Transcript Chapter 26: Macroeconomic Issues and Policy

Macroeconomic Issues and Policy
Using the tools of macroeconomic analysis,
we take up five issues in this chapter:
1. The effects of the stock market in the economy;
2. The way the Federal Reserve (Fed) reacts to the
state of the economy;
3. The lags in the economy’s response to monetary
and fiscal policy changes;
4. The legislation concerned with the federal
government budget; and
5. The cyclical behavior since 1980 of the
economies of Japan and five European countries.
© 2002 Prentice Hall Business Publishing
Principles of Economics, 6/e
Karl Case, Ray Fair
The Effects of the Stock Market
on the Economy
• One of the main components of household
wealth is the value of stocks held by
households.
• When stock prices rise, household wealth
increases, and when stock prices fall,
household wealth decreases.
• Stock prices affect the economy by
affecting household wealth, which affects
household consumption.
© 2002 Prentice Hall Business Publishing
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Karl Case, Ray Fair
The Stock Market Crash
of October 1987
• The stock market crash of October 1987
represented a large drop in household
wealth.
• In practice, after a $1.00 decrease in
wealth, consumption seems to be lower in
each future year by about four cents, or 4
percent of the decrease in wealth.
• The $1 trillion decrease in wealth in 1987
implies a $40 billion lower level of
consumption in 1988, or 1 percent of GDP.
© 2002 Prentice Hall Business Publishing
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Karl Case, Ray Fair
The Stock Market Crash
of October 1987
• The life-cycle theory of consumption
predicts that households smooth their
consumption over time.
• A decrease in wealth will not decrease
consumption in the current year by the full
amount of the decrease in wealth.
Instead, they cut consumption a little each
year.
© 2002 Prentice Hall Business Publishing
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The Stock Market Crash
of October 1987
• The stock market crash of 1987 did not
result in a recession in 1988 because
households and business firms did not
lower their expectations drastically.
• Because the initial decrease in wealth
turned out to be temporary, the negative
wealth effect was not nearly as large as it
otherwise would have been.
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Karl Case, Ray Fair
The Stock Market
Boom of 1995 – 2000
Highlights of the stock market boom of 1995
– 2000 include the following:
• It was by far the largest stock market boom
in U.S. history.
• It added roughly $14 trillion to household
wealth, about $2.5 trillion per year.
• About 1.7 of the 4.5 percent increase in
the growth rate of real GDP was due to the
stock market boom.
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The Federal Reserve’s Response to
the State of the Economy
• The Fed is likely to increase the money supply
during times of low output and low inflation.
• The opposite is also true: The Fed is likely to
decrease the money supply during times of
high output and high inflation.
• Stagflation is a more difficult problem for the
Fed.
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The Fed’s Response to
Low Output/Low Inflation
• When the economy is
on the flat portion of
the AS curve, an
increase in the money
supply will lead to an
increase in output with
very little increase in
the price level.
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The Fed’s Response to
High Output/High Inflation
• When the economy is
on the relatively steep
portion of the AS
curve, the Fed is likely
to contract the money
supply. This will lead
to a decrease in the
price level, with little
decrease in output.
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The Fed’s Response to Stagflation
• Stagflation is a more difficult problem to solve.
• If the Fed expands the
money supply, output will
rise, but so will inflation.
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• If the Fed contracts the
money supply, inflation
will fall, but so will output.
Principles of Economics, 6/e
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The Behavior of the Fed During the
1990 – 1991 Recession
• After the Fed became convinced that a
recession was at hand, it responded by
engaging in open market operations to
lower interest rates.
• Inflation was not a problem, so the Fed
could expand the economy without
worrying about inflationary pressures.
