Aggregate Demand Policy in Perspective Chapter 30

Laugher Curve Top Five Reasons to Study Economics 5. When you get drunk, you can tell everyone that you are just researching the law of diminishing marginal utility.

Laugher Curve Top Five Reasons to Study Economics 4. You can talk about money without having to make any. 3. You can say “trickle down” with a straight face.

Laugher Curve Top Five Reasons to Study Economics 2. When you are in the unemployment line, at least you know why you are there. 1. If you rearrange the letters in ECONOMICS, you get COMIC NOSE.

Supply Side versus Demand Side Policies The interrelationship between AS and AD is captured in the circular flow diagram. AS (production by firms) creates output and income, and hence AD (the potential demand to buy that output.

Supply Side versus Demand Side Policies The AS/AD model separates long-run aggregate supply from short-run aggregate demand forces. Demand-side policies (monetary and fiscal policy) shift the AD curve. Supply-side policies work by increasing potential output.

Supply Side versus Demand Side Policies Politicians are not constrained by models. They can, and do, often emphasize different interconnections.

Demand-Side and Supply-Side Policies Real output Price Level LAS Supply-side policies shift the LAS curve. SAS AD Demand-side policies (monetary and fiscal policies) shift the AD curve YP

Problems with Fiscal Policy Six assumptions of the AS/AD model lead to problems with fiscal policy: Financing the deficit doesn’t have any offsetting effects. The government knows what the situation is. The government knows the economy’s potential income level.

Problems with Fiscal Policy Six assumptions of the AS/AD model lead to problems with fiscal policy: The government has flexibility in changing spending and taxes. The size of the government debt doesn’t matter. Fiscal policy doesn’t negatively affect other government goals.

Financing the Deficit Doesn’t Have Offsetting Effects Some economists believe that government financing of deficit spending offsets the deficit’s expansionary effect. They believe that government borrowing increases interest rates and crowds out private investment.

Financing the Deficit Doesn’t Have Offsetting Effects Crowding out – the offsetting of a change in government expenditures by a change in private expenditures in the opposite direction.

Financing the Deficit Doesn’t Have Offsetting Effects Some economists argue that the effect of government expenditures is negative. They consider private spending to be more productive than government spending.

Financing the Deficit Doesn’t Have Offsetting Effects Crowding out also works in reverse in contractionary fiscal policy. When the government runs a surplus, it buys back bonds. Interest rates will drop, stimulating investment.

Partial Crowding Out Real output Price Level AD2 AD1 AD0 SAS Net effect Partial crowding out Y0 Y2 Y1

Knowing What the Situation Is Data problems limit the use of fiscal policy for fine tuning. Getting reliable numbers on the economy takes time. We may be in the middle of a recession and not know it.

Knowing What the Situation Is The government has large econometric models and leading indicators to predict where the economy will be in the near future. Economic forecasting is still very much an art and not a science.

Knowing the Level of Potential Income No one knows for sure the level of potential income. Potential income has been called the full-employment level of income.

Knowing the Level of Potential Income Differences in estimates of potential income often lead to different policy recommendations.

Knowing the Level of Potential Income In most cases, the U.S. economy is in an ambiguous state. Some economists will call for expansionary policy and others call for contractionary policy.

The Government’s Flexibility in Changing Taxes and Spending Putting fiscal policy into place takes time and has serious implementation problems. Numerous political and institutional realities in the U.S. today make it a difficult task to implement fiscal policy.

The Government’s Flexibility in Changing Taxes and Spending Squabbles between Congress and the President may delay implementing appropriate fiscal policy for months, even years.

Size of the Government Debt Doesn’t Matter These is no inherent reason why the adoption of activists policies should have caused high government deficits year after year.

Size of the Government Debt Doesn’t Matter Activist policy has led to an increase in government debt because: Early activists favored large increases in government spending as well as favoring the government's using fiscal policy. Politically, it is much easier for government to increase spending and decrease taxes than vice versa.

Size of the Government Debt Doesn’t Matter If one believes that debt is harmful, then there might be a reason not to conduct expansionary fiscal policy, even when the model calls for it.

Fiscal Policy Doesn’t Negatively Affect Other Government Goals An economy has many goals – achieving potential income is only one of those goals National economic goals often conflict.

Summary of the Problems While the six problems listed above do not necessarily eliminate fiscal policy altogether, they severely restrict it. Fiscal policy is a sledgehammer, not an instrument for fine-tuning.

Building Fiscal Policies Into Institutions Economists have attempted to create built-in fiscal policies. Automatic stabilizers – any government program or policy that counteracts the business cycle without any new government action.

Building Fiscal Policies Into Institutions Automatic stabilizers include welfare payments, unemployment insurance, and the income tax system.

Building Fiscal Policies Into Institutions Automatic stabilizers include welfare payments, unemployment insurance, and the income tax system.

How Automatic Stabilizers Work When the economy is in a recession, the unemployment rate rises. Unemployment insurance automatically is paid out to the unemployed, offsetting some of the fall in income.

How Automatic Stabilizers Work Government spending increase without an explicit act by the government. When incomes increase, government spending declines automatically.

How Automatic Stabilizers Work When the economy expands, tax revenues rise, slowing the economy. When the economy contracts, tax revenues decline, providing stimulus to the economy.

