principles of economics chapter 15

8/13/2019 principles of economics chapter 15

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Prepared by: Fernando Quijanoand Yvonn Quijano

2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair

Macroeconomic

Issues and Policy


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2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 3 of 40

Time Lags RegardingMonetary and Fiscal Policy

Time lagsare delays inthe economys response

to stabilization policies.


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Two Possible Time Paths for GDP

Path A is less stableit varies more over timethanpath B. Other things being equal, society prefers pathB to path A.


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Stabilization: The Fool in the Shower

Attempts to stabilize the economycan prove destabilizing because oftime lags.

Milton Friedman likened theseattempts to a fool in the shower.

The government is constantly

stimulating or contracting theeconomy at the wrong time.


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An expansionary policy that should have begun to takeeffect at pointAdoes not actually begin to have animpact until point D, when the economy is already on

an upswing.


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Hence, the policy pushes the economy to points F andG (instead of Fand G). Income varies more widelythan it would have if no policy had been implemented.


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Recognition Lags

The recogni t ion lagrefers tothe time it takes for policy

makers to recognize theexistence of a boom or aslump.


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Implementation Lags

The implementat ion lagis the timeit takes to put the desired policy intoeffect once economists and policymakers recognize that the economyis in a boom or a slump.

The implementation lag for monetary

policy is generally much shorter thanfor fiscal policy.


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Response Lags

The response lagis the time it takes forthe economy to adjust to the newconditions after a new policy is

implemented; the lag that occurs becauseof the operation of the economy itself.

The delay in the multiplier of governmentspending occurs because neither

individuals nor firms revise their spendingplans instantaneously.


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Monetary Policy

To make the monetary policy storyrealistic, two key points must beadded:

In practice, the Fed targets the interestrate rather than the money supply.

The interest rate value that the Fed

chooses depends on the state of theeconomy.


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Targeting the Interest Rate

The Fed can pick a money supplyvalue and accept the interest rateconsequences

Or

The Fed can pick an interest rate

value and accept the money supplyconsequences.


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The Feds Responseto the State of the Economy

The Fed is likely tolower the interest rate(and thus increase themoney supply) duringtimes of low output andlow inflation.


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When the economy ison the flat portion oftheAScurve, anincrease in the moneysupply will lead to anincrease in output with

very little increase inthe price level.


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Stagflation is a more difficult problemto solve.

If the Fed lowers the interest rate, outputwill rise, but so will the inflation rate(which is already too high).

If the Fed increases the interest rate, the

inflation rate will fall, but so will output(which is already too low).


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Data for Selected Variablesfor the 19892003 Period

Data for Selected Variables for the 1989 2003 Period

DATE

REAL GDP

GROWTH

RATE (%)

UNEMPL.

RATE (%)

INFL.

RATE (%)

THREE-

MONTH

T-BILL RATE

AAA

BOND

RATE

FED.

GOV.

SURPLUS SURPLUS/GDP

1989 I 5.0 5.2 4.3 8.5 9.7 - 108.8 -0.020

II 2.2 5.2 4.0 8.4 9.5 - 127.3 -0.023

III 1.9 5.3 2.9 7.9 9.0-140.6

-0.025

IV 1.4 5.4 3.1 7.6 8.9 -143.4 -0.0261990 I 5.1 5.3 4.5 7.8 9.2 -172.1 -0.030

II 0.9 5.3 4.7 7.8 9.4 -171.2 -0.030III -0.7 5.7 3.9 7.5 9.4 - 164.6 -0.028IV -3.2 6.1 3.5 7.0 9.3 -184.0 -0.031

1991 I -2.0 6.6 4.7 6.1 8.9 -160.1 -0.027II 2.3 6.8 2.9 5.6 8.9 - 213.4 -0.036III 1.0 6.9 2.5 5.4 8.8 -234.7 -0.039

IV 2.2 7.1 2.3 4.6 8.4-

253.1-0.042

1992 I 3.8 7.4 3.1 3.9 8.3 -288.3 -0.047II 3.8 7.6 2.2 3.7 8.3 -291.8 -0.046III 3.1 7.6 1.3 3.1 8.0 - 316.5 -0.050IV 5.4 7.4 2.5 3.1 8.0 -293.5 -0.045

