The potential need for stabilizing policy actions arises from economic disturbances.
Some of these disturbances, such as changes in money demand, consumption spending,
or investment demand, arise from within the private sector. Others, such as
wars, may arise for noneconomic reasons.
Wise policymakers work with what we know about the economy while also recognizing
the limits of our knowledge. Good policy design includes an assessment of
the risks associated with unforeseen errors.
The three key difficulties of stabilization policy are that (a) policy works with lags;
(b) the outcome of policy depends very much on private sector expectations, which
are difficult to predict and may react to policy; and (c) there is uncertainty about
both the structure of the economy and the shocks that hit the economy.
When forming economic policy, policymakers must choose between sudden policy
changes and gradual changes. Sudden policy changes may enhance the policymakers'
credibility but are based on limited information. Gradual changes allow policymakers
to incorporate new information as the economy moves toward its target.
For the purposes of policy, economic variables can be classified as targets (identified
goals of policy), instruments (the tools of policy), and indicators (economic
variables that signal whether we are getting close to our policy targets).
There are clearly occasions on which active monetary and fiscal policy actions
should be taken to stabilize the economy. These are situations in which the economy
has been affected by major disturbances.
Fine tuning—continuous attempts to stabilize the economy in the face of small
disturbances—is more controversial. If fine tuning is undertaken, it calls for small
policy responses in an attempt to moderate the economy's fluctuations, rather than to remove them entirely. A very active policy in response to small disturbances is
likely to destabilize the economy.
In the rules-versus-discretion debate, it is important to recognize that activist rules
are possible. The two important issues in the debate are how difficult it should be to
change policy and whether policy should be announced as far ahead as possible.
There is a tradeoff between the certainty about future policy that comes from rules
and the flexibility of the policymakers in responding to shocks.
Central bank independence is one avenue democracies use to add to the credibility
of policy and to help mitigate the problem of dynamic inconsistency.
