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C h a p t e r
16
MACROECONOMIC
POLICY
CHALLENGES
O u t l i n e
What Can Policy Do?
A. From 1991 to 1999, the U.S. economy performed well, but
slowed in 2000, and stopped in 2001 with unemployment
increasing
B. All major industrial countries had slowing economies in
2001; leaders began to speak of stimulus packages, but
not everybody agreed any stimulus was needed
C. What can and should policy makers do to achieve desirable
macroeconomic performance?
I.
Policy Goals
A. The domestic goals of macroeconomic policy are to
1. Achieve the highest sustainable rate of growth of
potential GDP.
2. Smooth out avoidable business cycle fluctuations.
3. Maintain low unemployment.
4. Maintain low inflation.
B. Potential GDP Growth
1. Rapid sustained real GDP growth can make a profound
contribution to economic well being.
2. From 1990 to 2000, the growth rate of real GDP per
person was 2 percent a year, at which rate output per
person doubles every 35 years. If it grew at 2.5
percent a year, doubling would take only 28 years; 4
percent would mean 18 years. Increasing the long-term
growth rate is very important.
C. The Business Cycle
1. Deviations of output from potential GDP are costly;
their extent is unknown because RBC suggests most
business cycles are fluctuations in potential GDP, but
eliminating such deviations as do exist is desirable.
D. Unemployment
1. High unemployment is wasteful and costly; low
unemployment causes bottlenecks and inefficiencies.
2. Keeping unemployment at the natural rate is desirable;
but its level is not known with certainty.
3. Lowering the natural rate if it is high is also a
goal.
E. Inflation
1. Predictability of inflation is a consensus goal; most
economists favor a measured rate of 0 to 3 percent per
annum, roughly equivalent to price stability given
measurement bias.
F. The Two Core Policy Indicators: Real GDP Growth and
Inflation
1. The first three of these goals are
growth rate of real GDP; the trend
independent. Hence the growth rate
inflation rate are the core policy
linked to the
inflation rate is
of real GDP and the
targets.
2. Figure 31.1 (page 733/387) graphs their performance
1961–2001.
II. Policy Tools and Performance
A. Fiscal policy is the use of the federal budget to achieve
macroeconomic objectives.Monetary policy is the adjustment
of the quantity of money in circulation and interest
rates by the Fed to achieve macroeconomic objectives.
B. Fiscal Policy since 1961
1. Fiscal policy was mildly expansionary during the
Kennedy years, more strongly expansionary during the
Vietnam War, expansionary during the first Reagan
administration, and less expansionary during the
Clinton years.
2. Figure 31.2 (page 734/388) graphs spending, taxes, and
deficit/surplus for 1961–2001.
C. Monetary Policy since 1961
1. Conducted by the Federal Reserve, monetary policy
involves changing interest rates and the quantity of
money to achieve macroeconomic objectives.
2. Figure 31.3 (page 735/389) graphs these three measures
for 1961–2001.
3. The thrust of monetary policy can be measured by M2
growth, the federal funds rate, and/or the real
federal funds rate.
4. The growth rate of M2 and the federal funds rate move
in opposite directions: when the Federal Reserve cuts
the federal funds rate, M2 growth increases and vice
versa.
5. Monetary growth was highest in the 1970s, when
inflation was highest.
6. Monetary policy tends to be expansionary before a
presidential election and contractionary after the
election. Exceptions were the terms of Jimmy Carter
and George Bush, Sr., both of whom failed to be
reelected.
7. M2 growth increased during the late 1990s and remained
high through 2002.
III. Long-Term Growth Policy
A. Policies that aim at increasing long-term growth must
increase
1. National saving
2. Investment in human capital
3. Investment in new technologies.
B. National Saving
1. National saving equals private saving plus government
saving.
2. In the United States, after fluctuating around an
average of 20 percent of GDP between 1960 and 1982,
national saving fell to a low of 16 percent of GDP in
1993. It increased until 1998 when it began to fall
again.
3. Figure 31.4 (page 737/391) shows national saving,
government saving, and net national saving for 1961–
2001.
