C H A P T E R 17 Macroeconomic Policy Debates Copyright © 2012 Pearson Prentice Hall All rights reserved Copyright © 2012 Pearson Prentice Hall All rights reserved 17-1 CHAPTER Macroeconomic Policy Debates 17 Economists are often cautious and try to warn policymakers that carrying out effective economic policy is difficult PREPARED BY Brock Williams Copyright © 2012 Pearson Prentice Hall All rights reserved C H A P T E R 17 Macroeconomic Policy Debates APPLYING THE CONCEPTS What are the long-term fiscal imbalances for the United States? New Methods to Measure the Long-Term Fiscal Imbalances for the United States Did the Federal Reserve cause the housing boom through excessively loose monetary policy? Would a Policy Rule Have Prevented the Housing Boom? Can the United States adopt a European-style value-added tax? Is a VAT in Our Future? Copyright © 2012 Pearson Prentice Hall All rights reserved 17-3 C H A P T E R 17 Macroeconomic Policy Debates 17.1 SHOULD WE BALANCE THE FEDERAL BUDGET? The Budget in Recent Decades ► FIGURE 17.1 Debt as a Percent of GDP, 1791–2009 The nation’s debt/GDP ratio tends to rise sharply during wars because more spending is needed to finance them However, the ratio also can rise during peacetime, as it did during the Reagan presidency in the 1980s Copyright © 2012 Pearson Prentice Hall All rights reserved 17-4 C H A P T E R 17 Macroeconomic Policy Debates 17.1 SHOULD WE BALANCE THE FEDERAL BUDGET? (cont’d) The Budget and Social Security •Federal budget figures include revenue and expenditures from the Social Security system Over the next decade, the Social Security portion of the budget is expected to run a surplus because of the huge number of baby boomers (those born between 1946 and 1964) currently paying taxes into the system •That surplus won’t last forever, though Some economists argue that Social Security funds should not be included in federal budget figures because the money will be needed to make future Social Security payments to these baby boomers •Over the longer horizon, the surpluses in the Social Security account will disappear and turn to deficits •As our society grows older, spending on both Social Security and Medicare will increase •That increase in spending is causing the CBO to predict emerging federal deficits and sharp increases in the debt/GDP ratio to levels comparable to those of World War II, unless taxes are raised and/or spending is cut significantly Copyright © 2012 Pearson Prentice Hall All rights reserved 17-5 C H A P T E R 17 Macroeconomic Policy Debates 17.1 SHOULD WE BALANCE THE FEDERAL BUDGET? (cont’d) Five Debates About Deficits DEBATE 1: DO DEFICITS LEAD TO INFLATION? government deficit = new borrowing from the public + new money created ● monetizing the deficit Purchases by a central bank of newly issued government bonds Large, stable countries like the United Kingdom, the United States, and Japan don’t monetize much of their debt because they are able to borrow from the public In these countries, deficits not lead inevitably to inflation During the recent recession, the Fed purchased massive amounts of bonds, but paid banks interest thus inducing them to hold additional reserves This prevented a large increase in the money supply held by the public Copyright © 2012 Pearson Prentice Hall All rights reserved 17-6 C H A P T E R 17 Macroeconomic Policy Debates 17.1 SHOULD WE BALANCE THE FEDERAL BUDGET? (cont’d) Five Debates About Deficits DEBATE 2: IS GOVERNMENT DEBT A BURDEN ON FUTURE GENERATIONS? The result of government deficits is that less savings are available to firms for investment Higher taxes will be imposed on future generations PRINCIPLE OF OPPORTUNITY COST The opportunity cost of something is what you sacrifice to get it ● Ricardian equivalence The proposition that it does not matter whether government expenditure is financed by taxes or debt Copyright © 2012 Pearson Prentice Hall All rights reserved 17-7 C H A P T E R 17 Macroeconomic Policy Debates 17.1 SHOULD WE BALANCE THE FEDERAL BUDGET? (cont’d) Five Debates About Deficits DEBATE 2: IS GOVERNMENT DEBT A BURDEN ON FUTURE GENERATIONS? ► FIGURE 17.2 International Comparisons of Government Debt as Percentage of GDP, 2009 Among developed countries, the United States has a relatively small percentage of debt to GDP Japan has the highest percentage of debt of the countries depicted Copyright © 2012 Pearson Prentice Hall All rights reserved 17-8 C H A P T E R 17 Macroeconomic Policy Debates 17.1 SHOULD WE BALANCE THE FEDERAL BUDGET? (cont’d) Five Debates About Deficits DEBATE 3: HOW DO DEFICITS AFFECT THE SIZE OF GOVERNMENT? Nobel Laureate James Buchanan has argued