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CHAPTER 30 Policy Timing, Deficit Targeting, and Stock Market Effects
PowerPoint Lectures for
Principles of Economics,
9e
; ;
By
Karl E. Case,
Ray C. Fair &
Sharon M. Oster
© 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster
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CHAPTER 30 Policy Timing, Deficit Targeting, and Stock Market Effects
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CHAPTER 30 Policy Timing, Deficit Targeting, and Stock Market Effects
PART VI FURTHER MACROECONOMICS ISSUES
Policy Timing, Deficit
Targeting, and Stock
Market Effects
30
CHAPTER OUTLINE
Time Lags Regarding Monetary and
Fiscal Policy
Stabilization
Recognition Lags
Implementation Lags
Response Lags
Fiscal Policy: Deficit Targeting
The Effects of Spending Cuts on the Deficit
Economic Stability and Deficit Reduction
Summary
The Stock Market and the Economy
Stocks and Bonds
Determining the price of a Stock
The Stock Market Since 1948
Stock Market Effects on the Economy
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CHAPTER 30 Policy Timing, Deficit Targeting, and Stock Market Effects
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.
A stabilization policy can be either monetary
or fiscal policy
One of the main problems economic
policymakers face is time lags.
Time lags are delays in the economy’s
response to stabilization policies.
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CHAPTER 30 Policy Timing, Deficit Targeting, and Stock Market Effects
Time Lags Regarding Monetary and Fiscal Policy
 FIGURE 30.1 Two Possible Time Paths for GDP
Path A is less stable—it varies more over time—than path B.
Other things being equal, society prefers path B to path A.
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Time Lags Regarding Monetary and Fiscal Policy
CHAPTER 30 Policy Timing, Deficit Targeting, and Stock Market Effects
Stabilization
 FIGURE 30.2 Possible Stabilization Timing Problems
Attempts to stabilize the economy can prove destabilizing because of time
lags. An expansionary policy that should have begun to take effect at point
A does not actually begin to have an impact until point D, when the
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CHAPTER 30 Policy Timing, Deficit Targeting, and Stock Market Effects
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.
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CHAPTER 30 Policy Timing, Deficit Targeting, and Stock Market Effects
Time Lags Regarding Monetary and Fiscal Policy
Recognition Lags
1. The recognition lag is the time it takes for policy
makers to recognize the existence of a boom or a
slump.
2. National income data is available only once a
quarter. In addition, there are different estimates
of each quarter’s economic performance.
a. The preliminary estimate is released about one
month after the end of the quarter.
b. The revised estimate is released about two
months after the end of the quarter..
d. Even the final estimate is subject to future
revisions as more data becomes available.
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CHAPTER 30 Policy Timing, Deficit Targeting, and Stock Market Effects
Implementation Lags
The implementation lag is 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.
Fiscal policy takes some time to start.. A majority of
each house plus the president must agree there is a
problem and then agree on what should be done
about it.
Monetary policy is decided by the 12 voting members of
the Federal Open Market Committee. Since this
group is well-trained and experienced in economics,
banking, and finance, they will usually reach an
agreement quickly.
For all these reasons, the implementation lag for
monetary policy is generally much shorter than for
fiscal policy.
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CHAPTER 30 Policy Timing, Deficit Targeting, and Stock Market Effects
Response Lags
The response lag is 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.
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CHAPTER 30 Policy Timing, Deficit Targeting, and Stock Market Effects
Response Lags for Fiscal Policy
The easiest way to understand response lags for fiscal policy
is to simply think about the multiplier process.
The multiplier exists because one group’s spending is another
group’s income. Increases in income are not spent
immediately because the timing of income and spending are
different.
It takes about a year for a change in fiscal policy to have its
full effect on the economy.
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CHAPTER 30 Policy Timing, Deficit Targeting, and Stock Market Effects
Response Lags for Monetary Policy
Changes in monetary policy change interest rates.
The change in interest rates causes changes in
planned investment and consumption spending.
It takes quite a while for planned investment to
respond to interest rate changes.
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Time Lags Regarding Monetary and Fiscal Policy
CHAPTER 30 Policy Timing, Deficit Targeting, and Stock Market Effects
Response Lags
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.
It takes about two years for a change in
monetary policy to have its full effect on
the economy.
