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ECONOMICS 5e
Michael Parkin
CHAPTER
18
Macroeconomic Policy
Challenges
Chapter 35 in Economics
Learning Objectives
• Describe the goals of macroeconomic
policy
• Describe the main features of fiscal policy
and monetary policy since 1960
• Explain how fiscal policy and monetary
policy influence long-term growth
Copyright © 2000 Addison Wesley Longman, Inc.
Slide 18-2
Learning Objectives (cont.)
• Evaluate fixed-rule and feedback-rule
policies to stabilize the business cycle
• Explain how fiscal policy influences the
natural rate of unemployment
• Explain why lowering inflation usually
brings recession
Copyright © 2000 Addison Wesley Longman, Inc.
Slide 18-3
Learning Objectives
• Describe the goals of macroeconomic
policy
• Describe the main features of fiscal policy
and monetary policy since 1960
• Explain how fiscal policy and monetary
policy influence long-term growth
Copyright © 2000 Addison Wesley Longman, Inc.
Slide 18-4
Policy Goals
The four main domestic macroeconomic
goals are:
1) Achieve the highest sustainable rate of
potential GDP growth.
2) Smooth our avoidable business cycle
fluctuations.
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Slide 18-5
Policy Goals
The four main domestic macroeconomic
goals are: (cont.)
3) Maintain low unemployment
4) Maintain low inflation
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Slide 18-6
Policy Goals
Potential GDP Growth
Sustained growth in real GDP can improve
economic well being tremendously
• Two percent growth rate means that
production doubles every 36 years
• Four percent takes 18 years
• Six percent takes 12 years
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Slide 18-7
Policy Goals
Potential GDP Growth
The limitations to sustainable growth are:
• The availability of natural resources.
• Environmental considerations.
• The willingness of people to save and invest.
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Slide 18-8
Policy Goals
The Business Cycle
• When potential GDP exceeds real GDP, output
is lost.
• When real GDP exceeds potential GDP, a
bottleneck may arise.
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Slide 18-9
Policy Goals
Unemployment
• Unemployed labor leads to lost output that
cannot be recovered.
• The accumulation of human capital slows.
• Social and psychological problems arise.
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Slide 18-10
Policy Goals
Unemployment
Extremely low rates of unemployment lead to
shortages of labor.
• New and expanding businesses face
difficulties in hiring.
• Production problems may arise.
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Slide 18-11
Policy Goals
Inflation
Stable inflation rates remove uncertainty
• Borrowers, lenders, employers, and employees
benefit
Some inflation is desirable
• Results of quality improvements
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Slide 18-12
Policy Goals
The Two Core Policy Indicators: Real GDP
Growth and Inflation
Real GDP growth is related to:
• Unemployment
• The business cycle
Therefore, maintaining real GDP growth is
related to two of our macroeconomic goals.
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Slide 18-13
Policy Goals
The Two Core Policy Indicators: Real GDP
Growth and Inflation
Real GDP growth and inflation are somewhat
related.
• However, they are largely independent.
So real GDP growth and inflation are the two
core policy targets.
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Slide 18-14
Macroeconomic Performance:
Real GDP and Inflation
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Slide 18-15
Learning Objectives
• Describe the goals of macroeconomic
policy
• Describe the main features of fiscal policy
and monetary policy since 1960
• Explain how fiscal policy and monetary
policy influence long-term growth
Copyright © 2000 Addison Wesley Longman, Inc.
Slide 18-16
Policy Tools and Performance
Recall:
Fiscal policy is the use of the fiscal 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.
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Slide 18-17
Policy Tools and Performance
Fiscal policy since 1960
• Fiscal policy was mildly expansionary during
the Kennedy years.
• Fiscal policy was strongly expansionary during
the later Johnson years when the Vietnam War
buildup occurred.
• During Nixon’s presidency, spending growth
was kept moderate.
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Slide 18-18
Policy Tools and Performance
Fiscal policy since 1960 (cont.)
• Under the pressure of the first OPEC oil shock,
spending soared during Ford’s presidency.
• The Carter years began with spending cuts, but
then spending climbed to a new high.
• During the first Reagan term, spending
continued to increase at first but it was later
held in check.
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Slide 18-19
Policy Tools and Performance
Fiscal policy since 1960 (cont.)
• During the second Reagan term, spending was
cut.
