1. Chapter 16: Theory and Reality
This chapter discusses the tools of macro policy and how they are used. It also compares the advantages of using discretionary policy versus a laissez faire policy.
McGraw-Hill/Irwin
Copyright © 2009 by The McGraw-Hill Companies, Inc. All Rights Reserved.

2. Theory and Reality
Business cycles persist but are not as bad as they used to be.
Economists place responsibility for the continuing problem of business cycles on real world “politics”.
Business cycles persist but aren’t as bad as they used to be. Today the economy fluctuates less than it used to. Economists place responsibility for the continuing problem of business cycles on real world “politics”. So politics influences the business cycle.
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3. Policy Tools
The three policy tools are fiscal policy, monetary policy, and supply-side policy.
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4. Fiscal Policy
Fiscal policy is the use of government taxes and spending to alter macroeconomic outcomes.
Fiscal policy is the use of government taxes and spending to alter macroeconomic outcomes. As stated earlier, fiscal policy deals with changes in government spending or taxes to stabilize the economy.
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5. Automatic Stabilizers
When the economy slows, tax revenues decline, and government spending increases automatically.
When the economy slows, tax revenues decline, and government spending increases automatically. This happens “automatically”.
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6. Automatic Stabilizers
Automatic stabilizers are federal expenditure or revenue items that automatically respond counter-cyclically to changes in national income.
Examples include unemployment benefits and income taxes
Automatic stabilizers are federal expenditure or revenue items that automatically respond counter-cyclically to changes in national income. Automatic stabilizers help smooth out the economy “automatically”, without action by anyone. Examples include unemployment benefits and income taxes.
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7. Automatic Stabilizers
When the economy slows, recessions automatically:
Reduce tax revenues
Increase government outlays
Widen budget deficits
When the economy slows, recessions automatically reduce tax revenues, increase government outlays, and widen budget deficits. Again, these things happen naturally, resulting in a deficit.
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8. Discretionary Policy
Fiscal policy refers to deliberate changes in tax or spending legislation.
Discretionary policy often has limited impacts on the economy.
Fiscal policy refers to deliberate changes in tax or spending legislation. Discretionary means deliberately or intentionally doing something. An example is if Congress passed a tax cut. Discretionary policy often has limited impacts on the economy.
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9. Discretionary Policy
The federal budget deficit jumped from $221 billion in fiscal year 1991 to $270 billion in fiscal year 1992.
The fiscal year (FY) is the 12-month period used for accounting purposes.
Most of this increase was due to automatic stabilizers.
The federal budget deficit jumped from $221 billion in fiscal year 1991 to $270 billion in fiscal year The fiscal year (FY) is the 12-month period used for accounting purposes. The fiscal year goes from October 1st of one year to September 30th of the following year. Most of this increase was due to automatic stabilizers.
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10. Monetary Policy
Monetary policy–the use of money and credit controls to influence macroeconomic activity.
The tools of monetary policy include:
Open-market operations
Discount-rate changes
Reserve requirements
Monetary policy is the use of money and credit controls to influence macroeconomic activity. As stated earlier, monetary policy deals with changes in the money supply by the Fed. The tools of monetary policy include open-market operations, discount-rate changes, and reserve requirements.
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11. Monetary Policy
The money supply (M1) includes currency held by the public, plus balances in transactions accounts.
The effectiveness of both fiscal and monetary policy depends on the shape of the AS curve.
The money supply (M1) includes currency held by the public, plus balances in transactions accounts. M1 is the most narrow and basic definition of the money supply. The effectiveness of both fiscal and monetary policy depends on the shape of the AS curve.
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12. Monetary Policy
If the AS curve is horizontal, changes in the money supply affect output only.
If the AS curve is vertical, changes in the money supply affect prices only.
If the AS curve is upward sloping, changes in the money supply affect both prices and output.
If the AS curve is horizontal, changes in the money supply affect output only. If the AS curve is vertical, changes in the money supply affect prices only. If the AS curve is upward sloping, changes in the money supply affect both prices and output. Depending on the shape of the AS curve, monetary policy will have different effects.
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13. Rules versus Discretion
Disagreements about the actual shape of the AS curve raise questions about how to conduct monetary policy.
There are clear risks of error in discretionary policy.
There are concerns about the potential effectiveness of monetary policy.
Disagreements about the actual shape of the AS curve raise questions about how to conduct monetary policy. There are clear risks of error in discretionary policy. There are concerns about the potential effectiveness of monetary policy. Discretionary policy may not always be effective and mistakes may be made.
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14. Rules versus Discretion
Some economists urge the Fed to play an active role in adjusting the money supply to changing economic conditions.
