ECN 204 Lecture Notes - Aggregate Demand, Dynamic Inconsistency, Disinflation
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Chapter 17: Five Debates over Macroeconomic Policy
Should Monetary and Fiscal Policymakers try to Stabilize Economy?
Left on their own, economies tends to fluctuate. Pessimism of households and firms causes a fall
in aggregate demand which causes a recession = no benefit for society and waste of resources.
Policymakers reduce the severity of economic fluctuations by leaning against the wind of
economic change- use monetary and fiscal policy to stabilize aggregate demand, output, and
employment. A more stable economy benefits everyone
Con: should NOT
Monetary and fiscal policy work with long lags, so policy must act in advance of economic
changes. But the shocks that cause fluctuations are unpredictable, and forecasting is highly
imprecise. If policy takes effect too late, it will worsen fluctuations. So leave economy to its own
Exercise: Active Policy Stabilization
Would you be more likely to support active stabilization if wages, prices, and expectations adjust quickly
in advance in response to economic changes, or if they adjust slowly?
Answer: If wages, prices, and expectations adjust slowly, it will take longer for the economy to return to
its natural rates of output and employment. In that case, there’s a better chance that expansionary
policy will act in time to alleviate the recession, rather than push the economy into an inflationary boom.
Should Monetary Policy be made by an Independent Central Bank?
Allowing elected officials to have influence in conducting monetary policy has two problems.
Politicians are sometimes tempted to use monetary policy to affect the outcome of elections
thus leading to fluctuations that reflect the electoral calendar – the political business cycle. Such
influence might lead to more inflation that is desirable. One way to avoid these difficulties is to
conduct monetary policy independent of political influence.
Cons: should NOT
An important advantage of elected officials having a say in conducting monetary policy is
accountability. The practical importance of time inconsistency is far from clear. The supposedly
enhanced credibility of monetary policy announcements that comes from central bank
independence seems to yield few dividends. The idea that elected policymakers might use
monetary policy to generate political business cycles seems at odds with the concept of rational
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