Stabilization Policy Lecture 22 Dr. Jennifer P. Wissink ©2017 Jennifer P. Wissink, all rights reserved. November 9, 2017 1

Announcements: MACRO Fall 2017 New MEL Quizzes Are Up Prelim 2 is graded Not bad See Bb for memo

Consider Two Possible Time Paths for GDP or Y* Path A is less stable—it varies more over time—than path B. Other things being equal, society prefers path B to path A. Can stabilization policy get us something more like path B?

Time Lags Regarding Monetary & Fiscal Policy The recognition lag refers to the time it takes for policy makers to recognize the existence of a boom or a slump. The implementation lag is the time it takes to put the desired policy into effect once economists and policy makers recognize that the economy is in a boom or a slump. The implementation lag for monetary policy is generally much shorter than for fiscal policy. The response lag is the time it takes for the economy to adjust to the new conditions after a new policy is implemented; the lag that occurs because of the operation of the economy itself. E.g., The delay in the multiplier of government spending occurs because neither individuals nor firms revise their spending plans instantaneously.

Stabilization Woe: “The Fool in the Shower” Attempts to stabilize the economy can prove destabilizing because of time lags. Milton Friedman likened these attempts to a “fool in the shower.” The government is constantly stimulating or contracting the economy at the wrong time.

“The Fool in the Shower” An expansionary policy that should have begun to take effect at point A does not actually begin to have an impact until point D, when the economy is already on an upswing.

“The Fool in the Shower” Hence, the policy pushes the economy to points F’ and G’ (instead of F and G). Income varies more widely than it would have if no policy had been implemented. If the government is the fool, can the Fed help control it?

The Typical Fed Response to the State of the Economy The Fed is likely to lower the interest rate (via an increase the money supply) during times of low output and low inflation. easy money This shifts AD to the right. When the economy is on the flat portion of the AS curve, an increase in the money supply will lead to an increase in output with very little increase in the price level.

The Typical Fed Response to the State of the Economy On the other hand… The Fed is likely to increase the interest rate (via a decrease the money supply) during times of high output and high inflation. tight money This shifts AD to the left. When the economy is on the relatively steep portion of the AS curve, contraction of the money supply will lead to a decrease in the price level, with little decrease in output. Famous/Funny quote by Harry S. Truman on what kind of economist he wants... “Give me a one-handed economist! All my economists say, On the one hand,... and on the other.”

The Typical Fed Response to the State of the Economy Stagflation is a more difficult problem for the Fed to help solve. If the Fed lowers the interest rate, output will rise, but so will the inflation rate (which is already too high). If the Fed increases the interest rate, the inflation rate will fall, but so will output (which is already too low). Supply side policies are more important when it comes to dealing with stagflation. GROWTH!

The Typical Fiscal Response to the State of the Economy Basic Policy Tools: G = government expenditures T = taxes Typically see expansionary policy (which shifts AD to right) when at low Y* and little inflation, and just the opposite with high Y* and troublesome inflation. Same concerns as with the Fed with stagflation. Note: Some G and T “policy” is built into the system by existing laws. The system has built in automatic stabilizers automatic destabilizers

Economic Stability & Fiscal Policy Automatic stabilizers refer to revenue and expenditure items in the federal budget that automatically change with the economy in such a way as to stabilize Y* or GDP. the tax code the government safety net, social insurance Automatic destabilizers refer to revenue and expenditure items in the federal budget that automatically change with the economy in such a way as to destabilize Y* or GDP. deficit targeting policy

FIGURE 9.6 The Federal Government Surplus (+) or Deficit (−) as a Percentage of GDP, 1993 I–2014 IV MyEconLab Real-time data

FIGURE 9.7 The Federal Government Debt as a Percentage of GDP, 1993 I–2014 IV MyEconLab Real-time data

Fiscal Policy: Deficit Targeting The Gramm-Rudman-Hollings Balanced Budget Act, passed by the U.S. Congress and signed by President Reagan in 1985, is a law that set out to reduce the federal deficit by $36 billion per year, with a deficit of zero slated for 1991. In practice, these targets never came close to being achieved. The deficits were: -149,730million in 1987 -155,178million in 1988 -152,639million in 1989 -221,036million in 1990

