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Chapter 16:
Theory and Reality
McGraw-Hill/Irwin
Copyright © 2009 by The McGraw-Hill Companies, Inc. All Rights Reserved.
Theory and Reality
o Business cycles persist but are not as bad
as they used to be.
o Economists place responsibility for the
continuing problem of business cycles on
real world “politics”.
16-2
LO-1
Policy Tools
16-3
LO-1
Fiscal Policy
o Fiscal policy is the use of government
taxes and spending to alter
macroeconomic outcomes.
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LO-1
Automatic Stabilizers
o When the economy slows, tax revenues
decline, and government spending
increases automatically.
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LO-1
Automatic Stabilizers
o Automatic stabilizers are federal
expenditure or revenue items that
automatically respond counter-cyclically to
changes in national income.
o Examples include unemployment benefits and
income taxes
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LO-1
Automatic Stabilizers
o When the economy slows, recessions
automatically:
o Reduce tax revenues
o Increase government outlays
o Widen budget deficits
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LO-1
Discretionary Policy
o Fiscal policy refers to deliberate changes
in tax or spending legislation.
o Discretionary policy often has limited
impacts on the economy.
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LO-1
Discretionary Policy
o The federal budget deficit jumped from
$221 billion in fiscal year 1991 to $270
billion in fiscal year 1992.
o The fiscal year (FY) is the 12-month period
used for accounting purposes.
o Most of this increase was due to automatic
stabilizers.
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LO-1
Monetary Policy
o Monetary policy–the use of money and
credit controls to influence
macroeconomic activity.
o The tools of monetary policy include:
o Open-market operations
o Discount-rate changes
o Reserve requirements
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LO-1
Monetary Policy
o The money supply (M1) includes
currency held by the public, plus balances
in transactions accounts.
o The effectiveness of both fiscal and
monetary policy depends on the shape of
the AS curve.
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LO-1
Monetary Policy
o If the AS curve is horizontal, changes in
the money supply affect output only.
o If the AS curve is vertical, changes in the
money supply affect prices only.
o If the AS curve is upward sloping,
changes in the money supply affect both
prices and output.
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LO-1
Rules versus Discretion
o Disagreements about the actual shape of
the AS curve raise questions about how to
conduct monetary policy.
o There are clear risks of error in
discretionary policy.
o There are concerns about the potential
effectiveness of monetary policy.
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LO-4
Rules versus Discretion
o Some economists urge the Fed to play an
active role in adjusting the money supply
to changing economic conditions.
o Others suggest that we would be better
served by fixed rules for money-supply
growth.
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LO-4
Supply-Side Policy
o The shape of the aggregate supply curve
limits the effectiveness of fiscal and
monetary policies.
o Supply-Side Policy–the use of tax rates,
(de)regulation, and other mechanisms to
increase the ability and willingness to
produce goods and services.
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LO-1
Supply-Side Policy
o The goal of a supply-side policy is to shift
the aggregate supply curve to the right.
o The supply-side toolbox is filled with a
variety of tools.
o These include tax cuts designed to
stimulate work effort, saving, and
investment.
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LO-1
Supply-Side Policy
o Deregulation may also reduce production
costs and stimulate investment.
o Expenditures on education, training, and
research expands our capacity to
produce.
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LO-1
Supply-Side Policy
o Immigration policy alters the size and
skills of the labor force and thus affects
aggregate supply as well.
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LO-1
Idealized Uses
o These fiscal, monetary, and supply-side
tools are potentially powerful levers for
controlling the economy.
o In principle, they can cure the excesses of the
business cycle.
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LO-2
Case 1: Recession
o Need to put people to work.
o The GDP gap must be closed:
o The GDP gap is the difference between fullemployment output and the amount of output
demanded at current price levels.
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LO-2
Case 1: Recession: Keynesians
o Emphasize the need to stimulate
aggregate demand with fiscal policy by:
o Cutting taxes
o Boosting government spending
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LO-2
Case 1: Recession: Keynesians
o The resulting stimulus will set off a
multiplier reaction:
o Multiplier–multiple by which an initial change
in aggregate spending will alter total
expenditure after an infinite number of
spending cycles.
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LO-2
Case 1: Recession: Keynesians
o Modern Keynesians acknowledge that
monetary policy might also help if it gives
investment spending a further boost.
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LO-2
Case 1: Recession: Monetarists
o See no point in discretionary policies.
o The aggregate supply curve is vertical at the
natural rate of unemployment
o Changes in fiscal or monetary policy are
ineffective because increases in AD only
cause inflation
o The appropriate response to a recession is
patience.
