Macroeconomic Policies

Study Questions

n 1. What are the three macroeconomic policy options available to the government?

n 2. Who conducts fiscal policy and how is it done?

n 3. How could increasing the Federal budget deficit lead to “crowding out”?

n 4. What is the connection between the Federal budget deficit and the national debt?

n 5. What type of fiscal policy should be implemented in an underperforming economy?

n 6. What type of fiscal policy should be implemented in an overheated economy?

n 7. What existing laws counteract the movement in the economy and thereby automatically stabilize the business cycle?

n 8. Who conducts monetary policy and how is it done?

n 9. What type of monetary policy should be implemented in an underperforming economy?

n 10. What type of monetary policy should be implemented in an overheated economy?

n 11. How does the implementation of supply-side policy differ from the implementation of either fiscal or monetary policy?

n 12. Why should supply-side policy focus only on shifting the Phillips Curve downward and to the left?

n 13. How does a change in income tax rates affect tax revenue collections, both immediately and after taxpayers modify their behavior?

The Macroeconomic Goal

n To operate at a GDP with full employment and stable prices.

¨ High unemployment is not acceptable

¨ Accelerating inflation is not acceptable

Full-Employment and the Phillips Curve

n The full-employment goal intersects the Phillips Curve at a point where:

¨ the trade-off between decreasing unemployment and increasing inflation becomes much worse.

¨ on the left side, inflation accelerates with scant improvement in unemployment

¨ on the right side, unemployment rises fast with little decrease in inflation

Figure 12-1. Full-Employment and the Phillips Curve

Policies to “Fix” the Economy

n A problem economy will self-correct, but over an unacceptable amount of time.

n Three policy options available to government:

¨ fiscal policy

¨ monetary policy

¨ supply-side policy

Fiscal Policy

n Congress and the President manipulate Federal government spending and tax laws.

n Purpose: to move the economy to a level of full-employment with stable prices.

n Designed to generate a movement along the existing Phillips Curve.

Federal Budget

n “Fiscal” refers to the Federal budget:

¨ Dollars coming in: tax bills generate tax revenues (T)

¨ Dollars going out: appropriations bills generate government expenditures (G)

n The Federal budget is usually in deficit:

¨ G > T

¨ Funds must be borrowed to pay the bills

Deficit, Borrowing, and “Crowding Out”

n When G > T, the US Treasury borrows in the credit market.

¨ Demand for funds increases.

¨ Interest rates rise.

n Excessive borrowing by the government leads to reduced funds available to the private sector. They are “crowded out” of the credit market.

Deficit, Borrowing, and the National Debt

n Each year’s budget deficit requires increased borrowing.

n The national debt increases when this added borrowing exceeds paying off matured debt instruments.

n Interest is paid on all of the national debt and comes to 7% of government expenditures.

Using Fiscal Policy

n Any increase in G or decrease in T will move the economy upward and to the left along the Phillips Curve, regardless of intention.

¨ inflation increases

¨ unemployment decreases

¨ the deficit increases

Using Fiscal Policy

n Any decrease in G or increase in T will move the economy downward and to the right along the Phillips Curve, regardless of intention.

¨ inflation decreases

¨ unemployment increases

¨ the deficit decreases

Multiplier Effect

n Any change in G or T will generate a multiplier effect.

¨ Added spending becomes new income to the sellers/producers.

¨ They partition their new income into saving (a leakage) and new spending, which becomes new income to others.

¨ This cycle continues to repeat, weakening as it leaks more savings each time.

n The end result is that the initial spending is multiplied into much more additional spending.

Multiplier Effect

n The multiplier effect is stronger for direct spending (due to a change in G) than for indirect spending (due to a change in T).

n The multiplier effect indicates that government needs only to get the cycle started (a “jumpstart”) and the natural workings of the economy will finish the job.

Fiscal Policy for an Underperforming Economy

n “Jumpstart” the economy:

¨ Increase G or decrease T

¨ The economy moves upward and to the left along the Phillips Curve.

