Macroeconomics Unit 18 Economic Theory and Reality

Introduction

This is one of the most important units of the course. This unit compares the major economic policy tools and discusses some of the obstacles to their success.

Why don’t things work the way they are supposed to work?

Policy Levers

Fiscal policy tools or levers are economic policies that affect the federal budget.

Fiscal policy tools are initiated and approved by Congress and the President.

Some fiscal policy tools are automatic stabilizers – unemployment benefits and tax revenues are examples. These automatic stabilizers are triggered by changing economic conditions and do not require legislative action.

Policy Levers

The basic fiscal policy tools that our government can use to change economic conditions are: • Tax increases/decreases • Government spending increases/decreases • Increase/decrease transfer payments Fiscal policy tools concentrate on increasing or decreasing aggregate demand.

Policy Levers

Monetary policy tools are designed to change the supply of money. Monetary policy is controlled by the Federal Reserve and not by the Congress or the President.

Monetary Policy tools consist of: • Changing discount rates (raise/lower) • Open Market Operations (buy/sell bonds) • Changing the reserve requirement (increase/decrease)

Policy Levers

Supply-side theory involves incentives to work, invest, and produce. Supply-side policy is affected by the federal budgetary process and also by legislation concerning regulations.

Key components of supply-side theory are: • Consumer and Business tax incentives • Deregulation • Human capital investment • Infrastructure improvement Congress and the President both make policy and spending decisions that affect the supply-side.

Recession

During a recessionary GDP gap, which economic policy lever is the most effective to use?

Keynes, who concentrated on fiscal policy would suggest cutting taxes and/or increasing government spending to shift AD to the right. The multiplier effect helps boost initial spending increases and tax cuts.

Keynes (Modern), a more modern adaptation of Keynesian theory, in addition to above, would propose monetary policy changes (interest rates cuts) which can increase the supply of money and help reduce recessionary effects.

Recession

Monetarists, in regards to the recessionary GDP gap believe that federal budgetary changes in the form of taxes or spending only alter the mix of output, not the demand.

Since the velocity of money is constant, recessionary problems are only temporary.

Monetarists believe that you should wait for the recession to end by itself – eventually when sales decline enough, interest rates will drop and new investment will occur.

Recession

Supply-side theory would eliminate a recessionary GDP gap by providing business with greater incentives to produce (tax incentives to invest in new capital, accelerated depreciation rates, etc.), cutting the marginal tax rates for investment and labor, and by reducing government regulation.

Increased government spending on infrastructure as well as increased spending by companies and the federal government on human capital investment are also key components of supply-side theory.

Inflation

An economy experiencing inflation is faced with swiftly rising prices. The economy is deemed to be “overheated” and needs to be “cooled off”.

An inflationary GDP gap occurs where current equilibrium GDP is greater than full employment GDP.

Aggregate demand needs to be reduced – the curve needs to shift to the left.

Inflation

To eliminate the inflationary GDP gap, Keynesians would concentrate on either raising taxes or decreasing government spending.

Increasing interest rates, like the discount rate are also an option.

The intent is to reduce the amount of money consumers have to spend, thereby reducing demand.

Politically, raising taxes and or decreasing government spending is not likely.

Inflation

Confronted with an inflationary GDP gap, Monetarists would concentrate their efforts on reducing the money supply.

To reduce the supply of money, monetarists would have the Federal Reserve sell bonds or raise the reserve requirement.

Monetarists believe that discount rate changes are not effective. Monetarists believe in a long-run vertical supply curve and that changes in the money supply will affect prices, not output.

Inflation

Supply-siders when faced with an inflationary GDP gap, believe that inflation is caused by a lack of output to satisfy demand and greater expansion in output is needed.

Government needs to provide more incentives to save and invest in capital. Taxes should be reduced, government regulation should also be reduced and import barriers lowered.

Notice that supply-side theory does not believe that excessive demand exists, only that insufficient supply exists.

Stagflation

Stagflation

occurs when significant unemployment and inflation both exist.

Stagflation can be caused by many factors: • Rising prices and unemployment due to structural problems.

• Excessively high tax rates.

• Costly government regulation.

• External “shocks”.

Stagflation

Solving stagflation usually requires a combination of policy options.

Supply-side policy which reduces tax rates, regulation, and encourages human capital investment will help.

Government spending on infrastructure improvements will help.

If an external “shock” occurred, many of these policy tools may be ineffective until sufficient time has passed.

