Chapter Thirty One
Deficit Reduction, Fed
Behavior, Stabilization,
Stock Market Effects, and Macro Issues Abroad

Gramm-Rudman-Hollings Bill
A bill passed by the U.S. Congress and signed by President Reagan in
1986, this law set out to reduce the deficit by $36 billion per year, with a deficit of zero slated for 1991.

Automatic Stabilizers
Automatic stabilizers are those revenues and expenditure items in the federal budget that automatically change with the economy in such a way as to stabilize GDP.

Deficit Targeting as an Automatic
Destabilizer
Positive boost to demand reduces the shock
(automatic stabilizers)
Negative
Demand Shock
Income Falls
Tax revenues drop; transfers increase
Deficit
Increases a. Without Deficit Targeting

Deficit Targeting as an Automatic
Destabilizer b. With Deficit Targeting
Negative
Demand Shock
Income Falls
Tax revenues drop; transfers increase
Deficit
Increases
Second negative demand shock reinforces first shock and worsens the contraction
(automatic destabilizers)
Tax rates raised or spending cut to reach deficit target

Price
Level, P
Fed’s Response to Low
Output/Low Inflation
AS
AD
0
AD
1
P
1
P
0
Y
0
Y
1
Aggregate Output, Y

Price
Level, P
Fed’s Response to High
Output/High Inflation
AD
0 AS
AD
1
P
0
P
1
Y
1
Y
0
Aggregate Output, Y

Stabilization Policy
Stabilization policy describes both monetary and fiscal policy, the goals of which are to smooth the fluctuations in output and employment and to keep prices as stable as possible.

Two paths for GDP...
Path A is less stable-it varies more over timethan path B.
B
A

Time Lags in Stabilization Policies
Time lags: Delays in the economy’s response to stabilization policies.
 Recognition lag
 Implementation lag
 Response lag

Recognition Lag
The recognition lag refers to the time it takes for policy makers to recognize the existence of a boom or a slump.

Implementation Lag
The implementation lag refers to 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.

Response Lag
The response lag refers to 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.

Two Major Recent Adjustments of the
Stock Market to Economic Conditions
 The Crash of October 1987
 The Stock Market Boom of
1995-1997

Review Terms & Concepts
 Automatic destabilizer
 Automatic stabilizer
 Deficit response index
(DRI)
 Gramm-Rudman-
Hollings Bill
 Implementation lag
 Negative demand shock
 Recognition lag
 Response lag
 Stabilization policy
 Time lag