Transcript Theory and Reality

Theory versus Reality
Chapter 18
McGraw-Hill/Irwin
Copyright © 2010 by the McGraw-Hill Companies, Inc. All rights reserved.
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?
18-2
The Policy Tools
Type of Policy
Fiscal
Monetary
Supply-side
Policy Instruments
Tax cuts and increases
Changes in government spending
Open market operations
Reserve requirements
Discount rates
Tax incentives for investment and saving
Deregulation
Human-capital investment
Infrastructure development
Free trade
Immigration
18-3
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
18-4
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
18-5
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
18-6
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
18-7
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
18-8
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
18-9
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
18-10
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
18-11
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
18-12
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
18-13
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
18-14
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
18-15
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
18-16
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
18-17
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
18-18
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
18-19
Fine-Tuning
• At one time, it was felt that policy could finetune 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
18-20
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
18-21
The Economic Record
18-22
Why Things Don’t Always Work
• Four obstacles to policy success:
–
–
–
–
Goal conflicts
Measurement problems
Design problems
Implementation problems
18-23
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
18-24
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
18-25
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
18-26
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
18-27
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”
18-28
Policy and Forecasts
• Forecasting the economic future is made more
complex because forecasts, policy decisions,
and economic outcomes are interdependent
Budget
projections
Economic
forecasts
Policy
decisions
External shocks
18-29
External Shocks
• An external shock can disrupt the economy
and ruin economic forecasts
• The very nature of external shocks is that they
are unanticipated
18-30
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
18-31
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
18-32
Time Lags
• There is a danger that the policy will get
enacted well after the problem it was created to
fix is gone
D
e
l
a
y
Problem
emerges
D
e
l
a
y
Problem
recognized
D
e
l
a
y
Response
formulated
D
e
l
a
y
Action
taken
Policy
impact
noticeable
18-33
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
18-34
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
18-35
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
18-36
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
18-37
Theory versus Reality
End of Chapter 18
McGraw-Hill/Irwin
Copyright © 2010 by the McGraw-Hill Companies, Inc. All rights reserved.