4. Increasing the government’s surplus would increase the
government saving component of national saving.
5. Tax policies that increase the after-tax rate of
return on saving would boost the private saving part
of national saving.
6. Monetary policy that preserves stable prices and
minimizes uncertainty about the future price level
also increases private saving.
C. Investment in Human Capital
1. Human capital can be obtained through formal schooling
and through on-the-job experience.
2. Improving the quality of schooling and enlarging
access to advanced training are policies the
government can undertake to spur the formation of
human capital.
D. Investment in New Technologies
1. Investment in new technologies benefits the nation
because new technologies are not subject to
diminishing returns and because they can spill over to
benefit all sectors of the economy.
2. The government’s research and experiment tax credit
reduces the taxes of firms that conduct research and
development and helps generate new technologies.
IV. Business Cycle and Unemployment Policy
A. Stabilization policies fall into three broad categories:
1. Fixed-rule policies
2. Feedback-rule policies
3. Discretionary policies
B. Fixed-Rule Policies
1. A fixed-rule policy specifies an action to be pursued
independently of the state of the economy.
2. Milton Friedman proposed a fixed rule that sets the
monetary growth rate at a level to achieve zero
average inflation.
C. Feedback-Rule Policies
1. A feedback-rule policy specifies how policy actions
respond to changes in the state of the economy.
2. The Fed’s policy of raising the interest rate in 1994
in response to a falling unemployment rate and
lowering the interest rate during 2001 in response to
a rising unemployment rate is an example of a
feedback-rule policy.
D. Discretionary Policies
1. A discretionary policy responds to the economy in a
possibly unique way that uses all available
information including perceived lessons from past
“mistakes.”
2. Though all policies have some element of discretion,
for the most part discretionary policy is a form of
sophisticated feedback rule policy.
E. Stabilizing Aggregate Demand Shocks
1. Figure 31.5 (page 740/394) illustrates the economy in
a recession. In this situation, either a fixed rule or
a feedback rule might be used.
2. Fixed-Rule: Monetarism.
a) A monetarist is an economist who believes that
fluctuations in the quantity of money are the main
source of economic fluctuations.
b) A monetarist advocates a fixed rule in which
neither fiscal policy nor monetary policy respond
to the depressed state of the economy.
c) Figure 31.6a (page 741/395) shows that under a
fixed rule, if the decrease in aggregate demand is
temporary, the economy returns to potential GDP and
full employment when aggregate demand recovers.
d) Figure 31.6b (page 741/395) shows that under a
fixed rule, if the decrease in aggregate demand is
permanent, the economy returns to potential GDP and
full employment when the money wage rate falls and
the SAS curve shifts rightward.
3. Feedback Rule: Keynesian Activism
a) A Keynesian activist is an economist who believes that
fluctuations in aggregate demand combined with
sticky wages (and/or sticky prices) are the main
source of economic fluctuations.
b) Figure 31.6c (page 741/395) shows that under a
feedback rule that uses fiscal or monetary
stimulation of aggregate demand, the AD curve
shifts rightward and real GDP increases to restore
full employment.
4. The Two Rules Compared
a) Under a fixed rule, the economy goes into recession
and remains there for as long as it takes the
economy under its own steam to return to full
employment.
b) Under a feedback rule, the policy action pulls the
economy out of recession.
F. So Feedback Rules are Better?
1. Despite the apparent superiority of feedback rules
many economists say that fixed rules do a better job
of stabilizing aggregate demand. Three reasons are
advanced:
a) Potential GDP is not known
b) Policy lags are longer than the forecast horizon
c) Feedback rule policies are less predictable than
fixed rule policies
2. Knowledge of Potential GDP
a) Proper use of feedback rules requires that
policymakers know whether policy should be
expansionary or contractionary.
b) But that requires knowledge of what is the
potential level of real GDP, which no one knows
with certainty.
3. Policy Lags and the Forecast Horizon
a) The effects of policy actions operate with lags.
b) These lags may be longer than policymakers can
forecast so that actions taken in response to
actual or forecasted events may have their maximum
effects only when the economy faces new problems.
c) This is illustrated with a discussion of Fed
policy.
