1. Theory and Reality

2. McGraw-Hill/Irwin © 2002 The McGraw-Hill Companies, Inc., All Rights Reserved. Theory and Reality Business cycles persist but aren’t as bad as they used to be.

3. McGraw-Hill/Irwin © 2002 The McGraw-Hill Companies, Inc., All Rights Reserved. Theory and Reality Economists place responsibility for the continuing problem of business cycles on real world “politics.”

4. McGraw-Hill/Irwin © 2002 The McGraw-Hill Companies, Inc., All Rights Reserved. Review of the Policy Levers Fiscal Policy Monetary Policy Supply-Side Policy

5. McGraw-Hill/Irwin © 2002 The McGraw-Hill Companies, Inc., All Rights Reserved. The Policy Levers

6. McGraw-Hill/Irwin © 2002 The McGraw-Hill Companies, Inc., All Rights Reserved. Fiscal Policy The use of government taxes and spending to alter macroeconomic outcomes.

7. McGraw-Hill/Irwin © 2002 The McGraw-Hill Companies, Inc., All Rights Reserved. Automatic Stabilizers When the economy slows, tax revenues decline, and government spending increases automatically.

8. McGraw-Hill/Irwin © 2002 The McGraw-Hill Companies, Inc., All Rights Reserved. Automatic Stabilizers Automatic stabilizers are federal expenditure or revenue items that automatically responds counter- cyclically to changes in national income. –Examples include unemployment benefits and income taxes.

9. McGraw-Hill/Irwin © 2002 The McGraw-Hill Companies, Inc., All Rights Reserved. Recessions Automatically: Reduce tax revenues when the economy slows. Increase government outlays when the economy slows. Widens budget deficits during recessions.

10. McGraw-Hill/Irwin © 2002 The McGraw-Hill Companies, Inc., All Rights Reserved. Fiscal Policy Milestones

11. McGraw-Hill/Irwin © 2002 The McGraw-Hill Companies, Inc., All Rights Reserved. Fiscal Policy Milestones

12. McGraw-Hill/Irwin © 2002 The McGraw-Hill Companies, Inc., All Rights Reserved. Fiscal Policy Milestones

13. McGraw-Hill/Irwin © 2002 The McGraw-Hill Companies, Inc., All Rights Reserved. Fiscal Policy Milestones

14. McGraw-Hill/Irwin © 2002 The McGraw-Hill Companies, Inc., All Rights Reserved. Discretionary Policy Fiscal policy refers to deliberate changes in tax or spending legislation.

15. McGraw-Hill/Irwin © 2002 The McGraw-Hill Companies, Inc., All Rights Reserved. Discretionary Policy Discretionary policy often has limited impacts on the economy.

16. McGraw-Hill/Irwin © 2002 The McGraw-Hill Companies, Inc., All Rights Reserved. Limited Impact of Discretionary Policy The federal budget deficit jumped from $221 billion in 1991 to $270 billion in 1992 –Most of this was due to automatic stabilizers.

17. McGraw-Hill/Irwin © 2002 The McGraw-Hill Companies, Inc., All Rights Reserved. Limited Impact of Discretionary Policy In 1996 and 1997, the budget deficit shrank more rapidly than expected. –The economy grew faster than anticipated. –Tax revenues increased and transfer payments declined. –Most of this was due to automatic stabilizers.

18. McGraw-Hill/Irwin © 2002 The McGraw-Hill Companies, Inc., All Rights Reserved. Monetary Policy The use of money and credit controls to influence macroeconomic activity.

19. McGraw-Hill/Irwin © 2002 The McGraw-Hill Companies, Inc., All Rights Reserved. Monetary Policy Tools of monetary policy: –Open-market operations –Discount rate changes –Reserve requirement changes

20. McGraw-Hill/Irwin © 2002 The McGraw-Hill Companies, Inc., All Rights Reserved. Monetary Policy The money supply (M1) includes currency held by the public, plus balances in transactions accounts.