¨ Unemployment falls, inflation rises and the deficit increases.

n The multiplier effect completes the job.

n The economy moves to full-employment.

Figure 12-2. Fiscal Policy in an Underperforming Economy

Fiscal Policy for an Overheated Economy

n “Jumpstart” the economy:

¨ Decrease G or increase T

¨ The economy moves downward and to the right along the Phillips Curve.

¨ Inflation falls, unemployment rises, and the deficit shrinks.

n The multiplier effect completes the job.

n The economy moves to full-employment.

Figure 12-3. Fiscal Policy in an Overheated Economy

Over-Correction

n Too much fiscal policy application could cause the economy to shoot right past the full-employment goal and trigger new problems:

¨ An overheated economy could become an underperforming economy.

¨ An underperforming economy could become an overheated economy.

Fiscal Policy Problems

n Time lags.

n Politics.

n Changes made in G and T without regard for the state of the economy.

Automatic Stabilizers

n Existing laws that go into effect immediately and counteract the movement in the economy.

¨ Income tax withholding law

¨ Unemployment compensation law.

Monetary Policy

n The Federal Reserve manipulates the money supply and interest rates.

n Purpose: to move the economy to a level of full-employment with stable prices.

n Designed to generate a movement along the existing Phillips Curve.

Conducting Monetary Policy

n The Fed uses one or more of its tools to change the size of the money supply and to change interest rates.

n These changes will affect total spending.

n As a result, the economy moves along the Phillips Curve.

n The Fed’s initial action will be multiplied in effect as the new spending becomes someone’s new income.

Monetary Policy in an Underperforming Economy

n The Fed conducts an “easy money” policy.

¨ lower the required reserve ratio

¨ lower the discount rate

¨ buy government securities in the open market

n All increase money supply, increase lending, and lower interest rates

n Total spending increases.

Figure 12-4. Monetary Policy in an Underperforming Economy

Monetary Policy in an Overheated Economy

n The Fed conducts a “tight money” policy.

¨ raise the required reserve ratio

¨ raise the discount rate

¨ sell government securities in the open market

n All decrease money supply, decrease lending, and raise interest rates

n Total spending decreases.

Figure 12-5. Monetary Policy in an Overheated Economy

Excessive Monetary Policy

n An excessive “easy money” policy could increase total spending too much and cause an overheated economy.

n An excessive “tight money” policy could decrease total spending too much and cause an underperforming economy.

Supply-Side Policy

n Congress and the President manipulate government regulations, incentive programs, and tax laws.

n Purpose:

¨ to expand production capability

¨ to spur individuals to produce more and to become more productive and innovative

n Designed to shift the Phillips Curve downward and to the left.

Figure 12-6. Supply-Side Policy

Supply-side Policy

n At no time should there be an intentional shift of the Phillips Curve upward and to the right.

¨ Stagflation: stagnating economic growth.

¨ Rising unemployment rates.

¨ Rising inflation rates.

Supply-side Policy

n Policies to lower production costs:

¨ reducing business taxes.

¨ lower costs of regulation compliance.

n Policies to increase productivity:

¨ increased incentive to work more or harder.

¨ improve human capital.

¨ encourage innovation.

¨ encourage implementation of new technology.

Lower Tax Rates

n Creates a greater reward for effort.

n Paying taxes at a lower tax rate becomes more cost-effective than paying to avoid taxes at a higher tax rate.

¨ tax rates fall

¨ earning income increases

¨ tax revenues increase

The J-Curve Effect

n Reduce tax rates:

¨ immediately, taxpayers pay less taxes on the same income, so tax revenues fall

¨ ultimately, taxpayers’ income rises as they work more/harder, and tax revenues rise.

n Increase tax rates:

¨ immediately, taxpayers pay more taxes on the same income, so tax revenues rise

¨ ultimately, taxpayers’ taxable income falls as they take action to shelter income from taxes, and tax revenues fall.

Figure 12-7. The J-Curve Effect