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Macroeconomics: Principles, Applications, and Tools
Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall.
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O’Sullivan, Sheffrin, Perez
6/e.
Macroeconomics: Principles, Applications, and Tools
Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall.
2 of 22
O’Sullivan, Sheffrin, Perez
6/e.
6/e.
O’Sullivan,
and ToolsSheffrin,
Applications,
Principles,
Macroeconomics:
6/e. Perez
Perez Sheffrin,
Tools O’Sullivan,
and
Economics: Principles
Macroeconomic Policy
Debates
Economists are often
cautious and try to warn
policymakers that carrying
out effective economic
policy is difficult.
PREPARED BY
FERNANDO QUIJANO, YVONN QUIJANO,
AND XIAO XUAN XU
Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall.
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17.1
SHOULD WE BALANCE THE FEDERAL BUDGET?
Macroeconomics: Principles, Applications, and Tools
O’Sullivan, Sheffrin, Perez
6/e.
C H A P T E R 17
Macroeconomic
Policy Debates
The Budget in Recent Decades
► FIGURE 17.1
Debt as a Percent of GDP,
1791–2007
The nation’s debt/GDP
ratio tends to rise sharply
during wars because more
spending is needed to
finance them. However, the
ratio also can rise during
peacetime, as it did during
the Reagan presidency in
the 1980s.
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17.1
SHOULD WE BALANCE THE FEDERAL BUDGET?
Macroeconomics: Principles, Applications, and Tools
O’Sullivan, Sheffrin, Perez
6/e.
C H A P T E R 17
Macroeconomic
Policy Debates
The Budget and Social Security
Federal budget figures include revenue and expenditures from the Social
Security system. Over the next decade, the Social Security portion of the
budget is expected to run a surplus because of the huge number of baby
boomers (those born between 1946 and 1964) currently paying taxes into the
system.
That surplus won’t last forever, though. Some economists argue that Social
Security funds should not be included in federal budget figures because the
money will be needed to make future Social Security payments to these baby
boomers. Over the longer horizon, the surpluses in the Social Security
account will disappear and turn to deficits. As our society grows older,
spending on both Social Security and Medicare will increase. That increase in
spending is causing the CBO to predict emerging federal deficits and sharp
increases in the debt/GDP ratio to levels comparable to those of World War II,
unless taxes are raised and/or spending is cut significantly.
Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall.
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17.1
SHOULD WE BALANCE THE FEDERAL BUDGET?
Macroeconomics: Principles, Applications, and Tools
O’Sullivan, Sheffrin, Perez
6/e.
C H A P T E R 17
Macroeconomic
Policy Debates
Five Debates About Deficits
DEBATE 1: DO DEFICITS LEAD TO INFLATION?
government deficit = new borrowing from the public + new money created
● monetizing the deficit
Purchases by a central bank of newly
issued government bonds.
Large, stable countries like the United Kingdom, the United States,
and Japan don’t monetize much of their debt because they are able
to borrow from the public. In these countries, deficits do not lead
inevitably to inflation.
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17.1
SHOULD WE BALANCE THE FEDERAL BUDGET?
Macroeconomics: Principles, Applications, and Tools
O’Sullivan, Sheffrin, Perez
6/e.
C H A P T E R 17
Macroeconomic
Policy Debates
Five Debates About Deficits
DEBATE 2: IS GOVERNMENT DEBT A BURDEN ON
FUTURE GENERATIONS?
The result of government deficits is that less savings are available to
firms for investment.
P R I N C I P L E O F O P P O RT U N I T Y C O S T
The opportunity cost of something is what you sacrifice to get it.
● Ricardian equivalence
The proposition that it does not matter
whether government expenditure is
financed by taxes or debt.
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17.1
SHOULD WE BALANCE THE FEDERAL BUDGET?
Macroeconomics: Principles, Applications, and Tools
O’Sullivan, Sheffrin, Perez
6/e.
C H A P T E R 17
Macroeconomic
Policy Debates
Five Debates About Deficits
DEBATE 2: IS GOVERNMENT DEBT A BURDEN ON
FUTURE GENERATIONS?
► FIGURE 17.2
International Comparisons of
Government Debt as
Percentage of GDP, 2005
Among developed countries,
the United States has a
relatively small percentage of
debt to GDP. Japan has the
highest percentage of debt of
the countries depicted.
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17.1
SHOULD WE BALANCE THE FEDERAL BUDGET?
O’Sullivan, Sheffrin, Perez
Five Debates About Deficits
Macroeconomics: Principles, Applications, and Tools
6/e.
C H A P T E R 17
Macroeconomic
Policy Debates
Therefore, financing government expenditures through deficits, rather than through
higher taxes, will inevitably lead to higher government spending and bigger
government.
DEBATE 3: HOW DO DEFICITS AFFECT THE SIZE
OF GOVERNMENT?
Nobel Laureate James Buchanan has argued that people are less aware of
government deficits than of the taxes they’re forced to pay.
