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CONFLICTING POLICY GOALS
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Chapter 1
General Economic Concepts
Chapter 2
What is Policy?
Chapter 3
History of Macroeconomic Policies in the United States
Chapter 4
Policy Goals: Maximum Employment
Chapter 5
Policy Goals: Maximum Production
Chapter 6
Policy Goals: Price Stability
Chapter 7
Policy Goals: External Balance
Chapter 8
Subsidiary Policy Goals
Chapter 9
Conflicting Policy Goals
Chapter 10
The Policy Makers
Chapter 11
The Policy Instruments
Chapter 12
The Decision-Making Processes
Chapter 13
The Policy Indicators
Chapter 14
The General Economic Model
Chapter 15
Monetarist Monetary and Fiscal Policies
Chapter 16
Keynesian Monetary and Fiscal Policies
Chapter 17
Debt Management Policies
Chapter 18
Incomes Policies
Chapter 19
Supply Management Policies
Chapter 20
The Long Wave
Chapter 21
Contemporary Issues
"It would be very nice if public decision-makers could take all four major and any subsidiary goals and accomplish them all without any adverse side effects. The problem is that in attempting to solve one problem, government officials may end up creating another problem or making another problem worse. They cannot necessarily achieve all goals simultaneously. Very often, decision-makers are faced with a trade-off, that is, they can solve one problem, but only at the expense of another."

Anonymous

  1. Inflation and Unemployment as a Trade-Off
  2. Inflation and the Balance of Trade as a Trade-Off
  3. Interest Rates and Balance of Trade as a Trade-Off
  4. Financial Market Stability and Economic Growth as a Trade-Off
  5. Planning Horizon and the Need for Coordination
  6. Lags in Making and Executing Policy
  7. Flexibility of Priorities Among the Policy Goals
  8. Summary
    Readings
    Websites
top    I. Inflation and Unemployment as a Trade-Off

The Phillips Curve: Wage Inflation and Unemployment

THE PHILLIPS CURVE
phillipscurve01

Source: Thomas M. Humphrey, "Changing Views
of the Phillips Curve," Monthly Review (FRBRich),
LIX(7) Jul 1973: 2.
The Phillips Curve shows that policy makers face a tradeoff when trying reduce unemployment and inflation and that they cannot solve both problems simultaneously. A.W. Phillips, an economist at the London School of Economics, studied the relationship between rates of change of hourly manufacturing earnings and the unemployment rate in the United Kingdom from 1861-1931. He first created a "scatter diagram." Then, for each year, he plotted the percentage change in wages on the Y-axis and the average unemployment rate on the X-axis. Finally, he regressed the wage changes against unemployment rates and found that the best fit of the dots in the scatter diagram was an inverse convex curve, indicating a long-run trade-off between wage rate changes and unemployment. The closer an economy comes to full-employment, the faster wages rise.

"The Relation Between Unemployment and the Rate of Change of Money Wage Rates in the United Kingdom, 1861-1957," A.W. Phillips, Economica, 25(100) Nov 1958: 285.

The Modified Phillips Curve: Price Inflation and Unemployment

Subsequent to Phillips' research, economists linked wage increases to price increases to show the probability of a long-run trade-off between inflation and unemployment. The link between wages and prices is the average productivity of labor for that year. In competitive equilibrium, the real wage is equal to the marginal product of labor.

w/p = MPL

Taking the derivative of the log of real wages and the marginal product of labor yields:

ln(w) - ln(P) = ln(MPL)

d{ln(w)}/dt - d{ln(P)}/dt = d{ln(MPL)}/dt

%Δw - %Δp = %ΔMPL

If the marginal product is constant over time (MPL = k) and equal to the average product of labor (MPL = APL), then

%Δw - %Δp = %ΔAPL

and

%Δp = %Δw - %ΔAPL

The inflation rate, then, is the difference between the annual percentage wage increase and the annual percentage change in productivity. If the change in the average product is 3% and labor is paid its productivity (that is, wages increase by 3%), the inflation rate is zero. If labor gets paid in excess of its productivity, the differential is reflected in a higher inflation rate. The whole Phillips curve shifts down by an amount equal to the percentage rate of change in average productivity to establish a long-run trade-off between inflation and unemployment.

