Principles of Economics Chapter 15

CHAPTER
15
Macroeconomic Issues and Policy
Prepared by: Fernando Quijano and Yvonn Quijano
2004 Prentice Hall Business Publishing
Principles of Economics, 7/e
Karl Case, Ray Fair
C H A P T E R 15: Macroeconomic Issues and Policy
Stabilization Policy
Stabilization policy describes both monetary and fiscal policy, the goals of which are to smooth out fluctuations in output and employment and to keep prices as stable as possible.
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Time Lags Regarding Monetary and Fiscal Policy

Time lags are delays in the economys response to stabilization policies.
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Two Possible Time Paths for GDP
Path A is less stableit varies more over timethan path B. Other things being equal, society prefers path B to path A.
2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 4 of 40
Stabilization: The Fool in the Shower

Attempts to stabilize the economy can prove destabilizing because of time lags. Milton Friedman likened these attempts to a fool in the shower. The government is constantly stimulating or contracting the economy at the wrong time.
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An expansionary policy that should have begun to take effect at point A does not actually begin to have an impact until point D, when the economy is already on an upswing.
Hence, the policy pushes the economy to points F and G (instead of F and G). Income varies more widely than it would have if no policy had been implemented.
Recognition Lags
The recognition lag refers to the time it takes for policy makers to recognize the existence of a boom or a slump.
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Implementation Lags
The implementation lag is the time it takes to put the desired policy into effect once economists and policy makers recognize that the economy is in a boom or a slump.
The implementation lag for monetary policy is generally much shorter than for fiscal policy.
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Response Lags
The response lag is the time it takes for the economy to adjust to the new conditions after a new policy is implemented; the lag that occurs because of the operation of the economy itself.
The delay in the multiplier of government spending occurs because neither individuals nor firms revise their spending plans instantaneously.
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Monetary Policy
To make the monetary policy story realistic, two key points must be added:
In practice, the Fed targets the interest rate rather than the money supply.
The interest rate value that the Fed chooses depends on the state of the economy.
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Targeting the Interest Rate

The Fed can pick a money supply value and accept the interest rate consequences Or
The Fed can pick an interest rate value and accept the money supply consequences.
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The Feds Response to the State of the Economy

The Fed is likely to lower the interest rate (and thus increase the money supply) during times of low output and low inflation.
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When the economy is on the flat portion of the AS curve, an increase in the money supply will lead to an increase in output with very little increase in the price level.
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The opposite is also true: The Fed is likely to increase the interest rate (and thus decrease the money supply) during times of high output and high inflation.
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When the economy is on the relatively steep portion of the AS curve, contraction of the money supply will lead to a decrease in the price level, with little decrease in output.
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Stagflation is a more difficult problem to solve.
If the Fed lowers the interest rate, output
will rise, but so will the inflation rate (which is already too high).
If the Fed increases the interest rate, the
inflation rate will fall, but so will output (which is already too low).
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Data for Selected Variables for the 1989 2003 Period

REAL GDP GROWTH RATE (%)
5.0 2.2 1.9 1.4 5.1 0.9 - 0.7 - 3.2 - 2.0 2.3 1.0 2.2 3.8 3.8 3.1 5.4 - 0.1 2.5 1.8 6.2
DATE
1989 I II III IV 1990 I II III IV 1991 I II III IV 1992 I II III IV 1993 I II III IV
UNEMPL. RATE (%)

5.2 5.2 5.3 5.4 5.3 5.3 5.7 6.1 6.6 6.8 6.9 7.1 7.4 7.6 7.6 7.4 7.2 7.1 6.8 6.6
INFL. RATE (%)

4.3 4.0 2.9 3.1 4.5 4.7 3.9 3.5 4.7 2.9 2.5 2.3 3.1 2.2 1.3 2.5 3.4 2.2 1.8 2.3
THREEMONTH T-BILL RATE

8.5 8.4 7.9 7.6 7.8 7.8 7.5 7.0 6.1 5.6 5.4 4.6 3.9 3.7 3.1 3.1 3.0 3.0 3.0 3.1
AAA BOND RATE

9.7 9.5 9.0 8.9 9.2 9.4 9.4 9.3 8.9 8.9 8.8 8.4 8.3 8.3 8.0 8.0 7.7 7.4 6.9 6.8
FED. GOV. SURPLUS

- 108.8 - 127.3 - 140.6 - 143.4 - 172.1 - 171.2 - 164.6 - 184.0 - 160.1 - 213.4 - 234.7 - 253.1 - 288.3 - 291.8 - 316.5 - 293.5 - 300.9 - 267.3 - 275.5 - 253.0
SURPLUS/GDP
- 0.020 - 0.023 - 0.025 - 0.026 - 0.030 - 0.030 - 0.028 - 0.031 - 0.027 - 0.036 - 0.039 - 0.042 - 0.047 - 0.046 - 0.050 - 0.045 - 0.046 - 0.041 - 0.041 - 0.037
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3.4 5.7 2.2 5.0 1.5 0.8 3.1 3.2 2.9 6.8 2.0 4.6 4.4 5.9 4.2 2.8 6.1 2.2 4.1 6.7
DATE
1994 I II III IV 1995 I II III IV 1996 I II III IV 1997 I II III IV 1998 I II III IV
UNEMPL. RATE (%)

