12. Rules vs. Discretion

Rules vs discretion

The debate between those who believe that policy intervention (active policy) in rxn to economic and financial crisis may improve the economy contrasted with who believe it tends to lengthen or exacerbate crisis and that predictable rules (passive policy) are needed instead

Policy lag

The amount of time that passes between a shock to the economy and the effects of a policy decision can be observed or measured

Inside lag

The time taken for government or central banks to respond to economic shocks; also called recognition or decision lag; more severe problem for fiscal policy than monetary policy

Outside lag

The amount of time it takes for government or central bank policy to have observable or measurable effects on the economy; more severe problem for monetary policy than fiscal policy

Expected inflation

Economic decision makers forecast inflation rates based on beliefs about the economy and the central bank

Rational expectations

Economic decision makers will incorporate all available information including expectations about the economy into their choices; policy actions can be rendered ineffective if economic decision makers anticipate their effects and adjust their expectations accordingly

Policy ineffectiveness

The idea that some policy actions will never achieve the desired results if the public can perceive or anticipate the policy decision

Policy credibility

The idea that a policy action will achieve exactly what it purports to do; moral suasion

Credibility effect

Economic decision-makers begin to trust policy maker after policies appear to be working effectively and markets adjust more quickly as decision-makers’ expectations change

Time-inconsistency problem

When policy makers announce one policy to influence market expectations but pursue a different policy

Phillips curve

A curve showing a theoretical relationship between the output gap (or unemployment rate) and the inflation rate

Short-run Phillips curve

A presumed trade-off between inflation and unemployment

Long-run Phillips curve

The presumed trade-off between inflation and unemployment breaks down in the long-run and the

Phillips curve becomes vertical when there is no output gap

Sacrifice ratio

The ratio of the trade off between the cost of unemployment and the inflation rate

Natural rate hypothesis

The rate of unemployment is insensitive to the inflation rate

Stagflation

When economic stagnation and high inflation rate occur together; prices rise and output falls; renders policy tools impotent if policies used to fight inflation may cause more economic stagnation

Misery index

Unemployment rate and inflation rate added together; used to characterize “the Great Inflation” period from 1968-1982, which is considered to be the greatest failure of macroeconomics

Federal Reserve Reform Act 1977

Called the “dual mandate” US Congress explicitly stated that the Fed’s goals should be:


1. Maximum employment (low unemployment 4-5%)
2. Stable prices (low inflation 2-3%)
3. Moderate long-term interest rates

Full Employment and Balanced Growth Act 1978

Called the “Humphrey-Hawkins Act” stated that the federal government’s goal should be :


1. Full employment (low unemployment 4-5%)
2. Growth in production (persistent real growth 3-4%)
3. Price stability (low inflation 2-3%)
4. Balance of trade and budget ( low budget deficits and low trade deficits)