use of domestic saving potential.

9. Conflicting Policies. There is the possibility of conflicts between the

prescribed policy mixes among governments of different countries.
According to Johnson, it is a difficult and highly complicated process to
arrive at the right combination of monetary and fiscal policies in all
countries simultaneously. If, however, such a combination is worked out
by trial and error, it may lead away from rather than toward equilibrium.

10. Long Time Lags. The model assumes that there are no long time lags
for the operation of monetary-fiscal policies. But both monetary and fiscal
lags are quite long and they retard the process of simultaneous equilibrium
of internal and external balance.

RULES VS DISCRETION IN ECONOMIC POLICY

In macroeconomic policy, there is a controversy over the issue of “rules vs

discretion”. The issue is whether monetary and fiscal authorities should
conduct policies in accordance with predetermined rules that lay down
how their policy variables will be determined in all future economic
situations, or whether they should be allowed to use their discretion in
determining the policy variables as situations arise.

As the economy is inherently unstable due to frequent aggregate demand

and supply shocks, these shocks lead to fluctuations in output,
employment and prices. Keynesians led by Tobin favour discretionary or
activist policy while monetarists led by Friedman oppose activist policy
and favour passive policy based on rules.

According to Keynesians, the economy is subject to many exogenous

shocks from factors like changes in expectations, political events,
international events such as oil crisis, war, etc. But usually they are money
shocks, demand shocks or price shocks. These exogenous shocks lead to
irregular cyclical fluctuations of varying intensity. Fluctuations being
unpredictable, they bring uncertainty in the economy thereby adversely
affecting investment and potential output. So they lead to recessions
resulting in high unemployment, fall in incomes and hardships to people.
Morever, Keynesian analysis is based on the premise that the private
sector is inherently unstable and is subject to frequent disturbances in
aggregate output, income and employment. If left to itself, it will cause
deviation from real income, output and employment from the full
employment level. Therefore, Keynesians argue that government should
follow activist fiscal and monetary policies to stabilise the economy.

To Keynesians, stabilisation policy means “leaning against the prevailing

economic wind.” It should stimulate the economy in recession and slow it
when overheated in boom. This requires deliberate changes in tax rates
and government expenditures, and tight or easy monetary policy during
booms or recessions. Thus activist or discretionary policy is flexible in
which government, monetary or other authorities decide what appropriate
policy should be adopted in current circumstances. It is formulated on a
case-by-case on yearly basis in which there is no commitment about future
policy.

Keynesian discretionary policy has been criticised by monetarists who

regard the private sector as inherently stable and consequently the
economy is basically stable. When disturbed by some change in basic
conditions, it will quickly revert to its long run path via relative price
changes. So discretionary stabilisation policy is not required. If such a
policy is implemented, it will increase rather than diminish fluctuations in
output, income and employment. They do not favour “fine tuning” the
economy and are critical of counter-cyclical discretionary policy. Such a
policy involves long, variable and uncertain time lags that make
stabilisation policy ineffective and destabilising. So the best policy is a
passive one which follows a “fixed long-run rule”. Under such a rule, the
money supply should grow at a constant rate of 3 per cent per year and
government’s fiscal deficit is fixed at 3 per cent of GDP per year. But
economists do not agree with monetarists on fixed long-run rules because
rules do not grow at the same rate. Economic environment may change
and past rules may no longer hold. Therefore, government should have the
discretion to change the rules. There should be flexibility of instruments
for maintaining stability of targets. For instance, money supply and
government spending are instruments of stabilisation policy that affect
such targets as prices, output, income and employment. Moreover, given
 that the economy and the knowledge about it are both changing overtime,
there is no need for laying down permanent policy rules that would tie
down the hands of monetary and fiscal authorities. Thus the practical issue
in the controversy over rules versus discretion becomes whether the policy
makers should announce in advance what policies they will follow in the
foreseable future.

Expectations, the Lucas Critique and New Classical Stabilisation Policy

New classicals do not agree with Keynesians and monetarists about macro
economic policy. According to them, only unexpected policy changes lead
to changes in real GDP. Robert Lucas explains how people form
expectations of the future. He assumes that consumers and firms
(economic agents) have accurate information about future economic
events. They have rational expectations because they take into account all
available information, especially about expected government actions. If
the government is following any consistent monetary or fiscal policy,
agents know about it and adjust their plans accordingly. So when the
government adopts the expected policy measure, it will not be effective
because it has been anticipated by agents who have already adjusted their
plans. So the government policy will be ineffective.

