Chapter 18: Six Debates over

Macroeconomic Policy

1
 Debate #1
1. Should monetary and fiscal policymakers try
to stabilize the economy?
• Changes in aggregate demand and aggregate
supply
– Short-run fluctuations in production and
employment
• Monetary and fiscal policy
– Can shift aggregate demand
– Influence these fluctuations
2
 Debate #1
Pro: policymakers should try to stabilize the
economy
• When aggregate demand is too small
– High unemployment
– Policymakers
• Boost government spending
• Cut taxes
• Expand the money supply

3
 Debate #1
Pro: policymakers should try to stabilize the
economy
• When aggregate demand is excessive
– High inflation
– Policymakers
• Cut government spending
• Raise taxes
• Reduce the money supply
– More stable economy, benefits everyone

4
 Debate #1
Con: policymakers should not try to stabilize
the economy
• Monetary and fiscal policy
– Do not affect the economy immediately
– Work with a long lag
• Monetary policy – about 6 months
• Fiscal policy – long political process, it can take
years
– Economic forecasting is highly imprecise

5
 Debate #1
Con: policymakers should not try to stabilize
the economy
• Policymakers trying to stabilize the economy
– Can do just the opposite
– Economic conditions can easily change

6
 Debate #2
2. Should the government fight recessions with
spending hikes rather than tax cuts?
• President George W. Bush, 2001
– Economy was slipping into a recession
– Cutting tax rates
• President Barack Obama, 2009
– Economy –worst recession in many decades
– Stimulus package – tax reductions and substantial
increases in government spending

7
 Debate #2
Pro: the government should fight recessions with
spending hikes
• Fundamental problem during recessions
– Inadequate aggregate demand
• Key to ending recessions
– Restore aggregate demand to a level consistent
with full employment

8
 Debate #2
Pro: the government should fight recessions with
spending hikes
• Monetary policy
– First line of defense - economic downturns
– Increasing the money supply
• Reduces interest rates
• Reduce the cost of borrowing
• Increased spending on investment
• Increased aggregate demand

9
 Debate #2
Pro: the government should fight recessions with
spending hikes
• Fiscal policy
– Cutting taxes
• Increased household disposable income
• Increase spending on consumption
– Increased government spending
• Adds directly to aggregate demand

10
 Debate #2
Pro: the government should fight recessions with
spending hikes
• Fiscal policy
– Multiplier effects
• Higher aggregate demand - Higher incomes
• Induces additional consumer spending
• Further increases in aggregate demand
– Particularly useful when the tools of monetary
policy lose their effectiveness

11
 Debate #2
Pro: the government should fight recessions
with spending hikes
• Economic downturn of 2008 and 2009
– The Fed cut its target interest rate to almost
zero
• Cannot reduce interest rates below zero
• Once interest rates are at zero, the Fed has lost its
most powerful tool
– Turn to fiscal policy

12
 Debate #2
Pro: the government should fight recessions with
spending hikes
• Traditional Keynesian analysis
– Increases in government purchases are a more
potent tool than decreases in taxes
• $1 tax cut – part of it may be saved
– Only part adds to AD
• $1 government spending – fully adds to AD

13
 Debate #2
Pro: the government should fight recessions
with spending hikes
• 2009, Obama administration estimations
– $1of tax cuts increases GDP by $0.99
– $1of government purchases increases GDP by
$1.59
– The $800 billion stimulus package
• Create or save more than 3 million jobs by the end
of the president’s second year in office

14
 Debate #2
Pro: the government should fight
recessions with spending hikes
• 3 kinds of government spending
– “Shovel-ready” projects
– Federal aid to state and local President Barack
Obama delivers

governments remarks at the

groundbreaking
of a road project
• Constitutionally required to run balanced funded by the
American
budgets Recovery and
Reinvestment
– Increased payments to the jobless - Act, Friday, June
18, 2010, in
unemployment insurance system Columbus, Ohio.

