1. PowerPoint Lectures for Principles of Economics, 9eBy
Karl E. Case, Ray C. Fair & Sharon M. Oster
; ;

3. Policy Timing, Deficit Targeting, and Stock Market Effects
Prepared by:
Fernando & Yvonn Quijano

4. 30 Policy Timing, Deficit Targeting, and Stock Market Effects
PART VI FURTHER MACROECONOMICS ISSUES 30
CHAPTER OUTLINE
Time Lags Regarding Monetary and Fiscal Policy
Stabilization Recognition Lags Implementation Lags Response Lags
Fiscal Policy: Deficit Targeting
The Effects of Spending Cuts on the Deficit
Economic Stability and Deficit Reduction
Summary
The Stock Market and the Economy
Stocks and Bonds
Determining the price of a Stock
The Stock Market Since 1948
Stock Market Effects on the Economy

5. 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.

6. Time Lags Regarding Monetary and Fiscal Policy
 FIGURE Two Possible Time Paths for GDP
Path A is less stable—it varies more over time—than path B. Other things being equal, society prefers path B to path A.

7. Time Lags Regarding Monetary and Fiscal Policy
Stabilization
 FIGURE Possible Stabilization Timing Problems
Attempts to stabilize the economy can prove destabilizing because of time lags. An expansionary policy that should have begun to take effect at point A does not actually begin to have an impact until point D, when the economy is already on an upswing. Hence, the policy pushes the economy to points E1, and F1, (instead of points E and F). Income varies more widely than it would have if no policy had been implemented.

8. 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.
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.

9. 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.

10. Time Lags Regarding Monetary and Fiscal Policy
Response Lags
Response Lags for 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 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.

11. Time Lags Regarding Monetary and Fiscal Policy
Response Lags
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.

12. 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 1991.
 FIGURE Deficit Reduction Targets under Gramm-Rudman-Hollings
The GRH legislation, passed in 1986, set out to lower the federal deficit by $36 billion per year. If the plan had worked, a zero deficit would have been achieved by 1991.

13. Fiscal Policy: Deficit Targeting
The Effects of Spending Cuts on the Deficit
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.
deficit response index (DRI) The amount by which the deficit changes with a $1 change in GDP.

14. Fiscal Policy: Deficit Targeting
The Effects of Spending Cuts on the Deficit
Monetary Policy to the Rescue?
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.

15. 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.
automatic stabilizers Revenue and expenditure items in the federal budget that automatically change with the economy in such a way as to stabilize GDP.
automatic destabilizers Revenue and expenditure items in the federal budget that automatically change with the economy in such a way as to destabilize GDP.

16. Fiscal Policy: Deficit Targeting
Economic Stability and Deficit Reduction
 FIGURE Deficit Targeting as an Automatic Destabilizer
Deficit targeting changes the way the economy responds to negative demand shocks because it does not allow the deficit to increase. The result is a smaller deficit but a larger decline in income than would have otherwise occurred.

17. Fiscal Policy: Deficit Targeting
Summary
It is clear that the GRH legislation, the balanced-budget amendment, and similar deficit targeting measures have some undesirable macroeconomic consequences.
Locking the economy into spending cuts during periods of negative demand shocks, as deficit-targeting measures do, is not a good way to manage the economy.

18. The Stock Market and the Economy
Stocks and Bonds
stock A certificate that certifies ownership of a certain portion of a firm.
capital gain An increase in the value of an asset.
realized capital gain The gain that occurs when the owner of an asset actually sells it for more than he or she paid for it.

19. The Stock Market and the Economy
Determining the Price of a Stock
Things that are likely to affect the price of a stock include:
What people expect its future dividends will be.
When the dividends are expected to be paid.
The amount of risk involved.

20. The Stock Market and the Economy
The Stock Market Since 1948
Dow Jones Industrial Average An index based on the stock prices of 30 actively traded large companies. The oldest and most widely followed index of stock market performance.
NASDAQ Composite An index based on the stock prices of over 5,000 companies traded on the NASDAQ Stock Market. The NASDAQ market takes its name from the National Association of Securities Dealers Automated Quotation System.
Standard and Poor’s 500 (S&P 500) An index based on the stock prices of 500 of the largest firms by market value.

21. The Stock Market and the Economy
The Stock Market Since 1948
 FIGURE The S&P 500 Stock Price Index, 1948 I–2007 IV

22. The Stock Market and the Economy
The Stock Market Since 1948
 FIGURE Ratio of After-Tax Profits to GDP, 1948 I–2007 IV

23. The Stock Market and the Economy
Stock Market Effects on the Economy
An increase in stock prices causes an increase in wealth, and consequently an increase in consumer spending.
Investment is also affected by higher stock prices. With a higher stock price, a firm can raise more money per share to finance investment projects.

24. The Stock Market and the Economy
Stock Market Effects on the Economy
The Crash of October 1987
The value of stocks in the United States fell by about a trillion dollars between August 1987 and the end of October 1987.
If the multiplier is 1.4, the total decrease in GDP would be about 1.4 x $40 billion = $56 billion, or about 1.4 percent of GDP.
The stock market crash of 1987 did not result in a recession in 1988 because households and business firms did not lower their expectations drastically.

25. The Stock Market and the Economy
Stock Market Effects on the Economy
The Boom of 1995–2000
 FIGURE Personal Saving Rate, 1995 I–2002 III

26. The Stock Market and the Economy
Stock Market Effects on the Economy
The Boom of 1995–2000
 FIGURE Investment-Output Ratio, 1995 I–2002 III

27. The Stock Market and the Economy
Stock Market Effects on the Economy
The Boom of 1995–2000
 FIGURE Ratio of Federal Government Budget Surplus to GDP, 1995 I–2002 III

28. The Stock Market and the Economy
Stock Market Effects on the Economy
The Boom of 1995–2000
 FIGURE Growth Rate of Real GDP, 1995 I–2002 III

29. The Stock Market and the Economy
Stock Market Effects on the Economy
The Boom of 1995–2000
 FIGURE The Unemployment Rate, 1995 I–2002 III

30. The Stock Market and the Economy
Stock Market Effects on the Economy
The Boom of 1995–2000
 FIGURE Inflation Rate, 1995 I–2002 III

31. The Stock Market and the Economy
Stock Market Effects on the Economy
Fed Policy and the Stock Market
 FIGURE Month Treasury Bill Rate, 1995 I–2002 III

32. Bubbles or Rational Investors?
The Stock Market and the Economy
Stock Market Effects on the Economy
The Post-Boom Economy
Both stock market wealth and housing wealth have important effects on the economy.
Bubbles or Rational Investors?
Bernanke’s Bubble Laboratory: Princeton Protégés of Fed Chief Study the Economics of Manias
Wall Street Journal

33. REVIEW TERMS AND CONCEPTS
automatic destabilizers
automatic stabilizers
capital gain
deficit response index (DRI)
Dow Jones Industrial Average
Gramm-Rudman-Hollings Act
implementation lag
NASDAQ Composite
negative demand shock
realized capital gain
recognition lag
response lag
stabilization policy
Standard and Poor’s 500 (S&P 500)
stock
time lags