1. McGraw-Hill/Irwin ©2008 The McGraw-Hill Companies, All Rights Reserved Theory and Reality Chapter 19

2. 2 Policy Tools There are three macroeconomic tools available to policymakers: Fiscal policy. Monetary policy. Supply-side policy. LO1

3. 3 Policy Tools LO1

4. 4 Fiscal Policy The basic tools of fiscal policy are contained in the federal budget. Fiscal policy is the use of government taxes and spending to alter macroeconomic outcomes. LO1

5. 5 Who Makes Fiscal Policy? Changes in taxes and government spending originate both in economic events and in explicit policy decisions. LO1

6. 6 Who Makes Fiscal Policy? Automatic stabilizers are federal expenditure or revenue items that automatically responds counter- cyclically to changes in national income. They act as a basic counter-cyclical feature of the federal budget. LO1

7. 7 Who Makes Fiscal Policy? Fiscal policy refers to deliberate changes in tax or spending legislation. Fiscal policy expands or shrinks the structural deficit to give the economy a shot of fiscal stimulus or fiscal restraint. LO1

8. 8 Who Makes Fiscal Policy? The structural deficit is federal revenues at full employment minus expenditures at full employment under prevailing fiscal policy. LO1

9. 9 Who Makes Fiscal Policy? Fiscal stimulus – Tax cuts or spending hikes intended to increase (shift) aggregate demand. Fiscal restraint – Tax hikes or spending cuts intended to reduce (shift) aggregate demand. LO1

10. 10 Monetary Policy Monetary Policy – The use of money and credit controls to influence macroeconomic activity. Monetary policy tools include open- market operations, discount-rate changes, and reserve requirements. LO1

11. 11 Monetary Policy Keynesians believe that interest rates are the critical policy lever. Monetarists believe the money supply is the critical variable. LO1

12. 12 Monetary Policy Monetarist believe the money supply should be expanded at a steady, predictable rate to ensure price stability and a natural rate of unemployment. Natural rate of unemployment – Long-term rate of unemployment determined by structural forces in labor and product markets. LO1

13. 13 Who Makes Monetary Policy? Monetary policy is made by the Federal Reserves Board of Governors. The Federal Open Market Committee decides which monetary- policy levers to pull. LO1

14. 14 Supply-Side Policy Supply-side policy focuses on incentives to work, invest, and produce. Supply-side policy – The use of tax rates, (de)regulation, and other mechanisms to increase the ability and willingness to produce goods and services. LO1

15. 15 Who Makes Supply-Side Policy? Fiscal and supply-side policies are often intertwined. Deciding whether to increase spending is a fiscal-policy decision. Deciding how to spend may entail supply-side policy. LO1

16. 16 Idealized Uses Fiscal, monetary, and supply-side tools are potentially powerful levers for controlling the economy. LO1

17. 17 Case 1: Recession Output and employment levels are far short of the economy’s full- employment potential. The recessionary GDP gap must be closed. Recessionary GDP gap – The amount by which equilibrium GDP falls short of full-employment GDP. LO2

18. 18 Case 1: Recession Keynesians emphasize the need to increase aggregate demand by cutting taxes or boosting government spending. Modern Keynesians acknowledge that monetary policy might also help. LO2

19. 19 Case 1: Recession In the Monetarists view, the appropriate response to a recession is patience. So long as the velocity of money (V) is constant, fiscal policy doesn’t matter. Velocity of money (V) – The number of times per year, on average, that a dollar is used to purchase final goods and services; PQ ÷ M. LO2

20. 20 Case 1: Recession Supply-siders would: Cut marginal tax rates on investment and labor. Reduce government regulation. Focus any government spending on long-run capacity expansion. LO2

21. 21 Case 2: Inflation Keynesians would close the inflationary GDP gap by raising taxes and lowering government spending. Keynesians would also increase interest rates to curb investment spending. Inflationary GDP gap — The amount by which equilibrium GDP exceeds full- employment GDP. LO2

22. 22 Case 2: Inflation Monetarists would simply cut the money supply. Supply-siders would look at the supply side of the market for ways to expand productive capacity. LO2

23. 23 Case 3: Stagflation Stagflation is much more of a gray area than recession or inflation individually. Stagflation – The simultaneous occurrence of substantial unemployment and inflation. Attempting to address one of the two problems will make the other problem worse. LO2

24. 24 Case 3: Stagflation If prices are rising before full employment is reached, there is likely to be some degree of structural unemployment. LO2

25. 25 Case 3: Stagflation High tax rates or costly regulations might contribute to stagflation. Stagflation may arise from an “external shock” like an earthquake or embargo. LO2

26. 26 Fine-Tuning At one time, it was widely believed that it was possible to fine-tune the economy to assure prosperity. Fine-tuning refers to adjustments in economic policy designed to counteract small changes in economic outcomes; continuous responses to changing economic conditions. LO2

27. 27 The Economic Record The economy’s track record does not live up to the high expectations of fine-tuning. Over the postwar period, the record includes nine years of outright recession and another nineteen years of growth recession.

