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CHAPTER 16 THEORY AND REALITY WHAT IS THIS CHAPTER ALL ABOUT? This chapter gives students a look at some of the limits policy makers confront in applying macroeconomic theory in the real world. Macroeconomic analysis is supposed to explain the business cycle and show policy makers how to control it. Yet, business cycles persist. Students should be challenged to think about the issue and discuss in class their views about whether the problem of persistent business cycles is one of theory or implementation. Progress through this chapter should stress the formulation of answers to the following key questions: 1. What is the ideal "package" of macro policies? 2. How well does our macro performance live up to the promises of that package? 3. What kinds of obstacles prevent us from doing better? NEW TO THIS EDITION New headline on budget deficits New headline on measurement problems New Question for Discussion Living Econ on “Should I vote my pocketbook?” LECTURE LAUNCHERS Where should you start? 1. Ask students, “If economists are so smart, why do we still have business cycles?” Remind them of external shocks, the political economy, and even disagreement among economists. Chapter 16 – Theory and Reality – Page 313 2. Ask students to list the various fiscal, monetary, and supply-side policy instruments. The list is provided in Table 16.1. 3. Ask students what types of policy would ideally be used during periods of recession, inflation, stagflation, and for fine-tuning the economy. A discussion of these issues is provided starting. 4. Ask students if they think we have been successful in achieving the goals of price stability, full employment, and economic growth. The section on the economic record, beginning helps answer these questions. COMMON STUDENT ERRORS Many students make these common errors. This same list is included in the student study guide. The first statement in each “common error” below is incorrect. Each incorrect statement is followed by a corrected version and an explanation. 1. Fiscal and monetary policies should be consistently applied to stimulate the economy. WRONG! Fiscal and monetary policies must be tailored to the specific economic problems faced by the government. RIGHT! The government sometimes needs to apply apparently contradictory monetary and fiscal policies in order to attain quite different goals. For example, an expansionary fiscal policy may be needed to stimulate the economy, but a contractionary monetary policy may be needed to raise interest rates so that foreign capital will be enticed into the United States. A policymaker must weigh the various goals and decide on the appropriate mix of tools to achieve them. 2. Fiscal, monetary, and stagflation policies are effective regardless of the income level of the economy. WRONG! The state of the economy in relation to full employment is important in determining the effectiveness of the various policies. RIGHT! If the economy is experiencing an excess aggregate demand, wage-price controls will prove ineffective in curbing inflation. At relatively low levels of GDP, however, wage-price controls can be effective in holding down inflation. Work force policies are often more effective in matching people with jobs when many people are looking for work than when unemployment is low. It is easier for the government to increase expenditures to stimulate the economy when there is a recession than to cut them back when there is excess aggregate demand. 3. Discretionary fiscal policies are better than automatic stabilizers at daily management of the economy. WRONG! Automatic stabilizers are a better option than discretionary fiscal policies for daily management of the economy. RIGHT! Chapter 16 – Theory and Reality – Page 314 There is a significant lag time between recognizing that problems exist in an economy and developing policy prescriptions to help remedy the problem. By the time discretionary fiscal policies begin taking effect, they often are trying to address problems that no longer exist. As a result, automatic stabilizers are usually a much better way of addressing economic problems. 4. The government has the power to prevent unemployment and inflation, but it just doesn’t want to use it. WRONG! The government has very little power to totally prevent unemployment and inflation. RIGHT! There is very little that the government can do to totally prevent unemployment and inflation. However, the government has been relatively successful in reducing the magnitude of unemployment and inflation through the use of fiscal and monetary policy. HEADLINES There are six Headline boxes in this chapter. Their titles are and the concepts they illustrate are: “Budget Deficit May Surpass $450 Billion” (Origins of Deficits) In 2003, the cost of the war and tax cuts caused the federal budget deficit to surpass $450 billion, reversing course from the 2000 surplus of $236 billion. “Falling Consumer Confidence Could Alter Fed Outlook” (Policy Adjustments) The outlook for the economy looks ominous as orders for big-ticket goods fell sharply and consumer confidence dropped to the lowest in more than a year. The Fed’s decisions on monetary policy reflect its outlook for the economy. When the outlook changes, so must Fed policy. "Macro Performance in the 1990s" (Comparative Performance) This Headline offers a look at international comparisons in the 90's in growth, unemployment and inflation. The U.S. inflation rate was about average while growth and unemployment performance were above average compared to other developed countries. "Despite Job Losses, the Recession is Finally Declared Officially Over” (Measurement problems) In 2003, the National Bureau of Economic Research determined that the 2001 recession, beginning in March 2001, ended eight months later. As the official arbiter of recession timing, the Bureau carefully examines data and is notoriously slow in reaching a conclusion. "This Just in: Recession Ended 21 Months Ago" (Measurement Problems) It takes economists time to sort out data - sometimes so much time that policies become irrelevant. In this case, a panel of economists realized that there had been a recession only after the recession had ended. Chapter 16 – Theory and Reality – Page 315 “Tough Calls in Economic Forecasting” (Macro Models) In presenting the annual economic outlook, the chairman of President Clinton’s Council of Economic Advisers was having nothing to do with all the recession talk going around. Even the most sophisticated computer models rely on basic assumptions about consumer and investor behavior. If the assumptions are wrong, the forecast will likely be wrong as well. “Japanese Tighten Belts” (Design Problems) In an attempt to stimulate the Japanese economy, Prime Minister Ryutaro Hashimoto proposed a tax cut that would give a typical household as much as $500 this year and again next year. Many Japanese households responded by saving the tax cut. The success of macro policy depends on how market participants respond to policy initiatives. Japanese consumers didn’t follow the Keynesian script. “Budget Economics, Politics Collide” (Politics vs. Economics) Economists who say tax cuts are a terrible idea oppose the big GOP tax packages moving through Congress. The result would be to accelerate consumer spending, pouring gasoline on the fire of an already hot economy. Tax cuts and increased spending are always politically appealing even if not economically ANNOTATED CONTENTS IN DETAIL I. Business Cycle Definition: Business Cycle - Alternating periods of economic growth and contraction. II. Policy Levers A. Business cycles persist but aren't as bad as they used to be. Economist place responsibility for continuing business-cycle problems on real world “politics.” B. The policy levers (Table 16.1) 1. Fiscal Policy Definition: Fiscal Policy –The use of government taxes and spending to alter macroeconomic outcomes 2. Automatic Stabilizers a. Definition: Automatic Stabilizers – Federal expenditure or revenue item that automatically responds countercyclically to changes in national income - e.g., unemployment benefits, income taxes. b. When the economy slows, tax revenues decline and government spending increases automatically. c. Recessions automatically: i. Reduce tax revenues when the economy slows. ii. Increase government outlays when the economy slows. iii. Widens budget deficits. 3. Fiscal Policy Milestones (Table 16.2) C. Discretionary Policy - Deliberate changes in tax or spending legislation. Chapter 16 – Theory and Reality – Page 316 1. 2. 3. D. Discretionary policy often has limited impacts on the economy a. The federal budget deficit jumped from $221 billion in 1991 to $270 billion in 1992 mostly due to automatic stabilizers. b. In 1996 and 1997, the economy grew faster than anticipated. Tax revenues increased, transfer payments declined and the budget deficit shrank more rapidly than expected. Most of this was due to automatic stabilizers. Fiscal year Definition: Fiscal Year – The twelve-month period used for accounting purposes; begins October 1 for federal government. Headline: “Budget Deficit May Surpass $450 Billion” (Origins of Deficits) In 2003, the cost of the war and tax cuts caused the federal budget deficit to surpass $450 billion, reversing course from the 2000 surplus of $236 billion. Monetary Policy Definition: Monetary Policy – The use of money and credit controls to influence macroeconomic activity. 1. Tools of monetary policy. a. Open-market operations b. Discount rate changes c. Reserve requirement changes. 2. Money Supply (M1) Definition: Money Supply (M1) – Currency held by the public, plus balances in transactions accounts. 