Chapter
15
Macroeconomic Issues
and Policy
Prepared by:
Fernando & Yvonn Quijano
© 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair
CHAPTER 15: Macroeconomic Issues and Policy
Macroeconomic Issues
and Policy
15
Chapter Outline
Time Lags Regarding Monetary and
Fiscal Policy
Stabilization: “The Fool in the Shower”
Recognition Lags
Implementation Lags
Response Lags
Monetary Policy
Controlling the Interest Rate
The Fed’s Response to the State
of the Economy
Monetary Policy Since 1990
Inflation Targeting
Fiscal Policy: Deficit Targeting
The Effects of Spending Cuts
on the Deficit
Economic Stability and Deficit
Reduction
Summary
Fiscal Policy Since 1990
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CHAPTER 15: Macroeconomic Issues and Policy
TIME LAGS REGARDING MONETARY
AND FISCAL POLICY
FIGURE 15.1 Two Possible Time Paths for GDP
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CHAPTER 15: Macroeconomic Issues and Policy
TIME LAGS REGARDING MONETARY
AND FISCAL 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.
time lags Delays in the economy’s
response to stabilization policies.
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CHAPTER 15: Macroeconomic Issues and Policy
The main goal of stabilization policy is to:
a. Take economic measures that enhance the
credibility of government institutions.
b. Be prepared to handle destabilizing economic
situations, such as a bank run.
c. Use monetary and fiscal policy to smooth out
fluctuations in output, employment, and prices.
d. Use economic policy to solve social problems
such as crime or child neglect.
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CHAPTER 15: Macroeconomic Issues and Policy
The main goal of stabilization policy is to:
a. Take economic measures that enhance the
credibility of government institutions.
b. Be prepared to handle destabilizing economic
situations, such as a bank run.
c. Use monetary and fiscal policy to smooth out
fluctuations in output, employment, and
prices.
d. Use economic policy to solve social problems
such as crime or child neglect.
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CHAPTER 15: Macroeconomic Issues and Policy
TIME LAGS REGARDING MONETARY
AND FISCAL POLICY
STABILIZATION: “THE FOOL IN THE SHOWER”
FIGURE 15.2 “The Fool in the Shower”—How Government
Policy Can Make Matters Worse
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CHAPTER 15: Macroeconomic Issues and Policy
A leading critic of stabilization policy that likened
government attempts to stabilize the economy to
a “fool in the shower” is:
a. John Maynard Keynes.
b. Adam Smith.
c. Milton Friedman.
d. Jean-Paul Sartre.
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CHAPTER 15: Macroeconomic Issues and Policy
A leading critic of stabilization policy that likened
government attempts to stabilize the economy to
a “fool in the shower” is:
a. John Maynard Keynes.
b. Adam Smith.
c. Milton Friedman.
d. Jean-Paul Sartre.
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CHAPTER 15: Macroeconomic Issues and Policy
TIME LAGS REGARDING MONETARY
AND FISCAL POLICY
RECOGNITION LAGS
recognition lag The time it takes for
policy makers to recognize the existence
of a boom or a slump.
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CHAPTER 15: Macroeconomic Issues and Policy
TIME LAGS REGARDING MONETARY
AND FISCAL POLICY
IMPLEMENTATION LAGS
implementation lag 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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CHAPTER 15: Macroeconomic Issues and Policy
TIME LAGS REGARDING MONETARY
AND FISCAL POLICY
RESPONSE LAGS
response lag 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.
What is most important is the total lag between the time a problem first occurs and the
time the corrective policies are felt.
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CHAPTER 15: Macroeconomic Issues and Policy
Which lag occurs because of the operation of the
economy, or the time it takes for the multiplier to
reach its full value?
a. The recognition lag.
b. The implementation lag.
c. The response lag.
d. All of the above refer to how the economy adjusts
after a new policy is implemented.
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CHAPTER 15: Macroeconomic Issues and Policy
Which lag occurs because of the operation of the
economy, or the time it takes for the multiplier to
reach its full value?
a. The recognition lag.
b. The implementation lag.
c. The response lag.
d. All of the above refer to how the economy adjusts
after a new policy is implemented.
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CHAPTER 15: Macroeconomic Issues and Policy
TIME LAGS REGARDING MONETARY
AND FISCAL POLICY
Response Lags for Fiscal Policy
Neither individuals nor firms revise their spending plans instantaneously. Until they
can make those revisions, extra government spending does not stimulate extra private
spending.
Response Lags for Monetary Policy
Monetary policy works by changing interest
rates, which then change planned investment.
The response of consumption and investment
to interest rate changes takes time.
