The Limitations of Stabilization Policy
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The Limitations of Stabilization Policy
Why Worry About Lags in Monetary Policy?
Steven T. Call,
This analogy illustrates that discretionary policies can be dangerous because the effects of monetary lags are long and variable: As you prepare to shave one morning, you turn the faucet on but there is no water pressure. After some unsuccessful amateur plumbing, you borrow hot water from a neighbor. Just when you bend down to splash a bit of borrowed water on your face, you get the very thing you do not expect or want‑‑your own faucet, opened earlier, begins to flood your bathroom; drowning is even a possibility.
Timing is Everything in Dueling and in Macro Policy
Steven T. Call,
This exercise illustrates the problem of proper timing in monetary and fiscal policy. Select two students and instruct them to role‑play a duel. Give each an imaginary gun (they can use their index fingers) with one bullet. Starting back to back, have them pace off 20 paces, turn, and fire. Should a dueler shoot immediately? If the participants are out of range, an immediate firing could mean certain death. However, once in range, delaying too long will also mean certain death. Conclusion. Success in dueling depends on correct timing. The same is true in making fiscal and monetary policy.
Lags in Dampening Fiscal and Monetary Effects
Jack Chism,
When government tries to stimulate the economy, there will often be delayed effects that reduce the effect of the change. For example, a sudden increase in the money supply might initially drop the market interest rate, but lagged demand effects might raise nominal income and also boost money demand, resulting in a hike in interest rates.
Here is a crude illustration of such cycles: imagine 30 or 40 grouchy farmers circling in a picket line in front of a grain elevator. The rainy weather is unpleasant, and one irate farmer hauls off and delivers a swift kick to the seat of the pants of the farmer marching in front of him. He immediately feels much better, and his spirits rise. The farmer in front of him responds by delivering a swift kick to the farmer in front of him, who relays it to the next. This continues around the circle with spirits rising as each man delivers a kick. The first farmer actually has a huge smile on his face until finally the echo of his action comes around and he is kicked, which point his spirits drop because of the slight pain he feels. He may feel better than before he started, but not as well as he did after he first delivered the kick. His feelings of happiness and well‑being are analogous to interest rates, or national income, or any other variable that shifts substantially and then corrects itself as all the related markets pursue equilibrium.
This colorful illustration sticks in my students' memories, and helps them remember the time factor when they trace the effects of various government attempts to manipulate the economy.
Ralph T. Byrns
An example that helps illustrate problems from discretionary policies if lags are long and variable: A gun that fires after the trigger is pulled, but the period between when you pull the trigger until the round fires is unpredictable. Institutional lags in monetary and fiscal policy making can also make a lasting impression. One of our favorite examples of an administrative lag is the Federal Reserve Act of 1913‑‑passed in response to the Panic of 1907. This example stresses the problem for fiscal policies that must pass Congress.
What If the Wrong Monetary Growth Rule is Adopted?
Ralph T. Byrns
Students often find the idea of a monetary growth rule appealing, but wonder what would happen if the rate of monetary growth selected were wrong, or if the federal budget, which is supposed to be roughly balanced at full employment, was based on erroneous estimates. Those who favor fixed rules view the precise rule set as less important to those who abhor discretion than strict adherence to a fixed rule. Suppose, for example, that a budget is erroneously set so that it generates a $50 billion deficit at full employment, that velocity is falling by 1% annually, and that the natural rate of economic growth is 3.5%. Ideally, the annual percentage growth of the money supply would be set at 4.5%. Suppose that a fixed percentage growth of 3% is imposed instead, so that consistent pressures for 1.5% deflation are realized each year. Should this rule be adjusted at policymakers' discretion? Advocates of rules say NO, predicting that people will make automatic adjustments superior to those of policymakers. Here is an analogy to suggest why.
