Frontiers of Macroeconomics

'l'he task o[ eronomic

sktbilizatiut requires keepittg llrc econorn:

too.fitr
ahrnv or lttltnu lhc lnth ol .slru,* high
.litnt
enltk4nt,rLt. Oru'tttt. l's |nfttlion, rntl lln tlu, lit.t ttt,ssiot.
I;lcxille anrl uitikml.lisral and nowl(r\ Polict,will alktu us to
ltold lltc n arror.t middlc t ourse.
sl.rutyin4

Pr-csidt'n

t .f

oh

1962)

The 1..S. ('c()lr()nrv has clrarrg<'d cnorntorrsly ovt'r

tlre last 5r0 r'<'ar-s. Thc sharcs of'lrrning arrd rnanrr[:tctrrring havt' rk'clirrcd. Pcorlt' rvor-k with corrrtutcr-s insfc:rrl

ol rvilh tr-actors.'li-adr-

nlAcltccol rorlr ics. Sornc

ol tlrt'se tlrcorics:rlc

<lrr

tllc

Ii'onticrs ol orrr science to(la\' l)ut will bc thc staplcs

of classlo<lrrr t'r'orronrics irr :r gcrrcr:rtion. \\t' arralyzc

shalt'

ctrrtr rrcrsics irrvolvirrg slror t-r trrr t't orr<nlic staliliz-a-

Ti't hlroloq',r has

tior. inclrrlin:t currcnt qurstions on tlrc loles ol rrrolrctittv antl liscal xllicr'. Sllotrkl tlrc g()vcrrunent st()p
tr-!ing to srn(x)tll ()rrt brrsincss cvclt's? Slrotrld policv
nrakcrs rclv olr fixt'<l rtrlcs ratlrcr tlrarr rliscretitlr? \l'r
llrcrr torrclrrtlc witlr :rrr e-lilogLre on tlrc irnp()rLrncc
of cconornic grotltlr.

is a grorving

of prodrrctiorr arrd <'onsrrr.r.r rt ion.

n l-. Kt'nncdy

rcrrrlrrtionizcrl rlailv lif-e.,\dvanccrl lt'lecomrnuni( ?lti()r'ls s'l,sl('nts cllablt' brrsin<'sscs lo cortr-ol thcir
opt't:ttions a< r'oss tlr' corn trv alrrl arourrrl f hc world.
uIcl evt'r rnox' rorvt'r-f rr I conr pul{.rs lravt' t'l irni rratccl
rrrarl of-thc tcdiorrs tasks that rrscd lo t'nrploy s<r
nrarrl reople.

Yt't, everr witlr thcsc tcctonic shifis in ()rrr ccl>

ll()nli(

sfrrctur-c, tl)c ccnlral goals ol rr)tr(rL,cc(F

trottrit ;olicy lcnrairr tlrc sunrc: stallc crrr tlol rrrc rr t.
grxrrl pay, lou' rr ncrrr rlovrrrcr t, r'isirrg protlrrttivitv
arrrl lcal irrctlrrcs,:urrl ltrr lrrrl staltlc inflatiorr.'l'lrc
clrallcrrtt'crnairrs to lirrtl lolicics tlrat c:ur atlrit.rc
thcst'ohjt'ctivt's.
'I lris clrartcr- uscs tlrc tools ol rnacr'()cc()r l()nrics tr cxnilrc sonrc ol totl:rl's rrriljor polict,isstrcs.
\lt' bcuirr n'itlr arr asscssrrcnt ol tlrc cor rser rrc rces
ol govcr-rrnrt rrt tlcficit-s arr<l rlcbt orr econornic lrctir.
itr'. \{t'tlrcrr pr('scnt sonrc ol tlrc ncu appr<taclres t<r

A. THE ECONOMIC
coNSEQUENCES OF THE
GOVERNITIENT DEBT

346

thc L'llitcrl Statcs cntclc(l tllc t$'clrt\.li|st ccrrtr[1,, iLs

liscal lolicics rvt'rc stablc arr<l tlrc lL'tlcl:l govclrlrncnt
-l'lrcn.
rvirs rrrrrrrirr4lr lrtrtlgct srrr-rltrs.
likc a rnorrstcr risirrg fiollr lhc tlecp. the l;uti;ct rlcficit rose trp to srvirlkxv
ttre nrti()rr's fiscll rcsolrrces:rrrd tcrrifl it-s popttl:rcc.
.,lvs

I
'lscAL Hlsl'oRY

347

The budget deficit increzrsed e.ren drrring the

of the mid-2000s as taxes were
cut and spending increased on new entirlement
programs and seemingly endless nars in lraq and
prosperous y'ears

Afghanistan. Therr, the nation's banking svstcrn ran

mammoth losses and the econonry rvent irrto a dcet
recession. Tax rer,-enrtes fell sharply, arrd hundrccls of

billions of dollars

spent to prop up thc financial svstem and stimrrlate the ecorrolny. F-or 2001), thc
federal government was nrnning arr anlltal dcficit o[
close to $2 trillion, rvhich rvas the largest pcrccnt of
GDP since \l'orld tA/ar II.
r.r'ere

Horv dicl the burlget decit get so high? lVhat are

the economic imp:rct.s of fiscal deficits? Tl.rese important qrrestions will be adclressed in this sectiou. ll'c
will scc that thc poprrlar conccrn with dcficits has a
Iirm cconouric lbrrnclation. Dcficit spending rnay be
rccessart'1<. rcducc thc lcrrgtlr arrd depth of recessions, .rarticulally rvhcn lhc ccorrorny is in a liquidiqtrap. But high dclicis clurirrg -rcrio<ls ol firll ernplol.
rrlcnL car.r.y scr.ious conscqucnccs, irrcltrdirrg reduced

national savirtg aDd iDvcstrncnl. arrcl slorvcr l0rrg-r'urr

ccon<rnic growth.
Govennent Eudgets. GovcrrrrrcnLs use budges to
plan and control tlleir fiscal aflair s. A budget shows,
fbr a given year, the plarrncd expenditures <;f governnlcnt progrms and the expected revenues from tax
systems. The budget qpically contains a list of specific programs (education, welfare, defense, etc.),
as well as Lax sources (individual income tax, socialinsurance Lnxes. etc. ) .
A budget surplus occurs rvhen all taxes and other

revenues exceed government expenditures for a

year. A budget de6cit is incurred when expenditures
exceed taxes. When revenues and expenditures are
equal drrring a given period-a rare event on the federal level-the government has a balanced budget.
\Ahen the government incurs a budget deficit, it
must borrow from the public to pay irs bills. To borrorv,
the government issrres bonds, which are lOtJs that
promise to pay money in the fiture. The government
debt (sometimes called the ltulilic dehl) consist-s of the
total or accumrated borrow'ings by the government;
it is the total dollar value of government krnds.
It is useful to distinguish berween the total debr

and the net debt. 'fhe

net rlebt, also called the ri

held la the ltuhlic, exclucles debt helcl b,v the government iLself. Net dett is oryned by horseholds, banks,
brsinesses, foreignen, and other nonfederrl entities.

The gzoss drt cquals thc ncr dcbt plus borrds <.rrvned
bv the goverrrnrcnt, plirnarilv by the social sccurity
tnrst frnd. 'Ihc social scctrrit,v trust f und is running
a largc surplus, so thc difleretlce between these two
col)ccpts is grorving rapidlv todar,.
Debt versus Deficit
People often confuse t}re debt with rhe
deficit. You can remember the difrerence
as follows: Debt is water in the tub. while
a deficit is water flowing into tle tub. The government
debt is e stock of liabilities of the government. The deficit is a flow of new debt incurred when the government
spends more than t rases in axes. For example, when the
government rn a deficit of $640 billion in 2008, it added
tjat amount to the stock of government debt. By contrast,
when the government enjoyed a surplus of $200 billion in
2000, this reduced the government debt by that amount.

FISCAL HISTORY
Likc Sisyphus, lbderal poliqmakers toil endlessly to
push the st<-ne of fiscal balance up the hill only to
have it roll down to crush them afin. The government prsscd law after larv in the 1980s and 1990s to
stop the rising deficit. No sooner uas the deficit ranquished than it reappeared and grew rapidly after
2001. \l'&s this trpical, or was it a new feature of the
Amercan economy?
DeficiLs were not new to the American econom brrt
large deficirs cluring peacetime are a unique feature of
recent econ<mic histon'. For the first two cennrries after
the American Revoludon, e feclerl government of
the Unitecl States generallv balanced its budget. Heaw
miliurry spending during nartime rvas financed b,v borrowing, so the gorernment debt soared in wanime. In
peacetime, the government rvould pa,v off some of its
debt, and the debt burden would shrink.
Then, starting in 1940, the fiscal affairs of state
began to change rapiclly. Thble l7-l illrminates the
maior trends. This uble lists the major fecleral buclget
categories and their shares in GDP for the periocl from
1940 to 2008. The key features were the follorving:

o The

share of federal spending and taxes grew

sharply from 1940 to 1960 primarily because of
the expansion of military arrd cilian spending.
This grorvth was financed by a significant increase
in individrral and comorate taxation.

CHAPTER I7 . 'RON'I'I!]RS OI,' MAC:ROECOiOMICS

348

Percent of GDP
Fedeml budget compoeot

1940

1960

l9E0

2000

m08

6.4

17.6

lE.5

20.6

r7.7

4.1

8.8
2.3

10.2
2.1

8.1
2.1

J.t

o.t

6.3

1.8

1.6

t.2
20.9
4.4
4.7

-3.2

Reveoue

Indidual income taxes

0.9

Corporation income taxes

Social insurance and retirement receipts

1.2
1.8

Other

2.7

2.8
3.0

9.4

r7,t

National defense and international affairs

1.8

Heal

21.2
5.3
2.0

lncome security

0.1
1.5

9.7
0.2

r.4

3.1

Social security

0.0

2.2

4.2

Net interect

0.9
5.2

1.3

1.9

2.7

4.7

18.2
3.2
3.6
2.6
4.2
2.3
2.4

-2.9

0.t

-2.6

2.4

Eryeuditres

Oer
Surplus or decit

3.0

4.3
1.7

2.5

TABLE l7-1. Federal Budget Trends, 1940-2008

The f'ederal share of e economy grew sharpll'from 1940 to 1960 as the Llnited States took
an active military role in world allairs during the hot and cold wars. After 1960, the federlspending share stabilized, but the composition of spending moved liom military to heal
care and r-ther social spcndin. Tlrc fedcrl government delicit grew sharplv in the 2000s as
revenues declined sharply due to indidral incornc-tax crrts.
Sorrre: f)ata are for fisral years and comt' tiom thc Drpanmen( ol the lieirsun. ()llice ol -Vanagemen! and Budgct,
and l)cpanmcn( of (j()mmcrcc. 'I'hcy arc sumtanzcd in Eonoat. Indrakrs, \ilabla xr Mqrn.uat.Ep.xt..css.gw/

o The period fiom

1960 L< 1980 markcd thc "Ncw

Society" prograrns fbr health, inc<rne sccurity,
and expanded social security. As a result, the
expenditure share grew shalply. The sharc of f'ederl revenues in GDP stabilized <ver this period.
Begrnning in 1981, both political parties declared

that the er of big Bovernment

wr.!i over. Presidents Ronald Reagan and George W. Bush intro

duced large urx cuts, which in each case led to
large government budget deficits. From 1980 to
2008, as shown in Table l7-1, the rti<-r of t<tal
f'ederal spending to GDP was essentially constant.
Spending on heal care rose sharpl,v as other
cilian programs were squezed.

among private and public consumption and investmcnt and providing inccntives to increase or reduce
outpul in particular scctors. From a macroeconomic
point of vicw, it is through fiscal policy that the budgct allects the key macroeconomic goals. More pre.
cisely, by fiscal policy we Inean thc sctting of taxes
and public expenditures to help darnpen the swings
of the business cvcle and contribute to e maintenance of a growing, high-employment econr.rrny, fi'ee

fiorn high or volatile inflation.

Stune earlv en thtrsiasts ol the Kevnesian approach
believed that fiscal policy wzrs like a knob they could
turn to crJntrol or "ne-tune" the pace of' the cconomy'. A bigger budget deficit meant nlorc stinrulus
fbr aggregate demand, which c<uld lower unem-

GOVERNMENT BUDGET POLICY

ployment and pull the econorny out of rccession.

A budgct surplus could sl<w down an overheatcd

The government budget serves two rnajor ecorronric

lnctions. First, it is a device by which the gnv'ernment
can set national priorities, allocating national output

ecorlorn,!'and danrpen the threat of iflation.

Few today hold such an idealized view r.l fiscal
poliql Wi many decades of practice, ec<-rnomies

THE SHOR't'-RLrN lMt'A(;',t ()t; (;()\'l.tRN!tUN

srill experience recessions and inflations. Fiscal policl rvorks better in theorv than in practice. Moreovcr. rnonetary policy has become the preferred tool

lbr nrodcrating

brrsin ess-c,vcle srr'ings.

349

t)t'l(:lTS

Still. rt'hen

uncrnploymcnt liscs, there is ttstallv strong public

presstrrc lbl thc govt-rnrnent to boost spending. In
this scction, rr'c will r-eview the major ways in which
llre govenrmcnt carr ernplov scal policy, and we
will cxanriuc thc pr-actical sholtcontil.tgs that har
become pparent.

THE ECONOMICS OFTHE

DEBTAND DEFICITS
No uracroccononric issrrc is more corrtroversial todav
than the irnpact ol-lalgc govcruurcnt deficits upon
thc econorny. Sornc arguc that largc dcficits arc plac-

ing a hcavl burdcn or lirtur-c gcncratiotrs. Othcrs

rcjoin that thcrc is littlc cvidcncc ol an inrpact ofdcG
icits on intcrest rates tr invcstncnt. Yc[ a third grorrp
argues that deficits are favrrable fbr lhc cconorny in
recessionary times.