15
 Debate #2
Con: the government should fight recessions with
tax cuts
• Tax cuts
– Increase AD
• Increase households’ disposable income
• By altering incentives - stimulate investment
– Increase AS
• Unemployed - incentive to search for jobs
• Employed - incentive to work longer hours

16
 Debate #2
Con: the government should fight recessions with
tax cuts
• Problems with increasing government spending
during recessions
– Government-spending multipliers – smaller
• Consumers - higher taxes in the future
– Cut back spending today
• Firms - reduced expectations of future profits
– Reduce investment spending today

17
 Debate #2
Con: the government should fight recessions with
tax cuts
• Problems with increasing government spending
during recessions
– Fast increase in spending
• Buy things of little public value
– “Bridges to nowhere”
– Careful and deliberate planning
• Long lags

18
 Debate #3
3. Should monetary policy be made by rule rather
than by discretion?
• Federal Open Market Committee
– Sets monetary policy – complete discretion
– Meets about every six weeks
• Evaluate the state of the economy
– Short-term interest rates
• Raise, lower, or leave unchanged
– The Fed - adjusts the money supply
19
 Debate #3
Pro: monetary policy should be made by rule
• Problems with discretionary monetary policy
– Does not limit incompetence and abuse of
power
• Political business cycle
– If central bankers ally with politicians
– Discretionary policy - can lead to economic fluctuations
that reflect the electoral calendar

20
 Debate #3
Pro: monetary policy should be made by rule
• Problems with discretionary monetary policy
– It might lead to more inflation than is desirable
• Time inconsistency of policy
– Central bankers – know there is no long-run trade-off
between inflation and unemployment
» Announce goal - zero inflation
» Short-run trade-off between inflation and
unemployment

21
 Debate #3
Con: monetary policy should not be made by
rule
• Discretionary monetary policy – flexible
– The Fed – various circumstances
– Better to appoint good people to conduct
monetary policy
• And then give them the freedom to do the best
they can
– The alleged problems with discretion
• Are largely hypothetical
22
 Debate #4
4. Should the central bank aim for zero
inflation?
• Inflation
– Prices rise when the government prints too
much money
– Society faces a short-run trade-off between
inflation and unemployment

23
 Debate #4
Pro: the central bank should aim for zero
inflation
• Six costs of inflation:
– Shoeleather costs associated with reduced
money holdings
– Menu costs associated with more frequent
adjustment of prices
– Increased variability of relative prices

24
 Debate #4
Pro: the central bank should aim for zero
inflation
• Six costs of inflation:
– Unintended changes in tax liabilities due to
non-indexation of the tax code
– Confusion and inconvenience resulting from a
changing unit of account
– Arbitrary redistributions of wealth associated
with dollar-denominated debts

25
 Debate #4
Pro: the central bank should aim for zero
inflation
• Reducing inflation
– Temporary: high unemployment & low output
– Long-run: no trade-off
– Temporary costs
– Permanent benefits

26
 Debate #4
• Con: the central bank should not aim for zero
inflation
• Benefits of zero inflation – are small
– Compared to moderate inflation
• Costs of reaching zero inflation are large
– Sacrifice ratio
– Social costs
• Small inflation - may be a good thing

27
 Debate #5
5. Should the government balance its budget?
• When the government spends more than it
collects in tax revenue
– It covers this budget deficit by issuing
government debt
• Affect saving, investment, and interest rates

28
 Debate #5
Pro: government should balance its budget
• Federal debt
– $712 billion in 1980
– $11.3 trillion in 2012
– $36,000 - each person’s share of the
government debt

“What?!? My share of
the government debt
is $36,000?”