Imagine that
a tourist enters a freeway going the wrong way. Should s/he attempt to drive as
quickly as possible to the nearest exit, swerving wildly to avoid collisions? A
better strategy would be to hug the left lane (the right lane from the
perspective of oncoming traffic) and drive slowly but steadily to allow other
drivers to adjust. This same advice is proffered the FED by those who favor a
rule, however erroneous. (NOTE: A colleague drove into
Monetary Policy and Insecticides
Joseph F. Winter,
Here is an analogy that enables students to understand why, after fifty years of activist policies, the effectiveness of discretionary monetary or fiscal policy seems exhausted.
Suppose that discretionary policy had never been used before. Businesses and financial institutions would have adjusted to the normal vagaries of the marketplace. The first dose of, say, contractionary monetary policy, would decrease excess reserves and the firms and intermediaries most vulnerable to "tight money" policies would succumb. More resilient enterprises would prosper, at least in a relative sense, while those weakened most would quickly learn to adapt to tight money by conserving on their cash balances, or, when next the FED tightened the money supply, they too would perish from the business scene. Like insects with variations in natural defense against a new insecticide, the survivors of tight money will grow increasingly immune through a Darwinian "survival of the fittest" process, while the gradual demise of all firms that are vulnerable to monetary restraint will ultimately render it ineffective, just as even the most potent of newly developed insecticides eventually loses its effectiveness. The adaptable groups survive and, with each renewed application, the effect on the adaptable group lessens. The result is an order immune to the pesticide and made stronger by lack of less adaptable predators or competition. The controllers answer with a new formula (or law), but they are pitted against a stronger and more adaptable foe. The result is the gradual erosion of the effectiveness of controls except as a barrier to competition (natural predation).
A Drinking Man's Guide to Monetary Policy
Gary Galles,
I have found that several drinking analogies can be helpful in getting students to remember some issues in monetary policy. They include the following:
a. Just like drinking, expansionary monetary policy provides a temporary high at first (real output growth and reduced unemployment), while the ill effects come later (an inflation "hangover"), and if you do enough of it for long enough, you can do serious lasting damage to yourself (cirrhosis of the economy).
b. Society builds up a tolerance for expansionary monetary policy (expectations adapt), requiring ever increasing amounts of monetary expansion to stay "high" (as in the accelerationist model).
c. Once a tolerance to drink (expansionary monetary policy) is established, withdrawal symptoms worse than any hangover can result if you stop (a stagflationary scenario) and may persist awhile (decelerating inflation) before you feel better again (unemployment falls back to the natural rate) and can lead a "normal" life.
d. Attempts to stop (expansionary monetary policy or drinking) are often short‑lived because the adverse effects come first and the good effects come later, and you may yield to short‑run pressures to feel better now (drink or reflate) despite the long‑run consequences.
e. As with some alcoholics who don't deliver on their promises to quit, if monetary authorities fail to fulfill promises to restrain inflation (i.e., they expand the money supply excessively), we learn not to believe their promises (we become hard to convince that monetary restraint will persist long enough to do much good about inflation before a reflation scenario occurs).
f. Some alcoholism counselors believe that drinking is hard to quit despite its known adverse effects (like hangovers) because the hangovers come enough later that your subconscious doesn't connect cause and effect, so that when the emotional decision to drink or not is made, the subconscious takes over and often results in the decision to drink. Similarly, expansionary monetary policy may be hard to quit because the long and variable lags make it hard to connect a specific policy decision to a specific result.
g. Just as alcoholics may join AA and become teetotalers, monetary authorities may give up trying to vary the money supply to engineer the "best" results and adopt a monetary growth rule (i.e., they may forego the short term high they could engineer because the long‑term adverse consequences are considered too costly).
h. Just as it may be hard for a drunken sailor to precisely determine where he is going (or for an observer to accurately predict where he is going) because of indecisiveness and imperfect control over his motor movements; it may be hard for the FED to precisely determine (or FED‑watchers to accurately guess) the growth path for the money supply, because of indecisiveness (they are supposed to hit many targets with monetary policy: unemployment, real output, inflation, value of the dollar internationally, foreign debt crises, etc. Unless we know which of these the FED is aiming at today, it will be hard to predict what growth path it was aiming for) or imperfect control (the FED has only indirect control over the money supply and that control is subject to long and variable lags).
i. Just as alcoholics might like a painless "cure" and researchers will search for one, economists might wish for and research into a painless "cure" for inflation (a change in policy regime).