Act u ol,

Structurol, o nd Cy clicol Budgets

Modern public finartcc disiingtrishcs bctwcclr strlrctrral and c'clical cleticis. l-hc itlca is sirnplt'. The
structural part ol thc btrdgct is activc-de terrtr ined
by discretionary policics sttch as tllosc covcritrg tax
rates, public-works or cducatiott spcttdittg, ol tltc sizc
of defeuse purchases. IIr cotrtrtist, thc rtrlilzrl part of'
the budget is determincd passively b;- thc statc of thc
business cycle, that is, by tllc cxtcl)t to wllich t)atiorral
income and output are high or low.'l'hc prccist'dcfin it

iors follow:

I'h c actual budget lt'< r t <ls tltc rc tttal tl, rlla l t'r rt't t<litLrrcs, r'cvcnues. lnrl tlclir its itt u uivt tt rt'r io<1.
'flic structural budgel calcLrlrrtt's rvltat q()\'('t-tt-

nlcnt rcvellllcs. cx.rt tttlitttrcs. urrtl dt'lit ils sottlrl

bt' if the c(()n()rr\ 1\'ct( ()[)rtitting :rt rott'trtial
()u u)Lt t.

The cyclical budget is tlrc tlillcr t'ttcc lt trlcclt tltt'

at trral blrdget itrr<l tltt' stru( tulitl lttttlgt't. lt ltrcstrt's
tht' irnpact of tllt' lrtsiltcss ctclt' ttt tlrt' lrtrrlgt't. lakirrg into ircc()r.lr)t tlc clli'ct rl tlrt'tlclt' ()tl r('\('l'llr('s,
crnenditrrrcs. lurrl tlte rlclit it.
Tlre clistinction betweeD the actual and tltc structrrral brrdgers is inrportant for policyrnakers who rvirtt
to distingrrish berueen l<-rng-term or trcld budgct
changes and short-tentt changcs that arc prinrarilv
driven b1' the bttsittcss cvclc. Stl'ucttlt'al srelrding
and rcvenues consist of'thc tliscrctionary Programs
enacted by- thc lcgislatrrle; cy'clical spendirrg and decis consist ol thc taxcs and sperrding thaf r(:lct autc
matically to thc statc of thc ccononry.
Thc rrati<-rn's saving atrrl investrrtenf balance is

primarily all'ectcd lry thc stlttctul-al btrdget. F,fforus

to change govcrnn)cr)t saving slrorrld focrs on the
structural budgcl bccausc- no dtrrahle clratrge comes
simply fiorn higlrcr lt'r,crrltcs due to:rn economic
boom.

llorv can rve sort through the conflicting poins

of view? At one extreme, we must avoid thc customary
practice of assunring that a public debt is bad becausc

private debtors are punished. On the other hand,

we must recognize the genuine problelns associatcd
th large government deficirs and the advantages
that come from a lorver government debt.

THE SHORT-RUN IMPACT OF

GOVERNMENT DEFICITS
Short Run vs. Long Run
It is useful to separte thc impact ol fiscal

policy

into the short run and the long run. Tltc shorl ntn.
in macroeconomics consideru sitrtaLions whcre lcss
than full emplovment ma,v prevail-that is, rvhcre
actual output mav difl'er from potcntial outPr.t. This
is the rvorld of the Keynesian rnultipliel tnodcl. Thc
Imtg run refers to a full<mployrncrt sitttatiotr, rvhere

actual output equals potential output.

l'his is the

rvorld of our economicgrorvtlt analvsis.

\te have rlreadv discussed the rr-lc of liscal policl'
in the short run, so that needs only a bricl rcvicw
in this section. The impact in the long run is trrrrc
novel and rvill be presented in thc next secLiotr.

Fiscol Policy ond the Multiplier Model

in earlicr chaptcrs lhc \a'av that fiscal
poliq affeca the econolny il) thc sltort 1-| is,
in an econtml'with lcss than ltrll emplorrnent.
Suppose that thc govcrntncnt prtrchases computers fbr iu schorls or rnissilcs for its armt'. Our
multiplier model sa1's that iIr thc short nn, rvith no
change in interest or e xchalrgc ratcs, (ll)P r.r'ill rise by
a multiplc (perhaps ltA or 2) timcs the increase in G.
The same argument applics (rvith a smaller multiplier) to reductions in taxcs, 7l At the sanre time, the

\4e discussed

CHAPTER | 7 . FRoNTIERS oF

3s0

govcmment deficit will rise because the deficit equals

and thus rises r'r'ith 7-culs or G increases.

This then is the basic result for rhe short nn:
With less than full employrnent, increases in the
structurl deficit arising from discretionary Tcurs or
G increases will tend to produce higher outprrt and
lower unemplolment, and perhaps higher inflation.
We must, howeve expand on the simplest multiplier analysis to incorporate the reactions of finanG

cial markets and monetary policl'. As ortpllt rises

and inflation threatens, central banks may raise
inf.erest rates, discouraging domestic investment.
Higher interest rates may also cause a country's foreign exchange rate to appreciate if the country has
a flexible exchange rate; the appreciation leads to
a decline in net expors. These financial reacrions
would tend to choke off or "crowd out' investment,
with a resulting decrease in the expendirure multiplier of our simplest model.
Fiscal policv tends lcl exparrd tlre ecorronrv in
thc short n1-1| is. when there irre rrrrern rloyed
rcsurlrccs. Hielrer spcncling and lorver tlx retes
ilrclcast: aggrcgatc tlcrrrand, ()utput, clnplovrnent,
ancl inflaiorr. Huwcvcr, tlris cxparrsiorran inrp:rct
is redtct'cl bl' the srrbscqrrcllt liltalrcial rcactiorrs rf
interest r?rtes and foreiglt cxchangc ratcs.

dramatic effect of govcrntncnt dcficis dtrring W<rrld

as wcll as drrring thc 1980s:nd the 2000s.
Most industrializcrl cotrntl ies are today saddled

u.ith largc public dcbts. 'fablc l7-2 compares rhe

fJnited States th scvcn other large countries.

Japan's clebt-GDP ratio has clirnbed sharply over the

last two clccaclcs because of the nation's aggressive
fiscal policy and a pr-olonged recessitn. Many econo
rnists worry thatjapan is caught in a vicious cycle of
high debt lcacling to high interest payments, which
in turn incrcasc thc growth of tlre debt.

Extemol vs. lntemot Debt

Thc finst distinction to be made is berween an internaf rlebt and an cxtcrnal debt. Intemtl goaenntnt
deht is owe<l bv a nation to its own residenls. Many
argrre that an intcrral dcbt poses no burden because
"we owe it all to otrrse lvcs." While this statement is
ovcrsirnplified, it does represent a genuine insight.
lfcach citizen owned $10,000 of government bonds
and wcrc liablc fbr the taxes to servicejust that debt,
it worrld makc lro scnsc to tltilrk of debt as a heavy
loacl of rocks that each citizcD nrust cany. People
simplv owe the debt to the rsclvcs.
An external debt is qrrite a different situarion. Al
cxternal dbt occurs when foreigners own a fraction
of the assels of a country For example, becausc of

Ratlo of Gross Government

Debt to GDP (%)

run-to

the impact of fiscal policy, and particularly a large

govemment debt, on investlnent and economic
growth. The analysis here deals with the costs of sercing a largc cxtcrnal clebt, the inefficiencies of lerying taxes to pay intcrcst on the dcbt, and the impacr
of the debt on capital accurrr ulati<n.

HistoricolTrcnds
Bcforc we begin our anal,vsis of government debr, it is
usefirl to reew historical trends. l-ong-nrn data for
the United States appear in the figure on page 404
of this text, which shows the ratio of net federal debr
to GDP since 1789. Notice how wars drove up the
ratio of de bt to GDP, while rapid ourpur growh wirh
gencrally balanced budges in peacetime reduced
the ratio of debt to GDP.
Figur e I 7-l shows e debtCDP atio for the llnirerl
States ovcr thc lilst seven decades. You can see the

A(lRO l:(l( )NOM ICS

\!hr II,

GOYERNMENT DEBTAND
ECONOMIC GROWTH
We turn now from the short ntn to tle long

lvf

l9t0 l99t 2000

Japan
Italy
France
United Kingdom
C,e rmany
United States
South Korea
Mexico

37

53
30

5l
l3
26
4
18

47
93
40
35
20
41
'r3
46

2007

10,6 t6l
lM
96
47
52
43
43
34
39
54
36
17
32
23
24

TABLE | 7-2. Central-Government Debt in Eight Major

Countries
Slow t:r'orrorni< growth and rising spending on endement
[)rograms led to grou'ing public debts in most major countries in the last three decades. Japan's rlebt-(iDP rario l('d

to a downgrading of the nation's (lcbl mting cvcn thouglr

Japan is one of tlrc wor'ltl's richcst countrics$)rf rre: ()F.(lD

nr

"4,81

t{t

.ng/lnr/t"r. tsfx.

35r

(;OV]RNNI]NT DF,BT AND ECONONI(] CROWTH

o
a
(!

()

U)

(L

oAO
o

6
o+u
()
t!

Year

FIGURE | 7- l. Debt-GDP Ratio for thc U.S. l'ederal Government

This ligrrre shows the rati() of net debt, or debt ir thc lratrrls o[ lht: Jrrrblic, to (iDP. See rhe
cfft'r't of lV<r'ld War ll alrcl the tw() Pcriods of supply-side ciix cuts orr lltt rutio.
Sorrrcc: Lr.S

()lfi((

,)t ManBcnrcrrt arrtl Brxlgct, ,rr:ril.rh|l

is large cr rren t-account deficits, the Ulrited Statcs

owcd thc rcst of the world $3 trillion at the cnd tf
200U. What this mt'ans is that [.t.S. residents will eventualll' havc to cxport that mlrch in goods and serrices
tr scll tllat rrrrch of the nation's assels to foreignerc.
Supposc that thc real interest rate on that debt is
5 pcrccnt pcr ycar. Then, each year, U.S. residenu
wttrltl nccrl to ship abroad $150 billion (about $500
pcr capita) to "service" the external debt.

ilrrrrlrt'rt trct
lol tollthe
rcsottrccs
availaltlc
srblr-;rclion firrn
So alr t'xtt'-rr;rl clebt definitclv <loes

srrrrrrtion in thc dcbtor ltati()ll. This lcssolt lt:ts lrt t'lt

Italrrctl tinrc rrd agairt bv devclotittg cottltlricspalticrrlar'lv whcn their cr'<'dil<r's rr':rlrtt'<l lh<'ir- tlclrt-s
raitl

bac k rrrickh'.

Efficiency Losses from Toxotion

,fu1 irrtcrnal debt reqrrires p:rYments of interest to lx)Ildholdcni, and taxes musf be levied for this ptrrpose. But
cvcn if thc sar.ne people were rxed to piry thc sarrle

^t

mn,q\Navss.g'1r/np/tablrs0S htnL

libk

l}.Tt{-

anlouDts they receive in interest, there would still bt'

tc t!krting e.lferls on. inrmliue.s that are inescapabll'

plescnt ir) thc casc o[ any t:rxes. Ta-ring Paula's interest ircorrc or wagcs to pav Pattla interest rvould intr<>
tlucc lnicloccorronr ic distortions. Parr'la might rvork
less ancl savc lcss: cithcr of these outcomes must be

reckoned

as a

distortion of elTiciency and well-being.

Displocement of Copitol
Perhaps the most scrious conseqttence tf a largc pttblic
rlebt is that it displaces capital frolrl tltc nal.iotr's stock

of prilate w'ealth. As a result, the pacc of cctIrolnic

growth slows and futrlre liling standards will tlcclinc.
What is the mechanism bv rvhich dcbt alIL'cLs
capital? Recall from our earlier discttssitltr that
people accumulate wealth ftrr a varictY of pttrposes, srrch as retirement, educatit.tt, antl Irortsing.
rrl'e can separate the assets peoPlc h()l(l il)to lwo
groups: (l) government debt and (2) capital likc
hotscs and firrancial assels like corporatc stocks
that represent ownership ol'private capital.

CHAPTERIT .

352

The effect of sovernmenr debt is rhat pcorlc will

accttmulate government debt irrstead o[ plivatc capital, and the nation's private capital stock will bc rliy
placed by public rlebt.

To illustrate this point, suppose that pcople

desire to hold exactly 1000 unis of wealth for retirement and other purposes. As the government debt
increases, people's holdings

of other

assets

will be

reduced dollar for dollar This occurs because as

the government sclls its borrds, other assets must
be reduced, since toral dcsired wealth holdings are
fixed. Brrt these other asscts ultilnalelv represcnt the
stock of private capital; stocks, b<.nds, and mortgages

are the countcrparts of fctories, equipment, and

houses. In this example, if the governmenr debt goes

FRONTIF,RS OF MA(]ROECONOMICS

up I00 unis, we would see that people's holdings of

capital and other privare assets fall by | 00 units. This
is the case of 100 percent displacement (which is thc
long-run analog of 100 percent crowding out).
Full displacement is rrnlikcly ro hold in practice.
The higher debt may increase intcrcst rates and stimulate domestic sal'ing. In addition, thc country may borrow abroad rather than reduce its domcsc invcstment
(as has been the case for the U.S. in recent years). The
exacl mounr of capital rlisplaccrnerrt will depend on
the conditions of production and on re saving behar.
ior of domestic horrseholds ard foreiglers.