Fiscal Policy: The Effects of G on the Deficit Consider: Government Expenditures (G) and Taxes (T) Recall: when G>T  we run a deficit. Recall: when G<T  we have a surplus. Consider: Changes in Y* and the deficit first... When Y* or GDP falls (contracts) the deficit tends to rise. WHY? Taxable income of households and taxable profits of firms fall. Automatic government payments also rise. When Y* or GDP rises (expands) the deficit tends to fall. WHY? Reverse the argument above... Now... recall... a decrease in G causes the economy to contract. Two effects on the deficit: tends to reduce it since you’ve reduced G, but… tends to increase it since you will contract the economy Now... recall... an increase in G causes the economy to expand. tends to increase it since you’ve increased G, but… tends to decrease it since you will expand the economy

Fiscal Policy: The Effects of Tax Policy on the Deficit Very similar to what we just said about G, but more complicated and harder to predict! Basically, a decrease in Taxes works “like” an increase in G. An increase in Taxes works “like” a decrease in G. BIG QUESTIONS WITH TAX POLICY: Whose taxes are changing? How do these people behave as a consequence? 4 Questions About Trump's Tax Plan (NPR 4/26/17) http://www.npr.org/2017/04/26/525683530/4-questions-about-trumps-tax-plan

Fiscal Policy: Consequences for Economic Stability & Deficit Reduction Congress often has two options: Choose a target deficit and adjust government spending and taxation to achieve this target. Decide how much to spend and tax regardless of the consequences on the deficit.

Deficit Targeting as an Automatic Destabilizer With deficit targeting, the contraction in the economy would be larger. With deficit targeting, taxes could be rising or government spending declining while the economy is experiencing a contraction.

So What Do We Do? Good question. Options Worry about spend less on what? tax more on whom? Worry about Short run? Long run? Both?

The Last Wrinkle: International Trade All economies, regardless of their size, depend to some extent on other economies and are affected by events outside their borders. It’s an OPEN Economy! 1970s: imports roughly 7% of US GDP 2008-2011: imports roughly 18%, 14%, 16%, 18% of US GDP Want to see others? http://data.worldbank.org/indicator/NE.IMP.GNFS.ZS The “internationalization” or “globalization” of the U.S. economy has occurred everywhere: in the private and public sectors, in input and output markets, in business firms and households.

Basics: Trade Surpluses & Deficits Trade Surplus: When a country exports more than it imports. Trade Deficit: When a country imports more than it exports.

TABLE 19.1 U.S. Balance of Trade (Exports Minus Imports), 1929–2012 (Billions of Dollars) +0.4 1991 −27.0 1933 +0.1 1992 −32.8 1945 −0.8 1993 −64.4 1955 +0.5 1994 −92.7 1960 +4.2 1995 −90.7 1965 +5.6 1996 −96.3 1970 +4.0 1997 −101.4 1975 +16.0 1998 −161.8 1976 −1.6 1999 −262.1 1977 −23.1 2000 −382.1 1978 −25.4 2001 −371.0 1979 −22.5 2002 −427.2 1980 −13.1 2003 −504.1 1981 −12.5 2004 −618.7 1982 −20.0 2005 −722.7 1983 −51.7 2006 −769.3 1984 −102.7 2007 −713.1 1985 −115.2 2008 −709.7 1986 −132.5 2009 −388.7 1987 −145.0 2010 2011 −511.6 −568.1 1988 −110.1 1989 −87.9 2012 −566.7 1990 −77.6

http://www.census.gov/briefrm/esbr/www/esbr042.html

The Economic Basis for Trade: Recall Comparative Advantage David Ricardo’s theory of comparative advantage: “specialization and free trade will benefit all trading partners (real wages will rise), even those that may be absolutely more efficient producers.” Recall England and Portugal Wine Cloth i>clicker question: Given the table, suppose Portugal and England are going to trade wine and cloth with each other. Suppose Portugal is making wine and England cloth. What is the lowest price (in terms of cloth) we would expect to see barrels of wine selling for? 1/10 a yard of cloth 1/20 a yard of cloth 10 yards of cloth 20 yards of cloth 10 barrels of wine LABOR (L) HOURS REQUIRED ENGLAND PORTUGAL 1 yd. cloth 2 hours 1 hour 1 barrel wine 40 hours 10 hours

