1. Theory and Reality
Chapter 19

2. Introduction
The purpose of macroeconomic theory is to explain the business cycle and show how to control it.
Business Cycle – Alternating periods of economic growth and contraction.

3. Introduction This chapter answers the following questions:
What is the ideal “package” of macro policies?
How well does our macro performance live up to the promises of that package?
What kind of obstacles prevents us from doing better?

4. Policy Levers
The macroeconomic tools available to policymakers are summarized in the following table.

5. Policy Levers

6. 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.

7. Fiscal policy
Tax cuts are supposed to stimulate spending by putting more income in the hands of consumers and businesses.

8. Fiscal policy
Tax increases are intended to curtail spending and reduce inflationary pressures.

9. Fiscal policy
Increases in government spending raise aggregate demand and so encourage more production.

10. Fiscal policy
A slowdown in government spending is supposed to restrain aggregate demand and lessen inflationary pressures.

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

12. Who Makes Fiscal Policy?
Automatic stabilizers are a basic countercyclical feature.
Automatic stabilizers are federal expenditure or revenue items that automatically responds countercyclically to changes in national income.

13. 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.

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

15. 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.

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

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

18. 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.

19. Who Makes Monetary Policy?
Twice a year the Fed provides Congress with a broad overview of the economy.

20. Who Makes Monetary Policy?
The Fed’s assessment is updated each month at meetings of the Federal Open Market Committee (FOMC).
The FOMC decides which monetary-policy levers to pull.

21. Supply-Side Policy
The focus of supply-side policy is to provide 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.

22. Supply-Side Policy
Supply-side economists argue that marginal tax rates and government regulation must be reduced to get more output without inflation.

23. Who Makes Supply-Side Policy?
Because tax rates are a basic tool of supply-side policy, fiscal and supply-side policies are often intertwined.

24. Who Makes Supply-Side Policy?
Deciding whether to increase spending is a fiscal-policy decision.
Deciding how to spend may entail supply-side policy.

25. Idealized Uses
Fiscal, monetary, and supply-side tools are potentially powerful levers for controlling the economy.
To see how, let us review their use in three distinct macroeconomic settings.

26. Case 1: Recession
Output and employment levels are far short of the economy’s full-employment potential.
Aggregate demand must be increased to close the recessionary GDP gap.
Recessionary GDP gap – The difference between full-employment GDP and equilibrium GDP.

27. Case 1: Recession
Keynesians emphasize the need to increase aggregate demand by cutting taxes or boosting government spending.

28. Case 1: Recession
The resulting stimulus will set off a multiplier reaction.
Multiplier – The multiple by which an initial change in aggregate spending will alter total expenditure after an infinite number of spending cycles; 1/(1-MPC).

29. Case 1: Recession
Modern Keynesians acknowledge that monetary policy might also help.
Increases in the money supply may lower interest rates and give the economy a further boost.

30. Case 1: Recession
Monetarists see no point in toying with the federal budget.
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.

31. Case 1: Recession
In the Monetarists view, the appropriate response to a recession is patience.

32. Case 1: Recession
Supply-siders emphasize the need to improve production incentives.
They would:
Cut marginal tax rates on investment and labor.
Reduce government regulation.
Focus any government spending on long-run capacity expansion.

33. Case 2: Inflation
Keynesians would close the inflationary GDP gap by shifting the aggregate demand curve to the left through higher taxes and lower government spending.
Inflationary GDP gap — The amount by which equilibrium GDP exceeds full-employment GDP.

34. Case 2: Inflation
Keynesians would also see the desirability of increasing interest rates to curb investment spending.

35. 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.

36. 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.

37. Case 3: Stagflation
Often attempting to address one of the two problems will make the other problem worse.

38. Case 3: Stagflation
Knowing the cause of stagflation can help develop appropriate fiscal and monetary tools.

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

40. 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.

41. Fine-Tuning
At one time, it was widely believed that it was possible to fine-tune the economy to assure prosperity.

42. Fine-Tuning
Fine-tuning refers to adjustments in economic policy designed to counteract small changes in economic outcomes; continuous responses to changing economic conditions.

43. The Economic Record
The economy’s track record does not live up to the high expectations of “fine-tuning.”

44. The Economic Record
Over the postwar period, the record includes nine years of outright recession and another nineteen years of growth recession.

45. 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.

46. The Economic Record
The economic performance of the United States in the 1990s was better than other Western nations.
Some countries did a better job of restraining prices or reducing unemployment.

47. The Economic Record Unemployment 12 1948 1950 1955 1960 1965 1970 1975
1980
1985
1990
1995
Inflation
Growth 8 4
2000 16
The record
The goal
The record
The goal
The record
The goal

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

49. Goal Conflicts
Most often goal conflicts originate in the short-run trade-off between unemployment and inflation.

50. 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.

51. 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.

52. Goal Conflicts
Since we live in a world of scarce resources, all policy decisions entail opportunity costs.

53. 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.

54. 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.

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

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

57. 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.

58. Leading Indicators
Unfortunately, the logical sequence of events doesn’t always unfold as anticipated.

59. Crystal Balls
Many people disregard economists’ forecast and indulge in their own personal “system” or their crystal balls.

60. Policy and Forecasts
The task of forecasting the economic future is made still more complex by the interdependency of forecasts, policy decisions, and economic outcomes.

61. Policy and Forecasts Budget projections Economic forecasts
Policy decisions
External shocks

62. 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.

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

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

65. Time Lags
Even if the right policy is formulated to solve an emerging economic problem, 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.

66. 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.

67. Policy impact noticeable
A Series of Time Lags
Problem emerges
Policy impact noticeable
Problem recognized
Response formulated
Action taken

68. Politics vs. Economics
A particular policy may be correct in view of the economy but might never be enacted due to political pressures.

69. 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.

70. Politics vs. Economics
Rather than political risks, Congress and the President often rely on the Fed to take the unpopular actions necessary to fight inflation.

71. Hands On or Hands Off?
We can conclude that consistent fine-tuning of the economy is not compatible with either our design capabilities or our decision-making procedures.

72. Hands Off
The case for a hands-off policy stance is based on practical, not theoretical, arguments.

73. Hands Off
Everyone agrees that discretionary policies could result in better economic performance.

74. Hands Off
Some argue that the practical requirements of monetary and fiscal management are too demanding and thus prone to failure.

75. 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.

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

77. 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.

78. New Classical Economics
Under rational expectations, the only policy that works is one that surprises people.

79. 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.

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

81. Hands On
It is difficult to determine if the stability is from discretionary policies or other changes or both.

82. Modest Expectations
The clamor for fixed policy rules is more a rebuke of past policy than a viable policy alternative.
We really have no choice but to pursue discretionary policies.

83. Modest Expectations
If public policy can create a few more jobs, a better mix of output, a little more growth and price stability, or an improved distribution of income, those initiatives are worthwhile.

84. Theory and Reality
End of Chapter 19