PRICE INFLATION VERSUS
WAGE INFLATION

phillipscurve02
Source: Thomas M. Humphrey, "Changing Views
of the Phillips Curve," Monthly Review (FRBRich),
LIX(7) Jul 1973: 4.
ATTAINABLE VERSUS
UNATTAINABLE OUTCOMES

phillipscurve03
Source: Thomas M. Humphrey, "Changing Views
of the Phillips Curve," Monthly Review (FRBRich),
LIX(7) Jul 1973: 5.

The revised Phillips curve shows the frontier of possible inflation and unemployment combinations available to society. The location of the curve fixes the inner boundary of attainable combinations. The slope of the curve shows the trade-offs or rates of exchange between policy goals. Any combination of inflation and unemployment below and to the left of the curve is unattainable. Any combination above and to the right is attainable) however such combinations are inferior to a point on the trade-off curve.

OPTIMUM FEASIBLE OUTCOME
phillipscurve04
Source: Thomas M. Humphrey, "Changing Views
of the Phillips Curve," Monthly Review (FRBRich),
LIX(7) Jul 1973: 6.
SOCIAL CHOICE OF OUTCOME
phillipscurve05
Source: Thomas M. Humphrey, "Changing Views
of the Phillips Curve," Monthly Review (FRBRich),
LIX(7) Jul 1973: 6.

The bowed-out curves are social disutility contours. Each contour shows all the combinations of inflation and unemployment resulting in a given level of social disutility. The closer to the origin the lower will be the level of disutility. The slopes of these contours reflect the relative weights that society (or the policy makers) assigns to the evils of inflation and unemployment. The best combination of inflation and unemployment that the policy makers can reach, given the Phillips curve constraint, is the mix appearing on the lowest attainable social disutility contour. Which combination is ultimately desired by society is a subjective valuation as determined by the disutility of increasing inflation and unemployment. The socially optimum combination would be the tangent of the Phillips curve with the highest social disutility curve, since combinations farther from the origin are less desirable.

POLICY CHOICES
phillipscurve06
Source: Thomas M. Humphrey, "Changing Views
of the Phillips Curve," Monthly Review (FRBRich),
LIX(7) Jul 1973: 7.
Given the unfavorable Phillips curve, policy makers are confronted with a cruel choice. They can achieve acceptable rates of inflation (point a) or unemployment (point b) but not both. Successive political administrations may differ in their evaluations of the social harmfulness of inflation relative to that of unemployment. Thus, in their policy deliberations, they will attach different relative weights to the two evils of inflation and unemployment. These weights will be reflected in the slopes of the disutility contours (as those contours are interpreted by policy makers.) The flat contours reflect the views of those attaching higher relative weight to the evils of inflation; the steep contours reflect the views of those attaching higher relative weight to the evils of unemployment.

Ideally, the disutility of the policy makers reflects the disutility of society; but as has been shown in the United States, successive administrations alternatively weight either inflation or unemployment with greater disutility: Democrats tend to implement policies to correct unemployment at the expense of inflation (point a) and Republicans tend to implement policies to control inflation at the expense of unemployment (point b). Some times the socially tolerable combination is not feasible with monetary and fiscal policies alone. Then, other measures may be needed to try to shift the Phillips curve back toward the origin. The rationale for the wage-guide posts and manpower policies implemented in the 1960s, was to shift the Phillips curve down to the zone of acceptable outcomes.

Early studies for the United States revealed non-inflationary expansion with a 5.5% unemployment rate. According to that study, if public decision-makers wanted to reduce the unemployment rate below the 5.5%. level, they would have to live with some inflation. If government officials were willing to live with some chronic inflation at maybe a 2% rate, then they could reduce unemployment to the 4% level. Hence, the definition of full-employment came to be 4% unemployment.

Explaining the Inflation-Unemployment Trade-Off

Why does inflation tend to rise as an economy approaches full employment and unemployment goes down? As long as the unemployment rate is very high and the economy has a vast pool of idle workers with appropriate talents and skills, firms can increase output by hiring qualified workers at the going wage to produce more output from excess capacity with little or no change in prices. However, as an economy approaches full employment, the pool of unemployed shrinks. To find the right workers for the available jobs to expand output, firms will draw from their competitors payroll by offering more attractive wages and benefits. The choice to hire from a competitor is rational, because those left in the dwindling pool of unemployed are the marginal workers — the structurally unemployed, who require costly training. If the company undertakes the training, this training raises the effective wage to labor and, subsequently, prices. If the worker pays for his own training, he will require higher explicit wages. Alternatively, the firm could try to pull from the pool of frictionally unemployed workers, but to do so requires increased search and information costs for employment agencies and want ads to find exactly the right worker for the job.

