Frontiers of Macroeconomics

'l'he task o[ eronomic sktbilizatiut requires keepittg llrc econorn:.litnt sl.rutyin4 too.fitr ahrnv or lttltnu lhc lnth ol .slru,* high

enltk4nt,rLt. Oru'tttt. l's |nfttlion, rntl lln tlu, lit.t ttt,ssiot.I;lcxille anrl uitikml.lisral and nowl(r\ Polict,will alktu us to

ltold lltc n arror.t middlc t ourse.Pr-csidt'n t

.f oh n l-. Kt'nncdy( 1962)

The 1..S. ('c()lr()nrv has clrarrg

I'lscAL Hlsl'oRY

The budget deficit increzrsed e.ren drrring theprosperous y'ears of the mid-2000s as taxes werecut and spending increased on new entirlementprograms and seemingly endless nars in lraq andAfghanistan. Therr, the nation's banking svstcrn ranmammoth losses and the econonry rvent irrto a dcetrecession. Tax rer,-enrtes fell sharply, arrd hundrccls ofbillions of dollars r.r'ere spent to prop up thc finan-cial svstem and stimrrlate the ecorrolny. F-or 2001), thcfederal government was nrnning arr anlltal dcficit o[close to $2 trillion, rvhich rvas the largest pcrccnt ofGDP since \l'orld tA/ar II.

Horv dicl the burlget decit get so high? lVhat arethe economic imp:rct.s of fiscal deficits? Tl.rese impor-tant qrrestions will be adclressed in this sectiou. ll'cwill scc that thc poprrlar conccrn with dcficits has aIirm cconouric lbrrnclation. Dcficit spending rnay berccessart'1

348 CHAPTER I7 . 'RON'I'I!]RS OI,' MAC:ROECOiOMICS

Percent of GDP

Fedeml budget compoeot

ReveoueIndidual income taxesCorporation income taxesSocial insurance and retirement receiptsOther

EryeuditresNational defense and international affairsHeallncome securitySocial securityNet interectOer

Surplus or decit

1940

6.40.91.21.82.7

9.41.80.11.50.00.95.2

-2.9

1960

17.6

4.12.83.0

r7,t9.70.2r.42.21.32.7

0.t

l9E0

lE.58.82.3J.t1.8

21.25.32.03.14.21.94.7

-2.6

2000

20.610.22.1o.t1.6

18.23.23.62.64.22.32.4

2.4

m08

r7.78.12.16.3t.2

20.94.44.73.04.31.72.5

-3.2

TABLE l7-1. Federal Budget Trends, 1940-2008The f'ederal share of e economy grew sharpll'from 1940 to 1960 as the Llnited States tookan active military role in world allairs during the hot and cold wars. After 1960, the federl-spending share stabilized, but the composition of spending moved liom military to healcare and r-ther social spcndin. Tlrc fedcrl government delicit grew sharplv in the 2000s asrevenues declined sharply due to indidral incornc-tax crrts.Sorrre: f)ata are for fisral years and comt' tiom thc Drpanmen( ol the lieirsun. ()llice ol -Vanagemen! and Budgct,and l)cpanmcn( of (j()mmcrcc. 'I'hcy arc sumtanzcd in Eonoat. Indrakrs, \ilabla xr Mqrn.uat.Ep.xt..css.gw/

o The period fiom 1960 L

THE SHOR't'-RLrN lMt'A(;',t ()t; (;()\'l.tRN!tUN l t)t'l(:lTS

srill experience recessions and inflations. Fiscal pol-icl rvorks better in theorv than in practice. More-ovcr. rnonetary policy has become the preferred toollbr nrodcrating brrsin ess-c,vcle srr'ings. Still. rt'henuncrnploymcnt liscs, there is ttstallv strong publicpresstrrc lbl thc govt-rnrnent to boost spending. Inthis scction, rr'c will r-eview the major ways in whichllre govenrmcnt carr ernplov scal policy, and wewill cxanriuc thc pr-actical sholtcontil.tgs that harbecome pparent.

