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Macroeconomic Policy Debates PREPARED BY: FERNANDO QUIJANO, YVONN QUIJANO, KYLE THIEL & APARNA SUBRAMANIAN © 2007 Pearson/Prentice Hall Economics: Principles, Applications, and Tools, 5e O’Sullivan • Sheffrin • Perez chapter 1 What are the long-term fiscal imbalances for the United States? New Methods to Measure the Long-Term Fiscal Imbalances for the United States 2 What does the current chairman of the Federal Reserve think about inflation targeting? Bernanke on Inflation Targeting 3 What type of tax is the “flat tax”? The Flat Tax Is a Tax on Consumption © 2007 Pearson/Prentice Hall Economics: Principles, Applications, and Tools, 5e O’Sullivan • Sheffrin • Perez 2 of 18 chapter 17.1 SHOULD WE BALANCE THE FEDERAL BUDGET? • government expenditures Spending on goods and services plus transfer payments. • surplus The amount by which government revenues exceed government expenditures in a given year. • deficit The amount by which government expenditures exceed government revenues in a given year. • government debt The total of all past government deficits. © 2007 Pearson/Prentice Hall Economics: Principles, Applications, and Tools, 5e O’Sullivan • Sheffrin • Perez 3 of 18 chapter 17.1 SHOULD WE BALANCE THE FEDERAL BUDGET? The Budget in Recent Decades ► FIGURE 17.1 Debt as a Percent of GDP, 1791–2005 © 2007 Pearson/Prentice Hall Economics: Principles, Applications, and Tools, 5e O’Sullivan • Sheffrin • Perez 4 of 18 chapter 17.1 SHOULD WE BALANCE THE FEDERAL BUDGET? The Budget and Social Security 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. © 2007 Pearson/Prentice Hall Economics: Principles, Applications, and Tools, 5e O’Sullivan • Sheffrin • Perez 5 of 18 chapter 17.1 SHOULD WE BALANCE THE FEDERAL BUDGET? Five Debates About Deficits DEBATE 2: IS GOVERNMENT DEBT A BURDEN ON FUTURE GENERATIONS? • Ricardian equivalence The proposition that it does not matter whether government expenditure is financed by taxes or debt. © 2007 Pearson/Prentice Hall Economics: Principles, Applications, and Tools, 5e O’Sullivan • Sheffrin • Perez 6 of 18 chapter 17.1 SHOULD WE BALANCE THE FEDERAL BUDGET? 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 © 2007 Pearson/Prentice Hall Economics: Principles, Applications, and Tools, 5e O’Sullivan • Sheffrin • Perez 7 of 18 chapter 17.1 SHOULD WE BALANCE THE FEDERAL BUDGET? Five Debates About Deficits DEBATE 3: HOW DO DEFICITS AFFECT THE SIZE OF GOVERNMENT? DEBATE 4: CAN DEFICITS BE GOOD FOR AN ECONOMY? © 2007 Pearson/Prentice Hall Economics: Principles, Applications, and Tools, 5e O’Sullivan • Sheffrin • Perez 8 of 18 chapter 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. Over time, there will be an escalating gap between revenues and expenditures, which would have to be met by outright borrowing. How can we measure the size of the gap? • Economists have developed a more comprehensive measure of a nation’s indebtedness. The method includes 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” was calculated in 2003 to be approximately $44 trillion, or four times GDP. • During World War II, government debt was only 1.2 times GDP. Problem: No one will lend the U.S. government that amount of money. Economists estimate that about 80 percent of the fiscal imbalance will stem from Medicare. © 2007 Pearson/Prentice Hall Economics: Principles, Applications, and Tools, 5e O’Sullivan • Sheffrin • Perez 9 of 18 chapter 17.1 SHOULD WE BALANCE THE FEDERAL BUDGET? Five Debates About Deficits DEBATE 5: WOULD A BALANCED-BUDGET AMENDMENT REALLY WORK? 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, for example, by taking some types of spending “off budget,” which means simply not counting them as part of the official budget. • Congress could also find non-budgetary ways to carry out the policies that it desires. © 2007 Pearson/Prentice Hall Economics: Principles, Applications, and Tools, 5e O’Sullivan • Sheffrin • Perez 10 of 18 chapter 17.2 SHOULD THE FED TARGET INFLATION? Two Debates About Inflation Targeting DEBATE 1: SHOULD THE FED FOCUS ON ONLY INFLATION? DEBATE 2: IF THERE WERE AN INFLATION TARGET, WHO WOULD SET IT? © 2007 Pearson/Prentice Hall Economics: Principles, Applications, and Tools, 5e O’Sullivan • Sheffrin • Perez 11 of 18 chapter BERNANKE ON INFLATION TARGETING APPLYING THE CONCEPTS #2: What does the current chairman of the Federal Reserve think about inflation targeting? Before he took over as chairman of the Federal Reserve in 2006, Ben Bernanke was an advocate for inflation targeting. • Inflation targeting increased the effectiveness of monetary policy because it provided a long-term anchor for inflation expectations. • As long as the private sector understood that the Fed was holding firm to long-run inflation targets, it would have added flexibility to use aggressive monetary policy in the short run to offset adverse shocks to the economy—without upsetting long-run inflation expectations. • He called inflation targeting a policy of constrained