© 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair Prepared by: Fernando & Yvonn Quijano 28 Chapter Macroeconomic Issues and Policy

CHAPTER 28: Macroeconomic Issues and Policy © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 2 of 30 Chapter Outline 28 Macroeconomic Issues and Policy Time Lags Regarding Monetary and Fiscal Policy Stabilization: “The Fool in the Shower” Recognition Lags Implementation Lags Response Lags Monetary Policy Controlling the Interest Rate The Fed’s Response to the State of the Economy Monetary Policy Since 1990 Inflation Targeting Fiscal Policy: Deficit Targeting The Effects of Spending Cuts on the Deficit Economic Stability and Deficit Reduction Summary Fiscal Policy Since 1990

CHAPTER 28: Macroeconomic Issues and Policy © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 3 of 30 TIME LAGS REGARDING MONETARY AND FISCAL POLICY FIGURE 15.1 Two Possible Time Paths for GDP

CHAPTER 28: Macroeconomic Issues and Policy © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 4 of 30 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.

CHAPTER 28: Macroeconomic Issues and Policy © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 5 of 30 TIME LAGS REGARDING MONETARY AND FISCAL POLICY STABILIZATION: “THE FOOL IN THE SHOWER” FIGURE 15.2 “The Fool in the Shower”—How Government Policy Can Make Matters Worse

CHAPTER 28: Macroeconomic Issues and Policy © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 6 of 30 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.

CHAPTER 28: Macroeconomic Issues and Policy © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 7 of 30 TIME LAGS REGARDING MONETARY AND FISCAL POLICY 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. The implementation lag for monetary policy is generally much shorter than for fiscal policy.

CHAPTER 28: Macroeconomic Issues and Policy © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 8 of 30 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. What is most important is the total lag between the time a problem first occurs and the time the corrective policies are felt.

CHAPTER 28: Macroeconomic Issues and Policy © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 9 of 30 TIME LAGS REGARDING MONETARY AND 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 Fiscal Policy 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.

CHAPTER 28: Macroeconomic Issues and Policy © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 10 of 30 TIME LAGS REGARDING MONETARY AND FISCAL POLICY 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.

CHAPTER 28: Macroeconomic Issues and Policy © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 11 of 30 MONETARY POLICY There are two key points that we must add to the monetary policy story to make the story realistic, as we do in this section. The first point is that in practice the Fed controls the interest rate rather than the money supply. The second point is that the interest rate value that the Fed chooses depends on the state of the economy.

CHAPTER 28: Macroeconomic Issues and Policy © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 12 of 30 MONETARY POLICY FIGURE 15.3 Fed Behavior

CHAPTER 28: Macroeconomic Issues and Policy © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 13 of 30 MONETARY POLICY CONTROLLING THE INTEREST RATE The first key point is that in practice the Fed chooses the interest rate value and accepts the money supply consequences, rather than vice versa. The Fed can pick a money supply value and accept the interest rate consequences, or it can pick an interest rate value and accept the money supply consequences.

CHAPTER 28: Macroeconomic Issues and Policy © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 14 of 30 MONETARY POLICY FIGURE 15.4 The Fed’s Response to Low Output/Low Inflation THE FED’S RESPONSE TO THE STATE OF THE ECONOMY The Fed is likely to lower the interest rate (and thus increase the money supply) during times of low output and low inflation.

CHAPTER 28: Macroeconomic Issues and Policy © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 15 of 30 MONETARY POLICY FIGURE 15.5The Fed’s Response to High Output/High Inflation The Fed is likely to increase the interest rate (and thus decrease the money supply) during times of high output and high inflation.

