1. © 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/eO’Sullivan/Sheffrin Prepared by: Fernando Quijano and Yvonn Quijano CHAPTERCHAPTER 31 Current Issues in Macroeconomic Policy

2. © 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Should We Balance the Federal Budget? Governments run a deficit when they spend more than they currently receive in revenues either from taxes or fees. A surplus occurs when total revenues exceed total expenditures.Governments run a deficit when they spend more than they currently receive in revenues either from taxes or fees. A surplus occurs when total revenues exceed total expenditures. Governments run a balanced budget when revenue equals spending—purchases of goods and services or transfer payments.Governments run a balanced budget when revenue equals spending—purchases of goods and services or transfer payments.

3. © 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Should We Balance the Federal Budget? Purchases of goods and services are included in GDP, but transfer payments—such as Social Security, welfare payments, and interest on the federal debt—are not included in GDP.Purchases of goods and services are included in GDP, but transfer payments—such as Social Security, welfare payments, and interest on the federal debt—are not included in GDP. To measure total spending by the government, we use government expenditure to include transfer payments and purchases of goods and services.To measure total spending by the government, we use government expenditure to include transfer payments and purchases of goods and services. The government debt is the total of all past deficits.The government debt is the total of all past deficits.

4. © 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Forecasts for the Budget Surplus, 2001-2011 The Congressional Budget Office (CBO) estimated that the federal government would continue to run surpluses throughout the decade.The Congressional Budget Office (CBO) estimated that the federal government would continue to run surpluses throughout the decade. The CBO estimated that in 2011 the ratio of debt to GDP would fall to 5.2% from its value of 32% in 2000.The CBO estimated that in 2011 the ratio of debt to GDP would fall to 5.2% from its value of 32% in 2000.

5. © 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Federal Debt as a Percent of GDP, 1791-2000 Except for the period in the 1980s, the ratio of debt to GDP rises sharply during wars and falls during peacetime.Except for the period in the 1980s, the ratio of debt to GDP rises sharply during wars and falls during peacetime.

6. © 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Do Deficits Lead to Inflation? If a government runs a deficit, it is spending more money than it is taking in, and the gap must be covered in some way.If a government runs a deficit, it is spending more money than it is taking in, and the gap must be covered in some way. Governments could use a mix of borrowing money and printing money to cover the gap, as long as the total covers its deficits.Governments could use a mix of borrowing money and printing money to cover the gap, as long as the total covers its deficits.

7. © 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Do Deficits Lead to Inflation? The United States Treasury Department always issues government bonds to finance the deficit. The Federal Reserve has the option of buying existing debt (including new issues).The United States Treasury Department always issues government bonds to finance the deficit. The Federal Reserve has the option of buying existing debt (including new issues). Economists call the purchase by a central bank of newly issued government bonds monetizing the deficit.Economists call the purchase by a central bank of newly issued government bonds monetizing the deficit. Monetizing the deficit would result in inflation, thus, the U.S. finances only a very small portion of our deficits by creating money.Monetizing the deficit would result in inflation, thus, the U.S. finances only a very small portion of our deficits by creating money.

8. © 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Is Government Debt a Burden on Future Generations? The national debt can pose two different burdens for society, both of which affect future generations.The national debt can pose two different burdens for society, both of which affect future generations. A large debt can reduce the amount of capital in the economy and thereby reduce future income and real wages.A large debt can reduce the amount of capital in the economy and thereby reduce future income and real wages. A large national debt will mean that future generations will have to pay higher taxes to finance the interest on the debt.A large national debt will mean that future generations will have to pay higher taxes to finance the interest on the debt.

9. © 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin U.S. Deficits and Unemployment Rates, 1970-2000 Because increases in the unemployment rate signal bad economic times, we expect the deficit to rise and fall with the unemployment rate.Because increases in the unemployment rate signal bad economic times, we expect the deficit to rise and fall with the unemployment rate.

10. © 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin U.S. Deficits and Unemployment Rates, 1970-2000 Over short periods, deficits can help the economy cope with shocks and maneuver out of recessions.Over short periods, deficits can help the economy cope with shocks and maneuver out of recessions.

11. © 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin How Would a Balanced Budget Amendment Really Work? Many constitutional amendments have been proposed so that each fiscal year the government’s revenues (excluding borrowing) are sufficient to cover expenditures.Many constitutional amendments have been proposed so that each fiscal year the government’s revenues (excluding borrowing) are sufficient to cover expenditures. Critics of a balanced budget amendment point to many different problems, including the lack of flexibility to deal with recessions; and the use of the constitution as the mechanism to enforce budget rules.Critics of a balanced budget amendment point to many different problems, including the lack of flexibility to deal with recessions; and the use of the constitution as the mechanism to enforce budget rules.

