1. Chapter 16
Macro Policy Debate:
Active or Passive?

2. Active Vs. Passive Approach
• Active Approach: This approach views the
economy as relatively unstable and unable to
recover from shocks when they occur.
– Economic fluctuations arise primarily from the
private sector, particularly investment, and
natural market forces may not help much or may
be too slow once the economy gets off track.
– How to get to potential output?
• Calls for government intervention and discretionary
policy!!!

3. Active Vs. Passive Approach
• The passive approach on the other hand,
views the economy as relatively stable and
able to recover from shocks when they do
occur.
– If the economy derails, natural market forces and
automatic stabilizers nudge it back on track in a
timely manner.
– Active discretionary policy is unnecessary and may
do more harm than good.

4. Active Approach
• Under the active approach, discretionary fiscal
or monetary policy can reduce the costs of an
unstable economy, such as higher
unemployment.

5. Passive Approach
• Discretionary policy may contribute to the
instability of the economy and is therefore
part of the problem, NOT the solution.

6. Closing a Contractionary Gap
• What should public officials do?
– Passive Approach: Wages and Prices are flexible
enough to adjust within a reasonable period to
labor shortages or surpluses.
• High unemployment causes wages to fall, reducing
production costs, and shifting the SRAS to the right
• Little reason for discretionary policy

7. Closing a Contractionary Gap
• What about the active approach?
– They believe that prices and wages are not that
flexible, particularly in the downward direction.
– When unemployment is higher than the natural
level, then market forces may be to slow to
respond.
• The slower market forces, the greater the lost of
output
– They are in favor of discretionary policy
• February 2009- $787 Billion stimulus plan

8. LO1
Closing a Contractionary
Gap
Exhibit 1
Price
level
130
125
(b) The active approach
Potential output
SRAS130
LRAS
AD
a
AD’
c
0 13.8 14.0 Real GDP
(a) The passive approach
Potential output
SRAS130
SRAS120
AD
a
LRAS
Price
level
130
125
120
b
0 13.8 14.0 Real GDP
At a: short-run equilibrium; unemployment > natural rate. Passive approach - panel (a) - high unemployment
eventually causes wages to fall, reducing the cost of doing business: shifts the SRAS curve rightward from
SRAS130 to SRAS120;potential output at b.
Active approach - panel (b) - shift the AD curve from AD to AD'. If the active policy works perfectly, the
economy moves to its potential output at c.

9. Closing an Expansionary Gap
• Passive: They argue that natural market forces
prompt workers and firms to negotiate higher
wages.
– Higher wages increase production costs, shifting
the SRAS to the left.
– This natural approach results in higher price
levels- inflation and decreases the economy’s
potential

10. Closing an Expansionary Gap
• Active Approach:
– The Fed attempted to cool down an overheated
economy by increasing its target interest rate- 17
steps between mid-2004 and mid-2006.
– Under active approach, the price level is lower.

11. LO1 Exhibit 2
Closing a Expansionary
Gap
(b) The active approach
Potential output
SRAS130
LRAS
d
c AD”
AD’
Price
level
135
130
0 14.0 14.2 Real GDP
(a) The passive approach
Potential output
SRAS140
SRAS130
AD”
LRAS
Price
level
140
135
130
d
c
e
0 14.0 14.2 Real GDP
At d – short-run equilibrium; $14.2 trillion >potential output. Unemployment < natural rate. Passive
approach - panel (a) - no change in policy; higher negotiated wage; higher costs; shifts SRAS curve to
SRAS140. New equilibrium, e: higher price level, lower output and employment. Active policy - reduce
aggregate demand - panel (b); new equilibrium - c - closing the expansionary gap without increasing
the price level.