1993 I -0.1 7.2 3.4 3.0 7.7 -300.9 -0.046II 2.5 7.1 2.2 3.0 7.4 -267.3 -0.041III 1.8 6.8 1.8 3.0 6.9 -275.5 -0.041IV 6.2 6.6 2.3 3.1 6.8 -253.0 -0.037


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DATE

REAL GDP

GROWTH

RATE (%)

UNEMPL.

RATE (%)

INFL.

RATE (%)

THREE-

MONTH

T-BILL RATE

AAA

BOND

RATE

FED.

GOV.

SURPLUS SURPLUS/GDP

1994 I 3.4 6.6 2.0 3.3 7.2 - 237.5 -0.034

II 5.7 6.2 1.8 4.0 7.9 -190.6 -0.027

III 2.2 6.0 2.4 4.5 8.2-211.8

-0.030

IV 5.0 5.6 1.9 5.3 8.6 -209.2 -0.029

1995 I 1.5 5.5 3.0 5.8 8.3 - 208.2 -0.029

II 0.8 5.7 1.7 5.6 7.7 - 189.0 -0.026

III 3.1 5.7 1.8 5.4 7.4 -197.5 -0.027IV 3.2 5.6 2.0 5.3 7.0 -173.1 -0.023

1996 I 2.9 5.6 2.5 5.0 7.0 -176.4 -0.023

II 6.8 5.5 1.4 5.0 7.6 -137.0 -0.018III 2.0 5.3 1.9 5.1 7.6 - 130.1 -0.017

IV 4.6 5.3 1.6 5.0 7.2-

103.9-

0.0131997 I 4.4 5.3 2.9 5.1 7.4 -86.5 -0.011II 5.9 5.0 1.9 5.1 7.6 - 68.2 -0.008III 4.2 4.8 1.2 5.1 7.2 -33.8 -0.004IV 2.8 4.7 1.4 5.1 6.9 - 25.0 -0.003

1998 I 6.1 4.7 1.1 5.1 6.7 19.6 0.002II 2.2 4.4 1.0 5.0 6.6 33.0 0.004III 4.1 4.5 1.4 4.8 6.5 65.7 0.007IV 6.7 4.4 1.1 4.3 6.3 57.1 0.006


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DATE

REAL GDP

GROWTH

RATE (%)

UNEMPL.

RATE (%)

INFL.

RATE (%)

THREE-

MONTH

T-BILL RATE

AAA

BOND

RATE

FED.

GOV.

SURPLUS SURPLUS/GDP

1999 I 3.1 4.3 1.8 4.4 6.4 85.1 0.009II 1.7 4.3 1.4 4.5 6.9 116.5 0.013

III 4.7 4.2 1.4 4.7 7.3 132.0 0.014IV 8.3 4.1 1.6 5.0 7.5 143.2 0.0152000 I 2.3 4.1 3.8 5.5 7.7 212.8 0.022

II 4.8 4.0 2.3 5.7 7.8 197.2 0.021III 0.6 4.0 1.6 6.0 7.6 213.1 0.022IV 1.1 3.9 2.1 6.0 7.4 193.8 0.019

2001 I -0.6 4.2 3.6 4.8 7.1 173.8 -0.017

II -1.6 4.4 2.5 3.7 7.2 199.6 0.014

III -0.3 4.8 2.2 3.2 7.1 -51.7 -0.005IV 2.7 5.6 -0.5 1.9 6.9 21.3 0.002

2002 I 5.0 5.6 1.4 1.8 6.6 -145.8 -0.014

II 1.3 5.9 1.3 1.7 6.7 -195.7 -0.019III 4.0 5.8 1.2 1.6 6.3 -210.5 -0.020IV 1.4 5.9 1.8 1.3 6.3 -247.7 -0.023

2003 I 1.9 5.8 2.5 1.2 6.0 -253.6 -0.024II

Note: The inflation rate is the percentage change in the GDP price deflator.