Act u ol, Structurol, o nd Cy clicol BudgetsModern public finartcc disiingtrishcs bctwcclr strlrc-trral and c'clical cleticis. l-hc itlca is sirnplt'. Thestructural part ol thc btrdgct is activc-de terrtr inedby discretionary policics sttch as tllosc covcritrg taxrates, public-works or cducatiott spcttdittg, ol tltc sizcof defeuse purchases. IIr cotrtrtist, thc rtrlilzrl part of'the budget is determincd passively b;- thc statc of thcbusiness cycle, that is, by tllc cxtcl)t to wllich t)atiorralincome and output are high or low.'l'hc prccist'dcfi-n it iors follow:

I'h c actual budget lt'< r t

3s0

govcmment deficit will rise because the deficit equalsT G and thus rises r'r'ith 7-culs or G increases.

This then is the basic result for rhe short nn:With less than full employrnent, increases in thestructurl deficit arising from discretionary Tcurs orG increases will tend to produce higher outprrt andlower unemplolment, and perhaps higher inflation.

We must, howeve expand on the simplest mul-tiplier analysis to incorporate the reactions of finan-cial markets and monetary policl'. As ortpllt risesand inflation threatens, central banks may raiseinf.erest rates, discouraging domestic investment.Higher interest rates may also cause a country's for-eign exchange rate to appreciate if the country hasa flexible exchange rate; the appreciation leads toa decline in net expors. These financial reacrionswould tend to choke off or "crowd out' investment,with a resulting decrease in the expendirure multi-plier of our simplest model.

Fiscal policv tends lcl exparrd tlre ecorronrv inthc short n1-1| is. when there irre rrrrern rloyedrcsurlrccs. Hielrer spcncling and lorver tlx retesilrclcast: aggrcgatc tlcrrrand, ()utput, clnplovrnent,ancl inflaiorr. Huwcvcr, tlris cxparrsiorran inrp:rctis redtct'cl bl' the srrbscqrrcllt liltalrcial rcactiorrs rfinterest r?rtes and foreiglt cxchangc ratcs.

GOYERNMENT DEBTANDECONOMIC GROWTHWe turn now from the short ntn to tle long run-tothe impact of fiscal policy, and particularly a largegovemment debt, on investlnent and economicgrowth. The analysis here deals with the costs of ser-cing a largc cxtcrnal clebt, the inefficiencies of lery-ing taxes to pay intcrcst on the dcbt, and the impacrof the debt on capital accurrr ulati

(;OV]RNNI]NT DF,BT AND ECONONI(] CROWTH

FIGURE | 7- l. Debt-GDP Ratio for thc U.S. l'ederal GovernmentThis ligrrre shows the rati() of net debt, or debt ir thc lratrrls o[ lht: Jrrrblic, to (iDP. See rhecfft'r't of lV

352

The effect of sovernmenr debt is rhat pcorlc willaccttmulate government debt irrstead o[ plivatc capi-tal, and the nation's private capital stock will bc rliyplaced by public rlebt.

To illustrate this point, suppose that pcopledesire to hold exactly 1000 unis of wealth for retire-ment and other purposes. As the government debtincreases, people's holdings of other assets will bereduced dollar for dollar This occurs because asthe government sclls its borrds, other assets mustbe reduced, since toral dcsired wealth holdings arefixed. Brrt these other asscts ultilnalelv represcnt thestock of private capital; stocks, b

GO\/ERNMENT DEI}1' ANI) I]CONOMI(] (iRO\'!TH

and demand for capital as a function of the realintcrcst rate or return on capital. As intcrcst ratesrise, firrns dcmand less capiuel rvhile individuals mayrvant to supply more. The equilibrium sh

3s4

\4hat is tlre irnpact of a budger srrrplus and adedinnry govcr nrncnt debr? I [ere, the :rr-grrnrcntr'orks irr thc otlrcr direction. A lrwer national debrmeans that rnorc ol rrational werlth is puf. itrt() capi-tal rirther than govcrrrment bonds. A higher capiralstock incrcascs the growth of

MODERN (:T,ASSICAI. I\IA(]ROECONo M I(:S

saw two maior rcvolutiolls in cconomics-the mar-ginal revolution in micr

35

Whilc rainstream business-qrle analysis rclicspt'imalily on thc Kel.nesian AS and ,4/) ntodcl, ancw brnch of'the classical school challengcs thcstandard approach. This theory called new clessicalmacroeconomics, was developed by Robcrt Lucas( Univcrsity of Chicago), Thomas Sargent (Stanlil.dUniversity and New York Unil'ersiqv), and RobcrtBarro (Harvard Universiry). This approach is rnuchin the spirit of the clacsical :rpproach in crrrphasizingthe role of flexible wages and rliccs, but it als

MODERN (ll.r\SSlCAl - MA(:R() l( r.) N( ) l\4 l ( ls

indefinitc frrttrre through the overlapping colrccrllsof each gcncratiolr abrttt iLs offspring.

