PowerPoint Lectures for Principles of Macroeconomics, 9e By Karl E. Case, Ray C. Fair & Sharon M. Oster ; ;

Policy Timing, Deficit Targeting, and Stock Market Effects Prepared by: Fernando & Yvonn Quijano

15 Policy Timing, Deficit Targeting, and Stock Market Effects PART IV FURTHER MACROECONOMICS ISSUES 15 CHAPTER OUTLINE Time Lags Regarding Monetary and Fiscal Policy Stabilization Recognition Lags Implementation Lags Response Lags Fiscal Policy: Deficit Targeting The Effects of Spending Cuts on the Deficit Economic Stability and Deficit Reduction Summary The Stock Market and the Economy Stocks and Bonds Determining the price of a Stock The Stock Market Since 1948 Stock Market Effects on the Economy

Time Lags Regarding Monetary and Fiscal Policy stabilization policy Describes both monetary and fiscal policy, the goals of which are to smooth out fluctuations in output and employment and to keep prices as stable as possible. time lags Delays in the economy’s response to stabilization policies.

Time Lags Regarding Monetary and Fiscal Policy  FIGURE 15.1 Two Possible Time Paths for GDP Path A is less stable—it varies more over time—than path B. Other things being equal, society prefers path B to path A.

Time Lags Regarding Monetary and Fiscal Policy Stabilization  FIGURE 15.2 Possible Stabilization Timing Problems Attempts to stabilize the economy can prove destabilizing because of time lags. 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. Hence, the policy pushes the economy to points E1, and F1, (instead of points E and F). Income varies more widely than it would have if no policy had been implemented.

Time Lags Regarding Monetary and Fiscal Policy Recognition Lags recognition lag The time it takes for policy makers to recognize the existence of a boom or a slump. Implementation Lags implementation lag 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.

Time Lags Regarding Monetary and Fiscal Policy Response Lags response lag The time that 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.

Time Lags Regarding Monetary and Fiscal Policy Response Lags Response Lags for Fiscal Policy Neither individuals nor firms revise their spending plans instantaneously. Until they can make those revisions, extra government spending does not stimulate extra private spending. Response Lags for Monetary Policy Monetary policy works by changing interest rates, which then change planned investment. The response of consumption and investment to interest rate changes takes time.

Time Lags Regarding Monetary and Fiscal Policy Response Lags Summary Stabilization is not easily achieved. It takes time for policy makers to recognize the existence of a problem, more time for them to implement a solution, and yet more time for firms and households to respond to the stabilization policies taken.

Fiscal Policy: Deficit Targeting Gramm-Rudman-Hollings Act Passed by the U.S. Congress and signed by President Reagan in 1986, this law set out to reduce the federal deficit by $36 billion per year, with a deficit of zero slated for 1991.  FIGURE 15.3 Deficit Reduction Targets under Gramm-Rudman-Hollings The GRH legislation, passed in 1986, set out to lower the federal deficit by $36 billion per year. If the plan had worked, a zero deficit would have been achieved by 1991.

Fiscal Policy: Deficit Targeting The Effects of Spending Cuts on the Deficit A cut in government spending causes the economy to contract. Both the taxable income of households and the profits of firms fall. The deficit tends to rise when GDP falls, and tends to fall when GDP rises. deficit response index (DRI) The amount by which the deficit changes with a $1 change in GDP.

Fiscal Policy: Deficit Targeting The Effects of Spending Cuts on the Deficit Monetary Policy to the Rescue? A zero multiplier can come about through renewed optimism on the part of households and firms or through very aggressive behavior on the part of the Fed, but because neither of these situations is very plausible, the multiplier is likely to be greater than zero. Thus, it is likely that to lower the deficit by a certain amount, the cut in government spending must be larger than that amount.

Fiscal Policy: Deficit Targeting Economic Stability and Deficit Reduction negative demand shock Something that causes a negative shift in consumption or investment schedules or that leads to a decrease in U.S. exports. automatic stabilizers Revenue and expenditure items in the federal budget that automatically change with the economy in such a way as to stabilize GDP. automatic destabilizers Revenue and expenditure items in the federal budget that automatically change with the economy in such a way as to destabilize GDP.