Although this argument may seem plausible, it presents two problems:
First, in recent U.S. history, spending by state and local governments has
grown much faster than federal spending. However, state and local
governments face many more restrictions when it comes to borrowing money
than the federal government faces.
Second, if politicians trying to get reelected really prefer higher government
spending and deficits to higher taxes and surpluses, why did the federal
government run surpluses in the late 1990s?
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Macroeconomics: Principles, Applications, and Tools
O’Sullivan, Sheffrin, Perez
6/e.
C H A P T E R 17
Macroeconomic
Policy Debates
APPLICATION
1
NEW METHODS TO MEASURE THE LONG-TERM
FISCAL IMBALANCES FOR THE UNITED STATES
APPLYING THE CONCEPTS #1: What are the long-term
fiscal imbalances for the United States?
Even though federal budget-deficit projections have increased in recent
years, they still don’t accurately portray the long-run fiscal problems
facing the United States.
As the population ages, life expectancies increase, and health-care
costs continue to grow, expenditures on Social Security and Medicare
are expected to increase significantly, too. Over time, there will be an
escalating gap between revenues and expenditures, which will have to
be met by outright borrowing.
Economists Jagadeesh Gokhale of the Cato Institute and Kent Smetters
of the University of Pennsylvania have developed a method for
estimating the present value of the gap between the government’s
revenues and expenditures and adding it to the current national debt.
The “fiscal imbalance” is approximately $44 trillion, or four times GDP.
Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall.
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17.1
SHOULD WE BALANCE THE FEDERAL BUDGET?
Macroeconomics: Principles, Applications, and Tools
O’Sullivan, Sheffrin, Perez
6/e.
C H A P T E R 17
Macroeconomic
Policy Debates
Five Debates About Deficits
DEBATE 4: CAN DEFICITS BE GOOD FOR AN
ECONOMY?
The government may deliberately run a deficit to pull the economy out
of a recession. The deficit the government creates puts additional
income into the hands of the public. With more money, people don’t
have to drastically cut their consumption spending. Because total
spending in the economy does not fall as much, the severity of the
recession is lessened.
Deficits can also play a role in tax smoothing. By running deficits and
only gradually raising taxes later to service the debt, we avoid creating
excess distortions in the economy.
Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall.
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17.1
SHOULD WE BALANCE THE FEDERAL BUDGET?
Macroeconomics: Principles, Applications, and Tools
O’Sullivan, Sheffrin, Perez
6/e.
C H A P T E R 17
Macroeconomic
Policy Debates
Five Debates About Deficits
DEBATE 5: WOULD A BALANCED-BUDGET
AMENDMENT REALLY WORK?
Proponents of the balanced-budget amendment say it will finally exert
discipline on the federal government, preventing large deficits in
peacetime, such as those that occurred in the 1980s.
Critics of a balanced-budget amendment point to many different
problems, such as the following:
• A balanced budget may not allow enough flexibility, or room, for the
government to effectively deal with recessions.
• The Constitution is not the right mechanism to try to enforce
complicated budget rules.
• Congress could devise special budgets to get around the
requirement.
• Congress could also find nonbudgetary ways to carry out the policies
that it desires.
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17.2
SHOULD THE FED TARGET INFLATION?
Macroeconomics: Principles, Applications, and Tools
O’Sullivan, Sheffrin, Perez
6/e.
C H A P T E R 17
Macroeconomic
Policy Debates
Two Debates About Inflation Targeting
DEBATE 1: SHOULD THE FED FOCUS ON ONLY INFLATION?
We have learned that in the long run, monetary policy can influence
only the level of prices, not the level of employment. Proponents of
inflation targeting argue that the Fed should have only one primary goal:
controlling inflation.
Before he took over as chairman of the Federal Reserve in 2006, Ben
Bernanke was an advocate for inflation targeting. Bernanke called
inflation targeting a policy of constrained discretion. Under inflation
targeting, the Fed could take actions to offset shocks to real output or to
the financial system, but it had to keep its long-run inflation targets in
clear view.
However, many economists disagree with the idea of inflation targeting
because they strongly object to the Fed concentrating solely on
controlling inflation. Economists also debate the level for an inflation
target. It is very difficult to measure changes in prices accurately when
there is a great deal of technological change occurring in the economy.
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Macroeconomics: Principles, Applications, and Tools
O’Sullivan, Sheffrin, Perez
6/e.
C H A P T E R 17
Macroeconomic
Policy Debates
APPLICATION
2
SHOULD CENTRAL BANKS TARGET ASSET PRICES?
APPLYING THE CONCEPTS #2: Should central banks pay
special attention to asset prices—such as stock prices, housing
prices, or exchange rates—as they determine monetary policy?
Some economists believe central banks should pay much more
attention to the prices of assets—stock prices or housing prices—as
they formulate monetary policy.
The recession beginning in December 2007 and the related problems
in the financial markets were due to a collapse in the housing market,
brought on by a correction to unsustainable increases in housing
prices.