Herc is lvhcrc tlre surprising result comcs: ll'the goverrrrncnt cttts taxes brt leaves expenditulcsunchanged, tltis ncccssarilv reqttires increased gov-ernment borrowing. But, th unchanged exPendi-tures, the govertrnrcnt will have lo raise tilxes at somepoint in the future to Pay tlre interest on ils new bor-rowing. In thc Rical-dian viclr', consrtmers h:rve ratin:rl expectatiotrs abott firttrrc policies, so when a tirKcul occlrs, they knorv thcy urust plan fol a filtllre taxincrease. They rvill thereforc incrcasc thcir saving bythe amount of the tax cut, and thcir- consumption*'ill remain unchanged. Mot-eovct, people take intoaccount the well-beirrg of thcir chilclren. So, even ifthe future [ax increasc cotncs after their lifetime,they will save enouglt to incrcasc their bequesls totheir children so that their childrclr carl pay thecxtra faxes.

The net result in the Ricar

358

and raisc lhe long-run rate of economic growth. Liketheir prccursor in 1981, these tax crrs led ro lower,rathcr than higher, tax revenues (see Table I7-|).

POLICY IMPLICATIONSP o li cy I n effectivenesj

Thc new classical approaches have several ir portantir.nplications for macroeconomic policy. Onc of'rhcnrost irfrportant conten[ions is the ine.[crtiueness oJ'sysltmatir fista,l ond monetary policie.s in reduring untm-Floynmtl.'I'hc basic idea here is that a preclictablcattempt to stirnulatc the economy u'ould be knor.r'nin arhance and would therefore have no effect onthe economy.

For exanrplc, supposc that the go\,ernment hasalrvays stimrrlated thc rcnally come to expcct thar behavior. They might sav rothemselves:

!-lections an: rrrnring. From experience I know thatlltc govcrnment ahans pumps up the econonry lrt:lion.clcctions. I will probabll.get an electi(,n+('ar lax (.ut,lut that rtill be follos'ed by a stealtll rax irrr.ru.asc nexryear. They can't fool me intr corsrrrrrirrg ntore, work-ing harder. and votitrg for incrrnbcnts.

This is the pocy-ineffectiveness eoem of classi-cal macroeconomics. Iil'ith l?tional expectations andflexible prices and wagcs, anticipated governmentpoliq' cannot affect real output or unemploment.

The Desirobility of Fixed Rules\\e describecl the motrctarist crse for fixed rules inChapter 10. New clssical macroeconomics pur-s thisargument on firmcr fboting. This approach holclsthat an economic policv can be dirided into m.o parts.a predictable parr (the "rule") and an unpredictablcpart ("discretion").

Neu' classical rnacroeconomisLs argue that disc.c-tion is a snare and a delusion. Policymakers, thcy con-tend, cannot fbrecast the economy anv bettct.thancan the privarc sector. Therefbre, by the rinte policy-makers act or-r tlrc rrclvs, f lexibly moving prices in nrat.-keus populated by well-informed buyers and scllcrshave already adaptctl to the news and reached thcirefficient supply-anddemand equilibriur. Tlrcr-c arcno further di"snelionury steps the government can takc

CI{APTER I7 . FRONTIERS OF NIA(]ROE(JONOMI(:S

to itrtprove thc outcome or prevent the uncmplo).rrrcrt tllat is caused bv temporarv rnispcrccptions orreal-businesscvcle shocks.