Fiscal Policy: Deficit Targeting Economic Stability and Deficit Reduction  FIGURE 15.4 Deficit Targeting as an Automatic Destabilizer Deficit targeting changes the way the economy responds to negative demand shocks because it does not allow the deficit to increase. The result is a smaller deficit but a larger decline in income than would have otherwise occurred.

Fiscal Policy: Deficit Targeting Summary It is clear that the GRH legislation, the balanced-budget amendment, and similar deficit targeting measures have some undesirable macroeconomic consequences. Locking the economy into spending cuts during periods of negative demand shocks, as deficit-targeting measures do, is not a good way to manage the economy.

The Stock Market and the Economy Stocks and Bonds stock A certificate that certifies ownership of a certain portion of a firm. capital gain An increase in the value of an asset. realized capital gain The gain that occurs when the owner of an asset actually sells it for more than he or she paid for it.

The Stock Market and the Economy Determining the Price of a Stock Things that are likely to affect the price of a stock include: What people expect its future dividends will be. When the dividends are expected to be paid. The amount of risk involved.

The Stock Market and the Economy The Stock Market Since 1948 Dow Jones Industrial Average An index based on the stock prices of 30 actively traded large companies. The oldest and most widely followed index of stock market performance. NASDAQ Composite An index based on the stock prices of over 5,000 companies traded on the NASDAQ Stock Market. The NASDAQ market takes its name from the National Association of Securities Dealers Automated Quotation System. Standard and Poor’s 500 (S&P 500) An index based on the stock prices of 500 of the largest firms by market value.

The Stock Market and the Economy The Stock Market Since 1948  FIGURE 15.5 The S&P 500 Stock Price Index, 1948 I–2007 IV

The Stock Market and the Economy The Stock Market Since 1948  FIGURE 15.6 Ratio of After-Tax Profits to GDP, 1948 I–2007 IV

The Stock Market and the Economy Stock Market Effects on the Economy An increase in stock prices causes an increase in wealth, and consequently an increase in consumer spending. Investment is also affected by higher stock prices. With a higher stock price, a firm can raise more money per share to finance investment projects.

The Stock Market and the Economy Stock Market Effects on the Economy The Crash of October 1987 The value of stocks in the United States fell by about a trillion dollars between August 1987 and the end of October 1987. If the multiplier is 1.4, the total decrease in GDP would be about 1.4 x $40 billion = $56 billion, or about 1.4 percent of GDP. The stock market crash of 1987 did not result in a recession in 1988 because households and business firms did not lower their expectations drastically.

The Stock Market and the Economy Stock Market Effects on the Economy The Boom of 1995–2000  FIGURE 15.7 Personal Saving Rate, 1995 I–2002 III

The Stock Market and the Economy Stock Market Effects on the Economy The Boom of 1995–2000  FIGURE 15.8 Investment-Output Ratio, 1995 I–2002 III

The Stock Market and the Economy Stock Market Effects on the Economy The Boom of 1995–2000  FIGURE 15.9 Ratio of Federal Government Budget Surplus to GDP, 1995 I–2002 III

The Stock Market and the Economy Stock Market Effects on the Economy The Boom of 1995–2000  FIGURE 15.10 Growth Rate of Real GDP, 1995 I–2002 III

The Stock Market and the Economy Stock Market Effects on the Economy The Boom of 1995–2000  FIGURE 15.11 The Unemployment Rate, 1995 I–2002 III

The Stock Market and the Economy Stock Market Effects on the Economy The Boom of 1995–2000  FIGURE 15.12 Inflation Rate, 1995 I–2002 III

The Stock Market and the Economy Stock Market Effects on the Economy Fed Policy and the Stock Market  FIGURE 15.13 3-Month Treasury Bill Rate, 1995 I–2002 III

Bubbles or Rational Investors? The Stock Market and the Economy Stock Market Effects on the Economy The Post-Boom Economy Both stock market wealth and housing wealth have important effects on the economy. Bubbles or Rational Investors? Bernanke’s Bubble Laboratory: Princeton Protégés of Fed Chief Study the Economics of Manias Wall Street Journal

REVIEW TERMS AND CONCEPTS automatic destabilizers automatic stabilizers capital gain deficit response index (DRI) Dow Jones Industrial Average Gramm-Rudman-Hollings Act implementation lag NASDAQ Composite negative demand shock realized capital gain recognition lag response lag stabilization policy Standard and Poor’s 500 (S&P 500) stock time lags