© 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair Macroeconomic Issues and Policy Using the tools of macroeconomic analysis, we take up five issues in this chapter: 1.The effects of the stock market in the economy; 2.The way the Federal Reserve (Fed) reacts to the state of the economy; 3.The lags in the economy’s response to monetary and fiscal policy changes; 4.The legislation concerned with the federal government budget; and 5.The cyclical behavior since 1980 of the economies of Japan and five European countries.

© 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair The Effects of the Stock Market on the Economy One of the main components of household wealth is the value of stocks held by households.One of the main components of household wealth is the value of stocks held by households. When stock prices rise, household wealth increases, and when stock prices fall, household wealth decreases.When stock prices rise, household wealth increases, and when stock prices fall, household wealth decreases. Stock prices affect the economy by affecting household wealth, which affects household consumption.Stock prices affect the economy by affecting household wealth, which affects household consumption.

© 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair The Stock Market Crash of October 1987 The stock market crash of October 1987 represented a large drop in household wealth.The stock market crash of October 1987 represented a large drop in household wealth. In practice, after a $1.00 decrease in wealth, consumption seems to be lower in each future year by about four cents, or 4 percent of the decrease in wealth.In practice, after a $1.00 decrease in wealth, consumption seems to be lower in each future year by about four cents, or 4 percent of the decrease in wealth. The $1 trillion decrease in wealth in 1987 implies a $40 billion lower level of consumption in 1988, or 1 percent of GDP.The $1 trillion decrease in wealth in 1987 implies a $40 billion lower level of consumption in 1988, or 1 percent of GDP.

© 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair The Stock Market Crash of October 1987 The life-cycle theory of consumption predicts that households smooth their consumption over time.The life-cycle theory of consumption predicts that households smooth their consumption over time. A decrease in wealth will not decrease consumption in the current year by the full amount of the decrease in wealth. Instead, they cut consumption a little each year.A decrease in wealth will not decrease consumption in the current year by the full amount of the decrease in wealth. Instead, they cut consumption a little each year.

© 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair The Stock Market Crash of October 1987 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 crash of 1987 did not result in a recession in 1988 because households and business firms did not lower their expectations drastically. Because the initial decrease in wealth turned out to be temporary, the negative wealth effect was not nearly as large as it otherwise would have been.Because the initial decrease in wealth turned out to be temporary, the negative wealth effect was not nearly as large as it otherwise would have been.

© 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair The Stock Market Boom of 1995 – 2000 Highlights of the stock market boom of 1995 – 2000 include the following: It was by far the largest stock market boom in U.S. history.It was by far the largest stock market boom in U.S. history. It added roughly $14 trillion to household wealth, about $2.5 trillion per year.It added roughly $14 trillion to household wealth, about $2.5 trillion per year. About 1.7 of the 4.5 percent increase in the growth rate of real GDP was due to the stock market boom.About 1.7 of the 4.5 percent increase in the growth rate of real GDP was due to the stock market boom.

© 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair The Federal Reserve’s Response to the State of the Economy The Fed is likely to increase the money supply during times of low output and low inflation.The Fed is likely to increase the money supply during times of low output and low inflation. The opposite is also true: The Fed is likely to decrease the money supply during times of high output and high inflation.The opposite is also true: The Fed is likely to decrease the money supply during times of high output and high inflation. Stagflation is a more difficult problem for the Fed.Stagflation is a more difficult problem for the Fed.

© 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair The Fed’s Response to Low Output/Low Inflation 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.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.

© 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair The Fed’s Response to High Output/High Inflation When the economy is on the relatively steep portion of the AS curve, the Fed is likely to contract the money supply. This will lead to a decrease in the price level, with little decrease in output.When the economy is on the relatively steep portion of the AS curve, the Fed is likely to contract the money supply. This will lead to a decrease in the price level, with little decrease in output.

© 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair The Fed’s Response to Stagflation Stagflation is a more difficult problem to solve.Stagflation is a more difficult problem to solve. If the Fed contracts the money supply, inflation will fall, but so will output.If the Fed contracts the money supply, inflation will fall, but so will output. If the Fed expands the money supply, output will rise, but so will inflation.If the Fed expands the money supply, output will rise, but so will inflation.

© 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair The Behavior of the Fed During the 1990 – 1991 Recession After the Fed became convinced that a recession was at hand, it responded by engaging in open market operations to lower interest rates.After the Fed became convinced that a recession was at hand, it responded by engaging in open market operations to lower interest rates. Inflation was not a problem, so the Fed could expand the economy without worrying about inflationary pressures.Inflation was not a problem, so the Fed could expand the economy without worrying about inflationary pressures.