Although they cannot make rhngs bcrtcr., goyern-nrcnt policies can denitely make things u'orse. Thegovclnr)crrr can generate unpredictable discretion-ary ptlicies that give misleading economic signals,confirse people, distorr their economic behalior, andcause wste. According to new classical lnacroecono-rnists, governmenls should avoid any discretionaryrnacroeconomic policies rather than risk producingsuch confsing "noise."

A New Synthesis?Alicl thrce decades of digesdng the neu' classi-cal appr-oach to macroeconomics, elements ol asvnthcsis ol old and new theories are beginDing toappcar. [,corrornists today emphasize the importanccof cxpccurtions. A useful disrinction is benvcctr rhcadaptilc (or "backwardJooking") approach andthe rrtional (or "f

1'IIIi INTF,RA(:TIOi OF MONETARY AND FISCAI, POI-I(JILS

TIlc nerr tlassitltl atrro:rch l() ltl:lcr(x'c()ll()lllicshas lrlottglrt Irtaur f r uitltrl insishts. l\'lost itttrottant, itrt'ntirtcls tts tlrat tltt ((()rt()lrl! is totrrlatcd hl ilrtt'lli-!.J('nt collsulll('ls irlttl it"cstols rr'lltl tt'act ttl atld

360

There are two situatiolrs when countercyclicalfiscal policies appcar to bc particularly useful. Onecase is fentporary tax cuts in recessions. Temporarytax cut.s may be airrrctl prirnarily at low- and micldle-income horse holds. l'hc r eason is that these htrrse-holds lravc high rrral girral propensities ro consllmetecarrse tlrcy havc littlc excess sang to fall back onin hard rimcs. Statistical studies indicare rhar thesemeasrrres havc indced been eflective itr increasingaggregate dcnranrl irr thc short run without leadingto long-rtrn fiscal tleficits.

Arr cvclr rnore importanr situatitn is when tlrceconorly is in a liquiclity trap and the central bankhas no firthcr- room to lower shorrterm inlercstrates. (Rccall ttr discussion of the liquidiry trap inOhaptcr 10.) 'I'his wzrs the case during rhe 2007-2009reccssion. Ill its eflbrt to revive rhe econonry, tlrcObarna adrninistration worked w'irh Oongrcss irr carly2009 to pass the largest fiscal stimrrhs packagc in Ll.S.histov. Vv'hile some people worried aborrt thc long-ternr in)pact of the fiscal stirnulus on the governrncrrrdebt, most nlacroccont.rnlisu believed th:rt fisc:rl nrl-iq was thc olllv li'asible wav to rerluce rhe deprh andthe selcritv ol the dorvnttrrn in this circrrmstanct'.

Effectiveness of Monetory Polcy. Compared to fis-cal poliry, monctar) policv operates mrrch mtre indi-rectly on the econoln\,. Wlerers:rn exp:rnsive scalpolicy actually hrrls goods and scnices or pus incomeinto the hands of consurreni and businesses, mon-etary policy affect.s spcndirrg bv altering interest rates,credit conclitions, exchangc ratcs, and iuset prices. Inthe early years of thc Kcyncsiarr revolution, some mac-roecononlists wcrc skcptical bout rhe effectivenessof monetary policy-sorne said, "Moneurry policy waslike pushing orr a string." Oler the lasr rwo decades,howeve these conccrlrs hare been put to resf as theFederal Reserue has sh

1'III.] INTF,RA(:TION OF MON]TARY AND 'IS(]AI, POI,I(]IES 3t

Sector

Investment sectorsGross private domestic investnent

Housing 18Rusiness fixed investment 30

Net exporLs

Conemption sector:Government purchases of goods and servicesPersonal consumption expcnditures

Memoranda:Ohange in real GDPChange in f'ederl deficit

Ctmge in ou9ut($, billion, 20118 prices)

13248

83

- 106

-68-38

26-

100

TABLE l7-3. Changing c Fiscal-Monetary MixWht wrrrld he tlre impact of a clr:rnge in llrt. flscal-monetary nrix for the Llnitcd Statr:s?This simulati

362

and output at its potenal. A new president decidesthat it s necessary to increase defense spendingsharply without raising taxes. By itself, this wouldincrease the government deficit nd increase aggre-gate demand. In this situation, the Federl Reservewould need to tighren monetary policy to preventthe economy from overheating. The result wouldbe higher real interesr rtes and an appreciation ofthe dollar exchange rare. The higher interest rateswould squeeze investment, while the appreciated dol-lar would reduce net exporu. The net effect there-fore would be that the higher defense spending wouldcrowd out domestic investment and net exports. Thispolicy was the one followed by the United States inthe 1980s and again in the 2000s.