21. McGraw-Hill/Irwin © 2002 The McGraw-Hill Companies, Inc., All Rights Reserved. Monetary Policy Effectiveness of both fiscal and monetary policy depends on the shape of the AS curve.

22. McGraw-Hill/Irwin © 2002 The McGraw-Hill Companies, Inc., All Rights Reserved. Monetary Policy If AS is horizontal, changes in the money supply affect output only. If AS is vertical, changes in the money supply affect prices only.

23. McGraw-Hill/Irwin © 2002 The McGraw-Hill Companies, Inc., All Rights Reserved. Monetary Policy If AS is upward sloping, changes in the money supply affect both prices and output.

24. McGraw-Hill/Irwin © 2002 The McGraw-Hill Companies, Inc., All Rights Reserved. Rules vs. Discretion Disagreements about the actual shape of the AS curve raise questions about how to conduct monetary policy.

25. McGraw-Hill/Irwin © 2002 The McGraw-Hill Companies, Inc., All Rights Reserved. Rules vs. Discretion There are clear risks of error in discretionary policy. There are concerns about potential effectiveness of monetary policy.

26. McGraw-Hill/Irwin © 2002 The McGraw-Hill Companies, Inc., All Rights Reserved. Rules vs. Discretion Some economists urge the Fed to play an active role in adjusting the money supply to changing economic conditions.

27. McGraw-Hill/Irwin © 2002 The McGraw-Hill Companies, Inc., All Rights Reserved. Rules vs. Discretion Others suggest that we would be better served by fixed rules for money-supply growth.

28. McGraw-Hill/Irwin © 2002 The McGraw-Hill Companies, Inc., All Rights Reserved. Monetary-Policy Milestones

29. McGraw-Hill/Irwin © 2002 The McGraw-Hill Companies, Inc., All Rights Reserved. Monetary-Policy Milestones

30. McGraw-Hill/Irwin © 2002 The McGraw-Hill Companies, Inc., All Rights Reserved. Monetary-Policy Milestones

31. McGraw-Hill/Irwin © 2002 The McGraw-Hill Companies, Inc., All Rights Reserved. Monetary-Policy Milestones

32. McGraw-Hill/Irwin © 2002 The McGraw-Hill Companies, Inc., All Rights Reserved. Monetary-Policy Milestones

33. McGraw-Hill/Irwin © 2002 The McGraw-Hill Companies, Inc., All Rights Reserved. Supply-Side Policy The use of tax rates, (de)regulation, and other mechanisms to increase the ability and willingness to produce goods and services.

34. McGraw-Hill/Irwin © 2002 The McGraw-Hill Companies, Inc., All Rights Reserved. Supply-Side Policy The shape of aggregate supply curve limits the effectiveness of fiscal and monetary policy.

35. McGraw-Hill/Irwin © 2002 The McGraw-Hill Companies, Inc., All Rights Reserved. Supply-Side Policy Goal of a supply-side policy is to shift the aggregate supply curve to the right.

36. McGraw-Hill/Irwin © 2002 The McGraw-Hill Companies, Inc., All Rights Reserved. Supply-Side Policy The supply-side toolbox is filled with a variety of tools.

37. McGraw-Hill/Irwin © 2002 The McGraw-Hill Companies, Inc., All Rights Reserved. Supply-Side Toolbox Tax cuts to stimulate work effort, saving, and increase investment.

38. McGraw-Hill/Irwin © 2002 The McGraw-Hill Companies, Inc., All Rights Reserved. Supply-Side Toolbox Deregulation may reduce production cost and stimulate investment.

39. McGraw-Hill/Irwin © 2002 The McGraw-Hill Companies, Inc., All Rights Reserved. Supply-Side Toolbox Expenditures on education training and research expands capacity to produce.

40. McGraw-Hill/Irwin © 2002 The McGraw-Hill Companies, Inc., All Rights Reserved. Supply-Side Toolbox Immigration policies alter the size and skill of labor force thus affecting aggregate supply.

