Five Debates over Macroeconomic Policy 23 Five Debates over Macroeconomic Policy

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?

Use Policy to Stabilize Business Cycle?

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

“Managing the Economy” Expansionary fiscal policy Government spending rose Vietnam War Great Society Programs Monetary policy The Fed – try to hold down interest rates Money supply – rose 13% per year High inflation (5-6% per year) Unemployment decreased Trade-off (Short-run AS)

The Phillips Curve in the 1960s This figure uses annual data from 1961 to 1968 on the unemployment rate and on the inflation rate (as measured by the GDP deflator) to show the negative relationship between inflation and unemployment.

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

The Cost of Reducing Inflation The Volker disinflation Paul Volker – chairman of the Fed, 1979 Peak inflation: 10% Sacrifice ratio = 5 (5% dec in GNP for 1% dec in inflation) Reducing inflation – great cost Rational expectations Reducing inflation – smaller cost 1984 inflation : Drops to 4% due to tightening monetary policy High unemployment: 10% Low output

The Volcker Disinflation 11 The Volcker Disinflation This figure shows annual data from 1979 to 1987 on the unemployment rate and on the inflation rate (as measured by the GDP deflator). The reduction in inflation during this period came at the cost of very high unemployment in 1982 and 1983. Note that the points labeled A, B, and C in this figure correspond roughly to the points in Figure 10.

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

The supply shocks of the 1970s This figure shows annual data from 1972 to 1981 on the unemployment rate and on the inflation rate (as measured by the GDP deflator). In the periods 1973–1975 and 1978–1981, increases in world oil prices led to higher inflation and higher unemployment.

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

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

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

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

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

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

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

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

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

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

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

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