© 2002 Prentice Hall Business Publishing
Principles of Economics, 6/e
Karl Case, Ray Fair
Data for Selected Variables for the
1989 – 2000 Period
Data for Selected Variables for the 1989 – 2000 Period
QUARTER
1989 I
II
III
IV
1990 I
II
III
IV
1991 I
II
III
IV
1992 I
II
III
IV
1993 I
II
III
IV
1994 I
II
III
IV
REAL GDP
GROWTH
RATE (%)
5.0
2.2
1.9
1.4
5.1
0.9
- 0.7
- 3.2
- 2.0
2.3
1.0
2.2
3.8
3.8
3.1
5.4
- 0.1
2.5
1.8
6.2
3.4
5.7
2.2
5.0
UNEMPLOYMENT INFLATION THREE-MONTH
RATE (%)
RATE (%)
T-BILL RATE
5.2
5.2
5.3
5.4
5.3
5.3
5.7
6.1
6.6
6.8
6.9
7.1
7.4
7.6
7.6
7.4
7.2
7.1
6.8
6.6
6.6
6.2
6.0
5.6
© 2002 Prentice Hall Business Publishing
4.3
4.0
2.9
3.1
4.5
4.7
3.9
3.5
4.7
2.9
2.5
2.3
3.1
2.2
1.3
2.5
3.4
2.2
1.8
2.3
2.0
1.8
2.4
1.9
8.5
8.4
7.9
7.6
7.8
7.8
7.5
7.0
6.1
5.6
5.4
4.6
3.9
3.7
3.1
3.1
3.0
3.0
3.0
3.1
3.3
4.0
4.5
5.3
Principles of Economics, 6/e
AAA
BOND
RATE
9.7
9.5
9.0
8.9
9.2
9.4
9.4
9.3
8.9
8.9
8.8
8.4
8.3
8.3
8.0
8.0
7.7
7.4
6.9
6.8
7.2
7.9
8.2
8.6
FEDERAL
GOVERNMENT
SURPLUS
SURPLUS/GDP
- 108.8
- 127.3
- 140.6
- 143.4
- 172.1
- 171.2
- 164.6
- 184.0
- 160.1
- 213.4
- 234.7
- 253.1
- 288.3
- 291.8
- 316.5
- 293.5
- 300.9
- 267.3
- 275.5
- 253.0
- 237.5
- 190.6
- 211.8
- 209.2
Karl Case, Ray Fair
- 0.020
- 0.023
- 0.025
- 0.026
- 0.030
- 0.030
- 0.028
- 0.031
- 0.027
- 0.036
- 0.039
- 0.042
- 0.047
- 0.046
- 0.050
- 0.045
- 0.046
- 0.041
- 0.041
- 0.037
- 0.034
- 0.027
- 0.030
- 0.029
Data for Selected Variables for the
1989 – 2000 Period
Data for Selected Variables for the 1989 – 2000 Period
QUARTER
1995 I
II
III
IV
1996 I
II
III
IV
1997 I
II
III
IV
1998 I
II
III
IV
1999 I
II
III
IV
2000 I
II
REAL GDP
GROWTH
RATE (%)
1.5
0.8
3.1
3.2
2.9
6.8
2.0
4.6
4.4
5.9
4.2
2.8
6.5
2.9
3.4
5.6
3.5
2.5
5.7
8.3
4.8
5.2
UNEMPLOYMENT INFLATION THREE-MONTH
RATE (%)
RATE (%)
T-BILL RATE
5.5
5.7
5.7
5.6
5.6
5.5
5.3
5.3
5.3
5.0
4.8
4.7
4.7
4.4
4.5
4.4
4.3
4.3
4.2
4.1
4.1
4.0
3.0
1.7
1.8
2.0
2.5
1.4
1.9
1.6
2.9
1.9
1.2
1.4
1.0
1.2
1.5
1.1
2.3
1.4
0.9
1.3
3.3
2.5
5.8
5.6
5.4
5.3
5.0
5.0
5.1
5.0
5.1
5.1
5.1
5.1
5.1
5.0
4.8
4.3
4.4
4.5
4.7
5.0
5.5
5.7
AAA
BOND
RATE
8.3
7.7
7.4
7.0
7.0
7.6
7.6
7.2
7.4
7.6
7.2
6.9
6.7
6.6
6.5
6.3
6.4
6.9
7.3
7.5
7.7
7.8
FEDERAL
GOVERNMENT
SURPLUS
SURPLUS/GDP
- 208.2
- 189.0
- 197.5
- 173.1
- 176.4
- 137.0
- 130.1
- 103.9
- 86.5
- 68.2
- 33.8
- 25.0
26.0
41.9
72.1
56.4
89.8
117.4
147.3
143.4
236.0
244.9
Note: The inflation rate is the percentage change in the GDP price index.