12. Problems with Active Policy
• Timely adoption and implementation of an
active policy is not easy.
• The Problem of Lags
– Recognition Lag: The time it takes to identify a
problem and determine how serious it is.
– Decision-marking lag: Once we know the problem,
we now have to decide how to fix it!!!
– Implementation lag: the time needed to introduce
a change in monetary or fiscal policy.
– Effective lag: The time needed for changes to
affect the economy.

13. Rational Expectations
• A school of thought that argues people from
expectations based on all available
information, including the likely future actions
of government policy makers.
– If discretionary policy is used often, then people
will come to expect the use of it.
– This means they will expect to see the effects on
output and price level.

14. Monetary Policy and Expectations
• Suppose the Fed conducts expansionary
monetary policy to increase AD
– The price level is now higher than workers
expected
– Workers have less purchasing power
– Time-inconsistency problem arises when policy
makers have an incentive to announce one policy
to shape expectations but then to pursue a
different policy once those expectations have
been formed and acted on.

15. Anticipating Monetary Policy
• If firms and workers expect the Fed to do
expansionary monetary policy, then they can
adjust their wage contracts and cost structure.

16. Policy Credibility
• The Fed needs some guarantee to do what
they said they were going to do.
– Some credible threat
• Cold Turkey: the announcement and
execution of tough measures to reduce high
inflation.

17. Limitations on Discretion
• The economy is so complex and economic
aggregates interact in such obscure ways and
with such varied lags that policy makers
cannot comprehend what is going on well
enough to pursue an active monetary or fiscal
policy.
– This is one view on why active approach does not
work

18. Rules and Rational Expectations
• Some Economists are more passive approach,
because they believe that people have a
pretty good idea of how the economy works
and what to expect from government policy
makers
– Monetary policy is fully anticipated by workers
and firms and it has NO effect on the level of
output, the effect is only on price levels.

19. The Phillips Curve
• A curve showing possible combinations of the
inflation rate and the unemployment rate
– The opportunity cost of reducing unemployment
was higher inflation.
– 1970s changed the view of the Phillips Curve
• Either shifted outward or it was no longer economic
reality

20. Hypothetical Phillips Curve
c
d
a
b
Phillips
curve
Unemployment rate
10
5
0 5 10 (percent)
Inflation rate
(percent change in price level)
The Phillips curve shows an
inverse relation between
unemployment and inflation.
Points a and b lie on the Phillips
curve and represent alternative
combinations of inflation and
unemployment that are
attainable as long as the curve
itself does not shift. Points c and
d are off the curve.
LO4 Exhibit 5

21. The Short-Run Phillips Curve
• The short-run Phillips curve is based on labor
contracts that reflect a given expected price
level, which implies a given expected rate of
inflation.

22. The Long-Run Phillips Curve
• When workers and employers adjust fully to
an unexpected change in AD, the long-run
Phillips curve is a vertical line drawn at the
economy’s natural rate of unemployment
– According to this analysis, policy makers cannot,
in the long-run, choose between unemployment
and inflation, they choose only among different
rates of inflation.

23. LO4 Exhibit 6
Aggregate Supply Curve and Phillips Curves in the Short
Run and Long Run
SRAS103
b
d
a AD’
AD
Potential output
LRAS
Price
level
105
103
101
e
AD”
c
0 13.9 14.0 14.1 Real GDP
5
3
Inflation rate (percent)
1
Short-run
Phillips curve
Unemployment
Long-run
Phillips curve
d
a
e
c
b
0 4 5 6 rate (percent)
Expected price level=103 (3% higher than current level) and AD; actual price level=103; potential output;
point a; unemployment=natural rate=5%
If AD > expected (AD'): price level=105 > expected; output>potential; higher inflation; lower unemployment.
If AD<expected: (AD“); price level=101<expected; output<potential; lower inflation; higher unemployment.

24. The Natural Rate Hypothesis
• In the long-run, the economy tends toward
the natural rate of unemployment
• This natural rate is largely independent of AD

25. Short-Run Phillips LO4 Curves Since 1960
Exhibit 7