Stabilization Policy

The Federal Reserve’s job is to take away the punch bowl just as the party gets going.

— William McChesney Martin

What we need is not a skilled monetary driver of the economic vehicle continuously turning the steering wheel to adjust to the unexpected irregularities of the route, but some means of keeping the monetary passenger who is in the back seat as ballast from occasionally leaning over and giving the steering wheel a jerk that threatens to send the car off the road.

— Milton Friedman

How should government policymakers respond to the business cycle? The two quotations above—the first from a former chairman of the Federal Reserve (the U.S. central bank), the second from a prominent critic of central banks—show the diversity of opinion over how this question is best answered.

Some economists, such as William McChesney Martin, view the economy as inherently unstable. They argue that the economy experiences frequent shocks to aggregate demand and aggregate supply. Unless policymakers use monetary and fiscal policy to stabilize the economy, these shocks will lead to unnecessary and inefficient fluctuations in output, unemployment, and inflation. According to the popular saying, macroeconomic policy should “lean against the wind,” stimulating the economy when it is depressed and slowing the economy when it is overheated.

Other economists, such as Milton Friedman, view the economy as naturally stable. They blame bad economic policies for the large and inefficient fluctuations we have sometimes experienced. They argue that economic policy should not try to “fine-tune” the economy. Instead, economic policymakers should admit their limited abilities and be satisfied if they do no harm.

This debate has persisted for decades with numerous protagonists advancing various arguments for their positions. It became especially relevant as economies around the world sank into recession in 2008. The fundamental issue is how policymakers should use the theory of short-run economic fluctuations developed in the preceding chapters.

In this chapter we ask two questions that arise in this debate. First, should monetary and fiscal policy take an active role in trying to stabilize the economy, or should policy remain passive? Second, should policymakers be free to use their discretion in responding to changing economic conditions, or should they be committed to following a fixed policy rule?