Transcript Theory versus Reality

Macro ECONOMIC
THEORY VS.
REALITY
Who makes the decision and what are the
choices?
18-1
Theory versus Reality
• Theory is supposed to explain the business cycle and how to
control it.
• What are our economic goals?
price stability
full employment
low inflation
economic growth
18-2
Policy Levers – Tools for
policymakers to use
• Fiscal Policy
• Monetary Policy
• Supply-side Policy
18-3
What are 3 basic questions
every economy asks?
• The answers to these questions as
applied for each of the levers can
change…
• I.e. under fiscal policy – W,H,F answers
would be different than under Supply
Side.
18-4
Many realities keep us from
reaching our economic goals:
–1. Conflicting advice comes from
Keynesians, monetarists, and supplysiders.
–2.Politics takes preference over
economics in Congress and the
presidency.
–3. A massive, unresponsive bureaucracy
exists.
18-5
Learning Objectives
•
Know what the tools of macro policy are.
• Know how the macro tools should work.
• . Know the constraints on policy
effectiveness.
18-6
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.
18-7
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.
18-8
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.
18-9
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.
18-10
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.
18-11
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.
18-12
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.
– (1980 7.1 unemployment, 12.5% inflation)
18-13
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.
– (late 50’s and early 60’s economy was so good the
idea of fine-tuning was created.) Not possible.
– Reality is: it is not possible to do.
18-14
Why Things Don’t Always
Work
• There are four obstacles to policy success
• Goal conflicts.
• Measurement problems.
• Design problems.
• Implementation problems.
18-15
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.
18-16
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. (computers)
• Some data (called leading indicators) tend to
predict turns in the business cycle. (break
down)
• External shocks are not predictable.
18-17
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?
18-18
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.
18-19
Hands on or Hands off???
• Hands on: proponents emphasize that there are
greater risks in doing nothing when the economy is
faltering. (witness depression.et.al.)
• They advocate active government intervention and
assure the country that the proposed “fix” implies
progress.
• Policy activists believe there is enough knowledge to
manipulate the economy through its troubles.
18-20
• Hands off: proponents argue that discretional
fiscal policy or monetary policy can help, but
the implementation problems are too great.
– New classical economics: the best way is for
government to provide a stable environment and
then get out of the way.
– Rational expectations: peoples’ spending actions
are based on available information, including
anticipating what the government will do. People
take actions to protect themselves, countering the
government’s action.
18-21
Know what the tools of macro
policy are.
•
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.
18-22
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.
18-23
Will the cycle ever
disappear?
18-24