that people are less aware of government deficits than of the taxes they’re forced to pay Therefore, financing government expenditures through deficits, rather than through higher taxes, will inevitably lead to higher government spending and bigger government Although this argument may seem plausible, it presents two problems: First, in recent U.S history, spending by state and local governments has grown much faster than federal spending However, state and local governments face many more restrictions when it comes to borrowing money than the federal government faces Second, if politicians trying to get reelected really prefer higher government spending and deficits to higher taxes and surpluses, why did the federal government run surpluses in the late 1990s? Copyright © 2012 Pearson Prentice Hall All rights reserved 17-9 C H A P T E R 17 Macroeconomic Policy Debates APPLICATION NEW METHODS TO MEASURE THE LONG-TERM FISCAL IMBALANCES FOR THE UNITED STATES APPLYING THE CONCEPTS #1: What are the long-term fiscal imbalances for the United States? •Even though federal budget-deficit projections have increased in recent years, they still don’t accurately portray the long-run fiscal problems facing the U.S •As the population ages, life expectancies increase, and health-care costs continue to grow, expenditures on Social Security and Medicare are expected to increase significantly, too •Over time, there will be an escalating gap between revenues and expenditures, which will have to be met by outright borrowing •Economists Jagadeesh Gokhale of the Cato Institute and Kent Smetters of the University of Pennsylvania have developed a method for estimating the present value of the gap between the government’s revenues and expenditures and adding it to the current national debt •The “fiscal imbalance” is approximately $63 trillion, or five times GDP Copyright © 2012 Pearson Prentice Hall All rights reserved 17-10 C H A P T E R 17 Macroeconomic Policy Debates 17.1 SHOULD WE BALANCE THE FEDERAL BUDGET? (cont’d) Five Debates About Deficits DEBATE 4: CAN DEFICITS BE GOOD FOR AN ECONOMY? The government may deliberately run a deficit to pull the economy out of a recession The deficit the government creates puts additional income into the hands of the public With more money, people don’t have to drastically cut their consumption spending Because total spending in the economy does not fall as much, the severity of the recession is lessened Deficits can also play a role in tax smoothing during periods of unusually high government expenditures By running deficits and only gradually raising taxes later to service the debt, we avoid creating excess distortions in the economy Copyright © 2012 Pearson Prentice Hall All rights reserved 17-11 C H A P T E R 17 Macroeconomic Policy Debates 17.1 SHOULD WE BALANCE THE FEDERAL BUDGET? (cont’d) Five Debates About Deficits DEBATE 5: WOULD A BALANCED-BUDGET AMENDMENT REALLY WORK? Proponents of the balanced-budget amendment say it will finally exert discipline on the federal government, preventing large deficits in peacetime, such as those that occurred in the 1980s Critics of a balanced-budget amendment point to many different problems, such as the following: • A balanced budget may not allow enough flexibility, or room, for the government to effectively deal with recessions • The Constitution is not the right mechanism to try to enforce complicated budget rules • Congress could devise special budgets to get around the requirement • Congress could also find nonbudgetary ways to carry out the policies that it desires Copyright © 2012 Pearson Prentice Hall All rights reserved 17-12 C H A P T E R 17 Macroeconomic Policy Debates 17.2 SHOULD THE FED TARGET INFLATION OR PURSUE OTHER OBJECTIVES? Two Debates About Inflation Targeting DEBATE 1: SHOULD THE FED FOCUS ON ONLY INFLATION? We have learned that in the long run, monetary policy can influence only the level of prices, not the level of employment Proponents of inflation targeting argue that the Fed should have only one primary goal: controlling inflation Before he took over as chairman of the Federal Reserve in 2006, Ben Bernanke was an advocate for inflation targeting Bernanke called inflation targeting a policy of constrained discretion Under inflation targeting, the Fed could take actions to offset shocks to real output or to the financial system, but it had to keep its long-run inflation targets in clear view However, many economists disagree with the idea of inflation targeting because they strongly object to the Fed concentrating solely on controlling inflation Economists also debate the level for an inflation target It is