Problems of implementation of stabilization policy: active and passive policy of the state

Economic stabilization is associated with many practical difficulties. These include:

a)  time lags of fiscal and monetary policy;

b)  imperfection of economic information;

c)  volatility of economic expectations;

d)  ambiguity of historical analogies.

The internal lag is the period of time between the moment of economic shock and the moment of taking economic policy response measures. Such internal lags are more typical for fiscal policy: the change in the course of monetary policy is carried out by the decision of the Central (National) Bank, while fiscal policy measures imply a long discussion in parliament.

The external lag is the period of time between the moment of adoption of an economic policy measure and the moment when the results of this measure appear. Such external lags are characteristic of monetary policy to a greater extent than for fiscal policy, since monetary instruments affect aggregate demand through a certain transfer mechanism.

Since investment projects are planned by firms in advance, it takes time, usually from 6 to 12 months, for, for example, investments in housing construction to respond to a change in the interest rate. Production investments have an even longer lag.

The same is true for net exports. In response to changes in the money supply and interest rate, the exchange rate changes, which, in turn, leads to a change in the volume of exports and imports and, accordingly, the value of net exports. If, for example, as a result of the depreciation of the exchange rate, some goods have become relatively cheaper, and others, on the contrary, have relatively risen in price, then consumers do not immediately switch to cheaper goods even when they are of very high quality – it takes some time for buyers to discover their advantages, change their preferences, etc. The elasticity of demand for imported goods will be in this case one of the main factors, determining the effectiveness of monetary policy measures.

On average, the lags of fiscal and monetary policy are 1-2 years. If measures were taken before the onset of a cyclical recession or during a recession, then the peak of the impact may appear in the opposite phase of the cycle (that is, in the rise) and increase the amplitude of the oscillations. This complicates the implementation of an active stabilization policy.

Automatic stabilizers of the economy partially solve this problem in industrialized countries. The creation of effective systems of progressive taxation and employment insurance is also a priority for transition economies, where the objective complexities of stabilization policy are combined with the lack of adequate tax, monetary and other mechanisms of macroeconomic regulation.

Pursuing a stabilization policy is also complicated by the fact that many economic events are almost unpredictable. These difficulties of macroeconomic forecasting are partially overcome by expanding and complicating macroeconomic models that make it possible to predict the dynamics of the main indicators of economic development. The index of leading indicators, which combines 11 blocks of data, provides the necessary information about possible fluctuations in the economy.

The choice between active and passive macroeconomic policy models is also complicated by the volatility of economic expectations. Determining the behavior of consumers, investors and other economic agents, expectations play a crucial role in the economy. The problem is that, on the one hand, the results of macroeconomic regulation largely depend on expectations, but, on the other hand, the expectations themselves are determined by economic policy measures.

When changes occur in the policy of the government and the Central (National) Bank, the expectations of economic agents and their economic behavior change. In order to effectively manage the economy, it is necessary to predict these changes, using rather complex economic models for calculations. The equations of the models should change in economic accordance with changes in state policy.

However, the reverse impact of policy on the formation of expectations is very difficult to formalize and “calculate”. Therefore, any macroeconomic models are to a certain extent imperfect, and R. Lucas critically evaluates their use to assess the effectiveness of economic policy. In this regard, a special term has appeared in modern economic theory – “lucas’s criticism”. In its most general form, its content boils down to the fact that traditional methods of analyzing the economic policy of the state cannot adequately reflect the impact of political changes on economic expectations.

This is especially important for calculating the levels of expected inflation and developing an anti-inflationary policy strategy. The adaptive component of expected inflation can be calculated as the sum of all inflation rates of past years, and the coefficient for each subsequent component characterizing the removal into the past is less than that of the previous one:

Pe = 0.4P–1 + 0.2P–2 + 0.1P–3 + …. +?

where Pe is the expected inflation;

0.4P–1 + 0.2P–2 + 0.1P–3 – adaptive (inertial) component;

? – rational component;

P-1 – last year’s inflation rate;

P-2 – the inflation rate of two years ago;

P-3 – the inflation rate of three years ago, etc.

The equation of expected inflation is an integral part of the general equilibrium model “aggregate demand – aggregate supply”:

1)        Y = ? +? *G–y*Ta +M/P (aggregate demand equation);

2)        P = Pe – ? (and – and*) + e (the equation of the Phillips curve derived from the equation of the curve AS);

3)        Pe = 0.4P–1 + 0.2P–2 + 0.1P–3 + …. + ?  (expected inflation equation);

4)        P = (1 + P) * P–1 (price level equation).

The external variables of the model are government spending G, taxes ta, money supply M, price shock?. As a result of the solution of the model, probabilistic values of the levels of employment, output, unemployment, inflation are derived, which can serve as guidelines for the development of alternative strategies for macroeconomic stabilization.

With prolonged inflation, economic agents cease to be mistaken about the consequences of fiscal and monetary expansion, they are more interested in economic information, quickly recognize targets and predict the results of politicians’ actions, which avoids “mistakes” in developing their decisions. This means that the inertial component of the expected inflation gradually decreases and eventually disappears altogether. At the same time, the rational component of expected inflation associated with changes in macroeconomic policy is increasing. It is this component that is the most difficult to quantify, which means that the results of the AD-AS model solution will not be able to be absolutely reliable, which complicates the choice of economic stabilization measures.

The choice between active and passive economic policies also depends on how the lessons of history are assessed. The view of stabilization policy is largely based on the notion of what role it has played in history: stabilizing or destabilizing. This approach is especially common in transition economies, where historical analogies to the current situation are constantly searched for and in this regard, the experience of the NEP, the experience of Stolypin’s reforms and other historical precedents are discussed.

However, different assessments of historical facts often contradict each other. History always allows not one, but many interpretations, since it is not easy to identify the true cause of macroeconomic fluctuations. Therefore, an appeal to history cannot definitively resolve the question of choosing a model of stabilization policy.