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LO-2
Case 1: Recession: Supply-Siders
o Believe that policy initiatives should focus
on changing the shape and position of the
aggregate supply curve.
o Improve production incentives
o Cut marginal tax rates on investment and
labor
o Reduce government regulation
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LO-2
Case 2: Inflation: Keynesians
o Need to restrain aggregate demand by:
o Raising taxes
o Cutting government spending
o Relying on the multiplier to cool down the
economy
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LO-2
Case 2: Inflation: Monetarists
o Believe that inflation reflects excessive
money-supply growth.
o Cut the money supply growth
o Convince market participants that cautious
monetary policy will be continued
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LO-2
Case 2: Inflation: Supply-Siders
o Point out that inflation implies both too
much money and not enough goods.
o Expand productive capacity
o Propose more incentives to save
o Cut taxes and regulations, encourage more
immigration, and lower import barriers
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LO-2
Case 3: Stagflation
o Stagflation is the simultaneous
occurrence of substantial unemployment
and inflation.
o There are no simple solutions for
stagflation.
o There is a need to balance the competing
threats of inflation and unemployment
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LO-2
Case 3: Stagflation
o Stagflation may be due to structural
unemployment:
o Structural unemployment–unemployment
caused by a mismatch between the skills (or
location) of job seekers and the requirements
(or location) of available jobs.
16-30
LO-2
Case 3: Stagflation
o There are several possible contributors to
stagflation:
– High tax rates or costly regulation.
– An external shock (such as a natural disaster)
or an abrupt change in world trade (such as
higher oil prices).
– The result is a leftward shift of the aggregate
supply curve.
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LO-2
Fine-Tuning
o Some people believe it is possible to finetune the economy:
o Fine-tuning–adjustments in economic policy
designed to counteract small changes in
economic outcomes; continuous responses
to changing economic conditions.
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LO-2
Fine-Tuning
o Fine-tuning entails continual adjustments
of policy levers.
o Choosing the right target for stimulus and
restraint is the key to fulfilling goals.
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LO-2
The Economic Record
o The economy’s track record does not live
up to these high expectations.
o The economy has had impressive longrun growth and improvement in the
standard of living, but we must also
recognize that our economic history has
experienced periods of recession, high
unemployment, and inflation.
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LO-3
Why Things Don’t Always Work
o We can distinguish four obstacles to
policy success:
o Goal conflicts
o Measurement problems
o Design problems
o Implementation problems
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LO-4
Goal Conflicts
o The Fed is traditionally viewed as the
guardian of price stability and tends to
favor policy restraint.
o The President and Congress favor policy
stimulus.
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LO-4
Goal Conflicts
o Distributional goals may also conflict with
macro objectives.
o Anti-inflationary policies may require
cutbacks in programs for the poor, the elderly,
or needy students.
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LO-4
Goal Conflicts
o Tight-money policies may be viewed as
too great a burden for small businesses.
o All policy decisions entail opportunity
costs.
o This means that we will always be
confronted with trade-offs.
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LO-4
Measurement Problems
o The available information is always dated
and incomplete.
o At best, we know what was happening in
the economy last month or last week.
16-39
LO-4
Forecasts
o In designing policy, policymakers must
depend on economic forecasts, that is,
informed guesses about what the
economy will look like in future periods.
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LO-4
Macro Models
o Those guesses are often based on
complex computer models of how the
economy works.
o Different models and data generate
different policy recommendations.
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LO-4
Design Problems
o We never know for sure how market
participants are going to respond to any
specific actions taken.
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LO-4
Implementation Problems
o To understand fully why things go wrong,
we must also consider the difficulties of
implementing a well-designed (and
credible) policy initiative.
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LO-4
Congressional Deliberations
o The legislative process takes time.
o Even if the right policy is formulated to
solve an emerging economic problem,
there is no assurance that it will be
implemented.
o And if it is implemented, there is no
assurance that it will take effect at the
right time.
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LO-4
Politics versus Economics
o Tax hikes and budget cuts rarely win
votes.
o On the other hand, tax cuts and porkbarrel spending are always popular.
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LO-4
Politics versus Economics
o Savvy politicians tend to stimulate the
economy before elections, then tighten
the fiscal restraints afterward.
o This creates a political business cycle–a
two-year pattern of short-run stops and
starts.
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LO-4
Hands Off or Hands On?
o Consistent fine-tuning of the economy is
not compatible with either our design
capabilities or our decision-making
procedures.
o We have not been able to make
adjustments to completely fulfill our
economic goals.
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LO-5
Hands-Off Policy
o Those who argue to leave the economy
alone say to abandon discretionary
policies altogether because fine-tuning
isn’t really possible.
o Milton Friedman advocated fixed-policy
rules instead of discretionary policies.
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LO-5
Hands-On Policy
o Those who support continued fine-tuning
emphasize that the historical record of
prices, employment, and growth has
improved since active fiscal and monetary
policies were adopted.
o With fixed rules it is impossible to maintain
a steady rate of money supply growth.
16-49
LO-5
Modest Expectations
o Discretionary policies will continue to be
used and continue to fall short of complete
success.
16-50
LO-5
Theory and
Reality
End of Chapter 16
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