Chapter Five Debates over Macroeconomic Policy 23

Should Policymakers Stabilize the Economy? Changes in aggregate demand and aggregate supply – Short-run fluctuations in production and employment Monetary and fiscal policy – Can shift aggregate demand – Influence these fluctuations Should policymakers influence short-run economic fluctuations? 2

Should Policymakers Stabilize the Economy? Pro: policymakers should try to stabilize the economy When aggregate demand is too small – Policymakers Boost government spending Cut taxes Expand the money supply 3

Should Policymakers Stabilize the Economy? Pro: policymakers should try to stabilize the economy When aggregate demand is excessive – Policymakers Cut government spending Raise taxes Reduce the money supply Lead to more stable economy – Benefits everyone 4

Should Policymakers Stabilize the Economy? Con: policymakers should not try to stabilize the economy Monetary and fiscal policy – Do not affect the economy immediately – Work with a long lag – Economic forecasting is highly imprecise Policymakers trying to stabilize the economy – Can do just the opposite – Economic conditions can easily change 5

Should Policymakers Stabilize the Economy? What do I think? Who cares? The case for intervention is stronger the quicker and more precisely fiscal and monetary policy can work. The case for intervention is stronger if the fluctuation is more severe. 6

Should Policymakers Stabilize the Economy? Recession of 1990? Maybe. Recession of 2001? No. Recession of 2007? DEFINITELY! 7

Monetary Policy: Rule or Discretion? Federal Reserve – discretionary power Pro: monetary policy should be made by rule Discretionary monetary policy - two problems – Does not limit incompetence and abuse of power Political business cycle – If central bankers ally with politicians – Discretionary policy - can lead to economic fluctuations that reflect the electoral calendar 8

Monetary Policy: Rule or Discretion? Pro: monetary policy should be made by rule Discretionary monetary policy - two problems – It might lead to more inflation than is desirable Time inconsistency of policy – Central bankers – know there is no long-run trade-off between inflation and unemployment » Announce goal - zero inflation » Short-run trade-off between inflation and unemployment To avoid the problems – Commit the central bank to a policy rule 9

Monetary Policy: Rule or Discretion? Con: monetary policy should not be made by rule Discretionary monetary policy – flexible – The Fed – various circumstances – Better to appoint good people to conduct monetary policy And then give them the freedom to do the best they can – The alleged problems with discretion Are largely hypothetical 10

Monetary Policy: Rule or Discretion? What do I think? You care. Hard to make rules when – the policy context is uncertain – the effects of policy are uncertain 11

Monetary Policy: Rule or Discretion? 12

Should Central Bank Aim for Zero Inflation? Pro: central bank should aim for zero inflation Six costs of inflation: – Shoeleather costs associated with reduced money holdings – Menu costs associated with more frequent adjustment of prices – Increased variability of relative prices 13

Should Central Bank Aim for Zero Inflation? Pro: central bank should aim for zero inflation Six costs of inflation: – Unintended changes in tax liabilities due to non-indexation of the tax code – Confusion and inconvenience resulting from a changing unit of account – Arbitrary redistributions of wealth associated with dollar-denominated debts 14

Should Central Bank Aim for Zero Inflation? Pro: central bank should aim for zero inflation Reducing inflation – Temporary: high unemployment & low output – Long-run: no trade-off – Temporary costs – Permanent benefits 15

Should Central Bank Aim for Zero Inflation? Con: central bank should not aim for zero inflation Benefits of zero inflation – Compared to moderate inflation – Are small Costs of reaching zero inflation are large Sacrifice ratio Social costs Small inflation – May be a good thing 16

Should Central Bank Aim for Zero Inflation? What do I think? What makes you think I think? Zero inflation is nuts. If for no other reason than that workers, ALL workers, are VERY resistant to wage reductions. The reasons for this will have to wait for a different course. But a little inflation is necessary to allow relative wages to fall for workers experiencing declining demand. 17

Should Central Bank Aim for Zero Inflation? 18

Should the Government Balance its Budget? Pro: government should balance its budget Government debt – Direct effect: place a burden on future generations – Macroeconomic effects Lower national saving Future generations: lower incomes & higher taxes Justifiable to run a budget deficit War Temporary downturn in economic activity 19