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CHAPTER 30 Policy Timing, Deficit Targeting, and Stock Market Effects
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 30.3 Deficit
Reduction Targets under
Gramm-Rudman-Hollings
The GRH legislation, passed
in 1986, set out to lower the
federal deficit by $36 billion
per year. If the plan had
worked, a zero deficit would
have been achieved by
1991.
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Fiscal Policy: Deficit Targeting
CHAPTER 30 Policy Timing, Deficit Targeting, and Stock Market Effects
The Effects of Spending Cuts on the Deficit
To estimate the response of the deficit to changes in
government spending, we need to decide how much a $1
change in government spending will change GDP and
then see what happens to the deficit when GDP changes.
The deficit response index (DRI) is the amount by which
the deficit changes with a $1 change in GDP.
The deficit does not fall dollar for dollar with a decrease in
government spending; it will fall by less. The reason, of
course, is that the reduction in G will cause income to fall,
reducing tax revenue.
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CHAPTER 30 Policy Timing, Deficit Targeting, and Stock Market Effects
Suppose we want to reduce the deficit by $20 billion.
A $1 billion reduction in government spending will reduce
income by about $1.40 billion (with a multiplier of 1.4).
With a deficit response index of -0.22 (based on U.S. data) the
deficit rises by $0.22 billion for every $1 billion decrease in
GDP.
Suppose we cut government spending by $20 billion. This will
reduce GDP by $20 x 1.4 = $28 billion. With a DRI of -0.22, the
deficit will increase by -$28 x -0.22 = $6.2 billion. The net
change in the deficit will be $20 billion - $6.2 billion = $13.8
billion reduction.
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Fiscal Policy: Deficit Targeting
CHAPTER 30 Policy Timing, Deficit Targeting, and Stock Market Effects
The Effects of Spending Cuts on the Deficit
Monetary Policy to the Rescue?
Was Congress so poorly informed about
macroeconomics that it would pass
legislation like GRH that could not possibly
work?
If the Fed were to offset the effects of a
decrease in government spending by
increasing the money supply, the interest
rate would fall and planned investment would
be stimulated, offsetting the impact of the
decrease in G. At the time GRH was passed
this would have required a huge change in
interest rates.
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Fiscal Policy: Deficit Targeting
CHAPTER 30 Policy Timing, Deficit Targeting, and Stock Market Effects
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 a country exports.
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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Fiscal Policy: Deficit Targeting
CHAPTER 30 Policy Timing, Deficit Targeting, and Stock Market Effects
Summary
It is clear that the GRH legislation, the
balanced-budget amendment, and similar
deficit targeting measures have some
undesirable macroeconomic consequences.
Locking the economy into spending cuts
during periods of negative demand shocks, as
deficit-targeting measures do, is not a good
way to manage the economy.
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CHAPTER 30 Policy Timing, Deficit Targeting, and Stock Market Effects
The Stock Market and the Economy
As recently as a decade ago
macroeconomics could ignore
the stock market because its
impact on the economy was small
(particularly in the short run).
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CHAPTER 30 Policy Timing, Deficit Targeting, and Stock Market Effects
The Stock Market and the Economy
Business Investment and Finance
1. Planned investment spending includes nonresidential
fixed investment, business equipment, and
residential fixed investment.
2. Investment projects are usually very large, often
requiring external financing.
a. Internal financing means payment out of retained
earnings.
b. External financing means some sort of instrument(s)
must be issued to raise additional funds.
3. Types of external financing include bank loans,
issuing bonds, and issuing stock.
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CHAPTER 30 Policy Timing, Deficit Targeting, and Stock Market Effects
A stock is a certificate that certifies ownership of a certain
portion of a firm.
If the price of a stock increases since the stockholder bought
it, the stockholder has a capital gain, an increase in the value
of an asset.
Capital gains exist only on paper. A realized capital gain is
the gain that occurs when the owner of an asset actually sells
it for more than he or she paid for it.
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CHAPTER 30 Policy Timing, Deficit Targeting, and Stock Market Effects
One excellent sources of data is
Yahoo! (http://finance.yahoo.com/).
For example, Microsoft has 9.13
billion shares outstanding. If you
happen to own 100 shares, you own
0.000001 percent of the Microsoft
Corporation. Bill Gates and Steve
Ballmer can still outvote you.
