Download Chapter Thirty One

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
Negative
Demand Shock
Income Falls
(automatic stabilizers)
Tax revenues
drop; transfers
increase
a. Without Deficit Targeting
Deficit
Increases
Deficit Targeting as an Automatic
Destabilizer
b. With Deficit Targeting
Negative
Demand Shock
Income Falls
Second negative demand shock
reinforces first shock and
worsens the contraction
(automatic destabilizers)
Tax revenues
drop; transfers
increase
Deficit
Increases
Tax rates raised or
spending cut to
reach deficit target
Fed’s Response to Low
Output/Low Inflation
Price
Level, P
AS
AD0
AD1
P1
P0
Y0
Y1
Aggregate Output, Y
Fed’s Response to High
Output/High Inflation
Price
Level, P
AD0
AS
AD1
P0
P1
Y1
Y0 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...
B
A
Path A is less stable-it varies more over timethan path B.
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
 Negative demand
 Automatic stabilizer
shock
 Recognition lag
 Response lag
 Stabilization policy
 Time lag
 Deficit response index
(DRI)
 Gramm-RudmanHollings Bill
 Implementation lag