The conventional wisdom of central bankers is that information about
asset prices should be considered only as it affects forecasts of
inflation or output. In particular, interest rates should not be raised to
“prick” any speculative bubbles.
Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall.
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17.2
SHOULD THE FED TARGET INFLATION?
Macroeconomics: Principles, Applications, and Tools
O’Sullivan, Sheffrin, Perez
6/e.
C H A P T E R 17
Macroeconomic
Policy Debates
Two Debates About Inflation Targeting
DEBATE 2: IF THERE WERE AN INFLATION TARGET, WHO
WOULD SET IT?
In the United Kingdom, which adopted targeting in 1992, the
elected government decides on the inflation target for the central
bank. In other countries, the central bank has more influence in
setting the inflation target.
Under current law, the Fed chairman reports regularly to
Congress, but the Fed has considerable power to use monetary
policy to stabilize output as well as to fight inflation as it pleases.
Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall.
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17.3
SHOULD WE TAX CONSUMPTION
RATHER THAN INCOME?
Macroeconomics: Principles, Applications, and Tools
O’Sullivan, Sheffrin, Perez
6/e.
C H A P T E R 17
Macroeconomic
Policy Debates
● consumption taxes
Taxes based on the consumption, not the
income, of individuals.
Two Debates About Consumption Taxation
DEBATE 1: WILL CONSUMPTION TAXES LEAD
TO MORE SAVINGS?
There is no question that taxing consumption instead of savings
creates an incentive to save. However, there’s no guarantee the
incentive will actually result in more money saved in the economy.
The tax system imposed on corporations in the United States also
creates disincentives to save and invest. Some economists have
argued that the corporate taxes lead to less-efficient investment
because they result in capital flowing into other sectors of the
economy (into real estate, for example) that do not suffer from
double taxation.
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17.3
SHOULD WE TAX CONSUMPTION
RATHER THAN INCOME?
O’Sullivan, Sheffrin, Perez
Two Debates About Consumption Taxation
Macroeconomics: Principles, Applications, and Tools
6/e.
C H A P T E R 17
Macroeconomic
Policy Debates
In practice, moving to a consumption-tax system could have a
major impact on the distribution of income in the economy.
DEBATE 2: ARE CONSUMPTION TAXES FAIR?
● capital gains
Profits investors earn when they sell stocks,
bonds, real estate, or other assets.
Suppose we simply exempted the returns from savings from the
income tax. This exception would clearly favor wealthy and highincome individuals who save the most and earn a lot of income in
interest, dividends, rents, and capital gains.
Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall.
17 of 22
17.3
SHOULD WE TAX CONSUMPTION
RATHER THAN INCOME?
Macroeconomics: Principles, Applications, and Tools
O’Sullivan, Sheffrin, Perez
6/e.
C H A P T E R 17
Macroeconomic
Policy Debates
Two Debates About Consumption Taxation
DEBATE 2: ARE CONSUMPTION TAXES FAIR?
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Macroeconomics: Principles, Applications, and Tools
O’Sullivan, Sheffrin, Perez
6/e.
C H A P T E R 17
Macroeconomic
Policy Debates
APPLICATION
3
TWO DIFFERENT DIRECTIONS FOR TAX REFORM
APPLYING THE CONCEPTS #3: What did the most recent
federal tax reform commission suggest as the most
appropriate directions for tax reform?
In 2005, the President’s Advisory Panel on Federal Tax Reform published its
report “Simple, Fair and Pro-Growth.” The panel proposed two different
proposals for consideration, one based on income tax principles and the other
based on consumption tax principles.
Both plans had several features in common. They lowered tax rates by
broadening the tax base. For example, deductions were eliminated for state
and local taxes and limited for health insurance premiums. Other aspects of
tax systems, such as programs for savings and childcare, were simplified. The
proposal also eliminated the alternative minimum tax, a provision originally
designed to ensure the very wealthy would pay taxes but which now affects
upper-middle class taxpayers.
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Macroeconomics: Principles, Applications, and Tools
O’Sullivan, Sheffrin, Perez
6/e.
C H A P T E R 17
Macroeconomic
Policy Debates
APPLICATION
3
TWO DIFFERENT DIRECTIONS FOR TAX REFORM?
APPLYING THE CONCEPTS #3: What did the most recent
federal tax reform commission suggest as the most
plausible directions for tax reform?
In 2005, the President’s Advisory Panel on Federal Tax Reform
published its report “Simple, Fair and Pro-Growth.” The panel
proposed two different proposals for consideration, one based on
income tax principles and the other based on consumption tax
principles.
The plans were not enacted into legislation but will be the source of
many excellent tax reform ideas for the future.
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KEY TERMS
Macroeconomics: Principles, Applications, and Tools
O’Sullivan, Sheffrin, Perez
6/e.
C H A P T E R 17
Macroeconomic
Policy Debates
capital gains
monetizing the deficit
consumption taxes
Ricardian equivalence
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