ch13 all macro__lecture_ppt

© 2015 Pearson Education, Inc

Chapter 13Countercyclical Macroeconomic

Policy

13 Countercyclical Macroeconomic Policy

Chapter Outline

13.1 The Role of Countercyclical Policies in Economic Fluctuations

13.2 Countercyclical Monetary Policy

13.3 Countercyclical Fiscal Policy

EBE How much does government expenditure stimulate GDP?

13.4 Policies That Blur the Line Between Fiscal and Monetary Policy



Key Ideas

1. Countercyclical policies attempt to reduce the intensity of economic fluctuations and smooth the growth rates of employment, GDP, and prices.

2. Countercyclical monetary policy reduces economic fluctuations by manipulating bank reserves and interest rates.



Key Ideas

3. Expansionary monetary policy increases bank reserves and decreases interest rates. Contractionary monetary policy decreases bank reserves and increases interest rates.

4. Countercyclical fiscal policy reduces fluctuations by manipulating government expenditures and taxes.



Key Ideas

5. Expansionary fiscal policy increases government expenditure and decreases taxes. Contractionary fiscal policy decreases government expenditure and increases taxes.



In the previous chapter, we looked at how the economy experiences recessions and expansions in the short run.

Exhibit 12.2 Percent Deviation Between U.S. Real GDP and Its Trend Line (1929–2013)



Countercyclical policies attempt to reduce the intensity of economic fluctuations and smooth the GDP growth rate.


Expansionary policy aims to reduce the severity of an economic recession by shifting labor demand to the right and “expanding”


economic activity (GDP). It is meant to “heat up” the economy.


Exhibit 13.1, Panel (a) The Effect of Countercyclical Policy on the Labor Market Panel




Exhibit 13.1, Panel (b) The Effect of Countercyclical Policy on the Labor Market Panel


Contractionary policy is used to slow down the economy when it grows too fast, or “overheats.”



Exhibit 12.15 Rightward Shift in the Labor Demand Curve



Question: Why would policymakers want to reduce employment and GDP growth?



Answer 1: A contractionary policy can reduce inflation by slowing the growth rate of the money supply.



Answer 2: A contractionary policy can reduce the risks of an extreme contraction by trying to cool off the economy before it overheats.

“I’m the fellow who takes away the punch bowl just when the party is getting good.”

—Former Fed Chairman William McChesney Martin, Jr.


Countercyclical monetary policy is conducted by the Federal Reserve, or Fed.

The Fed influences short-term interest rates, especially the federal funds rate.



An expansionary monetary policy lowers short-term interest rates to increase economic activity.

Question: How does a reduction in the overnight federal funds rate lead to more production?



Answer:


Exhibit 13.2 Expansionary Monetary Policy



The primary tool of monetary policy is the Fed’s control of the federal funds rate.

The Fed influences the federal funds rate through open market operations.


In an open market operation, the Fed transacts with private banks to increase or decrease bank reserves held at the Fed.

The Fed can increase the supply of reserves through open market purchases.

The Fed can decrease the supply of reserves through an open market sale.



13.2 Countercyclical Monetary PolicyOpen Market Purchase

Exhibit 13.5 Balance Sheet of the Fed Before and After $1 Billion Bond Purchase from Citibank


13.2 Countercyclical Monetary PolicyOpen Market Sale

Exhibit 13.4 Balance Sheet of Citibank Before and After $1 Billion Bond Sale to the Fed


Most of the time, total reserves held at the Fed fluctuate between $40 billion and $80 billion.

During and after the 2007–2009 recession, the Fed drastically expanded the quantity of reserves banks held to $2.5 trillion to drive down interest rates.

This dramatic increase was mostly due to an expansion in excess reserves—reserves above and beyond the regulatory minimum.




Exhibit 13.6 Total Reserves on Deposit at the Federal Reserve Bank (Monthly Data from January 1959 Through December 2013)


The Fed has other tools available to impact bank reserves:

1. Changing the reserve requirement

2. Changing the interest rate paid on reserves deposited at the Fed

3. Lending from the discount window

4. Quantitative easing

13.2 Countercyclical Monetary PolicyOther Tools of the Fed


The effectiveness of monetary policy depends on expectations about interest rates andinflation.

Long-term expected real interest rate = Long-term nominal interest rate – Long-term expected inflation rate




What about contractionary monetary policy?

It is the opposite of expansionary policy:

Contractionary monetary policy slows down growth in bank reserves, raises interest rates, reduces borrowing, slows growth in the money supply, and reduces the rate of inflation.


What happens if the central bank pushes the policy rate to the “zero lower bound”?

Let’s use the example of Japan from 1990 to 2010.




Exhibit 13.8 Japan’s Interbank Lending Rate from 1987 to 2013



-2

-1

0

1

2

3

4

Japan’s Consumer Price Index Inflation Rate from 1987 to 2013inflation rate (%)


The combination of the “zero lower bound” and deflation is a problem for monetary policy.

Why? Households and firms make investment decisions based on:

Expected real interest rate = Nominal interest rate – Expected inflation rate =

0% – (– 1%) = 1%



Monetary policymakers face many conflicting considerations:

The Fed would like to stimulate the economy during a recession…but the Fed does not want to risk runaway inflation.



The Taylor rule provides one answer:

Federal funds rate = Long-run federal funds rate target +

1.5(Inflation rate – Inflation rate target) +

0.5(Output gap in % points)

where


GDP Trend GDPOutput gap = 100

Trend GDP


The Taylor rule has two important parts:

1. It says that the Fed raises the federal funds rate 1.5 percentage points for each 1% increase in the inflation rate.

2. It says that the Fed raises the federal funds rate 0.5 percentage points for each 1% increase in the output gap.



The Taylor rule recommends that the federal funds rate should be at:

Federal funds rate = 3.5% + 1.5(1.5% – 2.0%) + 0.5(– 5%) = 0.25%



Countercyclical fiscal policy is passed by the legislative branch (i.e., Congress) and signed into law by the executive branch (i.e., the president).



