Chapter 14: Macroeconomic Policy Debates

The debate between the Keynesian stream, which argues for government intervention to prevent recessions and encourage growth, and the Classical stream, which argues for leaving it to the market, continues today.

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1. Rules vs. Discretion

• Discretionary Policy: A method where the government or central bank flexibly determines policy based on economic conditions. (Keynesian school)
• Policy by Rules: A method where policies are carried out according to pre-determined rules (e.g., increasing the money supply by 3% every year). (Monetarist school)

Issue of Time Lags: Because of the time it takes to decide on a policy (Inside Lag) and the time it takes for a policy to take effect (Outside Lag), discretionary policies can sometimes make the economy even more unstable.

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2. Lucas Critique

• Robert Lucas criticized that “because changes in government policy also change the expectations and behavior of economic agents, analyzing policy effects based on past data can be incorrect.”
• In other words, policies may not be as effective as expected because people perceive the government’s intentions and respond to them.

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3. Ricardian Equivalence

• A theory that even if the government increases spending by issuing national bonds instead of cutting taxes, consumers will increase savings instead of consumption, anticipating that taxes will rise in the future.
• Consequently, it reaches the conclusion that fiscal policy is ineffective in increasing aggregate demand.

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4. Rational Expectations

• A hypothesis that when people predict the future, they use all available information, including the direction of government policy, not just the past.
• Under rational expectations, anticipated government policies are offset by the private sector and fail to affect the real economy (income, unemployment), only changing prices (Policy Ineffectiveness Proposition).

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Key Checklist

• Which theory states that tax cuts have no effect on consumption because they imply future tax increases? (Answer: Ricardian Equivalence)
• What is the warning that predicting policy effects based only on past statistical data is dangerous? (Answer: Lucas Critique)
• What do we call it when the government implements policies ad-hoc according to the situation? (Answer: Discretionary Policy)
• Which hypothesis concludes that “government policy only changes prices and does not affect real income”? (Answer: Rational Expectations Hypothesis)