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Macro ECONOMIC THEORY VS. REALITYWho makes the decision and what are the choices?

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Theory versus Reality• Theory is supposed to explain the business cycle and how to

control it.

• What are our economic goals? price stability full employment low inflation economic growth

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Policy Levers – Tools for policymakers to use

• Fiscal Policy

•Monetary Policy

• Supply-side Policy

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What are 3 basic questions every economy asks?

• The answers to these questions as applied for each of the levers can change…

• I.e. under fiscal policy – W,H,F answers would be different than under Supply Side.

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Many realities keep us from reaching our economic goals:

–1. Conflicting advice comes from Keynesians, monetarists, and supply-siders.–2.Politics takes preference over

economics in Congress and the presidency.–3. A massive, unresponsive bureaucracy

exists.

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Learning Objectives

• Know what the tools of macro policy are.

• Know how the macro tools should work.

• . Know the constraints on policy effectiveness.

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Available Policy Tools• Fiscal policy:– Tax cuts and increases.– Changes in government

spending.

• Monetary policy:–Open market

operations.– Changes in reserve

requirements.– Changes in discount

rates.

• Supply-side policy:– Tax incentives for

saving and investment.–Deregulation.–Human capital

investment.– Infrastructure

development.– Free trade.– Immigration.

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Fiscal Policy

• Changes due to automatic stabilizers are a basic countercyclical feature of the economy.• Discretionary policy expands (or shrinks)

the structural deficit and gives the economy a shot of fiscal stimulus (or restraint).• They are a result of deliberate policy

decisions made by the president and Congress.

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Monetary Policy

• The Fed’s Board of Governors makes monetary policy, with its Open Market Committee pulling the levers.–Keynesians believe that interest rates are the

critical policy lever to shift aggregate demand.–Monetarists believe that the money supply is

the critical policy tool and that it should be expanded at a steady, predictable rate to ensure price stability at the natural rate of unemployment.

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Supply-Side Policy

• The focus of supply-side policy is to provide incentives to work, save, and invest.–Marginal tax rates and government

regulations must be reduced to get more output without inflation.

• Since the supply-side policy levers require changes in laws and regulations, the Congress and the president enact supply-side policy.–Fiscal and supply-side policies often get

entwined.

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Idealized Uses: Recession

• Goal: to close the recessionary GDP gap.–Keynesians want to increase AD by tax cuts or

spending increases. Also, they want falling interest rates to spur investment.–Monetarists see no use in fiscal policy.• Their appropriate response is patience.

–Supply-siders would cut tax rates and reduce regulation. Any spending increase should focus on long-run development.

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Idealized Uses: Inflation• Goal: to close the inflationary GDP gap.–Keynesians would decrease AD by raising taxes

and cutting government spending.–Monetarists would reduce the money supply.–Supply-siders would look for ways to expand

productive capacity.• It is both “too much money” and “not enough

goods.”• They propose incentives to save and not

spend.• They would cut taxes and regulations that

raise production costs.

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Idealized Uses: Stagflation

• Both inflation and unemployment are high, and economic growth is stagnant.– Fiscal restraint and tight money will reduce inflation

but increase unemployment.– Fiscal stimulus and easy money will reduce

unemployment but increase inflation.– If stagflation is caused by adverse policy (high taxes,

excessive regulation), supply-siders propose reversing those policies.– If stagflation is caused by external forces (oil price

spike, natural disaster), no policy can help much.– (1980 7.1 unemployment, 12.5% inflation)

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Fine-Tuning

• Fine-tuning: policy adjustments designed to counteract small changes in economic outcomes.• In 1946 Congress committed the government to macro

stability.– In 1978 Congress set goals of 4% unemployment, 3%

inflation, and 4% economic growth.– (late 50’s and early 60’s economy was so good the

idea of fine-tuning was created.) Not possible.

– Reality is: it is not possible to do.

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Why Things Don’t Always Work

• There are four obstacles to policy success• Goal conflicts.•Measurement problems.• Design problems.• Implementation problems.

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Goal Conflicts

• The trade-off between unemployment and inflation is a fiscal policy goal conflict.• The Fed wants fiscal stability, while the president

and Congress may be unwilling to raise taxes or cut spending.• Some cutbacks affect the neediest and become

politically impossible to enact.• All decisions have an opportunity cost, raising

conflict between the benefits and the cost of a policy option.

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Measurement Problems

• Measuring the macro variables takes time, so the results are not available for a month or so.• Policymakers rely on economic forecasts

made by “experts” using models that are tied to one theory or another. (computers)• Some data (called leading indicators) tend to

predict turns in the business cycle. (break down) • External shocks are not predictable.

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Design Problems

• Once we think we know what the problem is, we must design a “fix” for the problem.• Should we take–The Keynesian approach?–The monetarist approach?–The supply-sider approach?

• How will the marketplace respond to our plan?

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Implementation Problems

• Any “fix” must work through congressional deliberations and be approved by the president.• Once approved, there is no assurance it will be put

into effect in a timely manner.–The time lag may be so great that a stimulus

package may go into effect after a recession has ended.

• Political pressure may preclude a correct “fix” from ever being passed.

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Hands on or Hands off???

•Hands on: proponents emphasize that there are greater risks in doing nothing when the economy is faltering. (witness depression.et.al.)•They advocate active government intervention and assure the country that the proposed “fix” implies progress.•Policy activists believe there is enough knowledge to manipulate the economy through its troubles.

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•Hands off: proponents argue that discretional fiscal policy or monetary policy can help, but the implementation problems are too great.–New classical economics: the best way is for

government to provide a stable environment and then get out of the way.–Rational expectations: peoples’ spending actions

are based on available information, including anticipating what the government will do. People take actions to protect themselves, countering the government’s action.

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Know what the tools of macro policy are.• Know what the tools of macro policy are.–To end a recession, – cut taxes, increase government spending,

or expand the money supply.–To curb inflation, – reverse each of those policy tools.–To overcome stagflation, – combine fiscal and monetary levers with

supply-side incentives.

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Know how the macro tools should work –AD increases if we cut taxes, increase

government spending, or expand the money supply.–AD decreases if we raise taxes,

decrease government spending, or shrink the money supply.–AS increases if we reduce tax rates and decrease government regulation.

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Will the cycle ever disappear?