Problems and constraints facing policymakers

Overview

How time lags constrain macroeconomic policy, quality of economic data constrain policy and conflicts between objectives constrain what policy can achieve.

What you need to know

Answer each one before you reveal it.

Questions from this subtopic

Each one with the model answer underneath.

1. 1

   Analyse how time lags constrain macroeconomic policy.

   Model answer

   Four lags operate in sequence. Data on output, prices and employment arrive weeks or months after the period they describe and are then revised, so the current state of the economy is never known with confidence, which is the recognition lag. Deciding on a response takes time, particularly for fiscal measures requiring a budget and legislation, which is the decision lag. Implementing the decision takes longer still, especially for capital projects, which is the implementation lag. And the measure then works through the economy over a further period, with interest rate changes affecting inflation most strongly after a year and a half or more, which is the impact lag. The combined delay can exceed the length of the downturn being addressed, so a policy designed to counter a recession can arrive during the recovery and add to the following boom, making the cycle worse rather than better.

2. 2

   Why does the quality of economic data constrain policy?

   Model answer

   Policy has to be set on the basis of what the economy is doing now and will do next, but the figures available describe the recent past imperfectly. Early estimates of output are based on incomplete returns and are frequently revised by amounts large enough to change the picture entirely, so a quarter initially recorded as growth can later be recorded as contraction. Some concepts cannot be measured at all in real time, most importantly the sustainable level of output, which determines whether there is spare capacity and therefore whether stimulus is safe; estimates of it are revised heavily after the event. Inflation measures depend on a basket that becomes unrepresentative when spending patterns shift. And activity in the informal economy is invisible. Policymakers are therefore steering by indicators that are provisional, incomplete and sometimes wrong in direction.

3. 3

   Why is uncertainty about the size of a policy's effect a serious constraint?

   Model answer

   Even where the direction of an effect is agreed, its magnitude is not. How much a given rate change reduces spending depends on household debt, the mix of fixed and variable borrowing, confidence and the state of the banking system, all of which vary. How much of a fiscal injection circulates depends on how much is saved and how much goes on imports. The size of these responses is estimated from past episodes in which conditions differed, so an estimate can be badly wrong precisely when conditions are unusual. The consequence is that policymakers can be confident about which way to move and not about how far, which encourages small steps and gradual adjustment, and that in turn means policy is often too weak in a crisis, where a large and immediate response is needed.

4. 4

   Why do conflicts between objectives constrain what policy can achieve?

   Model answer

   There are more objectives than instruments, and the instruments act on several objectives at once. Raising demand to reduce unemployment raises inflation when capacity is limited and worsens the current account by raising imports. Raising interest rates to reduce inflation raises unemployment and appreciates the currency, which harms exporters. Consolidating the public finances restrains growth and often falls hardest on lower incomes. Raising the progressivity of taxation to improve distribution can weaken incentives. A single instrument cannot hit two targets independently, so pursuing one objective necessarily involves accepting a worse outcome on another, and the choice of which to prioritise is a political judgement rather than a technical one. This is why policy is always described as a trade-off and why disagreement about it is legitimate rather than a sign of error.

5. 5

   How does the lower bound on interest rates constrain policy?

   Model answer

   Nominal interest rates cannot be reduced far below zero, because savers can hold physical cash instead of accepting a negative return, so beyond a certain point cuts drive money out of the banking system rather than stimulating spending. That places a floor under the conventional instrument, and the floor binds precisely when it matters most, in a deep recession where the rate consistent with full employment may be substantially negative. The constraint is worse when inflation is very low, because it is the real rate that matters and a nominal floor of zero with inflation near zero means the real rate cannot fall below zero either. Policymakers must then turn to asset purchases, guidance about future rates or fiscal expansion, all of which are less well understood, harder to calibrate or slower to deploy.

6. 6

   How does a high level of public debt constrain policy?

   Model answer

   It constrains fiscal policy directly, because a government already borrowing heavily faces a market that may demand a higher yield for further issuance, and because a large stock makes the budget very sensitive to interest rates, so an expansion can be self-defeating if it raises the cost of servicing everything already owed. It reduces fiscal space, so the government may be unable to respond to the next shock at all, and it can force consolidation in a downturn, which deepens it. It constrains monetary policy indirectly, since a central bank raising rates knows it is worsening the government's position, which creates pressure not to act, and a government dependent on low rates has an interest in the central bank's decisions that threatens independence. And it narrows the range of options politically, since a large interest bill is a visible claim on revenue that makes new commitments harder to justify.

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