. frght,tscoHoose monetory policl. Suppose that a coun-try becomes concerned about a low naonal savingrte and desres to raise investment so as to incrasethe capital stock and boost the growth rete of potentialoutput.To implement this approach, the country couldraise consumpdon ta:res and squeeze transfer paymentsso as to reduce disposable income and thereby lowerconsumpton (ght fiscal policy).This would be accom-panied by an expansionary moneary policy to lowrinterest rates and raise inrestment,lower the exchangerate, :rnd expand net expors. Ths course wouldencourage pri\te nvestment by increasing public sav-ing. This was the economic philosophy of PresidentClinton which was embodied in the 1993 Budget Actand led to the budget surplus at decade's end.

RULES VS. DISCRETION\4'e have seen rhat liscal and monet^ala policy canin pineiltb stabilizc the economy. Many econornistsbelieve that counrries should i ltrncti.re takt: stcps toshave the pcaks and troughs off the busincss cyclc.Other econonriss arc skeptical of orl. ahilitv to fbrc-cast cycles and rakc thc right steps ar rhe right tirncfor the right reasons; this second grorrp concltr

RUI,ES vS, DIS(:RI.] ION

budget rules prodrrced significant scal disciplinc,hclpcd reduce the deficit over thc 1990s, and eventu-ally produccd the surplus afier 1998. Houcver, rvhenthe deficit changed to surplus and thc lrlgcncy ofdefi ci t-reduction decl ined, polic,lrnakers cvadecl theearlier budgct caps with gimmicks like "erncr-gencyspending" fbl predictable items like thc dccen-nial census. Fiually, in 2002, the budgct caps wcreallowed to expire. Matrv ccrnomisls believe that apay-as-you-go rule is a tscftrl mechanism to itrtposcbudget constrins on lcgislatttres, and there wercproposals to reinstate tltcsc in 2009.

Monetory Rules for the FeIn our discussiolr of nronetarism in Chapter 10, rvclaid out the crsc fbr fixed policy rules' The tracli-tional argumcnt fbl fixcd rules is that the pr-ivatceconomy is relativclv stable and active polic)'rnak-ing is likely' to destabilize rather than stabilize thceconom)'. Moreovet, Lo the extenf that a centralbank rrnder the thttrrlb o[ the government may bctempted to expatttl thc cconom!' beforc electiollsand to create a political btrsiness cycle, fixed rulesll tie its hands. lIl addition, modern macroec()ll(>nrists point to the valuc

364

this pcrir-d. Instead, the Fed concenrrated on tryilrgto cushion the economy from a deep recession atrdto prcvcnt wholesale banknrptcies of financial insti-tutions (scc the discussion of Bear, Stearns abovc).

Monet-ary policy cannot banish all rcccssiorrs orrenrovc cvery temporry spike of inflation. Howcver,working with fiscal policy, it can reduce thc chance ofspiraling cortrctions or hyperinfl ation.

Thc rlcbatc over ntles versrrs discr-ctiolr is orrco[ thc oltlest debates of political econorrry. fhisdilcnlrna reflecls the difficrrlt tradcolls tllat dcrtro-( rirtic socictics flce in makilrg decisions l)ctwcenshort-rrn policies intended t() atrr':rcr rolitical srrpport arrrl lorrg-rrrrr policies desiglrecl to iltrprovc tllcgeneral n'cllrc. There is no single best arpr.oaclr fbr.:tll timcs arrtl places. For rnonetarl tolicr', thc Lirrite

35THE SPIRI'I' OF I]NTF,RPRISE

Gmwlh rate(% per year)

0I,2

4

Real Income per Capita (constant Prices)

2000

s 24,00024,m024,m024,ffn

205()

$ 24,00039,47164,598

t70,560

2t00

$ 24,00064,916

t73,872l,2t 2,1 t8

TABLE l7-5. Small Diffcrcnces in Growth Rates Compound into l-arge IncomeDifferentials over e Decadcs

THE SPIRIT OF ENTERPRISEAlthough inlestment is a central lctor in cconomicgrowth, tcchnological advance is perhaps cvcll InoreimDortalrt. ll wc took the workers in 1900 ard dotr-bl or tr-iplcd their capital in mules, sadcllcs, picks,and corv paths, their productigv still coulcl not comecltse to that of today's l4'orkers using lrrrgc tl'actors'su-rcrhighwavs, and suPercomputcrs.

