The problem is that once we focus on economic policy, much that is not science comes into play. Politics becomes involved, and political posturing is amply rewarded by public attention.
Macroeconomic Issues and Policy
(Part B)
by
Charles Lamson
Recognition Lags
It takes time for policymakers to recognize a boom or a slump. Many important data---those from the national income and product accounts, for example---are available only quarterly. It usually takes several weeks to compile and prepare even the preliminary estimates for these figures. If the economy goes into a slump on January 1, the recession may not be detected until the data for the first quarter are available at the end of April. Moreover, the early national income and the product accounts data are only preliminary, based on an incomplete compilation of the various data sources. These estimates can, and often do, change as better data become available. This makes the interpretation of the initial estimates difficult, and recognition lags result. Implementation Lags The problems that lags pose for stabilization policy do not end once economists and policymakers recognize that the economy is in a slump or a boom. Even if everyone knows that the economy needs to be stimulated or reigned in, it takes time to put the desired policy into effect, especially for actions that involve fiscal policy. Implementation lags result. Each year Congress decides on the federal government's budget for the coming year. The tax laws and spending programs embodied in this budget are not subject to change once they are in place. If it becomes clear that the economy is entering a recession and is in need of a fiscal stimulus during the middle of the year, there is little that can be done. Until Congress authorizes more spending or a cut in taxes, changes in fiscal policy are not possible.  Monetary policy is less subject to the kinds of restrictions that slow down changes in fiscal policy. The Fed's chief tool to control the supply of money or the interest rate is open market operations---buying and selling government securities. Transactions in these securities take place in a highly developed market, and If the Fed wishes, it can buy or sell a large volume of securities in a very short period of time. The implementation lag for monetary policy is generally much shorter than for fiscal policy. When the Fed wishes to increase the supply of money, it goes into the open market and purchases government securities. This instantly increases the stock of money (bank reserves held at the Fed), and an expansion of the money supply begins. Response Lags Even after a macroeconomic problem has been recognized and the appropriate policies to correct it have been implemented, there are response lags---lags that occur because of the operation of the economy itself. Even after the government has formulated a policy and put it into place, the economy takes time to adjust to the new conditions. Although monetary policy can be adjusted and implemented more quickly than fiscal policy, it takes longer to make its effect felt on the economy because of response lags. What is most important is the total lag between the time a problem first occurred and the time the corrective policies are felt. Response Lags for Fiscal Policy One way to think about the response lag in fiscal policy is through the government spending multiplier. This multiplier measures the change in GDP caused by a given change in government spending or net taxes. It takes time for the multiplier to reach its full value. The result is a lag between the time a fiscal policy action is initiated and the time the full change in GDP is realized.  The reason for the response lag in fiscal policy---the delay and the multiplier process---is simple. During the first few months after an increase in government spending or a tax cut, there is not enough time for the firms or individuals who benefit directly from the extra government spending or the tax cut to increase their own spending. Neither individuals nor firms revise their spending plans instantaneously. Until they can make those revisions, extra government spending does not stimulate extra private spending. Changes in government purchases are a component of aggregate expenditure. When government purchases (G) rises, aggregate expenditure increases directly; when G falls, aggregate expenditure decreases directly. When personal taxes are changed, however, an additional step intervenes, giving rise to another lag. Suppose a tax cut has lowered personal income taxes across the board. Each household must decide what portion of its tax cut to spend and what portion to save. This decision is the extra step. Before the tax cut gets translated into extra spending, households must take the step of increasing their spending, which usually takes some time. With a business tax cut, there is a further complication. Firms must decide what to do with their added after-tax profits. If they pay out their added profits to households as dividends, the result is the same as with a personal tax cut. Households must decide whether to spend or to save the extra funds. Firms may also retain their added profits and use them for investment, but investment is a component of aggregate expenditure that requires planning and time.  In practice, it takes about a year for a change in taxes or in government spending to have its full effect on the economy. This means that if we increase spending to counteract a recession today, the full effects will not be felt for 12 months. By that time, the state of the economy might be very different. Response Lags for Monetary Policy Monetary policy works by changing interest rates, which then change planned investment. Interest rates can also affect consumption spending, as we discuss further in a future post. For now, it is enough to know that lower interest rates usually stimulate consumption spending and higher interest rates decrease consumption spending. The response of consumption and investment to interest rate changes takes time. Even if interest rates were to drop by 5 percent overnight, firms would not immediately increase their investment purchases. Firms generally make their investment plans several years in advance. If General Motors wants to respond to a decrease in interest rates by investing more, it will take some time---perhaps up to a year---to come up with plans for a new factory or assembly line. While such plans are being drawn, GM may spend little on new Investments. The effect of the decrease in interest rates may not make itself felt for quite some time. The response lags for monetary policy are even longer than response legs for fiscal policy. When government spending changes, there is a direct change in the sales of firms, which sell more as a result of the increased government purchases. When interest rates change, however, the sales of firms do not change until households change their consumption spending and/or firms change their investment spending. It takes time for households and firms to respond to interest rate changes. In this sense, interest rate changes are like tax-rate changes. The resulting change in firm sales must wait for households and firms to change their purchases of goods.  Summary Stabilization is not easily achieved. It takes time for policymakers to recognize the existence of a problem, more time for them to implement a solution, and yet more time for firms and households to respond to the stabilization policies taken. Monetary policy can be adjusted more quickly and easily than taxes or government spending, making it a useful instrument in stabilizing the economy. However, because the economy's response to monetary changes is probably slower than its response to changes in fiscal policy, tax and spending changes may also play a useful role in macroeconomic management. *CASE & FAIR, 2004, PRINCIPLES OF ECONOMICS, 7TH ED., PP. 577-579* end |
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