Optimal economic policies: Conduct by rule or by discretion?

One of the most fundamental topic of debate among economists is whether economic policy should be conducted by rule or by discretion. Policy is conducted by rule if politicians announce in advance how policy will respond to various situations. Policy is conducted by discretion if politicians are free to choose whatever policy seems appropriate at the time. The debate between rules and discretion is distinct from the debate between passive and active policy. Policy can be conducted by a rule and be either passive or active. Some economists believe that economic policy is too important to be left to the discretion of politicians. Although this view is more political than economic, estimating it is central to how we judge the role of economic policy. If politicians are incompetent, then we may not

give them the discretion to use the powerful tools of monetary and fiscal policy. Incompetence in economic policy arises for following reasons. Some economists view the political process as unstable, perhaps because it reflects on power of special interest groups. In addition, macroeconomics is complicated, and politicians often do not have appropriate knowledge of it to make judgments. This ignorance allows sometimes some policymakers to give incorrect but appealing solutions to different problems.If we guess that we can trust our politicians, discretion at the first view, appears much better than a fixed policy rule. Discretionary policy is flexible. As long as politicians are intelligent, there might appear to be no reason to deny them in responding to changing conditions.Even if we are assure that policy rules are superior to discretion in some aspects, the debate over macroeconomic policy is not over. If the central bank were to commit a rule for monetary policy, what rule should it choose? It is important to shortly discuss three policy rules that various economists protect. Monetarist economists (for instance, M. Friedman) confirms that the central bank keep the money supply growing at a stable rate. Monetarists believe that fluctuations in the money supply are responsible for most large fluctuations in the economy. They argue that slow and steady growth in the money supply would provide stable employment and prices. Although a monetarist policy rule might have prevented many of the economic fluctuations we have experienced historically, most economists believe that it is not the best policy rule. Steady growth in the money supply stabilizes demand only if the velocity of money is stable. Most economists believe that a policy rule needs to allow the money supply to adapt to various shocks to the economy. A second policy rule that economists widely support is a nominal GDP target. According to this rule, the central bank announces a planned way for nominal GDP. Since a nominal GDP target allows monetary policy to adapt to changes in the velocity of money, most economists believe it would lead to greater stability in output and prices than a monetarist policy rule. A third policy rule that is often confirmed is a target for the price level. According to this rule, the central bank announces a planned way for the price level and adapts the money supply when the actual price level is different from the target. Supporters of this rule usually believe that price stability should be the primary goal of monetary policy. For example, although most discussion of policy rules centres on monetary policy, economists and politicians also frequently propose rules for fiscal policy. The rule that has received the most attention is the balanced-budget rule. According to the balanced-budget rule, the government would not be allowed to spend more than it receives in tax revenue. We have analyzed whether policy should take an active or passive role in responding to economic fluctuations and whether policy should be conducted by rule or by discretion. There are many arguments on both sides of these questions. Perhaps the only clear conclusion is that there is no simple and understandable arguments for any view of macroeconomic policy. Economists play a key role in the formulation of economic policy because the economics is complicated, this role is often difficult. Anyway, someone must advice economic politicians. That difficult job falls to economists. The role of economists in the policy process is wider than only to give advice to politicians.

New Keynesian economics

Economists do not agree on the best way to explain short-run economic fluctuations. There are two major schools of thought: new classical economics and new Keynesian economics. New classical economists advocate models in which wages and prices adjust quickly to clear markets. The market-clearing models examined in the chapter-the worker-misperception and imperfect-information models-were popular among new classical economists in the 1970s. More recently, many new classical economists have turned their attention to real-business-cycle theory, which applies

the tenets of the classical model-price flexibility and monetary neutrality-to explain economic fluctuations. New Keynesian economists believe that the market-clearing models cannot explain short-run economic fluctuations, and so they advocate models with sticky wages and prices. In The General Theory, Keynes urged economists to abandon the classical presumption that wages and prices adjust quickly to equilibrate markets. He emphasized that aggregate demand is a primary determinant of

national income in the short run. New Keynesian economists accept these basic conclusions. In their research, New Keynesian economists try to develop more fully the Keynesian approach to economic fluctuations. Much New Keynesian research is aimed at refining the theory of aggregate supply by explaining how wages and prices behave in the short run. This work tries to identify more precisely the market imperfections that make wages and prices sticky and that cause the economy to return only slowly to the natural rate. In this section we discuss some of these recent developments.

Date: 2016-01-14; view: 507