• During the Bush years, government purchases
took an increased percentage of GDP, but taxes
took a smaller percentage.
• A tax bill in 1993 increased taxes, so revenues
increased during the Clinton presidency.
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Slide 18-20
Policy Tools and Performance
Monetary policy since 1960
• During the 1960s, the M2 growth rate averaged
7 percent a year and ranged between a low of 4
percent in 1969 and a high of 9 percent in 1967.
• It increased to average 10 percent a year
between 1970 and 1983 and hit a peak of 14
percent in 1976.
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Slide 18-21
Policy Tools and Performance
Monetary policy since 1960 (cont.)
• M2 growth fell steadily from 12 percent in
1983 to less than 1 percent in 1994, but then
increased in 1995.
• The federal funds rate trended upward from
1960 through 1981 and then trended downward.
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Slide 18-22
Policy Tools and Performance
Monetary policy since 1960 (cont.)
• The federal funds rate fell through 1975 and
then increased and remained high through most
of the 1980s.
• The federal funds rate fell during the early
1990s, but then began to rise again through
1995.
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Slide 18-23
The Fiscal Policy Record:
A Summary
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Slide 18-24
The Monetary Policy Record:
A Summary
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Slide 18-25
Learning Objectives
• Describe the goals of macroeconomic
policy
• Describe the main features of fiscal policy
and monetary policy since 1960
• Explain how fiscal policy and monetary
policy influence long-term growth
Copyright © 2000 Addison Wesley Longman, Inc.
Slide 18-26
Long-Term Growth Policy
Monetary policy contributes to long-term
growth by keeping the inflation rate low.
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Slide 18-27
Long-Term Growth Policy
Fiscal policy contributes to long-term growth
by influencing private decisions.
These are:
• National saving
• Investment in human capital
• Investment in new technologies
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Slide 18-28
Long-Term Growth Policy
National Saving
National saving is private saving plus
government saving.
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Slide 18-29
Long-Term Growth Policy
National Saving
• Increased government saving results from
reducing or eliminating the deficit.
• Increased private saving would result from:
1) Increase the after-tax rate of return on saving.
2) Cut taxes on interest income and capital
gains.
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Slide 18-30
Saving Rates in the
United States: 1960–1999
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Slide 18-31
Long-Term Growth Policy
Investment in Human Capital
A person is likely to earn a greater income:
1) The more years the person remains in school.
2) The greater the number of years of work
experience.
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Slide 18-32
Long-Term Growth Policy
The government’s policies regarding
investment in human capital are a result of:
1) Social returns exceeding private returns.
2) Individuals acquiring too little human
capital.
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Slide 18-33
Long-Term Growth Policy
Governments attempt to increase human capital
by:
1) Subsidizing schooling.
2) Helping set standards of achievement.
3) Setting examples as an employer.
4) Encouraging best-practice training programs.
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Slide 18-34
Long-Term Growth Policy
Investment in New Technologies
New technology development is special because:
1) Diminishing returns appear not to be a problem.
2) The benefits influence all parts of the economy.
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Slide 18-35
Long-Term Growth Policy
Governments can encourage technological
development by:
1) Providing tax incentives for research and
development.
2) Encouraging business research with tax
credits.
Copyright © 2000 Addison Wesley Longman, Inc.
Slide 18-36
Learning Objectives (cont.)
• Evaluate fixed-rule and feedback-rule
policies to stabilize the business cycle
• Explain how fiscal policy influences the
natural rate of unemployment
Copyright © 2000 Addison Wesley Longman, Inc.
Slide 18-37
Business Cycle and
Unemployment Policy
The three categories of fiscal and monetary
policies are:
1) Fixed-rule policies
2) Feedback-rule policies
3) Discretionary policies
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Slide 18-38
Business Cycle and
Unemployment Policy
Fixed-Rule Policies
A fixed rule policy specifies an action to be
pursued independently of the state of the
economy.
• Examples: constant money supply growth rate,
balancing the budget
Copyright © 2000 Addison Wesley Longman, Inc.
Slide 18-39
Business Cycle and
Unemployment Policy
Feedback-Rule Policies
A feedback-rule policy specifies how policy
actions respond to changes in the state of the
economy.
• Examples: Fed’s interest rate policies, automatic
changes in tax revenues and
transfer payments
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Slide 18-40
Business Cycle and
Unemployment Policy
Discretionary Policies
A discretionary policy responds to the state of
the economy in a possibly unique way that uses
all the information available, including lessons
learned from passed experiences.
