Chapter 18:Theory versus Reality

Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin

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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.

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Learning Objectives

• 18-01. Know what the tools of macro policy are.

• 18-02. Know how the macro tools should work.

• 18-03. Know the constraints on policy effectiveness.

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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.

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Fiscal Policy

• Changes due to automatic stabilizers are a basic countercyclical feature of the economy.

• Discretionary policy expands (or shrinks) the structural deficit and gives the economy a shot of fiscal stimulus (or restraint).– They are a result of deliberate policy decisions

made by the president and Congress.

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Monetary Policy

• The Fed’s Board of Governors makes monetary policy, with its Open Market Committee pulling the levers.– Keynesians believe that interest rates are the

critical policy lever to shift aggregate demand.– Monetarists believe that the money supply is the

critical policy tool and that it should be expanded at a steady, predictable rate to ensure price stability at the natural rate of unemployment.

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

incentives to work, save, and invest.– Marginal tax rates and government regulations

must be reduced to get more output without inflation.

• Since the supply-side policy levers require changes in laws and regulations, the Congress and the president enact supply-side policy.– Fiscal and supply-side policies often get entwined.

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Idealized Uses: Recession

• Goal: to close the recessionary GDP gap.– Keynesians want to increase AD by tax cuts or

spending increases. Also, they want falling interest rates to spur investment.

– Monetarists see no use in fiscal policy.• Their appropriate response is patience.

– Supply-siders would cut tax rates and reduce regulation. Any spending increase should focus on long-run development.

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Idealized Uses: Inflation• Goal: to close the inflationary GDP gap.– Keynesians would decrease AD by raising taxes

and cutting government spending.– Monetarists would reduce the money supply.– Supply-siders would look for ways to expand

productive capacity.• It is both “too much money” and “not enough goods.”• They propose incentives to save and not spend.• They would cut taxes and regulations that raise

production costs.

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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 stagflation is caused by adverse policy (high

taxes, excessive regulation), supply-siders propose reversing those policies.

– If stagflation is caused by external forces (oil price spike, natural disaster), no policy can help much.

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Fine-Tuning• Fine-tuning: policy adjustments designed to

counteract small changes in economic outcomes.

• In 1946 Congress committed the government to macro stability.– 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.

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Goal Conflicts• The trade-off between unemployment and

inflation is a fiscal policy goal conflict.• The Fed wants fiscal stability, while the

president and Congress may be unwilling to raise taxes or cut spending.

• Some cutbacks affect the neediest and become politically impossible to enact.

• All decisions have an opportunity cost, raising conflict between the benefits and the cost of a policy option.

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Measurement Problems

• Measuring the macro variables takes time, so the results are not available for a month or so.

• Policymakers rely on economic forecasts made by “experts” using models that are tied to one theory or another.

• Some data (called leading indicators) tend to predict turns in the business cycle.

• External shocks are not predictable.

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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?

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Implementation Problems• Any “fix” must work through congressional

deliberations and be approved by the president.

• Once approved, there is no assurance it will 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.