very difficult to measure changes in prices accurately when there is a great deal of technological change occurring in the economy Copyright © 2012 Pearson Prentice Hall All rights reserved 17-13 C H A P T E R 17 Macroeconomic Policy Debates APPLICATION WOULD A POLICY RULE HAVE PREVENTED THE HOUSING BOOM? APPLYING THE CONCEPTS #2: Did the Federal Reserve cause the housing boom through excessively loose monetary policy? •John Taylor of Stanford argued that the Fed’s “easy money” policy from mid-2001 through 2004 was responsible for the housing boom •The Fed lowered interest rates from percent in 2001 to percent in 2004 Using the Taylor Principle, he found they should have raised it to percent •He showed that housing starts, which are very sensitive to interest rates would have been much lower and the boom and bust would have been avoided Copyright © 2012 Pearson Prentice Hall All rights reserved 17-14 C H A P T E R 17 Macroeconomic Policy Debates 17.2 SHOULD THE FED TARGET INFLATION OR PURSUE OTHER OBJECTIVES? (cont’d) Two Debates About Inflation Targeting DEBATE 2: IF THERE WERE AN INFLATION TARGET, WHO WOULD SET IT? In the United Kingdom, which adopted targeting in 1992, the elected government decides on the inflation target for the central bank In other countries, the central bank has more influence in setting the inflation target Under current law, the Fed chairman reports regularly to Congress, but the Fed has considerable power to use monetary policy to stabilize output as well as to fight inflation as it pleases Copyright © 2012 Pearson Prentice Hall All rights reserved 17-15 C H A P T E R 17 Macroeconomic Policy Debates 17.3 SHOULD WE TAX CONSUMPTION RATHER THAN INCOME? ● consumption taxes Taxes based on the consumption, not the income, of individuals Two Debates About Consumption Taxation DEBATE 1: WILL CONSUMPTION TAXES LEAD TO MORE SAVINGS? There is no question that taxing consumption instead of savings creates an incentive to save However, there’s no guarantee the incentive will actually result in more money saved in the economy People will want to take advantage of this incentive and reduce consumption and increase savings On the other hand, people will also want to spend more because, with the tax cut, they are wealthier Copyright © 2012 Pearson Prentice Hall All rights reserved 17-16 C H A P T E R 17 Macroeconomic Policy Debates 17.3 SHOULD WE TAX CONSUMPTION RATHER THAN INCOME? (cont’d) Two Debates About Consumption Taxation DEBATE 2: ARE CONSUMPTION TAXES FAIR? ● capital gains Profits investors earn when they sell stocks, bonds, real estate, or other assets In practice, moving to a consumption-tax system could have a major impact on the distribution of income in the economy Suppose we simply exempted the returns from savings from the income tax This exception would clearly favor wealthy and high-income individuals who save the most and earn a lot of income in interest, dividends, rents, and capital gains Copyright © 2012 Pearson Prentice Hall All rights reserved 17-17 C H A P T E R 17 Macroeconomic Policy Debates 17.3 SHOULD WE TAX CONSUMPTION RATHER THAN INCOME? (cont’d) Two Debates About Consumption Taxation DEBATE 2: ARE CONSUMPTION TAXES FAIR? Copyright © 2012 Pearson Prentice Hall All rights reserved 17-18 C H A P T E R 17 Macroeconomic Policy Debates APPLICATION IS A VAT IN OUR FUTURE? APPLYING THE CONCEPTS #3: Can the United States adopt a European-style value-added tax? •Virtually all developed countries use a value-added tax; a VAT The United States is a prominent exception •A VAT is essentially a sales tax added at each stage of production It is embedded and easy to collect, however it tends to be high; 17.5 percent in the United Kingdom •A VAT would be regressive and might impinge on state taxing authority Copyright © 2012 Pearson Prentice Hall All rights reserved 17-19 C H A P T E R 17 Macroeconomic Policy Debates KEY TERMS capital gains monetizing the deficit consumption taxes Ricardian equivalence Copyright © 2012 Pearson Prentice Hall All rights reserved 17-20 ... rights reserved 17- 3 C H A P T E R 17 Macroeconomic Policy Debates 17. 1 SHOULD WE BALANCE THE FEDERAL BUDGET? The Budget in Recent Decades ► FIGURE 17. 1 Debt as a Percent of GDP, 179 1–2009 The... reserved 17- 4 C H A P T E R 17 Macroeconomic Policy Debates 17. 1 SHOULD WE BALANCE THE FEDERAL BUDGET? (cont’d) The Budget and Social Security •Federal budget figures include revenue and expenditures... have been much lower and the boom and bust would have been avoided Copyright © 2012 Pearson Prentice Hall All rights reserved 17- 14 C H A P T E R 17 Macroeconomic Policy Debates 17. 2 SHOULD THE FED