CHAPTER 30 Policy Timing, Deficit Targeting, and Stock Market Effects

PowerPoint Lectures for

Principles of Economics,
9e
; ;

By
Karl E. Case,
Ray C. Fair &
Sharon M. Oster

2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster

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CHAPTER 30 Policy Timing, Deficit Targeting, and Stock Market Effects

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PART VI FURTHER MACROECONOMICS ISSUES

30

Policy Timing, Deficit

Targeting, and Stock
Market Effects

Prepared by:
Fernando & Yvonn Quijano
2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster

CHAPTER 30 Policy Timing, Deficit Targeting, and Stock Market Effects

PART VI FURTHER MACROECONOMICS ISSUES

Policy Timing, Deficit

Targeting, and Stock
Market Effects

30
CHAPTER OUTLINE
Time Lags Regarding Monetary and
Fiscal Policy
Stabilization
Recognition Lags
Implementation Lags
Response Lags
Fiscal Policy: Deficit Targeting
The Effects of Spending Cuts on the Deficit
Economic Stability and Deficit Reduction
Summary
The Stock Market and the Economy
Stocks and Bonds
Determining the price of a Stock
The Stock Market Since 1948
Stock Market Effects on the Economy

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CHAPTER 30 Policy Timing, Deficit Targeting, and Stock Market Effects

Time Lags Regarding Monetary and Fiscal Policy

stabilization policy Describes both monetary and

fiscal policy, the goals of which are to smooth out
fluctuations in output and employment and to keep
prices as stable as possible.
time lags Delays in the economys response to
stabilization policies.

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CHAPTER 30 Policy Timing, Deficit Targeting, and Stock Market Effects

Time Lags Regarding Monetary and Fiscal Policy

FIGURE 30.1 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.

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Time Lags Regarding Monetary and Fiscal Policy

CHAPTER 30 Policy Timing, Deficit Targeting, and Stock Market Effects

Stabilization

FIGURE 30.2 Possible Stabilization Timing Problems

Attempts to stabilize the economy can prove destabilizing because of time lags. 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 E1, and F1, (instead of
points E and F). Income varies more widely than it would have if no policy had been implemented.

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Time Lags Regarding Monetary and Fiscal Policy

CHAPTER 30 Policy Timing, Deficit Targeting, and Stock Market Effects

Recognition Lags

recognition lag The time it takes for policy

makers to recognize the existence of a boom or a
slump.

Implementation Lags
implementation lag 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.

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Time Lags Regarding Monetary and Fiscal Policy

CHAPTER 30 Policy Timing, Deficit Targeting, and Stock Market Effects

Response Lags

response lag The time that 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.

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Time Lags Regarding Monetary and Fiscal Policy

CHAPTER 30 Policy Timing, Deficit Targeting, and Stock Market Effects

Response Lags
Response Lags for Fiscal Policy
Neither individuals nor firms revise their spending
plans instantaneously. Until they can make those
revisions, extra government spending does not
stimulate extra private spending.
Response Lags for Monetary Policy
Monetary policy works by changing interest rates,
which then change planned investment.
The response of consumption and investment to
interest rate changes takes time.

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Time Lags Regarding Monetary and Fiscal Policy

CHAPTER 30 Policy Timing, Deficit Targeting, and Stock Market Effects

Response Lags
Summary
Stabilization is not easily achieved. It takes time for
policy makers to recognize the existence of a
problem, more time for them to implement a
solution, and yet more time for firms and
households to respond to the stabilization policies
taken.

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CHAPTER 30 Policy Timing, Deficit Targeting, and Stock Market Effects

Fiscal Policy: Deficit Targeting

Gramm-Rudman-Hollings Act Passed by the
U.S. Congress and signed by President Reagan in
1986, this law set out to reduce the federal deficit
by $36 billion per year, with a deficit of zero slated
for 1991.
FIGURE 30.3 Deficit
Reduction Targets under GrammRudman-Hollings
The GRH legislation, passed in
1986, set out to lower the federal
deficit by $36 billion per year. If
the plan had worked, a zero deficit
would have been achieved by
1991.

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Fiscal Policy: Deficit Targeting

CHAPTER 30 Policy Timing, Deficit Targeting, and Stock Market Effects

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.
deficit response index (DRI) The amount by
which the deficit changes with a $1 change in
GDP.

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Fiscal Policy: Deficit Targeting

CHAPTER 30 Policy Timing, Deficit Targeting, and Stock Market Effects

The Effects of Spending Cuts on the Deficit

Monetary Policy to the Rescue?
A zero multiplier can come about through renewed
optimism on the part of households and firms or
through very aggressive behavior on the part of
the Fed, but because neither of these situations is
very plausible, the multiplier is likely to be greater
than zero. Thus, it is likely that to lower the deficit
by a certain amount, the cut in government
spending must be larger than that amount.

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Fiscal Policy: Deficit Targeting

CHAPTER 30 Policy Timing, Deficit Targeting, and Stock Market Effects

Economic Stability and Deficit Reduction

negative demand shock Something that causes
a negative shift in consumption or investment
schedules or that leads to a decrease in U.S.
exports.
automatic stabilizers Revenue and expenditure
items in the federal budget that automatically
change with the economy in such a way as to
stabilize GDP.
automatic destabilizers 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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Fiscal Policy: Deficit Targeting

CHAPTER 30 Policy Timing, Deficit Targeting, and Stock Market Effects

Economic Stability and Deficit Reduction

FIGURE 30.4 Deficit Targeting as an Automatic Destabilizer

Deficit targeting changes the way the economy responds to negative demand shocks because it does not
allow the deficit to increase. The result is a smaller deficit but a larger decline in income than would have
otherwise occurred.