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Slide 18-41
Business Cycle and
Unemployment Policy
Stabilizing Aggregate Demand Shocks
Suppose there is an unexpected decrease in
aggregate demand.
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Slide 18-42
Price level (GDP deflator, 1992 = 100)
A Decrease in Aggregate Demand
LAS
140
130
SAS
120
A decrease in
aggregate
demand brings
recession
110
105
100
AD0
0
6.5
7.0
AD1
7.5
Real GDP (trillions of 1992 dollars)
Copyright © 2000 Addison Wesley Longman, Inc.
Slide 18-43
Business Cycle and
Unemployment Policy
Stabilizing Aggregate Demand Shocks
The economy responds differently depending
which policy is used to stimulate aggregate
demand.
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Slide 18-44
Business Cycle and
Unemployment Policy
Stabilizing Aggregate Demand Shocks
Fixed Rule: Monetarism
Monetarists are economists who believe that
fluctuations in the money stock are the main
source of economic fluctuations.
The effect of a policy depends on whether the
chance in aggregate demand is temporary or
permanent.
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Slide 18-45
Business Cycle and
Unemployment Policy
Stabilizing Aggregate Demand Shocks
Feedback Rule: Keynesian Activism
A Keynesian activist is an economist who
believes that fluctuations in aggregate
demand combined with sticky wages (and/or
stick prices) are the main source of economic
fluctuations.
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Slide 18-46
Business Cycle and
Unemployment Policy
The Two Rules Compared
Fixed-Rule
The economy goes into a recession and stays
there until aggregate demand increases on its
own.
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Slide 18-47
Business Cycle and
Unemployment Policy
The Two Rules Compared
Feedback-Rule
The economy is pulled out of its recession
by the policy and held there by a gradual
policy-induced decrease in aggregate
demand.
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Slide 18-48
Price level (GDP deflator, 1992 = 100)
Two Stabilization Policies:
Aggregate Demand Shock
140
LAS
130
SAS
120
Fixed Rule: Temporary
Demand Shock
110
105
100
AD0
AD1
0
5.5 6.0 6.5 7.0 7.5 8.0
Real GDP (trillions of 1992 dollars)
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Slide 18-49
Price level (GDP deflator, 1992 = 100)
Two Stabilization Policies:
Aggregate Demand Shock
140
LAS
130
SAS0
120
110
105
100
95
SAS1
Fixed Rule: Permanent
Demand Shock
AD0
AD1
0
5.5 6.0 6.5 7.0 7.5 8.0
Real GDP (trillions of 1992 dollars)
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Slide 18-50
Price level (GDP deflator, 1992 = 100)
Two Stabilization Policies:
Aggregate Demand Shock
140
LAS
130
SAS
120
Feedback Rule
110
105
100
AD0
AD1
0
5.5 6.0 6.5 7.0 7.5 8.0
Real GDP (trillions of 1992 dollars)
Copyright © 2000 Addison Wesley Longman, Inc.
Slide 18-51
Business Cycle and
Unemployment Policy
Some economists are in favor of a fixedrule policy because:
1) Potential GDP is not known.
2) Policy lags are longer than the forecast
horizon.
3) Feedback-rule policies are less
predictable than fixed-rule policies.
Copyright © 2000 Addison Wesley Longman, Inc.
Slide 18-52
Business Cycle and
Unemployment Policy
Stabilizing Aggregate Supply Shocks
• Real business cycle theorists believe that
fluctuations in real GDP are caused by
fluctuations in productivity growth.
• Since wages are flexible unemployment is
always at its natural rate.
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Slide 18-53
Business Cycle and
Unemployment Policy
Stabilizing Aggregate Supply Shocks (Cont.)
Under these conditions the feedback-rule policy
will make price level fluctuations more severe
than they otherwise would be.
Copyright © 2000 Addison Wesley Longman, Inc.
Slide 18-54
Price level (GDP deflator, 1992 = 100)
Responding to a
Productivity Growth Slowdown
140
Feedback-rule LAS1
outcome
LAS0
130
120
110
100
0
Fixed-rule
outcome
Productivity
slowdown
lowers
potential GDP
AD0
5.5 6.0 6.5 7.0 7.5 8.0
Real GDP (trillions of 1992 dollars)
Copyright © 2000 Addison Wesley Longman, Inc.