SOURCE OF THE INFLATION-UNEMPLOYMENT TRADE-OFF
phillipscurve07

In the diagram to the above, the economy is in full-employment equilibrium at its natural output level of Q1 when aggregate demand is AD1 and the price level is P0. At that point, firms have only their minimum excess capacity (approximately 15%) and the economy is operating at its natural unemployment rate (u1). The economy has only frictional unemployment and structural unemployment. No cyclical unemployment exists.

When aggregate demand falls from AD1 to AD0, firms cut back on production and lay off workers. Output falls from Q1 to Q0 and the unemployment rate increases from u1 to u0. At Q1, firms have a lot of excess capacity (more than 15%) and the pool of unemployed workers is very large (u0 > u1). The new unemployment is cyclical unemployment. Prices may or may not decrease immediately.

Subsequently, when aggregate demand rises from AD0 to AD1, firms are free to choose those workers which are best suited to fill the job vacancies from among the pool of unemployed workers. Since the pool is vast, these workers can be rehired at the going wage and prices remain stable at P0 as output increases from Q0 to Q1. At Q1, the economy is once again producing at its natural output and unemployment has fallen back to its natural unemployment rate. When aggregate demand increases above AD1 and businesses attempt to produce more to satisfy the additional demand, they can do so only with an increase in the rate of inflation.

When aggregate demand rises from AD1 to AD2, the pool of idle workers shrinks and firms are forced to hire from competitors, retrain workers from the pool of structurally unemployed persons, or increase their search effort (time adn money) to get someone who is frictionally unemployed (between jobs or new to the labor force). In all of these cases, the costs of production rise and prices rise from P0 to P2. Inflation appears.

When aggregate demand rises from AD2 to AD3, all unemployment is eliminated. The economy is producing its maximum output, Qmax. However, hiring the last available workers forces firms to incur even more costs, such that prices rise to P3. An increase in aggregate demand from AD3to AD4 at maximum output raises only prices from P3 to P4, as firms have used up all of their idle capacity and no more labor is available to increase production.

Monetary and fiscal policies are demand-management policies. They shift the aggregate demand curve in and out. As just demonstrated, changes in aggregate demand move the economy along its Phillips curve.

Expansionary monetary and fiscal policies, designed to reduce unemployment, increase aggregate demand. As aggregate demand increases from AD0 to AD1 to AD2 to AD3 to AD4, real output rises from Q0 to Q1 to Q2 to Qmax and unemployment falls from u0 to u1 to u2 to umin, but prices rise from P0 to P1 to P3 to P4. The economy moves up the Phillips curve and unemployment is reduced as inflation picks up.

Contractionary monetary and fiscal policies, designed to reduce inflation, decrease aggregate demand. As aggregate demand decreases from AD4 to AD3 to AD2 to AD1 to AD0, prices fall from P4 to P3 to P1 to P0, but real output falls from Qmax to Q2 to Q1 to Q0, and unemployment rises from umin to u2 to ul to u0. The economy moves down the curve and inflation decreases as unemployment increases.

Short-Run Versus Long-Run Inflation-Unemployment Trade-Off

Recent studies indicate that a long-run trade-off between inflation and unemployment may not exist. Rather, there are a series of short-run trade-offs and in the long-run the curve is perfectly price inelastic at some natural rate of unemployment. Taking groups of five ten-year periods, several different curves can be identified. Sometimes the curve shifts upward to the right; at others, it shifts down to the left. As the curve shifts up, the economy enters a period of stagflation, when both unemployment and inflation rates are high. When the curve shifts down, the economy enters a period of non-inflationary growth.

The Phillips curve shifts up and down for several reasons. First of all, the growth of oligopolistic industries and their growing market power, which has prevented prices from falling so fast, as in the past, during recessions, will shift the curve up to the right. On the other hand, cost increases can be easily passed along in the form of "administered prices." To shift the curve back down, more stringent anti-trust legislation and enforcement is necessary to force competitive price behavior.