© 2002 Prentice Hall Business Publishing
Principles of Economics, 6/e
Karl Case, Ray Fair
- 0.029
- 0.026
- 0.027
- 0.023
- 0.023
- 0.018
- 0.017
- 0.013
- 0.011
- 0.008
- 0.004
- 0.003
0.003
0.005
0.008
0.006
0.010
0.013
0.016
0.015
0.024
0.025
Data for Selected Variables for the
1989 – 2000 Period
Data for Selected Variables for the 1989 – 2000 Period
QUARTER
1995 I
II
III
IV
1996 I
II
III
IV
1997 I
II
III
IV
1998 I
II
III
IV
1999 I
II
III
IV
2000 I
II
REAL GDP
GROWTH
RATE (%)
1.5
0.8
3.1
3.2
2.9
6.8
2.0
4.6
4.4
5.9
4.2
2.8
6.5
2.9
3.4
5.6
3.5
2.5
5.7
8.3
4.8
5.2
UNEMPLOYMENT INFLATION THREE-MONTH
RATE (%)
RATE (%)
T-BILL RATE
5.5
5.7
5.7
5.6
5.6
5.5
5.3
5.3
5.3
5.0
4.8
4.7
4.7
4.4
4.5
4.4
4.3
4.3
4.2
4.1
4.1
4.0
3.0
1.7
1.8
2.0
2.5
1.4
1.9
1.6
2.9
1.9
1.2
1.4
1.0
1.2
1.5
1.1
2.3
1.4
0.9
1.3
3.3
2.5
5.8
5.6
5.4
5.3
5.0
5.0
5.1
5.0
5.1
5.1
5.1
5.1
5.1
5.0
4.8
4.3
4.4
4.5
4.7
5.0
5.5
5.7
AAA
BOND
RATE
8.3
7.7
7.4
7.0
7.0
7.6
7.6
7.2
7.4
7.6
7.2
6.9
6.7
6.6
6.5
6.3
6.4
6.9
7.3
7.5
7.7
7.8
FEDERAL
GOVERNMENT
SURPLUS
SURPLUS/GDP
- 208.2
- 189.0
- 197.5
- 173.1
- 176.4
- 137.0
- 130.1
- 103.9
- 86.5
- 68.2
- 33.8
- 25.0
26.0
41.9
72.1
56.4
89.8
117.4
147.3
143.4
236.0
244.9
Note: The inflation rate is the percentage change in the GDP price index.
© 2002 Prentice Hall Business Publishing
Principles of Economics, 6/e
Karl Case, Ray Fair
- 0.029
- 0.026
- 0.027
- 0.023
- 0.023
- 0.018
- 0.017
- 0.013
- 0.011
- 0.008
- 0.004
- 0.003
0.003
0.005
0.008
0.006
0.010
0.013
0.016
0.015
0.024
0.025
The Behavior of the Fed
in 1993 and 1994
• During this period, inflation was not a
problem, so the Fed had room to stimulate
the economy and kept its expansionary
policy.
• By the end of 1993 the Fed was worried
about inflation problems in the future, and
decided to begin slowing down the
economy.
© 2002 Prentice Hall Business Publishing
Principles of Economics, 6/e
Karl Case, Ray Fair
The Behavior of the Fed
in 1995 – 1997
• Inflation did not become a problem after
1994, and the Fed lowered interest rates.
• The three-month Treasury bill rate
remained at roughly 5.0 percent
throughout 1996 and 1997.
• During this period, the economy
experienced good growth, low
unemployment, low inflation, and a
balanced government budget!
© 2002 Prentice Hall Business Publishing
Principles of Economics, 6/e
Karl Case, Ray Fair
The Behavior of the Fed
in 1998 – 2000
• Based on concerns about the Asian
financial crisis, the Fed lowered the bill
rate to 4.3 percent in the fourth quarter of
1998.
