CHAPTER
15
Macroeconomic
Issues and Policy
Prepared by: Fernando Quijano
and Yvonn Quijano
© 2004 Prentice Hall Business Publishing
Principles of Economics, 7/e
Karl Case, Ray Fair
C H A P T E R 15: Macroeconomic Issues and Policy
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.
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C H A P T E R 15: Macroeconomic Issues and Policy
Time Lags Regarding
Monetary and Fiscal Policy
• Time lags are delays in
the economy’s response
to stabilization policies.
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C H A P T E R 15: Macroeconomic Issues and Policy
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.
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C H A P T E R 15: Macroeconomic Issues and Policy
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.
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C H A P T E R 15: Macroeconomic Issues and Policy
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.
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C H A P T E R 15: Macroeconomic Issues and Policy
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.
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C H A P T E R 15: Macroeconomic Issues and Policy
Recognition Lags
• The recognition lag refers to
the time it takes for policy
makers to recognize the
existence of a boom or a
slump.
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C H A P T E R 15: Macroeconomic Issues and Policy
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.
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C H A P T E R 15: Macroeconomic Issues and Policy
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.
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C H A P T E R 15: Macroeconomic Issues and Policy
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.
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C H A P T E R 15: Macroeconomic Issues and Policy
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.
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C H A P T E R 15: Macroeconomic Issues and Policy
The Fed’s Response
to the State of the Economy
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• The Fed is likely to
lower the interest rate
(and thus increase the
money supply) during
times of low output and
low inflation.
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C H A P T E R 15: Macroeconomic Issues and Policy
The Fed’s Response
to the State of the Economy
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• 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.
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C H A P T E R 15: Macroeconomic Issues and Policy
The Fed’s Response
to the State of the Economy
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• 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.
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C H A P T E R 15: Macroeconomic Issues and Policy
The Fed’s Response
to the State of the Economy
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• 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.
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C H A P T E R 15: Macroeconomic Issues and Policy
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).
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C H A P T E R 15: Macroeconomic Issues and Policy
Data for Selected Variables
for the 1989 – 2003 Period
Data for Selected Variables for the 1989 – 2003 Period
DATE
REAL GDP
GROWTH
RATE (%)
UNEMPL.
RATE (%)
INFL.
RATE (%)
THREEMONTH
T-BILL RATE
AAA
BOND
RATE
FED.
GOV.
SURPLUS
SURPLUS/GDP
1989 I
II
III
5.0
2.2
1.9
5.2
5.2
5.3
4.3
4.0
2.9
8.5
8.4
7.9
9.7
9.5
9.0
- 108.8
- 127.3
- 140.6
- 0.020
- 0.023
- 0.025
IV
1990 I
II
III
IV
1991 I
II
III
IV
1992 I
II
III
IV
1993 I
II
III
IV
1.4
5.1
0.9
- 0.7
- 3.2
- 2.0
2.3
1.0
2.2
3.8
3.8
3.1
5.4
- 0.1
2.5
1.8
6.2
5.4
5.3
5.3
5.7
6.1
6.6
6.8
6.9
7.1
7.4
7.6
7.6
7.4
7.2
7.1
6.8
6.6
3.1
4.5
4.7
3.9
3.5
4.7
2.9
2.5
2.3
3.1
2.2
1.3
2.5
3.4
2.2
1.8
2.3
7.6
7.8
7.8
7.5
7.0
6.1
5.6
5.4
4.6
3.9
3.7
3.1
3.1
3.0
3.0
3.0
3.1
8.9
9.2
9.4
9.4
9.3
8.9
8.9
8.8
8.4
8.3
8.3
8.0
8.0
7.7
7.4
6.9
6.8
- 143.4
- 172.1
- 171.2
- 164.6
- 184.0
- 160.1
- 213.4
- 234.7
- 253.1
- 288.3
- 291.8
- 316.5
- 293.5
- 300.9
- 267.3
- 275.5
- 253.0
- 0.026
- 0.030
- 0.030
- 0.028
- 0.031
- 0.027
- 0.036
- 0.039
- 0.042
- 0.047
- 0.046
- 0.050
- 0.045
- 0.046
- 0.041
- 0.041
- 0.037
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C H A P T E R 15: Macroeconomic Issues and Policy
Data for Selected Variables
for the 1989 – 2003 Period
Data for Selected Variables for the 1989 – 2003 Period
DATE
1994 I
II
III
IV
1995 I
II
III
IV
1996 I
II
III
IV
1997 I
II
III
IV
1998 I
II
III
IV
REAL GDP
GROWTH
RATE (%)
UNEMPL.
RATE (%)
3.4
5.7
2.2
5.0
1.5
0.8
3.1
3.2
2.9
6.8
2.0
4.6
4.4
5.9
4.2
2.8
6.1
2.2
4.1
6.7
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6.6
6.2
6.0
5.6
5.5
5.7
5.7
5.6
5.6
5.5
5.3
5.3
5.3
5.0
4.8
4.7
4.7
4.4
4.5
4.4
INFL.