Second, supply-shocks that raise non-labor production costs will shift the curve up to the right. Short (agricultural) crops and oil embargoes will shift the curve up. Bumper crops and the disintegration of OPEC will shift the curve back down.

Third, a mismatch of job applicants for job vacancies may occur and this will shift the curve up. Better training for job openings, relocation programs, and an improved flow of job information between employers and applicants will shift the curve down.

Fourth, a slow down in productivity increases will shift the curve up. When marginal product is less than average product, the average falls. This decreases the differential between wages and prices and shifts the curve up to the right. Increased regulation and non-capacity-increasing capital requirements lower average product. To shift the curve down, reduced regulation and a business climate that raises the expected profitability of capacity-increasing capital is required. Changes in technology also shift the curve down.

Finally, an increase in inflationary expectations will shift the curve up. As long as workers have "money illusion", stimulatory policy measures will increase output and reduce unemployment. As long as money wages are more important than real wages to workers, they can be fooled into working for higher money wages while the purchasing power of that money income is eroded by higher rates of inflation. But once workers realize that price increases are reducing the purchasing power of their money incomes, they will demand cost of living increases in addition to productivity gains.

EXPECTATIONS HYPOTHESIS
phillipscurve08
ACCELERATIONIST HYPOTHESIS
phillipscurve09
Attempts to lower the unemployment rate from the natural rate, un, to u1, via movement along short-run trade-off curve S0 will evoke wage bargaining and other adaptations to inflationary expectations. The economy will travel the path ABCDE to the new equilibrium, point E, where unemployment is the same, but inflation is higher than it was originally. Initially, these increases will be tied to past inflation rates, because the presumption is that tomorrow will look a lot like today just as today looks a lot like yesterday. However' higher wages lead to higher prices and eventually workers catch on. In their next round of negotiations, workers will ask for wage increases based on the expected rate of inflation. With fixed demand, each round of higher wages leads to higher prices, lower output, less employment, and higher unemployment rates. Building inflationary expectations into wage bargaining agreements shifts the Phillips curve up to the right. If the government uses expansionary monetary or fiscal policies to restimulate the economy and reduce unemployment, the inflationary process is reignited and the Phillips curve shifts to the right once again, restoring the economy to its natural rate of unemployment. Accelerationists take the expectations hypothesis one step further. They argue that attempts to maintain unemployment at some rate (u1) below the natural rate (un) will provoke explosive, ever-accelerating inflation. If policy makers attempt to reduce unemployment with simulative measures, then, as prices start to rise, workers will negotiate for matching wage increases. However, the only way the additional employment can be sustained is if real wages are depressed. To keep real wages depressed, prices must continue to rise and rise faster than wages in order to sustain the lower rate of unemployment — or that actual inflation must outpace expected inflation. The economy will travel the path ABCD with the rate of inflation rising from P1 to P2 to P3, etc.
Source: Thomas M. Humphrey, "Changing Views of the Phillips Curve," Monthly Review (FRBRich), LIX(7) Jul 1973: 8. Source: Thomas M. Humphrey, "Changing Views of the Phillips Curve," Monthly Review (FRBRich), LIX(7) Jul 1973: 10.

To shift the curve down, demand management policies must be reversed. The strategy must be to force a high rate of unemployment to bring down the rate of inflation before deflationary expectations and lower wage demands restore both a lower rate of inflation and a lower rate of unemployment. In the end, however, the economy will "loop" around some natural rate of unemployment. If the actual unemployment rate falls below the natural unemployment rate, the economy cannot move, unless labor can be fooled into working for money wages rather than real wages. If it rises above, inflationary expectations fall.