Fine-tuning

Fine-tuning

is the process of making small adjustments in economic policy.

Fine-tuning enables the economy to stay on course – low unemployment and low inflation.

Fine-tuning consists of fiscal or monetary stimulus when unemployment is increasing.

If inflation might be a problem, then monetary restraint or mild fiscal restraint can help. A mild reduction in government spending or an increase in interest rates are both examples of fine-tuning to avoid inflation.

The Economic Record

Over the past 50+ years our economy has experienced periods of high unemployment, high inflation, and high growth.

We have also experienced slow growth, low unemployment, and low inflation.

The long term growth trend has been at 3% growth in real GDP. Periods of growth less than 3% are called

growth recessions

.

Why Don’t Things Work???

In general there are four obstacles to policy success: Goal Conflicts Measurement Problems Design Problems Implementation Problems

Goal Conflicts

The most frequent source of

goal conflicts

are the policy decisions revolving around inflation and unemployment.

Policies designed to reduce unemployment can cause inflation to increase.

Policies designed to reduce inflation can cause unemployment to increase.

If balancing the budget is a policy goal, then any increase in government spending will require an increase in government revenue.

Goal Conflicts

Goal conflicts

occur when politicians make promises in order to get elected to office.

Often upon election, the conflicts become apparent.

Choices will be made by evaluating the opportunity cost of each policy choice.

Those choices which produce the least opportunity cost are likely to be chosen.

Measurement Problems

Economic data is produced weekly, monthly, quarterly, annually.

When data is produced there is often a time lag from the period being measured to the period when the data is produced.

For example, data which can provide information about unemployment, CPI, PPI, inflation, business investment, consumer spending, consumer confidence are often delayed by a month or more. This can cause

measurement problems

.

Measurement Problems

When evaluating economic data, trends are very important. Therefore a one period reduction or increase may not indicate a problem.

It may take 6 or more months before a trend is noticed and action is desired.

Economic forecasts are based upon assumptions that may change.

External shocks to the economy can significantly alter future economic conditions.

Design Problems

Design problems

refer to the actual response to an economic condition. Our response may be based upon sound economic theory and policy.

Consumers, businesses may not respond like the theories indicate.

For example, if the government cuts taxes by 20%, consumers are expected to spend most of the tax cut (MPC = .90). If they don’t, then we have a design problem.

Implementation Problems

Tax cuts and changes in government spending require the approval of Congress and the President.

Policy changes can occur as legislation moves through the House and Senate.

Politics often gets in the way of good policy.

The resulting economic package may be weaker than originally proposed or contain provisions which reduce its effectiveness.

Implementation Problems

One of the most serious implementation problems is associated with

time lags

. Many economic policy changes require congressional and presidential approval.

By the time the policy is adopted and implemented into the budget, economic conditions could be worse (or better).

Additional changes may be needed because of the time lag – but you will have to wait until the data is published that indicates the effectiveness of existing policy, then propose changes, then get legislative and presidential approval and then…now you understand the problem!!!

Implementation Problems

Federal Reserve policy changes can help.

Fed policy changes do not require congressional or presidential approval.

Fed changes can be implemented quickly.

It may take some time to measure the effect, but Fed policy changes can offer a temporary or permanent solution to minor economic disturbances. Most economists, especially Monetarists, believe that Fed policy changes are more effective on inflation than recessions.

Maintaining the Economy

Policy makers argue whether the economy should be subject to frequent fine-tuning.

Pressure to make economic adjustments is high during major elections – regardless of the long-term consequences. Politicians are eager to please voters with massive spending programs and/or tax cuts.

Some economists believe that the government should provide a stable economic environment and then “stay out of the way”.

Maintaining the Economy

Rational expectation

decisions.

theory is a hypothesis that people’s spending decisions are based on all available information, including the anticipated or future effects of government policy People will spend based upon their perceptions of economic conditions, income level, and expectations of the future. Often the media shapes consumer perceptions of current and future economic conditions. Do you get all of your economic news from one TV station or a single newspaper? If so, you may not receive a balanced viewpoint on the economy.

Do you think your spending decisions are based upon your perceptions of the current and future economic conditions? Think about it…

Summary

• Policy levers, policy types.

• Sources of fiscal, monetary, and supply-side policy.

• Economic conditions and policy responses.

• Fine-tuning.

• Past history of economic goals and reality.

• Goal conflicts and measurement problems, design problems and implementation problems.

• Federal budgetary process and timetable.

• Rational expectations.