RATE (%)
2.0
1.8
2.4
1.9
3.0
1.7
1.8
2.0
2.5
1.4
1.9
1.6
2.9
1.9
1.2
1.4
1.1
1.0
1.4
1.1
THREEMONTH
T-BILL RATE
3.3
4.0
4.5
5.3
5.8
5.6
5.4
5.3
5.0
5.0
5.1
5.0
5.1
5.1
5.1
5.1
5.1
5.0
4.8
4.3
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AAA
BOND
RATE
7.2
7.9
8.2
8.6
8.3
7.7
7.4
7.0
7.0
7.6
7.6
7.2
7.4
7.6
7.2
6.9
6.7
6.6
6.5
6.3
FED.
GOV.
SURPLUS
- 237.5
- 190.6
- 211.8
- 209.2
- 208.2
- 189.0
- 197.5
- 173.1
- 176.4
- 137.0
- 130.1
- 103.9
- 86.5
- 68.2
- 33.8
- 25.0
19.6
33.0
65.7
57.1
SURPLUS/GDP
- 0.034
- 0.027
- 0.030
- 0.029
- 0.029
- 0.026
- 0.027
- 0.023
- 0.023
- 0.018
- 0.017
- 0.013
- 0.011
- 0.008
- 0.004
- 0.003
0.002
0.004
0.007
0.006
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C H A P T E R 15: Macroeconomic Issues and Policy
Data for Selected Variables
for the 1989 – 2003 Period
Data for Selected Variables for the 1989 – 2003 Period
DATE
1999 I
II
III
IV
2000 I
II
III
IV
2001 I
II
III
IV
2002 I
II
III
IV
2003 I
II
REAL GDP
GROWTH
RATE (%)
UNEMPL.
RATE (%)
INFL.
RATE (%)
4.3
4.3
4.2
4.1
4.1
4.0
4.0
3.9
4.2
4.4
4.8
5.6
5.6
5.9
5.8
5.9
5.8
1.8
1.4
1.4
1.6
3.8
2.3
1.6
2.1
3.6
2.5
2.2
-0.5
1.4
1.3
1.2
1.8
2.5
3.1
1.7
4.7
8.3
2.3
4.8
0.6
1.1
-0.6
-1.6
-0.3
2.7
5.0
1.3
4.0
1.4
1.9
THREEMONTH
T-BILL RATE
4.4
4.5
4.7
5.0
5.5
5.7
6.0
6.0
4.8
3.7
3.2
1.9
1.8
1.7
1.6
1.3
1.2
AAA
BOND
RATE
6.4
6.9
7.3
7.5
7.7
7.8
7.6
7.4
7.1
7.2
7.1
6.9
6.6
6.7
6.3
6.3
6.0
FED.
GOV.
SURPLUS
85.1
116.5
132.0
143.2
212.8
197.2
213.1
193.8
173.8
199.6
-51.7
21.3
-145.8
-195.7
-210.5
-247.7
-253.6
SURPLUS/GDP
0.009
0.013
0.014
0.015
0.022
0.021
0.022
0.019
-0.017
0.014
-0.005
0.002
-0.014
-0.019
-0.020
-0.023
-0.024
Note: The inflation rate is the percentage change in the GDP price deflator.
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C H A P T E R 15: Macroeconomic Issues and Policy
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.
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C H A P T E R 15: Macroeconomic Issues and Policy
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.
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C H A P T E R 15: Macroeconomic Issues and Policy
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!
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C H A P T E R 15: Macroeconomic Issues and Policy
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.
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C H A P T E R 15: Macroeconomic Issues and Policy
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.
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C H A P T E R 15: Macroeconomic Issues and Policy
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!
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C H A P T E R 15: Macroeconomic Issues and Policy
Fiscal Policy: Deficit Targeting
• The Gramm-RudmanHollings 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.
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C H A P T E R 15: Macroeconomic Issues and Policy
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.
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C H A P T E R 15: Macroeconomic Issues and Policy
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.
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C H A P T E R 15: Macroeconomic Issues and Policy
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.
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C H A P T E R 15: Macroeconomic Issues and Policy
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.
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C H A P T E R 15: Macroeconomic Issues and Policy
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.
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C H A P T E R 15: Macroeconomic Issues and Policy
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.
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C H A P T E R 15: Macroeconomic Issues and Policy
Deficit Targeting as
an Automatic Destabilizer
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C H A P T E R 15: Macroeconomic Issues and Policy
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.
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C H A P T E R 15: Macroeconomic Issues and Policy
Federal Personal Income Taxes as a
Percent of Taxable Income, 1990 I-2003 II
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C H A P T E R 15: Macroeconomic Issues and Policy
Federal Government Consumption Expenditures
as a Percent of GDP, 1990 I-2003 II
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C H A P T E R 15: Macroeconomic Issues and Policy
Federal Transfer Payments and Grants-inAid as a Percent of GDP, 1990 I-2003 II
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C H A P T E R 15: Macroeconomic Issues and Policy
Federal Interest Payments as a
Percent of GDP, 1990 I-2003 II
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C H A P T E R 15: Macroeconomic Issues and Policy
Review Terms and Concepts
automatic destabilizer
negative demand shock
automatic stabilizer
recognition lag
deficit response index (dri)
response lag
Gramm-Rudman-Hollings Bill
stabilization policy
implementation lag
time lags
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