ALTERNATIVE DYNAMIC DISEQUILIBRIUM PATHS
phillipscurve10 phillipscurve11
Policy makers may elect to travel a path off the long-run Phillips curve instead of occupying a point on the curve. If they choose the vertical path at the left, they will hold unemployment at uu and hope that the inflation rate will not accelerate. If they choose the clockwise loop, they will be willing to let unemployment fluctuate within the range u1 to u2. Unemployment will be raised when inflationary expectations develop and lowered when they subside. If inflationary expectations are deeply entrenched and downwardly inflexible, inflation may be resistant to all but the most protracted sieges of severe unemployment. In such cases, the economy may be trapped in a deadlock like point C, where both high inflation and high unemployment persist interminably. Here, extraordinary policy measures, such as wage-price freezes and similar controls, may be used to break up and dispel the inflationary expectations. These policies shorten the period of high unemployment needed for inflation to decline to acceptable levels like point D.
Source: Thomas M. Humphrey, "Changing Views of the Phillips Curve," Monthly Review (FRBRich), LIX(7) Jul 1973: 12.

If there are, in fact, a series of short-run, rather than one long-run Phillips curve, then public decision-makers can deal with inflation and unemployment, provided they are willing to risk periods of high inflation and unemployment to restore low rates of both. Alternatively, they need to implement policies that shift the aggregate supply curve out as aggregate demand increases. These include training and relocating workers, improving the flow of job information, inducing an economic climate for profitable investment, enforcing antitrust laws, reducing burdensome regulations, mitigating supply-side shocks, and taking measures to increase productivity.

top    II. Inflation and the Balance of Trade as a Trade-Off

A country's rate of inflation and its balance of trade and foreign exchange rate are inversely related. As a country's rate of inflation rises relative to the rest of the world, domestic goods for export become more expensive to foreigners and foreign goods for import become cheaper. As imports rise and exports fall, a country's trade surplus deteriorates to a deficit. As a country's rate of inflation falls relative to the rest of the world, domestic goods for export become cheaper for foreigners and foreign goods for import become more expensive. As exports rise and imports fall, a country's trade deficit improves to a surplus.

INFLATION AND THE BALANCE OF TRADE TRADE-OFF
botandrelativeinflationrate

To correct a country's trade deficit, the country must export more than it imports. The country must devalue its currency to achieve this turnaround. To effect a devaluation, the central bank must increase the money supply; but this is inflationary. As the country's exchange rate falls, its goods become cheaper to foreigners and foreign goods become more expensive in the domestic country. Initially, foreign exporters and domestic importers may cut prices and profit margins to maintain competitiveness and market share. However, after a while, when profit margins are squeezed to nothing, importers must raise price to cover increases in the value of the foreign currency and the general level of prices rises. Increasing prices on imports makes it easier for domestic producers to raise prices and inflation heats up. By the same token, as the country's goods become cheaper abroad and foreign demand picks up, the composition of the country's output is shifted around. More goods are produced for export and less is available for domestic consumption. Rationing this smaller supply among domestic buyers pulls up prices and helps to ignite the fire of inflation at home. The domestic country will end up with higher prices and more inflation. Alternatively, fiscal policy could be restrictive to slow demand growth and inflation. The consequence, however, is lower interest rates and a flight of capital.

To correct a country's trade surplus, the country must import more than it exports. The country must revalue its currency to achieve this turnaround. To effect a revaluation, the central bank must decrease the money supply; but this is deflationary. As the country's exchange rate rises, its goods become more expensive to foreigners and foreign goods become cheaper in the domestic country. Initially, domestic exporters and foreign importers may cut prices and profit margins to maintain competitiveness and market share. However, after a while, when profit margins are squeezed to nothing, they must raise price to cover increases in the value of the foreign currency. This makes exports less competitive and slows export growth. Meanwhile, decreasing prices on imports makes it more difficult for domestic producers to raise prices. Disinflation and then deflation set in. As the country's goods become more expensive abroad and foreign demand falls, the composition of the country's output is shifted around. More goods are produced for domestic consumption and less is available for export. This excess supply of domestic commodities pushes down prices and helps to fuel a deflationary spiral. The consequence of a deflationary spiral is unemployment.

top    III. Interest Rates and Balance of Trade as a Trade-Off

A country's interest rates and its balance of trade are inversely related. When a country's interest rates are high, both absolutely and relative to the rest of the world, and capital is free to flow between countries on a risk-reward basis, international funds will flow from countries with lower real interest rates to countries with higher real interest rates. As a result of the high demand for that country's currency for investment purposes, the currency may become overvalued. The balance of trade will deteriorate and it will take ever-increasing amounts of capital flowing into the country to offset trade deficits to maintain balance in the international accounts and prevent a drain on the country's international reserves.