© 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair Data for Selected Variables for the 1989 – 2000 Period QUARTER REAL GDP GROWTH RATE (%) UNEMPLOYMENT RATE (%) INFLATION RATE (%) THREE-MONTH T-BILL RATE AAA BOND RATE FEDERAL GOVERNMENT SURPLUS SURPLUS/GDP 1989I   II   III   IV   I   II   III    IV    I    II   III   IV   I   II   III   IV   I    II   III   IV   I   II   III   IV   0.029

© 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair Data for Selected Variables for the 1989 – 2000 Period QUARTER REAL GDP GROWTH RATE (%) UNEMPLOYMENT RATE (%) INFLATION RATE (%) THREE-MONTH T-BILL RATE AAA BOND RATE FEDERAL GOVERNMENT SURPLUS SURPLUS/GDP 1995I   II   III   IV   I   II   III   IV   I  86.5  II  68.2  III  33.8  IV  25.0  I II III IV I II III IV I II Note: The inflation rate is the percentage change in the GDP price index.

© 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair Data for Selected Variables for the 1989 – 2000 Period QUARTER REAL GDP GROWTH RATE (%) UNEMPLOYMENT RATE (%) INFLATION RATE (%) THREE-MONTH T-BILL RATE AAA BOND RATE FEDERAL GOVERNMENT SURPLUS SURPLUS/GDP 1995I   II   III   IV   I   II   III   IV   I  86.5  II  68.2  III  33.8  IV  25.0  I II III IV I II III IV I II Note: The inflation rate is the percentage change in the GDP price index.

© 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair The Behavior of the Fed in 1993 and 1994 During this period, inflation was not a problem, so the Fed had room to stimulate the economy and kept its expansionary policy.During this period, inflation was not a problem, so the Fed had room to stimulate the economy and kept its expansionary policy. By the end of 1993 the Fed was worried about inflation problems in the future, and decided to begin slowing down the economy.By the end of 1993 the Fed was worried about inflation problems in the future, and decided to begin slowing down the economy.

© 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair The Behavior of the Fed in 1995 – 1997 Inflation did not become a problem after 1994, and the Fed lowered interest rates.Inflation did not become a problem after 1994, and the Fed lowered interest rates. The three-month Treasury bill rate remained at roughly 5.0 percent throughout 1996 and 1997.The three-month Treasury bill rate remained at roughly 5.0 percent throughout 1996 and During this period, the economy experienced good growth, low unemployment, low inflation, and a balanced government budget!During this period, the economy experienced good growth, low unemployment, low inflation, and a balanced government budget!

© 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair The Behavior of the Fed in 1998 – 2000 Based on concerns about the Asian financial crisis, the Fed lowered the bill rate to 4.3 percent in the fourth quarter of 1998.Based on concerns about the Asian financial crisis, the Fed lowered the bill rate to 4.3 percent in the fourth quarter of The Asian crisis did not affect the U.S. economy very much, and the Fed began raising the bill rate on fears that the economy might be overheating.The Asian crisis did not affect the U.S. economy very much, and the Fed began raising the bill rate on fears that the economy might be overheating.

© 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair Lags in the Economy’s Response to 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.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 are delays in the economy’s response to stabilization policies.Time lags are delays in the economy’s response to stabilization policies.

© 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair Two 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.

© 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair Stabilization: “The Fool in the Shower” Attempts to stabilize the economy can prove destabilizing because of time lags.Attempts to stabilize the economy can prove destabilizing because of time lags. Milton Friedman likened these attempts to a “fool in the shower.” The shower starts out cold, so the fool turns up the hot water. Nothing happens right away, so he turns up the hot water further. Then, the hot water comes on and scalds him. And the same thing happens when he starts turning on the cold water.Milton Friedman likened these attempts to a “fool in the shower.” The shower starts out cold, so the fool turns up the hot water. Nothing happens right away, so he turns up the hot water further. Then, the hot water comes on and scalds him. And the same thing happens when he starts turning on the cold water.

© 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair Stabilization: “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. 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.

© 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair Types of Lags The recognition lag refers to the time it takes for policy makers to recognize the existence of a boom or a slump.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 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 implementation lag for monetary policy is generally much shorter than for fiscal policy.

© 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair Types of Lags 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.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. There is a delay in the multiplier process because neither individuals nor firms revise their spending plans instantaneously.There is a delay in the multiplier process because neither individuals nor firms revise their spending plans instantaneously.

© 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair Government Budget Policy The Gramm-Rudman- Hollings Bill, passed by the U.S. Congress and signed by President Reagan in 1986, is a law that set out to reduce the federal deficit by $36 billion per year, with a deficit of zero slated for 1991.The Gramm-Rudman- Hollings Bill, passed by the U.S. Congress and signed by President Reagan in 1986, is a law that set out to reduce the federal deficit by $36 billion per year, with a deficit of zero slated for In practice, these targets never came close to being achieved.In practice, these targets never came close to being achieved.

