1. 27 Prepared by: Fernando Quijano and Yvonn Quijano © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair Macroeconomic Issues and Policy

2. C H A P T E R 27: Macroeconomic Issues and Policy © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 2 of 40 Stabilization 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.

3. C H A P T E R 27: Macroeconomic Issues and Policy © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 3 of 40 Time Lags Regarding Monetary and Fiscal Policy Time lags are delays in the economy’s response to stabilization policies.

4. C H A P T E R 27: Macroeconomic Issues and Policy © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 4 of 40 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.

5. C H A P T E R 27: Macroeconomic Issues and Policy © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 5 of 40 Stabilization: “The Fool in the Shower” Attempts to stabilize the economy can prove destabilizing because of time lags. Milton Friedman likened these attempts to a “fool in the shower.” The government is constantly stimulating or contracting the economy at the wrong time.

6. C H A P T E R 27: Macroeconomic Issues and Policy © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 6 of 40 Stabilization: “The Fool in the Shower” 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.

7. C H A P T E R 27: Macroeconomic Issues and Policy © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 7 of 40 Stabilization: “The Fool in the Shower” Hence, the policy pushes the economy to points F’ and G’ (instead of F and G). Income varies more widely than it would have if no policy had been implemented.

8. C H A P T E R 27: Macroeconomic Issues and Policy © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 8 of 40 Recognition Lags The recognition lag refers to the time it takes for policy makers to recognize the existence of a boom or a slump.

9. C H A P T E R 27: Macroeconomic Issues and Policy © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 9 of 40 Implementation Lags The implementation lag is 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.

10. C H A P T E R 27: Macroeconomic Issues and Policy © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 10 of 40 Response Lags The response lag is the time 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. The delay in the multiplier of government spending occurs because neither individuals nor firms revise their spending plans instantaneously.

11. C H A P T E R 27: Macroeconomic Issues and Policy © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 11 of 40 Monetary Policy To make the monetary policy story realistic, two key points must be added: In practice, the Fed targets the interest rate rather than the money supply. The interest rate value that the Fed chooses depends on the state of the economy.

12. C H A P T E R 27: Macroeconomic Issues and Policy © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 12 of 40 Targeting the Interest Rate The Fed can pick a money supply value and accept the interest rate consequences Or The Fed can pick an interest rate value and accept the money supply consequences.

13. C H A P T E R 27: Macroeconomic Issues and Policy © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 13 of 40 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.

14. C H A P T E R 27: Macroeconomic Issues and Policy © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 14 of 40 The Fed’s Response to the State of the Economy When the economy is on the flat portion of the AS curve, an increase in the money supply will lead to an increase in output with very little increase in the price level.

15. C H A P T E R 27: Macroeconomic Issues and Policy © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 15 of 40 The Fed’s Response to the State of the Economy The opposite is also true: The Fed is likely to increase the interest rate (and thus decrease the money supply) during times of high output and high inflation.

16. C H A P T E R 27: Macroeconomic Issues and Policy © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 16 of 40 The Fed’s Response to the State of the Economy When the economy is on the relatively steep portion of the AS curve, contraction of the money supply will lead to a decrease in the price level, with little decrease in output.

17. C H A P T E R 27: Macroeconomic Issues and Policy © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 17 of 40 The Fed’s Response to the State of the Economy Stagflation is a more difficult problem to solve. If the Fed lowers the interest rate, output will rise, but so will the inflation rate (which is already too high). If the Fed increases the interest rate, the inflation rate will fall, but so will output (which is already too low).

18. C H A P T E R 27: Macroeconomic Issues and Policy © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 18 of 40 Data for Selected Variables for the 1989 – 2003 Period DATE REAL GDP GROWTH RATE (%) UNEMPL. RATE (%) INFL. RATE (%) THREE- MONTH T-BILL RATE AAA BOND RATE FED. GOV. SURPLUSSURPLUS/GDP 1989I5.05.24.38.59.7  108.8  0.020 II2.25.24.08.49.5  127.3  0.023 III1.95.32.97.99.0  140.6  0.025 IV1.45.43.17.68.9  143.4  0.026 1990I5.15.34.57.89.2  172.1  0.030 II0.95.34.77.89.4  171.2  0.030 III  0.7 5.73.97.59.4  164.6  0.028 IV  3.2 6.13.57.09.3  184.0  0.031 1991I  2.0 6.64.76.18.9  160.1  0.027 II2.36.82.95.68.9  213.4  0.036 III1.06.92.55.48.8  234.7  0.039 IV2.27.12.34.68.4  253.1  0.042 1992I3.87.43.13.98.3  288.3  0.047 II3.87.62.23.78.3  291.8  0.046 III3.17.61.33.18.0  316.5  0.050 IV5.47.42.53.18.0  293.5  0.045 1993I  0.1 7.23.43.07.7  300.9  0.046 II2.57.12.23.07.4  267.3  0.041 III1.86.81.83.06.9  275.5  0.041 IV6.26.62.33.16.8  253.0  0.037

