Chapter 16: Theory and Reality

Chapter 16Theory and RealityMacroeconomics: Policy ToolsPolicy tools for macroeconomics:Fiscal policy.Monetary policy.Supply-side policy.16-*Table 16.116-*Fiscal PolicyFiscal policy is the use of government taxes and spending to alter macroeconomic outcomes, consisting of:Automatic stabilizers.Discretionary policy.16-*Automatic Stabilizers Automatic stabilizers are federal expenditure or revenue items that automatically respond counter-cyclically to changes in national income.Such stabilizers don’t require an additional act of Congress.Examples include unemployment benefits and income tax collections.16-*These actions “kick in” at the start of a recession, and automatically:Reduce tax revenues.Increase government outlays.Widen budget deficits.They counteract the shifting of AD to the left and help stabilize the economy.Automatic Stabilizers 16-*Discretionary PolicyDiscretionary policy refers to deliberate changes in tax or spending legislation.Additional spending and tax revenue decreases can increase the federal budget deficit.Reduced spending and tax revenue increases can decrease the deficit. 16-*Monetary Policy Monetary policy: the use of money and credit controls to influence macroeconomic activity.The tools of monetary policy include:Open-market operations.Discount rate changes.Reserve requirements.16-*If the AS curve is horizontal, changes in the money supply affect output only.If the AS curve is vertical, changes in the money supply affect prices only.If the AS curve is upward-sloping, changes in the money supply affect both prices and output.Monetary Policy 16-*Supply-Side Policy Supply-side policy: the use of tax rates, (de)regulation, and other mechanisms to increase the ability and willingness to produce goods and services.The shape of the AS curve limits the effectiveness of fiscal and monetary policies. Supply-side policy concentrates on shifting the AS, not the AD, curve.16-*Supply-side policy wants to shift the AS curve to the right.The supply-side tools are:Tax cuts to stimulate work effort, saving, and investment.Deregulation to reduce production costs and stimulate investment.Spending on education, training, and research to expand the capacity to produce.Supply-Side Policy 16-*Case 1: RecessionOutput and employment fall far short of the full-employment potential.Need to put people to work and increase output.The GDP gap must be closed.16-*Case 1: Recession – KeynesiansEmphasize the need to stimulate AD with fiscal policy by:Cutting taxes.Boosting government spending.Setting off a multiplier reaction to the stimulus.AD will shift right, closing the GDP gap.16-*Case 1: Recession – MonetaristsSee no point in discretionary policies.They assume the AS curve is vertical at the natural rate of unemploymentChanges in fiscal or monetary policy are ineffective because increases in AD only cause inflation.The appropriate response to a recession is patience.16-*Case 1: Recession – Supply-SidersBelieve that policy initiatives should focus on changing the shape and repositioning the AS curve to the right.Improve production incentives.Cut marginal tax rates on investment and labor.Reduce government regulation.16-*Case 2: Inflation – KeynesiansNeed to restrain AD by:Raising taxes.Cutting government spending.Relying on the multiplier to cool down the economy.AD will shift left, closing the GDP gap.16-*Case 2: Inflation – MonetaristsBelieve that inflation reflects excessive money supply growth.Their response: Raise interest rates.Cut the money supply.Convince market participants that cautious monetary policy will be continued.16-*Case 2: Inflation – Supply-SidersPoint out that inflation implies both too much money and not enough goods.Expand productive capacity.Propose more incentives to save.Cut taxes and regulations, encourage more immigration, and lower import barriers.16-*Case 3: StagflationStagflation is the simultaneous occurrence of substantial unemployment and inflation.There are no simple solutions for stagflation.There is a need to balance the competing threats of inflation and unemployment16-*There are several possible contributors to stagflation:High tax rates or costly regulation.An external shock (such as a natural disaster) or an abrupt change in world trade (such as higher oil prices).The result is a leftward shift of the AS curve.Case 3: Stagflation16-*Figure 16.216-*Why Things Don’t Always WorkWe can distinguish four obstacles to policy success:Goal conflicts.Measurement problems.Design problems.Implementation problems.16-*Politics versus EconomicsTax hikes and budget cuts rarely win votes.On the other hand, tax cuts and pork-barrel spending are always popular.Because of this, deficits will continue to be with us, and the federal debt will increase.16-*Savvy politicians tend to stimulate the economy before elections, then tighten the fiscal restraints afterward.This creates a political business cycle: a two-year pattern of short-run stops and starts.Politics versus Economics16-*