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CHAPTER 15: Macroeconomic Issues and Policy
TIME LAGS REGARDING MONETARY
AND FISCAL POLICY
Summary
Stabilization is not easily achieved. It takes time
for policy makers to recognize the existence of
a problem, more time for them to implement a
solution, and yet more time for firms and
households to respond to the stabilization
policies taken.
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CHAPTER 15: Macroeconomic Issues and Policy
Which of the following changes in fiscal policy has a
shorter response lag than the others?
a. An increase in government spending.
b. A cut in personal taxes.
c. A cut in business taxes.
d. All of the above measures have about the same
response lag.
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CHAPTER 15: Macroeconomic Issues and Policy
Which of the following changes in fiscal policy has a
shorter response lag than the others?
a. An increase in government spending.
b. A cut in personal taxes.
c. A cut in business taxes.
d. All of the above measures have about the same
response lag.
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CHAPTER 15: Macroeconomic Issues and Policy
MONETARY POLICY
There are two key points that we must add to
the monetary policy story to make the story
realistic, as we do in this section.
The first point is that in practice the Fed
controls the interest rate rather than the money
supply.
The second point is that the interest rate value
that the Fed chooses depends on the state of
the economy.
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CHAPTER 15: Macroeconomic Issues and Policy
MONETARY POLICY
FIGURE 15.3 Fed Behavior
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CHAPTER 15: Macroeconomic Issues and Policy
MONETARY POLICY
CONTROLLING THE INTEREST RATE
The Fed can pick a money supply value and
accept the interest rate consequences, or it can
pick an interest rate value and accept the
money supply consequences.
The first key point is that in practice the Fed chooses the interest rate value and accepts
the money supply consequences, rather than vice versa.
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CHAPTER 15: Macroeconomic Issues and Policy
How much the interest rate changes when the money
supply changes depends on the shape of the
demand for money curve. More precisely:
a. The steeper the money demand curve, the larger
is the change in the interest rate for a given size
change in government securities.
b. The steeper the money demand curve, the
smaller is the change in the interest rate for a
given size change in government securities.
c. The steeper the money demand curve, the
greater the effectiveness of monetary policy.
d. The steeper the money supply curve, the greater
its control over the demand for money.
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CHAPTER 15: Macroeconomic Issues and Policy
How much the interest rate changes when the money
supply changes depends on the shape of the
demand for money curve. More precisely:
a. The steeper the money demand curve, the
larger is the change in the interest rate for a
given size change in government securities.
b. The steeper the money demand curve, the
smaller is the change in the interest rate for a
given size change in government securities.
c. The steeper the money demand curve, the
greater the effectiveness of monetary policy.
d. The steeper the money supply curve, the greater
its control over the demand for money.
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CHAPTER 15: Macroeconomic Issues and Policy
MONETARY POLICY
THE FED’S RESPONSE TO THE STATE OF THE
ECONOMY
FIGURE 15.4 The Fed’s Response
to Low Output/Low
Inflation
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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CHAPTER 15: Macroeconomic Issues and Policy
MONETARY POLICY
FIGURE 15.5 The Fed’s Response
to High Output/High
Inflation
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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CHAPTER 15: Macroeconomic Issues and Policy
Which of the following statements is entirely correct?
a. The Fed is likely to increase the interest rate
during times of high output and low inflation.
b. The Fed is likely to lower the interest rate during
times of low output and low inflation.
c. The Fed is likely to lower the interest rate during
times of high output and low inflation.
d. The Fed is likely to increase the interest rate
during times of low output and low output and
inflation.
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CHAPTER 15: Macroeconomic Issues and Policy
Which of the following statements is entirely correct?
a. The Fed is likely to increase the interest rate
during times of high output and low inflation.
b. The Fed is likely to lower the interest rate
during times of low output and low inflation.
c. The Fed is likely to lower the interest rate during
times of high output and low inflation.
d. The Fed is likely to increase the interest rate
during times of low output and low output and
inflation.
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CHAPTER 15: Macroeconomic Issues and Policy
MONETARY POLICY
MONETARY POLICY SINCE 1990
TABLE 15.1 Data for Selected Variables for the 1989 I–2005 II Period
DATE
1989 I
II
III
IV
1990 I
II
III
IV
1991 I
II
III
IV
1992 I
II
III
IV
1993 I
II
III
IV
REAL GDP
GROWTH
RATE (%)
4.1
2.7
2.9
1.0
4.7
1.0
0.0
-3.0
-2.0
2.6
1.9
1.9
4.2
3.9
4.0
4.5
0.5
2.0
2.1
5.5
UNEMPL.
