Theory versus Reality Theory is supposed to explain the business cycle and how to control it. Many realities keep us from reaching our economic goals: Conflicting advice comes from Keynesians, monetarists, and supply-siders. Politics takes preference over economics in Congress and the presidency. A massive, unresponsive bureaucracy exists. This chapter summarizes macro policies and attempts to bring them into the real world.

Learning Objectives 18-01. Know what the tools of macro policy are. 18-02. Know how the macro tools should work. 18-03. Know the constraints on policy effectiveness. We will review the chapter using these objectives.

Available Policy Tools Fiscal policy: Tax cuts and increases. Changes in government spending. Monetary policy: Open market operations. Changes in reserve requirements. Changes in discount rates. Supply-side policy: Tax incentives for saving and investment. Deregulation. Human capital investment. Infrastructure development. Free trade. Immigration. This is a summary slide collecting the various levers in each of the three policy tools.

Fiscal Policy Changes due to automatic stabilizers are a basic countercyclical feature of the economy. Discretionary policy expands (or shrinks) the structural deficit and gives the economy a shot of fiscal stimulus (or restraint). They are a result of deliberate policy decisions made by the president and Congress. Summarizes fiscal policy.

Monetary Policy The Fed’s Board of Governors makes monetary policy, with its Open Market Committee pulling the levers. Keynesians believe that interest rates are the critical policy lever to shift aggregate demand. Monetarists believe that the money supply is the critical policy tool and that it should be expanded at a steady, predictable rate to ensure price stability at the natural rate of unemployment. Summarizes monetary policy.

Supply-Side Policy The focus of supply-side policy is to provide incentives to work, save, and invest. Marginal tax rates and government regulations must be reduced to get more output without inflation. Since the supply-side policy levers require changes in laws and regulations, the Congress and the president enact supply-side policy. Fiscal and supply-side policies often get entwined. Summarizes supply-side policy.

Idealized Uses: Recession Goal: to close the recessionary GDP gap. Keynesians want to increase AD by tax cuts or spending increases. Also, they want falling interest rates to spur investment. Monetarists see no use in fiscal policy. Their appropriate response is patience. Supply-siders would cut tax rates and reduce regulation. Any spending increase should focus on long-run development. This looks at the policies from a problem point of view – here, a recession.

Idealized Uses: Inflation Goal: to close the inflationary GDP gap. Keynesians would decrease AD by raising taxes and cutting government spending. Monetarists would reduce the money supply. Supply-siders would look for ways to expand productive capacity. It is both “too much money” and “not enough goods.” They propose incentives to save and not spend. They would cut taxes and regulations that raise production costs. Here, for inflation.

Idealized Uses: Stagflation Both inflation and unemployment are high, and economic growth is stagnant. Fiscal restraint and tight money will reduce inflation but increase unemployment. Fiscal stimulus and easy money will reduce unemployment but increase inflation. If stagflation is caused by adverse policy (high taxes, excessive regulation), supply-siders propose reversing those policies. If stagflation is caused by external forces (oil price spike, natural disaster), no policy can help much. Here, for stagflation.

Fine-Tuning Fine-tuning: policy adjustments designed to counteract small changes in economic outcomes. In 1946 Congress committed the government to macro stability. In 1978 Congress set goals of 4% unemployment, 3% inflation, and 4% economic growth. The reality is that government has difficulty making fine-tuning adjustments to meet these conflicting goals. The term “fine-tuning” is a residual from early TV sets that had a channel selector surrounded by a dial that made the picture clearer. It fine-tuned the picture. Keynesians championed fine-tuning to have policy makers continuously monitor the economy and “tweak” it when it seemed to move away from some ideal state. Congress actually set these conflicting goals as the “ideal.”

Goal Conflicts The trade-off between unemployment and inflation is a fiscal policy goal conflict. The Fed wants fiscal stability, while the president and Congress may be unwilling to raise taxes or cut spending. Some cutbacks affect the neediest and become politically impossible to enact. All decisions have an opportunity cost, raising conflict between the benefits and the cost of a policy option. You might remind your students that politics always trumps economics in any discussion.

Measurement Problems Measuring the macro variables takes time, so the results are not available for a month or so. Policymakers rely on economic forecasts made by “experts” using models that are tied to one theory or another. Some data (called leading indicators) tend to predict turns in the business cycle. External shocks are not predictable. The final report of GDP for the second quarter of each year does not become public until three months later. The second quarter ends in June, and that final report comes out in September. Preliminary reports in July and August will be revised by the later report. This is the reason why expert forecasts are relied upon.

Design Problems Once we think we know what the problem is, we must design a “fix” for the problem. Should we take The Keynesian approach? The monetarist approach? The supply-sider approach? How will the marketplace respond to our plan? We have looked at the various approaches. Each has its advocates. Which will be used depends on the number of people in power who advocate each approach as well as their ability to persuade the others.

Implementation Problems Any “fix” must work through congressional deliberations and be approved by the president. Once approved, there is no assurance it will be put into effect in a timely manner. The time lag may be so great that a stimulus package may go into effect after a recession has ended. Political pressure may preclude a correct “fix” from ever being passed. Time is lost just getting the data. Time goes by as Congress deliberates. Time will pass as the bureaucracy implements the policy. More time goes by as the implemented policy hits the street. More time passes to get the multiplier effect to work.