Chapter Thirty One Deficit Reduction, Fed Behavior, Stabilization, Stock Market Effects, and Macro Issues Abroad

Gramm-Rudman-Hollings Bill A bill passed by the U.S. Congress and signed by President Reagan in 1986, this law set out to reduce the deficit by $36 billion per year, with a deficit of zero slated for 1991.

Automatic Stabilizers Automatic stabilizers Automatic stabilizers are those revenues and expenditure items in the federal budget that automatically change with the economy in such a way as to stabilize GDP.

Deficit Targeting as an Automatic Destabilizer Negative Demand Shock Income Falls Tax revenues drop; transfers increase Deficit Increases Positive boost to demand reduces the shock (automatic stabilizers) a. Without Deficit Targeting

Deficit Targeting as an Automatic Destabilizer Negative Demand Shock Income Falls Tax revenues drop; transfers increase Deficit Increases (automatic destabilizers) b. With Deficit Targeting Second negative demand shock reinforces first shock and worsens the contraction Tax rates raised or spending cut to reach deficit target

Fed’s Response to Low Output/Low Inflation Aggregate Output, Y Price Level, P AD 0 AD 1 P0P0 P1P1 Y0Y0 Y1Y1 AS

Fed’s Response to High Output/High Inflation Aggregate Output, Y Price Level, P AD 0 AD 1 P0P0 P1P1 Y0Y0 Y1Y1 AS

Stabilization Policy Stabilization policy Stabilization policy describes both monetary and fiscal policy, the goals of which are to smooth the fluctuations in output and employment and to keep prices as stable as possible.

Two paths for GDP... B A Path A is less stable-it varies more over time- than path B.

Time Lags in Stabilization Policies Time lags: Delays in the economy’s response to stabilization policies. 4 Recognition lag 4 Implementation lag 4 Response lag

Recognition Lag recognition lag The recognition lag refers to the time it takes for policy makers to recognize the existence of a boom or a slump.

Implementation Lag implementation lag The implementation lag refers to 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.

Response Lag response lag The response lag refers to 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.

Two Major Recent Adjustments of the Stock Market to Economic Conditions 4 The Crash of October The Stock Market Boom of

Review Terms & Concepts 4 Automatic destabilizer 4 Automatic stabilizer 4 Deficit response index (DRI) 4 Gramm-Rudman- Hollings Bill 4 Implementation lag 4 Negative demand shock 4 Recognition lag 4 Response lag 4 Stabilization policy 4 Time lag