© 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair 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.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.The deficit tends to rise when GDP falls, and tends to fall when GDP rises.

© 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair The Effects of Spending Cuts on the Deficit The deficit response index (DRI) is the amount by which the deficit changes with a $1 change in GDP.The deficit response index (DRI) is the amount by which the deficit changes with a $1 change in GDP. If the DRI equals .22, for example, the deficit rises by $0.22 billion for each $1 billion decrease in GDP.If the DRI equals .22, for example, the deficit rises by $0.22 billion for each $1 billion decrease in GDP. Spending cuts must be larger than the deficit reduction we wish to achieve.Spending cuts must be larger than the deficit reduction we wish to achieve.

© 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair Economic Stability and Deficit Reduction Congress has two options:Congress has two options: 1. Choose a target deficit and adjust government spending and taxation to achieve this target, or 2. Decide how much to spend and tax regardless of the consequences on the deficit. A negative demand shock is something that causes a negative shift in consumption or investment schedules or that leads to a decrease in U.S. exports.A negative demand shock is something that causes a negative shift in consumption or investment schedules or that leads to a decrease in U.S. exports.

© 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair Economic Stability and Deficit Reduction 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 GDP.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 GDP.

© 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair Economic Stability and Deficit Reduction Without deficit targeting, an increase in the deficit caused by a negative demand shock provides an automatic stabilizer during contractions. Tax revenues decrease, and transfer payments rise.Without deficit targeting, an increase in the deficit caused by a negative demand shock provides an automatic stabilizer during contractions. Tax revenues decrease, and transfer payments rise. With deficit targeting, taxes could be rising or government spending declining while the economy is experiencing a contraction. Deficit targeting measures have undesirable macroeconomic consequences.With deficit targeting, taxes could be rising or government spending declining while the economy is experiencing a contraction. Deficit targeting measures have undesirable macroeconomic consequences.

© 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair Deficit Targeting as an Automatic Stabilizer

© 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair Business Cycles in Other Countries The overall performance of the Japanese economy was good until 1992, when the growth rate slowed considerably, and the unemployment rate rose.The overall performance of the Japanese economy was good until 1992, when the growth rate slowed considerably, and the unemployment rate rose. The Bank of Japan eased monetary policy. By 1999, the short-term interest rate was essentially zero, but this monetary-policy stimulus was not sufficient to prevent the slowdown from lasting a number of years.The Bank of Japan eased monetary policy. By 1999, the short-term interest rate was essentially zero, but this monetary-policy stimulus was not sufficient to prevent the slowdown from lasting a number of years.

© 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair Business Cycles in Other Countries In the United Kingdom and other European countries, a pattern of low or negative growth in the early 1980s, and then again in the early 1990s, has been accompanied by a fairly high level of unemployment.In the United Kingdom and other European countries, a pattern of low or negative growth in the early 1980s, and then again in the early 1990s, has been accompanied by a fairly high level of unemployment. Some say that the prevalence of high unemployment rates is caused by generous social welfare benefits in Europe—especially unemployment benefits.Some say that the prevalence of high unemployment rates is caused by generous social welfare benefits in Europe—especially unemployment benefits.

© 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair Data for Selected Variables for Six Countries, 1980 – 1999 Data for Selected Variables for Six Countries, GDP GROWTH RATE INFLATION RATE UNEMPLOYMENT RATE SHORT-TERM INTEREST RATE GDP GROWTH RATE INFLATION RATE UNEMPLOYMENT RATE SHORT-TERM INTEREST RATE United Kingdom Spain 1980  NA NA  NA13.0  NA  

© 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair Data for Selected Variables for Six Countries, 1980 – 1999 Data for Selected Variables for Six Countries, GDP GROWTH RATE INFLATION RATE UNEMPLOYMENT RATE SHORT-TERM INTEREST RATE GDP GROWTH RATE INFLATION RATE UNEMPLOYMENT RATE SHORT-TERM INTEREST RATE FranceItaly NA NA NA NA  

© 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair Data for Selected Variables for Six Countries, 1980 – 1999 Data for Selected Variables for Six Countries, GDP GROWTH RATE INFLATION RATE UNEMPLOYMENT RATE SHORT-TERM INTEREST RATE GDP GROWTH RATE INFLATION RATE UNEMPLOYMENT RATE SHORT-TERM INTEREST RATE GermanyJapan      Source: Organization for Economic Cooperation and Development (OECD) and IMF.