• The Asian crisis did not affect the U.S.
economy very much, and the Fed began
raising the bill rate on fears that the
economy might be overheating.
© 2002 Prentice Hall Business Publishing
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Lags in the Economy’s Response to
Monetary and Fiscal Policy
• Stabilization policy describes both
monetary and fiscal policy, the goals of
which are to smooth out fluctuations in
output and employment and to keep prices
as stable as possible.
• Time lags are delays in the economy’s
response to stabilization policies.
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Two Time Paths for GDP
Path A is less stable—it varies more over time—than
path B. Other things being equal, society prefers
path B to path A.
© 2002 Prentice Hall Business Publishing
Principles of Economics, 6/e
Karl Case, Ray Fair
Stabilization: “The Fool in the Shower”
• Attempts to stabilize the economy can prove
destabilizing because of time lags.
• Milton Friedman likened these attempts to a
“fool in the shower.” The shower starts out
cold, so the fool turns up the hot water.
Nothing happens right away, so he turns up
the hot water further. Then, the hot water
comes on and scalds him. And the same
thing happens when he starts turning on the
cold water.
© 2002 Prentice Hall Business Publishing
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Karl Case, Ray Fair
Stabilization: “The Fool in the Shower”
An expansionary policy that
should have begun to take
effect at point A does not
actually begin to have an
impact until point D, when the
economy is already on an
upswing. Hence, the policy
pushes the economy to points
F’ and G’ (instead of F and
G). Income varies more
widely than it would have if no
policy had been implemented.
© 2002 Prentice Hall Business Publishing
Principles of Economics, 6/e
Karl Case, Ray Fair
Types of Lags
• The recognition lag refers to the time it
takes for policy makers to recognize the
existence of a boom or a slump.
• The implementation lag is the time it takes
to put the desired policy into effect once
economists and policy makers recognize
that the economy is in a boom or a slump.
• The implementation lag for monetary policy
is generally much shorter than for fiscal
policy.
© 2002 Prentice Hall Business Publishing
Principles of Economics, 6/e
Karl Case, Ray Fair
Types of Lags
• The response lag is the time it takes for
the economy to adjust to the new conditions
after a new policy is implemented; the lag
that occurs because of the operation of the
economy itself.
• There is a delay in the multiplier process
because neither individuals nor firms revise
their spending plans instantaneously.
© 2002 Prentice Hall Business Publishing
Principles of Economics, 6/e
Karl Case, Ray Fair
Government Budget Policy
• The Gramm-RudmanHollings Bill, passed by
the U.S. Congress and
signed by President
Reagan in 1986, is a law
that set out to reduce the
federal deficit by $36 billion
per year, with a deficit of
zero slated for 1991.
• In practice, these targets
never came close to being
achieved.
© 2002 Prentice Hall Business Publishing
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The Effects of Spending Cuts
on the Deficit
• A cut in government
spending causes the
economy to contract.
Both the taxable
income of households
and the profits of firms
fall.
• The deficit tends to
rise when GDP falls,
and tends to fall when
GDP rises.
© 2002 Prentice Hall Business Publishing
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Karl Case, Ray Fair
The Effects of Spending Cuts
on the Deficit
• The deficit response index (DRI) is the
amount by which the deficit changes with a
$1 change in GDP.
• If the DRI equals -.22, for example, the
deficit rises by $0.22 billion for each $1
billion decrease in GDP.
• Spending cuts must be larger than the
deficit reduction we wish to achieve.
© 2002 Prentice Hall Business Publishing
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Economic Stability and
Deficit Reduction
•
Congress has two options:
1. Choose a target deficit and adjust
government spending and taxation to achieve
this target, or
2. Decide how much to spend and tax
regardless of the consequences on the
deficit.
•
A negative demand shock is something
that causes a negative shift in
consumption or investment schedules or
that leads to a decrease in U.S. exports.
© 2002 Prentice Hall Business Publishing
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Karl Case, Ray Fair
Economic Stability and
Deficit Reduction
•
Automatic stabilizers refer
to revenue and expenditure
items in the federal budget
that automatically change
with the economy in such a
way as to stabilize GDP.
