1. 18 Theory versus Reality LO18-1 LO18-2 LO18-3
The tools of macro policy
How macro tools should work
The constraints on policy effectiveness

2. Theory versus Reality
Theory is supposed to explain the business cycle and how to control it.
Many realities keep us from reaching our economic goals:
Conflicting advice comes from Keynesians, monetarists, and supply-siders.
Politics takes preference over economics in Congress and the presidency.
A massive, unresponsive bureaucracy exists.
This chapter summarizes macro policies and attempts to bring them into the real world.

3. Theory and Reality
In this chapter we look at the sources of these frustrations.
Specifically,
What is the ideal package of macro policies?
How well does our macro performance live up to the promises of that package?
What kinds of obstacles prevent us from doing better?

4. Available Policy Tools
Fiscal policy:
Tax cuts and increases.
Changes in government spending.
Monetary policy:
Open market operations.
Changes in reserve requirements.
Changes in discount rates.
Supply-side policy:
Tax incentives for saving and investment.
Deregulation.
Human capital investment.
Infrastructure development.
Free trade.
Immigration.
This is a summary slide collecting the various levers in each of the three policy tools.

5. Fiscal Policy
Automatic stabilizers: A basic countercyclical feature of the federal budget.
Discretionary fiscal policy: deliberate policy decisions made to expand (or shrink) the structural deficit and give the economy a shot of fiscal stimulus (or restraint).
Summarizes fiscal policy.

6. Monetary Policy The Fed’s Board of Governors makes monetary policy.
The Federal Open Market Committee pulls the levers.
Keynesians believe that changing interest rates are the critical policy lever to shift aggregate demand.
Monetarists believe that expanding the money supply at a steady, predictable rate is the critical policy tool.
Summarizes monetary policy.

7. Supply-Side Policy
A long-run policy to provide incentives to work, save, and invest.
Marginal tax rates and government regulations must be reduced to get more output without inflation.
The supply-side policy levers require changes in laws and regulations, so the Congress and the president must enact supply-side policy.
Fiscal and supply-side policies often get entwined.
Summarizes supply-side policy.

8. Idealized Uses: Recession
Goal: to close the recessionary GDP gap.
Keynesians: Increase AD by tax cuts or spending increases. Also, decrease interest rates to spur investment.
Monetarists: Fiscal policy doesn’t matter. The appropriate response is patience.
Supply-siders: Cut tax rates and reduce regulation to improve production incentives and long-run development.
This looks at the policies from a problem point of view – here, a recession.

9. Idealized Uses: Inflation
Goal: to close the inflationary GDP gap.
Keynesians: Decrease AD by raising taxes and cutting government spending.
Monetarists: Reduce the money supply.
Supply-siders: Expand productive capacity.
Here, for inflation.

10. Idealized Uses: Stagflation
Both inflation and unemployment are high, and economic growth is stagnant.
Fiscal restraint and tight money will reduce inflation but increase unemployment.
Fiscal stimulus and easy money will reduce unemployment but increase inflation.
If caused by adverse policy (high taxes, excessive regulation), supply-siders propose reversing those policies.
If caused by external forces (oil price spike, natural disaster), no policy can help much.
Here, for stagflation.

11. Fine-Tuning
Fine-tuning: policy adjustments designed to counteract small changes in economic outcomes.
In 1978 Congress set goals of 4% unemployment, 3% inflation, and 4% economic growth.
The reality is that government has difficulty making fine-tuning adjustments to meet these conflicting goals.
The term “fine-tuning” is a residual from early TV sets that had a channel selector surrounded by a dial that made the picture clearer. It fine-tuned the picture.
Keynesians championed fine-tuning to have policy makers continuously monitor the economy and “tweak” it when it seemed to move away from some ideal state.
Congress actually set these conflicting goals as the “ideal.”

12. The Economic Record
Here you can show recessions, recoveries, stagflation, and the changes in the variables . Also, you can contrast the goal with reality.