Expansionary fiscal policy uses higher government expenditure and lower taxes to increase the growth rate of real GDP.

Contractionary fiscal policy uses lower government expenditure and higher taxes to reduce the growth rate of real GDP.



Automatic countercyclical components are aspects of fiscal policy that automatically partially offset economic fluctuations—for example, unemployment insurance and food stamps.



Discretionary countercyclical components are aspects of fiscal policy that policymakers deliberately enact in response to economic fluctuations—for example, the $787 billion American Recovery and Reinvestment Act of 2009.




Exhibit 13.9 U.S. Government Accounts from 2007 to 2010 Combining Federal, State, and Local Governments (Constant 2009 Dollars)


13.3 Countercyclical Fiscal PolicyAnalysis of Expenditure-Based Fiscal Policy

The government expenditure multiplier is the $m change in GDP resulting from a $1 change in government expenditures.

Crowding out occurs when rising government expenditures partially or even fully displace expenditures by households and firms.


13.3 Countercyclical Fiscal PolicyGovernment Expenditure Multiplier

National income accounting identity:

Y = C + I + G + X – M

A $1 increase in G under the first scenario:

[Y + 1] = C + I + [G + 1] + X – M

Question: What is the value of the multiplier? © 2015 Pearson Education, Inc


Answer: The government expenditure multiplier m under the first scenario is $1/$1 = 1.

A $1 increase in G under the second scenario:

[Y + 2] = [C + 1] + I + [G + 1] + X – M

Question: What is the value of the multiplier?



Answer: The government expenditure multiplier m under the second scenario is $2/$1 = 2.

A $1 increase in G under the third scenario:

[Y + 3] = [C + 1] + [I + 1] + [G + 1] + X – M



Answer: The government expenditure multiplier m under the third scenario is $3/$1 = 3.

Advocates of expenditure-based fiscal policy believe that the government expenditure multiplier lies between 1 and 2 but can be as high as 3 for certain types of government spending.



A $1 increase in G under the crowding out scenario:

Y = C + [I – 1] + [G + 1] + X – M





Answer: The government expenditure multiplier m under the crowding out scenario is $0/$1 = 0.

Critics of expenditure-based fiscal policy emphasize crowding out and believe that the government expenditure multiplier is well below 1 and might even be close to zero.



Question: Which is the “right” scenario?

Answer: Economists are not completely sure. However, they do believe that the multiplier is larger when the economy is well below trend and closer to zero when the economy is close to potential.



Question: What was the impact of the $120 billion in government expenditures of the American Recovery and Reinvestment Act in 2009?

Caveat: We assume a multiplier of 1.5 since the economy was in a deep recession.



Answer:

1.5 × $120 billion = $180 billion

Or:

$180 billion 100 = 1.3% of GDP

$14 trillion


13.3 Countercyclical Fiscal PolicyGovernment Taxation Multiplier

National income accounting identity:

Y = C + I + G + X – M

A $1 decrease in taxes under the first scenario:

[Y + 1] = [C + 1] + I + X – M




Answer: The government taxation multiplier munder the first scenario is $1/$1 = 1.

A $1 decrease in taxes under the second scenario:

[Y + 2] = [C + 2] + I + G + X – M




Answer: The government expenditure multiplier m under the second scenario is $2/$1 = 2.

A $1 decrease in taxes under the third scenario:

[Y + 1] = [C + 2] + [I – 1] + G + X – M




Answer: The government expenditure multiplier m under the third scenario is $1/$1 = 1.

A $1 decrease in taxes under the fourth scenario:

[Y + 1] = [C + 2] + I + G + X – [M + 1]




Answer: The government expenditure multiplier m under the fourth scenario is $1/$1 = 1.



Question: Which is the “right” scenario?

Answer: Economists believe that the government taxation multiplier is between 0 and 2, depending on (1) the level of consumption and (2) anticipation of future tax increases.



Question: What was the impact of the $65 billion in tax cuts of the American Recovery and Reinvestment Act in 2009?

Caveat: We assume a multiplier of 1.0.

Answer: 1.0 × $65 billion = $65 billion or:

$65 billion 100 = 0.5% of GDP$14 trillion



A few specific fiscal policies are directly targeted at the labor market:

1. Unemployment insurance

2. Wage subsidies



Exhibit 13.10 The Impact of a $1 Wage Subsidy



However, government programs can suffer from:

1. Policy waste

2. Policy lags


Question: How much does government expenditure stimulate GDP?



Data: U.S. quarterly GDP data for 1939 to 2008 and historical news coverage.

Problem: Government expenditure and GDP are simultaneously determined, so does expenditure cause GDP or vice versa?

Solution: Valerie Ramey identifies “random” government expenditure resulting from foreign events.



Question: How much does government expenditure stimulate GDP?

Answer: The government expenditure multiplier is estimated to be between 0.6 and 1.2.



Some countercyclical policies represent a mix of fiscal and monetary policy.

One example is the Troubled Asset Relief Program (TARP), passed in October 2008.



TARP authorized the Treasury Department to spend $700 billion to stabilize the banks. This amount was later reduced to $450 billion in 2010.

$250 billion was spent to increase the capital base of U.S. banks.

The remaining amount was spent on the nearly bankrupt companies General Motors, Chrysler, and AIG.



ch13 all macro__lecture_ppt

Education

pearson education

economic fluctuations

economic fluctuations

economic fluctuations

expansionary monetary

expansionary fiscal

economic recession

economic activity gdp