Should the Government Balance its Budget? Pro: government should balance its budget Not all budget deficits can be justified by war or recession – 1980 – 1995, government debt Increased from 26 to 50% of GDP – No major military conflict – No major economic downturn Causes – Easier to increase government spending – Than to increase taxes 20

Should the Government Balance its Budget? Con: government should not balance its budget The problem of government debt – Often exaggerated – Government debt - tax burden on younger generations Not large compared to lifetime income Lifetime income = $1.6 million Debt = $17,000 per person – 1% of lifetime income 21

Should the Government Balance its Budget? Con: government should not balance its budget Budget deficit – Just one piece of a large picture Of how the government chooses to raise and spend money Fiscal policy – Affect different generations of taxpayers 22

Should the Government Balance its Budget? What do I think? Bullwinkle is a dope. This one is easy: The government should balance its budget ACROSS THE BUSINESS CYCLE!!!! Save during booms, spend during recessions to reduce fluctuations. 23

Should the Government Balance its Budget? 24

Tax Laws - Reformed to Encourage Saving? Pro: tax laws should be reformed to encourage saving Nation’s saving rate – Determinant of long-run economic prosperity U.S. tax system - discourages saving – Tax the return to saving quite heavily – Tax some forms of capital income twice – Inheritance tax rate - as high as 55% Other policies and institutions Discourage saving 25

Tax Laws - Reformed to Encourage Saving? Pro: tax laws should be reformed to encourage saving Tax code – improved to encourage saving – Preferential treatment to some types of retirement saving – Consumption tax 26

Tax Laws - Reformed to Encourage Saving? Con: tax laws should not be reformed to encourage saving Fairly distribution of the tax burden Tax policies – to encourage saving – Increase the tax burden on people who cannot afford to save – May not be effective Substitution effect Income effect 27

Tax Laws - Reformed to Encourage Saving? Con: tax laws should not be reformed to encourage saving Other ways to increase national saving – No tax breaks to the rich – National saving = private + public saving Raise public saving – By reducing the budget deficit – Raise taxes on the wealthy 28

Tax Laws - Reformed to Encourage Saving? What do I think? This one is dumb. – There’s no evidence to suggest that any policy can effectively encourage savings – Once again, there’s a price effect and an income effect and they pretty much cancel – So if no policy seems to work, then there’s not much point in adopting a policy, no? 29

CASE STUDY from Ch. 19: The Falling Dollar U.S. trade-weighted nominal exchange rate index, March 1973 = From 10/2005 to 6/2008, the dollar depreciated 17.3%

The effects of a government budget deficit From chapter Real Interest Rate S1S1 Demand Quantity of Loanable Funds (a) The Market for Loanable Funds Real Interest Rate NCO Net capital outflow (b) Net Capital Outflow r1r1 Real Exchange Rate S1S1 Demand Quantity of Dollars (c) The Market for Foreign-Currency Exchange E1E1 When the government runs a budget deficit, it reduces the supply of loanable funds from S 1 to S 2 in panel (a). The interest rate rises from r 1 to r 2 to balance the supply and demand for loanable funds. In panel (b), the higher interest rate reduces net capital outflow. Reduced net capital outflow, in turn, reduces the supply of dollars in the market for foreign-currency exchange from S 1 to S 2 in panel (c). This fall in the supply of dollars causes the real exchange rate to appreciate from E 1 to E 2. The appreciation of the exchange rate pushes the trade balance toward deficit. S2S2 r1r1 A 1. A budget deficit reduces the supply of loanable funds... r2r2 B which increases the real interest rate... r2r which in turn reduces net capital outflow. S2S2 4. The decrease in net capital outflow reduces the supply of dollars to be exchanged into foreign currency... E2E Which causes the real exchange rate to appreciate.

U.S. Saving, Investment, and NCO, Saving NCO (% of GDP) Investment

The End Thanks to Zach Ward, John Singleton, Rebecca Jennings, Jongheuk Kim, Hao Bo! THINK LIKE AN ECONOMIST!!!!! 33