INTEREST RATES AND THE BALANCE OF TRADE TRADE-OFF
botandrelativeinterestrate

If the monetary authority attempts to bring down interest rates, the exchange rate will fall. Foreigners may withdraw their capital in search of better risk-return rewards elsewhere. The country's currency may then "free-fall", forcing a further flight of capital, and its interest rates will then rise very rapidly, choking off domestic spending. Bringing interest rates down too far, too fast will have the negative effect of forcing saving from the country and constraining investment necessary for expanding the output of both domestic consumption and export goods.

Very often it is the speed of adjustment, rather than the type of adjustment, that determines whether or not a country achieves balance in its international accounts. In general, interest rates and capital flows respond more quickly than do prices and trade. If a devaluation to improve the trade balance forces a flight of capital, the currency may depreciate to a point where it is severely undervalued. At the much lowered exchange rate, real exports may not increase rapidly enough or real imports may not fall fast enough to correct the previous deficit. In the mean time, this adverse change in the terms of trade from the devaluation will make the trade imbalance significantly worse for a long period of time before it improves.

top    IV. Financial Market Stability and Economic Growth as a Trade-Off

When interest rates are subject to extremely volatile fluctuations, uncertainty over the future course of rates — up or down — inhibits investment spending. To promote investment spending and capital accumulation, interest rates should be fairly stable or predictable. Only in a relatively stable interest rate environment will businesses be able to calculate accurately the cost of capital and its returns.

Stable interest rates, however, are not without their costs. Unless the monetary authority is extremely sagacious, it may stabilize rates at levels that are either too high or too low. If interest rates are stabilized at too low a level, the money supply will have to expand more rapidly to accommodate a larger demand. The end result may be inflation. If interest rates are stabilized at too high a level, the money supply will have to contract to match a smaller demand. The end result may be unemployment.

top    V. Planning Horizon and the Need for Coordination

What time horizon do policy makers consider in selecting an operating target? an intermediate target? the ultimate goal? Not all of the links between the policy tools and goals are effective in the same time frame and a great deal of coordination is needed to achieve the ultimate goals) at the same time.

The Humphrey-Hawkins (Full Employment and Balanced Growth) Act of 1978 requires the administration to set annual numerical goals for key targets such as employment and unemployment, production, real income, productivity, and prices over a five year period. Goals for the first two years are considered the operating targets or short-term goals and for the following three years, the intermediate targets or medium-term goals.

The terminology in Humphrey-Hawkins may be somewhat confusing. If operating and intermediate targets are used in that sense, then there is a conflict in the adjustment period or "link" time between fiscal policy and monetary policy.

With monetary policy, the operating and intermediate targets can be reached more quickly as changes in the policy tools work their way through reserves and short-term rates to monetary aggregates and long-term rates within a matter of weeks. The Federal Reserve works with a much shorter time frame for its operating and intermediate targets, hitting the annual numerical goals established by the administration with a variable lag. Monetarist Milton Friedman estimates that changes in the money supply (a monetary intermediate target) may take any where from 6 months to 2 years to filter through the economy and influence the ultimate goals.

Meanwhile, fiscal policy has a more certain and immediate affect on the aggregate economy, but its affect may be short-lived and exhaust itself, unless repeated. Since monetary and fiscal policies have variable effective lags, respectively, much coordination is required to achieve the ultimate goals at the same time — one, two, or three years down the road.

top    VI. Lags in Making and Executing Policy

The theoretical differences between Monetarists and Keynesians are more often than not trumped by practical considerations in policy making. One of these practical considerations is the set of lags with which policy is made and becomes effective.

The policy process has three inside lags (the recognition lag, the decision-making lag or the administrative lag, and the implementation lag or the execution lag) and one outside lag (the effectiveness lag or the impact lag). The inside and outside lags differ for the various macroeconomic policies. In general, the inside lags for monetary policy are quick, while the outside lag is long, variable, and asymmetric. The inside lags for fiscal policy [and incomes policy and supply-side policy — any policy that requires congressional action] are long, variable, and asymmetric, while the outside lag is quick.

Inside lags

The recognition lag is the time between the onset of a problem and its recognition by someone in an official capacity who can make a decision to correct the problem.

