CHAPTER 18 Macroeconomic Policy Challenges Chapter 35 in Economics Michael Parkin ECONOMICS 5e

Slide 18-2 Copyright © 2000 Addison Wesley Longman, Inc. Learning Objectives Describe the goals of macroeconomic policy Describe the main features of fiscal policy and monetary policy since 1960 Explain how fiscal policy and monetary policy influence long-term growth

Slide 18-3 Copyright © 2000 Addison Wesley Longman, Inc. Learning Objectives (cont.) Evaluate fixed-rule and feedback-rule policies to stabilize the business cycle Explain how fiscal policy influences the natural rate of unemployment Explain why lowering inflation usually brings recession

Slide 18-4 Copyright © 2000 Addison Wesley Longman, Inc. Learning Objectives Describe the goals of macroeconomic policy Describe the main features of fiscal policy and monetary policy since 1960 Explain how fiscal policy and monetary policy influence long-term growth

Slide 18-5 Copyright © 2000 Addison Wesley Longman, Inc. Policy Goals The four main domestic macroeconomic goals are: 1) Achieve the highest sustainable rate of potential GDP growth. 2) Smooth our avoidable business cycle fluctuations.

Slide 18-6 Copyright © 2000 Addison Wesley Longman, Inc. Policy Goals 3) Maintain low unemployment 4) Maintain low inflation The four main domestic macroeconomic goals are : (cont.)

Slide 18-7 Copyright © 2000 Addison Wesley Longman, Inc. Policy Goals Potential GDP Growth Sustained growth in real GDP can improve economic well being tremendously Two percent growth rate means that production doubles every 36 years Four percent takes 18 years Six percent takes 12 years

Slide 18-8 Copyright © 2000 Addison Wesley Longman, Inc. Policy Goals Potential GDP Growth The limitations to sustainable growth are: The availability of natural resources. Environmental considerations. The willingness of people to save and invest.

Slide 18-9 Copyright © 2000 Addison Wesley Longman, Inc. Policy Goals The Business Cycle When potential GDP exceeds real GDP, output is lost. When real GDP exceeds potential GDP, a bottleneck may arise.

Slide Copyright © 2000 Addison Wesley Longman, Inc. Policy Goals Unemployment Unemployed labor leads to lost output that cannot be recovered. The accumulation of human capital slows. Social and psychological problems arise.

Slide Copyright © 2000 Addison Wesley Longman, Inc. Policy Goals Unemployment Extremely low rates of unemployment lead to shortages of labor. New and expanding businesses face difficulties in hiring. Production problems may arise.

Slide Copyright © 2000 Addison Wesley Longman, Inc. Policy Goals Inflation Stable inflation rates remove uncertainty Borrowers, lenders, employers, and employees benefit Some inflation is desirable Results of quality improvements

Slide Copyright © 2000 Addison Wesley Longman, Inc. Policy Goals The Two Core Policy Indicators: Real GDP Growth and Inflation Real GDP growth is related to: Unemployment The business cycle Therefore, maintaining real GDP growth is related to two of our macroeconomic goals.

Slide Copyright © 2000 Addison Wesley Longman, Inc. Policy Goals The Two Core Policy Indicators: Real GDP Growth and Inflation Real GDP growth and inflation are somewhat related. However, they are largely independent. So real GDP growth and inflation are the two core policy targets.

Slide Copyright © 2000 Addison Wesley Longman, Inc. Macroeconomic Performance: Real GDP and Inflation

Slide Copyright © 2000 Addison Wesley Longman, Inc. Learning Objectives Describe the goals of macroeconomic policy Describe the main features of fiscal policy and monetary policy since 1960 Explain how fiscal policy and monetary policy influence long-term growth

Slide Copyright © 2000 Addison Wesley Longman, Inc. Policy Tools and Performance Recall: Fiscal policy is the use of the fiscal budget to achieve macroeconomic objectives. Monetary policy is the adjustment of the quantity of money in circulation and interest rates by the FED to achieve macroeconomic objectives.

Slide Copyright © 2000 Addison Wesley Longman, Inc. Policy Tools and Performance Fiscal policy since 1960 Fiscal policy was mildly expansionary during the Kennedy years. Fiscal policy was strongly expansionary during the later Johnson years when the Vietnam War buildup occurred. During Nixon’s presidency, spending growth was kept moderate.

Slide Copyright © 2000 Addison Wesley Longman, Inc. Policy Tools and Performance Fiscal policy since 1960 (cont.) Under the pressure of the first OPEC oil shock, spending soared during Ford’s presidency. The Carter years began with spending cuts, but then spending climbed to a new high. During the first Reagan term, spending continued to increase at first but it was later held in check.