41. McGraw-Hill/Irwin © 2002 The McGraw-Hill Companies, Inc., All Rights Reserved. Supply-Side Policy Milestones

42. McGraw-Hill/Irwin © 2002 The McGraw-Hill Companies, Inc., All Rights Reserved. Supply-Side Policy Milestones

43. McGraw-Hill/Irwin © 2002 The McGraw-Hill Companies, Inc., All Rights Reserved. Supply-Side Policy Milestones

44. McGraw-Hill/Irwin © 2002 The McGraw-Hill Companies, Inc., All Rights Reserved. Supply-Side Policy Milestones

45. McGraw-Hill/Irwin © 2002 The McGraw-Hill Companies, Inc., All Rights Reserved. Supply-Side Policy Milestones

46. McGraw-Hill/Irwin © 2002 The McGraw-Hill Companies, Inc., All Rights Reserved. Idealized Uses Fiscal, monetary, and supply-side tools are potentially powerful levers. –In principle, they can cure the excesses of the business cycle.

47. McGraw-Hill/Irwin © 2002 The McGraw-Hill Companies, Inc., All Rights Reserved. Case 1: Recession Need to put people to work. The GDP gap needs to be closed. –The GDP gap is the difference between full-employment output and the amount of output demanded at current price levels.

48. McGraw-Hill/Irwin © 2002 The McGraw-Hill Companies, Inc., All Rights Reserved. Case 1: Recession: Keynesians Emphasize the need to stimulate aggregate demand with fiscal policy. –Cut taxes –Increase government spending

49. McGraw-Hill/Irwin © 2002 The McGraw-Hill Companies, Inc., All Rights Reserved. Case 1: Recession: Keynesians The resulting stimulus will set off a multiplier reaction. –The multiplier is the multiple by which an initial change in aggregate spending will alter total expenditure after an infinite number of spending cycles.

50. McGraw-Hill/Irwin © 2002 The McGraw-Hill Companies, Inc., All Rights Reserved. Case 1: Recession: Keynesians Neo-Keynesians acknowledge that monetary policy might also help if it gives investment a boost.

51. McGraw-Hill/Irwin © 2002 The McGraw-Hill Companies, Inc., All Rights Reserved. Case 1: Recession: Monetarists See no point in discretionary policies. –Aggregate supply curve is vertical at “natural” rate of unemployment. –Changes in fiscal or monetary policy ineffective because increases in AD only cause inflation.

52. McGraw-Hill/Irwin © 2002 The McGraw-Hill Companies, Inc., All Rights Reserved. Case 1: Recession: Monetarists The appropriate response to a recession is patience.

53. McGraw-Hill/Irwin © 2002 The McGraw-Hill Companies, Inc., All Rights Reserved. Case 1: Recession: Supply- Siders Policy initiatives should change shape and position of aggregate supply curve. –Improve production incentives. –Reduce government regulation. –Cut marginal tax rates on investment and labor.

54. McGraw-Hill/Irwin © 2002 The McGraw-Hill Companies, Inc., All Rights Reserved. Case 2: Inflation: Keynesians Need to restrain aggregate demand. –Raise taxes –Cut government spending –Rely on multiplier to cool economy

55. McGraw-Hill/Irwin © 2002 The McGraw-Hill Companies, Inc., All Rights Reserved. Case 2: Inflation: Monetarists Inflation reflects excessive money- supply growth. –Cut money supply growth. –Convince market participants that cautious monetary policy will be continued.

56. McGraw-Hill/Irwin © 2002 The McGraw-Hill Companies, Inc., All Rights Reserved. Case 2: Inflation: Supply-Siders Inflation implies “too much money” and “not enough goods.” –Expand productive capacity. –Provide incentives to save. –Cut taxes and regulations and lower import barriers.

57. McGraw-Hill/Irwin © 2002 The McGraw-Hill Companies, Inc., All Rights Reserved. Case 3: Stagflation Stagflation is the simultaneous occurrence of substantial unemployment and inflation.