RATE (%)
5.2
5.2
5.3
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
7.1
7.1
6.8
6.6
INFL.
RATE (%)
4.6
3.9
2.9
2.8
4.9
4.7
3.6
3.0
4.8
2.6
2.8
2.2
2.5
2.1
1.8
2.1
3.2
2.2
1.7
2.1
3-MONTH
T-BILL RATE
8.5
8.4
7.8
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
AAA
BOND
RATE
9.7
9.5
9.0
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
SURPLUS
AS %
OF /GDP
-2.1
-2.4
-2.5
-2.5
-2.9
-3.0
-2.8
-3.1
-2.7
-3.6
-3.9
-4.1
-4.7
-4.6
-5.0
-4.5
-4.6
-4.1
-4.1
-3.7
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CHAPTER 15: Macroeconomic Issues and Policy
MONETARY POLICY
TABLE 15.1 Data for Selected Variables for the 1989 I–2005 II Period (cont’d.)
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
1999 I
II
III
IV
REAL GDP
GROWTH
RATE (%)
4.1
5.3
2.3
4.8
1.1
0.7
3.3
3.0
2.9
6.7
3.4
4.8
3.1
6.2
5.1
3.0
4.5
2.7
4.7
6.2
3.4
3.4
4.7
7.3
UNEMPL.
RATE (%)
6.6
6.2
6.0
5.6
5.5
5.7
5.7
5.6
5.5
5.5
5.3
5.3
5.2
5.0
4.9
4.7
4.6
4.4
4.5
4.4
4.3
4.2
4.2
4.1
INFL.
RATE (%)
2.4
1.7
2.6
1.9
2.6
1.4
1.9
1.9
2.4
1.6
1.3
2.1
2.6
0.7
1.4
1.3
1.0
0.7
1.5
1.4
1.6
1.4
1.4
1.7
3-MONTH
T-BILL RATE
3.2
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
4.4
4.5
4.7
5.0
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
6.4
6.9
7.3
7.5
SURPLUS
AS %
OF /GDP
-3.4
-2.7
-3.0
-3.0
-2.9
-2.7
-2.7
-2.4
-2.4
-1.8
-1.7
-1.4
-1.1
-0.8
-0.4
-0.4
0.2
0.3
0.7
0.6
0.9
1.1
1.2
1.3
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CHAPTER 15: Macroeconomic Issues and Policy
MONETARY POLICY
TABLE 15.1 Data for Selected Variables for the 1989 I–2005 II Period (cont’d.)
DATE
2000 I
II
III
IV
2001 I
II
III
IV
2002 I
II
III
IV
2003 I
II
III
IV
2004 I
II
III
IV
2005 I
II
REAL GDP
GROWTH
RATE (%)
1.0
6.4
-0.5
2.1
-0.5
1.2
-1.4
1.6
2.7
2.2
2.4
0.2
1.7
3.7
7.2
3.6
4.3
3.5
4.0
3.3
3.8
3.4
UNEMPL.
RATE (%)
4.1
3.9
4.0
3.9
4.2
4.4
4.8
5.5
5.7
5.8
5.7
5.9
5.8
6.1
6.1
5.9
5.6
5.6
5.5
5.4
5.3
5.1
INFL.
RATE (%)
3.6
1.7
2.1
1.6
3.3
3.3
1.5
2.0
1.5
1.4
1.5
2.2
3.1
1.1
1.9
1.8
3.7
3.9
1.3
2.7
3.0
2.6
3-MONTH
T-BILL RATE
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
1.0
0.9
0.9
0.9
1.1
1.5
2.0
2.5
2.9
AAA
BOND
RATE
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
5.3
5.7
5.7
5.5
5.9
5.6
5.5
5.3
5.1
SURPLUS
AS %
OF /GDP
2.2
1.8
1.9
1.7
1.6
1.2
-0.9
0.0
-2.0
-2.3
-2.3
-2.8
-2.8
-3.4
-4.1
-3.6
-3.7
-3.5
-3.5
-3.1
-2.4
-2.1
Note: The inflation rate is the percentage change in the GDP price deflator. SURP denotes the federal government surplus (+) or deficit (-).
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CHAPTER 15: Macroeconomic Issues and Policy
MONETARY POLICY
INFLATION TARGETING
inflation targeting When a monetary
authority chooses its interest rate values
with the aim of keeping the inflation rate
within some specified band over some
specified horizon.
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CHAPTER 15: Macroeconomic Issues and Policy
FISCAL POLICY: DEFICIT TARGETING
Gramm-Rudman-Hollings Act Passed
by the U.S. Congress and signed by
President Reagan in 1986, this law set
out to reduce the federal deficit by $36
billion per year, with a deficit of zero
slated for 1991.
