Macroeconomic Policy

Policy makers have at their command two broad classes of policies with which to affect the economy. Monetary policy is controlled by the Federal Reserve System（the Fed）.The instruments of monetary policy are changes in the stock of money, changes in the interest rate—the discount rate—at which the Fed lends money to banks, and some controls over the banking system. Fiscal policy is under the control of the Congress, and usually is initiated by the executive branch of the government.The instruments of fiscal policy are tax rates and government spending.

One of the central facts of policy is that the effects of monetary and fiscal policy on the economy are not fully predictable, neither in their timing nor in the extent to which they affect demand or supply. These two uncertainties are at the heart of the problem of stabilization policy.Stabilization policies are monetary and fiscal policies designed to moderate the fluctuations of the economy—in particular, fluctuations in the rates of growth, inflation, and unemployment.

The recent fluctuations of the rates of inflation and unemployment, suggest strongly that stabilization policy has not been fully successful in keeping them within narrow bounds. The failures of stabilization policy are due mostly to uncertainty about the way it works.

However, questions of political economy are also involved in the way stabilization policy has been operated.The speed at which to proceed in trying to eliminate unemployment, at the risk of increasing inflation, is a matter of judgment about both the economy and the costs of mistakes.Those who regard the costs of unemployment as high, relative to the costs of inflation, will run greater risks of inflation to reduce unemployment than will those who regard the costs of inflation as primary and unemployment as a relatively minor misfortune.

Political economy affects stabilization policy in more ways than through the costs which policy makers of different political persuasions attach to inflation and unemployment, and the risks they are willing to undertake in trying to improve the economic situation. There is also the so-called political business cycle, which is based on the observation that election results are affected by economic conditions.When the economic situation is improving and the unemployment rate is falling, incumbent presidents tend to be reelected. There is thus the incentive to policy makers running for reelection, or who wish to affect the election results, to use stabilization policy to produce booming economic conditions before elections.

Stabilization policy is also known as countercyclical policy, that is, policy 12 to moderate the trade cycle or business cycle.The cycles in the past 20 years have been far from regular.The behavior, and even the existence, of the trade cycle is substantially affected by the conduct of stabilization policy.Successful stabilization policy smooths out the cycle, while unsuccessful stabilization policy may worsen the fluctuations of the economy.Indeed, one of the tenets of monetarism is that the major fluctuations of the economy are a result of government actions rather than the inherent instability of the economy's private sector.

Rudiger Dornbusch and Stanley Fischer, Macroeconomics 3rd ed.© 1984, pp.17-18.Reprinted by permission of McGraw-Hill Book Company.

KeyTerms and Concepts

Federal Reserve System a coordinated group of financial institutes acts as the central bank of the United States, issuing paper currency, supervising the commercial banks of the country, and implementing monetary policy.

monetary policy the policy that the federal government takes to adjust the money supply, the availability of loanable funds, or the level of interest rates so as to influence general economic activity.

stock of money quantity of money related to money supply.

fiscal policy The federal government influences general economic activity by changing the level of government spending or taxes.

trade cycle regularly recurring periods of recession and recovery.

business cycle see“trade cycle.”