Geometric Analysis. Thc process b,v which the

stock of capital is displaced in the long run is illustrated in Figrrrc l7-2. The left panel shows the supply

(a) No Dobt

(b) Wlth Government Debt

g 1)

q1)

o.

ID

9a

o^
aat

a
o

o
(!

-o
o

o)
()

.=4
E
()

(!

(|)

4,500
Private captal stock (K)

;00

4,000

AK
Private capital stock (K)

FIGURE | 7-2. Government Debt Displaces Private Capital

Finns demand capiurl, while households supply capital by savirr; r) pri\ate and public
assets. The dem:rnd cun'e is the downward-sloring brrsirrr.ss tlcmand for K, while the supply
cune is the upward-sloping lrorscll<ld surrly of wcalth.
Beforedebt case in (a) slrows tlrc cqrrilibrirrm without government debt: K is 4000 and
e real interesr rat<r is 4 pcrccnt.
Afte r<lc[t c:ue in (b) shows the impacr of 1000 unirs ol governrncnr (lcbt. ttebt shifs
the net supplv of K to the left by rhe 1000 units ot the governlnen t drlrt. The new equilibium arises norrhwest along the dentandlbr-K cu rr,,e, nroving fr.om point rl to point B The
interest rate is higher, lirms are discouragcrl lirrrn lr'kling K, and the capital stock fa s.

353

GO\/ERNMENT DEI}1' ANI) I]CONOMI(] (iRO\'!TH

and demand for capital as a function of the real

intcrcst rate or return on capital. As intcrcst rates
rise, firrns dcmand less capiuel rvhile individuals may
rvant to supply more. The equilibrium sh<wn is fbr a
capital stock of 4000 units th a real interest rate ol'

Output (no debt)

I(!

-g

4 percent.
Ntrw say

tllal the government debt rises froln 0

to 1000-bccausc of war, recession, supplv-side fis.

increase

in debt

a-s

Capital stock (no debl)

o.

cal policies, or sonle othcr rcason. The impact of the

increase in dcbt carr bc secn in the right-hand diagram of Figure l7-2. T'his figure shows the 1000-unit

a shift in the supply-of-capital

Capital stock (with debt)

(or.S.S) cune. l\s depictcd, the horrseholds' supply<rfcapital schedule shif'ts 1000 units to the left, to.S'.S"

\te represent an increrse in govcrnment debt as

a lefnrzrd shift in the ht.uscholds' strpply<rf-capital
schedule. Note that, becausc tlrc .5.S ctrn'e rePresenls

the amount of prirate capital that people willingly

hold at each interest rate, thc capital holclings are
equal to the to&l wealth holdings minrrs the holdings of government debt. Siltcc thc amotrnt of gor'
elnment debt (or BscLs othcr than capital) rises bv
1000, the amount of privatc capital that people can
brry after they own the 1000 rtnits of government debt
is l00O less than total rvealth at each interest rate.
Therefore, if .SS reprcsents thc total w'ealth held by
people, .S'.S' (equal to 55 less 1000) rcpresenl.s the
total amount of capital held by pcoplc. ln short, after
1000 rrnits of governmcnt dcbt arc sold, the new
suppl,r'<rf<apital schedule is S'S'.
As the supply of capital drics up-with national
saving going into goventlncnt lrcnds rather than
into housing or into cornpanics' stocks and bondsthe market equilibriuln nrovcs northwest along e
demand-for-K curve. lrtct-cst mtcs rise. Firms slow their

Growng debt
Time

FIGURE l7-3. Impact of Government Debt on Economic

Groqth

'Ihe solid lines show the paths of carital artd otltput il the
f{r)v('rnnrcnt balances it-s books and has rto <k:lrt. Whcr
the govcrnrn(:nI ircrrn a debt, prilate capiurl is redtlccrl.
The dashcrl lint's illustrate the imPact on capital and
put of the higher govt nuttt:trt debt.

<ttt-

Debt ond Grovtth

If we consider all thc cffects of gol'ernment debt on
the econr-nrv, a largc public clebt is likely to reduce
long-run cconornic growth. Figure l7-3 illustrates
this conncction. Say that an economv were to oPcI'
ate over tinc with no debt. According to the Prit)ciplcs of economic grorvth outlined in Chapter I |, thc
capital stock and potential output would f<rllow thc
hypothctical paths indiczrted by the solid bluc litres

rc l7-3.

purchases of new lctorics, trucks, and computers.

in

In the illustrativc new long-nrn equilibrium, the

capital stock flls lionr 4000 to 3500. Thus, in this
example, 1000 unis of government debt have di;placed 500 units of prirate capital. Such a reductioll
has significant cconomic effects, of course. With less
capital, potential orrtptrt, wages, and the nati<n's
income are ltwer lhan they worrlcl otherwise be.

Ncxt consider a situation with a gr'owing national

dcbt. A.s the debt accumulates over tillrc, more and
nrore capital is displaced, as showlt bv the riashed
grcen line for the capiurl stock in thc bottom of Figtre | ?-3. ds taxes are raised to pa,v interest on the
dcbt, inefciencies further lower outPut. Also, an
incrcase in external debt l<wers llational income
and laises the frcdon of natit.rral otltPtlt that has to
bc set aside for servicing the ex(ertlal clebt. All the
cffects taken together, outPut and constlmPtion hill
grow more slowly than they would have had there
becn no large governmcnt debt and deficit, as can
be sccn by cornparing the top lines in Figurc l7-3.

The diagrarns irt F-igrtre I 7-2 are illustrative. Economists do not havc a firm estimate of the rnagnitude

of the displacetncnt cffect. In a look at historical

trends, the best eviclcnce suggesls that domestic capital is partiall,v displaced by govcrnment debt but that
some of the impact comes in highcr forcign debt.

F-igu

3s4

CHAPTER I7 . T'RoNTIERS OF' NIA(]ROE(]ONOMICS

\4hat is tlre irnpact of a budger srrrplus and a

dedinnry govcr nrncnt debr? I [ere, the :rr-grrnrcnt
r'orks irr thc otlrcr direction. A lrwer national debr
means that rnorc ol rrational werlth is puf. itrt() capital rirther than govcrrrment bonds. A higher capiral
stock incrcascs the growth of <ltrfprrt alld iltcr<'ascs
wages anrl consunlpti()n pcr pers()n.
This is tlrt' rrrajor roitrt;rlxlrt tlrt' krngnrn irnrat.t of'
a larqt' govr.r-nrrrcnt rlcltt orr r.tolronlic {rolvlh: 1\ ltg(l
qo\jenlr)rent (lcllt tcrxl:! t() rc(luc(] tht'growth in
tolt'rrti:rl orrt:lrt lrcaust- it rlispla<cs privarc c:rpital, int-r cirs<'s

the inefliciclrcv liont t:r\nti()n. anrl Iirrces:l nati()n Ir)

re(hrce consullrptiou t() sel1'ic(' irs Iirr<'ign Jll.<rvilru.

policy. Consider the following debate berween Senators

Hawk and Dove:

Senator Dove: The economy is tipping inro recession.

We cannot afford to sit around while millions of people lose their jobs. Now is the me for a big smulus
package with tax cuts and new spending on infrastructure and pressing public needs. Recessions are not the
time for old-hshioned dogmas about deficits.

Senator Hawk A

huge stimulus package today would

be the height of fiscal irresponsblir/. Wrh higher

tovernment spending, the deficit will grow even

larger, interest rates will rise, and businesses will
reduce rher spending on new plant, equipment, and
informaon technolo$/. With all the critical needs
facing the narion, we can ill-afford slower economic

Defi

cit Confusions Unraveled

Having completed our analysis of the economc impacts of deficits and debt, we can

Make sure that you understand

summarize the key poinB by unraveling

are both right

some of the major confusions n ths area.

The impact of fiscal policy on the econonry is one of
the most misunderstood facets of macroeconomics. The
confusion arises because fiscal policy opertes differendy
depending upon the time period:

ln the short run, higler spending ond lowcr tox rotes tend
to ncreose oggregote demond ond therebl to roise output
ond lwter unemplolme .ffi s is rhe Ke)rnesian mpact
of fiscal policy, which operates by raising actual output
relatiye to potental output. We would expect thar the
expansionary impact of fiscal policy-the increase n
capacity utilization-would last at most for a few years.
It might be offset by a monetary tightening, especally if

Srowth over the next decade.

the central bank thought the economy was operating

near the inflation danger zone.
ln the long run, higher spending ond lower aox rctes tend
o depress the grwth rote of he economy. This is the
growth impact of fiscal policy. The trowth mpact
concerns tie mpact of government deficis on the
national savng and nvestment balance in a fullemployment economl. lf taxes are lower, this will

decrease public saving and, because private savrng is

unlikely to rise as much as public savng falls, total
national saving and investment will decline.The investment declne wll lead to slower growth n the captal
stock and therefore n potential output.
These two impacs of fiscal policy can easily confuse
people and are the source of many debates about fiscal

lying the postions of the

.. .

tie

implcit theores under-

two distinguished senators.They

and both wrong.

B. ADVANCES IN MODERN
}IACROECONOMTCS
Orrr rlrilosorhv in tllis textbook is to consider all
the irnportant schools ol thought. \{'e emphasize the
tnodern rnainstr-cal Kcyncsian approach a-s the best
rvay t() exrlairr thc brrsiress cycle in marker econe
nies. At tllc satnc tintc, the forces behind long-mn
ccononric growth are best rrrrclerstood by using the
ncoclassical gn)wth m()del.
WJrile our ke,v task has heen to prcscnt mainstlcanr thinking, experience shows how inrportant it
is to kct'p our nrinds open fo alternativc points of
vicw. 'I'irnc and irgain in science, the or-thodoxies
ol onc cra are ()vcrturned by rrew discovcrics in the
ncxt. Schools, likc people, are srrbjcct to hardening
ol tlrc arteries. Studenls leant thc cnrballlcd truth
fiorrr lhcir teachcrs and sacred textbooks. and the
irttpcrll'c tions in rhe orrhodox doctritrcs are glossed
ovc|. us uDimporfanl. F()r exan.r plc,.Jolr rr Stuart Mill,
onc ol thc f{reatest econonlisls and philosophers of
all tirrre, wrofe in his 184i1 classi<:, Pnru:ipks of Politi
tal lironomt: "Ilappily, thcrc is rrothing in the lalrs of
Valtrt'which remrins for tlre rrcscnt and arry future
w itcr to cleirr up." Y'et the rext ccntuty and a half

MODERN (:T,ASSICAI. I\IA(]ROECONo

saw two maior rcvolutiolls

355

I(:S

in cconomics-the

mar-

ginal revolution in micr<.ec<Irornics atrd thc discor'

cly oI nracroeconomics.
Historians of science obsene that thc Progress
<-l scicrcc is discontinuous. New schotls of thotrght
risc, splcad their irfluence, and convince skcptics. In
this scction, rce sketch some of the leaditrg rew litrcs
ol tlrinking irr rnodern macroeconomics.

q)

()

Ep"
o-

P'

CLASSICAL MACROECONOMICS
AND SAY'S LAvv
Since e dawn o[ ecorromics two centuries

:rgo.
a nrarket economy has

economists have wottdcrcd if

a tendencv to rnove spotrtaneottsly touard

a long-

run, full-cmplovlnr:nt cqtrilibrirm without the need

frrr government ilrtcrvcntiotr. Using modern langrage, we labcl as cleesical those approaches that
ernphasize the selfuorrcctiug forccs in an economl.
The classical approach holds that prices and uages
are flexible and thrt the ccotrotnf is stahle, so rhe
economy moves autolnaticallv arrd quickl,"- to irs fullemployment equilibriurn.
Soy's Low of Morkets
Befbrc Kc,vnes rteleloped his macroec<.nolllic
theorics, the rn:rjor economic thinkers geltcrally
adhcred to the cl:rsscal view of the ccolronrv, at lcast
in good tinres. F,arly economists knew abottt btrsiness cycle s, brt thev ewed them as temporary atld
self+orrcctirtg ahcrrations.
Classical anal,vsis revolved arorrnd Say's l-aw
of Makee. 'Ihis theory advocated in 1803 b1' thc
Frcnch cconomist J. R. Say, states that overProduction is inrpossiblc bf it.s very nature. This is solnetimes cxprcsscd as "suppl,v creates its own delnattd'"
This law rcs$ on a ew that there is no esserltial diff'erencc bctwcen a monetary economy an(l a bartcl
econorny-in other h'ords, people can aflbrd to buy
whatcvcr lactories can produce. Sa,v's l,aw is illtrstrted in t-igure l7-4. In the classical rv()rld, outPr1
is detcrrnincd by aggregate suppll', and aggrcgatc
delnand affccts onlv the price level.
A long lirre of the most distinguished ecoltomists,

incltrding David Ricardo (1817), John Stuart Mill

(l84tt), and Alfred Marshall (1890), subscribcrl to
the clssical nlacrocconotnic erv that overproduction is impossiblc.

v"

Y"

Real outout

FIGURE | 7-4, In the Real Brsiness Cycle, Output

Changcs Come from Technological Shocks

In the classical as rvell er-s thc lt:al-businesscycle (RBC)

arproach, A.J reflects classical flexible wagcs atr<l prices
an<l is thclclirre vertic:rl. Outpur fluctuadons comc as
technological shocks pet colate through e economl'. This
gure sho*s how a dr'<'lirt' in productivity can be the cause
of a RBC recession. Can yotr sce why policies to increase
,{l) rrill afl'ect prices but not output?
The clissical view is tltat lhc cconolny In()ves
its firll-t'rtt plolrrten t eqrrilitr
rirrnr. Olranges ir the rrtrItcv surplv, fiscal policv,
irrrt'snnent, or <ther spelttlilr lctol-s have lro lirsting irnpact up()n otttptlt ot etnplovtnt-trl. Pdces:rtrd

all ()nrrticallv tor\'rrd

wagcs adjrrsr qrricklv ancl

t'rn

flcxibll to

rnaintail.r [irll

rloylent.

