No Such Thing as a Free Lunch: Principles of Economics (Part 147)

Economists agree about economics - and that's a science - and they disagree about economic policy because that's a value judgment... I've had profound disagreements on policy with the famous Milton Friedman. But, on economics, we agree.

Franco Modigliani

Macroeconomic Issues and Policy (Part A)

by

Charles Lamson

The news media carry articles dealing with macroeconomic problems daily, and macroeconomic issues and policies are an important part of many political campaigns. By using what we have learned about how the macroeconomy works, we can now examine in greater depth various issues and problems.

In the next several posts we look more deeply at monetary and fiscal policy. We first consider a problem that both types of policymakers face, but particularly fiscal policy makers, which is the problem of time lags. We will see that it is not easy to get the timing right when trying to stabilize the economy. We then turn to more detailed looks at monetary and fiscal policy.

Time Lags Regarding Monetary and Fiscal Policy

One of the objectives of monetary and fiscal policy is stabilization of the economy. Consider the two possible time paths for aggregate output (income) (Y) shown in Figure 1. In path B (the light blue line), the fluctuations in GDP are smaller than those in path A (the dark blue line). One aim of stabilization policy is to smooth out fluctuations and output, to try to move along the economy along a path like B instead of A. Stabilization policy is also concerned with the stability of prices. Here the goal is not to prevent the overall price level from rising at all but instead to achieve an inflation rate that is as close to zero as possible given the government's other goals of high and stable levels of output and employment.

Stabilization goals are not easy to achieve. The existence of various kinds of time lags, or delays in the response of the economy to stabilization policies, can make the economy difficult to control. Economists generally recognize three kinds of time lags: recognition lags, implementation lags, end response lags. We will consider each, but we will begin with an analogy.

Stabilization: "The Fool in the Shower"

Milton Friedman, a leading critic of stabilization policy, likened the government's attempt to stabilize the economy to a "fool in the shower." The shower starts out too cold, because the pipes have not yet warmed up. So the fool turns up the hot water. Nothing happens, so he turns up the hot water further. The hot water comes on and scalds him. He immediately turns up the cold water. Nothing happens right away, so he turns up the cold further. When the cold water finally starts to come up he finds the shower too cold, and so it goes.

Critics of stabilization policy argue that the situation in Figure 2 is typical of the interaction between the government and the rest of the economy. This is not necessarily true. We need to know more about the nature of the various kinds of lags before deciding whether stabilization policy is good or bad. 

*CASE & FAIR, 2004, PRINCIPLES OF ECONOMICS, 7TH ED., PP. 575-577*

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