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Fiscal Policy: Deficit Targeting

CHAPTER 30 Policy Timing, Deficit Targeting, and Stock Market Effects

Summary
It is clear that the GRH legislation, the balancedbudget amendment, and similar deficit targeting
measures have some undesirable macroeconomic
consequences.
Locking the economy into spending cuts during
periods of negative demand shocks, as deficittargeting measures do, is not a good way to
manage the economy.

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The Stock Market and the Economy

CHAPTER 30 Policy Timing, Deficit Targeting, and Stock Market Effects

Stocks and Bonds

stock A certificate that certifies ownership of a
certain portion of a firm.
capital gain An increase in the value of an asset.

realized capital gain The gain that occurs when

the owner of an asset actually sells it for more than
he or she paid for it.

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The Stock Market and the Economy

CHAPTER 30 Policy Timing, Deficit Targeting, and Stock Market Effects

Determining the Price of a Stock

Things that are likely to affect the price of a stock

include:

What people expect its future dividends will

be.

When the dividends are expected to be paid.

The amount of risk involved.

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The Stock Market and the Economy

CHAPTER 30 Policy Timing, Deficit Targeting, and Stock Market Effects

The Stock Market Since 1948

Dow Jones Industrial Average An index based
on the stock prices of 30 actively traded large
companies. The oldest and most widely followed
index of stock market performance.
NASDAQ Composite An index based on the
stock prices of over 5,000 companies traded on
the NASDAQ Stock Market. The NASDAQ market
takes its name from the National Association of
Securities Dealers Automated Quotation System.
Standard and Poors 500 (S&P 500) An index
based on the stock prices of 500 of the largest
firms by market value.

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The Stock Market and the Economy

CHAPTER 30 Policy Timing, Deficit Targeting, and Stock Market Effects

The Stock Market Since 1948

FIGURE 30.5 The S&P 500 Stock Price Index, 1948 I2007 IV

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The Stock Market and the Economy

CHAPTER 30 Policy Timing, Deficit Targeting, and Stock Market Effects

The Stock Market Since 1948

FIGURE 30.6 Ratio of After-Tax Profits to GDP, 1948 I2007 IV

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The Stock Market and the Economy

CHAPTER 30 Policy Timing, Deficit Targeting, and Stock Market Effects

Stock Market Effects on the Economy

An increase in stock prices causes an increase in
wealth, and consequently an increase in consumer
spending.
Investment is also affected by higher stock prices.
With a higher stock price, a firm can raise more
money per share to finance investment projects.

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The Stock Market and the Economy

CHAPTER 30 Policy Timing, Deficit Targeting, and Stock Market Effects

Stock Market Effects on the Economy

The Crash of October 1987
The value of stocks in the United States fell by
about a trillion dollars between August 1987 and
the end of October 1987.
If the multiplier is 1.4, the total decrease in GDP
would be about 1.4 x $40 billion = $56 billion, or
about 1.4 percent of GDP.
The stock market crash of 1987 did not result in a
recession in 1988 because households and
business firms did not lower their expectations
drastically.

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The Stock Market and the Economy

CHAPTER 30 Policy Timing, Deficit Targeting, and Stock Market Effects

Stock Market Effects on the Economy

The Boom of 19952000

FIGURE 30.7 Personal Saving Rate, 1995 I2002 III

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The Stock Market and the Economy

CHAPTER 30 Policy Timing, Deficit Targeting, and Stock Market Effects

Stock Market Effects on the Economy

The Boom of 19952000

FIGURE 30.8 Investment-Output Ratio, 1995 I2002 III

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The Stock Market and the Economy

CHAPTER 30 Policy Timing, Deficit Targeting, and Stock Market Effects

Stock Market Effects on the Economy

The Boom of 19952000

FIGURE 30.9 Ratio of Federal Government Budget Surplus to GDP, 1995 I2002 III

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The Stock Market and the Economy

CHAPTER 30 Policy Timing, Deficit Targeting, and Stock Market Effects

Stock Market Effects on the Economy

The Boom of 19952000

FIGURE 30.10 Growth Rate of Real GDP, 1995 I2002 III

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The Stock Market and the Economy

CHAPTER 30 Policy Timing, Deficit Targeting, and Stock Market Effects

Stock Market Effects on the Economy

The Boom of 19952000

FIGURE 30.11 The Unemployment Rate, 1995 I2002 III

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The Stock Market and the Economy

CHAPTER 30 Policy Timing, Deficit Targeting, and Stock Market Effects

Stock Market Effects on the Economy

The Boom of 19952000

FIGURE 30.12 Inflation Rate, 1995 I2002 III

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The Stock Market and the Economy

CHAPTER 30 Policy Timing, Deficit Targeting, and Stock Market Effects

Stock Market Effects on the Economy

Fed Policy and the Stock Market

FIGURE 30.13 3-Month Treasury Bill Rate, 1995 I2002 III

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The Stock Market and the Economy

CHAPTER 30 Policy Timing, Deficit Targeting, and Stock Market Effects

Stock Market Effects on the Economy

The Post-Boom Economy
Both stock market wealth and housing wealth have
important effects on the economy.

Bubbles or Rational
Investors?
Bernankes Bubble Laboratory:
Princeton Protgs of Fed
Chief Study the Economics of
Manias
Wall Street Journal

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CHAPTER 30 Policy Timing, Deficit Targeting, and Stock Market Effects

REVIEW TERMS AND CONCEPTS

automatic destabilizers

negative demand shock

automatic stabilizers

realized capital gain

capital gain

recognition lag

deficit response index (DRI)

response lag

Dow Jones Industrial Average

stabilization policy

Gramm-Rudman-Hollings Act

Standard and Poors 500 (S&P 500)

implementation lag

stock

NASDAQ Composite

time lags

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