6.6 6.2 6.0 5.6 5.5 5.7 5.7 5.6 5.6 5.5 5.3 5.3 5.3 5.0 4.8 4.7 4.7 4.4 4.5 4.4
INFL. RATE (%)

2.0 1.8 2.4 1.9 3.0 1.7 1.8 2.0 2.5 1.4 1.9 1.6 2.9 1.9 1.2 1.4 1.1 1.0 1.4 1.1

3.3 4.0 4.5 5.3 5.8 5.6 5.4 5.3 5.0 5.0 5.1 5.0 5.1 5.1 5.1 5.1 5.1 5.0 4.8 4.3
AAA BOND RATE

7.2 7.9 8.2 8.6 8.3 7.7 7.4 7.0 7.0 7.6 7.6 7.2 7.4 7.6 7.2 6.9 6.7 6.6 6.5 6.3
FED. GOV. SURPLUS

- 237.5 - 190.6 - 211.8 - 209.2 - 208.2 - 189.0 - 197.5 - 173.1 - 176.4 - 137.0 - 130.1 - 103.9 - 86.5 - 68.2 - 33.8 - 25.0 19.6 33.0 65.7 57.1
SURPLUS/GDP
- 0.034 - 0.027 - 0.030 - 0.029 - 0.029 - 0.026 - 0.027 - 0.023 - 0.023 - 0.018 - 0.017 - 0.013 - 0.011 - 0.008 - 0.004 - 0.003 0.002 0.004 0.007 0.006
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3.1 1.7 4.7 8.3 2.3 4.8 0.6 1.1 -0.6 -1.6 -0.3 2.7 5.0 1.3 4.0 1.4 1.9
DATE
1999 I II III IV 2000 I II III IV 2001 I II III IV 2002 I II III IV 2003 I II
UNEMPL. RATE (%)

4.3 4.3 4.2 4.1 4.1 4.0 4.0 3.9 4.2 4.4 4.8 5.6 5.6 5.9 5.8 5.9 5.8
INFL. RATE (%)

1.8 1.4 1.4 1.6 3.8 2.3 1.6 2.1 3.6 2.5 2.2 -0.5 1.4 1.3 1.2 1.8 2.5

4.4 4.5 4.7 5.0 5.5 5.7 6.0 6.0 4.8 3.7 3.2 1.9 1.8 1.7 1.6 1.3 1.2
AAA BOND RATE

6.4 6.9 7.3 7.5 7.7 7.8 7.6 7.4 7.1 7.2 7.1 6.9 6.6 6.7 6.3 6.3 6.0
FED. GOV. SURPLUS

85.1 116.5 132.0 143.2 212.8 197.2 213.1 193.8 173.8 199.6 -51.7 21.3 -145.8 -195.7 -210.5 -247.7 -253.6
SURPLUS/GDP
0.009 0.013 0.014 0.015 0.022 0.021 0.022 0.019 -0.017 0.014 -0.005 0.002 -0.014 -0.019 -0.020 -0.023 -0.024
Note: The inflation rate is the percentage change in the GDP price deflator.
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The 1990 1991 Recession

After the Fed became convinced that a recession was at hand, it responded by engaging in open market operations to lower interest rates.
Inflation was not a problem, so the Fed could expand the economy without worrying about inflationary pressures.
Principles of Economics, 7/e Karl Case, Ray Fair 21 of 40
1993 1994
During this period, inflation was not a problem, so the Fed had room to stimulate the economy and kept its expansionary policy.
By the end of 1993 the Fed was worried about inflation problems in the future, and decided to begin slowing down the economy.
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1995 1997
Inflation did not become a problem after 1994, and the Fed lowered interest rates. The three-month Treasury bill rate remained at roughly 5.0 percent throughout 1996 and 1997.
During this period, the economy experienced good growth, low unemployment, low inflation, and a balanced government budget!
1998 2000
Based on concerns about the Asian financial crisis, the Fed lowered the bill rate to 4.3 percent in the fourth quarter of 1998.
The Asian crisis did not affect the U.S. economy very much, and the Fed began raising the bill rate on fears that the economy might be overheating.
2001 2003
A recession was officially declared in 2001.
The Fed responded by perhaps the most expansionary policy in its history.
Many expected that the attacks on September 11, 2001 would extend the recession, but the growth rate of output was high enough to keep the unemployment rate roughly unchanged.
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Fiscal Policy: Deficit Targeting

Many fiscal policy discussions center around the size of the federal government surplus or deficit. In the last decade, we have seen a substantial deficit turn into a surplus (between 1998 and 2001) and back into a deficit!
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Fiscal Policy: Deficit Targeting

