Macroeconomics: Policy Tools Policy tools for macroeconomics: Fiscal Policy Monetary Policy Supply-side Policy The three policy tools for macroeconomics are fiscal policy, monetary policy, and supply-side policy. LO-1

Table 16.1

Fiscal Policy Fiscal policy is the use of government taxes and spending to alter macroeconomic outcomes. Fiscal policy is the use of government taxes and spending to alter macroeconomic outcomes. As stated earlier, fiscal policy deals with changes in government spending or taxes to stabilize the economy. LO-1

Table 16.2

Automatic Stabilizers Automatic stabilizers are federal expenditure or revenue items that automatically respond counter-cyclically to changes in national income. Such stabilizers don’t require an additional act of Congress. Examples include unemployment benefits and income taxes Automatic stabilizers are federal expenditure or revenue items that automatically respond counter-cyclically to changes in national income. Automatic stabilizers help smooth out the economy “automatically”, without action by anyone. Examples include unemployment benefits and income taxes. Such stabilizers don’t require an additional act of Congress. LO-1

Discretionary Policy Fiscal policy refers to deliberate changes in tax or spending legislation. Discretionary policy often has limited impacts on the economy. Additional spending and tax revenue losses created a $1.4 trillion federal deficit in 2009. Fiscal policy refers to deliberate changes in tax or spending legislation. Discretionary means that an action is deliberate or intentional. An example is a tax cut passed by Congress. Discretionary policy often has limited impacts on the economy. LO-1

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 Monetary policy is the use of money and credit controls to influence macroeconomic activity. As stated earlier, monetary policy deals with changes in the money supply by the Fed. The tools of monetary policy include open-market operations, discount-rate changes, and reserve requirements. LO-1

Table 16.3

Supply-Side Policy The shape of the aggregate supply curve limits the effectiveness of fiscal and monetary policies. 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 aggregate supply curve limits the effectiveness of fiscal and monetary policies. Supply-side policy is the use of tax rates, (de)regulation, and other mechanisms to increase the ability and willingness to produce goods and services. LO-1

Table 16.4

Case 1: Recession Need to put people to work. The GDP gap must be closed: The GDP gap is the difference between full-employment output and the amount of output demanded at current price levels. Case 1 is a recession. There is a need to put people to work and the GDP gap must be closed. The GDP gap is the difference between full-employment output and the amount of output demanded at current price levels. LO-2

Case 1: Recession: Keynesians Emphasize the need to stimulate aggregate demand with fiscal policy by: Cutting taxes Boosting government spending In this case, Keynesians emphasize the need to stimulate aggregate demand with fiscal policy by cutting taxes or boosting government spending. Keynesians are strong believers in fiscal policy. LO-2

Case 1: Recession: Monetarists See no point in discretionary policies. The aggregate supply 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. The Monetarists see no point in discretionary policies. They believe the aggregate supply curve is vertical at the natural rate of employment. Changes in fiscal or monetary policy are ineffective because increases in AD only cause inflation. The appropriate response to a recession is patience. They believe in laissez-faire. LO-2

Case 1: Recession: Supply-Siders Believe that policy initiatives should focus on changing the shape and position of the aggregate supply curve. Improve production incentives Cut marginal tax rates on investment and labor Reduce government regulation Supply-siders believe that policy initiatives should focus on changing the shape and position of the aggregate supply curve. They emphasize the need to improve production incentives, to cut marginal tax rates on investment and labor, and to reduce government regulation. Supply-siders believe that tax cuts and deregulation will increase aggregate supply. LO-2

Case 2: Inflation: Keynesians Need to restrain aggregate demand by: Raising taxes Cutting government spending Relying on the multiplier to cool down the economy Case 2 is inflation. Keynesians say there is a need to restrain aggregate demand by raising taxes, cutting government spending, and relying on the multiplier to cool down the economy. Inflation is caused by “too much money chasing too few goods”, so the solution is to decrease spending. LO-2

Case 2: Inflation: Monetarists Believe that inflation reflects excessive money supply growth. Cut the money supply Convince market participants that cautious monetary policy will be continued Monetarists believe that inflation reflects excessive money-supply growth. They would cut the money supply and convince market participants that cautious monetary policy will be continued. Decreasing the money supply will reduce spending. LO-2

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 Supply-siders point out that inflation implies both too much money and not enough goods. They would expand productive capacity, propose more incentives to save, cut taxes and regulations, encourage more immigration, and lower import barriers. Again, tax cuts and deregulation are the answers. LO-2

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 Case 3 is stagflation. Stagflation is the simultaneous occurrence of substantial unemployment and inflation. Stagflation is a combination of the words stagnation (referring to a recession) and inflation. There are no simple solutions for stagflation. There is a need to balance the competing threats of inflation and unemployment. LO-2

Why Things Don’t Always Work We can distinguish four obstacles to policy success: Goal conflicts Measurement problems Design problems Implementation problems We can distinguish four obstacles to policy success. They are goal conflicts, measurement problems, design problems, and implementation problems. LO-4

Congressional Deliberations The legislative process takes time. Even if the right policy is formulated to solve an emerging economic problem, there is no assurance that it will be implemented. And if it is implemented, there is no assurance that it will take effect at the right time. The legislative process takes time. Even if the right policy is formulated to solve an emerging economic problem, there is no assurance that it will be implemented. And if it is implemented, there is no assurance that it will take effect at the right time. There are time lags involved with every step of the process that may reduce the policy’s effectiveness. LO-4

Politics versus Economics Tax hikes and budget cuts rarely win votes. On the other hand, tax cuts and pork-barrel spending are always popular. Tax hikes and budget cuts rarely win votes. On the other hand, tax cuts and pork-barrel spending are always popular. It is difficult to raise taxes and cut spending, because voters don’t like it. LO-4