3. The effectiveness of both fiscal and monetary policy depends on the shape of the AS curve. a. If AS is horizontal, changes in the money supply affect output only. b. If AS is vertical, changes in the money supply affect prices only. c. If AS is upward sloping, changes in the money supply affect both prices and output. 4. Rules vs. Discretion a. Disagreements about the actual shape of the AS curve raise questions about how to conduct monetary policy. b. Some economists urge the Fed to play an active role in adjusting the money supply to changing economic conditions. Others suggest that we would be better served by fixed rules for moneysupply growth. 5. Monetary-Policy Milestones (Table 16.3) 6. “Falling consumer confidence could alter Fed outlook” (Policy Adjustments) The outlook for the economy looks ominous as orders for big-ticket goods fell sharply and consumer confidence dropped to the lowest in more than a year. The Fed’s decisions on monetary policy reflect its outlook for the economy. When the outlook changes, so must Fed policy. Chapter 16 – Theory and Reality – Page 317 E. Supply-Side Policy 1. Definition: Supply Side Policy – The use of tax rates, (de)regulation, and other mechanisms to increase the ability and willingness to produce goods and services. 2. The shape of aggregate supply curve can limit the effectiveness of fiscal and monetary policy. 3. The supply-side goal is to shift aggregate supply curve to the right. The supply-side tool box include: a. Tax cuts to stimulate work effort, saving and increase investment. b. Deregulation may reduce production cost and stimulate investment. c. Expenditures on education training and research expands capacity to produce. d. Immigration policies alter size and skill of labor force thus affecting the AS. 4. Supply-side milestones (Table 16.4) 5. Fiscal and supply-side policies often intertwined via tax code. III. Idealized Uses A. B. Case 1: Recession - Need to put people to work 1. GDP Gap Definition: GDP Gap – The difference between full-employment output and the amount of output demanded at current price levels. 2. Keynesians a. Emphasize need to stimulate aggregate demand. b. Expansionary fiscal policies i. Tax cuts or ii. Increases in government spending. c. Multiplier Definition: Multiplier – The multiple by which an initial change in aggregate spending will alter total expenditure after an infinite number of spending cycles: 1/(1-MPC) d. Neo-Keynesians acknowledge that monetary policy might also help if it gives investment a boost. 3. Monetarists a. Monetarists believe the aggregate supply curve is vertical at the "natural" rate of unemployment. (Figure 14.6) b. Changes in fiscal or monetary policy ineffective because they shift AD but only cause inflation. 4. Supply-siders a. Policy initiatives should change shape and position of aggregate supply curve. b. Emphasize need to improve production incentives through i. Reduced government regulation. ii. Cuts in marginal tax rates on investment and labor. Case 2: Inflation - Need to restrain aggregate demand 1. Keynesians a. Raise taxes. Chapter 16 – Theory and Reality – Page 318 2. 3. IV. C. Case 3: Stagflation (Figure 16.1) 1. Definition: Stagflation – The simultaneous occurrence of substantial unemployment and inflation. 2. Structural unemployment Definition: Structural Unemployment – Unemployment caused by a mismatch between the skills (or location) of job seekers and the requirements (or location) of available jobs. 3. Possible contributors to stagflation a. High tax rates or costly regulation. b. "External shocks" such as natural disasters or an abrupt change in world trade (an oil embargo). i. High oil prices during the Gulf War (1990-91) ii. Asian currency crisis (1997-98) c. Leftward shift of aggregate supply. D. Fine-Tuning 1. Definition: Fine-tuning – Adjustments in economic policy designed to counteract small changes in economic outcomes; continuous responses to changing economic conditions. 2. Continual adjustments of policy levers (monetary and fiscal). 3. Choosing right target for stimulus and restraint is key to fulfilling goals. The Economic Record - (Figure 16.2) A. B. V. b. Cut government spending. c. Reliance on multiplier to cool economy. Monetarists a. Cut money supply - inflation reflects excessive money-supply growth. b. Convince market participants that cautious monetary policy will be continued (Expectations important). Supply-siders a. Expansion of productive capacity. (Shift AS) b. Incentives to save. c. Cut taxes and regulations and lower import barriers. The U.S. economy has impressive long-run growth and improvement in the standard of living. Headline: - Comparative Performance - "Macro Performance in the 1990s." This Headline offers a look at international comparisons in the 90's in growth, unemployment and inflation. The U.S. inflation rate was about average while growth and unemployment performance were above average compared to other developed countries. Why Things Don't Always Work A. Four obstacles to policy success 1. Goal conflicts 2. Measurement problems 3. Design problems 4. Implementation problems Chapter 16 – Theory and Reality – Page 319 B. Goal conflicts 1. The Fed is traditionally viewed as the guardian of price stability and tends to favor policy restraint. 