19. C H A P T E R 27: Macroeconomic Issues and Policy © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 19 of 40 Data for Selected Variables for the 1989 – 2003 Period DATE REAL GDP GROWTH RATE (%) UNEMPL. RATE (%) INFL. RATE (%) THREE- MONTH T-BILL RATE AAA BOND RATE FED. GOV. SURPLUSSURPLUS/GDP 1994I3.46.62.03.37.2  237.5  0.034 II5.76.21.84.07.9  190.6  0.027 III2.26.02.44.58.2  211.8  0.030 IV5.05.61.95.38.6  209.2  0.029 1995I1.55.53.05.88.3  208.2  0.029 II0.85.71.75.67.7  189.0  0.026 III3.15.71.85.47.4  197.5  0.027 IV3.25.62.05.37.0  173.1  0.023 1996I2.95.62.55.07.0  176.4  0.023 II6.85.51.45.07.6  137.0  0.018 III2.05.31.95.17.6  130.1  0.017 IV4.65.31.65.07.2  103.9  0.013 1997I4.45.32.95.17.4  86.5  0.011 II5.95.01.95.17.6  68.2  0.008 III4.24.81.25.17.2  33.8  0.004 IV2.84.71.45.16.9  25.0  0.003 1998I6.14.71.15.16.719.60.002 II2.24.41.05.06.633.00.004 III4.14.51.44.86.565.70.007 IV6.74.41.14.36.357.10.006

20. C H A P T E R 27: Macroeconomic Issues and Policy © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 20 of 40 Data for Selected Variables for the 1989 – 2003 Period DATE REAL GDP GROWTH RATE (%) UNEMPL. RATE (%) INFL. RATE (%) THREE- MONTH T-BILL RATE AAA BOND RATE FED. GOV. SURPLUSSURPLUS/GDP 1999I3.14.31.84.46.485.10.009 II1.74.31.44.56.9116.50.013 III4.74.21.44.77.3132.00.014 IV8.34.11.65.07.5143.20.015 2000I2.34.13.85.57.7212.80.022 II4.84.02.35.77.8197.20.021 III0.64.01.66.07.6213.10.022 IV1.13.92.16.07.4193.80.019 2001I-0.64.23.64.87.1173.8-0.017 II-1.64.42.53.77.2199.60.014 III-0.34.82.23.27.1-51.7-0.005 IV2.75.6-0.51.96.921.30.002 2002I5.05.61.41.86.6-145.8-0.014 II1.35.91.31.76.7-195.7-0.019 III4.05.81.21.66.3-210.5-0.020 IV1.45.91.81.36.3-247.7-0.023 2003I1.95.82.51.26.0-253.6-0.024 II Note: The inflation rate is the percentage change in the GDP price deflator.

21. C H A P T E R 27: Macroeconomic Issues and Policy © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 21 of 40 The 1990 – 1991 Recession After the Fed became convinced that a recession was at hand, it responded by engaging in open market operations to lower interest rates. Inflation was not a problem, so the Fed could expand the economy without worrying about inflationary pressures.

22. C H A P T E R 27: Macroeconomic Issues and Policy © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 22 of 40 1993 – 1994 During this period, inflation was not a problem, so the Fed had room to stimulate the economy and kept its expansionary policy. By the end of 1993 the Fed was worried about inflation problems in the future, and decided to begin slowing down the economy.

23. C H A P T E R 27: Macroeconomic Issues and Policy © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 23 of 40 1995 – 1997 Inflation did not become a problem after 1994, and the Fed lowered interest rates. The three-month Treasury bill rate remained at roughly 5.0 percent throughout 1996 and 1997. During this period, the economy experienced good growth, low unemployment, low inflation, and a balanced government budget!