Slide Copyright © 2000 Addison Wesley Longman, Inc. Policy Tools and Performance Fiscal policy since 1960 (cont.) During the second Reagan term, spending was cut. During the Bush years, government purchases took an increased percentage of GDP, but taxes took a smaller percentage. A tax bill in 1993 increased taxes, so revenues increased during the Clinton presidency.

Slide Copyright © 2000 Addison Wesley Longman, Inc. Policy Tools and Performance Monetary policy since 1960 During the 1960s, the M2 growth rate averaged 7 percent a year and ranged between a low of 4 percent in 1969 and a high of 9 percent in It increased to average 10 percent a year between 1970 and 1983 and hit a peak of 14 percent in 1976.

Slide Copyright © 2000 Addison Wesley Longman, Inc. Policy Tools and Performance Monetary policy since 1960 (cont.) M2 growth fell steadily from 12 percent in 1983 to less than 1 percent in 1994, but then increased in The federal funds rate trended upward from 1960 through 1981 and then trended downward.

Slide Copyright © 2000 Addison Wesley Longman, Inc. Policy Tools and Performance Monetary policy since 1960 (cont.) The federal funds rate fell through 1975 and then increased and remained high through most of the 1980s. The federal funds rate fell during the early 1990s, but then began to rise again through 1995.

Slide Copyright © 2000 Addison Wesley Longman, Inc. The Fiscal Policy Record: A Summary

Slide Copyright © 2000 Addison Wesley Longman, Inc. The Monetary Policy Record: A Summary

Slide Copyright © 2000 Addison Wesley Longman, Inc. Learning Objectives Describe the goals of macroeconomic policy Describe the main features of fiscal policy and monetary policy since 1960 Explain how fiscal policy and monetary policy influence long-term growth

Slide Copyright © 2000 Addison Wesley Longman, Inc. Long-Term Growth Policy Monetary policy contributes to long-term growth by keeping the inflation rate low.

Slide Copyright © 2000 Addison Wesley Longman, Inc. Long-Term Growth Policy Fiscal policy contributes to long-term growth by influencing private decisions. These are: National saving Investment in human capital Investment in new technologies

Slide Copyright © 2000 Addison Wesley Longman, Inc. Long-Term Growth Policy National Saving National saving is private saving plus government saving.

Slide Copyright © 2000 Addison Wesley Longman, Inc. Long-Term Growth Policy National Saving Increased government saving results from reducing or eliminating the deficit. Increased private saving would result from: 1) Increase the after-tax rate of return on saving. 2) Cut taxes on interest income and capital gains.

Slide Copyright © 2000 Addison Wesley Longman, Inc. Saving Rates in the United States: 1960–1999

Slide Copyright © 2000 Addison Wesley Longman, Inc. Long-Term Growth Policy Investment in Human Capital A person is likely to earn a greater income: 1) The more years the person remains in school. 2) The greater the number of years of work experience.

Slide Copyright © 2000 Addison Wesley Longman, Inc. Long-Term Growth Policy The government’s policies regarding investment in human capital are a result of: 1) Social returns exceeding private returns. 2)Individuals acquiring too little human capital.

Slide Copyright © 2000 Addison Wesley Longman, Inc. Long-Term Growth Policy Governments attempt to increase human capital by: 1) Subsidizing schooling. 2) Helping set standards of achievement. 3) Setting examples as an employer. 4) Encouraging best-practice training programs.

Slide Copyright © 2000 Addison Wesley Longman, Inc. Long-Term Growth Policy Investment in New Technologies New technology development is special because: 1) Diminishing returns appear not to be a problem. 2) The benefits influence all parts of the economy.

Slide Copyright © 2000 Addison Wesley Longman, Inc. Long-Term Growth Policy Governments can encourage technological development by: 1) Providing tax incentives for research and development. 2) Encouraging business research with tax credits.