2. The President and Congress favor policy stimulus. 3. The end result may entail a mix of contradictory policies. 4. Distributional goals may also conflict with macro objectives. Antiinflationary policies may require cutbacks for poor, the elderly, or needy students. 5. Tight-money policies may be viewed as too great a burden for small businesses. 6. All policy decisions entail opportunity costs. C. Measurement Problems 1. At best, we know what was happening in the economy last month or last week. 2. Forecasts - in designing policy, policymakers must depend on economic forecasts. Note: Policy design is subject to forecast errors. 3. Headline: "Despite Job Losses, the Recession is Finally Declared Officially Over” (Measurement problems) In 2003, the National Bureau of Economic Research determined that the 2001 recession, beginning in March 2001, ended eight months later. As the official arbiter of recession timing, the Bureau carefully examines data and is notoriously slow in reaching a conclusion. 4. D. Macro Models a. Forecasts are based on complex computer models of how economy works. b. Economists "feed" inputs. i. How economy allegedly works. ii. Assumed values for critical economic variables. c. Different models and data generate different policy recommendations. d. Headline: “Tough Calls in Economic Forecasting” (Macro Models) In presenting the annual economic outlook, the chairman of President Clinton’s Council of Economic Advisers was having nothing to do with all the recession talk going around. Even the most sophisticated computer models rely on basic assumptions about consumer and investor behavior. If the assumptions are wrong, the forecast will likely be wrong as well. Design Problems 1. We never know for sure how market participants are going to respond to any specific actions taken. 2. Headline: “Japanese Tighten Belts” (Design Problems) In an attempt to stimulate the Japanese economy, Prime Minister Ryutaro Hashimoto proposed a tax cut that would give a typical household as much as $500 this year and again next year. Many Japanese households responded by saving the tax cut. The success of Chapter 16 – Theory and Reality – Page 320 macro policy depends on how market participants respond to policy initiatives. Japanese consumers didn’t follow the Keynesian script. E. VI. Implementation Problems 1. Congressional Deliberations a. Legislative process takes time. b. Even if the right policy is formulated to solve an emerging economic problem, there is no assurance that it will be implemented c. If a policy is implemented, there is no assurance that it will take effect at the right time. 2. Policy Response: A Series of Time Lags (Figure 16.3) 3. Politics vs. Economics a. Tax hikes and budget cuts rarely win votes. b. Political business cycle - two year pattern of short-run stops and starts. c. Headline: “Budget Economics, Politics Collide” (Politics vs. Economics) Economists who say tax cuts are a terrible idea oppose the big GOP tax packages moving through Congress. The result would be to accelerate consumer spending, pouring gasoline on the fire of an already hot economy. Tax cuts and increased spending are always politically appealing even if not economically desirable. Politics can derail sound economic advice. Policy Perspectives A. Hands off or Hands on? 1. In view of the goal conflicts, measurement design, and implementation problems, it is less surprising that things sometimes go wrong than that things often work out right. 2. Consistent fine-tuning of economy is not compatible with either design capabilities or our decision-making procedures. B. Hands-Off Policy - Those who argue to leave the economy alone. 1. They argue that fine-tuning is not really possible, thus we should abandon discretionary policies. 2. Milton Friedman - advocates fixed policy rules. 3. The case for a hands-off policy stance is based on practical arguments more than on theory. C. Hands-On Policy - Those who support continued fine-tuning. 1. Critics of hands-off policies acknowledge policy blunders, but emphasize the historical record of prices, employment and growth improvements. 