28. 28 The Economic Record A growth recession is a period during which real GDP grows, but at a rate below the long-term trend of 3 percent.

29. 29 The Economic Record The economic performance of the U.S. has been better than other Western nations. Other economies haven’t have grown as fast or reduced unemployment as much as the U.S. Some countries have done a better job of restraining prices.

30. 30 The Economic Record

31. 31 The Economic Record

32. 32 The Economic Record

33. 33 Why Things Don’t Always Work There are four obstacles to policy success: Goal conflicts. Measurement problems. Design problems. Implementation problems. LO3

34. 34 Goal Conflicts Most often goal conflicts originate in the short-run trade-off between unemployment and inflation. All policy decisions entail opportunity costs. LO3

35. 35 Goal Conflicts The goal conflict is often institutionalized in the decision making process. The Fed is traditionally viewed as the guardian of price stability. The President and Congress worry more about people’s jobs and government programs. LO3

36. 36 Goal Conflicts Distributional goals may conflict with macro objectives. Anti-inflationary policies may require cutbacks in programs for the poor, the elderly, or needy students. These cutbacks may be politically impossible. LO3

37. 37 Measurement Problems The processes of data collection, assembly, and presentation take time, even in this age of high-speed computers. At best, we know what was happening in the economy last month or last week. LO3

38. 38 Measurement Problems The average recession lasts about 11 months, but official data generally do not even confirm the existence of a recession until 8 months after a downturn starts. LO3

39. 39 Forecasts In designing policy, policymakers must depend on economic forecasts, that is, informed guesses about what the economy will look like in future periods. LO3

40. 40 Macro Models Those guesses are often based on econometric macro models which are mathematical summaries of the economy’s past performance. LO3

41. 41 Leading Indicators Many people prefer to use leading indicators to divine the future. Leading indicators are things we can observe today that are logically liked to future production. LO3

42. 42 Crystal Balls Many people disregard economists’ forecast and indulge in their own personal system or their crystal balls. LO3

43. 43 Policy and Forecasts Forecasting the economic future is made more complex because forecasts, policy decisions, and economic outcomes are interdependent. LO3

44. 44 Policy and Forecasts Budget projections Policy decisions Economic forecasts External shocks LO3

45. 45 External Shocks An external shock can disrupt the economy and ruin economic forecasts. LO3

46. 46 Design Problem We need to chart our course — to design an economic plan. It is difficult to predict how market participants will respond to any specific economic policy action. LO3

47. 47 Implementation Problems A good idea has little value unless someone puts it to use. It is often difficult to implement a well-designed policy. LO3

48. 48 Congressional Deliberations Once the President decides on a policy, he must ask Congress to enact legislation to implement it. There is no guarantee that Congress will do so. LO3

49. 49 Time Lags Even if the right policy is formulated, there is no assurance it will be implemented. Even if it is implemented, there is no assurance that it will take effect at the right time. LO3

50. 50 Time Lags In fact, there is a danger that the policy will get enacted well after the problem it was created to fix is gone. LO3

51. 51 Time Lags Problem emerges Policy impact noticeable Problem recognized Response formulated Action taken LO3

52. 52 Politics vs. Economics A particular policy may be right for the economy but might never be enacted due to political pressures. LO3

53. 53 Politics vs. Economics Congress tends to hold fiscal policy hostage to electoral concerns. This has created a kind of policy- induced business cycle — a pattern of short-run stops and starts. LO3

54. 54 Politics vs. Economics Congress and the President often rely on the Fed to take the unpopular actions necessary to fight inflation. LO3

55. 55 Hands On or Hands Off? Consistent fine-tuning of the economy is not compatible with either our design capabilities or our decision-making procedures. LO3

56. 56 Hands Off Everyone agrees that discretionary policies could result in better economic performance. Some argue that the practical requirements of monetary and fiscal management are too demanding and thus prone to failure. LO3

57. 57 New Classical Economics According to the New Classical Economists, it is best for the government to provide a stable environment and then stay out of the way. LO3

58. 58 New Classical Economics This laissez-faire conclusion is based on the notion of rational expectations. Rational expectations – the hypothesis that people’s spending decisions are based on all available information, including the anticipated effects of government intervention. LO3

59. 59 New Classical Economics Acting on rational expectations, consumers anticipate the results of government policies and adapt immediately. Thus rendering the policy ineffective. The only policy that works is one that surprises people. LO3

60. 60 Hands On Proponents of a hands-on policy admit the possibility of occasional blunders. They emphasize the greater risks of doing nothing when the economy is faltering. LO3

61. 61 Hands On Historically, the economy has been much more stable during the time of discretionary policy (as opposed to earlier times). LO3

62. 62 Hands On It is difficult to determine if the stability is from discretionary policies or other changes or both. The clamor for fixed policy rules is more a rebuke of past policy than a viable policy alternative. LO3

63. 63 Modest Expectations Public policy initiatives are worthwhile if they: create a few more jobs, a better mix of output, a little more growth and price stability, and/or an improved distribution of income. LO3

64. McGraw-Hill/Irwin ©2008 The McGraw-Hill Companies, All Rights Reserved Theory and Reality End of Chapter 19