Monetary policy tends to have a very short recognition lag. The Chair of the Federal Reserve System is generally charged with the authority to identify economic and financial problems and to call meetings to discuss a problem and decide on an appropriate course of action. Some Chairs, like Paul Volcker, have been quick to identify problems. Some Chairs, like Alan Greenspan, have been quick to anticipate problems before they occur. Other Chairs have been more lax in identifying problems. Hence, the great inflation of the 1970s.

Fiscal policy tends to have a very long recognition lag. The President is generally charged with leading the nation and, therefore, with the responsibility for identifying economic and financial problems. However, no President wants to admit that the economy is not doing well under his/her administration. Therefore, the President tends to postpone identification of a problem for as long as possible so that he/she can, hopefully, pass any problems along to his/her successor.

The decision-making lag or the administrative lag is the time between the recognition of a problem by someone in an official capacity who can make a decision to correct the problem and the making of the decision to correct it.

Monetary policy tends to have a very short decision-making lag. The Federal Open Market Committee (FOMC), the body charged with making monetary policy decisions, meets eight (8) times each year. The Committee also has the authority to act in between meetings, should an emergency arise.

Fiscal policy tends to have a very long and asymmetric decision-making lag. Fiscal policy decision-making is shared between the President and Congress. Before the government can spend or change tax collections, it must have the appropriate authorization. This authorization comes through the passage of laws. All spending and tax bills must pass through the House and Senate before the President can sign them into law. This process is long and tedious.

In addition, the fiscal policy decision-making lag asymmetric. Congress and the President are quicker to pass into law bills that increase spending and reduce taxes than they are to pass into law bills that reduce government spending and raise taxes. The latter legislation is not so politically appetizing as the former legislation.

The implementation lag or execution lag is the time between the making of the decision to correct a macroeconomic problem and the implementation or execution of the measures to be used to correct the problem.

Monetary policy tends to have a very short implementation lag. Once the FOMC meets and decides on a strategy for monetary policy, it sends a directive to the Manager of the System Open Market Account (SOMA) to implement. The next day the Manager is buying or selling U.S. government securities for the SOMA, pursuant to the directive.

Fiscal policy tends to have a very long and variable implementation lag. If the President and Congress agree on a tax measure to correct the problem, then employers can have new withholding schedules inside of two weeks. However, even if the President and Congress agree on a spending measure, it often takes much longer to implement. Implementation of spending on a public works job takes much longer than simply paying people to stay home. It may involve everything from land acquisition to toilet bowl cleaning.

Outside lags

The effectiveness lag or the impact lag is the time between the implementation or execution of the measures to be used to correct the problem and the correction of the problem.

Monetary policy tends to have a long, variable, and asymmetric effectiveness lag. Monetary policy may take any where from six (6) months to two (2) years to become effective. Its effectiveness is also asymmetric. It is more effective in restraining inflation than for stimulating economic activity.

Fiscal policy tends to have a short effectiveness lag and is quickly exhausted. Fiscal policy is effective the moment spending changes but is generally exhausted before one (1) year. Because changes in spending are simply changes the velocity of money balances, fiscal policy may require additional injections or reductions in order to accomplish the desired goal. It is more effective for stimulating economic activity than for restraining inflation.

top    VII. Flexibility of Priorities Among the Policy Goals

Fortunately or unfortunately, neither the Employment Act of 1946 nor the Humphrey-Hawkins Act set priorities among the goals. If all goals could be achieved simultaneously, there would be little need to set priorities. We could simply set about to achieve all goals simultaneously. However, conflicts are evident and the decision-makers must set priorities for the goals.

In some cases, this lack of formal priorities has left the government free to choose as crises come and go. At one point we target inflation, at another point we target unemployment, depending on which seems to be the more severe crisis. In other instances, a government has become preoccupied with a goal, long after it has ceased to be a major problem. How does a government know what should be its priority for public policy? And which should take second, third, and fourth place?