2. With fixed rules, it is impossible to maintain a steady rate of growth in the money supply. D. Modest Expectations - Discretionary policies will continue to be used and continue to fall short of complete success. Chapter 16 – Theory and Reality – Page 321 IN-CLASS DEBATE, EXTENDING THE DEBATE, AND DEBATE PROJECTS In-class Debate What good are macroeconomists? Few would argue that we should throw out all the macroeconomists. However, in terms of policymaking, it is debatable whether or not macroeconomists have made a substantial contribution to policymaking. What are macroeconomists able to do reasonably well? What can macroeconomists not do very well? How would you grade macroeconomics as a successful science on a scale from A to F? Teaching note After students have answered question one individually, post signs on different walls of the room labeled with the grades A to F. Ask students to stand up and move to the part of the room representing their position. Call on individual students to explain their position. Announce that students may shift position if they change their minds based on student comments. Follow with an individual writing assignment. Extending the Debate What’s the theory? What’s the reality? The specifics of US monetary and fiscal policy change constantly. But some of the debate about what monetary or fiscal policy is appropriate at a moment in time results from differences in political philosophy. Some people believe government intervention often can improve things— they have a “hands on” bias. Some people believe government intervention most often makes things worse—they have a “hands off” bias. Here are the web sites to four organizations, two at the “hands on” end of the spectrum and two at the “hands off” end. For hands on go to United for a Fair Economy at http://www.ufenet.org/about/index.html Or, the Economic Policy Institute at http://www.epinet.org/content.cfm/about For hands off go to the Cato Institute at http://www.cato.org/about/about.html Or, the American Enterprise Institute at http://www.aei.org/about/filter./default.asp Please visit the web sites and use them to answer the following questions: 1. What is the rationale for a “hands on” perspective as stated in the “about” page of the first two web sites? 2. Identify two policies that call for hands on intervention. (Go back to the home page for each organization to explore the policies they advocate.) Chapter 16 – Theory and Reality – Page 322 3. What is the rationale for a “hands off” perspective as stated in the “about” page of the second two web sites? 4. Identify two policies that call for hands off. (Go back to the home page for each organization to explore the policies they advocate.) 5. Pick one policy from 2) and 4). In each case, how would the other side criticize the policies you have chosen? Teaching notes Use information gathered by students out of class to conduct an in-class cooperative controversy. Or, use the information for individually-written essays on the topic. Format: Organize students into groups of two. (Use instructor assignment or random assignment so that friends don’t work together.) One half of the groups take the pro side; the other half take the con side. Each pair lists the strongest three arguments for their position. Then pairs combine into groups of four with one pair on each side of the debate. One pair reads their reasons while the other side listens. Then reverse so that the other pair reads their reasons. Group of four selects strongest argument on each side and, if appropriate, reaches consensus on final position. Debate project For related debate material see “Economic Growth” in Chapter 1. ANSWERS TO QUESTIONS FOR DISCUSSION, WEB ACTIVITIES AND PROBLEMS QUESTIONS FOR DISCUSSION 1. What policies would Keynesian, Monetarists, and Supply-siders advocate for a. Restraining inflation? b. Reducing unemployment? Keynesians a. To restrain inflation, Keynesian’s recommend policy levers that decrease (shift to the left) AD. Thus, they would argue for increases in taxes, decreases in government spending, and a decrease in the money supply (caused by buying government bonds in open market operations, increasing the discount rate, or increasing the reserve requirements). b. To reduce unemployment, Keynesian’s recommend policy levers that increase (shift to the right) AD. Thus, they would argue for decreases in taxes, increases in government spending, and an increase in the money supply (caused by selling government bonds in open market operations, decreasing the discount rate, or decreasing the reserve requirements). Chapter 16 – Theory and Reality – Page 323 Monetarists see no point in discretionary policies since they believe the AS curve is vertical at the ‘natural’ rate of unemployment. Thus, their prescription to inflation and unemployment is ‘patience’. There should be no attempt to fine-tune the economy. They would also argue for a steady change in the money supply at a rate consistent with the desired long-term growth rate of the economy. Supply-siders a. To restrain inflation, supply-siders argue policy levers should be used to shift the location and shape of the AS curve. In this case, they would argue for a shift of AS to the right by cutting taxes and regulations and also lowering import barriers to allow cheaper foreign goods into the markets. b. To reduce unemployment, supply-siders argue again that policy levels should be used to shift the location and shape of the AS curve. In this case, they would argue for cuts in marginal tax rates on investment and labor. They would also look for ways to reduce government regulation to reduce the cost of producing goods and services. 