State Government Finance and Procyclical Fiscal Policy State constitutional provisions mandating balanced budgets act as automatic destabilizers. These states cut spending and raise taxes during recessions and increase spending and cut taxes during expansions.

State Government Finance and Procyclical Fiscal Policy Procyclical fiscal policy – changes in government spending and taxes that increase the cyclical fluctuations in the economy instead of reducing them.

State Government Finance and Procyclical Fiscal Policy Economists have suggested alternatives to state government procyclical budget policy. Establish rainy-season funds. Use five-year rolling-average budgeting procedure.

The Negative Side of Automatic Stabilizers Automatic stabilizers have their problems. When the economy first starts climbing out of a recession, automatic stabilizers may slow down the process.

Building Keynesian Policies Into Institutions Despite these problems, most economists believe automatic stabilizers have played an important role in reducing fluctuations in the economy.

Decrease in Fluctuations in the Economy 20% 15 10 5 20 1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000 2010 Percent change in real GDP around the trend Before demand management Active demand management Modern period

Conventional Wisdom about Monetary and Fiscal Policy Monetary and fiscal policy are useful to achieve high growth, low inflation, and low unemployment.

Conventional Wisdom about Monetary and Fiscal Policy Of the two, monetary policy is the more important policy for short-run stabilization. It is more flexible and less influenced by politics than fiscal policy.

Conventional Wisdom about Monetary and Fiscal Policy Option Advantages Disadvantages Monetary policy Expasionary Interest rates may fall. Economy may grow. Decreases unemployment. Inflation may worsen. Capital outflow. Trade deficit may increase. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.

Conventional Wisdom about Monetary and Fiscal Policy Option Advantages Disadvantages Monetary policy Contractionary Helps fight inflation. Trade deficit may decrease. Capital inflow. Risks recession. Increases un-employment. Slows growth. May help cause short-run problems. Interest rates may rise. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.

Conventional Wisdom about Monetary and Fiscal Policy Option Advantages Disadvantages Fiscal policy Expansionary May increase output growth. May help solve short-run poli-tical problems. Decreases unemployment Budget deficit worsens. Hurts country’s ability to borrow in the future. Trade deficit may increase. Upward pres-sure on interest rate. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.

Conventional Wisdom about Monetary and Fiscal Policy Option Advantages Disadvantages Fiscal policy Contractionary May help fight inflation. May allow a bet-ter monetary-fiscal mix. Trade deficit may decrease. Interest rates may fall. Risks recession. Increases unemployment. Slows output growth in short run. May help cause short-run political problems. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.

Alternatives and Supplements to Monetary and Fiscal Policy Monetary and fiscal policy aren’t the only policies that affect aggregate demand. Any policy that affects autonomous spending without having offsetting effects on other expenditures can achieve the same results.

Directed Investment Policies: Policy Affecting Expectations Poor investor expectations can become self-fulfilling. If they expect a recession, they might not invest, driving the economy into a Depression.

Rosy Scenario: Talking the Economy into Fiscal Health Gloomy government pronouncements may affect expectations and decrease investment and consumption spending. Rosy scenario – government policy of making optimistic predictions and never making gloomy predictions.

Financial Guarantees Government guarantees or promises of guarantees can bolster business confidence.

Autonomous Consumption Policy Making credit more available to consumers can expand aggregate demand. Economists watch indexes of consumer credit and consumer confidence to gauge the direction of the economy.

Trade Policy and Export-Led Growth Export-led growth policies – policies designed to stimulate U.S. exports and increase aggregate expenditures on U.S. goods. Any policy that restricts imports will have the same effect on the economy.

Interdependencies in the Global Economy Any time a nation attempts to restrict imports, it is equivalent to getting another country to follow an import-led decline of its economy.

Interdependencies in the Global Economy There is a risk of retaliation whenever a nation applies trade restrictions against another nation.

Exchange Rate Policies Exchange rate policy – a policy of deliberately affecting a country’s exchange rate in order to affect its trade balance. A low value of a country’s currency relative to other currencies encourages exports and discourages imports, and vice versa.

Credibility in Aggregate Demand Policy Effective policy must be credible policy.

Rational Expectations People generally act rationally in the sense that they are forward looking. Rational expectations – forward-looking expectations that use available information.

Rational Expectations For example, if the public is convinced that the Fed is deadly serious about its goal of cooling down the economy, the policy will work.

Uncertainty About the Effects of Policy The central role of expectations means that there is a great deal of uncertainty in the economy. There are a multiplicity of expectational strategies which can shift rapidly.

Uncertainty About the Effects of Policy This undermines the ability to develop deterministic models of the economy which gives the economy an unpredictability that precludes fine tuning.

Uncertainty About the Effects of Policy Depending on the beliefs that individuals have, monetary and fiscal policy will work in different ways.

Policy Regimes and Expectations A policy regime is a rule. It is a predetermined statement of the policy that will be followed in various circumstances.

Policy Regimes and Expectations A policy is a one-time reaction to a problem. It is chosen without a predetermined framework.

Policy Regimes and Expectations Policy regimes can help generate the expectations that make the government’s tools work.

Rules versus Discretion and Credibility The focus on credibility has led to a call for rules to guide policy rather than giving policymakers wide policy discretion.

Aggregate Demand Policy in Perspective End of Chapter 30