In most Western countries, priorities are revealed through secret ballot box elections of public officials who best represent individual priorities. The winners of these elections, then, represent the collective priorities of society. In general, the emphasis has shifted among goals, depending on the administration in power. In the United States, Democrat administrations have tended to emphasize employment opportunities, while Republican administrations have been concerned more often with price stabilization. Intermittently, other priorities rise to the surface, such as public credibility with Iran-Contra, Abscam, Watergate, and the Lewinsky Affair, social welfare issues (the homeless), national security, the trade balance, and the federal budget deficit.

Very often public officials will switch the priority of goals as public sentiment changes. Between elections, public opinion polls are taken by independent organizations asking the "man on the street" how he feels about different problems. In the 1950s, the primary issues were creeping inflation and the Cold War. In the 1960s, they were civil rights, poverty, and the Vietnam War. In the 1970s, stagflation, OPEC, and international relations took center stage. By the 1980s, unemployment, slow growth, and the twin deficits in the federal government's budget and the trade balance were important to Americans. Ten years before, the trade balance was a thorn in America's side, a minor irritation, and the budget deficit was considered simply a "cost of doing business," but certainly nothing serious. The 1990s brought concerns about health insurance, education, crime, and the federal budget deficit. Today, Americans still worry about health insurance and education, but crime is down and the federal government's budget is in surplus. Nothing is sacrosanct, and, very often, priorities shift before old problems have been solved and previous goals achieved.

top     Summary

The state of the economy may not permit policy makers to achieve all of the mandated macroeconomic goals simultaneously. The government must prioritize these goals and then attack them in priority order. This inability to achieve all goals simultaneously and their resultant prioritization is reflected in the divergent platforms of the two major U.S. political parties: the Republicans and the Democrats. The voters ultimately get to determine which goals will receive first priority by voting for their favored decision makers in elections.

top    Readings

The Relation between Unemployment and the Rate of Change of Money Wage Rates in the United Kingdom, 1861-1957, A.W. Phillips, Economica., 25 Nov 1950: 233-99

The Postwar American Economy: Performance and Problems, Alvin H. Hansen, W.W. Norton & Co., New York, 1964: ch. 5

Making Monetary and Fiscal Policy, G.L. Bach, Brookings Institute, Washington, DC, 1971: ch. 3

Changing Views of the Phillips Curve, Thomas M. Humphrey, Monthly Review (FRBRich), LIX(7) Jul 1973: 2-13

Rational Expectations — Fresh Ideas that Challenge Some Established Views of Policy Making, Clarence W. Nelson, Annual Report (FRBMinn), 1977

The Inflation-Unemployment Trade-Off: A Critique of the Literature, Anthony M. Santomero and John J. Seater, Journal of Economic Literature, XVI(2) Jun 1978: 499-544

The Role of Productivity Gains in Solving National Economic Problems, G. William Miller, Voice (FRBDal), Dec 1978

The Battle Against Unemployment and Inflation, M.S. Bailey and A.M. Okun, W.W. Norton & Co., New York, 1982

Inflation and Unemployment, James Tobin, American Economic Review, LXXII(1) Mar 1982: 1-18

Macroeconomics of Stagflation under Flexible Exchange Rates, Pentti J. Kouri, American Economic Review, LXXII(2) May 1982: 390-95

Nobel Views on Inflation and Unemployment, Carl E. Walsh, Economic Letter (FRBSF), 97(1) 10 Jan 1997

Is Noninflationary Growth an Oxymoron? David Altig, Terry Fitzgerald, and Peter Rupert, Economic Commentary (FRBClev), 1 May 1997

Is There an Inflation Puzzle? Cara S. Lown and Robert Rich, Economic Policy Review (FRBNY), 3(4) Dec 1997

Easing Monetary Policy: Dynamic Effects with Adaptive Expectations, J. Bradford DeLong, University of California, Berkley, 10 Mar 1998

The Monetary Policy Reaction Function, J. Bradford DeLong, University of California, Berkley, 12 Apr 1998

The Implications of Technological Changes, Alan Greenspan, Charlotte Chamber of Commerce, Charlotte, NC, 10 Jul 1998

Question: Is There A New Economy? Alan Greenspan, Speech, The Haas Annual Business Faculty Research Dialogue, University of California, Berkeley, CA, 4 Sept 1998

The U.S. New Keynesian Phillips Curve: An Empirical Assessment, Alain Guay and FlorianPelgrin, Working Paper2004-35, Bank of Canada, Sep 2004

top    Websites



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