2. Should economic policies respond immediately to any changes in reported unemployment or inflation rates? When should a response be undertaken? The problem is to differentiate between a statistical "blip" and a trend. Finetuning advocates will be in favor of responding relatively quickly. Monetarists will advocate doing nothing. Supply-siders might propose waiting. 3. Suppose that it is an election year and that aggregate demand is growing so fast that it threatens to set off an inflationary movement. Why might Congress and the president hesitate to cut back on government spending or raise taxes, as economic theory suggests is appropriate? Political considerations, unfortunately, can and do outweigh economic fundamentals on occasion. Tax hikes and reduced government spending are not usually well received by consumers/voters. The goal for politicians may be to get reelected and then deal with economic problems. 4. In his fiscal 1997 budget, President Clinton proposed decreases in defense spending to help reduce the budget deficit. Should military spending be subject to macroeconomic constraints? What programs should be expanded or contracted to bring about needed changes in the budget? Is it feasible? Again, the role of political issues is highlighted. From a strictly economic viewpoint, aggregate spending should be subject to macroeconomic constraints. Macro theory provides no guidelines on which spending should be targeted. 5. What is the “amazing phenomenon” referred to in the Headline on p. 357? Tax revenue fell for three straight years for the first time since the Great Depression. 6. Are we better off or worse off because of the discretionary macro policies of the last two years? How could you tell? Answers here should start by identifying discretionary policy actions that have taken place during the last two years. Next they should look at changes in the unemployment rate, Real GDP, and inflation. Chapter 16 – Theory and Reality – Page 324 7. Suppose that the economy is slumping into recession and needs a fiscal-policy boost. Voters, however, are opposed to larger federal deficits. What should policy makers do? The federal government could initiate a balanced budget increase in spending, i.e. G = T . This kind of spending change has a positive spending multiplier of 1 and would stimulate the economy. The government could also simply cut taxes in the hope that voters’ satisfaction with lower taxes will outweigh their more abstract concern with budget deficits. The government might also try to raise expectations and confidence with "rosy" economic projections. Another thing they could do is to use monetary policy to reduce interest rates and hope that such a move will encourage more investment spending. It will also serve to reduce the size of government's expenditures on interest. 8. Outline a macro policy package for attaining full employment and price stability in the next 12 months. What obstacles, if any, will impede attainment of these goals? Answers will depend on the state of the economy when this question is assigned. The biggest obstacle is going to be the policy lags. It is relatively easy to prescribe a change in government spending or taxes or both, but it is more difficult – and potentially time consuming – for Congress and the President to agree on what government spending or taxes to change and by how much. Even after that is done, it takes time for the policy to actually have an impact on the economy. Attaining these goals in 12 months is rather ambitious. 9. What should the Fed have done in late 2000 when consumer confidence started falling (See Headline, p. 359)? Would that entail fine-tuning? In cases where a drop in consumer confidence results in a decrease in AD resulting in increased unemployment, the Fed should decrease interest rates using its monetary tools (buying government securities through open market operations, decreasing the discount rate, or decreasing the reserve requirement). 10. Democrats labeled President Bush’s 2001 tax-cut plan as a “giveaway to the rich” because it gave the richest taxpayers the largest tax cuts. Corporate America also complained that there was no business tax cuts in the Bush plan. How would such criticism affect the lag time for fiscal policy? The lag time for fiscal policy consists of three components: the time it takes to recognize a problem exists, the time it takes to debate what to do about the problem, and then the time it takes for the policy to work its way fully through the economy. In this case, the criticisms listed in the question affect the time it takes to debate what to do about the problem. The more controversial any fiscal policy is, the more Congress will debate the proposed policy change. WEB ACTIVITIES 1. Log on to http://www.cbo.gov/.Click on current