58. McGraw-Hill/Irwin © 2002 The McGraw-Hill Companies, Inc., All Rights Reserved. Case 3: Stagflation There are no simple solutions for stagflation. –Need to balance competing threats of inflation and unemployment.

59. McGraw-Hill/Irwin © 2002 The McGraw-Hill Companies, Inc., All Rights Reserved. Case 3: Stagflation Stagflation may be due to structural unemployment. –Structural unemployment is caused by a mismatch between the skills (or location) of job seekers and the requirements (or location) of available jobs.

60. McGraw-Hill/Irwin © 2002 The McGraw-Hill Companies, Inc., All Rights Reserved. Case 3: Stagflation Possible contributors to stagflation. –High tax rates or costly regulation. –“External shocks” such as natural disasters or an abrupt change in world trade (an oil embargo). –Leftward shift of aggregate supply.

61. McGraw-Hill/Irwin © 2002 The McGraw-Hill Companies, Inc., All Rights Reserved. P2P2 Q2Q2 AS 1 P1P1 REAL OUTPUT (real GDP per time period) PRICE LEVEL (average price per unit of output) QFQF AS 2 Full employment QUQU Stagflation AD

62. McGraw-Hill/Irwin © 2002 The McGraw-Hill Companies, Inc., All Rights Reserved. Fine-Tuning Some people believe it is possible to fine tune the economy. –Fine tuning refers to adjustments in economic policy designed to counteract small changes in economic outcomes.

63. McGraw-Hill/Irwin © 2002 The McGraw-Hill Companies, Inc., All Rights Reserved. Fine-Tuning Fine-tuning entails continual adjustments of policy levers.

64. McGraw-Hill/Irwin © 2002 The McGraw-Hill Companies, Inc., All Rights Reserved. Fine-Tuning Choosing the right target for stimulus and restraint is key to fulfilling goals.

65. McGraw-Hill/Irwin © 2002 The McGraw-Hill Companies, Inc., All Rights Reserved. The Economic Record The economy has had impressive long- run growth and improvement in standard of living.

66. McGraw-Hill/Irwin © 2002 The McGraw-Hill Companies, Inc., All Rights Reserved. The record 0 2 4 6 8 10 12 UNEMPLOYMENT RATE (percent) 194819501955196019651970197519801985199019952000 The goal The Economic Record: Unemployment Rate

67. McGraw-Hill/Irwin © 2002 The McGraw-Hill Companies, Inc., All Rights Reserved. The goal The record 1948 3 RATE OF INFLATION (percent) 2000 0 2 4 6 8 10 12 –2 14 16 1950195519601965197019751980198519901995 The Economic Record: Rate of Inflation

68. McGraw-Hill/Irwin © 2002 The McGraw-Hill Companies, Inc., All Rights Reserved. The goal 19481950 RATE OF REAL GROWTH (percent) 2000195519601965197019751980198519901995 2 4 6 8 10 –2 0 The record The Economic Record: Rate of Real Growth

69. McGraw-Hill/Irwin © 2002 The McGraw-Hill Companies, Inc., All Rights Reserved. Why Things Don’t Always Work Four obstacles to policy success: –Goal conflicts –Measurement problems –Design problems –Implementation problems

70. McGraw-Hill/Irwin © 2002 The McGraw-Hill Companies, Inc., All Rights Reserved. Goal Conflicts Traditionally the guardian of price stability, the Fed favors policy restraint. The President and Congress favor policy stimulus.

71. McGraw-Hill/Irwin © 2002 The McGraw-Hill Companies, Inc., All Rights Reserved. Goal Conflicts Distributional goals may conflict with macro objectives. –Anti-inflationary policies may require cutbacks for poor, the elderly, or needy students.

72. McGraw-Hill/Irwin © 2002 The McGraw-Hill Companies, Inc., All Rights Reserved. Goal Conflicts Tight-money policies may be viewed as too great a burden for small businesses. All policy decisions entail opportunity costs.

