Lecture Essentials of Economics: Chapter 16 - Bradley R. Schiller, Cynthia Hill

Chapter 16 Theory and reality, after reading this chapter, you should be able to: Identify the major tools of macro policy, explain how macro tools can fix macro problems, depict the track record of macro outcomes, describe major impediments to policy success, discuss the pros and cons of discretionary policy.

Chapter  16 Theory and Reality Copyright © 2014 McGraw­Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw­Hill Education Macroeconomics:  Policy Tools Policy tools for macroeconomics: • Fiscal policy • Monetary policy • Supply-side policy 16­2 Table 16.1 16­3 Fiscal Policy • Fiscal policy is the use of government taxes and spending to alter macroeconomic outcomes, consisting of: – Automatic stabilizers – Discretionary policy 16­4 Automatic Stabilizers  • Automatic stabilizers are federal expenditure or revenue items that automatically respond countercyclically to changes in national income • Such stabilizers don’t require an additional act of Congress ‒ Examples include unemployment benefits and income tax collections 16­5 Automatic Stabilizers  • 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 16­6 Discretionary Policy • Discretionary 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 16­7 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 16­8 Monetary Policy  • 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 16­9 Supply­Side 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 16­10 Supply­Side Policy  • 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 16­11 Case 1: Recession • Output 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 16­12 Case 1: Recession – Keynesians • Emphasize 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 16­13 Case 1: Recession –  Monetarists • See no point in discretionary policies – They assume the AS curve is vertical at the natural rate of unemployment – Changes in fiscal or monetary policy are ineffective because increases in AD only cause inflation • The appropriate response to a recession is patience 16­14 Case 1: Recession – Supply­ Siders • Believe 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 16­15 Case 2: Inflation –  Keynesians • Need 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 16­16 Case 2: Inflation –  Monetarists • Believe 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 16­17 Case 2: Inflation – Supply­ Siders • Point 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 16­18 Case 3: Stagflation • Stagflation 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 unemployment 16­19 Case 3: Stagflation • 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 16­20 Figure 16.2 16­21 Why Things Don’t  Always Work • We can distinguish four obstacles to policy success: – Goal conflicts – Measurement problems – Design problems – Implementation problems 16­22 Politics versus  Economics • Tax hikes and budget cuts rarely win votes • On the other hand, tax cuts and porkbarrel spending are always popular • Because of this, deficits will continue to be with us, and the federal debt will increase 16­23 Politics versus  Economics • 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 16­24 ...Macroeconomics:  Policy Tools Policy tools for macroeconomics: • Fiscal policy • Monetary policy • Supply-side policy 16 2 Table 16. 1 16 3 Fiscal Policy • Fiscal policy is the use of government... 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 10 Supply­Side Policy  • Supply-side... prices only • If the AS curve is upward-sloping, changes in the money supply affect both prices and output 16 9 Supply­Side Policy  • Supply-side policy: the use of tax rates, (de)regulation, and