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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