CHAPTER 30 Policy Timing, Deficit Targeting, and Stock Market Effects © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 1 of 31 PowerPoint Lectures for Principles of Economics, 9e By Karl E. Case, Ray C. Fair & Sharon M. Oster ; ;

CHAPTER 30 Policy Timing, Deficit Targeting, and Stock Market Effects © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 2 of 31

CHAPTER 30 Policy Timing, Deficit Targeting, and Stock Market Effects © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 3 of 31 Time Lags Regarding Monetary andFiscal PolicyStabilizationRecognition LagsImplementation LagsResponse LagsFiscal Policy: Deficit TargetingThe Effects of Spending Cuts on the DeficitEconomic Stability and Deficit ReductionSummaryThe Stock Market and the EconomyStocks and BondsDetermining the price of a StockThe Stock Market Since 1948Stock Market Effects on the Economy CHAPTER OUTLINE Policy Timing, Deficit Targeting, and Stock Market Effects 30 PART VI FURTHER MACROECONOMICS ISSUES

CHAPTER 30 Policy Timing, Deficit Targeting, and Stock Market Effects © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 4 of 31 Time Lags Regarding Monetary and Fiscal Policy stabilization policy Describes both monetary and fiscal policy, the goals of which are to smooth out fluctuations in output and employment and to keep prices as stable as possible. A stabilization policy can be either monetary or fiscal policy One of the main problems economic policymakers face is time lags. Time lags are delays in the economy’s response to stabilization policies.

CHAPTER 30 Policy Timing, Deficit Targeting, and Stock Market Effects © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 5 of 31 Time Lags Regarding Monetary and Fiscal Policy Path A is less stable—it varies more over time—than path B. Other things being equal, society prefers path B to path A.  FIGURE 30.1 Two Possible Time Paths for GDP

CHAPTER 30 Policy Timing, Deficit Targeting, and Stock Market Effects © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 6 of 31 Time Lags Regarding Monetary and Fiscal Policy Attempts to stabilize the economy can prove destabilizing because of time lags. An expansionary policy that should have begun to take effect at point A does not actually begin to have an impact until point D, when the economy is already on an upswing. Hence, the policy pushes the economy to points E 1, and F 1, (instead of points E and F). Income varies more widely than it would have if no policy had been implemented.  FIGURE 30.2 Possible Stabilization Timing Problems Stabilization

CHAPTER 30 Policy Timing, Deficit Targeting, and Stock Market Effects © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 7 of 31 Time Lags Regarding Monetary and Fiscal Policy Response Lags response lag The time that it takes for the economy to adjust to the new conditions after a new policy is implemented; the lag that occurs because of the operation of the economy itself.

CHAPTER 30 Policy Timing, Deficit Targeting, and Stock Market Effects © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster Time Lags Regarding Monetary and Fiscal Policy Recognition Lags 1.The recognition lag is the time it takes for policy makers to recognize the existence of a boom or a slump. 2.National income data is available only once a quarter. In addition, there are different estimates of each quarter’s economic performance. a.The preliminary estimate is released about one month after the end of the quarter. b.The revised estimate is released about two months after the end of the quarter.. d.Even the final estimate is subject to future revisions as more data becomes available. 8 of 31

CHAPTER 30 Policy Timing, Deficit Targeting, and Stock Market Effects © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster Implementation Lags The implementation lag is the time it takes to put the desired policy into effect once economists and policy makers recognize that the economy is in a boom or a slump. Fiscal policy takes some time to start.. A majority of each house plus the president must agree there is a problem and then agree on what should be done about it. Monetary policy is decided by the 12 voting members of the Federal Open Market Committee. Since this group is well-trained and experienced in economics, banking, and finance, they will usually reach an agreement quickly. For all these reasons, the implementation lag for monetary policy is generally much shorter than for fiscal policy. 9 of 31

CHAPTER 30 Policy Timing, Deficit Targeting, and Stock Market Effects © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 10 of 31 Response Lags The response lag is the time that it takes for the economy to adjust to the new conditions after a new policy is implemented; the lag that occurs because of the operation of the economy itself.

CHAPTER 30 Policy Timing, Deficit Targeting, and Stock Market Effects © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 11 of 31 Response Lags for Fiscal Policy The easiest way to understand response lags for fiscal policy is to simply think about the multiplier process. The multiplier exists because one group ’ s spending is another group ’ s income. Increases in income are not spent immediately because the timing of income and spending are different. It takes about a year for a change in fiscal policy to have its full effect on the economy.

CHAPTER 30 Policy Timing, Deficit Targeting, and Stock Market Effects © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 12 of 31 Response Lags for Monetary Policy Changes in monetary policy change interest rates. The change in interest rates causes changes in planned investment and consumption spending. It takes quite a while for planned investment to respond to interest rate changes.