29
 Debate #5
Pro: government should balance its budget
• Government debt
– Direct effect: place a burden on future
generations
– Macroeconomic effects
• Lower national saving
• Future generations: lower incomes and higher
taxes

30
 Debate #5
Pro: government should balance its budget
• Justifiable to run a budget deficit
– War
– Temporary downturn in economic activity
• Not all budget deficits can be justified by war
or recession

31
 Debate #5
Pro: government should balance its budget
• 1980 – 1995, government debt as percentage
of GDP
– Increased from 26 to 50% of GDP
• No major military conflict
• No major economic downturn
– Causes
• Easier to increase government spending
• Than to increase taxes

32
 Debate #5
Pro: government should balance its budget
• Budget deficit in recent years
– Wars in Iraq and Afghanistan
– Effects of the recessions in 2001 and 2008–
2009
– Imperative that this deficit not signal a return
to the unsustainable fiscal policy of an earlier
era

33
 Debate #5
Pro: government should balance its budget
• Aim for a balanced budget
– Greater national saving
– Greater investment
– Economic growth

34
 Debate #5
Con: government should not balance its budget
• The problem of government debt
– Often exaggerated
– Government debt - tax burden on younger
generations
• Not large compared to lifetime income
• Lifetime income = $2 million
• Debt = $36,000 per person
– 2% of lifetime income

35
 Debate #5
Con: government should not balance its budget
• Budget deficit
– Just one piece of a large picture
• Of how the government chooses to raise and
spend money
• Fiscal policy
– Affect different generations of taxpayers

36
 Debate #5
Con: government should not balance its budget
• Government debt - can continue to rise
forever
– Burden of the government debt relative to the
size of the nation’s income
– Economy – grows over time
– Nation’s ability to pay the interest on the
government debt grows over time as well

37
 Debate #5
Con: government should not balance its budget
• Government debt - can continue to rise
forever
– As long as the government debt grows more
slowly than the nation’s income
• There is nothing to prevent the government debt
from growing forever
– Real output of the U.S. economy
• Grows on average about 3% per year

38
 Debate #5
Con: government should not balance its budget
• Government debt - can continue to rise forever
– If the inflation rate is 2% per year
– Nominal income grows: 5% per year
• Real output grows: 3% per year
– Government debt can rise by 5% per year
without increasing the ratio of debt to income

39
 Debate #5
Con: government should not balance its budget
• Government debt - can continue to rise
forever
– 2012, federal government debt: $11.3 trillion
• $565 billion is 5%
• As long as the federal budget deficit is smaller
than $565 billion, the policy is sustainable

40
 Debate #5
Con: government should not balance its budget
• Very large budget deficits cannot persist
forever
– 2009-2012, federal budget deficit: over $1
trillion very year
• Driven by extraordinary circumstances
• Major financial crisis
• Deep economic downturn
• Policy responses to these events

41
 Debate #5
Con: government should not balance its budget
• 2009-2012, federal budget deficit
– No one suggests that a deficit of this
magnitude can continue
– But zero is the wrong target for fiscal
policymakers

42
 Debate #6
6. Should the tax laws be reformed to
encourage saving?
• Nation’s standard of living
– Depends on its ability to produce goods and
services
• Determined by how much it saves and invests for
the future

43
 Debate #6
Pro: the tax laws should be reformed to
encourage saving
• Nation’s saving rate
– Determinant of long-run economic prosperity
• U.S. tax system - discourages saving
– Tax the return to saving quite heavily
– Tax some forms of capital income twice
– Inheritance tax rate - as high as 55%

44
 Debate #6
Pro: the tax laws should be reformed to
encourage saving
• Other policies and institutions
– Discourage saving
• Tax code – improved to encourage saving
– Preferential treatment to some types of
retirement saving
– Consumption tax

45
 Debate #6
Con: the tax laws should not be reformed to
encourage saving
• Fairly distribution of the tax burden
• Tax policies – to encourage saving
– Increase the tax burden on people who
cannot afford to save
– May not be effective
• Substitution effect
• Income effect

46
 Debate #6
Con: the tax laws should not be reformed to
encourage saving
• Other ways to increase national saving
– No tax breaks to the rich
– National saving = private + public saving
• Raise public saving
– By reducing the budget deficit
– Raise taxes on the wealthy

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