economic and budget projections. Access the most recent update. a. What is the CBO’s projection for economic growth in the coming year? b. Can monetary policy be used to help improve this forecast? If so, how? c. Can fiscal policy be used to help improve this forecast? If so, how? Chapter 16 – Theory and Reality – Page 325 The answers to this question will depend upon the time period in which you access the report. Your answer should include discussion of the monetary tools of open market operations, changing the discount rate and changing the reserve requirement. The fiscal policy tools would include changing government spending, transfer payments, and taxes. If the U.S. economy began to enter a recession, the possible uses of monetary policy that could be used to improve the economy include buying bonds in the open market, lowering the discount rate, and decreasing the reserve requirement. Fiscal policy tools include decreasing taxes and increasing federal spending. 2. Log on to www.dismal.com and click on the link for economic indicators. a. What does this chart suggest about economic growth in the U.S.? b. Why might this data be unreliable in predicting growth in the next 12 months? a. b. The answer to this question depends on the time period in which you access the data. Using past performance of the economy to predict the future growth may be unreliable because the current economy does not necessarily reflect the conditions that have existed in the past. 3. Log on to http://w3.access.gpo.gov/eop/ and click on the Economic Report of the President. Look on the last page of the report. How does U.S. economic growth compare to other major industrial nations economic growth during the last 20 years? In general, the rate of growth in the U.S. economy exceeded growth in all other nations during the last 20 years. PROBLEMS 1. The 1997 fiscal policy package included roughly $200 billion in government spending cuts and $70 billion in tax cuts. If all the tax cuts were given to households, by how much would aggregate demand shift (a) initially and (b) ultimately as a result of the policy package? a. AD would initially decrease by $200 billion (due to the decrease in government spending) but, at the same time, increase by some percentage of the $70 billion in tax cuts. Given the tax cut, the consumers will only increase their spending by the MPC x Taxes. If we assume an MPC of 0.80, then consumption spending will increase by $56 billion due to a $70 billion tax cut. The net impact is that AD will initially decrease by $144 billion. b. The ultimate change in equilibrium GDP will depend on the value of the MPC and the multipliers. Again assuming an MPC of 0.80 then the multiplied changes in AD will be: -200 billion x 5 = -1,000 billion +56 billion x 5 = + 280 billion ___________ -$ 720 billion Chapter 16 – Theory and Reality – Page 326 2. Suppose the federal budget is balanced but that automatic stabilizers increase tax revenues by $20 billion per year and decrease transfer payments (e.g., welfare, unemployment benefits) by $8 billion per year for every 1-percentage point change in the real GDP growth. Using this information, complete the following table: Change in Change in Change in Change in GDP Growth Rate Tax Revenue Transfer Payments Budget Balance Nominal GDP $7,000 $8,000 $9,000 Government expenditure $700 $800 $900 Taxes collected $600 $800 $1,000 Exports $300 $300 $300 Imports $100 $300 $500 Inflation (index) 1.00 1.04 1.15 Unemployment rate 10% 4% 3.5% Pollution index 1.00 1.80 2.00 -2% -$40 billion +$16 billion -$24 billion +1% +$20 billion -$8 billion +$12 billion +3% +$60 billion -$24 billion +$36 billion 3. Based on the information in the preceding question, what will happen to the federal budget balance if the economy falls into a recession of –2.0 percent from a growth path of +2.5 percent? If the economy falls into a recession of –2.0 percent, resulting in a budget balance change of -$24 billion, from a growth path of +2.5 percent, resulting in a budget balance change of +$30 billion, the net result would be a -$54 billion change in the budget balance. 4. The following table presents hypothetical data on government expenditure, taxes, exports, imports, inflation, unemployment, and pollution for three levels of equilibrium income (GDP). A government decision maker is trying to determine the optimal level of government expenditures, with each of the three columns being a possible choice. At the time of the choice the inflation index is 1.0. Dollar amounts are in billions per year. (a) (b) (c) (d) (e) Compute the federal budget balance, balance of trade, and real GDP for each level of nominal GDP. What government expenditure level would best accomplish each of the following goals? Lowest taxes collected, largest trade surplus, lowers pollution, lowest inflation rate, lowest unemployment rate, highest amount of public goods and services, highest real income, balancing