73. McGraw-Hill/Irwin © 2002 The McGraw-Hill Companies, Inc., All Rights Reserved. Measurement Problems Measurement problems are a very basic policy constraint. Available data is always dated and incomplete.

74. McGraw-Hill/Irwin © 2002 The McGraw-Hill Companies, Inc., All Rights Reserved. Measurement Problems At best, we know what was happening in the economy last month or last week.

75. McGraw-Hill/Irwin © 2002 The McGraw-Hill Companies, Inc., All Rights Reserved. Forecasts In designing policy, policymakers must depend on economic forecasts.

76. McGraw-Hill/Irwin © 2002 The McGraw-Hill Companies, Inc., All Rights Reserved. Macro Models Forecasts are based on complex computer models of how the economy works. Different models and data generate different policy recommendations.

77. McGraw-Hill/Irwin © 2002 The McGraw-Hill Companies, Inc., All Rights Reserved. Design Problems We never know for sure how market participants are going to respond to any specific actions taken.

78. McGraw-Hill/Irwin © 2002 The McGraw-Hill Companies, Inc., All Rights Reserved. Implementation Problems It may be difficult to implement a well- designed (and credible) policy initiative.

79. McGraw-Hill/Irwin © 2002 The McGraw-Hill Companies, Inc., All Rights Reserved. Congressional Deliberations The legislative process takes time.

80. McGraw-Hill/Irwin © 2002 The McGraw-Hill Companies, Inc., All Rights Reserved. Congressional Deliberations Even if the right policy is formulated to solve an emerging economic problem, there is no assurance that it will be implemented.

81. McGraw-Hill/Irwin © 2002 The McGraw-Hill Companies, Inc., All Rights Reserved. Congressional Deliberations If policy is implemented, there is no assurance that it will take effect at the right time.

82. McGraw-Hill/Irwin © 2002 The McGraw-Hill Companies, Inc., All Rights Reserved. Problem emerges Policy impact noticeable Problem recognized Response formulated Action taken Policy Response: A Series of Time Lags

83. McGraw-Hill/Irwin © 2002 The McGraw-Hill Companies, Inc., All Rights Reserved. Politics vs. Economics Tax hikes and budget cuts rarely win votes. Tax cuts and pork-barrel spending tend to make voters happy.

84. McGraw-Hill/Irwin © 2002 The McGraw-Hill Companies, Inc., All Rights Reserved. Political Business Cycle Politicians tend to stimulate the economy before elections and tighten fiscal restraints afterward. Creates a political business cycle — a two year pattern of short-run stops and starts.

85. McGraw-Hill/Irwin © 2002 The McGraw-Hill Companies, Inc., All Rights Reserved. Hands Off or Hands On? Consistent fine-tuning of economy is not compatible with either design capabilities or our decision-making procedures.

86. McGraw-Hill/Irwin © 2002 The McGraw-Hill Companies, Inc., All Rights Reserved. Hands Off or Hands On? We have not been able to make adjustments to completely fulfill our economic goals.

87. McGraw-Hill/Irwin © 2002 The McGraw-Hill Companies, Inc., All Rights Reserved. Hands-Off Policy Those who argue to leave the economy alone: –Abandon discretionary policies because fine-tuning isn’t really possible. –Milton Friedman advocates fixed policy rules. –Based on practical arguments more than on theory.

88. McGraw-Hill/Irwin © 2002 The McGraw-Hill Companies, Inc., All Rights Reserved. Hands-On Policy Those who support continued fine- tuning: –Emphasize the historical record of prices, employment and growth improvements. –With fixed rules it is impossible to maintain steady rate of money supply growth.

89. McGraw-Hill/Irwin © 2002 The McGraw-Hill Companies, Inc., All Rights Reserved. Modest Expectations Discretionary policies will continue to be used and continue to fall short of complete success.

90. McGraw-Hill/Irwin © 2002 The McGraw-Hill Companies, Inc., All Rights Reserved. Theory and Reality End of Chapter 16