Inflation Bias and Other Problems
of Policy Formulation
The apparent ease with which full employment is maintained in our model is misleading, and
you should not come away from our discussion of policy with the idea that it is easy to keep
the macroeconomy on a steady course. Here are just a few of the many problems that can arise:
1. Sticky nominal prices not only give a government the power to raise output when
it is abnormally low, but also may tempt it to create a politically useful economic boom,
say, just before a close election. This temptation causes problems when workers and
firms anticipate it in advance, for they will raise wage demands and prices in the expectation
of expansionary policies. The government will then find itself in the position of
having to use expansionary policy tools merely to prevent the recession that higher
domestic prices otherwise would cause! As a result, macroeconomic policy will display
an inflation bias, leading to high inflation but no average gain in output. Such an
increase in inflation occurred in the United States, as well as in many other countries,
during the 1970s. The inflation bias problem has led to a search for institutions—for
example, central banks that operate independently of the government in power—that
might convince market actors that government policies will not be used in a shortsighted
way, at the expense of long-term price stability. As we noted in Chapter 15,
many central banks throughout the world now seek to reach announced target levels of
(low) inflation. Chapters 20 and 22 will discuss some of these efforts in greater detail.9
2. In practice, it is sometimes hard to be sure whether a disturbance to the economy
originates in the output or the asset markets. Yet a government concerned about the
exchange rate effect of its policy response needs to know the source of the disturbance
before it can choose between monetary and fiscal policy.
3. Real-world policy choices are frequently determined by bureaucratic necessities
rather than by detailed consideration of whether shocks to the economy are real (that
is, they originate in the output market) or monetary. Shifts in fiscal policy often can be
made only after lengthy legislative deliberation, while monetary policy is usually exercised
expeditiously by the central bank. To avoid procedural delays, governments are
likely to respond to disturbances by changing monetary policy even when a shift in
fiscal policy would be more appropriate.
4. Another problem with fiscal policy is its impact on the government budget. A tax
cut or spending increase may lead to a larger government budget deficit, which must
sooner or later be closed by a fiscal reversal, as happened following the multibillion-dollar
DD1 DD2
9For a clear and detailed discussion of the inflation bias problem, see Chapter 14 in Andrew B. Abel, Ben S.
Bernanke, and Dean Croushore, Macroeconomics, 7th ed. (Boston: Addison Wesley, 2011). The inflation bias
problem can arise even when the government’s policies are not politically motivated, as Abel, Bernanke, and
Croushore explain. The basic idea is that when factors like minimum wage laws keep output inefficiently low by
lowering employment, monetary expansion that raises employment may move the economy toward a more efficient
use of its total resources. The government might wish to reach a better resource allocation purely on the
grounds that such a change potentially benefits everyone in the economy. But the private sector’s expectation of
such policies still will generate inflation.
442 PART THREE Exchange Rates and Open-Economy Macroeconomics
fiscal stimulus package sponsored by the Obama administration in the United States in
2009. Unfortunately, there is no guarantee that the government will have the political will
to synchronize these actions with the state of the business cycle. The state of the electoral
cycle may be more important, as we have seen.
5. Policies that appear to act swiftly in our simple model operate in reality with
lags of varying lengths. At the same time, the difficulty of evaluating the size and
persistence of a given shock makes it hard to know precisely how much monetary or
fiscal medicine to administer. These uncertainties force policy makers to base their
actions on forecasts and hunches that may turn out to be quite wide of the mark.
of Policy Formulation
The apparent ease with which full employment is maintained in our model is misleading, and
you should not come away from our discussion of policy with the idea that it is easy to keep
the macroeconomy on a steady course. Here are just a few of the many problems that can arise:
1. Sticky nominal prices not only give a government the power to raise output when
it is abnormally low, but also may tempt it to create a politically useful economic boom,
say, just before a close election. This temptation causes problems when workers and
firms anticipate it in advance, for they will raise wage demands and prices in the expectation
of expansionary policies. The government will then find itself in the position of
having to use expansionary policy tools merely to prevent the recession that higher
domestic prices otherwise would cause! As a result, macroeconomic policy will display
an inflation bias, leading to high inflation but no average gain in output. Such an
increase in inflation occurred in the United States, as well as in many other countries,
during the 1970s. The inflation bias problem has led to a search for institutions—for
example, central banks that operate independently of the government in power—that
might convince market actors that government policies will not be used in a shortsighted
way, at the expense of long-term price stability. As we noted in Chapter 15,
many central banks throughout the world now seek to reach announced target levels of
(low) inflation. Chapters 20 and 22 will discuss some of these efforts in greater detail.9
2. In practice, it is sometimes hard to be sure whether a disturbance to the economy
originates in the output or the asset markets. Yet a government concerned about the
exchange rate effect of its policy response needs to know the source of the disturbance
before it can choose between monetary and fiscal policy.
3. Real-world policy choices are frequently determined by bureaucratic necessities
rather than by detailed consideration of whether shocks to the economy are real (that
is, they originate in the output market) or monetary. Shifts in fiscal policy often can be
made only after lengthy legislative deliberation, while monetary policy is usually exercised
expeditiously by the central bank. To avoid procedural delays, governments are
likely to respond to disturbances by changing monetary policy even when a shift in
fiscal policy would be more appropriate.
4. Another problem with fiscal policy is its impact on the government budget. A tax
cut or spending increase may lead to a larger government budget deficit, which must
sooner or later be closed by a fiscal reversal, as happened following the multibillion-dollar
DD1 DD2
9For a clear and detailed discussion of the inflation bias problem, see Chapter 14 in Andrew B. Abel, Ben S.
Bernanke, and Dean Croushore, Macroeconomics, 7th ed. (Boston: Addison Wesley, 2011). The inflation bias
problem can arise even when the government’s policies are not politically motivated, as Abel, Bernanke, and
Croushore explain. The basic idea is that when factors like minimum wage laws keep output inefficiently low by
lowering employment, monetary expansion that raises employment may move the economy toward a more efficient
use of its total resources. The government might wish to reach a better resource allocation purely on the
grounds that such a change potentially benefits everyone in the economy. But the private sector’s expectation of
such policies still will generate inflation.
442 PART THREE Exchange Rates and Open-Economy Macroeconomics
fiscal stimulus package sponsored by the Obama administration in the United States in
2009. Unfortunately, there is no guarantee that the government will have the political will
to synchronize these actions with the state of the business cycle. The state of the electoral
cycle may be more important, as we have seen.
5. Policies that appear to act swiftly in our simple model operate in reality with
lags of varying lengths. At the same time, the difficulty of evaluating the size and
persistence of a given shock makes it hard to know precisely how much monetary or
fiscal medicine to administer. These uncertainties force policy makers to base their
actions on forecasts and hunches that may turn out to be quite wide of the mark.
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