© 2002 Prentice Hall Business Publishing
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Karl Case, Ray Fair
Economic Stability and
Deficit Reduction
•
Without deficit targeting, an increase in
the deficit caused by a negative demand
shock provides an automatic stabilizer
during contractions. Tax revenues
decrease, and transfer payments rise.
•
With deficit targeting, taxes could be
rising or government spending declining
while the economy is experiencing a
contraction. Deficit targeting measures
have undesirable macroeconomic
consequences.
© 2002 Prentice Hall Business Publishing
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Karl Case, Ray Fair
Deficit Targeting as an
Automatic Stabilizer
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Business Cycles in Other Countries
• The overall performance of the Japanese
economy was good until 1992, when the
growth rate slowed considerably, and the
unemployment rate rose.
• The Bank of Japan eased monetary policy.
By 1999, the short-term interest rate was
essentially zero, but this monetary-policy
stimulus was not sufficient to prevent the
slowdown from lasting a number of years.
© 2002 Prentice Hall Business Publishing
Principles of Economics, 6/e
Karl Case, Ray Fair
Business Cycles in Other Countries
• In the United Kingdom and other European
countries, a pattern of low or negative
growth in the early 1980s, and then again
in the early 1990s, has been accompanied
by a fairly high level of unemployment.
• Some say that the prevalence of high
unemployment rates is caused by
generous social welfare benefits in
Europe—especially unemployment
benefits.
© 2002 Prentice Hall Business Publishing
Principles of Economics, 6/e
Karl Case, Ray Fair
Data for Selected Variables
for Six Countries, 1980 – 1999
Data for Selected Variables for Six Countries, 1980 - 1999
GDP
GROWTH
RATE
INFLATION
RATE
UNEMPLOYMENT
RATE
SHORT-TERM
INTEREST
RATE
GDP
GROWTH
RATE
INFLATION
RATE
United Kingdom
1980
1981
1982
1983
1984
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
-1.6
-1.3
1.5
3.6
2.5
3.5
4.4
4.8
5.0
2.1
0.6
-1.5
0.1
2.3
4.4
2.8
2.6
3.5
2.2
1.7
18.8
11.4
7.8
5.3
4.4
5.9
3.2
5.0
6.1
7.4
7.6
6.7
4.0
2.8
1.5
2.5
3.3
2.9
3.2
1.6
© 2002 Prentice Hall Business Publishing
NA
NA
10.3
11.1
11.2
11.5
11.6
10.6
8.7
7.3
7.1
8.9
10.0
10.5
9.6
8.7
8.2
7.0
6.3
6.1
UNEMPLOYMENT
RATE
SHORT-TERM
INTEREST
RATE
Spain
15.2
13.0
11.5
9.6
9.3
11.6
10.4
9.3
9.8
13.1
14.1
11.0
8.9
5.2
5.2
6.3
5.8
6.5
6.8
5.0
2.2
-0.1
1.5
2.2
1.5
1.7
3.2
5.6
5.2
4.7
3.7
2.3
0.7
-1.2
2.3
2.7
2.3
3.8
4.0
3.7
Principles of Economics, 6/e
13.4
12.6