13. Why Things Don’t Always Work
There are four obstacles to policy success
Goal conflicts.
Measurement problems.
Design problems.
Implementation problems.
Described on the next slides.

14. Goal Conflicts
Fiscal policy has a trade-off between unemployment and inflation.
The Fed wants fiscal stability, but the president and Congress may be unwilling to raise taxes or cut spending.
Some cutbacks may become politically impossible to enact.
Opportunity cost: conflict between the benefit and the cost of a policy option.
You might remind your students that politics always trumps economics in any discussion.

15. Measurement Problems
Measuring the macro variables takes time, so the results are not available for a month or more.
Policymakers rely on economic forecasts made by “experts” using models that are tied to one theory or another.
Some data (e.g., Leading Economic Index) try to predict turns in the business cycle.
External shocks are not predictable.
The final report of GDP for the second quarter of each year does not become public until three months later. The second quarter ends in June, and that final report comes out in September. Preliminary reports in July and August will be revised by the later report.
This is the reason why expert forecasts are relied upon.

16. Design Problems
Once we think we know what the problem is, we must design a “fix” for the problem.
Should we take
The Keynesian approach?
The monetarist approach?
The supply-sider approach?
How will the marketplace respond to our plan?
We have looked at the various approaches. Each has its advocates. Which will be used depends on the number of people in power who advocate each approach as well as their ability to persuade the others.

17. Implementation Problems
Any “fix” must work through congressional deliberations and be approved by the president.
Once approved, will it be put into effect in a timely manner?
The time lag may be so great that a stimulus package may go into effect after a recession has ended.
Political pressure may preclude a correct “fix” from ever being passed.
Time is lost just getting the data. Time goes by as Congress deliberates. Time will pass as the bureaucracy implements the policy. More time goes by as the implemented policy hits the street. More time passes to get the multiplier effect to work.

18. Time Lags
It is highly possible that the impact of the policy may not occur until after the problem has begun to “fix” itself.

19. Application: The Economy Tomorrow
Hands on? Or Hands off?
Hands on: Policy activists emphasize that there are greater risks in doing nothing when the economy is faltering.
They advocate active government intervention and assure the country that the proposed “fix” implies progress.
They believe there is enough knowledge to manipulate the economy through its troubles.
Elected officials know they were sent to Washington to do something; doing nothing might not be an option. 19

20. Application: The Economy Tomorrow
Hands on? Or Hands off?
Hands off: proponents argue that discretional fiscal policy or monetary policy can help, but the implementation problems are too great.
New classical economics: government should provide a stable environment and then get out of the way.
Rational expectations: people anticipate what the government will do and take actions to protect themselves, countering the government’s action.
There is no prospect for this argument to be resolved in the near future.

21. Application: The Economy Tomorrow

22. Revisiting the Learning Objectives
LO18-1 Know what the tools of macro policy are
To end a recession, cut taxes, increase government spending, or expand the money supply.
To curb inflation, reverse each of those policy tools.
To overcome stagflation, combine fiscal and monetary levers with supply-side incentives.
Here we begin the review of the chapter.

23. Revisiting the Learning Objectives
LO18-2 Know how the macro tools should work
AD increases if we cut taxes, increase government spending, or expand the money supply.
AD decreases if we raise taxes, decrease government spending, or shrink the money supply.
AS increases if we reduce tax rates and decrease government regulation.

24. Revisiting the Learning Objectives
LO18-3 Know the constraints on policy effectiveness
Implementing macro policy is difficult due to several obstacles:
Goal conflicts.
Measurement problems.
Design problems.
Implementation problems.
This leads to the hands-on versus hands-off argument.

25. Looking Ahead: Chapter 19
International Trade
After learning about this chapter, you should know
What comparative advantage is.
What the gains from trade are.
How trade barriers affect prices, output, and incomes.