From Terms of Trade to Exchange Rates The ratio at which a country can trade domestic products for imported products is the terms of trade. Was easy with only two goods like guns & butter. We looked at internal MOC versus terms of trade. When we have more than two goods and two countries and lots of trade  money  currencies  currencies need to be exchanged  foreign exchange rates. An exchange rate is the ratio at which two currencies are traded, or the price of one currency in terms of another. For any pair of countries, there is a range of exchange rates that can lead to both countries realizing the gains from specialization and comparative advantage.

Exchange Rates and Comparative Advantage If exchange rates end up in the right ranges, the free market will drive each country to shift resources into those sectors in which it enjoys a comparative advantage. Only those products in which a country has a comparative advantage will be competitive in world markets.

Sources of Comparative Advantage The Heckscher-Ohlin (H-O) Theorem is a theory that explains the existence of a country’s comparative advantage by its factor endowments. Factor endowments: the quantity and quality of labor, land, and natural resources of a country. Eli Heckscher and Bertil Ohlin: economists from Sweden, circa 1933. According to the H-O theorem, a country has a comparative advantage in the production of a product if that country is relatively well endowed with inputs used intensively in the production of that product.

Sources of Comparative Advantage A country with a great deal of good fertile land… California & Iowa in agriculture Brazil and coffee beans A country with a large amount of accumulated capital… New Jersey in oil refining South Korea and passenger cars A country well-endowed with human capital… New York in highly technical financial services US and advanced education Check out this site! Very interesting and oddly fun. http://www.worldsrichestcountries.com/top_us_exports.html

Other Suggested Explanations for Observed Trade Flows Product differentiation and competitive markets Acquired comparative advantage Economies of scale and scope However, because evidence suggests that economies of scale are exhausted at relatively small size in most industries, it seems unlikely that they constitute a valid explanation of world trade patterns. Trading Environments, Openness of Economy Free Trade Policy Protectionist Policy

Keeping Track of Trade: Foreign Exchange & The Balance of Payments Foreign exchange is simply all currencies other than the domestic currency of a given country. The balance of payments: it’s the record of a country’s transactions in goods, services, and assets with the rest of the world. It’s a record of the country’s sources (supply) and uses (demand) of foreign exchange. Note: it’s not a “balance sheet”. But: the overall account always balances. It’s broken into two pieces the Current Account the Capital Account

TABLE 20.1 United States Balance of Payments, 2011 37.7 (11) Net capital account transactions and financial derivatives (13) Balance of payments (5 + 10 + 11 + 12) −89.2 (12) Statistical discrepancy 517.4 (10) Balance on capital account (6 + 7 + 8 + 9) 211.8 (9) Change in foreign government assets in the United States −119.5 (8) Change in U.S. government assets abroad (increase is −) 789.2 (7) Change in foreign private assets in the United States −364.1 (6) Change in private U.S. assets abroad (increase is −) Capital Account −465.9 (5) Balance on current account (1 + 2 + 3 + 4) −133.1 (4) Net transfer payments 227.0 (3) Net investment income −517.6 Income payments on investments 744.6 Income received on investments 178.6 (2) Net export of services −427.4 Imports of services 606.0 Exports of services −738.4 (1) Net export of goods −2,235.8 Goods imports 1,497.4 Goods exports Current Account Billions of dollars TABLE 20.1 United States Balance of Payments, 2011 All transactions that bring foreign exchange into the United States are credited (+) to the current account; all transactions that cause the United States to lose foreign exchange are debited (−) to the current account