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The 19901991 Recession

After the Fed became convinced thata recession was at hand, itresponded by engaging in open

market operations to lower interestrates.

Inflation was not a problem, so the

Fed could expand the economywithout worrying about inflationarypressures.


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19931994

During this period, inflation was not aproblem, so the Fed had room tostimulate the economy and kept its

expansionary policy.

By the end of 1993 the Fed wasworried about inflation problems in

the future, and decided to beginslowing down the economy.


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19951997

Inflation did not become a problemafter 1994, and the Fed loweredinterest rates. The three-month

Treasury bill rate remained atroughly 5.0 percent throughout 1996and 1997.

During this period, the economyexperienced good growth, lowunemployment, low inflation, and abalanced government budget!


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19982000

Based on concerns about the Asianfinancial crisis, the Fed lowered thebill rate to 4.3 percent in the fourth

quarter of 1998.

The Asian crisis did not affect theU.S. economy very much, and the

Fed began raising the bill rate onfears that the economy might beoverheating.


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Fiscal Policy: Deficit Targeting

Many fiscal policy discussions centeraround the size of the federalgovernment surplus or deficit.

In the last decade, we have seen asubstantial deficit turn into a surplus(between 1998 and 2001) and back

into a deficit!


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Fiscal Policy: Deficit Targeting

The Gramm-Rudman-Hol l ings Bi l l, passed bythe U.S. Congress and

signed by PresidentReagan in 1986, is a lawthat set out to reduce thefederal deficit by $36 billionper year, with a deficit ofzero slated for 1991.

In practice, these targetsnever came close to being

achieved.

Th Eff f


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The Effects ofSpending Cuts on the Deficit

A cut in government spendingcauses the economy to contract.Both the taxable income of

households and the profits of firmsfall.

The deficit tends to rise when GDP

falls, and tends to fall when GDPrises.

Th Eff t f


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The Effects ofSpending Cuts on the Deficit

The def ic i t response index(DRI)isthe amount by which the deficitchanges with a $1 change in GDP.

If the DRI equals -.22, for example,the deficit rises by $0.22 billion foreach $1 billion decrease in GDP.

E i St bilit


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Economic Stabilityand Deficit Reduction

Spending cuts must be larger thanthe deficit reduction we wish toachieve. Congress has two

options:1. Choose a target deficit and adjust

government spending and taxation toachieve this target, or

2. Decide how much to spend and taxregardless of the consequences on thedeficit.


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Automatic stabi l izersrefer torevenue and expenditure items in

the federal budget thatautomatically change with theeconomy in such a way as tostabilize GDP.

E i St bilit


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Automatic destabi l izersrefer torevenue and expenditure items in

the federal budget thatautomatically change with theeconomy in such a way as todestabilize GDP.


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Fiscal Policy Since 1990

The average tax rate rose sharplyunder President Clinton and fellsharply under President Bush.

The deficit is a concern when taxrates are falling and spending isrising.

F d l P l I T


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Federal Personal Income Taxes as aPercent of Taxable Income, 1990 I-2003 II


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Federal Government Consumption Expendituresas a Percent of GDP, 1990 I-2003 II

F d l T f P t d G t i


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Federal Transfer Payments and Grants-in-Aid as a Percent of GDP, 1990 I-2003 II

F d l I t t P t


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Federal Interest Payments as aPercent of GDP, 1990 I-2003 II


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negative demand shock

recognition lag

response lag

stabilization policy

time lags

automatic destabilizer

automatic stabilizer

deficit response index (dri)

Gramm-Rudman-Hollings Bill

implementation lag

principles of economics chapter 15

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