12. © 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Should the Federal Reserve Aim for Zero Inflation? A zero inflation rate would mean complete price stability.A zero inflation rate would mean complete price stability. To achieve zero inflation, the Fed would have to take two actions:To achieve zero inflation, the Fed would have to take two actions: It would have to use monetary policy to bring the inflation rate to zero from a positive level.It would have to use monetary policy to bring the inflation rate to zero from a positive level. It would need to commit to a policy of keeping inflation at zero and not have any other goals.It would need to commit to a policy of keeping inflation at zero and not have any other goals.

13. © 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin How Costly Is It to Reduce Inflation? Economists who study this problem have developed a rough rule of thumb:Economists who study this problem have developed a rough rule of thumb: When actual unemployment exceeds the natural rate of unemployment by 1 percentage point for one year, the inflation rate falls by 0.5 percentage points per year.When actual unemployment exceeds the natural rate of unemployment by 1 percentage point for one year, the inflation rate falls by 0.5 percentage points per year.

14. © 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin How Costly Is It to Reduce Inflation? Some economists argue that if the Fed was credible in its commitment to reduce inflation, the increase in unemployment could be smaller.Some economists argue that if the Fed was credible in its commitment to reduce inflation, the increase in unemployment could be smaller. One complicating factor in measuring the costs of reducing inflation is that the burden of increased unemployment would not be evenly spread across the economy.One complicating factor in measuring the costs of reducing inflation is that the burden of increased unemployment would not be evenly spread across the economy.

15. © 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Should Monetary Policy Target Only Inflation? A single goal of price stability would enhance credibility, making the private sector more responsive to changes in economic policy.A single goal of price stability would enhance credibility, making the private sector more responsive to changes in economic policy. Economists who object to the Fed’s single goal of price stability point out that automatic fiscal stabilizers are often not sufficient to cushion the economy in the face of shocks.Economists who object to the Fed’s single goal of price stability point out that automatic fiscal stabilizers are often not sufficient to cushion the economy in the face of shocks.

16. © 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Should Monetary Policy Target Only Inflation? “Opportunistic disinflation” is a new phrase about monetary policy that encourages the Fed to take advantage of favorable shocks in the economy in order to accomplish a permanent reduction in inflation without creating excess unemployment.“Opportunistic disinflation” is a new phrase about monetary policy that encourages the Fed to take advantage of favorable shocks in the economy in order to accomplish a permanent reduction in inflation without creating excess unemployment.

17. © 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Should Tax Policy Be Designed Solely for Growth? The low savings rate in the U.S. economy hurts our long-run growth prospects because our investment spending is limited by our own savings.The low savings rate in the U.S. economy hurts our long-run growth prospects because our investment spending is limited by our own savings. Tax systems which are based on consumption do not penalize individuals who save. Sales taxes in the U.S. and value added taxes abroad are familiar examples of consumption taxes.Tax systems which are based on consumption do not penalize individuals who save. Sales taxes in the U.S. and value added taxes abroad are familiar examples of consumption taxes.

18. © 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Will Consumption Taxes Lead to More Savings? Taxes have both a substitution effect and an income effect.Taxes have both a substitution effect and an income effect. Substitution effect: reducing the tax rate on savings provides direct incentives for increased saving.Substitution effect: reducing the tax rate on savings provides direct incentives for increased saving. Income effect: with lower tax rates on savings, individuals have more wealth and will consume more which means they will also save less.Income effect: with lower tax rates on savings, individuals have more wealth and will consume more which means they will also save less.

19. © 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Will Consumption Taxes Lead to More Savings? Whether savings increase or decrease when tax rates are cut, ultimately must be settled by careful research.Whether savings increase or decrease when tax rates are cut, ultimately must be settled by careful research. Although there has been much research on the effects of taxation on saving, it is far from conclusive.Although there has been much research on the effects of taxation on saving, it is far from conclusive.

20. © 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Are Consumption Taxes Fair? In practice, moving to a consumption tax system, for example by exempting the return on savings from the income tax, would have a major impact on the distribution of income in the economy.In practice, moving to a consumption tax system, for example by exempting the return on savings from the income tax, would have a major impact on the distribution of income in the economy. It is the wealthy individuals who save the most and earn income through interest, dividends, rents, and capital gains.It is the wealthy individuals who save the most and earn income through interest, dividends, rents, and capital gains. Capital assets are highly concentrated among the wealthy in the economy.Capital assets are highly concentrated among the wealthy in the economy.

21. © 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Share of Capital Gains by Income Income Class Share of Capital Gains $10,000-20,0002.6% $20,000-30,0002.9% $30,000-40,0004.4% $40,000-50,0003.4% $50,000-75,0009.0% $75,000-100,0008.5% $100,000-200,00015.7% $200,000 and over 56.8%