MODERN CLASSICAL
MACROECONOMICS
W'hile classical economists were preaching the impos-

sibilitl' of persistent unemPloynlcrll., cclectic econc>

rist^s of the 1930s could hardly igrtorc the vast army
of unemployed workeni begging lbl work ancl selling
pencils on street corners. Keyrtcs's 'I'hc Gmnal Theory of limltlqmtnl, Intercst and Monq (1936) offered
an alternative macroeconottic thcory-a new set of
theoretical spectacles fbr looking at the imPacts of

'fhe analyriis of business cycles and short-run aggrcgate demand prescntcd irr this text reflects the nrodcrn synthesis of

shocks and economic policics.

thc Ke)'nesian approach.

35

Whilc rainstream business-qrle analysis rclics

pt'imalily on thc Kel.nesian AS and ,4/) ntodcl, a
ncw brnch of'the classical school challengcs thc
standard approach. This theory called new clessical
macroeconomics, was developed by Robcrt Lucas
( Univcrsity of Chicago), Thomas Sargent (Stanlil.d
University and New York Unil'ersiqv), and Robcrt
Barro (Harvard Universiry). This approach is rnuch
in the spirit of the clacsical :rpproach in crrrphasizing
the role of flexible wages and rliccs, but it als< adds
a new feature called rational cxpcctations to cxplain
observations such as the Phillips crurvc.

Rotionol Expectotons
The major innovaf.ion of ner4' classical ecorromics has
been to introdtce the principlc ol rational expectations into macroeconornics. Sonrc backgrclund on
expectations will help to explain tlris llew approach.
In man,v areas of economics, particrrlarly th<se invoh.
ing investmenr and financial dccisions, expec&rrions
are a central factor in rlccisitrr nraking. They influence how much businesses rvill spcnd or) investment
goods and whether consrrmers spcrrd norv or save for
the f uture. For example, assume that you arc considedng how much to spend on yorrr first housc. Ytrur
decision will be affectecl by your expedati615 ilq
your fture income, family size, and lirturc horrsing
prices.

How do people form rheir expcctarions? Accord-

ing to the rational+xpectations hypothesis, expectat-i<ns are unbiased and based on all available
inlbnnation.
\4'e pause for a statistical aside: A forecast is
unbiased if it contains no systcrnatic f<rrecasting
crrors. Clearly, a forecast cannot always be perfectly
accuratc-you cannot foresee how a coin flip will
cornc up on a single toss. Howcvcr, vou should not
connit the statistical sin of r- by predicting that
a f'air coin will come up rails 25 pcr.ccnt ol the time.
You would be making an unbiascd loreca-st if you
prcdicted that the coin wolrld conte up tails 50 perccnt tf thc time or that each of the nurnbcr.s on a die
r+'ould, <n averzrge, come up onc-sixth of the time.
People have rtional expectations whcn, in addition to lacking bias, t.hey usc all available information
in rnaking their decisions.'Ihis irnplies that people
understand how the econonr,v works arrd what the
govcrtrrnent is doing. Thrrs, srrpposc that the government always boosts spending in cl<:ction.vears to

CHAPTER

I7 .

I'RONTIERS OF MACROE(]ONOMI(;S

prorrrotc its election prospects. [.lnder rational cxpectations, pcople will anticipate this kincl of bc'havior

an(l act accordingly. (Recall that this principle is

also an important aasumption bchind thc elficientrnarket hrporhesis of financial nrarkcts, irs described
in Ohapter 9.)

Reol Eusiness Cycles

The major application of nodcl-n clrusical macroeccF
nomics is an excitirrg licld known as real-brrsines+
cycle (RBC) theory. 'fhis theory was developerl
principally by Firrrr Kydland and Edward C. Prescort,
who won the Nrbcl Prizc lbr their work in this area.
This approach holds that business cycles are prmarilv dre to technological shocks and do not invoke
any monetary or dcrrrand-side fbrces.
In the RBC approach, shrcks ro technology,
investment, or thc labor supply change the porenrial
outplrt of rhe ecoDorrry. In other words, the shocks
shif a uLit al A.Scurvc. Thcse supply shocks are trans-

mitted into actrral orrtptrt by the fluctuations of aggregate supply and arc conrpleteli' independent of AD.
Similarhi movcrncl)ts in tlre unemploymenl rate are
the result of movcmcnts in the naturl rate of unemployment (the NAIRLI) rluc cither to microeconomic
forces, srch as thc intcnsity of sectoral shocks, or to
tax and re6nllatory policics. Standard Keynesian monetary and fiscal policics havc ro effect on output or
employment in RRC rnodcls; they aff'ect only ,4D and

the price level. Figurc I 7-4 shows an cxample of a

RBC recession causcd bv a dccline in productil'iry.

The RicordianYiew of Fiscol Policy

One of the nlost inlluential criticisms of Kevnesian
macroeconomics was a new vierv of the role of fiscal policy. This vicrv, knowu rs the Ricardian view of
scal poticy and dcvclopcd by Harvard Universiw's
Robert Barro, argucs that changes in tax rtes have
no impact upon consurtrption spending.
Th is idea is a logical extension of the life<1.cle

model of consrrmprion, intlodtced in Chapter 6.

Under the Ricardian vicw, indiriduals are farsighted
and form part of a succession of family members,
like a clynasty. Parcnts care not only abotrt their own
consrrmptioD but also about the well-being o[ rheir
chilclren; thc children, in turn, care about the wellbeing of their own childrcn; and so on. This stnlcture, called 'dvnastic pref'crences," implies that
the current genemtiolr's lrorizr-rr stretches into the

MODERN (ll.r\SSlCAl - MA(:R() l( r.) N(

) l\4 l (

357

ls

indefinitc frrttrre through the overlapping colrccrlls

of each gcncratiolr abrttt iLs offspring.
Herc is lvhcrc tlre surprising result comcs: ll'
the goverrrrncnt cttts taxes brt leaves expenditulcs
unchanged, tltis ncccssarilv reqttires increased government borrowing. But, th unchanged exPenditures, the govertrnrcnt will have lo raise tilxes at some
point in the future to Pay tlre interest on ils new borrowing. In thc Rical-dian viclr', consrtmers h:rve rati<>
n:rl expectatiotrs abott firttrrc policies, so when a tirK
cul occlrs, they knorv thcy urust plan fol a filtllre tax
increase. They rvill thereforc incrcasc thcir saving by
the amount of the tax cut, and thcir- consumption
*'ill remain unchanged. Mot-eovct, people take into
account the well-beirrg of thcir chilclren. So, even if
the future [ax increasc cotncs after their lifetime,
they will save enouglt to incrcasc their bequesls to
their children so that their childrclr carl pay the
cxtra faxes.
The net result in the Ricar<lian view is that tax
changes have no itnpact upon consrtmption. Moreover, government del)t is Dot net deht from the
point of view of h<useh<-lds bccatsc thev offset
tlrcsc assels in their mental calctrlatiolrs ll'ith the
preselrt value of taxes that ntttst llc paid to service
the government debt.
The Ricardian vierv of dcbl and deficirs has
stirred much c()nl.rovcrsv atllollg lnacroeconomists.
Critics point out that it rcqrrircs that horrseholds be
extremely farsightctl, rlannirrg to give bequess to
their children and constantll weighirrg their own
interests against [llosc of' their descendants. The
chain would be brokcn il'thcre rvere n< children, no
bequests, no conccru for children, or poor foresight'
The empirical eviclclrcc to clate prodes little sup
pon for the Ricardian vicw, but it is a tseful reminder
of the logical lirnitatiorrs on fiscal policy.

Efficiency Woges
Another important t'cccnr development, fusing clemenLs ()f both classical arrd Kelnesian econorrlics,
is called efficiency-wage theory. This approach was
developed by L.dmtrnd Phelps (Columbia Univcrsigv),.loscph Stiglitz (Ciolurnbia [Jniversiry), andJanct
Yellen (president of tlrc Fcdenl Resen'e Bank of San
Francisco). It explains Lhc rigidiry of real wages and
the existence ol'ilrvolulltary unemplolment in terms
of firms' attempts to itrcrcasc prodrrctit1' by keeping
rvages above the lnarkct-clca ring level' According to

this theory higher wages lead to higher- prodttctivity bccarrse rvorkers are healthier, becatst wr'kcrs
will have higher morale and be less likely tt-r surf thc
Intcrnct at work f()r fear of losing theirjobs, bccatlse
good workers are less likely to quit and look lbr nc*
j<-rbs, ancl bccaus<' higher wages may attrct bettel'
workcts.

lirlns raise their wages to increase worker pr<-r'

dtrctivity, job scckem may be rvilling to stand in line
fbr thcsc highpayingjobs, thereby producing involuntary uncrnploylnent. The innolation in this theory
is that invrluntary uncnrploymenl is an equilibrium
feature and will rtot disappeal over lime.
As

SupplSide Economics

ly 198,0s, a grorrp of economists and jour

naliss dcvclopcd a popular school kn<trr as supplyside economics, which cmphasized incentives and
tax cuLs as a nlcans ol' itrcr-ea-sing economic growth.
Supplv-side ccononlics was espoused forcefull,v by
Presiderrt Rcagan in the llnited States (1981-1989)
an<i by Pr-inrc Minister Thatcher in Grert Britail

In the

ear

1979-1990).

Supply siders argucd that Kevnesians, in their

excessive conccrlr with the btlsiness cycle, had
ignored the irnpact of tax rates alld incentives on ec<>
nomic growth. According to srrpply siders, high taxes
lead peoplc to rcducc their labor and capital supply.
Indeed, supply.side economisls like Arthur LafIL'r
srrggestcd that high tax rates might actually lowcr
rx rcvcrlucs. This Laffet+urue proposition holds that
high tax ratcs shrink the Lrx base because tltcy rcdtrcc
ccr,rnomic actiry To fix what the,v view as atr incfficicnt tax system, srrpply-side econolrlists l-oposcd
a radical rcstnrctrtring of the urx svstem, tltrouglt an
apploach sometimes called "suppl'r'side tax cut.s."
Afier occrrpying center surgc dtrring thc l9tl0s,
tlrc srrpplv-side theories largell' waned aficr Rorrald
Rcagan left office. In studying this pcriod, econcr
mists have generally f<rund that ntatty of-thc srrppl'-

ttrl by ccortomic
cxperience. Supply-side tax cuLs proclttccd lcwer, not
higher, revenues.
Marry ol' the supply-side policics wcrc revived in
200I, r,r'hen President George \l'. Bush strccessfully
ncgotiatcd ancrfher rornd of inconle-tax ctlts. These
cuts wclc mtion:rlized not by the argulllclrt that they
wotrld raise revenlles but, instead, bv thc thcory that
the,v would improve the efcicnc,v ol thc tax svstem
sirlc assertions were not suppor

358

CI{APTER I7 . FRONTIERS OF NIA(]ROE(JONOMI(:S

and raisc lhe long-run rate of economic growth. Like

their prccursor in 1981, these tax crrs led ro lower,
rathcr than higher, tax revenues (see Table I7-|).

POLICY IMPLICATIONS
P o li

cy

effectivenesj

Thc new classical approaches have several ir portant

ir.nplications for macroeconomic policy. Onc of'rhc
nrost irfrportant conten[ions is the ine.[crtiueness oJ'
sysltmatir fista,l ond monetary policie.s in reduring untmFloynmtl.'I'hc basic idea here is that a preclictablc
attempt to stirnulatc the economy u'ould be knor.r'n
in arhance and would therefore have no effect on
the economy.
For exanrplc, supposc that the go\,ernment has
alrvays stimrrlated thc rc<.nomy whenever elections
were approaching. Alier a couple of episodes of
politically Inotir,atcd fiscal polict, people would ratic>
nally come to expcct thar behavior. They might sav ro
themselves:
!-lections an: rrrnring. From experience I know that
lltc govcrnment ahans pumps up the econonry lrt:lion.
clcctions. I will probabll.get an electi(,n+('ar lax (.ut,
lut that rtill be follos'ed by a stealtll rax irrr.ru.asc nexr
year. They can't fool me intr corsrrrrrirrg ntore, working harder. and votitrg for incrrnbcnts.

This is the pocy-ineffectiveness eoem of classical macroeconomics. Iil'ith l?tional expectations and
flexible prices and wagcs, anticipated government
poliq' cannot affect real output or unemploment.

The Desirobility of Fixed Rules

\\e describecl the motrctarist crse for fixed rules in
Chapter 10. New clssical macroeconomics pur-s this

argument on firmcr fboting. This approach holcls

that an economic policv can be dirided into m.o parts.
a predictable parr (the "rule") and an unpredictablc
part ("discretion").
Neu' classical rnacroeconomisLs argue that disc.c-

tion is a snare and a delusion. Policymakers, thcy contend, cannot fbrecast the economy anv bettct.than
can the privarc sector. Therefbre, by the rinte policymakers act or-r tlrc rrclvs, f lexibly moving prices in nrat.keus populated by well-informed buyers and scllcrs
have already adaptctl to the news and reached thcir

efficient supply-anddemand equilibriur. Tlrcr-c arc

no further di"snelionury steps the government can takc

to itrtprove thc outcome or prevent the uncmplo).

rrrcrt tllat is caused bv temporarv rnispcrccptions or
real-businesscvcle shocks.
Although they cannot make rhngs bcrtcr., goyernnrcnt policies can denitely make things u'orse. The

govclnr)crrr can generate unpredictable discretion-

ary ptlicies that give misleading economic signals,

confirse people, distorr their economic behalior, and
cause wste. According to new classical lnacroeconornists, governmenls should avoid any discretionary
rnacroeconomic policies rather than risk producing
such confsing "noise."