CHAPTER 30 Policy Timing, Deficit Targeting, and Stock Market Effects © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 13 of 31 Time Lags Regarding Monetary and Fiscal Policy Response Lags Summary Stabilization is not easily achieved. It takes time for policy makers to recognize the existence of a problem, more time for them to implement a solution, and yet more time for firms and households to respond to the stabilization policies taken. It takes about two years for a change in monetary policy to have its full effect on the economy.

CHAPTER 30 Policy Timing, Deficit Targeting, and Stock Market Effects © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 14 of 31 Fiscal Policy: Deficit Targeting Gramm-Rudman-Hollings Act Passed by the U.S. Congress and signed by President Reagan in 1986, this law set out to reduce the federal deficit by $36 billion per year, with a deficit of zero slated for The GRH legislation, passed in 1986, set out to lower the federal deficit by $36 billion per year. If the plan had worked, a zero deficit would have been achieved by  FIGURE 30.3 Deficit Reduction Targets under Gramm-Rudman-Hollings

CHAPTER 30 Policy Timing, Deficit Targeting, and Stock Market Effects © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 15 of 31 Fiscal Policy: Deficit Targeting The Effects of Spending Cuts on the Deficit To estimate the response of the deficit to changes in government spending, we need to decide how much a $1 change in government spending will change GDP and then see what happens to the deficit when GDP changes. The deficit response index (DRI) is the amount by which the deficit changes with a $1 change in GDP. The deficit does not fall dollar for dollar with a decrease in government spending; it will fall by less. The reason, of course, is that the reduction in G will cause income to fall, reducing tax revenue.

CHAPTER 30 Policy Timing, Deficit Targeting, and Stock Market Effects © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 16 of 31 Suppose we want to reduce the deficit by $20 billion. A $1 billion reduction in government spending will reduce income by about $1.40 billion (with a multiplier of 1.4). With a deficit response index of (based on U.S. data) the deficit rises by $0.22 billion for every $1 billion decrease in GDP. Suppose we cut government spending by $20 billion. This will reduce GDP by $20 x 1.4 = $28 billion. With a DRI of -0.22, the deficit will increase by -$28 x = $6.2 billion. The net change in the deficit will be $20 billion - $6.2 billion = $13.8 billion reduction.

CHAPTER 30 Policy Timing, Deficit Targeting, and Stock Market Effects © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 17 of 31 Fiscal Policy: Deficit Targeting The Effects of Spending Cuts on the Deficit Monetary Policy to the Rescue? Was Congress so poorly informed about macroeconomics that it would pass legislation like GRH that could not possibly work? If the Fed were to offset the effects of a decrease in government spending by increasing the money supply, the interest rate would fall and planned investment would be stimulated, offsetting the impact of the decrease in G. At the time GRH was passed this would have required a huge change in interest rates.

CHAPTER 30 Policy Timing, Deficit Targeting, and Stock Market Effects © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 18 of 31 Fiscal Policy: Deficit Targeting Economic Stability and Deficit Reduction negative demand shock Something that causes a negative shift in consumption or investment schedules or that leads to a decrease in a country exports. automatic stabilizers Revenue and expenditure items in the federal budget that automatically change with the economy in such a way as to stabilize GDP. automatic destabilizers Revenue and expenditure items in the federal budget that automatically change with the economy in such a way as to destabilize GDP.

CHAPTER 30 Policy Timing, Deficit Targeting, and Stock Market Effects © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 19 of 31 Fiscal Policy: Deficit Targeting Summary It is clear that the GRH legislation, the balanced-budget amendment, and similar deficit targeting measures have some undesirable macroeconomic consequences. Locking the economy into spending cuts during periods of negative demand shocks, as deficit-targeting measures do, is not a good way to manage the economy.

CHAPTER 30 Policy Timing, Deficit Targeting, and Stock Market Effects © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster The Stock Market and the Economy As recently as a decade ago macroeconomics could ignore the stock market because its impact on the economy was small (particularly in the short run). 20 of 31

CHAPTER 30 Policy Timing, Deficit Targeting, and Stock Market Effects © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster The Stock Market and the Economy Business Investment and Finance 1.Planned investment spending includes nonresidential fixed investment, business equipment, and residential fixed investment. 2.Investment projects are usually very large, often requiring external financing. a.Internal financing means payment out of retained earnings. b.External financing means some sort of instrument(s) must be issued to raise additional funds. 3.Types of external financing include bank loans, issuing bonds, and issuing stock. 21 of 31

CHAPTER 30 Policy Timing, Deficit Targeting, and Stock Market Effects © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 22 of 31 A stock is a certificate that certifies ownership of a certain portion of a firm. If the price of a stock increases since the stockholder bought it, the stockholder has a capital gain, an increase in the value of an asset. Capital gains exist only on paper. A realized capital gain is the gain that occurs when the owner of an asset actually sells it for more than he or she paid for it.