F oste ri n g Te chn o I ogi col Advo n ceWhile it is easy to see how technological adrancepronlotcs grolvth in productity ancl living stan-dards, govcrnmelrt"s cannot simply conrnrand peopleto think hardcr or be smarter. Centrally plannerlsocialist cortrtr-ies rrsed "sticks" to Prollrotc science,tcchnology, and innoration, but their cflbrs failedbecause rtcithcr the institutions nor thc "catrots" u'erepresent Lo cncollrage both innmote rapid tcchnological change best whcn tlrcy scta sound econt.tnic and legal framework with strongintellectual propcrqv righrs and then allow grcat cconomic fieedorn within that framework. Frct mrktts ittlnbu rapital, lnodtu.Ls, ul ittc.s haue Pmaed lo b lh? rul.fefiik wil lor inrnualion anl technotgical chang.

Within thc framework of free markes, go\crn-ments can fbstcr rapid technological changc lxrth byencouraging lcw ideas and by ensuring that tcchnol-ogies are efl'ectivcly uscd. Policies can focus t.tr boththe supply sidc and thc demand side.

Promoting Demond for Better Technofogies. 'Iheworld is lull of supcrior technologies that tlavc notbeen adoptcd; othcrwise, how could we explain thc

vast dillcrcnccs in procluctivity shown in Tablc l7-4?In c

3

last half-century hs becn the Unitecl Srares, rvhichcombincs cornpanv supporr for applied escarchwith topnotch university basic research gcncrouslvsupportcd b,v government funcling. Particrrlarlv otrt-standing havc bcen e impressive improvements inbiomedical tcchnologv in the form of new drrrgs andequipment that bcnefit consumers directly in dailylife. The govcrnrllcnt's rolc in supporring For-profirresearch is accornplished by a strong patent systcrn,predictablc and cost-ellectit'e regulations, and flscalincentivcs strch as the current R&D tax credit.

Second, governments can adrance technologiesat homc through encouraging invesrmenr by lbreignfirrns. As lbreign counrries reach and pass the funeri-can technological fronrier, they can also contributeto Arneican krrow-how by establishing operations inthe Unitcd Statcs. The last rwo decades have broughta numbcr 0l Japanese automakers to thc LlnitedStates, and Japanese

SU M MARY

and spend if thc r:conomy were operadng at potentialoutput. The cvclical lrrr

38 CHAPTER I7 FR()NTt URS ()F MA(tR()!.c()NOl\ttCs

CONCEPTS FOR REVIEW

The Economics of Debt andDeficitsgovernment budgetbudget deficit, surplrls, arrd balanccbudget;

ac tualstru ctura Icvclical

short-mn impact of'l.J arrrl 7'on outprrtlong nrn impacls ()n cconomic grotth:

internal vs. cxternal debtdisl()rtions from taxationdisplacement of capiurl

Advances in ModernMacroeconomicsSav's Iaw of Mlrrketsraonal (lirrwardJooking)

expectrti()11s, a(lal)liv(. ( lrat kward-looking) (.x lx'( tr( i()ns

roliry-i r rr.ffcc tivcn ess theoremrcal brsiness cvcle. cfficiency rvagesRicardian riew

QLlus l r( )NS t-oR Dls(:ussloN

tht' < arital stock encl up smaller? Illustratt' rrsing Fig-ure l7-2.

3. l'race the impact rtpott tltt' f{(}vcr-nnlent clebt, thenation's capiL-rl stock, and real ()tlt[)tlt ol a H()vcrnl]relltprogranr that borrows abroad and spctttls lltc trtonc'on tlr(' f()ll(wirg:a. Capital t