A New Synthesis?

Alicl thrce

decades of digesdng the neu' classical appr-oach to macroeconomics, elements ol a

svnthcsis ol old and new theories are beginDing to
appcar. [,corrornists today emphasize the importancc
of cxpccurtions. A useful disrinction is benvcctr rhc
adaptilc (or "backwardJooking") approach and
the rrtional (or "f<rrwardJooking") approach. -fhc
:rdaptivc assurnption hclds rhat people form their
expectatiorrs orr the ba;is of past informarion; rlc
forward-looking or rational approach rl'as descr-ibed
atlove. Tlrc inrportancc <f fonvard-looking expectations is cncial to undenitanding behalior, parricularly in cornpctitivc aucrion markes like those in the

financial scctor:
Somc rnacr<.economists have begrrn to fusc the
ncrv classical view of expectations with thc Keynesiarr vicrv of product and labor markers. This syrthesis
is crnbodicd ir macroeconomic models that assurne
( | ) lalmr and goods markets display inflexiblc wagcs
and plicr-s, (2) the prices in firrancial auction n)arkcts adjust rapidly to economic shocks and cxpectations, and (3) the expectations in atction rnarkels
arc fbrned in a forwardlooking *'ay.
Olrc irnportant forecast of srch ncw approaches
is that forwardJooking models tend to have large
'jtrrnps" or discontinuous changes in il)tcrcst rtes,
stock prices, foreign exchangc rates, and oil prices
in reaction to major news. Sharp reactions are often
seen after electiolrs or whcrr wars break out. For
example, when the Unirecl Statcs invaded Iraq in
March 2003, oil prices declirrcd by 35 percent and
stock prices rose by l0 perccnt in a singlc weeh. The
new classical prediction o[ 'junrpy" pt-ices replicates
orre rcalistic feature of arction markets and thus suggcsts one area where [orr'ard-10<king expectations
rnight be important in the real world.

1'IIIi INTF,RA(:TIOi

359

OF MONETARY AND FISCAI, POI-I(JILS

TIlc nerr tlassitltl atrro:rch l() ltl:lcr(x'c()ll()lllics

has lrlottglrt Irtaur f r uitltrl insishts. l\'lost itttrottant, it
rt'ntirtcls tts tlrat tltt ((()rt()lrl! is totrrlatcd hl ilrtt'lli-

collsulll('ls irlttl it"cstols rr'lltl tt'act ttl atld <ft<'tt

nti( il)irt(' r()licr'. Tlris teattiol lrlttl cort tt tt'rl-r:at liotl
( ur :r( llt;tllv t Itirtrgc llte r\:.t\ tllc c( ()ll()Itlr lrt'llrVt's
!.J('nt

C. STABTLIZING THE EGONO}IY

The period since \Abrlcl \4hr ll has bcclr onc of rcmarkable economic progress for the high-incomc nrarket
dcmocracies. Average incomes altd enrPlovnlcnt gre*'
rapidl irrternadonal trde broadencd and dccpcnccl,
ard rnany poor cotrntres, notably India and China,
beg'an tt.r closc the gap with rich countries.
The econonrics performed so well that sonte
proclailncd a "Ctca( Moderation," in which business
cycles werc disaprcaring. Some "new" economics textbooks virtually ignored the macroeconomics of busi-

Demond Monogement
The top consideratitn in busincss-cyclc management
is the overall state of the ecotromy and thc trecd to
adiust aggreKte demand. When thc ccononry is
stagnating, scal and monetary policies car bc uscd
to stimulate the economy and protnote ecotrortlic
recoveln'. When inflation threatens, lnonctarv alrd liscal policies can help slorv the econonry and daltpetr
inflatior.rary fires. These are examples of dnund tungemn4 which refers to the active use ol rnoltcLaly

and llscal policies to affect the level of aggregatc

dcrnand.
Suppose, for example, that the economy is enterirrg a scvclc recession. Output is low relative to iLs
potential. lt'hat can the government do to revive the
lagging econorny? lt carr increase ag[;regate demand

raising money growth or b,v boosting government

spending or both. ,Alicr thc cconomy has responded
to the monetary arrd liscal stimrtlrts, ottPut grow
and employrnent will incrcase and ttnemployment
will fall. (\A'trat steps ct-ulcl thc government take durb,v

ness c,vcles.

ing inflationary

This fn rasy was dispclled with the financial crisis

and decp reccssion that began in 2007. Words like
"recession' and "dcprcssion "-rvh ich had been banished t<-r the histor,v books-again took on meaning
in people's daily livcs.
It is critical o find xrlicics which can help avoid
the excesses of the busilrcss cyclc. We have seen that
the pa of output and priccs is dctermined by the
interacdon of aggreg'atc strpply and aggregate demand.

Let's reew the relativc strctrgths and weaknesses

of monetary polio' ancl fiscal policl'.

Huueuet; lnlicizs dtsigrud lt stalnkz lht bttsittcss qth musl

oferatc primarily thmryh hdr inqd ut agrugate drmawL

The gorernment can aflect rc growtlr of aggregate

clemand primarily through e use oI'is monetary and
fiscal levers and thereby ccruttte r tcccssiolts.

These obsen-ations lcavc oPen two crttcial ques

tions: What is the bcst nrix of nonetary and fiscal

policies for stabilizing thc ccononv? Shorrlcl there be
tight rules on policy-making, or should polio'rnakers
be allowed great discrction in thcir actions?

peri<-rds?

Fiscol Policy. ln the earlv stages of the

Keynesian revolution, tnacrocconomisrs emphasized
scal policy as the most powcrful and balanced remedy for demand managcmclrl. Critics of scal policy
pointed to shortcontittgs stclntning from riming, politics, and macroecontlnic tl)e oIy.
One concern is the tinrc span ber*'een cyclical
shock and policy respotrse. It takcs time to recognize

fhe

Role

of

that a cyclical turning point hes becn reachedrhe policy lag. For example, it took one year for
the NBER to declare the latcst business<rycle peak.
(The December 2007 pcak was not announced until
December 2008.) Alicr a turning point is identified,
it urkes time ftr the Prcsidcnt to decide rvhat policies are necessary ard tlcn still more time for the
Congress to act. Finally, cvctr whcn taxalion or spend-

ing is changed, thele is an cffcctiveness lag before

THE INTERACTION OF I-IONETARY

AND FISCAL POLICIES
For large economies like the United Statcs or

the economy resportds.

Euroland, the best combination of lronctary and

fiscal policies ll depend upon two fctors: tlre
nced lbr dcmand management and the desircd

Critics also point out that it is easier to cut taxes

than to raise tltcm, and easier to raise spending than
to cut it. l)uring the 1960s, Congress was enthusiastic about passing the Kennedl'fohnson tax cuts'
Two years latcr, whcn the Vietnam \'[hr expansion
ignited inflationar-y prcsstrcs, contractionary Poli-

fiscal-rnonctary nrix.

cies rcere called fbr.

360

There are two situatiolrs when countercyclical

fiscal policies appcar to bc particularly useful. One
case is fentporary tax cuts in recessions. Temporary
tax cut.s may be airrrctl prirnarily at low- and micldle-

income horse holds. l'hc r eason is that these htrrseholds lravc high rrral girral propensities ro consllme
tecarrse tlrcy havc littlc excess sang to fall back on
in hard rimcs. Statistical studies indicare rhar these
measrrres havc indced been eflective itr increasing
aggregate dcnranrl irr thc short run without leading
to long-rtrn fiscal tleficits.
Arr cvclr rnore importanr situatitn is when tlrc
econorly is in a liquiclity trap and the central bank
has no firthcr- room to lower shorrterm inlercst
rates. (Rccall ttr discussion of the liquidiry trap in
Ohaptcr 10.) 'I'his wzrs the case during rhe 2007-2009
reccssion. Ill its eflbrt to revive rhe econonry, tlrc
Obarna adrninistration worked w'irh Oongrcss irr carly
2009 to pass the largest fiscal stimrrhs packagc in Ll.S.
histov. Vv'hile some people worried aborrt thc longternr in)pact of the fiscal stirnulus on the governrncrrr
debt, most nlacroccont.rnlisu believed th:rt fisc:rl nrliq was thc olllv li'asible wav to rerluce rhe deprh and
the selcritv ol the dorvnttrrn in this circrrmstanct'.
Effectiveness of Monetory Polcy. Compared to fiscal poliry, monctar) policv operates mrrch mtre indirectly on the econoln\,. Wlerers:rn exp:rnsive scal
policy actually hrrls goods and scnices or pus income
into the hands of consurreni and businesses, monetary policy affect.s spcndirrg bv altering interest rates,
credit conclitions, exchangc ratcs, and iuset prices. In
the early years of thc Kcyncsiarr revolution, some macroecononlists wcrc skcptical bout rhe effectiveness
of monetary policy-sorne said, "Moneurry policy was
like pushing orr a string." Oler the lasr rwo decades,
howeve these conccrlrs hare been put to resf as the
Federal Reserue has sh<,xvn isell' quite capable of
slowing dorvn, or specding up, thc cconomy.
The Fecleral Rcscrvc is rrruch better placed ro
conduct stabilization policy tharr are the fiscal-policy
makers. hs surff of prol'cssional cconomisLs can recognize cvclical movenrcnts as wcll as anyone. And it
can move quickly rvhcn tht- nced arises. For example,
a cascade of failrrres o[ llnarrcial institutions caused a
major financial clisis wlrcn the investment-banking
firm Rea Sleal lrs lracl st.r'ere liqrridiw problents ou
Friday, March 14, 2008.'I'he Fed needed to come ur)
with a solrrtion bclol c nrarkels opened on M<lnday

CHAPTER I7 . FRONTII]RS OF MA(:ROT](:ONOMI(:S

rnonring. Ry Sunday, working with the U.S. Treasury

Dep?rrtrnent, tlrc lctl had engineered a takeover of
Bear by J.P. Morgan ard lad opened atr entire new
credit facility lbr its prirnary dealers. It is difficrlt to
corrceive of any lcgislatrrre urking such complex measrtrcs in srrch a slttr t tirne.

A ko, ingr-etlicnt in Fed policy is its independence, arr<l thc Fcd has proved that it can stand
thc hcat of'rnakin politically unpopular decisions
wlrcn thcy alc ncccsslry to slow inflation. Most
irnportant is that-with some q ualifications-from
tlre point of view of demand man?rgemerrt, monclary polic)'can do, or unclo, anyrhing rhat fiscal
polic,carr accomplish. The major lesenarion is
that il tllc economy gets stuck in a liquidiw trap,
rvith nornirral interest rates at or ltear zero, thcn
nronctary policy loses irs ability ro stimulatc thc
cconorny. When the econonlv is in or ncar a liquiditv trap, fiscal policy musr rherefore takc ovcr ttre
rnajor expansionary role.

\4t'can summaze the current state of fiscal and

Inonctarv policy zrs follows:
lit'carsc ol thcir political indepcrrdence and rapirl
decisior rrraking, tcntral banks are rvell placed ro be
orr lhr. li'ont line of rlcfensc in stabilizing the ecollot.nv
atrrinsl brrsint.ss< r'r'le shocLs. Discretitnar' fiscal policy is rtseful irr rcccssir.rns iu a one-time stinrtrltrs. lvtlren
the ('c()n()rny arrr oachcs a litrridin, trap, fiscal policv
ntllst be llrt' rrirrr: t, s()trrcc of c< olrol1ric stilDtrlLrs.

The Fiscol-Monetory Mix

Thc scconcl fctor aflecting

fiscrl and mone&rry policy is thc rlesirctl fiscal-monetary mix, which rcfers 1<r

thc lclativc strength of fiscal and monerary policics

anrl tlrcir cllect on dillerenr secton of the econont!'.
A thange in the Jtsral-monetary mixis an approach which
tightcrrs onc policy while easing the other in such a
w?ry that aggrcgatc dcfirand and therefore totrl outprrt rernain constant. The basic idea is that fiscal policv anrl rnonctaly policy are substitutes in demand
man?lfJcmcnt. tsr.rt whilc alternative combinations of
monetar] alrrl liscal policies can be used to srabiliz.e
the ec()nornv, thcy have clifferent impacts upon the
co'r\xtsi.liort ol outpt-lr. Bv varying the mix oF raxes,
govcrnrncnt spending, and monet:rry policy, thc: gor.
cnlrnL'nt can change the fraction of GDP devotcd to
brsirrcss invcstrncnt, consumption, net exports! and
govcrnlrlcnt purclrases of goods and services.