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The Stock Market and the Economy
CHAPTER 30 Policy Timing, Deficit Targeting, and Stock Market Effects
Determining the Price of a Stock
Things that are likely to affect the price of a
stock include:
•
What people expect its future dividends
will be.
•
When the dividends are expected to be
paid.
•
The amount of risk involved.
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CHAPTER 30 Policy Timing, Deficit Targeting, and Stock Market Effects
Types of stocks
(1) Common stock is not
guaranteed any cash income.
While many stocks pay dividends
and have paid them for a number
of years, the payments are
always made on the
recommendation of the board of
directors.
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CHAPTER 30 Policy Timing, Deficit Targeting, and Stock Market Effects
(2) Most shares of stock are bought
and sold in the secondary market,
meaning the shares were not
purchased directly from the company
that issued them. These previously
owned shares form the basis for most
of the daily trading volume on the
stock exchanges. The main
participants in the secondary market
are brokers and dealers.
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CHAPTER 30 Policy Timing, Deficit Targeting, and Stock Market Effects
(3) If a firm wants to issue additional stock
to help finance a project, that stock is sold
in the primary market. The main
participants in the primary market are
investment banks.
The process of selling new issues to
investors is called underwriting. In the
case of a new stock issue, this sale is an
initial public offering (IPO). Dealers earn a
commission that is built into the price of
the security offering,
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CHAPTER 30 Policy Timing, Deficit Targeting, and Stock Market Effects
Third markets
Third markets are markets in which listed
securities are traded over the counter by
investors that are not listed with a stock
exchange. Also known as an OTC or Over
The Counter Market, the third market has
traditionally been utilized as a means of
trading large blocks of stocks between
institutions. However, this is changing as
more individual investors begin to explore
third market transactions.
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CHAPTER 30 Policy Timing, Deficit Targeting, and Stock Market Effects
Fourth market
Fourth market trading is direct
institution-to-institution ( B to B)
trading without using the service of
broker-dealers. It is impossible to
estimate the volume of fourth
market activity because trades are
not subject to reporting
requirements. Studies have
suggested that several millions
shares are traded per day.
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The Stock Market and the Economy
CHAPTER 30 Policy Timing, Deficit Targeting, and Stock Market Effects
The Stock Market Since 1948
Dow Jones Industrial Average An index based
on the stock prices of 30 actively traded large
companies. The oldest and most widely
followed index of stock market performance.
NASDAQ Composite An index based on the
stock prices of over 5,000 companies traded
on the NASDAQ Stock Market. The NASDAQ
market takes its name from the National
Association of Securities Dealers Automated
Quotation System.
Standard and Poor’s 500 (S&P 500) An index
based on the stock prices of 500 of the largest
firms by market value.
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The Stock Market and the Economy
CHAPTER 30 Policy Timing, Deficit Targeting, and Stock Market Effects
Stock Market Effects on the Economy
An increase in stock prices causes an increase in
wealth, and consequently an increase in consumer
spending.
Investment is also affected by higher stock prices.
With a higher stock price, a firm can raise more
money per share to finance investment projects.
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CHAPTER 30 Policy Timing, Deficit Targeting, and Stock Market Effects
© 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster
CHAPTER 30 Policy Timing, Deficit Targeting, and Stock Market Effects
© 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster
The Stock Market and the Economy
CHAPTER 30 Policy Timing, Deficit Targeting, and Stock Market Effects
Stock Market Effects on the Economy
The Post-Boom Economy
Both stock market wealth and housing wealth have
important effects on the economy.
Bubbles or Rational
Investors?
Bernanke’s Bubble Laboratory:
Princeton Protégés of Fed
Chief Study the Economics of
Manias
Wall Street Journal
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CHAPTER 30 Policy Timing, Deficit Targeting, and Stock Market Effects
REVIEW TERMS AND CONCEPTS
automatic destabilizers
negative demand shock
automatic stabilizers
realized capital gain
capital gain
recognition lag
deficit response index (DRI)
response lag
Dow Jones Industrial Average
stabilization policy
Gramm-Rudman-Hollings Act
Standard and Poor’s 500 (S&P 500)
implementation lag
stock
NASDAQ Composite
time lags
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