Policymakers Should Not Try to Stabilize the Economy
POLICYMAKERS SHOULD NOT TRY TO STABILIZE THE ECONOMY
The development of macroeconomic theory has shown policymakers how to reduce the severity of economic fluctuations. By “leaning against the wind” of economic change, monetary and fiscal policy can stabilize aggregate demand and, thereby, production and employment. Although monetary and fiscal policy can be used to stabilize the economy in theory, there are substantial obstacles to the use of such policies in practice. One problem is that monetary and fiscal policy does not affect the economy immediately but instead work with a long lag. Monetary policy affects aggregate demand by changing interest rates, which in turn affect spending, especially residential and business investment. But many households and firms set their spending plans in advance. As a result, it takes time for changes in interest rates to alter the aggregate demand for goods and services. Many studies indicate that changes in monetary policy have little effect on aggregate demand until about six months after the change is made. Fiscal policy works with a lag because of the long political process that governs changes in spending and taxes. To make any change in fiscal policy, a bill must go through congressional committees, pass both the House and the Senate, and be signed by the president. It can take years to propose, pass, and implement a major change in fiscal policy. Because of these long lags, policymakers who want to stabilize the economy need to look ahead to economic conditions that are likely to prevail when their actions will take effect.
Unfortunately, economic forecasting is highly imprecise, in part because macroeconomics is such a primitive science and in part because the shocks that cause economic fluctuations are intrinsically unpredictable. Thus, when policymakers change monetary or fiscal policy, they must rely on educated guesses about future economic conditions. All too often, policymakers trying to stabilize the
The development of macroeconomic theory has shown policymakers how to reduce the severity of economic fluctuations. By “leaning against the wind” of economic change, monetary and fiscal policy can stabilize aggregate demand and, thereby, production and employment. Although monetary and fiscal policy can be used to stabilize the economy in theory, there are substantial obstacles to the use of such policies in practice. One problem is that monetary and fiscal policy does not affect the economy immediately but instead work with a long lag. Monetary policy affects aggregate demand by changing interest rates, which in turn affect spending, especially residential and business investment. But many households and firms set their spending plans in advance. As a result, it takes time for changes in interest rates to alter the aggregate demand for goods and services. Many studies indicate that changes in monetary policy have little effect on aggregate demand until about six months after the change is made. Fiscal policy works with a lag because of the long political process that governs changes in spending and taxes. To make any change in fiscal policy, a bill must go through congressional committees, pass both the House and the Senate, and be signed by the president. It can take years to propose, pass, and implement a major change in fiscal policy. Because of these long lags, policymakers who want to stabilize the economy need to look ahead to economic conditions that are likely to prevail when their actions will take effect.
Unfortunately, economic forecasting is highly imprecise, in part because macroeconomics is such a primitive science and in part because the shocks that cause economic fluctuations are intrinsically unpredictable. Thus, when policymakers change monetary or fiscal policy, they must rely on educated guesses about future economic conditions. All too often, policymakers trying to stabilize the