Others suggest that we would be better served by fixed rules for money-supply growth.
Some economists urge the Fed to play an active role in adjusting the money supply to changing economic conditions. Others suggest that we would be better served by fixed rules for money-supply growth. This is the debate as to whether the Fed should play an active or passive role with regard to monetary policy.
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15. Supply-Side Policy
The shape of the aggregate supply curve limits the effectiveness of fiscal and monetary policies.
Supply-Side Policy–the use of tax rates, (de)regulation, and other mechanisms to increase the ability and willingness to produce goods and services.
The shape of the aggregate supply curve limits the effectiveness of fiscal and monetary policies. Supply-side policy is the use of tax rates, (de)regulation, and other mechanisms to increase the ability and willingness to produce goods and services. This is also called supply-side economics.
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16. Supply-Side Policy
The goal of a supply-side policy is to shift the aggregate supply curve to the right.
The supply-side toolbox is filled with a variety of tools.
These include tax cuts designed to stimulate work effort, saving, and investment.
The goal of a supply-side policy is to shift the aggregate supply curve to the right. The supply-side toolbox is filled with a variety of tools. These include tax cuts designed to stimulate work effort, saving, and investment. The idea behind supply-side policy is that tax cuts will raise production and increase AS.
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17. Supply-Side Policy
Deregulation may also reduce production costs and stimulate investment.
Expenditures on education, training, and research expands our capacity to produce.
Deregulation may also reduce production costs and stimulate investment. Expenditures on education, training, and research expands our capacity to produce. The idea is that deregulation will lower costs to businesses and allow them to produce more.
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18. Supply-Side Policy
Immigration policy alters the size and skills of the labor force and thus affects aggregate supply as well.
Immigration policy alters the size and skills of the labor force and thus affects aggregate supply as well. More immigration leads to more workers in the labor force.
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19. Idealized Uses
These fiscal, monetary, and supply-side tools are potentially powerful levers for controlling the economy.
In principle, they can cure the excesses of the business cycle.
These fiscal, monetary, and supply-side tools are potentially powerful levers for controlling the economy. In principle, they can cure the excesses of the business cycle. These three tools can correct the problems of the free market.
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20. Case 1: Recession Need to put people to work.
The GDP gap must be closed:
The GDP gap is the difference between full-employment output and the amount of output demanded at current price levels.
Case 1 is a recession. There is a need to put people to work and the GDP gap must be closed. The GDP gap is the difference between full-employment output and the amount of output demanded at current price levels. The cure for a recession is to increase spending and shift the aggregate demand curve to the right.
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21. Case 1: Recession: Keynesians
Emphasize the need to stimulate aggregate demand with fiscal policy by:
Cutting taxes
Boosting government spending
In this case, Keynesians <CANE-Z-INS> emphasize the need to stimulate aggregate demand with fiscal policy by cutting taxes or boosting government spending. Keynesians are strong believers in fiscal policy.
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22. Case 1: Recession: Keynesians
The resulting stimulus will set off a multiplier reaction:
Multiplier–multiple by which an initial change in aggregate spending will alter total expenditure after an infinite number of spending cycles.
The resulting stimulus will set off a multiplier reaction. The multiplier is the multiple by which an initial changes in aggregate spending will alter total expenditure after an infinite number of spending cycles. The multiplier is like a domino effect which causes a chain reaction in the economy.
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23. Case 1: Recession: Keynesians
Modern Keynesians acknowledge that monetary policy might also help if it gives investment spending a further boost.
Modern Keynesians acknowledge that monetary policy might also help if it gives investment spending a further boost. They think that monetary policy can help do the job.
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24. Case 1: Recession: Monetarists
See no point in discretionary policies.
The aggregate supply curve is vertical at the natural rate of unemployment
Changes in fiscal or monetary policy are ineffective because increases in AD only cause inflation
The appropriate response to a recession is patience.
The Monetarists see no point in discretionary policies. They believe the aggregate supply curve is vertical at the natural rate of employment. Changes in fiscal or monetary policy are ineffective because increases in AD only cause inflation. The appropriate response to a recession is patience. They believe in laissez faire, just like Adam Smith.
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25. Case 1: Recession: Supply-Siders
Believe that policy initiatives should focus on changing the shape and position of the aggregate supply curve.
Improve production incentives
Cut marginal tax rates on investment and labor
Reduce government regulation
Supply-siders believe that policy initiatives should focus on changing the shape and position of the aggregate supply curve. They emphasize the need to improve production incentives, to cut marginal tax rates on investment and labor, and to reduce government regulation. Supply-siders believe that tax cuts and deregulation will increase aggregate supply.