3t

1'III.] INTF,RA(:TION OF MON]TARY AND 'IS(]AI, POI,I(]IES

Ctmge in ou9ut
($, billion, 20118 prices)

Sector

132

Investment sectors
Gross private domestic investnent

Housing

48
18

Rusiness fixed
Net exporLs

investment

30
83

Conemption sector:

106

26
100

-68
-38

Government purchases of goods and services

Personal consumption expcnditures

Memoranda:
Ohange in real GDP
Change in f'ederl deficit

TABLE l7-3. Changing c Fiscal-Monetary Mix

Wht wrrrld he tlre impact of a clr:rnge in llrt. flscal-monetary nrix for the Llnitcd Statr:s?
This simulati<rr assuntcs rhar the t-ederl deficit is ct|t by $l(x) billion through higher
personal taxes and ltwcr fi:<leral nondefense expenditurcs whilr: tllt- Federal Resen'e uses
ioneurry policv to keep rrnt.rnrk)ynlent on an rrnchangetl traicctory. The sintlation akes
the average of the changes frorn lltt: baseline Path over the peri<xl 200(L2O()ll'
Sorrrtr:: Siul;rtirr rsing lltc DRI rxxlel{,1

Effeca

of

tlrt Lr.S c(tn.nl}

of Monetor ond Fiscot

impact of changittg
tlre
To undcrritatrcl
Chonging the Mix

Poficies.
the fiscal-moneurry trtix, lct's cxamine a specific set
o[ policies. Suppose that thc lederal government
rcdrces the federl btrdgct dcficit bv $100 billion
and that the Fed loweru irtcrcst rales fo offset the
contractionary impact ol such a fiscal policy.
We can estimate the ittrpact usir.rg a quantitative
cconomic model. Table l7-3 shows the resulus of this
cxpcriment. Two interesting l'catrrcs emerge: First,
thc simulation indicates that a changc in the scallnorrctary mix would indeed changc tl.rc composition
of rcal GDP. While the deficit dcclincs by $| 00 billion'
business investment gocs uP by $30 billion. Investnrent ir horrsing also increa;es as ilrtcl'cst rtes fall.
consurnptiot.t declines,

result is clearly sensitive to thc reaction of financial

nrarkels arrd exchange raLes to the deficit-reduction
packagc, it srtggests that some of thc poprtlar analyses
a package may bc nrisleading.

ol thc inrpact of such

Many analys.s have argued that a dcficit-redttction

packagc would have a significarlt irnpact upon
dorncstic brsiness investment and rrpon productivity. However, to the extent that lowcr cleficits mainly
incr casc net exporls and housirtg, thc nation is likelv
to cxpcrience relatively little incrcasc in prodrrctity
growth. According to the estimates, cttLting the hudgct dcficit by $l0O bil'lion will rise tltc growth rate
of -rotcntial oltplt from 2.3 perccnt per year to 2.5
pcrccnt pcr year over a lGyear pcriod. Perhaps the
small sizc of the payoff explains wh,v it is so hard to
muster lhc political uill to cut the deficit'

strrrent.'l'his sitntlation
cal-rnoncnry mix might

Alternative Mixes in Practice

The fiscal-monetary mix has been sharply

r,ltPrt.

'I-hc simtrlation contaills otrc particttlarly interesting rcsult: Net expors rise fr rnorc tlran either
housing or bttsiness xed irvesLlncnt' This occurs
becausc o[ the strong deprcciation of the clollar
which rcstrlts from the lower intcrcst ratcs. \'!'h ile this
I

debated in American economic policy. Here

are two maior alternatives:

fscol-tight monetory policf. Assume that the

econony begns in an nal stuaton with low inflaon
Loose

362

CHAPTER I7 . FRONTIERS OF MA(:R()I-(:ONOIICS

and output at its potenal. A new president decides

it s necessary to increase defense spending

that

sharply without raising taxes. By itself, this would

increase the government deficit nd increase aggregate demand. In this situation, the Federl Reserve
would need to tighren monetary policy to prevent
the economy from overheating. The result would
be higher real interesr rtes and an appreciation of
the dollar exchange rare. The higher interest rates
would squeeze investment, while the appreciated dollar would reduce net exporu. The net effect therefore would be that the higher defense spending would
crowd out domestic investment and net exports. This
policy was the one followed by the United States in
the 1980s and again in the 2000s.
frght,tscoHoose monetory policl. Suppose that a coun-

try

becomes concerned about a low naonal saving

rte and desres to raise investment so as to incrase
the capital stock and boost the growth rete of potential
output.To implement this approach, the country could

again dulinlt booms, as a countercyclical fiscal policy

would rcquire. For that reason, conscrvatives have
nradc scvcral attempls to limir rhe ability t-rf Congress
to appr-opriate nerv funds or increasc thc deficit.
At thc same time, monetary consclvatives would
like to tic the hands of central banks and lbrce them
to targct inf lati<.n. Such a policy woulcl clininate the
lncermintv about poliq and en hance thc cre ditrility
of the ccntral bank as an inflation fighter.
At thc rnost general level, rhe dcbatc about
'nlcs vcrsrrs discretion" boils down to wllcther the
advanurges <-rl flexibility in decision rnaking are outwcigllcd by the uncertainrics and potential abuse in
uncolstrained decisions. Thosc who believe that the
cconornv is inherently rnstablc and complex and
lhat governments gerrerally lnakc wise decisions are
ctrnfirrtable nith giring policylnakcrs wide discretion
to react aggressivelv to stabilizc the economy. Those
wlt believe thar the governnrcnt is the major destabilizing force in rhe econonry ard that policymakers

raise consumpdon ta:res and squeeze transfer payments

so as to reduce disposable income and thereby lower
consumpton (ght fiscal policy).This would be accompanied by an expansionary moneary policy to lowr

are prone to selfishncss a|rd rnisjudgments favor tying

tle hands of the fiscal and nrorrctary authoriries.

interest rates and raise inrestment,lower the exchange

As deficirs began to grow during the lg80s, manl'

people argued rhar Congrcss lacks the self<onrrol to
ctrrb excessive sper.rding and a burgeoning governrnent debt. One proposal put tbrth by consenaves

rate, :rnd expand net expors. Ths course would

encourage pri\te nvestment by increasing public sav-

This was the economic philosophy of President

Clinton which was embodied in the 1993 Budget Act
and led to the budget surplus at decade's end.
ing.

RULES VS. DISCRETION

\4'e have seen rhat liscal and monet^ala policy can
in pineiltb stabilizc the economy. Many econornists
believe that counrries should i ltrncti.re takt: stcps to
shave the pcaks and troughs

off the busincss cyclc.

Other econonriss arc skeptical of orl. ahilitv to fbrccast cycles and rakc thc right steps ar rhe right tirnc
for the right reasons; this second grorrp concltr<.lcs
that governmcllt cannot be trtrsted to r.nakc good
economic policy, s<_r is freedom to act should be
strictly limited.
For examplc, fiscal consenatives worry that it's
easier for Conglcss tr increase spendirrg aud cut.
taxes than to do the re!rse. That nrcans it's casy
1o increase the brrclgct deficit during reccssions lut
much harder ro turr around and shrink thc dcficit

Eudget Constraints on Legislotures?

was a conslilutional anrndnunl requiring a balanced hudSuch an amendmcnt was criticized by economists

gz.

because it would nrakc it dilficult to use fiscal nolicv

to fight recessions. lb clatc. none of the propose
constitutional amendrucnts has pissed Congress.

Instead, Congrcss lcgislated a series of lrudgelary rulzs to limit spmding and tax rcdudio.r. The lirst
attempf was thc Gr?rnrrRudman Act in 1985, whiclr
requirerl rhat thc deficit be reduced bv a spccified
dollar amorrrrt cach year and that the brrdget bc balanced by 1991. This approach failed to limir spcnding and was abandoltcd.
A second approaclr w.:; a pa\vrs)ou-gn btulget rul,
which w:rs adoprcd in 1990. This reqrrired tl.rat Congress
find the r evcnrcs to pay frrr any new spending program.
In a sense, pav-a-s-)'ou-go imposes a budget cotrstnint
on Cnngress, rcquiring that the cosls of new progrnls
be explicitly recognized either through higher taxcs or
through a redtrction in other spending.
14har was thc inr-ract <rf the budget constl.ain ts
on Congrcss? Ect.nomic studies indicatc tlrat thc

33

RUI,ES vS, DIS(:RI.] ION

budget rules prodrrced significant scal disciplinc,

hclpcd reduce the deficit over thc 1990s, and eventually produccd the surplus afier 1998. Houcver, rvhen
the deficit changed to surplus and thc lrlgcncy of
defi ci t-reduction decl ined, polic,lrnakers cvadecl the
earlier budgct caps with gimmicks like "erncr-gency
spending" fbl predictable items like thc dccennial census. Fiually, in 2002, the budgct caps wcre
allowed to expire. Matrv ccrnomisls believe that a
pay-as-you-go rule is a tscftrl mechanism to itrtposc
budget constrins on lcgislatttres, and there werc
proposals to reinstate tltcsc in 2009.

Monetory Rules for the Fe

In our discussiolr of nronetarism in Chapter 10, rvc
laid out the crsc fbr fixed policy rules' The traclitional argumcnt fbl fixcd rules is that the pr-ivatc
economy is relativclv stable and active polic)'rnaking is likely' to destabilize rather than stabilize thc
econom)'. Moreovet, Lo the extenf that a central
bank rrnder the thttrrlb o[ the government may bc
tempted to expatttl thc cconom!' beforc electiolls
and to create a political btrsiness cycle, fixed rules
ll tie its hands. lIl addition, modern macroec()ll(>
nrists point to the valuc <-rf lrcing able to comnit to
actiorr in adrance. If thc cclltral bank can commit tt'
lbllow a norinflatiortarl' rulc, pcople's expecutions
raill adapt to this rule alrd inflationar- expectatons
may be dampened.

One of the most inlPortan t new developlnents itt

rhc last decade has been tltc trcud toward inflation
targcting in many coutttrics. Inllation targeting is the
announcement of official targct ranges for the inflatiorr rate along n'ith an explicit statement that low
and stable inflati<.n is thc ovcrriding goal of monetary policl'. Inflation targctirrg in hard or soft varieties
has been adopted in rccctrt vears by many industrial-

ized countries, including Car.rada, Britain, Australia,

and Nerv Zealand- Moreovcr, the treaty authorizillg
the new European Ccntral Bank mandates that pricc
snbilin' be the ECB's priman' obiective, although it
is not formally rcqtrircd to urget inflatiorl. A tlrtlnber of ec<)n<rnists arrd legislators are advocating this
irpproach tbr thc Llnited Sntes as well.
In flatiorr targetin g invohes the ftrllorving:

The government or ccntlal bank announces that

rnonctary policv uill strive Lo kccp inflation near
a nurrrcrically specified target.

T'hc targef rrsually invohes a rIrge, such as

ll pcrccnt per verr, rather than literal pricc

sta-

to

bility. Gcnerally, the government targeLs a core

inllation rate, such as the CPI excluding volatile
food and ettcrgt' rriccs.
Inflation is thc pliman'or overriding target of
policv in thc nrcditn run rnd long run. However, countrics alwavs tnake room for short-run
stabili zation objectives, particrlarl)- with respect
to output, unemPlo,vrttellt, linalrcial stability,
and the foreign exchangr ratc. Thcse short-run
objectives recognize that supplv slrocks can affect
outprt and unemployment ancl that it may be
dcsirable to have temporary departtrrcs from the
inflation target to avoid excessive unellrplovtncttt
or ()ul"put losses.

ProponcnLs of inflation urrgetitlg Poillt to nrarly

adlarrtagcs. If there is no long-run tradeoll bctrvecn
uncnplovnrcnt and inflation, a sensible irllatior target is that ratc which maximizes the efficiencv of tlrc
price svstcnr. ()ur analrsis of inflation in Chaptcr' | 6
suggested that a low and suble rate of inflatitn rvottld

pronlotc cllicicncy and minimize unneccssar;- rcclisribution of income and weal. In additi<n, some
economists bclicvc that a strong and credible commirment to ltw and stable inflation will improve thc

short-run i r f la tion-tt nem plogn e n t trade<.rfl'. Fi nall,r"

an explicit inflation target rvould increa-se thc tr-alls
parcncv ol ttrolrctarl policr'.
Inflati0n targctit-rg is a compromise betwccn ntlebased approachcs and purely discredonarv policics.
The main disadvantagc wotld come if the celrtral
bank began to rcly too rigidly on the inflatiolr rtrlc
and theretry allorvcd excessive unemploynrent iIr pcriods of severe supplv shocks. Skeptics worry that the
econoIly is too complex to be governed by fixcd nles.
Arguing bv analogy, the.,v ask whethcr one world advc>
cate a fixcd spccd limit for cars or an autornatic pilot
for aircrali in all kinds ofweather and errtcrgcncies.
Critics point to the frnancial crisis ol 2007-2009
irs an cxatnple of the peril of relying orr rigid targets.
Thc t-cd lowered interest rates arld cxpanded credit
throughout this period, evclt thotgh srrpply shocks

wcre raising inflation abtvc the Fed's "comfort

zone." lf e Fed had fbcuscd entirely on inflatiolr

inflation-targeting aprroach, it would have

raiscd interest rates, tightened crcdit, and reinforced
the rcccssiotrary lendencies and ec<-rlrolnic distress in
rurrcler an

364

CHAPTER

this pcrir-d. Instead, the Fed concenrrated on tryilrg

to cushion the economy from a deep recession atrd
to prcvcnt wholesale banknrptcies of financial institutions (scc the discussion of Bear, Stearns abovc).
Monet-ary policy cannot banish all rcccssiorrs or
renrovc cvery temporry spike of inflation. Howcver,
working with fiscal policy, it can reduce thc chance of
spiraling cortrctions or hyperinfl ation.

Thc rlcbatc over ntles versrrs discr-ctiolr is orrc

debates of political econorrry. fhis
dilcnlrna reflecls the difficrrlt tradcolls tllat dcrtro( rirtic socictics flce in makilrg decisions l)ctwcen

o[ thc oltlest

short-rrn policies intended t() atrr':rcr rolitical srrp

port arrrl lorrg-rrrrr policies desiglrecl to iltrprovc tllc
general n'cllrc. There is no single best arpr.oaclr fbr.
:tll timcs arrtl places. For rnonetarl tolicr', thc Lirrite<l
Sfatcs has lcstlved the dilenrrra bv cr.cating alr illdeperrrlcut ccrrtral bank, accountalle t0 thc lcgislature
hrrf givcrr rliscretion to act forcefulh'whcn ccontlrric

or inarrcial clises alise.

f

I7 .

