1 Chapter 16 Macroeconomic Policies © 2003 South-Western College Publishing

2 Macroeconomic Policies  Expansionary Policies  Monetary and fiscal policies that are used to try to increase the equilibrium level of income and output in the economy  Contractionary Policies  Monetary and fiscal policies that are used to try to lower aggregate demand for output in the economy to a level that can be achieved with full employment of all resources

3 Expansionary Policies  Automatic Stabilizers  Forces within the economy that naturally tend to counteract recessions and inflation; ex., the Social Security system, unemployment compensation, progressive income tax  Fiscal drag  Slowing effect on the economy resulting from a budget surplus  Fiscal stimulus  Activating effect on on the economy resulting from a budget deficit

4 Expansionary Policies  Monetary policy  Increase in the money supply  lower interest rates  increases the level of aggregate expenditures during periods of high unemployment  Discretionary fiscal policy  Tax financing  Debt financing  Financing by creating money

5 Tax Financing  When taxation used to finance increased government spending, caution must be used so as not to tax funds that would otherwise be used for consumption & investment  Object here should be to design a tax to absorb idle funds

6 Debt Financing  If purpose is to increase aggregate spending, borrowing is more desirable method of raising funds for government spending  Source of the borrowing has a direct bearing on the effectiveness of this approach  Crowding out  Occurs when deficit spending by the government drives interest rates up and leads to declines in private investment spending

7 Debt Financing  Ricardian Equivalence Theorem  Proposition that if makes no difference whether government spending is financed by taxes or a deficit  In either case, the transfer of resources from the private sector to the government leads to having no net effect on the aggregate economy  Based on rational expectations, individuals realize that deficits must be paid off in the future  taxes will rise to pay off the debt  they will reduce spending just as they would if taxes were increased

8 Financing by Creating Money  Treasury sells bonds to the Fed (or to the public) to finance government spending  When Treasury (or public) spends this money to make purchases, the result is an increase in the money supply  This process is referred to as either  Printing money because it increases the money supply  Monetizing the debt

9 Methods of Increasing Government Spending  Increase government spending and hold taxes constant  Hold government spending constant and decrease taxes (tax rebate plan)  Increase government spending and increase taxes proportionally  Balanced budget multiplier

10 Discretionary Government Spending  Discretionary government spending  Transfer payments  Public works  Problems with discretionary spending  Difficult to end a government spending program  Problems balancing when the program is needed and when it can begin

11 Expanding the Economy  The Great Depression  The New Deal  Expansionary Policies of the 1960s  Expansionary Policies of the 1970s, 1980s & 1990s  Recession of  Recessions of 1980 and 1982  Recession of  2001 Recession

12 Recession and Deflation  Deflation  persistent decrease in the level of prices  Disinflation  a slowdown in the rate of inflation

13 Inflation & Types of Inflation  Inflation  Persistent increase in the level of prices  Demand-Pull Inflation  Occurs when the total demand for goods and services exceeds the available supply of goods and services in the short run  Cost-Push Inflation  Characterized by a spiral of wage and benefit cost increases and price increases  Stagflation  Inflation and high unemployment occurring at the same time

14 Measures to Reduce Total Spending  Automatic Stabilizers  Monetary Policy  Use of measures to reduce the money supply  Other Measures  Credit restraints, limits on borrowing for stock purchases  Government Surplus  Hold taxes and decrease spending  Increase taxes and hold or decrease spending  Decrease taxes and decrease spending  Borrowing

15 Wartime Inflation  Wartime economy entails a significant reallocation of resources  Need for Reducing Consumption and Investment  Taxation  Voluntary Savings  Compulsory Savings  Other Measures

16 Trade-Off Between Unemployment and Inflation  Phillips curve  Curve showing the relationship between unemployment and inflation  More accurately describes the short-run rather than the long-run relationship  Natural rate of unemployment

17 Hyperinflation in Latin America  Hyperinflation  Inflation that feeds on itself to go out of control, creating severe distortions in an economy and rendering its currency almost worthless  Central and South America  Bolivia experienced a 11,750% inflation rate in 1985  Argentina has experienced inflation rates as high as 3,030% in 1989  Inflation rates in Venezuela have ranged from 31% in 1992 to 61% in 1994

18 Contracting the Economy – 1960s  Use of voluntary wage and price guideposts suggested by President Kennedy  President Johnson imposed a temporary 10% surcharge on personal and corporate income taxes  Surtax fell more heavily on savings than consumption with result that little success was achieved in arresting inflation

19 Contracting the Economy – 1970s  President Nixon declared a 90-day freeze on all prices, wages, and rents  Imposed surtax on imports  Asked Congress to reduce personal taxes and repeal some excise taxes  Wage and price freeze offered only temporary success  Stagflation  President Carter once again announced a set of voluntary wage and price controls that were largely unsuccessful

20 Contracting the Economy – 1980s  Reagan shifted from a demand-side approach to dealing with the dual problems of unemployment and inflation to a number of supply side measures  Measures  Encourage saving  Stimulate investment  Motivate work effort  Generally successful

21 Contracting the Economy – 1990s  Kuwaiti oil Crisis and Gulf War  Increased taxes without reducing government spending  Increased money supply  President Clinton  Contractionary fiscal policy  Expansionary monetary policy  Presided over longest peacetime expansion in U.S.