The Gramm-RudmanHollings Bill, passed by the U.S. Congress and signed by President Reagan in 1986, is a law that set out to reduce the federal deficit by $36 billion per year, with a deficit of zero slated for 1991.
In practice, these targets never came close to being achieved.
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The Effects of Spending Cuts on the Deficit

A cut in government spending causes the economy to contract. Both the taxable income of households and the profits of firms fall.
The deficit tends to rise when GDP falls, and tends to fall when GDP rises.
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The Effects of Spending Cuts on the Deficit

The deficit response index (DRI) is the amount by which the deficit changes with a $1 change in GDP. If the DRI equals -.22, for example, the deficit rises by $0.22 billion for each $1 billion decrease in GDP.
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Economic Stability and Deficit Reduction

Spending cuts must be larger than the deficit reduction we wish to achieve. Congress has two options:
1. Choose a target deficit and adjust
government spending and taxation to achieve this target, or

2. Decide how much to spend and tax
regardless of the consequences on the deficit.
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A negative demand shock is something that causes a negative shift in consumption or investment schedules or that leads to a decrease in U.S. exports.
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Automatic stabilizers refer to revenue and expenditure items in the federal budget that automatically change with the economy in such a way as to stabilize GDP.
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Automatic destabilizers refer to revenue and expenditure items in the federal budget that automatically change with the economy in such a way as to destabilize GDP.
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Deficit Targeting as an Automatic Destabilizer
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Fiscal Policy Since 1990

The average tax rate rose sharply under President Clinton and fell sharply under President Bush. The deficit is a concern when tax rates are falling and spending is rising.
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Federal Personal Income Taxes as a Percent of Taxable Income, 1990 I-2003 II
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Federal Government Consumption Expenditures as a Percent of GDP, 1990 I-2003 II
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Federal Transfer Payments and Grants-inAid as a Percent of GDP, 1990 I-2003 II
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Federal Interest Payments as a Percent of GDP, 1990 I-2003 II
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Review Terms and Concepts

automatic destabilizer automatic stabilizer deficit response index (dri) Gramm-Rudman-Hollings Bill implementation lag negative demand shock recognition lag response lag stabilization policy time lags
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CHAPTER

Prepared by: Fernando Quijano and Yvonn Quijano

2004 Prentice Hall Business Publishing

Principles of Economics, 7/e

Karl Case, Ray Fair

C H A P T E R 15: Macroeconomic Issues and Policy

2004 Prentice Hall Business Publishing

Principles of Economics, 7/e

Karl Case, Ray Fair

C H A P T E R 15: Macroeconomic Issues and Policy

Time Lags Regarding Monetary and Fiscal Policy

2004 Prentice Hall Business Publishing

Principles of Economics, 7/e

Karl Case, Ray Fair

C H A P T E R 15: Macroeconomic Issues and Policy

Two Possible Time Paths for GDP

C H A P T E R 15: Macroeconomic Issues and Policy

Stabilization: The Fool in the Shower

2004 Prentice Hall Business Publishing

Principles of Economics, 7/e

Karl Case, Ray Fair

C H A P T E R 15: Macroeconomic Issues and Policy

Stabilization: The Fool in the Shower

C H A P T E R 15: Macroeconomic Issues and Policy

Stabilization: The Fool in the Shower

C H A P T E R 15: Macroeconomic Issues and Policy

2004 Prentice Hall Business Publishing

Principles of Economics, 7/e

Karl Case, Ray Fair

C H A P T E R 15: Macroeconomic Issues and Policy

2004 Prentice Hall Business Publishing

Principles of Economics, 7/e

Karl Case, Ray Fair

C H A P T E R 15: Macroeconomic Issues and Policy

2004 Prentice Hall Business Publishing

Principles of Economics, 7/e

Karl Case, Ray Fair

C H A P T E R 15: Macroeconomic Issues and Policy

2004 Prentice Hall Business Publishing

Principles of Economics, 7/e

Karl Case, Ray Fair

C H A P T E R 15: Macroeconomic Issues and Policy

Targeting the Interest Rate

2004 Prentice Hall Business Publishing

Principles of Economics, 7/e

Karl Case, Ray Fair

C H A P T E R 15: Macroeconomic Issues and Policy

The Feds Response to the State of the Economy

2004 Prentice Hall Business Publishing

Principles of Economics, 7/e

Karl Case, Ray Fair

C H A P T E R 15: Macroeconomic Issues and Policy

The Feds Response to the State of the Economy

2004 Prentice Hall Business Publishing

Principles of Economics, 7/e

Karl Case, Ray Fair

C H A P T E R 15: Macroeconomic Issues and Policy

The Feds Response to the State of the Economy

2004 Prentice Hall Business Publishing

Principles of Economics, 7/e

Karl Case, Ray Fair

C H A P T E R 15: Macroeconomic Issues and Policy

The Feds Response to the State of the Economy