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26. Case 2: Inflation: Keynesians
Need to restrain aggregate demand by:
Raising taxes
Cutting government spending
Relying on the multiplier to cool down the economy
Case 2 is inflation. Keynesians say there is a need to restrain aggregate demand by raising taxes, cutting government spending, and relying on the multiplier to cool down the economy. Inflation is caused by “too much money chasing too few goods”, so the solution is to decrease spending.
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27. Case 2: Inflation: Monetarists
Believe that inflation reflects excessive money-supply growth.
Cut the money supply growth
Convince market participants that cautious monetary policy will be continued
Monetarists believe that inflation reflects excessive money-supply growth. They would cut the money supply growth and convince market participants that cautious monetary policy will be continued. By decreasing the money supply, this will reduce spending.
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28. Case 2: Inflation: Supply-Siders
Point out that inflation implies both too much money and not enough goods.
Expand productive capacity
Propose more incentives to save
Cut taxes and regulations, encourage more immigration, and lower import barriers
Supply-siders point out that inflation implies both too much money and not enough goods. They would expand productive capacity, propose more incentives to save, cut taxes and regulations, encourage more immigration, and lower import barriers. Again, tax cuts and deregulation are the answers.
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29. Case 3: Stagflation
Stagflation is the simultaneous occurrence of substantial unemployment and inflation.
There are no simple solutions for stagflation.
There is a need to balance the competing threats of inflation and unemployment
Case 3 is stagflation. Stagflation is the simultaneous occurrence of substantial unemployment and inflation. Stagflation is a combination of the words stagnation and inflation. There are no simple solutions for stagflation. There is a need to balance the competing threats of inflation and unemployment.
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30. Case 3: Stagflation Stagflation may be due to structural unemployment:
Structural unemployment–unemployment caused by a mismatch between the skills (or location) of job seekers and the requirements (or location) of available jobs.
Stagflation may be due to structural unemployment. Structural unemployment is unemployment caused by a mismatch between the skills (or location) of job seekers and the requirements (or location) of available jobs. As explained earlier, this is unemployment due to mismatched or inappropriate job skills.
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31. Case 3: Stagflation
There are several possible contributors to stagflation:
High tax rates or costly regulation.
An external shock (such as a natural disaster) or an abrupt change in world trade (such as higher oil prices).
The result is a leftward shift of the aggregate supply curve.
There are several possible contributors to stagflation. They include high tax rates or costly regulation, an external shock (such as a natural disaster), or an abrupt change in world trade (such as higher oil prices). The result is a leftward shift of the aggregate supply curve. Stagflation means a decrease in AS, resulting in an increase in the price level and a decrease in the quantity of output.
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32. Fine-Tuning
Some people believe it is possible to fine-tune the economy:
Fine-tuning–adjustments in economic policy designed to counteract small changes in economic outcomes; continuous responses to changing economic conditions.
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 or continuous responses to changing economic conditions. Fine-tuning means manipulating or tweaking the economy to make it better.
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33. Fine-Tuning
Fine-tuning entails continual adjustments of policy levers.
Choosing the right target for stimulus and restraint is the key to fulfilling goals.
Fine-tuning entails continual adjustments of policy levers. Choosing the right target for stimulus and restraint is the key to fulfilling goals. Fine-tuning can be difficult.
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34. The Economic Record
The economy’s track record does not live up to these high expectations.
The economy has had impressive long-run growth and improvement in the standard of living, but we must also recognize that our economic history has experienced periods of recession, high unemployment, and inflation.
The economy’s track record does not live up to these high expectations. The economy has had impressive long-run growth and improvement in the standard of living, but we must also recognize that our economic history has experienced periods of recession, high unemployment, and inflation. In reality, the economy has good times as well as bad times.
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35. Why Things Don’t Always Work
We can distinguish four obstacles to policy success:
Goal conflicts
Measurement problems
Design problems
Implementation problems
We can distinguish four obstacles to policy success. They are goal conflicts, measurement problems, design problems, and implementation problems. There are several things that explain why things don’t always work.
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36. Goal Conflicts
The Fed is traditionally viewed as the guardian of price stability and tends to favor policy restraint.
The President and Congress favor policy stimulus.
The Fed is traditionally viewed as the guardian of price stability and tends to favor policy restraint. The President and Congress favor policy stimulus. The Fed tends to have different goals than the President and Congress. The result is that they may work against each other.
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37. Goal Conflicts
Distributional goals may also conflict with macro objectives.
Anti-inflationary policies may require cutbacks in programs for the poor, the elderly, or needy students.