Slide Copyright © 2000 Addison Wesley Longman, Inc. Learning Objectives (cont.) Evaluate fixed-rule and feedback-rule policies to stabilize the business cycle Explain how fiscal policy influences the natural rate of unemployment

Slide Copyright © 2000 Addison Wesley Longman, Inc. Business Cycle and Unemployment Policy The three categories of fiscal and monetary policies are: 1) Fixed-rule policies 2) Feedback-rule policies 3) Discretionary policies

Slide Copyright © 2000 Addison Wesley Longman, Inc. Business Cycle and Unemployment Policy Fixed-Rule Policies A fixed rule policy specifies an action to be pursued independently of the state of the economy. Examples: constant money supply growth rate, balancing the budget

Slide Copyright © 2000 Addison Wesley Longman, Inc. Business Cycle and Unemployment Policy Feedback-Rule Policies A feedback-rule policy specifies how policy actions respond to changes in the state of the economy. Examples: Fed’s interest rate policies, automatic changes in tax revenues and transfer payments

Slide Copyright © 2000 Addison Wesley Longman, Inc. Business Cycle and Unemployment Policy Discretionary Policies A discretionary policy responds to the state of the economy in a possibly unique way that uses all the information available, including lessons learned from passed experiences.

Slide Copyright © 2000 Addison Wesley Longman, Inc. Business Cycle and Unemployment Policy Stabilizing Aggregate Demand Shocks Suppose there is an unexpected decrease in aggregate demand.

Slide Copyright © 2000 Addison Wesley Longman, Inc. A Decrease in Aggregate Demand Real GDP (trillions of 1992 dollars) Price level (GDP deflator, 1992 = 100) LAS AD SAS A decrease in aggregate demand brings recession AD 1 0

Slide Copyright © 2000 Addison Wesley Longman, Inc. Business Cycle and Unemployment Policy Stabilizing Aggregate Demand Shocks The economy responds differently depending which policy is used to stimulate aggregate demand.

Slide Copyright © 2000 Addison Wesley Longman, Inc. Business Cycle and Unemployment Policy Stabilizing Aggregate Demand Shocks Fixed Rule: Monetarism Monetarists are economists who believe that fluctuations in the money stock are the main source of economic fluctuations. The effect of a policy depends on whether the chance in aggregate demand is temporary or permanent.

Slide Copyright © 2000 Addison Wesley Longman, Inc. Business Cycle and Unemployment Policy Stabilizing Aggregate Demand Shocks Feedback Rule: Keynesian Activism A Keynesian activist is an economist who believes that fluctuations in aggregate demand combined with sticky wages (and/or stick prices) are the main source of economic fluctuations.

Slide Copyright © 2000 Addison Wesley Longman, Inc. Business Cycle and Unemployment Policy The Two Rules Compared Fixed-Rule The economy goes into a recession and stays there until aggregate demand increases on its own.

Slide Copyright © 2000 Addison Wesley Longman, Inc. Business Cycle and Unemployment Policy The Two Rules Compared Feedback-Rule The economy is pulled out of its recession by the policy and held there by a gradual policy-induced decrease in aggregate demand.

Slide Copyright © 2000 Addison Wesley Longman, Inc. Two Stabilization Policies: Aggregate Demand Shock Real GDP (trillions of 1992 dollars) Price level (GDP deflator, 1992 = 100) LAS AD SAS AD 0 Fixed Rule: Temporary Demand Shock 0

Slide Copyright © 2000 Addison Wesley Longman, Inc. Two Stabilization Policies: Aggregate Demand Shock Real GDP (trillions of 1992 dollars) Price level (GDP deflator, 1992 = 100) LAS AD Fixed Rule: Permanent Demand Shock AD 0 SAS 0 SAS

Slide Copyright © 2000 Addison Wesley Longman, Inc. Two Stabilization Policies: Aggregate Demand Shock Real GDP (trillions of 1992 dollars) Price level (GDP deflator, 1992 = 100) SAS LAS AD AD 0 Feedback Rule 0

Slide Copyright © 2000 Addison Wesley Longman, Inc. Business Cycle and Unemployment Policy Some economists are in favor of a fixed- rule policy because: 1) Potential GDP is not known. 2)Policy lags are longer than the forecast horizon. 3) Feedback-rule policies are less predictable than fixed-rule policies.

Slide Copyright © 2000 Addison Wesley Longman, Inc. Business Cycle and Unemployment Policy Stabilizing Aggregate Supply Shocks Real business cycle theorists believe that fluctuations in real GDP are caused by fluctuations in productivity growth. Since wages are flexible unemployment is always at its natural rate.

Slide Copyright © 2000 Addison Wesley Longman, Inc. Business Cycle and Unemployment Policy Stabilizing Aggregate Supply Shocks (Cont.) Under these conditions the feedback-rule policy will make price level fluctuations more severe than they otherwise would be.