Cormtry

FRONTIF.RS O' MA(:ROE(;ONOMICS

Per cepia GDB 2)6

United States
Hong lbng
United Kingdom
J"pan
Germany
Slovenia
South Korea
Poland
Mexico
Botswana

Argenna
China
Nigeria
C,ongo

M,070
39,200
33,650

32,8.()
32,6{t0

28,970
22,990
14,250

l1,990
I I,730
I I,670
4,660

r,410
270

TABLE | 7-4. Current Incomes Represcnt Effecrs of

Past Growth

Those countries that havc grown most rapidl;l in the past

have reached thc lrighcst levels of per capiu GDP trxlav.
Sotrcc: \{tr ll

tlurk

D. ECONOMIC GROWTH

AND HUTIAN WELFARE

\4'e have come to thc cnd ol' our suney of modern
rnacroeconomics. Let rs stcp back and reflecf on
tllc centrl long-nrn ntessagc as stated by economisr
joumalist Paul Knrgman:
Produc ivirv isn't everying, but in the lorrg rrrn ir is
alnrost t.verything. A country's abilitv to irnprove is
lir.ing standards o\r time dcp(:l(ls almost enrirely on
its abiliry to raise its output IX.r worker.

Prornoting

high and growing standard of ling

is one of thc Iiudarnental

for the nation's residenLs

goals

of

rtracroec<nomic policy. Bccarrsc the curof' l-cal income reflect"s thc history ol the
groulh of pr r-rcluctivity, we can measlr r.c thc relative
success of past growth by examining rhc pcr capita
GDPs of clillcrent countries. A short list is Drescnted
in Tablc l7-4. This table comparcs incornes by using
lnt n: husinglownlarlfi exc h an gc ra tcs tha t measure
the prrrchasing power of (or qrrantity of goods ancl
serviccs thar can be boughr by) rlillerent national
crrrrclrcics. Evidentll', rhe Ilnited States has been
srccessfrl in its past growfh perforrnarrce. Perhaps

ren

lz,ucl

the most worrisome issrc in rccent years is that the

growth in living standards ltas nt.r been universally
sharcd around the worlcl.
Ll discussions of growth ratcs, the numbers
oftcn scenr tiny. A successful policy rnight increase
a countrv's grorvth rate by only I pcrcentage pont
pcr year (recall the esrimatcd inlpact of the defi-

cit-reduction packagc in thc last section). Bur

over long periods, this lnakes a big difference.
Table l7-5 shows how rin)' acorns grow into mighty
oaks s small growf h-ratc dilll'rences cumulate and
cornpound over rime. A 4 pcrct: nt-per-year growth
clifll''ence leads ro a 5O-fold difl'erence in income
lcvels over a centllry.
How can public policy boost cc<_rnomic growth? As
wc crnphasized in orrr chaptcrs orr economic Browth,
thc growth of outprrt per worker and of ling standards depends upon a countt]'s saring rate and upon

ius technological advarce. Issues involng saling

were discussed ea'licr in this chapter. Technological
change inclrrdes not only new producm and processcs

but also improvenrcnts in management as well as

entrepreneurship and the spirit of enterprise-and
we close our discrssiolt with this topic.

35

THE SPIRI'I' OF I]NTF,RPRISE

Real Income per Capita (constant Prices)

Gmwlh rate
0

I
,2

2t00

205()

2000

(% per year)

24,000

24,000
39,471
64,598

24,m0
24,m0

24,ffn

24,000
64,916

t73,872

l,2t

t70,560

2,1

t8

TABLE l7-5. Small Diffcrcnces in Growth Rates Compound into l-arge Income
Differentials over e Decadcs

vast dillcrcnccs

THE SPIRIT OF ENTERPRISE

Although inlestment is a central lctor in cconomic
growth, tcchnological advance is perhaps cvcll Inore
imDortalrt. ll wc took the workers in 1900 ard dotr-

bl or tr-iplcd their capital in mules, sadcllcs,

picks,

and corv paths, their productigv still coulcl not come

cltse to that of today's l4'orkers using lrrrgc tl'actors'
su-rcrhighwavs, and suPercomputcrs.
F oste ri n g Te chn o I ogi col Advo n ce
While it is easy to see how technological adrance
pronlotcs grolvth in productity ancl living stan-

dards, govcrnmelrt"s cannot simply conrnrand people

to think hardcr or be smarter. Centrally plannerl
socialist cortrtr-ies rrsed "sticks" to Prollrotc science,
tcchnology, and innoration, but their cflbrs failed
because rtcithcr the institutions nor thc "catrots" u'ere
Lo cncollrage both inn<vation alrd introdllction ol ncw tcchnologies. Governmctrts oftcn prc>

present

mote rapid tcchnological change best whcn tlrcy sct

a sound econt.tnic and legal framework with strong
intellectual propcrqv righrs and then allow grcat cco
nomic fieedorn within that framework. Frct mrktts itt
lnbu rapital, lnodtu.Ls, ul ittc.s haue Pmaed lo b lh? rul
.fefiik wil lor inrnualion anl technotgical chang.

Within thc framework of free markes, go\crnments can fbstcr rapid technological changc lxrth by
encouraging lcw ideas and by ensuring that tcchnologies are efl'ectivcly uscd. Policies can focus t.tr both
the supply sidc and thc demand side.

Promoting Demond for Better Technofogies. 'Ihe

world is lull of supcrior technologies that tlavc not
been adoptcd; othcrwise, how could we explain thc

In

c<.rnsiclc ri

tt

in procluctivity shown in Tablc l7-4?

tech nolog,v policies, therefbrc, govcrn-

ments t|lrrst cnstre that rms and industries Inovc tc

ward thc trchnulngiral ltonlira adopting the best-practicc
technolog.v ar"ailablc in the global marketplacc.

Thc nrajor lcsson here is that "necessity is thc

r.rl invcntion." In other words, rigorous cortrpctition arrrong firms and industries is the ultinrte discipline tlrat ctrsures innovation.Just as adtletcs pcrform
better rvhcn the,v are trying to out-run tht: ir competitors, so arc firms sprrrred to improve thcir products
and processes whcn the ctors are given larrrc and
fortune whilc thc laggards may go bankrupt.
Vigorous cornPctition involves both dolncstic

mother

and foreign conlPctitors. For large coulltrics on

the technological fi'ontier, clomestic compctitior) is
necessary to pK)lnotc innovation. The movculcl)t to
deregulation ovcr thc last three decades has bror.rglrt
competitiorr 1o airli]res, energl', telecomnrttlrications,

and nance, ard thc positive impact on irrnovation

has been drnatic. For small or technologically
backward countrics, intport competition is crucial t<r
aclopting advanced tcchnologies and ensuring prodrrct market competition.
Promoting Supply of New Techaologies. Rapid ect>
nomic growth requircs prrshing out the technological frontier by incrcasing the supply of inventiolrs as
well as ensuring that there is adequate delrtand for
existing adlanced tcchnologies. There are three ways
by which governments calr cllcorlrage the supply r-rf
new technologies.
First, governnretlts can ensure that the basic science, engineering, atrd tcchnology are appropriatcl,v
srrpported. In this respcct, the world leader in thc

cHAPTER

last half-century hs becn the Unitecl Srares, rvhich

combincs cornpanv supporr for applied escarch
with topnotch university basic research gcncrouslv
supportcd b,v government funcling. Particrrlarlv otrtstanding havc bcen e impressive improvements in
biomedical tcchnologv in the form of new drrrgs and
equipment that bcnefit consumers directly in daily
life. The govcrnrllcnt's rolc in supporring For-profir
research is accornplished by a strong patent systcrn,
predictablc and cost-ellectit'e regulations, and flscal
incentivcs strch as the current R&D tax credit.
Second, governments can adrance technologies
at homc through encouraging invesrmenr by lbreign
firrns. As lbreign counrries reach and pass the funerican technological fronrier, they can also contribute
to Arneican krrow-how by establishing operations in
the Unitcd Statcs. The last rwo decades have brought
a numbcr 0l Japanese automakers to thc Llnited
States, and Japanese<lwned plants lravc introduced
ncw technologies and managerial practices to the
bcrefit oF both the profits of .Japanese shareholders
and the productivity of Anrerican rvorkers.
Third, goternmenls can promote new technolo
gics by pursuing sound macroecorrornic policies.
Thesc include Iorv and stable faxes on capital income
and a low cost of capital to firms. Inclccd, the importance ol the cost of capital brings us back full circle to
the issue of-the low saling rare and high real interest
ratc. Anerican firms are sometintcs accused of being
myopic and being unlling ro invcst fbr the lorrg
mn. At least part of rhis nryopia comes fiom being
Faced with high real interesr rates-high r.eal interest

7 .

FRONTTERS

()l MA(:ROE(:ONO! tCS

the "ecoromic specncles" through which firms look

when considering their tcchnological policies. If real
interest rates &'ere lowcr, firrrrs would view long-ternr,
high-risk projecLs such as invcstments in technology more favorablr,, and thc incleascd investment in
knowledge would lead to rnorc rapid improvemenrs
irr technology and producrivitv.

Valediction on Economic Growth

Following the Ke)rnesian revolution, the
leaders ofthe market democracies believed

that they could flourish and grow rapidlr.

By using the tools of modern economics, countries could
moderte the extremes of unemployment and inflation,
poverty and weakh, privilege and deprivation. Indeed, manr
of these goals were achieved as the market economies
experienced a period of output expansion and employment trowth never seen before.
At the same me, Marxists carped that capitalism was
doomed to crsh in a cataclysmic depression; ecologists
fretted that market economies would choke on ther own
fumes; and lberbrians worried that government planning
was leading us down t}te road to serfdom. Bur the pessimists overlooked t}e spirit of enterprise, which was nurtured by an open society and free markets and which led
to a continuous stream of technological improvements.
A valediction from John Maynard Keynes, as timely
today as t was in an earlier age, provides a fining summary
of our survey of modern economcs:
It is Enrerprise whch bulds and improves rhe world! possessions. lf Enterprise is afgot, rvealth accumultes whatever

ratcs Jbrce rational American firnrs

payolls

to look for qr.rick

in their inl'esrments. A change in economic

happens to Thrrft; and if Enterprise is asleep. weal decays

whareverThrift may be doing.

policy that lowered real ntcrest rates would change

su]|tltARY
A. The Economic

Consequences

ofthe Goyernment

cxx'rrrlitures. Macroecononric policy rlt.pcnds upon

fiscal policy, which compriscs rlrr. overall stance of

Debt

l.

Brrdgcs are systems used by govcrnments and org-nizations to plan and rrrrrtrol expenditures arrd revenues. BudgeLs

alc in srrrplrrs (or deficit) when rhc

government l'ras rr.vt.nues gre;rter (or less) tharr its

2,

spending arrd taxes.

Econonrists ricparate the actual budget into it-s stnctural ar<l ctclical componenrs. 'l he strrcttft| bldget
calcrltcs horv much the governnrerrt urrrrlrl collect

'ffi

SU M MARY

and spend if thc r:conomy were operadng at potential

output. The cvclical lrrr<lget accounLs fbr the impact
ol the bu^siness cycle on utx revertttcs, t'xrt'tt<lilures,
and the dcficit. 'lb asses-s fiscal policv, we shorrld pav
close attention t() lh(: stl uctural dehcit; changes in the
cvclical deficit are a r-rz of t'llatrges in the econom,v'
while structurl deficis are a rnrr.rz ttf r'ltanges in the
('c()rrony.

3.

4.

arr<l rrncnrployment is largely voluntary

emment policies cannot affcct rcal outPut and

rrrr<'rnployment. The theory of the real busirtcss cyck:

[)()ints l() supply-side technological disturbances and

to labor nrarkct shifis as the clues to business{,vcle
fluctuaons.

9. What is our appraisrl of the contfibutiorr

<l the new

classical approach t< shon-run macrocconotrrics? T'hc
ncw r'lassir:al approach properly insists that e econ'

omy is populatc<l bv firrwardlooking consumers and

investors. These econonlit a(l(,ts r('ac[ to and olten
andcipate policy and can thercl)v changt' cconomic
lx'lravior. 'l'his lesson is part-icularl]" important in nattcial markcts, wlrr:rr: reacdons and anticipations often

rtrrr arld the long nn. Reew the box orr rac 354

and tlrt: dirrinished capital accumulation that c()rlr('s

from capital <lisrlaccnrent.

