Lecture Outlines - Week 11

Economic Theory and Reality (Ch. 16 of Schiller)

What is the ideal package of macroeconomic policies?

How well does policy work?

What obstacles prevent us from doing better?

Also: Summarize macro policy and provide a capstone experience for the macroeconomics elements of the course.

Fiscal Policy Review

The basic tools of fiscal policy are contained in the federal budgetary process.

• Goal: Increase aggregate demand as a way of reducing unemployment.
• Method: Cut consumer taxes, increase government spending.

• Goal: Decrease aggregate demand as a way of reducing inflation.
• Method: Raise consumer taxes, reduce government spending.

NOTE: SEE TABLE 16.2 IN TEXT -- EXAMPLES OF DISCRETIONARY FISCAL POLICY LEGISLATION

Automatic Stabilizers:

There are aspects of federal taxation and spending that work toward automatically stabilizing the business cycle. Automatic stabilizers are a type of automatic or non-discretionary fiscal policy.

Examples:

1. Taxes fall and low-income assistance spending rises during recessions.
2. Taxes rise and low-income assistance spending falls during periods of rapid growth.

Do automatic stabilizers help to balance the budget in any given year?

No. During recessions, automatic stabilizers lead to larger budget deficits, while during periods of rapid economic growth, automatic stabilizers lead to smaller budget deficits or even surpluses.

Monetary Policy Review

The basic tools of monetary policy are controlled by the Federal Reserve Bank.

1. Expansionary monetary policy?

• Goal: Increase aggregate demand.
• Method: Increase money supply, reduce discount rate or Fed funds rate.

1. Contractionary monetary policy?

• Goal: Decrease aggregate demand.
• Method: Reduce money supply, increase discount rate or Fed funds rate.

Monetary rules vs. monetary discretion: Expansionary and contractionary fiscal policy are discretionary, or planned for specific circumstances. Some have argued that discretionary monetary policy has created more problems over the last 20 years than benefits. The alternative is to have a relatively strict rule that allows the money supply to grow based on things like the growth rate in the overall economy.

NOTE: TABLE 16.3 ON EXAMPLES OF KEY DISCRETIONARY MONETARY POLICY MOTIVES

Supply Side Review

What is the supply-side notion of appropriate economic policy?

• Pursue policies that enhance the productivity and profitability of business firms, thus promoting capital investment and ultimately an increase in productivity (more output from a given set of inputs) and an increase in production capacity.
• The anticipated benefits of supply-side policy are faster rates of economic growth and limited inflation.
• Examples: AS curve will shift outward if business taxes are reduced, if taxes are cut on business investment, if regulatory costs are reduced, such as through deregulation, if education is enhanced to increase the value of human capital, of government invests in needed infrastructure such as roads, ports, and technological infrastructure, and if welfare policies are hardened to promote a larger labor force.

NOTE: SEE TABLE 16.4 FOR EXAMPLES OF POLICIES WITH SUPPLY-SIDE IMPLICATIONS

• Performance vs. goals

Why Things Don't Always Work

1. Goal Conflicts: Some constituencies (young people, unemployed, minorities, unions) prefer policies to reduce unemployment, while other constituencies (retired people, bankers and lenders, bond holders) prefer policies to reduce inflation. The Fed usually sides with controlling inflation, while those more subject to voter pressure (President, Congress) tend to be more concerned about creating jobs and reducing unemployment. Thus it may be impossible to coordinate macro policy, or to fashion any perfect policy to moderate the business cycle.

 

2. Measurement Problems: How do we know in advance whether or not the economy is becoming dangerously inflationary, or edging into a recession? Forecasting is very difficult. If we wait until we know for sure, then we miss the opportunity to really avoid the problem to begin with.

 

3. Design Problem: Theory provides indications of how people or businesses respond to discretionary policy such as tax cuts, but in reality they may act very differently. For example, cutting income taxes to increase spending (AD) may instead be funneled into savings if consumers lack confidence in the future.

 

4. Implementation Problems: In terms of fiscal policy, Congress and the President may waste valuable time arguing over who should benefit from increases spending, subsidies, or tax cuts. Example: Cut capital gains taxes to the rich, or cut income taxes to the middle class. The time between emergence of a problem and policy response to a problem may become more than a year, particularly for fiscal policy, and these policy lags may largely or even totally eliminate the effectiveness of macro policy.