13.9
11.8
11.6
7.7
11.1
5.8
5.7
7.1
7.3
7.1
6.9
4.3
4.0
4.8
3.4
2.1
2.3
2.5
NA
NA
14.9
17.5
20.3
21.7
21.2
20.6
19.5
17.2
16.2
16.4
18.4
22.7
24.1
22.9
22.2
20.8
18.8
15.9
Karl Case, Ray Fair
15.7
15.8
15.7
19.8
13.4
10.9
8.6
8.0
10.8
13.6
14.2
12.5
12.4
10.5
8.1
9.8
7.2
5.0
3.8
3.0
Data for Selected Variables
for Six Countries, 1980 – 1999
Data for Selected Variables for Six Countries, 1980 - 1999
GDP
GROWTH
RATE
INFLATION
RATE
UNEMPLOYMENT
RATE
SHORT-TERM
INTEREST
RATE
GDP
GROWTH
RATE
INFLATION
RATE
France
1980
1981
1982
1983
1984
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
1.3
0.6
2.2
0.8
1.3
1.8
2.4
2.2
4.2
4.1
2.6
1.0
1.5
-1.0
2.0
1.7
1.1
2.0
3.3
2.4
11.7
12.0
12.1
9.6
7.5
5.8
5.3
3.0
3.1
3.2
2.9
3.0
2.0
2.4
1.8
1.7
1.4
1.4
0.8
0.6
© 2002 Prentice Hall Business Publishing
UNEMPLOYMENT
RATE
SHORT-TERM
INTEREST
RATE
Italy
NA
NA
7.7
8.1
9.7
10.1
10.2
10.4
9.8
9.3
9.0
9.5
10.4
11.7
12.3
11.7
12.4
12.3
11.8
11.3
11.9
15.3
14.9
12.5
11.7
9.9
7.7
8.0
7.5
9.1
9.9
9.5
10.4
8.8
5.7
6.4
3.7
3.2
3.4
2.7
3.5
0.5
0.5
1.2
2.6
2.8
2.8
3.1
3.9
4.9
2.0
1.4
0.8
-0.9
2.2
2.9
0.9
1.5
1.3
1.0
Principles of Economics, 6/e
20.9
19.1
17.0
15.1
11.6
9.0
7.8
6.1
6.8
6.5
8.2
7.6
4.5
3.9
3.5
5.0
5.2
2.6
2.8
1.7
NA
NA
6.4
7.5
8.0
8.3
9.0
9.8
9.8
9.8
9.0
8.6
8.8
10.3
11.2
11.6
11.7
12.0
11.9
11.3
Karl Case, Ray Fair
15.9
19.7
19.4
17.9
15.4
13.7
11.4
10.7
11.1
12.6
12.4
12.5
14.3
10.6
9.2
10.9
8.5
6.3
4.6
2.9
Data for Selected Variables
for Six Countries, 1980 – 1999
Data for Selected Variables for Six Countries, 1980 - 1999
GDP
GROWTH
RATE
INFLATION
RATE
UNEMPLOYMENT
RATE
SHORT-TERM
INTEREST
RATE
GDP
GROWTH
RATE
INFLATION
RATE
Germany
1980
1981
1982
1983
1984
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
1.0
0.1
-0.9
1.8
2.8
2.0
2.3
1.5
3.7
3.6
5.7
5.1
2.2
-1.1
1.2
2.9
0.8
1.5
2.2
1.3
5.0
4.2
4.4
3.2
2.1
2.1
3.2
1.9
1.5
2.4
3.2
3.9
5.0
3.7
3.7
0.8
1.0
0.8
1.0
0.6
UNEMPLOYMENT
RATE
Japan
2.6
4.0
5.7
6.9
7.1
7.2
6.5
6.3
6.2
5.6
4.8
4.2
4.5
7.9
8.4
8.2
8.9
9.9
9.4
8.7
7.9
10.4
8.3
5.6
5.9
5.0
3.9
3.3
3.6
6.3
8.1
8.3
8.3
6.2
5.1
4.4
3.4
3.3
3.4
2.9
2.8
3.2
3.1
2.3
3.9
4.4
2.9
4.2
6.2
4.8
5.1
3.8
1.0
0.3
0.6
1.5
5.0
1.4
-2.8
1.4
5.4
4.1
1.8
1.8
2.6
2.1
1.7
0.1
0.7
2.0
2.3
2.7
1.7
0.6
0.2
-0.6
-1.4
0.1
0.3
0.0
2.0
2.2
2.4
2.7
2.7
2.6
2.8
2.8
2.5
2.3
2.1
2.1
2.2
2.5
2.9
3.1
3.4
3.4
4.1
4.7
Source: Organization for Economic Cooperation and Development (OECD) and IMF.
© 2002 Prentice Hall Business Publishing
SHORT-TERM
INTEREST
RATE
Principles of Economics, 6/e
Karl Case, Ray Fair
10.9
7.4
6.9
6.4
6.1
6.5
4.8
3.5
3.6
4.9
7.2
7.5
4.6
3.1
2.2
1.2
0.5
0.5
0.4
0.1