B. Advances in J'lodern J'lacroeconomics

7. (llassical economists relied rrpon Say's Iaw of Markes,
wlrich holds that "supply creates its or'r'r rk'rnarrrl." Irt
m<xlt'rrr language, the cl:Lssical approach m('arrs thal

8.

flcxibk: wagcs and prices quickly remove Any (:x( (rris

supply or dt:tnatrd atrd thereby reesablish full cmrloyment. In a classical s]Titeln, macroeconomic policv
ha-s no role to rlay in stabilizing the real economy,
although it will still affc( l th(! l)ath of Prices.
New classical macroecon<lmics holtls that exPectatiors arc rational, prices and wages are flcxiblc,

The policv-

ineffectivcncss tlrcox:nl holds that predictable gov-

The govcrnrn('nt debt represents the accumulated borrowings from thc puhlit:. It is the sum ol'past decis' A
u.seful meuure of the sizc of tht' rlt'lrt is the debt{iDP
mdo, which for the United Sates has tt'rtltr<l to rise
durirrg war lirrtc arrd lall dunng peaceme.
In underritan<lirtg tlrc impact of government deficits
and debt, it is crucial to tlistirtgrrish between che shtrt

and nrakc srrrt: you undershnd why a larger dcficit < aIr
increase outprtt irr thc short run while decreilsing output in the long ntn5. 'lb tlre degree that we borrow frorrr abr-<ad lbr consunrpon and pledge posterigv to pay bat k tltc inlercst
and princil)al on stch extemerl debt, our dcsccndatrts
will indeed find tltctts<'lv<'s sacrificing consumPtion
to service this debt. If wt' lt:avt: luture generaons an
internal debt but no change in carital slock, there are
variou.s internal effecs. The process o[ taxittg Pctel to
pay Paula, or taxing Paula to pay Paula, carr irtr'olvc
\arious nri(r(x:(-oroln ic distortions of Producti\ity
and effrciency brt shrrrkl rrot b,e cotlfirsed with owing
monel/ to anothcr corntry.
6. Economic grow mly slow if the public dclrt displaces
<apital. This syndrome occurs when PeoPlc srrl)$tlul('
public rlt'lrt firl capital or prirate irssels, thereby rt'rlttr'
ing the ccorrrnry's prirate captal stock. In the long
run, a larger governnlcttl <k'ht rnay slow the growth
ol potential output and constrtrrl)ti()tr hccause ol-the
c()sls ol sen'icing an external debt, thc int:flicir:lcies
tlrat arisc fionr uexing to pay the interest on tlrc tlt'lrt,

l6r

have drmatic effects.

C, Stabilizing the Economy

I0. Nations face rwo considertions ill s(:ttillg tnonetary
and fiscal policies: the aPProPriate ltvcl of ar<:-

l.

gatc <l<:rnand and the best monetary-scal mix. Ttrt:

mix of fiscal arrrl rtrortclaty policies helps determine
the composition of GDP. A lriglr-irlvestnrent strategy
would call for a budget surpltrs alottg with low real
interest rates.
Shorl<l goverrments fbllow fixed ntles -rr disr:re
tion? Thc answer involves both positive economics
and normativc valr<'s. (lorlservatives often espouse
rules, while liberals often advot:al<: aclive fine-tuning
to attain econ<mic goals. More basic is th<'qrrestioll
o[ whcther active and discretionary policics stal)ilize
or dcstabilizc thc economy. Economists often strcss
the neerl for crulihb policies, whether credibility is
generated by rigitl rtrlt:s or by wise leadership. A
recent trend among countrit's is irlllation targeting
fbr nroDetar), policy, which is a flcxiblc rrle-based
syst('rn lhat seLs a meditm-term inflation largcl
whilc allowirtg short-run flexibility when economit:
shocks makc attairrirrg a rigid inflation target too
costlY.

D, Economic Growth and Human Welfare

12. Remember the dicturn: "Plrxluctirity isn't evcrying,
but in the long ntn it is alrrt('sl cverything." A country's abilin' to improve ils living standards over me
depends almost entirely on its abilit;r to improve e
technologies and capital used by tlrr: wor kforce.
13. Pr-onroting economic growth entails advalrr:itrg technology. The major role of government is to (:nsrrc l-ree
markcls, I)rotcct strong intellectual propertv righls,
promote gorotr.s <rrrnpetition, and support basic science and technology.

38

FR()NTt URS ()F MA(tR()!.c()NOl\ttCs

CHAPTER I7

CONCEPTS FOR REVIEW

The Economics of Debt and
Deficits

Advances in Modern
Macroeconomics

fixed rtrles ls. discretion

inflatior.r trrgetit) g

government budget
budget deficit, surplrls, arrd balancc

Sav's

Iaw of Mlrrkets
raonal (lirrwardJooking)

Long-Run Growth

budget;
ac tual

expectrti()11s,

looking)

stru ctura

(.x

r<:aclring thc tcchnological fronuer vs.

rrrong it orrbvard

a(lal)liv(. ( lrat kward-

lx'(

tr(

i()ns

Ke,vnes's

roliry-i rr.ffcc tivcn ess theorem

rcal brsiness cvcle. cfficiency rvages
Ricardian riew <l fiscal policy
r

cvclical

short-mn impact of'l.J arrrl 7'on outprrt

long nrn impacls ()n cconomic grotth:
internal vs. cxternal debt
disl()rtions from taxation
displacement of capiurl

spirit of

terprise

Stabilization
dcrnart<l lrrarragt.rrrcttt
f

iscal-lrolrctan' mix

FURTHER READING AND NTERNET WEBSITES

Further Reading

Websites

The Krrr;nran quotadon is front l,rrrl Krugnran,

Dimin

u hed

llxlp

| a/on

'l'he :lge

of

r ( N{lT Press, (i:rmbr-idgr:, i\lirss.. I 09( ) ).

p- 9. \lanv of the foundadons ol rcu' classi< al t.r'orronrics

were developecl bv Robert l,rcas ancl rt'rrrlrlislrt'rl in ,flrr/.r
in Btrsittss Cacb'fhcorl (NllT Pr ess, ( larrrlrritlgc. Mass.. l!)90).
I\{odern efcienc}:wage rhe()rv is rrt.scrrted in Edmrncl
Phelps, .llrzrf ura I Slumlts: 'l'h lomt liquililniurn l'heor-y ol
Unempknntnl, Inlnsl, ttd Ass,ls (Hanarcl Liniversih, Press,
Cam bridge, Mass., 1994).

A nontechnical reyicw o[ the diffcrent

schools

()l

Economic issucs rnd data on f is( al rolicr; budges, and the

clebt arc rcgtrlarlv providcrl lry tlrc nonpartisan Congres
sionll lhrdget ()flice. whir:lr is srafli'd bv professional econ<>
misLs. Reccrt dtxttrre rrts an.ar:rilable at unlLL.cbo_grt.

A srncy o[ issrres involved in inllatiolt taru('(ing can be

fortnd in I 2003 speech by Fcd <.hair Bt:r Bernanke,'A
I'ct spectir,e otr Irrf atior Talgctirr," at urnt.fedtralrcscrrr.
f

gou/ Iloanldoc.t / Sltterltes/ 2O07 / 2O070 I 25 / dlfault. htm. Realbtrsiness<;-cf <' tht'ory lras its own website 11 dge.rep?.m.g/
in x.htnl.

macroeconouics is pror,ided bv Paul -trgman, Pel ling

Itrcsperit: h)rcnomir Scnse and Nonx,nse h the.|ge oflhuitti.rhed
l:xpKkttions (Norton, Nerv tbrk, 199,1).

QUESTTONS FOR DTSCUSSTON

l.

A t<rl|mon confusion is tht betweerr tlrt'<lt'bt arrrl the

deficit. Explain each of thc firllowing:

a. A brrdget cleficir lcads to a growing go\l.llmt'nr

b.
c.

dt.lt.
Redrrcing the deficit does not rt-.rlrrr.t.tlrc gt>r,crnmenr debr.
Redrrcing the govertrnr(.nt <lt'llt rcquires nrnning;t
bttdget sur plus.

d.

l-rer thorglr tlr(. f{()ve rnme nt deficit nas reduced

irr tlrc 1993-1998 period, the gol'ernmenr debl sri]l
rosc in these years,

2. Is it possiblc that govt:r

rrrrrt.rrt mrzcs might have a

displ:rcerrrt:rr I <:fl'<r'l akrng with gor.emmenr debt?
'l hrs, if thc
Hr)vcrrlment werc to promise large flture
social sct rrrily benefis to workcrs, wolrld wot kers fccl
riclrcr? Might they reduce saving as a resrlt? Could

QLlus l r( )NS t-oR

39

Dls(:ussloN

tht' < arital stock encl up smaller? Illustratt' rrsing Fig-

3.

ure l7-2.
l'race the impact rtpott tltt' f{(}vcr-nnlent clebt, the

nation's capiL-rl stock, and real ()tlt[)tlt ol a H()vcrnl]rellt

progranr that borrows abroad and spctttls lltc trtonc'

on tlr(' f()ll(wirg:
Capital t< <h ill lor oil, which is exported (as did
Mexico irt thc | 970s)
b, Grain to feed its porttlatiort (as did Nigeria in the

a.

4.

20(,0s)
C()nstr rrct a graph

a. Thc

raths

like that in Figure l7-3 showirr5:

ol consrtmption and net exPorts willr

and without a larg<: government debt

b. The paths of cottsrurt rtiott rvith a birlanced budget
and wi a government fist al sttt rltts
5. Revicw the debate between the senat()ni on ragc 31'14.
Explain wlrich sr'rator wortld be correct in the ftrlloning sitrratiorts:
a. The govemnr('nt in( r('s(:d rliliurrr spending dur'
ing the Great Dcrrcssiott.
b. 'I'he government redttccd tax ratt's clttritrg ir period
ol lirll emplovment in the carl" | 960s.
c. Tlrc government rc.tsed to rise tax('s rltrr-ing the
frrll<'rrrploynre nt periocl of thc Vietnam War.
6. Suppose somc()n(: a<lvocates that monetlry PolicY
should target a specific inflatior ratc cvclr vear-sitli 2
r4hat art thc vari()trs arplllx'r( ('nt per rear for e CPL
mcrrts ftrr artd against this proposal? Specically. torrsider thc <lifficrrltics ()l attaining ir strict inflation targct
after a sharp suprlv shrx-k shills the Phillips crtn'e up.
Oonrpare a rigid inflation targt't with a llexible inflation arget in which the targcl wotl<l lx'atlained rt the
t'rr<l

ol a

d.

Decrese the number of immigrants s() lhat lll('

lalx-force declines b1 5 percent.
e. Increasc in\'('st rr)(: n l.\ ir htttnalr capiul (or education and on-the-job training) ll' I 1x'rcent of ODP.
8. J. M. Kelnes wrote, "[f the Treastrn w(:r(' t< fill ol<l bottles witlr bankn<tes, bttry them in distsc<l ctal trrirtt:s,
arlrl lcave it to private enterprise to dig the notcs ttP
agairr, thcr-r: nt'ed br ro more ttnemploment and e
real incomt <f tlrt'r'<nrlrrnitt wrtrld plobabl,v become
a goocl cleal greater than it a< trrally is" ('l'he Cnnul'l'l*or, p. 129). Explain why Kevncs's arralvsis ol tltc trtility ol a cliscretionary public-works progranr rrriglrt tx:
( ( )r r (:(:t during a depression. I Iow could well<lesigrretl
nonclar'\' rolicics lrave the sanre impact on emplo,vment whilc pro(lrrr irr a lalgt't quantin'of usetirl goods
and sen'ices?
9, What would Keynesians and new classical rrlact-o('( ()tl(]
rrrists rlcdict to be the impacts of each of the follos'ing orr tlrt' c0rrlse ol pt-ices, outPtlt, iurd emPloyment?
In eaclr casr', h()l(l tax mtes and interest rates constanl
rrnless specifically rn('n I it)rl('(l;
a. A large tax cut
b. A large cut in intercst rl('s
c. A wave of innorations that itt( r('as('s tx)t(:ntial outl)ut l)y l0 percent
d. A llrrst ol cxporls
10. Advanced problem (ott tatittttal exPec&rtions); Consider the effect of radonal exP('ctati()trs ()tl cotlsumP

tion behavior.

a.

crt

i->year peri<xl.

tarrrlidates hir.ve proposed the policies listtrl

below to speed t'tottotrtic grorvth in recent t'ears. For
each, explain qualitatively th('irrrpact lrPon the grosth
of rotential outprtt and up()n thc Htr)wlh (,l Per caPiur

7. Political

pot('ntial ()utput. lf Possible, give a trtantitativt' cstimate of th(' int rr'st' itr dre gt'o$th of potentiirl otltpttt
and per cirpita pot('Iltial (tutPtt over the next decade
a. Ctrt the federal btrrlgct <lclicit (or- rise the sttrplrrs) by 2 Percent of GDP, itttt<'asitrg the ratio of
investment to GDI bl the sam< aln()tltll.
b. Inclcase the ederal stbsidy ro R&D b" ry'.r pt'rct:rtt
of()f)P, assrrnring that this subsidy *ill increanc privirte R&D llv tlrt'sarnt: antouut atrd tht R&D has ir
social rate of rettrn that is 4 tinlcs thal ol Priv:te

b.

ortize that their average lifetime inc<ntt's will

onll $2 billion per vear, not bv $20 billion rcr yt'ar'. \{'hat woultl be the reaction of sttch
r-t:t

in< rcast: bv

consumers? Artalvzt', thetr, dre impact of rational

expecurons on lht: t'flt:t tivcrcrs ol temporary tax

c.

lDl'estment.
I)t'r-rease rtelnse spending b1

firll t'rnrkryrnent.

l pertcnt of (il)P

at

that the got'ernment proposes a tcmporar) tax

tl'$20 billion, lasdng f<rr a ver. Consumers
rrith atlartivt' (:xl)cctaor.ts consequendy assttme
that their disposalllt in< tnrt's wotlrl be $20 billion
lrigher every yetr. \4ttat woul<l lx' thr: restrldng
irnpact otr consrtmpdon spending arrtl (lDP irt thc
sirrrrl<' rrrrrltirlicr rnodel of Chapter 7?
Next supJ.ros('tl)al coltstlnlers have rational expecbdons. They rationallv lirlr:cast tlrat the tax cut is
onl,v lirr I year. Being 'life<ycltr ( ()rrsrrIllcIT, the,v
Say

c.

uts.

Finally; :rssume that consumers behal't' atcorditrg

to tlrt' Ricardiar view. llhat wottld bc thc inrl)( t
o[ the tax ( ul tttt saving and consumPtion? Explain
the differenccs lx'twt'crl the tnodels discussed irl
a" b. and c.