Macroeconomic Policy Challenges

The basic idea of macroeconomic policy is to use fiscal and monetary policy to achieve an output gap that is neither so high that it leads to excessive unemployment and lost output nor too low that it leads to rising inflation. However, this is not nearly as simple as it sounds.

Model Uncertainty

We do not know the true macroeconomic model. We do not know the "natural rate of unemployment," which is the rate below which we would start to experience increasing inflation. We do not know the exact relationship between interest rates and aggregate demand. We do not know the exact relationship between fiscal policy and aggregate demand. Because of all this "model uncertainty," policy is more a matter of trial and error than exact science.

Time Lags

Time lags are another complicating factor in macroeconomic policy. First, there is recognition lag. Our economic data gives us a rearview mirror through which to view the economy. We may discover only after the fact that the economy has been in recession for a year, or that our estimate of the natural rate of unemployment is too optimistic. Second, there is implementation lag. Economists might recognize a recession, but it may take some time for Congress to enact a stimulative tax cut or spending program. Finally, there is impact lag. There may be a lag of several quarters between a cut in interest rates and the response of aggregate demand. For example, a drop in interest rates is supposed to raise the cost of foreign goods, but even if the exchange rate moves in the right direction it may take a while for foreign producers to mark up the prices of their exports to us. And even after prices change, it may take a while before domestic buyers switch from imported products to domestic products.

The combination of model uncertainty and time lags makes a mockery of the notion of "fine tuning" the economy to always be at optimum performance. Instead, policymakers try to adjust slowly and more-or-less grope to the best outcome that they can achieve.

Internal Vs. External Balance

There can be a conflict between internal and external balance. Internal balance means having the output gap be close to zero. External balance means having the trade balance be close to zero. If the output gap is negative, you want to raise interest rates in order to hold down inflation. If the trade balance is in deficit, you want to lower interest rates in order to increase the cost of foreign goods. If you have both problems at the same time, what do you do?

A further complication is that sometimes it is desirable to have a stable exchange rate, in order to avoid harming companies with assets or liabilities denominated in foreign currency. If you need to maintain a stable exchange rate for financial stability, but you need to deal with a trade imbalance, what do you do?

The United States has tended to ignore the issue of external balance. We run a large trade deficit every year, which means that we build up large debts to foreign investors. Whether this is sustainable is unclear. However, unlike most other countries, we have less to fear from exchange rate changes, since our debts tend to be denominated in our domestic currency, the dollar.

Supply Shocks and Staglation

In the 1970's, we experienced two spikes in oil prices. The increase in energy costs, along with slow productivity, came to be called a "supply shock" by economists. A supply shock means an increase in the rate of unemployment at which higher inflation is triggered. What this means is that policymakers face an unappetizing choice: either accept higher unemployment than was typical before, or put up with higher inflation. The combination of high unemployment and high inflation is called stagflation.

When stagflation first appeared in the early 1970's, the first attempt to stop it was the imposition of wage and price controls late in 1971, during the Nixon Administration. In the short run, this kept inflation in check and allowed monetary stimulus to reduce the unemployment rate, but the price control regime broke down within a few years, and the economy sank quickly into worse staglation than before.

In fact, it was the decontrol of oil prices by the Reagan Administration in 1981, along with the anti-inflation efforts of Paul Volcker's Federal Reserve, that paved the way for the end of stagflation. Price controls have been discredited as a remedy. If stagflation were to break out again, economists might suggest "supply side" measures that would reduce taxes and regulations that are thought to raise prices. However, we do not have a handy macroeconomic solution to the problem.


It seems that periodically investors get swept away by euphoria. In Japan in the late 1980's, the prices of stocks were boosted to astronomical levels. Land prices also soared, so that Tokyo became worth more than the entire state of California. In the early 1990's, these "bubbles" popped, leading to a steep slump in output that persists to this day.

In the United States, the Internet produced a bubble, in which Internet stocks (the so-called "dotcoms") were valued at tens of billions of dollars, even though few of them ever earned any profits. In March of 2000, the Internet bubble popped, and most Internet stocks saw their market valuations fall by over 95 percent. Non-Internet stocks, which also had become overpriced, also fell off sharply between March of 2000 and the fall of 2002.

Asset bubbles appear to help the economy while they occur, but the economy suffers when the bubbles pop. A bubble in stock prices helps to raise Tobin's q, the ratio of the market value of capital to replacement cost. This is very stimulative for investment. However, when the bubble pops, investment falls off. MOreover, high stock prices give households a lot of paper wealth, which leads them to spend more and save less. After the bubble pops, households try to restore the value of their savings by cutting back on spending, which lowers aggregate demand.

What is the right policy prescription for asset bubbles? One school of thought is that the Federal Reserve should be pro-active in stopping bubbles during the euphoric phase. One approach would be to raise interest rates. Another approach would be to raise margin requirements, which might serve to dampen speculation in the stock market. (Speculators sometimes buy stock "on margin," meaning that they put up cash for part of the stock, and finance the rest with loans collateralized by the stock. Raising margin requirements means requiring investors to put up a higher percentage of cash and use loans for a lower share of the purchase.)

On the other hand, I think that most economists are doubtful that the Fed or another government agency can clearly distinguish a bubble from a case of justified optimism. After all, if it were obvious that stocks were over-valued, the market would be likely to drive prices down.

Another argument against trying to pop bubbles is the point of view that the macroeconomic damage of a bubble comes only when it pops. It would seem ideal if you could let the economy enjoy the ride when a bubble is taking place. Once the bubble pops, you would step in with stimulative macroeconomic policy to cushion the fall.