Distributional goals may also conflict with macro objectives. Anti-inflationary policies may require cutbacks in programs for the poor, the elderly, or needy students. Sometimes painful choices or trade-offs must be made.
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38. Goal Conflicts
Tight-money policies may be viewed as too great a burden for small businesses.
All policy decisions entail opportunity costs.
This means that we will always be confronted with trade-offs.
Tight-money policies may be viewed as too great a burden for small businesses. All policy decisions entail opportunity costs. This means that we will always be confronted with trade-offs.
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39. Measurement Problems
The available information is always dated and incomplete.
At best, we know what was happening in the economy last month or last week.
The available information is always dated and incomplete. At best, we know what was happening in the economy last month or last week. In the real world, there often is not access to perfect information. This leads to measurement problems.
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40. Forecasts
In designing policy, policymakers must depend on economic forecasts, that is, informed guesses about what the economy will look like in future periods.
In designing policy, policymakers must depend on economic forecasts, that is, informed guesses about what the economy will look like in future periods. It involves a lot of “guesstimates” about the future.
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41. Macro Models
Those guesses are often based on complex computer models of how the economy works.
Different models and data generate different policy recommendations.
Those guesses are often based on complex computer models of how the economy works. Different models and data generate different policy recommendations. Different scenarios may give different recommendations to policymakers.
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42. Design Problems
We never know for sure how market participants are going to respond to any specific actions taken.
We never know for sure how market participants are going to respond to any specific actions taken. Consumers might not do the right thing for the economy.
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43. Implementation Problems
To understand fully why things go wrong, we must also consider the difficulties of implementing a well-designed (and credible) policy initiative.
To understand fully why things go wrong, we must also consider the difficulties of implementing a well-designed (and credible) policy initiative.
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44. Congressional Deliberations
The legislative process takes time.
Even if the right policy is formulated to solve an emerging economic problem, there is no assurance that it will be implemented.
And if it is implemented, there is no assurance that it will take effect at the right time.
The legislative process takes time. Even if the right policy is formulated to solve an emerging economic problem, there is no assurance that it will be implemented. And if it is implemented, there is no assurance that it will take effect at the right time. There are time lags involved in every step of the process which may reduce the policy’s effectiveness.
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45. Politics versus Economics
Tax hikes and budget cuts rarely win votes.
On the other hand, tax cuts and pork-barrel spending are always popular.
Tax hikes and budget cuts rarely win votes. On the other hand, tax cuts and pork-barrel spending are always popular. It is difficult to raise taxes and cut spending, because voters don’t like it.
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46. Politics versus Economics
Savvy politicians tend to stimulate the economy before elections, then tighten the fiscal restraints afterward.
This creates a political business cycle–a two-year pattern of short-run stops and starts.
Savvy politicians tend to stimulate the economy before elections, then tighten the fiscal restraints afterward. This creates a political business cycle, a two-year pattern of short-run stops and starts. The political business cycle means that politicians may manipulate the economy to make themselves look good in order to gain votes.
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47. Hands Off or Hands On?
Consistent fine-tuning of the economy is not compatible with either our design capabilities or our decision-making procedures.
We have not been able to make adjustments to completely fulfill our economic goals.
Consistent fine-tuning of the economy is not compatible with either our design capabilities or our decision-making procedures. We have not been able to make adjustments to completely fulfill our economic goals.
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48. Hands-Off Policy
Those who argue to leave the economy alone say to abandon discretionary policies altogether because fine-tuning isn’t really possible.
Milton Friedman advocated fixed-policy rules instead of discretionary policies.
Those who argue to leave the economy alone say to abandon discretionary policies altogether because fine-tuning isn’t really possible. Milton Friedman advocated fixed-policy rules instead of discretionary policies. This represents a laissez faire or hands-off policy.
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49. Hands-On Policy
Those who support continued fine-tuning emphasize that the historical record of prices, employment, and growth has improved since active fiscal and monetary policies were adopted.
With fixed rules it is impossible to maintain a steady rate of money supply growth.
Those who support continued fine-tuning emphasize that the historical record of prices, employment, and growth has improved since active fiscal and monetary policies were adopted. With fixed rules it is impossible to maintain a steady rate of money supply growth. This represents a hands-on policy.
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50. Modest Expectations
Discretionary policies will continue to be used and continue to fall short of complete success.
Discretionary policies will continue to be used and continue to fall short of complete success. Discretionary policies are the norm, but they are far from perfect.
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51. Theory and Reality End of Chapter 16
In conclusion, this chapter explained the three tools of macro policy- fiscal policy, monetary policy, and supply-side policy. It also looked at the pros and cons of each. There is no such thing as a “perfect” policy tool.
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