24. C H A P T E R 27: Macroeconomic Issues and Policy © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 24 of 40 1998 – 2000 Based on concerns about the Asian financial crisis, the Fed lowered the bill rate to 4.3 percent in the fourth quarter of 1998. The Asian crisis did not affect the U.S. economy very much, and the Fed began raising the bill rate on fears that the economy might be overheating.

25. C H A P T E R 27: Macroeconomic Issues and Policy © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 25 of 40 2001 – 2003 A recession was officially declared in 2001. The Fed responded by perhaps the most expansionary policy in its history. Many expected that the attacks on September 11, 2001 would extend the recession, but the growth rate of output was high enough to keep the unemployment rate roughly unchanged.

26. C H A P T E R 27: Macroeconomic Issues and Policy © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 26 of 40 Fiscal Policy: Deficit Targeting Many fiscal policy discussions center around the size of the federal government surplus or deficit. In the last decade, we have seen a substantial deficit turn into a surplus (between 1998 and 2001) and back into a deficit!

27. C H A P T E R 27: Macroeconomic Issues and Policy © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 27 of 40 Fiscal Policy: Deficit Targeting The Gramm-Rudman- Hollings Bill, passed by the U.S. Congress and signed by President Reagan in 1986, is a law that set out to reduce the federal deficit by $36 billion per year, with a deficit of zero slated for 1991. In practice, these targets never came close to being achieved.

28. C H A P T E R 27: Macroeconomic Issues and Policy © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 28 of 40 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.

29. C H A P T E R 27: Macroeconomic Issues and Policy © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 29 of 40 The Effects of Spending Cuts on the Deficit The deficit response index (DRI) is the amount by which the deficit changes with a $1 change in GDP. If the DRI equals .22, for example, the deficit rises by $0.22 billion for each $1 billion decrease in GDP.

30. C H A P T E R 27: Macroeconomic Issues and Policy © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 30 of 40 Economic Stability and Deficit Reduction Spending cuts must be larger than the deficit reduction we wish to achieve. Congress has two options: 1. Choose a target deficit and adjust government spending and taxation to achieve this target, or 2. Decide how much to spend and tax regardless of the consequences on the deficit.

31. C H A P T E R 27: Macroeconomic Issues and Policy © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 31 of 40 Economic Stability and Deficit Reduction A negative demand shock is something that causes a negative shift in consumption or investment schedules or that leads to a decrease in U.S. exports.

32. C H A P T E R 27: Macroeconomic Issues and Policy © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 32 of 40 Economic Stability and Deficit Reduction Automatic stabilizers refer to revenue and expenditure items in the federal budget that automatically change with the economy in such a way as to stabilize GDP.

33. C H A P T E R 27: Macroeconomic Issues and Policy © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 33 of 40 Economic Stability and Deficit Reduction Automatic destabilizers refer to revenue and expenditure items in the federal budget that automatically change with the economy in such a way as to destabilize GDP.

34. C H A P T E R 27: Macroeconomic Issues and Policy © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 34 of 40 Deficit Targeting as an Automatic Destabilizer

35. C H A P T E R 27: Macroeconomic Issues and Policy © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 35 of 40 Fiscal Policy Since 1990 The average tax rate rose sharply under President Clinton and fell sharply under President Bush. The deficit is a concern when tax rates are falling and spending is rising.

36. C H A P T E R 27: Macroeconomic Issues and Policy © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 36 of 40 Federal Personal Income Taxes as a Percent of Taxable Income, 1990 I-2003 II

37. C H A P T E R 27: Macroeconomic Issues and Policy © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 37 of 40 Federal Government Consumption Expenditures as a Percent of GDP, 1990 I-2003 II

38. C H A P T E R 27: Macroeconomic Issues and Policy © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 38 of 40 Federal Transfer Payments and Grants-in- Aid as a Percent of GDP, 1990 I-2003 II

39. C H A P T E R 27: Macroeconomic Issues and Policy © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 39 of 40 Federal Interest Payments as a Percent of GDP, 1990 I-2003 II

40. C H A P T E R 27: Macroeconomic Issues and Policy © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 40 of 40 Review Terms and Concepts negative demand shock negative demand shock recognition lag recognition lag response lag response lag stabilization policy stabilization policy time lags time lags automatic destabilizer automatic destabilizer automatic stabilizer automatic stabilizer deficit response index (dri) deficit response index (dri) Gramm-Rudman-Hollings Bill Gramm-Rudman-Hollings Bill implementation lag implementation lag