the federal budget, achieving a balance of trade, maintaining price stability, achieving full employment. What government expenditure levels would most flagrantly violate each of the preceding goals? Which policy would be in the best interests of the country? What policies, in addition to changes in government expenditures, might the government use to attain more of its desired goals? Chapter 16 – Theory and Reality – Page 327 (a) Completing the information from the table in the text: Nominal GDP 7000 Federal Budget Balance -100 Balance of Trade 200 Real GDP 7000 (b) 8000 0 0 7692 9000 100 -200 7826 The level of expenditures that would best accomplishes each goal, and (c) the level that would most flagrantly violate each goal. BEST EXPENDITURE 700 700 700 700 900 900 900 800 800 700 800 GOAL TO BE ACCOMPLISHED Lowest taxes Largest trade surplus Lowest pollution Lowest inflation rate Lowest unemployment rate Most public goods and services Highest Real Income Balanced federal budget Balancing balance of trade Price stability Full employment WORST EXPENDITURE 900 900 900 900 700 700 700 700,900 700,900 900 700 (d) There is no clear best policy because there are competing macroeconomic goals. (e) Monetary policy and supply side policies, as well as changing taxes, might be used in addition to changes in government spending in the attempt to attain more desirable goals. Chapter 16 – Theory and Reality – Page 328 MEDIA EXERCISE Chapter 16 Theory and Reality Name: ___________________ Section: __________________ Grade: ___________________ Newspapers and on-line news services contain a great deal of information about the problems that prevent government from taking appropriate or timely action. Find such an article and use it to fulfill the following instructions and questions: 1. Mount a copy (do not cut up newspapers or magazines) of the article on a letter-sized page or print an article from an Internet news agency such as www.cnn.com, www.msnbc.com, www.abc.com, www.nytimes.com, etc. 2. Find an article that illustrates one of the four obstacles to policy success. The obstacle may have occurred in the past, may be a current obstacle, or may occur in the future. Below the article, write down which one of the following obstacles to success is illustrated by the article you have selected: Goal conflicts. Measurement problems. Design problems. Implementation problems. 3. Underline the passage (not more than a sentence) that specifically mentions the obstacle you have listed below the article. 4. Who is responsible for determining the policy? Use an arrow to locate the place in the article where the responsible person or organization is mentioned. 5. What event or situation requires a policy response? Circle a passage that describes why the policy was needed, is needed, or may be needed in the future. 6. In the remaining space below your article, indicate the source (name of newspaper, magazine or web site), title (newspaper headline, magazine article, or web article title), date, and page for the article you have chosen. Use this format: Source: _____________________ Date: ______________ Page: _____________ Title: __________________________________________________________ If this information also appears in the article itself, circle each item. 7. Neatness counts. Chapter 16 – Theory and Reality – Page 329 Professor's Note Learning Objective for Media Exercise To encourage students to recognize the obstacles that can block economic policy. Suggestions for Correcting Media Exercise The only issue to be checked is whether the underlined portion of the article does indeed represent the kind of policy obstacle indicated below the article. Likely Student Mistakes and Lecture Opportunities Examples from the student papers can often be used to show how policy obstacles can lead to counterproductive rather than counter cyclical (or productive) policies; e.g., agricultural setaside policies may be burdening the government while wheat shortages plague the economy or the Fed's tightening of interest rates may occur after the effects of inflation have already occurred. By discussing this chapter on the day that the students have turned in this assignment, it should be possible to go around the room and find some gems to illustrate the problems of policymaking. One of the most theoretically useful points to illustrate is the problem of lags in recognizing, designing, and implementing policy. SUPPLEMENTARY SOURCES Symposium: “Fiscal Policy” The Journal of Economic Perspectives, Summer 2000, pp. 3 – 74. Accessible discussion of current research on fiscal policy. Gramlich, Edward M. "Distinguished Lecture on Economics in Government: Setting National Priorities: 1992," The Journal of Economic Perspectives, Spring 1992, pp. 13-44. Mentions the "peace dividend" and provides an easily readable (for beginning students) discussion of macroeconomic objectives. Chapter 16 – Theory and Reality – Page 330