FIGURE 15.6 Deficit Reduction
Targets under
Gramm-RudmanHollings
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CHAPTER 15: Macroeconomic Issues and Policy
FISCAL POLICY: DEFICIT TARGETING
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.
deficit response index (DRI) The
amount by which the deficit changes
with a $1 change in GDP.
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CHAPTER 15: Macroeconomic Issues and Policy
Fill in the blank. When there is a contraction in the
economy, automatic spending cuts to reduce the
deficit would have to be ___________ the
corresponding increase in government
expenditures.
a. exactly equal to
b. greater than
c. less than
d. exactly twice as large as
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CHAPTER 15: Macroeconomic Issues and Policy
Fill in the blank. When there is a contraction in the
economy, automatic spending cuts to reduce the
deficit would have to be ___________ the
corresponding increase in government
expenditures.
a. exactly equal to
b. greater than
c. less than
d. exactly twice as large as
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CHAPTER 15: Macroeconomic Issues and Policy
FISCAL POLICY: DEFICIT TARGETING
Monetary Policy to the Rescue?
A zero multiplier can come about through renewed optimism on the part of households
and firms or through very aggressive behavior on the part of the Fed, but because
neither of these situations is very plausible, the multiplier is likely to be greater than
zero. Thus, it is likely that to lower the deficit by a certain amount, the cut in government
spending must be larger than that amount.
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CHAPTER 15: Macroeconomic Issues and Policy
To prevent the change in output arising from a cut in
government spending, the Fed could try to:
a. decrease the interest rate, but the amount of
intervention would have to be substantial.
b. decrease the interest rate, which would require
only a slight increase in the money supply.
c. increase the interest rate substantially by lowering
the money supply only slightly.
d. shift the AD curve to the left.
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CHAPTER 15: Macroeconomic Issues and Policy
To prevent the change in output arising from a cut in
government spending, the Fed could try to:
a. decrease the interest rate, but the amount of
intervention would have to be substantial.
b. decrease the interest rate, which would require
only a slight increase in the money supply.
c. increase the interest rate substantially by lowering
the money supply only slightly.
d. shift the AD curve to the left.
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CHAPTER 15: Macroeconomic Issues and Policy
FISCAL POLICY: DEFICIT TARGETING
ECONOMIC STABILITY AND DEFICIT REDUCTION
negative demand shock 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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CHAPTER 15: Macroeconomic Issues and Policy
FISCAL POLICY: DEFICIT TARGETING
automatic stabilizers Revenue and
expenditure items in the federal budget
that automatically change with the
economy in such a way as to stabilize
GDP.
automatic destabilizers 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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CHAPTER 15: Macroeconomic Issues and Policy
FISCAL POLICY: DEFICIT TARGETING
FIGURE 15.7 Deficit Targeting as an Automatic Destabilizer
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CHAPTER 15: Macroeconomic Issues and Policy
In a world without deficit targeting, the deficit is:
a. An automatic stabilizer.
b. An automatic destabilizer.
c. A negative demand shock.
d. Maximized.
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CHAPTER 15: Macroeconomic Issues and Policy
In a world without deficit targeting, the deficit is:
a. An automatic stabilizer.
b. An automatic destabilizer.
c. A negative demand shock.
d. Maximized.
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CHAPTER 15: Macroeconomic Issues and Policy
FISCAL POLICY SINCE 1990
FIGURE 15.8 Federal Personal Income Taxes as a Percentage
of Taxable Income, 1990 I–2005 II
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CHAPTER 15: Macroeconomic Issues and Policy
FISCAL POLICY SINCE 1990
FIGURE 15.9 Federal Government Consumption Expenditures
as a Percentage of GDP, 1990 I–2005 II
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CHAPTER 15: Macroeconomic Issues and Policy
FISCAL POLICY SINCE 1990
FIGURE 15.10 Federal Transfer Payments and Grants-in-aid as
a Percentage of GDP, 1990 I–2005 II
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CHAPTER 15: Macroeconomic Issues and Policy
FISCAL POLICY SINCE 1990
FIGURE 15.11 Federal Interest Payments as a Percentage of
GDP, 1990 I–2005 II
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CHAPTER 15: Macroeconomic Issues and Policy
REVIEW TERMS AND CONCEPTS
automatic destabilizer
automatic stabilizer
deficit response index
(DRI)
Gramm-RudmanHollings Act
implementation lag
inflation targeting
negative demand shock
recognition lag
response lag
stabilization policy
time lags
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