CHAPTER 30 Policy Timing, Deficit Targeting, and Stock Market Effects © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 23 of 31 One excellent sources of data is Yahoo! ( For example, Microsoft has 9.13 billion shares outstanding. If you happen to own 100 shares, you own percent of the Microsoft Corporation. Bill Gates and Steve Ballmer can still outvote you.

CHAPTER 30 Policy Timing, Deficit Targeting, and Stock Market Effects © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 24 of 31 The Stock Market and the Economy Determining the Price of a Stock Things that are likely to affect the price of a stock include: What people expect its future dividends will be. When the dividends are expected to be paid. The amount of risk involved.

CHAPTER 30 Policy Timing, Deficit Targeting, and Stock Market Effects © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster Types of stocks (1) Common stock is not guaranteed any cash income. While many stocks pay dividends and have paid them for a number of years, the payments are always made on the recommendation of the board of directors. 25 of 31

CHAPTER 30 Policy Timing, Deficit Targeting, and Stock Market Effects © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 26 of 31 (2) Most shares of stock are bought and sold in the secondary market, meaning the shares were not purchased directly from the company that issued them. These previously owned shares form the basis for most of the daily trading volume on the stock exchanges. The main participants in the secondary market are brokers and dealers.

CHAPTER 30 Policy Timing, Deficit Targeting, and Stock Market Effects © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 27 of 31 (3) If a firm wants to issue additional stock to help finance a project, that stock is sold in the primary market. The main participants in the primary market are investment banks. The process of selling new issues to investors is called underwriting. In the case of a new stock issue, this sale is an initial public offering (IPO). Dealers earn a commission that is built into the price of the security offering,

CHAPTER 30 Policy Timing, Deficit Targeting, and Stock Market Effects © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster Third markets Third markets are markets in which listed securities are traded over the counter by investors that are not listed with a stock exchange. Also known as an OTC or Over The Counter Market, the third market has traditionally been utilized as a means of trading large blocks of stocks between institutions. However, this is changing as more individual investors begin to explore third market transactions. 28 of 31

CHAPTER 30 Policy Timing, Deficit Targeting, and Stock Market Effects © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster Fourth market Fourth market trading is direct institution-to-institution ( B to B) trading without using the service of broker-dealers. It is impossible to estimate the volume of fourth market activity because trades are not subject to reporting requirements. Studies have suggested that several millions shares are traded per day. 29 of 31

CHAPTER 30 Policy Timing, Deficit Targeting, and Stock Market Effects © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 30 of 31 The Stock Market and the Economy The Stock Market Since 1948 Dow Jones Industrial Average An index based on the stock prices of 30 actively traded large companies. The oldest and most widely followed index of stock market performance. NASDAQ Composite An index based on the stock prices of over 5,000 companies traded on the NASDAQ Stock Market. The NASDAQ market takes its name from the National Association of Securities Dealers Automated Quotation System. Standard and Poor’s 500 (S&P 500) An index based on the stock prices of 500 of the largest firms by market value.

CHAPTER 30 Policy Timing, Deficit Targeting, and Stock Market Effects © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 31 of 31 The Stock Market and the Economy Stock Market Effects on the Economy An increase in stock prices causes an increase in wealth, and consequently an increase in consumer spending. Investment is also affected by higher stock prices. With a higher stock price, a firm can raise more money per share to finance investment projects.

CHAPTER 30 Policy Timing, Deficit Targeting, and Stock Market Effects © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster

CHAPTER 30 Policy Timing, Deficit Targeting, and Stock Market Effects © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster

CHAPTER 30 Policy Timing, Deficit Targeting, and Stock Market Effects © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 34 of 31 The Stock Market and the Economy Stock Market Effects on the Economy The Post-Boom Economy Both stock market wealth and housing wealth have important effects on the economy. Bubbles or RationalInvestors? Bernanke’s Bubble Laboratory: Princeton Protégés of Fed Chief Study the Economics of Manias Wall Street Journal

CHAPTER 30 Policy Timing, Deficit Targeting, and Stock Market Effects © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 35 of 31 automatic destabilizers automatic stabilizers capital gain deficit response index (DRI) Dow Jones Industrial Average Gramm-Rudman-Hollings Act implementation lag NASDAQ Composite REVIEW TERMS AND CONCEPTS negative demand shock realized capital gain recognition lag response lag stabilization policy Standard and Poor’s 500 (S&P 500) stock time lags