is above the natural rate. In the feedback-rule case, policy returns AD to its initial level quickly, and the downturn in the economy is but a transitory phenomenon.
As Parkin notes, recent Fed behavior corresponds to the feedback-rule case: with expansionary policy followed throughout 1992 (when UR was 7.4 percent) and 1993 (UR=6.8 percent), followed by slowing of money growth and increased interest rates in 1994 (UR=6.1 percent) in an effort to achieve a "soft landing" -- i.e., convergence of actual to potential GDP without overshooting or backsliding into a recession.
Further, despite the apparent superiority of feedback policies (as outlined above), some economists are doubtful as to the value of such policies because of the existence of policy lags. That is, the ripple effects from expansionary monetary policy to lower interest rates to increased investment and purchases of durable goods to increased incomes from increased expenditures to the effects of higher incomes inducing higher consumption, take time. This means that by the time the full force of policy is in play (typically, 9 months to two years after policy is initiated), the dose of medicine may no longer be appropriate.
In addition to policy lags, uncertainty as to the level of potential GDP and the natural rate of unemployment may mean that there will be corresponding uncertainty not only about the desired magnitude of policy but also the direction (expansionary or contractionary). This is especially relevant in a dynamic world where potential GDP is usually changing, probably slowly but maybe not, and at times like the present, when there is disagreement as to where we are with respect to the natural rate. Finally, the unpredictability of feedback policy means that policy itself can contribute to unexpected fluctuations in aggregate demand.
Policy to combat inflation
There are two distinct aspects to anti-inflation policy: preventing inflation from breaking out (typically when the economy is at or near full employment, as is presently the case) and bringing an existing inflation under control (analogous to fire prevention and fire fighting, respectively).
Preventing inflation from breaking out means avoiding both demand-pull and cost-push inflation. But the issues surrounding stabilizing the business cycle that we've been discussing are directly tied to demand-pull inflation. That is, we focused above on policy to avoid letting the economy stay in recession by stabilizing aggregate demand; but avoiding demand-driven recession is the other side of the coin of avoiding a demand-pull inflation. Hence, as Parkin notes, the business cycle and unemployment policy that we just looked at is also an anti-(demand-pull) inflation policy.
Consider now policy to avoid cost-push inflation. As Parkin's analysis in Fig. 17.8 and the related discussion of the OPEC oil price increases of 1973-74 and 1980 show, a fixed-rule policy is far superior to a feedback-rule policy for purposes of avoiding cost-push inflation.
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The reason for this is that supply (cost) shocks such as these become inflationary only if they are accomodated by an increase in the rate of growth of the money supply (as happened in the mid-1970s but not in the early 1980s). Such an increase is not possible with a fixed rule, but can occur if a feedback rule or other feedback-based discretionary policy is used.
Finally, we consider policy seeking to slow inflation. The key issue here is whether or not the policy seeking to slow inflation is correctly anticipated. In brief, incorrectly anticipated policy changes seeking to lower inflation can do so, but often only at the cost of recession (as was the case in the early 1980s).
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By contrast, if the Fed can convince economic agents that it will indeed slow the rate of growth of the money supply, the corresponding impact on expectations and hence wage adjustments will help to lower inflation without emergence of recession.
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