Gary Galles,
A useful analogy exists between physicians and macroeconomic forecasters/policy makers. What everyone wants of each is the same, but the forecaster has a more difficult problem.
Everyone wants, first, an instant diagnosis that nothing is seriously wrong and, second, a cheap, painless and immediate cure with no side effects. Both physicians and macroeconomic policy makers/forecasters have problems in doing this, but the policy maker has more difficulty for several reasons: first, both inside and outside lag problems are more difficult because problems cannot be observed or responses chosen as quickly and how long before effects occur is more uncertain; second, the data problem is worse because you don't have the patient's current temperature, only the past temperature, which is constantly being revised, and what you want to know isn't always knowable, such as how much of inventory investment was unplanned; third, side effects of treatments are often worse and sometimes precede the beneficial effects, e.g., slowing money growth to slow inflation, with a recession that comes before the benefit; fourth, people start responding to announced policies while they occur, and even before, in some hard to predict ways, while viruses and molecules don't, e.g., rational expectations effects; fifth, forecasting problems are worse, because macroeconomic policy is not subject to controlled experimentation to establish expected responses and there are so many other variables that affect the result which must therefore also be forecast rather than known; sixth, there are the confounding effects of political self‑interest in biasing forecasts as a way to push a political agenda, i.e., intentional mis‑diagnosis, without effective peer review and clear, accepted standards; etc.
The analogy can be extended as instructors see fit, but the basic comparison between macroeconomic policy, definitely not part of the world undergraduates live in and something more familiar that is part of their experience is helpful in setting forth the difficulties faced by forecasters, training students not to expect simple, clear, correct policy actions, and seeing that the issue is one of imperfect information and forecasts vs. even worse ones, not perfects vs. imperfect.
Forecasting: The Economist and the Meteorologist
Mike Cohick,
I like to compare the economist's use of data for forecasting to the meteorologist's. The meteorologist has timely data, collected by highly calibrated instruments which are positioned in a dense network around the world. This data is updated frequently, some data hourly, some twice daily, and is entered into a global communications network for nearly instantaneous use. The forecasting models used by meteorologists are based on the equations of physics, consider second‑ and third‑order perturbations, and require enormous capacity, high speed computations. With all this, the accuracy of forecasts diminishes quickly beyond 72 hours from data collection time.
The economist must use data that is not timely, frequently 2 weeks to a month old, collected by people who are not positioned as densely across the world as would be desirable. The data is updated monthly, or even less frequently in some parts of the world, and there is no equivalent global communications network. The forecasting models used by economists are based upon empirical fits of small bits of data and upon mathematical formulations of human behavior patterns. Mainly first‑order perturbations are considered. With these handicaps, the economist tries to forecast economic activity one to two years out. It is little wonder that economic forecasting accuracy is not very high.
Improve
the
Edward C. Koziara,
One
way to excite students about macroeconomics is to relate economic objectives to
politics and in particular to elections. In the
Presidential Election Year
Year After Presidential Election Year
Mid‑Term Congressional Elections
Year Prior to Presidential Election Year
Have students
look at unemployment rates, inflation rates and growth rates from 1946 to the
present by type of year. Does the economy perform better in presidential
election years as opposed to other years? Ask the students whether the evidence
indicates a connection between an incumbent president running for reelection
and improved economic numbers as opposed to a situation where the president has
served out his two terms and the numbers are not as good. What happens in mid‑term
congressional elections? Are the incumbent parties' losses at mid‑term
explained by economics or other factors? Does the economy do worse right after
a presidential election? Or, does the economy bottom out at mid‑term? Is
there a political business cycle? What evidence for such a cycle exists and how
can it be manipulated? Using the same date, have students decide if there is
evidence which supports the Democrats as the party of full employment and the
Republicans as the party of price stability. Would the
Bees and Rational Expectations
Ali T. Akarca,
Of all the assumptions in economics, the one that annoys students the most is that of rationality. The students simply do not believe that most people, including themselves, behave in a rational manner. Because they have even less faith in the rationality of non‑human species, dramatic examples of rational behavior on the part of animals and insects really surprise them and cause them to give more credit to this assumption.