4. Predictability of Policies
a) Fixed rules are more predictable; feedback rules
inflict more uncertainty on the economy.
b) When determining interest rates and wage contracts,
people need to forecast future inflation rates.
c) They can do so more easily and accurately when
policies are predictable.
G. Stabilizing Aggregate Supply Shocks
1. Real business cycle economists suggest another reason
for the failure of feedback rules: Fluctuations in GDP
are caused by fluctuations in productivity growth,
that is, by shifts in the aggregate supply curve.
2. According to this view, the short-run and long-run
aggregate supply curves are identical.
3. A slowdown in productivity growth shifts the aggregate
supply curve leftward.
4. With a fixed rule, a decrease in LAS has no effect on
policy, so AD does not change, and the result of the
decrease in LAS is a fall in real GDP and an increase
in the price level.
5. Because the aggregate supply curve is vertical,
changes in aggregate demand do not change the level of
GDP, so policy changes in aggregate demand have no
useful effect on real GDP. Figure 31.7 (page 744/398)
illustrates.
H. Natural Rate Policies
1. There are no costless ways to lower the natural rate.
2. Two possibilities are
a) Reducing the generosity of unemployment
compensation, thus making the opportunity cost of
unemployment higher and reducing search times;
b) Reducing the minimum real wage rate, increasing the
demand for labor.
V. Anti-Inflation Policy
A. Avoiding demand-pull inflation is like to avoiding
demand-deficiency recession and is achieved by
stabilizing aggregate demand. Avoiding cost-push
inflation and slowing inflation if it does occur raise
special problems.
B. Avoiding Cost-Push Inflation
1. Cost-push inflation originates when cost increases
decrease short-run aggregate supply and shift the SAS
curve s leftward. Figure 31.8 (page 746/400)
illustrates responding to an OPEC price increase.
2. Monetarist Fixed Rule
a) In the face of a leftward shift in the SAS curve,
fixed rules for monetary policy allows the economy
to suffer stagflation whereby real GDP falls and
the price level rises.
b) Eventually, the SAS curve returns to its original
position, and the level of output returns to full
employment.
3. Keynesian Feedback Rule
a) If the SAS curve shifts leftward, feedback rules
increase the money supply and government spending
and cut taxes.
b) The policies shift the AD curve rightward,
increasing real GDP and the price level.
4. Incentives to push up costs
a) With fixed rules, a boost in, say, money wages
results in unemployment; with feedback rules,
unemployment is more temporary.
b) Hence workers have a greater incentive to demand
higher wages under a feedback rule; that is, the
incentive to seize a temporary gain by boosting the
price of a resource is greater under a feedback
rule.
c) This incentive is a disadvantage of feedback rules.
B. Slowing Inflation
1. A Surprise Inflation Reduction
a) If a reduction in the inflation rate is a surprise,
a recession results as the economy moves along a
short-run Phillips curve.
b) Alternatively, the AD curve unexpectedly moves
leftward, with the price level and real GDP falling
as a recession hits the economy.
c) Figure 31.9 (page 748/402) illustrates with AD-AS
and Phillips curves.
2. A Credible Announced Inflation Reduction
a) If the Fed credibly announces its goal to reduce
the inflation rate, inflation slows and real GDP
does not change.
C. Inflation Reduction in Practice
In practice, most reductions in inflation cause
recessions because people do not believe Fed
announcements; rather they base their expectations on Fed
actions.
D. Balancing the Inflation and Real GDP Objective: The
Taylor Rule
1. The Taylor Rule suggests targeting inflation, say a
target of 2 percent inflation a year, but then being
explicit about the target for the federal funds rate
if inflation deviates from its target rate.
2. This is intended to reduce the uncertainties produced
by Fed-watching to divine the Fed’s intentions from
its behavior rather than its pronouncements.
3. Figure 31.10 (page 749/403) compares actual Federal
Funds Rate to the Taylor rule for 1971 to 2001, and
shows that they are close but not identical.