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Chapter 16
Theory and Reality
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Macroeconomics:
Policy Tools
Policy tools for macroeconomics:
• Fiscal policy.
• Monetary policy.
• Supply-side policy.
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Table 16.1
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Fiscal Policy
• Fiscal policy is the use of government
taxes and spending to alter
macroeconomic outcomes, consisting of:
– Automatic stabilizers.
– Discretionary policy.
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Automatic Stabilizers
• Automatic stabilizers are federal
expenditure or revenue items that
automatically respond counter-cyclically
to changes in national income.
• Such stabilizers don’t require an
additional act of Congress.
‒ Examples include unemployment
benefits and income tax collections.
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Automatic Stabilizers
• These actions “kick in” at the start of a
recession, and automatically:
– Reduce tax revenues.
– Increase government outlays.
– Widen budget deficits.
• They counteract the shifting of AD to the
left and help stabilize the economy.
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Discretionary Policy
• Discretionary policy refers to deliberate
changes in tax or spending legislation.
– Additional spending and tax revenue
decreases can increase the federal budget
deficit.
– Reduced spending and tax revenue increases
can decrease the deficit.
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Monetary Policy
• Monetary policy: the use of money and
credit controls to influence
macroeconomic activity.
• The tools of monetary policy include:
– Open-market operations.
– Discount rate changes.
– Reserve requirements.
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Monetary Policy
• If the AS curve is horizontal, changes in the
money supply affect output only.
• If the AS curve is vertical, changes in the
money supply affect prices only.
• If the AS curve is upward-sloping, changes
in the money supply affect both prices and
output.
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Supply-Side Policy
• Supply-side policy: the use of tax rates,
(de)regulation, and other mechanisms to
increase the ability and willingness to
produce goods and services.
– The shape of the AS curve limits the
effectiveness of fiscal and monetary policies.
– Supply-side policy concentrates on shifting
the AS, not the AD, curve.
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Supply-Side Policy
• Supply-side policy wants to shift the AS
curve to the right.
• The supply-side tools are:
– Tax cuts to stimulate work effort, saving, and
investment.
– Deregulation to reduce production costs and
stimulate investment.
– Spending on education, training, and research
to expand the capacity to produce.
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Case 1: Recession
• Output and employment fall far short of
the full-employment potential.
• Need to put people to work and increase
output.
• The GDP gap must be closed.
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Case 1: Recession – Keynesians
• Emphasize the need to stimulate AD with
fiscal policy by:
– Cutting taxes.
– Boosting government spending.
– Setting off a multiplier reaction to the
stimulus.
• AD will shift right, closing the GDP gap.
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Case 1: Recession – Monetarists
• See no point in discretionary policies.
– They assume the AS curve is vertical at the
natural rate of unemployment
– Changes in fiscal or monetary policy are
ineffective because increases in AD only cause
inflation.
• The appropriate response to a recession is
patience.
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Case 1: Recession – Supply-Siders
• Believe that policy initiatives should focus
on changing the shape and repositioning
the AS curve to the right.
– Improve production incentives.
– Cut marginal tax rates on investment and
labor.
– Reduce government regulation.
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Case 2: Inflation – Keynesians
• Need to restrain AD by:
– Raising taxes.
– Cutting government spending.
– Relying on the multiplier to cool down the
economy.
• AD will shift left, closing the GDP gap.
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Case 2: Inflation – Monetarists
• Believe that inflation reflects excessive
money supply growth.
• Their response: Raise interest rates.
– Cut the money supply.
– Convince market participants that cautious
monetary policy will be continued.
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Case 2: Inflation – Supply-Siders
• Point out that inflation implies both too
much money and not enough goods.
– Expand productive capacity.
– Propose more incentives to save.
– Cut taxes and regulations, encourage more
immigration, and lower import barriers.
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Case 3: Stagflation
• Stagflation is the simultaneous
occurrence of substantial unemployment
and inflation.
• There are no simple solutions for
stagflation.
– There is a need to balance the competing
threats of inflation and unemployment
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Case 3: Stagflation
• There are several possible contributors to
stagflation:
– High tax rates or costly regulation.
– An external shock (such as a natural disaster)
or an abrupt change in world trade (such as
higher oil prices).
• The result is a leftward shift of the AS
curve.
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Figure 16.2
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Why Things Don’t
Always Work
• We can distinguish four obstacles to policy
success:
– Goal conflicts.
– Measurement problems.
– Design problems.
– Implementation problems.
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Politics versus
Economics
• Tax hikes and budget cuts rarely win votes.
• On the other hand, tax cuts and porkbarrel spending are always popular.
• Because of this, deficits will continue to be
with us, and the federal debt will increase.
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Politics versus
Economics
• Savvy politicians tend to stimulate the
economy before elections, then tighten
the fiscal restraints afterward.
• This creates a political business cycle: a
two-year pattern of short-run stops and
starts.
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