In this regard, I found the following real‑life experiment on bees, which I read in the science section of a newspaper, to be very helpful in motivating students to understand the rational expectations assumption. The aim of the experiment was to study communication between bees. It involved placing a container of nectar in the field to be discovered by a bee from the colony being observed. When the latter occurs, the bee immediately returns to its hive to inform the others of the find through an elaborate dance which is what the scientists wanted to observe. In order to generate more observations, every morning the experimenters would move the nectar container a couple of hundred yards away. In each of the first three days, they noticed that it was taking less and less time for the first bee to find the nectar and for the others to follow. On the fourth morning, however, when they went to place the nectar container in a new position, they were shocked to find the bees already there, waiting for them.
Without realizing, the scientists must have been moving the nectar in a certain pattern. It was not important for their experiment. It was, however, important for the bees, and apparently, they learned to form rational expectations about it.
Dick Kennedy,
A price ceiling is a price set below the market price. Governments use price ceilings in attempts to curtail inflation at various times. The best examples of the use of price ceilings are World War II and in 1971‑74, during the Nixon Administration. How do price ceilings affect the economy?
a. If imposed for any length of time, price ceilings will result in shortages of goods and services. In Figure 18‑1, buyers or demanders want 120 million pounds of butter at the price ceiling of $.75, but sellers wish to supply only 80 million pounds of butter at the administered price. The result is a 40 million pound shortage at the administered price of $.75.
b. To cope with the shortage, some centralized form of rationing will probably be imposed, as during World War II.
c. How are ration stamps to be issued equitably? How many stamps for a family of four? For a family of six?
d. Black markets will develop in which butter is sold above the legal price. Even with the patriotism associated with winning WWII, black markets were widespread by 1944, and price ceilings were not imposed until early 1943.
e. Enforcement problems‑‑in an
economy as vast as the
f. There are hundreds of ways to circumvent price controls. Make candy bars smaller; put less chocolate or nuts in them; sell a cheaper grade of lumber; provide shoddy service, etc.
g. Finally price ceilings do not truly curtail inflation; price ceilings only treat the symptoms of this disease, not its root causes.
Figure 18‑1
Wage and Price Control Illusions
Gerald J. Lynch,
I often find medical analogies helpful in explaining economic concepts to undergraduates. I have had particular success with a comparison between wage and price controls as a solution for inflation and a shot of cortisone taken for a knee injury. The cortisone masks the real problem in the knee by deadening the nerve endings. If those nerve endings were allowed to do their job they would send signals to the brain telling it that something is wrong with that knee and it should not be abused. The result of the cortisone not allowing these nerve endings to transmit that vital information is often much more serious and causes more long‑term damage than was originally experienced.
The same is true with wage and price controls and the effect they have on price. Price changes are often signals which tell the economy that something is amiss‑‑the rate of growth of the money supply is too high, government is spending too much, or consumers want less home heating oil and more gasoline. The only way we know, for example, that the forces which lead to inflation are strong, is when we observe that inflation through price increases. If that price signal is squelched through controls, then often more severe damage and misallocations can occur than before the cortisone‑like wage and price controls were applied. Although it is difficult to support the point that either inflation or pain is good, it is relatively easy to show that they may be better than illusions.
Ralph T. Byrns
Compare
and contrast the New Classical Macroeconomics, i.e. the natural unemployment
and interest rate theories and its rational expectations extensions, to the
predictions and policy conclusions to the classical model. A circle can
represent the theoretical developments since 1936. Place the classical model at
the top of the circle. At
Figure 18‑2