There is also rational ignorance on the part of agents because they have no
incentive to inform themselves about government policy. This ignorance
suggests that economists should be cautious when offering policy advice.
When policy makers estimate the effect of any policy change, they need to
know how people’s expectations will respond to the policy change.
According to Lucas, using traditional macroeconomic models for policy
analysis will be erroneous when used to predict the effects of changes in
policy. This is because they do not take into account the impact of policy
changes on people’s expectations. This is known as the Lucas critique.

Let us first take fiscal policy. The Keynesians advocate an “activist” fiscal
policy to reduce unemployment. But, according to new classicals a tax cut
and/or increase in government spending will reduce unemployment only if
its short-run effects on the economy are unexpected (or unanticipated) by
people. In other words, an expansionary fiscal policy may have short-term
effects on reducing unemployment provided people do not anticipate that
prices will rise. But when the government persists with such a policy,
people expect the rate of inflation to rise. So the workers will press for
higher wages in anticipation of more inflation in the future and firms will
raise the prices of their products in anticipation of the rise in future costs.
As a result, fiscal policy will become ineffective in the short-run. It may
cause more unemployment and inflation in the long-run when the
government tries to control inflation.

Similarly, if the government adopts an expansionary monetary policy by

increasing the money supply to reduce unemployment, it is also
ineffective in the short-run. Such a policy may reduce unemployment in
the short-run provided its effects on the economy are unanticipated. But
when the government persists with such an expansionary monetary policy,
people expect the inflation rate to rise. Firms raise the prices of their
products to overcome the anticipated inflation so that there is no effect on
production. Similarly, workers press for higher wages in anticipation of
inflation and firms do not employ more workers. So there is no effect on
employment.

Thus new classicals suggest that expansionary fiscal and monetary

policies will have a temporary effect on unemployment and if continued
may cause more inflation and unemployment. For such policies to be
successful, they must be unanticipated by the people. Once people
anticipate these policies and make adjustments towards them, the
economy reverts back to the natural rate of unemployment. Thus for
expansionary fiscal and monetary policies to have an impact on
unemployment in the short-run, the government must be able to fool the
people. But it is unlikely to happen all the time. If the government
continues to persist with such policies, they become ineffective because
people cannot be fooled for long and they anticipate their effects on
production and unemployment. Thus fiscal-monetary policies become
ineffective in the short-run. According to new classicals, inflation can be
controlled without causing widespread unemployment, if the government
announces fiscal and monetary measures and convinces the people about
it and do not take them by surprise.

New classicals also restate the monetarist fixed long-run policy rules.
 “Since these rules are either ineffective in achieving changes in short-run
real output and/or or increase uncertainty, the government should not use
them. Instead, it should adopt a constant money supply growth rate rule
and a balanced budget.”

LAGS IN EFFECTS OF ECONOMIC POLICY

One of the limitations of monetary and fiscal policies in countercyclical

manner is the existence of time lags. It takes time for the monetary and
fiscal authorities to realise the need for action and its recognition, and the
taking of action and the effect of the action on economic activity.
According to Friedman, monetary and fiscal actions affect economic
conditions only after a lag that is “both long and variable”. Friedman
distinguishes among three basic lags: the recognition lag, the
administrative lag, and the operation lag. These lags are explained as
under:

1. The Recognition Lag. It refers to the time between the development of

a need for action and the recognition of that need by the monetary and
fiscal authorities. It is difficult to know the occurrence of a turning point
in a business cycle and recognise the need for action by the authorities.
Empirical evidence in the U.S. suggests that in the past the Federal
Reserve Bank recognised the need for monetary action only three months
after the trough in a business cycle and about six months after a boom had
started. Thus the recognition lag has been longer at the peaks than at the
troughs.

2. The Administrative Lag. This relates to the period of time that occurs
when the monetary and fiscal authorities recognise the need for action and
the data on which action is actually taken. The length of the administrative
lag (or decision or action lag) varies with the type of policy being
considered and the decision-making process of the authorities. Usually,
this lag is very short. The administrative lag and the recognition lag taken
together are termed as inside lags because they fall within the jurisdiction
of the authorities. Sometimes, it is difficult to distinguish between the two
because the time between recognition of the need for action and the taking
of action is so short that the administrative lag becomes the recognition