Theory versus RealityChapter 18

Copyright © 2010 by the McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin

18-2

Theory versus Reality

• No matter how hard we try to eliminate it, the business cycle seems to persist– What’s 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?

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The Policy ToolsType of Policy Policy Instruments

Fiscal Tax cuts and increases Changes in government spending

Monetary Open market operations Reserve requirements Discount rates

Supply-side Tax incentives for investment and saving Deregulation Human-capital investment Infrastructure development Free trade Immigration

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Fiscal Policy

• Fiscal policy: The use of government taxes and spending to alter macroeconomic outcomes

• Fiscal policy refers to deliberate changes in tax or spending legislation

18-5

Who Makes Fiscal Policy?

• Fiscal policy expands or shrinks the structural deficit to give the economy a shot of fiscal stimulus or fiscal restraint– Structural deficit: Federal revenues at full

employment minus expenditures at full employment under prevailing fiscal policy

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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

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Monetary Policy

• Monetary Policy: The use of money and credit controls to influence macroeconomic outcomes

• Monetary policy tools include – Open-market operations– Discount-rate changes– Reserve requirements

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Monetary Policy

• Keynesians believe that interest rates are the critical policy lever

• Monetarists believe money supply is the critical variable 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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Who Makes Monetary Policy?

• Monetary policy is made by the Federal Reserve’s Board of Governors

• Twice a year the Fed provides Congress with a broad overview of the economic outlook and monetary objectives

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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 incentives, (de)regulation, and other mechanisms to increase the ability and willingness to produce goods and services

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Who Makes Supply-Side Policy?

• Supply-siders argue that marginal tax rates and government regulation must be reduced in order to get more output without added inflation

• Deciding whether to increase spending is a fiscal policy decision; deciding how to spend available funds may entail supply-side policy

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Idealized Uses

• Fiscal, monetary, and supply-side tools are potentially powerful levers for controlling the economy

• Depending on the situation, they can cure the excesses of the business cycle and promote faster economic growth

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Case 1: Recession

• Output and employment levels are far short of the economy’s full-employment potential

• Keynesians emphasize need to increase aggregate demand by cutting taxes or boosting government spending– Modern Keynesians acknowledge that monetary

policy might also help

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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

• As sales and output slow, interest rates will decline and new investment will be stimulated

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Case 1: Recession

• Supply-siders emphasize the need to improve production incentives– Cut marginal tax rates on investment and labor– Reduce government regulation– Focus any government spending on long-run

capacity expansion

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Case 2: Inflation

• Keynesians would address an inflationary GDP gap by raising taxes and lowering government spending, shifting AD leftward– Keynesians would also increase interest rates to

curb investment spending

• Monetarists would simply cut the money supply

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Case 2: Inflation

• Supply-siders would point out that inflation implies both “too much money” and “not enough goods”

• Look at the supply side of the market for ways to expand productive capacity

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Case 3: Stagflation

• Stagflation is much more of a gray area, since attempting to address recession or inflation individually can make the other problem worse– Stagflation: The simultaneous occurrence of

substantial unemployment and inflation

• Knowing the causes of stagflation may help achieve the desired balance

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Case 3: Stagflation

• If prices are rising before full employment is reached there may be structural unemployment

• High taxes or costly regulations might contribute to stagflation

• Stagflation may arise from an external shock

• No familiar policy tool is likely to provide a complete cure

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Fine-Tuning

• At one time, it was felt that policy could fine-tune the economy to assure prosperity– Fine-tuning: Adjustments in economic policy

designed to counteract small changes in economic outcomes; continuous responses to changing economic conditions

• The economy’s track record does not live up to the high expectations of fine-tuning

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The Economic Record

– Economic history is punctuated by periods of recession, high unemployment, inflation, and recurring concern for the distribution of income and mix of output

Source: Economic Report of the President, 2009 and Congressional Budget Office

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The Economic Record

18-23

Why Things Don’t Always Work

• Four obstacles to policy success:– Goal conflicts– Measurement problems– Design problems– Implementation problems

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Goal Conflicts

• Most often goal conflicts originate in short-run trade-off between unemployment and inflation

• 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

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Goal Conflicts

• Distributional goals may conflict with macro objectives– Anti-inflationary policies may require cutbacks in

programs for the poor, the elderly, or others– These cutbacks may be politically impossible

• All policy decisions entail opportunity costs

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Measurement Problems

• The processes of data collection, assembly, and presentation take time

• At best, we know what was happening in the economy last month or last week

• An average recession lasts about 11 months, but official data generally don’t confirm its existence until 8 months after one begins

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Forecasts

• In designing policy, policymakers must depend on economic forecasts — informed guesses about what the economy will look like in future periods

• Those guesses are often based on econometric macro models, which are mathematical summaries of the economy’s performance

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Leading Indicators and Crystal Balls

• Many people prefer to use leading indicators– Leading indicators are things we can observe

today that are logically linked to future production– One of the most popular is the Index of Leading

Economic Indicators

• Others disregard economists’ forecasts and use their own “crystal balls”

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Policy and Forecasts

• Forecasting the economic future is made more complex because forecasts, policy decisions, and economic outcomes are interdependent

Budget projections

Policy decisions

Economic forecasts

External shocks

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External Shocks

• An external shock can disrupt the economy and ruin economic forecasts

• The very nature of external shocks is that they are unanticipated

18-31

Design Problem

• Suppose the outlook is bad and we want to steer the economy past looming dangers

• We need to design an economic plan

• It is difficult to predict how market participants will respond to any specific economic policy action

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Implementation Problems

• Even if the right policy is formulated, there is no assurance it will be implemented

• Congressional deliberations can stall or derail fiscal policy

• Even if it is implemented, there is no assurance that it will take effect at the right time

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Time Lags

• There is a danger that the policy will get enacted well after the problem it was created to fix is gone

Problem emerges

Policy impact

noticeable

Problem recognized

Response formulated

Action taken

Delay

Delay

Delay

Delay

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Politics vs. Economics

• A particular policy may be right for the economy but might never be enacted due to political pressures

• Congress tends to hold fiscal policy hostage to electoral concerns

• Politicians often rely on the Fed to take the unpopular actions necessary to fight inflation

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Hands On or Hands Off?

• We haven’t been able to make all the minor adjustments necessary to fulfill our goals completely

• Everyone agrees that discretionary policies could result in better economic performance

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Hands On or Hands Off?

• Some argue that the practical requirements of monetary and fiscal management are too demanding and thus prone to failure

• Proponents of a hands-on policy admit the possibility of occasional blunders, but emphasize the greater risks of doing nothing when the economy is faltering

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Hands On or Hands Off?

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

• Even though it’s impossible to reach all our goals, we can’t abandon conscientious attempts to get as close as possible

Theory versus RealityEnd of Chapter 18

Copyright © 2010 by the McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin