Five Debates over
Macroeconomic
Policy
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12
The Continuing Economic Debate
Even though economists in general agree on the main
macroeconomic theoretical concepts they largely differ on
how the theory should be applied for solving the immediate
issues with which the governments must deal.
Today’s lecture aims to provide the arguments of both sides in five
leading debates over the economic policy:
1. whether policy makers should try to stabilize the economy?
2. whether monetary policy should be made by rule rather than
by discretion?
3. whether the government should balance its budget?
4. whether the tax laws should be reformed to encourage
saving?
5. whether the UK should join the European monetary union?
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Should Monetary and Fiscal Policy
Makers Try to Stabilize the Economy?
• Advocates of active monetary and fiscal policy
view the economy as inherently unstable and
believe that policy can manage aggregate demand
in order to offset the inherent instability.
• Critics of active monetary and fiscal policy
emphasize that policy affects the economy with a
lag and that our ability to forecast future
economic conditions is poor. As a result,
attempts to stabilize the economy can end up
being destabilizing.
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Pro: Policy Makers Should Try to
Stabilize the Economy
1. When households and firms feel pessimistic, aggregate demand
falls. This causes output to fall and unemployment to rise.
2. There is no reason for the economy to suffer through a recession
when policy makers can reduce the severity of economic
fluctuations.
3. Thus, policy makers should take an active role in leading the
economy to stability.
4. When aggregate demand is inadequate to ensure full employment,
policy makers should act to boost spending in the economy. When
aggregate demand is excessive and there is a risk of inflation,
policymakers should act to lower spending.
5. Such policy actions put macroeconomic theory to its best use by
leading to a more stable economy.
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Con: Policy Makers Should Not Try
to Stabilize the Economy
1.There are substantial difficulties associated with
running fiscal and monetary policy. One of the
most important problems to remember is the time
lag that often occurs with policy.
2. Economic conditions change over time. Thus,
policy effects that occur with a lag may hit the
economy at the wrong time, leading to a more
unstable economy.
3. Therefore, policy makers should refrain from
intervening and be content with “doing no harm.”
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Should Monetary Policy Be Made by
Rule Rather than by Discretion?
• Advocates of rules for monetary policy argue
that discretionary policy can suffer from
incompetence, abuse of power, and time
inconsistency.
• Critics of rules for monetary policy argue that
discretionary policy is more flexible in
responding to changing economic
circumstances.
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Pro: Monetary Policy Should Be
Made by Rule
1. Discretion in the conduct of monetary policy has at least
three problems:
•
•
•
It does not limit incompetence and abuse of power.
There may be problems if monetary policy committee
members disagree about the future rate of inflation and so
disagree about interest rate changes.
There is also the problem that the people responsible for
making decisions about interest rates, that affect millions of
people, are unelected and not democratically accountable.
2. One way to avoid these problems is to force the central
bank to follow a monetary rule. This rule could be
flexible enough to allow for some information on the
state of the economy.
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Con: Monetary Policy Should Not
Be Made By Rule
1. Discretionary monetary policy allows
flexibility. This gives the central bank the
ability to react to unforeseen situations
quickly.
2. It is also unclear that central bankers use
policy to help political parties.
3. Nor is it clear that the time-inconsistency of
monetary policy makers is a major problem.
4. It would also be very difficult to specify a
precise rule.
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Should the Government Balance Its
Budget?
• Advocates of a balanced government budget argue that
budget deficits impose a burden on future generations
by raising their taxes and lowering their incomes.
• Critics of a balanced government budget argue that the
deficit is only one small piece of fiscal policy. Singleminded concern about the budget deficit can obscure
the many ways in which policy, including various
spending programes, affect different generations. It
also ignores the important role of automatic fiscal
stabilizers in ironing out fluctuations over the
economic cycle.
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Pro: The Government Should
Balance Its Budget
1. Future generations of taxpayers will be burdened by the
government’s debt. This will lower the standard of living for
these future generations.
2. Budget deficits cause crowding out. Reduced national
saving raises interest rates and lowers investment. A lower
capital stock reduces productivity and thus leads to a smaller
amount of economic growth than would have occurred in
the absence of this budget deficit.
3. It is sometimes justifiable to run budget deficits, such as in
times of war or recession. However, if the government runs
a deficit during a recession it should run a budget surplus
when the economy recovers. Over the course of the business
cycle, the government budget should be balanced.
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Con: Government Should Not
Balance Its Budget
1. The problems caused by the government debt are
overstated. The future generation’s burden of debt
is relatively small when compared with their
lifetime incomes.
2. It is important that any change in government
spending is examined for external effects.
• If education spending is cut, for example, this may well
lead to lower economic growth in the future.
3. Governments should distinguish between
borrowing to finance investment and borrowing
to finance current expenditure.
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Should the Tax Laws Be Reformed
to Encourage Saving?
• Advocates of tax incentives for saving point out that
society discourages saving in many ways, such as by
heavily taxing the income from capital and by reducing
benefits for those who have accumulated wealth. They
endorse reforming the tax laws to encourage saving.
• Critics of tax incentives for saving argue that many
proposed changes to stimulate saving would primarily
benefit the wealthy, who do not need a tax break. They
also argue that such changes might have only a small effect
on private saving. Raising public saving by increasing the
government’s budget surplus would provide a more direct
and equitable way to increase national saving.
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Pro: Tax Laws Should Be Reformed
to Encourage Saving
1. The greater the amount of saving in an economy, the more
funds there are available for investment. This increases
productivity, raising the nation’s standard of living.
2. Because people respond to incentives, changing the tax
laws to make saving more attractive will raise the amount
of funds saved. Current laws tax the return on saving
fairly heavily.
3. Tax laws are not the only government policy that
discourage saving. Some government benefits, such as
long-term care and pensions are often means-tested.
4. There are various ways to change the tax laws to
encourage saving.
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Con: The Tax Laws Should Not Be
Reformed to Encourage Saving
1. Increasing saving is not the only goal of tax policy.
Policy makers are interested in using tax policy to
redistribute income, making sure that the burden of
taxation falls on those who can most afford it.
2. Saving can be increased in other ways. For example,
governments could lower budget deficits (or increase
budget surpluses) to raise public saving.
3. Lowering the tax on capital income lowers the
revenue of the government. This may increase the
budget deficit, lower public saving, and push national
saving down as well.
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Should the UK Join European
Monetary Union?
• Advocates of UK membership of EMU membership
emphasize the reduction in transaction costs in
international trade that would follow from adopting the
euro. The loss of exchange rate adjustment would be
countered by ending the exchange rate volatility and
swings in competitiveness that UK industry has
suffered for the last 30 years.
• Sceptics point out that a ‘one-size-fits-all’ monetary
policy may not suit the UK economy and could lead to
substantial short-term fluctuations in output and
unemployment, while the present UK monetary policy
framework appears to be working well.
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Pro: The UK Should Join EMU
1. There would be reduced transaction costs in trade between the
UK and other EMU countries.
2. The monetary policy regime in the EMU is not dissimilar to
that in the UK.
3. EMU is the final step in the creation of the Single European
Market and the USA provides and example of the advantage of
a huge domestic market in which all transactions are made in
the same currency.
4. Joining EMU would lead to closer financial market integration
leading to increased competition and efficiency gains in
financial services.
5. Joining EMU would enhance the attractiveness of the UK as a
destination for foreign direct investment.
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Con: The UK Should Not Join EMU
• The UK’s trade with EMU countries constitutes a
smaller fraction of GDP than is the case of many EMU
countries.
• The UK would be giving up control over its own
monetary policy and the ability to use the exchange
rate as a means of macroeconomic adjustment.
• The UK would be subject to constraints on its fiscal
policy too.
• The argument that greater financial integration could
cushion the UK from shocks that might cause
recessions might be exaggerated.
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Conclusion
• The study of economics does not always make
it easy to choose among alternative policies.
• By clarifying the inevitable trade-offs that
policy makers face, it can make the choice more
difficult.
• Few if any policies come with benefits but not
cost.
• If you hear politicians or commentators offering
you a free lunch you should look for the hidden
price tag.
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