CHAPTER 28: Macroeconomic Issues and Policy © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 16 of 30 MONETARY POLICY MONETARY POLICY SINCE 1990 TABLE 15.1 Data for Selected Variables for the 1989 I–2005 II Period DATE REAL GDP GROWTH RATE (%) UNEMPL. RATE (%) INFL. RATE (%) 3-MONTH T-BILL RATE AAA BOND RATE SURPLUS AS % OF /GDP 1989I II III IV I II III IV I II III IV I II III IV I II III IV

CHAPTER 28: Macroeconomic Issues and Policy © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 17 of 30 MONETARY POLICY TABLE 15.1 Data for Selected Variables for the 1989 I–2005 II Period (cont’d.) DATE REAL GDP GROWTH RATE (%) UNEMPL. RATE (%) INFL. RATE (%) 3-MONTH T-BILL RATE AAA BOND RATE SURPLUS AS % OF /GDP 1994I II III IV I II III IV I II III IV I II III IV I II III IV I II III IV

CHAPTER 28: Macroeconomic Issues and Policy © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 18 of 30 MONETARY POLICY TABLE 15.1 Data for Selected Variables for the 1989 I–2005 II Period (cont’d.) DATE REAL GDP GROWTH RATE (%) UNEMPL. RATE (%) INFL. RATE (%) 3-MONTH T-BILL RATE AAA BOND RATE SURPLUS AS % OF /GDP 2000I II III IV I II III IV I II III IV I II III IV I II III IV I II Note: The inflation rate is the percentage change in the GDP price deflator. SURP denotes the federal government surplus (+) or deficit (-).

CHAPTER 28: Macroeconomic Issues and Policy © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 19 of 30 MONETARY POLICY INFLATION TARGETING inflation targeting When a monetary authority chooses its interest rate values with the aim of keeping the inflation rate within some specified band over some specified horizon.

CHAPTER 28: Macroeconomic Issues and Policy © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 20 of 30 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 FIGURE 15.6Deficit Reduction Targets under Gramm-Rudman- Hollings

CHAPTER 28: Macroeconomic Issues and Policy © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 21 of 30 FISCAL POLICY: DEFICIT TARGETING 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 EFFECTS OF SPENDING CUTS ON THE DEFICIT deficit response index (DRI) The amount by which the deficit changes with a $1 change in GDP.

CHAPTER 28: Macroeconomic Issues and Policy © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 22 of 30 FISCAL POLICY: DEFICIT TARGETING 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. Monetary Policy to the Rescue?

CHAPTER 28: Macroeconomic Issues and Policy © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 23 of 30 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.

CHAPTER 28: Macroeconomic Issues and Policy © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 24 of 30 FISCAL POLICY: DEFICIT TARGETING automatic destabilizers Revenue and expenditure items in the federal budget that automatically change with the economy in such a way as to destabilize GDP. automatic stabilizers Revenue and expenditure items in the federal budget that automatically change with the economy in such a way as to stabilize GDP.

CHAPTER 28: Macroeconomic Issues and Policy © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 25 of 30 FISCAL POLICY: DEFICIT TARGETING FIGURE 15.7Deficit Targeting as an Automatic Destabilizer

CHAPTER 28: Macroeconomic Issues and Policy © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 26 of 30 FISCAL POLICY SINCE 1990 FIGURE 15.8Federal Personal Income Taxes as a Percentage of Taxable Income, 1990 I–2005 II

CHAPTER 28: Macroeconomic Issues and Policy © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 27 of 30 FISCAL POLICY SINCE 1990 FIGURE 15.9Federal Government Consumption Expenditures as a Percentage of GDP, 1990 I–2005 II

CHAPTER 28: Macroeconomic Issues and Policy © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 28 of 30 FISCAL POLICY SINCE 1990 FIGURE Federal Transfer Payments and Grants-in-aid as a Percentage of GDP, 1990 I–2005 II

CHAPTER 28: Macroeconomic Issues and Policy © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 29 of 30 FISCAL POLICY SINCE 1990 FIGURE Federal Interest Payments as a Percentage of GDP, 1990 I–2005 II

CHAPTER 28: Macroeconomic Issues and Policy © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 30 of 30 automatic destabilizer automatic stabilizer deficit response index (DRI) Gramm-Rudman- Hollings Act implementation lag REVIEW TERMS AND CONCEPTS inflation targeting negative demand shock recognition lag response lag stabilization policy time lags