Slide Copyright © 2000 Addison Wesley Longman, Inc. Responding to a Productivity Growth Slowdown Real GDP (trillions of 1992 dollars) Price level (GDP deflator, 1992 = 100) LAS AD 0 LAS 1 Productivity slowdown lowers potential GDP Feedback-rule outcome Fixed-rule outcome 0

Slide Copyright © 2000 Addison Wesley Longman, Inc. Business Cycle and Unemployment Policy Nominal GDP Targeting Nominal GDP targeting is an attempt to keep the growth rate on nominal GDP steady. Recognizes the fixed rule Disregards the monetarist fixed rule

Slide Copyright © 2000 Addison Wesley Longman, Inc. Business Cycle and Unemployment Policy Nominal GDP Targeting (cont.) It uses feedback rules for fiscal and monetary policy to hit a fixed nominal GDP growth target. Its intention is to keep nominal GDP growth steady. This may prevent excessive inflation and severe recession.

Slide Copyright © 2000 Addison Wesley Longman, Inc. Learning Objectives (cont.) Evaluate fixed-rule and feedback-rule policies to stabilize the business cycle Explain how fiscal policy influences the natural rate of unemployment

Slide Copyright © 2000 Addison Wesley Longman, Inc. Business Cycle and Unemployment Policy Natural Rate Policies Natural rate policies are designed to decrease the natural rate of unemployment.

Slide Copyright © 2000 Addison Wesley Longman, Inc. Business Cycle and Unemployment Policy There are several ways to possibly lower the natural rate of unemployment. They are: 1) Reduce unemployment benefits. 2) Shorten the period the benefits are paid.

Slide Copyright © 2000 Addison Wesley Longman, Inc. Business Cycle and Unemployment Policy There are several ways to attempt to lower the natural rate of unemployment. (cont.) 3)Restrict the benefits to those in training programs. 4)Lower the minimum real wage rate.

Slide Copyright © 2000 Addison Wesley Longman, Inc. Learning Objectives (cont.) Evaluate fixed-rule and feedback rule policies to contain inflation and explain why lowering inflation usually brings recession

Slide Copyright © 2000 Addison Wesley Longman, Inc. Inflation Policy Avoiding Cost-Push Inflation Cost shocks become inflationary if accompanied by increases in the money supply. Possible using a monetary policy feedback rule. Not possible using a monetary fixed-rule policy.

Slide Copyright © 2000 Addison Wesley Longman, Inc. SAS 1 Responding to an OPEC Oil Price Increase Real GDP (trillions of 1992 dollars) Price level (GDP deflator, 1992 = 100) AD 0 LAS 8.5 SAS 0 Stagflation Fixed Rule 0

Slide Copyright © 2000 Addison Wesley Longman, Inc. SAS 1 AD 1 Responding to an OPEC Oil Price Increase Real GDP (trillions of 1992 dollars) Price level (GDP deflator, 1992 = 100) AD 0 LAS 8.5 SAS 0 Feedback Rule 125 Cost-push inflation 0

Slide Copyright © 2000 Addison Wesley Longman, Inc. Inflation Policy Slowing Inflation The two scenarios we will investigate are: 1) A surprise inflation reduction 2) A credible announced inflation reduction

Slide Copyright © 2000 Addison Wesley Longman, Inc. SAS 1 AD 1 Lowering Inflation Real GDP (trillions of 1992 dollars) LAS SAS 0 AD Price level (GDP deflator, 1992 = 100) AD 2 SAS Aggregate demand and Aggregate Supply Unexpected decrease in AD Unanticipated decrease in AD lowers inflation 0

Slide Copyright © 2000 Addison Wesley Longman, Inc. Lowering Inflation Unemployment (percentage of labor force) Inflation (percent per year) 6 SRPC LRPC SRPC 1 5 Unexpected fall in inflation brings recession Anticipated fall in inflation maintains full employment 0

Slide Copyright © 2000 Addison Wesley Longman, Inc. Inflation Policy Inflation Reduction in Practice People look at the Fed’s past actions to form their expectations. The Fed has developed a reputation of being anti-inflationary. This is valuable because it helps the Fed contain inflation.

Slide Copyright © 2000 Addison Wesley Longman, Inc. Inflation Policy A Truly Independent Fed To strengthen the Fed’s reputation as the guardian of price stability is to make it more independent from government. Similar to German and Swiss central banks.

Slide Copyright © 2000 Addison Wesley Longman, Inc. Inflation Policy A Truly Independent Fed (cont.) Research has shown a more independent central bank has delivered a lower average inflation rate without lowering GDP growth or increasing unemployment.

Slide Copyright © 2000 Addison Wesley Longman, Inc. The End