Transcript Theory versus Reality

13e
Chapter 18:
Theory versus Reality
McGraw-Hill/Irwin
Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved.
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.
18-3
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.
18-5
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.
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