Slide 18-55
Business Cycle and
Unemployment Policy
Nominal GDP Targeting
Nominal GDP targeting is an attempt to keep
the growth rate on nominal GDP steady.
• Recognizes the fixed rule
• Disregards the monetarist fixed rule
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Slide 18-56
Business Cycle and
Unemployment Policy
Nominal GDP Targeting (cont.)
• It uses feedback rules for fiscal and monetary
policy to hit a fixed nominal GDP growth
target.
• Its intention is to keep nominal GDP growth
steady.
• This may prevent excessive inflation and severe
recession.
Copyright © 2000 Addison Wesley Longman, Inc.
Slide 18-57
Learning Objectives (cont.)
• Evaluate fixed-rule and feedback-rule
policies to stabilize the business cycle
• Explain how fiscal policy influences the
natural rate of unemployment
Copyright © 2000 Addison Wesley Longman, Inc.
Slide 18-58
Business Cycle and
Unemployment Policy
Natural Rate Policies
Natural rate policies are designed to decrease
the natural rate of unemployment.
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Slide 18-59
Business Cycle and
Unemployment Policy
There are several ways to possibly lower the
natural rate of unemployment. They are:
1) Reduce unemployment benefits.
2) Shorten the period the benefits are paid.
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Slide 18-60
Business Cycle and
Unemployment Policy
There are several ways to attempt to lower
the natural rate of unemployment. (cont.)
3) Restrict the benefits to those in training
programs.
4) Lower the minimum real wage rate.
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Slide 18-61
Learning Objectives (cont.)
Evaluate fixed-rule and feedback rule
policies to contain inflation and explain why
lowering inflation usually brings recession
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Slide 18-62
Inflation Policy
Avoiding Cost-Push Inflation
Cost shocks become inflationary if
accompanied by increases in the money supply.
• Possible using a monetary policy feedback
rule.
• Not possible using a monetary fixed-rule
policy.
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Slide 18-63
Price level (GDP deflator, 1992 = 100)
Responding to an
OPEC Oil Price Increase
130
SAS1
LAS
140
Stagflation
SAS0
Fixed Rule
120
110
100
AD0
0
6.0 6.5 7.0 7.5 8.0 8.5
Real GDP (trillions of 1992 dollars)
Copyright © 2000 Addison Wesley Longman, Inc.
Slide 18-64
Price level (GDP deflator, 1992 = 100)
Responding to an
OPEC Oil Price Increase
140
SAS1
LAS
SAS0
130
125
120
Feedback Rule
110
Cost-push
inflation
100
AD0
0
AD1
6.0 6.5 7.0 7.5 8.0 8.5
Real GDP (trillions of 1992 dollars)
Copyright © 2000 Addison Wesley Longman, Inc.
Slide 18-65
Inflation Policy
Slowing Inflation
The two scenarios we will investigate are:
1) A surprise inflation reduction
2) A credible announced inflation reduction
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Slide 18-66
Price level (GDP deflator, 1992 = 100)
Lowering Inflation
Unexpected
decrease in AD
SAS1
LAS
Unanticipated decrease
in AD lowers inflation
121.0
118.8
SAS2
SAS0
115.5
Aggregate demand and
Aggregate Supply
110.0
AD1
AD2
0
AD0
6.5 7.0
Real GDP (trillions of 1992 dollars)
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Slide 18-67
Lowering Inflation
Inflation (percent per year)
LRPC
Unexpected fall
in inflation brings
recession
10
8
Anticipated fall
in inflation
maintains full
employment
5
SRPC0
SRPC1
0
6
9
Unemployment (percentage of labor force)
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Slide 18-68
Inflation Policy
Inflation Reduction in Practice
• People look at the Fed’s past actions to form
their expectations.
• The Fed has developed a reputation of being
anti-inflationary.
• This is valuable because it helps the Fed
contain inflation.
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Slide 18-69
Inflation Policy
A Truly Independent Fed
To strengthen the Fed’s reputation as the
guardian of price stability is to make it more
independent from government.
• Similar to German and Swiss central banks.
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Slide 18-70
Inflation Policy
A Truly Independent Fed (cont.)
Research has shown a more independent central
bank has delivered a lower average inflation
rate without lowering GDP growth or
increasing unemployment.
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Slide 18-71
The End
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Slide 18-72