discretion. • Bernanke advocated that the Fed publish its inflation targets and make available its own forecasts of inflation for the next two years. • To preserve credibility over the long term, inflation targeting provided a structure to policy that the private sector could understand. © 2007 Pearson/Prentice Hall Economics: Principles, Applications, and Tools, 5e O’Sullivan • Sheffrin • Perez 12 of 18 chapter Extra Application 5 THE DEMOCRATS PLAYBOOK FOR BUSINESS The election results are in and America voted for change and the Democratic majority has a full slate of macroeconomic issues to tackle. According to various prognosticators some of the more pressing issues we are likely to see addressed in 2007 are an increase in the minimum wage and some legislation giving Congress the ability to negotiate prescription drug prices with pharmaceutical companies. • Other hot button issues include guest worker programs for immigrants and trade issues that involve greater environment and labor protections. • Big oil companies may not fare well with repeals of tax breaks likely and certain tax changes designed to repeal benefits targeting high income households while providing more breaks for the middle class. • Sarbanes-Oxley reform and tort reform are also likely targets designed to make U.S. business more competitive. • Other issues include deficit reduction and increased spending on education and alternative-energy research. As you can see there are dozens of worthy projects that need governmental attention. Can they do it all? Time will tell how far Congress gets on this very aggressive agenda. © 2007 Pearson/Prentice Hall Economics: Principles, Applications, and Tools, 5e O’Sullivan • Sheffrin • Perez 13 of 18 chapter 17.3 SHOULD WE TAX CONSUMPTION RATHER THAN INCOME? • 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? © 2007 Pearson/Prentice Hall Economics: Principles, Applications, and Tools, 5e O’Sullivan • Sheffrin • Perez 14 of 18 chapter Extra Application 4 FRENCH CONSUMER SPENDING DROPS SHARPLY French consumers spent less money in September as consumer spending on manufactured goods fell by 2.7 percent over the previous month. The decline was the largest fall in nearly ten years and casts doubt on the recent supposed upswing in consumer spending. While many economists expected a correction from the strong 3.0 percent increase posted in August, most did not expect this magnitude. • The primary consumer goods taking the hit were textiles and leather goods, a category that fell by nearly 10 percent. • While spending was down for the month, the quarterly data continue to support modest economic growth. Marginal Propensity to Consume (MPC) Marginal Propensity to Save (MPS) MPC + MPS = 1 Consumers either spend, or save, each dollar of income. The fraction of the next dollar (or Euro in this case) that is consumed or spent is known as the marginal propensity to consume or MPC. The fraction of the next Euro saved is known as the marginal propensity to save or MPS. Consumer spending is one of the primary components of aggregate expenditures. Consumption, business investment, government spending and net exports all represent the major categories that drive the economy. If consumption falls and the other components do not increase by enough to offset the decline, then overall economic growth will fall as well. © 2007 Pearson/Prentice Hall Economics: Principles, Applications, and Tools, 5e O’Sullivan • Sheffrin • Perez 15 of 18 chapter 17.3 SHOULD WE TAX CONSUMPTION RATHER THAN INCOME? Two Debates About Consumption Taxation DEBATE 2: ARE CONSUMPTION TAXES FAIR? • capital gains Profits investors earn when they sell stocks, bonds, real estate, or other assets. © 2007 Pearson/Prentice Hall Economics: Principles, Applications, and Tools, 5e O’Sullivan • Sheffrin • Perez 16 of 18 chapter THE FLAT TAX IS A TAX ON CONSUMPTION APPLYING THE CONCEPTS #3: What type of tax is the “flat tax”? The “flat tax” brings the personal income tax and corporate income tax into a single, unified tax system. • One low, single tax rate applies to both businesses and individuals. • Wage payments are deducted by businesses before they pay taxes. • Would allow businesses to deduct any investment spending they make from their income before the tax is calculated. • Can essentially be viewed as a type of consumption tax. The flat tax has an important feature that ensures that wealthy individuals still pay taxes. • Example: 14 million iPods were shipped in 2006. • Profit for each iPod: $100 • Total profit: $1.4 billion • Under this version of the flat tax, these extraordinary gains would be taxed in full. © 2007 Pearson/Prentice Hall Economics: Principles, Applications, and Tools, 5e O’Sullivan • Sheffrin • Perez 17 of 18 chapter capital gains government expenditures consumption taxes monetizing the deficit deficit Ricardian equivalence government debt surplus © 2007 Pearson/Prentice Hall Economics: Principles, Applications, and Tools, 5e O’Sullivan • Sheffrin • Perez 18 of 18